FinTech is undergoing rapid change and as it does, the intensity of disruption is growing. In this episode of Research in Action, Ian McDonald, a research analyst who covers the industry, joins Director of Research Matt Peron in a discussion about FinTech’s evolution and what it could mean for the future of financial services.

Key Takeaways

• FinTech as an industry is evolving quickly, with dramatic consequences for the distribution of financial services.
• Initially, this change was marked by the shift from analog to digital (e.g., the bank branch becomes an app). But now, disruption has become more systemic, with new non-bank players threatening to displace incumbents.
• In this dynamic environment, investors should consider a new framework for valuing financial services companies – one in which payments and software merge – and be prepared for even more disruption and potential growth opportunities in the coming years.

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Carolyn Bigda: QR codes, digital wallets, buy-now-pay-later schemes, P2P and B2B payments. Over the past year, digital transactions have exploded in number and kind and led to dramatic changes in financial services as a whole. We’re talking about the exciting and fast-growing world of financial technology, or FinTech. And today, we’re joined by Ian McDonald, a research analyst at Janus Henderson who focuses on the industry. He’ll help explain the explosive innovation taking place in consumer and business transactions, accelerated by the COVID-19 pandemic, which forced much of the physical economy to move online and demanded new financial solutions. What are these newfangled financial services? Where is the industry headed next? And what does it mean for the broader financials sector? I’m Carolyn Bigda.

Matt Peron: I’m Matt Peron.

Matt, a month or two ago, you asked Ian to present to the broader Research Team at Janus Henderson about the evolution of FinTech. Why did you think it was time to take stock of how FinTech has evolved? Why now?

Peron: Well, Carolyn, as you mentioned in the beginning, there’s been this explosive innovation over the past few years in this space. Ian’s been tracking that very closely, but I thought we were at some sort of turning point where all this new innovation has come out and we should stop, reset, take stock, as you say, and look at the broader landscape and how it’s going to play out over the next five years. And this will help shape a strategy for how we invest, how we research in this very important growing sector.

Bigda: Okay, so we’ve sort of come to an important point in FinTech’s evolution, and Ian, in that presentation, you described the first phase of FinTech as the period when analog became digital. What do you mean by that?

Ian McDonald: Sure, this is a really crucial point in the transformation of financial services. And what I mean is like putting a digital overlay on analog systems. So, maybe a fitting analogy would be to music, where you used to store your music on a cassette tape and it was encoded in a magnetic stripe, and now it exists on your phone in bits and bytes. The same can be true with your credit card today. Your credentials are stored on a magstripe on your card or they can be tokenized into a digital wallet on your phone. I think Brian Moynihan, who’s the CEO of Bank of America, he used to talk about the idea of a bank in your pocket, and that’s a really good analogy for describing this era of FinTech, which is the branch becomes an app, a car becomes a digital wallet, your stockbroker was replaced by an online trading platform.

And there’s a few important parts here to highlight. One is the user experience is getting a lot better as we move to digital channels. It’s faster, it’s more convenient, there’s less headaches. You can see people today even bemoaning when you have to make a call to your bank or head into the branch, so that moving to a digital channel certainly increases the user experience. But on the bank side, there’s also enormous cost savings. So, it might be, you might estimate a dollar or two to serve someone when they walk into a branch versus pennies in a digital channel.

So, we really just put a digital overlay on analog systems. And the important point to remember is two things: The distribution of financial services did not change in this era. It would still remain with the banks and the incumbents. There were certainly digitally forward companies. We can think of Visa, MasterCard, JPMorgan, Capital One – which has always been a digitally forward bank – Progressive in auto insurance, and some new players like PayPal. But by and large, we just transformed analog processes – paper, check, people – into digital processes, and large banks maintain their role in the ecosystem.

Bigda: Okay, so the branch was replaced by the app, essentially. But you say that the industry is already sort of moving on to bigger and better things now, even if not all of us have embraced this first phase, such as myself. I’m not sure I have yet to pay for anything with a digital wallet. But in this next phase, which is where we are now, FinTech, as you explain it, is becoming embedded and in context. So, what’s happening now, and why do I keep hearing the term API in this context?

