FinTech: We’re just getting started

Global FinTech investment in 2017 was unprecedented with $16.6B of capital (+20% compared to 2016) deployed across 1,128 deals. Despite this, some have argued that FinTech’s days are numbered and that it is less clear how much opportunity still remains for future innovation. Proponents of this line of thought argue that most traditional financial services have already been unbundled and that large startups that dominate areas like payments, lending, and investing have even begun to re-bundle services. Moreover, despite the uptick in investment into the sector, the early-stage portion of overall financing dropped to a 5-year low which has further supported the belief that most of the innovation in FinTech has already happened.

At Matrix, we believe that we are still in the early innings of the financial services disruption. While FinTech startups have done very well in the last decade, there is still room for more great companies to be built. As a follow-up to our previous article where we introduced the Matrix FinTech Index, we have put together a corollary to that piece where we specify 7 tailwinds that have powered FinTech innovation for the last 10 years, discuss key drivers for future innovation, and identify the subcategories we believe are most promising.

Review of 7 important tailwinds for innovation in FinTech the last 10 years

  • Mobile has been leveraged as an enabler: Companies like Squareleveraged mobile as a way to reduce the cost of doing business for merchants by allowing for new features like secure payments via mobile applications.
  • The financial crisis created unmet demand: Incumbent’s unwillingness to lend to credit poor individuals and high-risk SMBs created a window of opportunity for companies like Lending Club and OnDeck to fulfill this unmet demand.
  • The payments infrastructure opened up to developers: APIs and developer tools made available by companies like Braintree and Stripeallowed developers to integrate payment processing into their websites without the need to maintain a merchant account.
  • Online banking penetration unlocked important customer data: Deeper penetration of online banking has made it possible for companies like Yodlee to allow users to see all their banking information on one screen and others like Credit Karma to provide credit monitoring services.
  • Core financial services have been unbundled: Many sub-segments traditionally handled solely by the banks have been unbundled. For example, SoFi is helping with borrowing, Xoom with money transfers and Mint with financial management.
  • The cloud provided a new distribution channel to serve SMBs: Companies like Kabbage, which provides loans to SMBs, can now justify serving lower life time value customers like SMBs due to the lower customer acquisition costs associated with the cloud.
  • Digital disintermediation provided greater value to consumers: Companies like WealthfrontBetterment and Robinhood all reduce the fees charged by brokerages and traditional investment managers providing greater alpha to retail investors.

Key drivers for innovation in the next 10 years

Many of these 7 trends will continue to play a role in FinTech innovation moving forward. But we have identified 3 additional drivers for innovation in FinTech going forward.

1. Incumbent failures are really coming into focus.

Traditional financial institutions are anachronistic. They serve their customers with antiquated products and are often slow to innovate due to both their size and regulatory burdens. Moreover, financial products have historically not been customer-centric, as banks devote most of their resources to optimizing their data and analysis and boosting their bottom line. Consequently, incumbents in financial services have largely failed to meet the needs of consumers, and the emergence of FinTech has put their shortcomings under the spotlight.

Figure 1

While financial services as an industry has been notorious for low consumer trust levels, consumer trust has plunged even further in the wake of fraud, scandals, and data breaches (e.g. Wells Fargo and Equifax). Additionally, poor customer experience has left consumers with limited loyalty to their financial services providers.

2. Millennials are emerging as the new source of spending power.

Millennials are the largest generation in American history consisting of over 70 million people born between 1980 and 2000. Millennials are digital-first users who grew up distrustful of banks and are generally more inclined to try FinTech applications. Furthermore, while traditional financial services has focused on large pools of wealth characteristic of older generations, FinTech innovation is making financial services and products much more accessible to younger generations.

Figure 2

3. Due to the transition of profit pools, incumbents are going to become a lot more acquisitive in the coming months.

Incumbents have begun to acquire FinTech companies as a means to compete against innovative startups and other acquisitive incumbents. Many of the acquisitions so far have been centered around automation of basic tasks. In the last 5 years, 18 FinTech startups have been acquired by banks, with 8 acquisitions occurring since the beginning of 2017. We believe that there is much more opportunity and incentive to acquire — especially for technologies that go beyond automation.