McDonald: Good question. And the describing of moving from analog to digital, that process seems to have run its course. If you don’t have a digital strategy by now, you’d be in quite some trouble. And you have exactly the right words: It’s embedded and in context, API. And then I’m going to add another important variable and that is non-bank distribution. And so, if I take those in order, embedded and in context really describes the user experience. And for a while, myself or the FinTech community, we were using this word, the “Uberization” of financial services. And that’s because the Uber experience is so cool, where the payment happens in the background. So, you open the app, you hail a ride, you get in, you arrive, you say thanks, you close the door and you walk away. And it’s in the background that your card was authorized at the hailing of the ride and then it was charged at completion. So, it’s invisible, and the idea of payments is just embedded in the ridesharing software. And so, we don’t come out of the Uber app to pay from a wallet, whether that’s a, you know, a cowhide wallet or a digital wallet. We stay in the Uber app. And in time, we’re not going to come out of a messaging app to send money to friends because messaging is the context for P2P, and we’re not going to come out of the Instagram app; when you want to buy that grill thermometer, you’re just going see the picture, you’re going to swipe and then it’s delivered you know, a day or two later, or same day. But we don’t have to come out of the Instagram app. And we can even think of not coming out of a commerce app or site for an installment loan, where if you think about Peloton, you can have the installment lending happening at the same time that you’re shopping for the bike, and you don’t need to come out and go to a bank and apply for a loan. It’s all happening in context. So, the idea of embedded financial services is that we’re going to be experiencing financial services or procuring them in the software that we use every day.

And you mentioned API, which is important because embedding financial services and software is enabled by APIs. And API stands for an application programming interface. It’s a software intermediary that allows two applications to talk to each other. So, if you imagine you have an engaged user base – that could be Robinhood with stock traders or it could be Mint, which is a popular budgeting app – and you’d like to offer your users a debit card. You don’t have to call up a bank and ask them to code into your app so that you can issue a card. You would go to Marqeta, which is a FinTech company, they have a developer portal, and you would use their API to launch your card program. So, you can interact with the bank software via a gateway, if you will, an API, in order to launch your program quite quickly.

And in the last piece that I mentioned, which is non-bank distribution, this is really the important – this is the piece that’s of greatest economic importance. And that is that these financial services I’m describing, whether it’s payments, lending, capital, payroll, they’re now being distributed via software companies, not just banks. So – and this is what Angela Strange, she’s a partner at Andreessen Horowitz – she wrote a note about a year ago that says, “Every company is going to be a FinTech company.” And this is what she means by it: That if you have an aggregated set of users and trust – trust is important in financial services – you can embed financial services into your product offering. This happens for consumers as well as SMBs. If I take a small business example: In the old days, if you wanted to start a small business, you probably had two stops in the beginning. The first one would be you stop at a realtor because you need a storefront to sell your goods, and then you’d have to go to a bank to set up a business account to fund the business, perhaps get a loan and to have an account to receive sales receipts. But now you can simply just go to Shopify. It’ll have a digital storefront; they’ll give you a merchant account; they have payment acceptance, including PayPal and Alibaba and all different tender choices. And in time, they’re going to offer you capital and other financial services. So, the big takeaway is that distribution of financial services is changing. We’ve introduced new players into the ecosystem, software players, and that’s quite different than the earlier description of a digital overlay because the incumbents are challenged in this period.

Bigda: Right, so I’m noticing the trend, which is little by little, the traditional banks are sort of being phased out. And so, as you mentioned, it’s a lot more of these startup companies, more tech-based companies that are entering into the scene. And so, are these really now coming to dominate this market space?

McDonald: Right, so I think the way we had frame the earlier discussion was the evolution of FinTech. And so, what we’re really describing is the intensity of disruption of the traditional banking model. It’s getting hotter and hotter and hotter as we move from the simple analog to digital to embedded and in context, and then perhaps further down the line to decentralized networks and cryptocurrencies – the intensity of disruption or disintermediation of the legacy systems is getting hotter and hotter.

So, the players are changing, the skillsets are changing; and actually Jamie Dimon, the CEO of JPMorgan was last week on an earnings call and said they’re going to be spending an enormous amount on their tech budget, over $12 billion in ’22 and beyond in order to compete. And you know, his words are, “Silicon Valley is coming for us,” and he’s right. So, JPMorgan is actually having to take the savings from 1.0, that analog-to-digital transition, and put that and more investing into kind of FinTech 2.0, the embedded and in context, in order to compete.

So, it’s quite tough because legacy systems, you know, eat up so much of the budget that you’re spending a lot of money just to keep things alive and then some of that goes to innovation. So, the incumbents are not dead, it’s just that we think the opportunity in the FinTech space for these pure plays is just enormous. So, we’re really laser-focused on trying to find the winners there.

Bigda: And it sounds like, too, it’s not just sort of phasing – I mean, the incumbents aren’t dead, like you said, but this change is actually altering sort of how business is done, sort of how the economy functions in a way. The example that you gave about a small business and how it would actually set up, I mean, that’s, you know, a totally different pattern now. And even with consumers, I know when I go online and shop, I see this new thing called buy now, pay later. Can you maybe talk a little bit about how this evolution has actually changed sort of the way transactions are done in the economy?

McDonald: Sure. We can think of, I guess with the lens of a user experience, as you mentioned, it’s kind of evolving from, say, writing a check to pay your landscaper to paying via PayPal or Venmo. And I think, I’d like to take some of these services to the extremes because I think we will. But in time, we’re going to have a broad array of financial services that are actually automated and executed by code. And the examples I usually use are auto-save and auto-rate surf and auto-refi. And by that, by auto-save, I mean you’re going to get your paycheck direct deposited into an account, it’s going to be machine learning and artificial intelligence that reads both your inflows and outflows. And when your money comes in, it will say, ‘Well, here’s how much you have to put aside in order to pay your bills and here’s what’s okay to save.’ And when it says okay to save, it will then go out on the web and see that Capital One is offering a 3% on deposits while Synchrony is offering 2%, and it will auto-allocate to the bank with the highest APR. You can imagine you’ll have auto-refis; you’ll have a mortgage, and once interest rates fall below an amount where you can have a payback period on the application fees, it will automatically refi your mortgage. You’ll robo-allocate your assets, either depending on your risk tolerance or perhaps, you know, life stages or age. You’ll have robo-tax automation. We’re going to have a smart wallet that allows, that will give you a hint on, you know, which card you should use for which merchant to earn the most rewards. We’ll have streaming wages, which I’m really excited about, which just like we stream Netflix and content, we’re going to be able to stream the money that we earned; rather than a two-week paycheck, we’ll be able to see our earnings live. We’ll have pay-per-mile auto insurance. So, you can see how software and banking and financial services are really coming together and creating some exciting experiences for the user.

Bigda: That could be a little scary to see my earnings live. I’m not sure I’m ready for that. It also sounds like I might not have a choice anymore. I will eventually be forced to adopt this digital wallet. But talk to me a little bit about on the business side of it because it’s not just for consumers and transactions. We also see this affecting how businesses collect and process transactions and connect with customers online and send invoices and even manage payroll. How have these backend processes change over the past year as part of this evolution?

McDonald: Sure, that’s a good question, too. And maybe if I can continue with the music analogy from earlier: You know, the music was on a cassette tape and it was hard to make a playlist. You guys, at least I remember, the mixtape and how hard that was and important it was or a good gift it was. But as we move from a digital format, of course, you can make a playlist now in a minute. You can have software make one for you, given your preferences. You can even use somebody else’s with similar tastes, and it’s, you know, playlists are easy to do because we now have metadata on the artists, the genre, the year the song was created, etc. So, moving information into a digital world is easy, and then we can combine it and arrange it in exciting ways.

And so, in this case, you mentioned invoices. In an analog world, it’s actually really hard, believe it or not, to attach a payment to an invoice, a B2B payment. Business-to-business payments are still dominated by check, if you can believe that, and it requires auditing and reconciliation, and that’s time-consuming and expensive. You have to write the invoice number in the bottom left-hand corner of the check and then someone has to read it and reconcile. It’s actually crazy that it’s 2022 and this is still happening. But you can imagine with digital payments, you can attach a message along with the invoice and voila, you’re done. So, the backend infrastructure is really changing to keep up with the user experience.

Bigda: So, I mean the way you talk about this, Ian, it seems like FinTech’s tentacles are reaching into every aspect of the economy and that this opportunity is just almost limitless at this point. Could you talk to us a little bit about the market size for these financial solutions and, you know, how much bigger could it grow from here?