Figure 3

5 subcategories we are most excited about

Ultimately we believe the incumbents will continue to lose ground to the FinTechs and that there is plenty of opportunity for entrepreneurs to build enduring companies in the sector. Great companies will certainly be built across the entire financial services industry, but here are a few sub-categories within FinTech that we think are particularly exciting:

  • Payments: Even with all the innovation to date in payments, there continue to be pain points throughout the category and many customer demographics remain underserved. In order to be successful in this category, new entrants will need to build on-top of existing payment rails, serve large TAMs and go after new use cases.
  • Investing / wealth management: Despite recent innovation by players like WealthfrontBettermentRobinhood and others, wealth management remains dominated by the incumbents. This reality makes the category a ripe one for entrepreneurs as there are large TAMs, poor customer experiences and a new generation (i.e. millennials) that have unmet needs. Success here will require intuitive design, low fees and efficient customer acquisition.
  • Infrastructure Apps: Financial institutions suffer from bloated cost structures in the middle and back office for tasks like fraud/ risk management, collections, invoice management and customer support. There’s an opportunity for entrepreneurs to provide software tools that reduce costs and allow for more efficient work flows if they can manage the lengthy sales cycles and procurement processes.
  • SMB tools: Companies like Gusto and Namely, have begun to serve SMBs in areas like payroll and benefits administration. Even so, SMBs remain largely underserved compared to larger enterprises. FinTech companies that can acquire SMBs efficiently and provide enterprise-level experiences will be able to generate enough value to their customers to create large outcomes.
  • B2B Lending tools: On the consumer side, lending has become pretty crowded with some of the winners already declared. But on the enterprise side, the category is very ripe. The opportunity for entrepreneurs is in leveraging data at cloud scale combined with advances in machine learning to allow enterprises to better assess borrower risk and drive higher yield.

The author would like to thank Sreyas Misra for his contributions to this piece.

Revolutionizing wealth management with Jon Stein, Founder & CEO of Betterment

In this fourth episode of Focus on the Founder, Jon Stein, Co-founder & CEO of Betterment joins us to discuss his career journey, experience starting Betterment while in business school and thoughts on wealth management and investing more broadly.

Jon Stein (Founder & CEO, Betterment)

Achieving Personalization At-Scale

Betterment is a robo-advisor platform that provides investment advice and wealth management at a low price point. The wealth management space is fiercely competitive. Startups like Betterment, Wealthfront, and Robinhood as well as incumbents like Vanguard and Schwab have all entered the space, competing to provide personalized, low-cost advice to consumers.

Since Betterment launched in 2010, their assets under management have grown rapidly, reaching almost $12 billion earlier this month. During this conversation, Jon discusses his experiences growing Betterment, and how Betterment has succeeded in such a competitive environment through truly putting the customer first. As always, you can find the full podcast episode on SoundCloudiTunes, and Google Play.


Key Thoughts from Jon on…

The reasons behind founding Betterment:

While working for the First Manhattan Consulting Group, Jon advised some of the world’s largest banks and brokerages. In the process, Jon gained an insider’s perspective on how banks operate and serve their customers. His product-development engagements with banks typically involved working on the key aspects of their products such as default rates and internal transfer pricing. Notably, these larger players paid almost no attention to their customers during the product-development process, as they focused much more on optimizing their data and existing flows, which Jon found perplexing. While working in Australia, Jon encountered user-centric financial products not available in the US at the time, such as the mortgage-offset account which combines a traditional mortgage and deposit account.

These experiences helped frame the problem that Betterment aims to solve — that “the old way of managing money is broken.” Investment management should be held to a higher standard — one which focuses far more on consumers.

Building a team:

Jon committed to starting Betterment before starting his MBA at Columbia Business School. In the early days, building Betterment was a two-fold challenge — building the actual product and navigating the regulatory challenges of being an investment advisor.

Sean Owen, Jon’s roommate at the time, provided much of the early engineering expertise. Sean was a software engineer at Google who studied computer science at Harvard, and built the back-end of Betterment while Jon worked on the front-end. Jon eventually met Eli Broverman during a weekly poker game. Eli, who was then a securities attorney, provided the legal expertise and helped Jon navigate through complex regulatory landscape. Sean and Eli’s skillsets were diverse and congruent with the early challenges that Jon needed to solve.