McDonald: Sure, and I really like talking about this, and I actually wrote a note recently for our team about embedded financial services and it was titled, “Not the Icing, But the Cake.” And the idea is, I think the initial reaction, when we think about software and financial services, is that you have software, this vertical specific software. It has highly recurring revenue, a very sticky customer base and that financial services would be a nice cross-sell. And what we’ll see is that the truth is the financial services profit pool could easily eclipse the standalone software revenue. So, if we look at a company like Toast, which sells restaurant software, its revenue is 65% financial services and 35% software. A company like AvidXchange, which does B2B payments, is the same. The majority of revenue is coming from payments as opposed to software. So, it’s an exciting piece where the pie can actually be really big in financial services relative to the standalone software profit pool.

I actually think there might be two ways to think about this, and one is around activity levels and how those accelerate as we move from analog to digital. You know, there’s a statistic that I heard a few years ago and I’m not up to date on it, but it was something along the lines that we’re going to take more pictures this year than we’ve ever taken in the entire history of film. And that comes with digital cameras, very low storage costs and then, of course, social media. But when you think about financial services, we’re really in a position now with real-time payments and P2P, that when you meaningfully lower costs, we’re going to see activity explode. And one example of that might be micro payments where we might have tipping on Twitter where you can send someone a couple of pennies if you like the content that they’re posting. So, we’re seeing an explosion of activity, which is one part of how we address the financial services TAM [total addressable market] and how quick it can grow.

But from an investing framework, I really like to think about financial service adjacency. So how does banking and commerce work together? How does social commerce work and trying to wrap our head around what is the financial service addressable market versus what is the tech addressable market? Because I think this intersection of payments and software is going to be really huge.

Peron: I was just going to say one of the things you mentioned, B2B earlier. One of the things I’m really excited about also, an interesting application, is the idea of managing the supply chain using blockchain. So, you can really track every piece of the supply chain or trade receivables in the traditional banking world. So, there’s all kinds of applications that we’re excited about where this can go, the tentacles that you described earlier.

Bigda: All right, so let’s get down to brass tacks though, because the opportunity set seems to be enormous. But as an investor, you probably can only pick, you know, a handful of stocks to invest in. So, when you’re looking at companies in this space now and thinking about this industry, what are the attributes that you’re looking for in a company?

McDonald: This is where we spend most of our time obviously, translating a FinTech framework into actionable ideas. I’m going to give you two answers. The first one is I think is an easier answer, which is, if you were a traditional bank analyst, you might be looking at the bank’s return on equity relative to its cost of equity. And this would, this multiple would inform a price-to-book ratio that you pay. Obviously, the higher the ROE [return on equity] relative to the cost of equity, the more you’d be willing to pay for the bank.

I think in FinTech, we’ve moved to LTV, the lifetime value of a customer, and CAC, the cost to acquire customer. And this ratio of LTV has kind of replaced, you know, the ROE, cost-of-equity framework. It’s the new return on capital framework, LTV to CAC. And we always want to drill down to the lowest unit we can, whether that’s a factory or a store or a user, but it’s particularly important to understand the lifetime economics of fast-growing FinTechs because many of them are losing money today in the investment phase.

So, the easy answer is, we want good unit economics, we want great management, we want a large and growing investable market. We want a product that’s differentiated. We like barriers to entry or at least a good start, all the good stuff. And we want to pay a reasonable price for looking at a range of scenarios. That’s kind of the easy answer. I think a more nuanced answer would be we really care about the data that informs the business and then how that’s monetized. And one of the analogies we use is looking at the Internet giants. They built this wonderful business on gathering data on user attention – so Facebook with its social graph, Amazon on how you navigate an online store in your purchase history, and then Google with search and then they monetize that attention via ads and commerce. So, the model is really attention data monetized. And with FinTech, the foundational innovation is gathering payments and bank data that was once locked up in your bank account but is now accessed by third parties, and so the model is payments data monetized.

So, we really want to think about, one, payments data is the gold standard because it’s better than search data or intentional data, it’s actually what you’ve been doing. We want to think about where companies get their data. In a P2P network cash app, Venmo, PayPal? Do they get it by replacing a bank account altogether, like Chime? Do you peer into bank accounts, like a company called Plaid? Do you attach financial services into vertical software, like Toast does? Do you move up the funnel into wages and payroll, like Ceridian does? So, where do you get the data? That’s important. And then there’s innovations on how to monetize. You can get a huge take rate on buy now, pay later with your SKU-level data. You can get, you can earn software revenue from business intelligence at Toast, like menu optimization. You can do inventory and supply chain management, as Matt mentioned, like Lightspeed. You can offer merchants zero loans with no cost to acquire, like Square does. So, we’re really thinking about a framework of where do you get the data and how do you monetize it? And we think FinTech and software can be just as big an idea as the Internet giants were, you know, five or 10 years ago.