The fundraising journey:

Betterment launched at TechCrunch Disrupt in 2010, where they competed against 500+ entrants, many of which had already raised some amount of funding. Betterment went on to win the competition, giving him crucial exposure to customers and investors. Immediately following the competition, Betterment signed up 400 new customers, who helped drive Betterment’s initial organic growth by way of referrals. The boost in credibility from the event made it easier to hire new employees, and helped Betterment rapidly grow from what was at the time a four-person team.

Just as important, preparing for the Disrupt presentation helped Jon and his team internalize their story and understand how to best pitch the idea. A month following the TechCrunch competition, Jon was able to raise $3 million from Bessemer Venture Partners.

How Betterment puts customers first:

Since the initial investment from Bessemer, Betterment has secured $275 million in funding and has grown significantly in employee count and AUM. In this period of growth, Jon doubled down on the theme of bringing the voice of the customer into every interaction. This focus has helped Betterment withstand the test of time and compete effectively against a host of startups and incumbents offering similar services.

Private Robo-Advisors in the Wealth-Technology Category

Source: CB Insights

Betterment puts the customer first by:

1. Personalizing advice

Betterment’s vision is to provide excellent financial guidance that is easy to understand and available to everyone. Betterment is unique in that it offers a spectrum of interaction-types: customers who prefer human interaction can receive hybrid-robo solutions through Betterment’s unlimited text messaging and premium telephone access services. By prioritizing the education of their end-user, Betterment offers a suite of solutions to improve consumer-access to financial markets.

2. Building trust

Financial services as an industry has historically had a low NPS. Betterment strives to build trust with its customers as both an ethical obligation and a means of differentiation. In addition to investment advice, Betterment publishes scores of articles helping consumers understand their personal finances, navigate through tax reform, and manage their expenses. Betterment also has no holdings of their own; thus, they eliminate many of the conflicts of interest present in most banks.

3. Combining responsibility with wealth creation

Betterment offers a way for consumers to hold well-diversified portfolios that are also socially responsible through their socially responsible investing (SRI) portfolio. Social responsibility doesn’t just afford Betterment an additional dimension of personalization; it also reflects well on their brand as an ethical investment advisor.

The future of investment management:

In this bull market, massive amounts of capital have been pushed into indices and ETFs, which represent a little over 10% of the global equity market capitalization. In fact, these indices and ETFs, spearheaded by firms like BlackRock and Vanguard, have outperformed an overwhelming majority of hedge funds.

Net flows into U.S.-based passively managed funds and out of active funds in the first half of each year

Source: Bloomberg, ICI

Jon explains that Betterment is here to stay even in increasingly likely bear market scenarios, as the same principles of minimizing cost and managing tax burdens that currently power Betterment’s platform still apply during downturns. Through careful risk-management, alternative investment strategies, and optimizing customer behavior to prevent market panic, Betterment aims not only to protect its customers in bear markets but also provide them competitive returns.

Money 2020: 12 lessons from this year’s conference

Earlier this week I attended Money2020 in Las Vegas. In just over 5 years, Money2020 has become the leading industry conference for everything to do with FinTech. It’s a jam-packed but valuable 4 days of expert panels, startup pitches, networking events and keynotes from industry leaders. I was there for just under 24 hours, which meant the experience was even more of a blur. This post is my attempt to capture twelve of the biggest learnings from the conference.

Lesson 1: Money is still the #1 biggest stressor for most Americans, understandably so. Dan Wernikoff from Intuit was one of the keynote speakers Tuesday morning and some of the data points he surfaced on consumer behaviors around money are sobering:

  1. 44% of Americans cannot come up with $400 for an emergency.
  2. 49% of Mint users spend more than they make.
  3. Intuit customers on average paid $1,700 a year in interest.

Lesson 2: Most financial institutions are not adequately meeting the needs of their customers. Despite the potential opportunity created by the high stress around money, banks and other financial institutions really struggle to provide the experience their customers need. This is in part because most financial institutions are product centric not customer centric. The result has been notoriously low NPS scores and a disenchanted end user. Even more alarmingly, most customers of the leading banking brands distrust their banks:

Capture

Lesson 3: Among an already pretty unhappy customer base, millennials are the most disenfranchised of all. As Philippe Dintrans, Chief Digital Officer at Cognizant put it, most financial institutions are totally missing the mark with millennials. That is in part because millennials exhibit fundamentally different behaviors than earlier generations around things like savings. 63% of millennials are focused on saving towards desired life goals (e.g. getting out of student debt, purchasing a home, etc.) as compared to 45% of gen Xers and baby boomers. 55% of gen Xers and baby boomers are focused on developing savings towards retirement, where only 37% of millennials are planning for retirement

Lesson 4: FinTech startups have capitalized on the failures of incumbents by addressing specific pain-points with carefully designed products. The examples are smattered across financial services but a few examples that stand-out:

  • Wealth management was traditionally a confusing and fee-heavy landscape to navigate. Betterment created a beautiful and educational product that reduced fees and enabled a better user experience.
  • Peer-to-peer money transfers traditionally required a manual process that took days and trips to the bank. Venmo made it simple, quick and fun to do P2P payments.
  • SMBs used to have to use clunky check-out payment methods that locked them into a set location and required back-end processing to reconcile the books. Stripe enabled any merchant anywhere to accept payments with ease using an iPad.
  • Applying for, managing and refinancing loans was historically a painful process for most students. SoFi provided students with an easy way to apply for and refinance their loans all with the promise of a lower interest rate.

Lesson 5: Barriers to entry have never been lower to starting a FinTech business. It’s not just that the cost of starting a business in tech has been dramatically reduced (which has been well documented). In FinTech, there are also important industry-specific enablers allowing startups to enter and compete with the incumbents:

  • Insurgents don’t need a large balance sheet to open business. For example, marketplaces like LendingClub and Prosper connect borrowers and lenders without underwriting any of the loans.
  • Regulatory hurdles, for almost every sub-category within FinTech (with the exception of Blockchain / crypto assets), have been removed thanks to early pioneers like PayPal.
  • Platforms and developer tools like Stripe and Shopify have reduced development costs and time-to-market dramatically enabling SMB merchants to sell with the same ease as larger enterprises.

Lesson 6: Large and enduring companies have been and will continue to be built in FinTech. In two decades, PayPal, the “original” FinTech startup has reached a market cap of $84B. By comparison AMEX, which was founded a 167 years ago, has a market cap of $82B. Many more enduring companies will be built in FinTech in the years to come.

Capture 2

Lesson 7: There is no shortage of venture money. As of today there are 36 FinTech unicorns globally – that number represents 17% of the total share of unicorns. The venture market has realized the breadth of opportunity in FinTech and more money has poured into FinTech than ever before. In 2008, the number of FinTech companies funded was just over 200. In 2016, the number of FinTech companies receiving venture capital exceeded 5,000. In the same time period, venture funding from a dollar perspective climbed from <$1B to close to $60B.

Lesson 8: Great companies are being built across categories. With this increase in FinTech funding, great new companies are being built and entire sub-categories, from payments to insurance, are being served in new ways. Some of the really big winners of today either didn’t exist or were in their infancy 10 years ago. A few examples include publicly traded companies (LendingClub, Square, etc.), unicorns (Stripe, Sofi, GreenSky, CreditKarma, AvidXchange, Gusto, etc,) and several others that are well on their way (Betterment, Affirm, Plaid, etc.)

Lesson 9: Many think that the big area of opportunity for FinTech is in Blockchain/ crypto assets but that may not necessarily be true. Blockchain/ crypto assets are certainly getting all the attention right now but there are plenty of other areas that are just as interesting on both the B2C and B2B sides of the table. Some areas that are particularly exciting include:

  • Consumer: (1) personal financial management, (2) insurance, (3) real estate and (4) investing / wealth management
  • Enterprise: (1) institutional investing, (2) infrastructure apps, (3) SMB tools, (4) commercial insurance and (5) security & fraud detection

Lesson 10: Blockchain – lots of noise but few clear signals. Bitcoin today is trading at $5,500+ per coin and the total market cap of all cryptocurrencies is $170B. ICOs meanwhile have raised $8B in 2017 to-date. In the midst of this some things are clearer than others. What is clear today is that crypto assets have a definite use case as a store of value. What’s less clear is how we get from there to the end goal of software with no central operator, which is the big promise behind blockchain. The big advantage to blockchain, as Adam Ludwin from Chain put it, is “censorship resistance” (access is unfettered and transactions are unstoppable) but we have yet to see killer applications that can cannibalize existing practices.

Lesson 11: It’s not all about the U.S. ~1/3 of today’s FinTech unicorns are outside the U.S. (Asia + Europe). U.S. FinTech companies can likely learn a bit from their peers in other geographies. Behavioral and cultural differences certainly exist but there are a few clear examples of this that came up during one of the payment-focused panels. For example, in China, WeChat is using messaging capability to allow social payments. Stan Chudnovsky, the Head of Product for Facebook’s Messenger, revealed during one of the payments sessions that Facebook is developing this and expects it to be a key use case in the next 18-24 months. But in this space we are certainly followers not leaders.

Lesson 12: The FinTech community grows more vibrant and robust each year. Money 2020 was founded 5 years ago and since its launch then has grown into the leading FinTech conference globally. There are now 11,000+ attendees, more than 1,700 CEOs & Presidents and 85 countries represented. Still a lot of opportunity ahead but the numbers speak clearly to the vibrancy and enthusiasm in the community. Many thanks to the founders of Money2020 Anil Aggarwal, Simran Aggarwal and Jonathan Weiner for another great conference. Looking forward to next year!

P2P Lending: The Early Regulatory Environment & Today’s Emerging Landscape

Over the course of the last century government has always found a way to influence the course of business through regulation. Traditionally, however, the government has tended to focus regulatory efforts on large enterprises. The vast majority of startups often fly under the radar as they are too small to really create concerns for regulators. The select few that do balloon into bigger companies through super-sonic growth, i.e. the Ubers and AirBnBs of the world, often do encounter regulatory hurdles as they grow into large enterprises. The reality, however, is that government regulation, in certain industries, can be game changing even at the earliest of stages. We need look no further than peer-to-peer (P2P) lending as an example.

Going back a decade to the mid-2000s, P2P lending was a nascent industry that had begun to shape into a two-horse race between Prosper (founded in 2005) and Lending Club (founded a year later in 2006). At the time, U.S. consumers had about $880 billion in credit outstanding and the virtual marketplaces for P2P lending were thought to reach $300 billion in loan origination per year by 2025. It was (and still is) a huge and growing market with lots of potential. As the first mover in the space, Prosper had jumped out in front by the end of 2007, facilitating 10x the number of loan originations as Lending Club. But 7 years later, Lending Club went on to IPO in December of 2014 and now has an enterprise value of $9.6B. Prosper has fallen to a distant 2nd and has struggled to find demand for an IPO—withdrawing its filing process on numerous occasions. So what happened?

The answer is government regulation, which provided Lending Club with a huge competitive advantage over Prosper in the early days of P2P lending. The critical issue that came up in 2008-2009 was over whether the SEC would view the loan transactions Prosper and Lending Club were facilitating as promissory notes, without any filing requirements, or securities, which (at the time) had extensive and very expensive filing requirements.

Prosper took a more passive “wait and see” approach to this regulatory issue—hoping that regulators would simply view the underlying assets as promissory notes and leave them alone. Lending Club, however, had the foresight early on to see the danger with this approach. If the industry was forced to file with the SEC, everyone would have to shut down for 6 months and submit to the long and expensive registration process. As such, Lending Club chose to take a proactive approach in being the first movers to file. Moreover, they actually helped the SEC shape much of the regulation in P2P lending which provided them with a huge short-term advantage over the competition.

As soon as Lending Club finished their filing process, the SEC then ruled that every other P2P lending marketplace would have to do the same. This meant that they came out of the process right when everyone else had to temporarily shut down for 6-9 months. So for ~9 months (time it took Prosper to emerge from the process) they were effectively the only player in P2P lending, right as the market took off courtesy of the tailwinds provided by the financial crisis.

Many of the other early players essentially shut down due to the heavy costs of filing and the lost time. Prosper managed to hobble out of the process but by then the damage had been done. With 9 months of green field, Lending Club had built out both sides of the two-sided marketplace, enhanced their network effects and customer captivity and emerged as the #1 player in P2P lending. The last 5 years Prosper has been playing catch-up as best it can. So government regulation was game-changing early on in P2P lending.

However, the story doesn’t really end there. While Prosper and Lending Club continue to do pretty well, the challenge for both of them is that they don’t have much by way of long term competitive advantages. The image below shows their respective competitive advantages at 2 different points in time.

ca

We’ve already discussed the early days of P2P lending, so let’s shift our focus on what is happening now in 4 cores areas: (1) government regulation, (2) scale, (3) customer captivity and (4) cost.

  • Government Regulation: Having cleared the SEC regulatory filing process, Prosper emerged wounded but alive. The problem with regulation now, however, is that in many ways Propser and Lending Club cleared the way for everyone else. The SEC filing process is now much faster and less costly. So there no longer exists a true competitive advantage for either from a regulatory perspective.
  • Economies of Scale: Neither Prosper nor Lending Club ever had an advantage in terms of fixed costs. These are software marketplace business that are not capital intensive; that basic principle remains true today. What has changed is the strength of the network effects.
    • Since dropping the auction-style borrower/lender matching process and migrating to the Lending Club method of assessing credit risk (through FICO scores and other metrics), the number of credit-worthy borrowers and therefore lenders willing to lend has increased tremendously on Prosper’s platform. The result has been a strengthening of Prosper’s network effects. They have now done $2B in total loan origination, which is a third of the $6B Lending Club had done.
    • The challenge though for both Lending Club and Prosper, however, is that the networks effects are not unique to their platforms. Lenders are simply in search of credit-worthy individuals in this low interest rate environment. As lenders on these platforms continue to move away from individuals and towards institutions, they will be increasingly more willing to multi-home across multiple platforms in search of the most credit-worthy borrowers and the highest yields. Borrowers will also multi-home in an effort to find the lowest interest rates as well as the most personalized / specific marketplace—hence the rise of P2P lending in specific verticals (more on this below).
  • Customer Captivity: Admittedly, I don’t have much by way of evidence but my belief is that as network effects begin to dwindle on both Prosper and Lending Club, so too will customer captivity. This will be most notable in terms of customer acquisition costs. Around 2010/2011 it cost Lending Club ~$40-$60 to acquire each borrower and ~$20 to acquire each lender. I am positive that this is higher than CAC in 2009-2010 when Lending Club barreled its way out of the SEC filing process as the only player and lower than what they will have to spend in years to come to acquire customers. Expect to see marketing and sales spends as a % of revenue to increase as well as higher churn and a lowered ARPU/CAC ratio.
  • (Supply) Cost: Early on, Lending Club and Prosper may have had a slight supply advantage in terms of proprietary knowledge and/or special resources. Their algorithms matching borrowers and lenders as well as probability of default may have provided them with a slight edge—particularly given the larger amounts of data they had as a result of being in business longer than others. Unfortunately, this too is not a sustainable competitive advantage. The technology in P2P lending over time has become increasingly commoditized—there are only so many ways you can assess credit-worthiness and, given enough brain-power and time, the technology can be easily replicated.

So the overall affect for both Prosper and Lending Club has been a weakening of their competitive advantages vis a vis the rest of the P2P lending market. This has resulted in a whole slew of new entrants fighting for share and cutting into the once high (as high as 40% for Lending Club) margins. Here’s a look at how the competitive landscape is shaping up today:

cl

In particular, the last few years have given rise to vertically focused P2P lending marketplaces. These vertical P2P lending marketplaces focus on specific verticals like student lending (SoFi, CommonBond, etc.) or SMB lending (OnDeck, CAN Capital, etc.) Because they offer a specific focus or thematic lending opportunity, the network effects and customer captivity of these offerings tends to be high. While still mostly small and narrowly-focused, these vertical P2P lenders have broadened the P2P lending marketplace into more than just a 2-horse race.