Peron: And that’s why the 2.0 paradigm that Ian laid out in the framework that he laid out to me, caught my eye. There’s this Cambrian explosion, I think, of innovation and ideas. And if we don’t have a map and a roadmap on how to approach the space – and I think Ian just laid that out very eloquently – then you’re just chasing the next idea. What we want to have is a five-year roadmap and a plan so that we can approach the space in a coherent fashion and that’ll be the most productive in terms of our research efforts.

Bigda: Yes, I liked the term you used, Cambrian explosion, because it does seem like there are just so many players right now pursuing lots of different avenues. I think you laid it out pretty well, Ian, and you referenced the tech sector, where there’s been a lot of consolidation. And do you see that happening in the FinTech space eventually?

McDonald: I have a quote in my mind, I’m not sure who to attribute to today. But it’s, ‘There’s two ways to make money, unbundling and bundling.’ And so, we’re in the stage right now where we’re kind of unbundling the bank and we’re seeing very good point solutions for something that used to be, you know, wrapped up in a single entity. And so, we’re in the unbundling stage, but over time, we’re probably going to bundle them back together again. So, it goes in waves. Today, we’re seeing awesome point solutions, but they’ll eventually come back together and be wrapped. So, we’ll certainly see consolidation down the line.

Bigda: So, as this space grows, what are some of the risks that you are keeping an eye on? Are there broad concerns about cybersecurity, delinquencies and charge-offs, consumers don’t make these installment payments, you know, through these new applications, fraud? I mean what are some of the big risks that you’re keeping an eye on at this point?

McDonald: There’s three that kind of come to mind. You mentioned delinquencies and charge-offs, so lending for sure. If we look at the profit pool of banking, lending and net interest income that comes from lending is the largest piece of it. So, it’s a very big profit pool, but it’s hard to do and we’re not sure that we’re seeing models today that really have anything new to add. We have some ideas on what might be disruptive, whether it’s alternative data, differentiated positioning in a repayment stack. But so far, we’re very wary of models that are leading with credit. It reminds me of a Seinfeld episode where he does the reservation and then he kind of gets to the desk and he’s like, taking the reservation is easy, it’s holding it that really matters. And obviously, lending money is easy, getting it back is hard. And so, we’re wary of models that lead with lending for sure.

Another piece that’s really hard to tease out is COVID and the stimulus impact. It’s obviously had an exaggerated positive benefit to companies that were digitally forward online and particularly focused on the lower end of the market, the unbanked or the underbanked segment where we saw a lot of stimulus flow into those accounts. So, it’s difficult for us to, its sometimes difficult for us to tease out what is durable growth and what has been a bit of luck around COVID and stimulus, so we’re paying quite a bit of attention to that.

And then the third piece is inorganic growth. You know, depending on who you talk to, putting two cloud software companies together can be really easy or impossible. And so, you know, it’s nothing new for us to prefer organic growth over a roll up, but a lot of these companies prior to becoming public did quite a bit of acquisition activity. And so, we’re looking for platforms that have kind of built themselves in a more organic fashion and are somewhat cautious on the roll ups.

Peron: Another thing that we are mindful of is the innovation pace, right? You could have something that’s come out with an innovation and you find out that someone actually has a better mousetrap, if you will, and you’re seeing this sort of very furious pace of innovation, which also can be a risk to companies as they roll out. Is that something on your radar screen?

McDonald: Yes, sure. And you know, I think the fancy words for this would be there’s foundational innovation, there’s cascading innovation. And I probably have a story about, you know, a warship platform from the 1900s that I can tell you, but the idea of the foundational innovation here is that access to bank data is available to third parties. Open banking would be a way to describe that. That’s what’s key, is we’re allowed to distribute financial services from non-banks. The cascading innovation is the part that gets exciting. So, we don’t want to limit ourselves to like say, ‘Hey, that is brand new and that looks terrific. I’ve never seen that before,’ and ignore the parts where ‘Hey, there’s a lot of other things. We’re combining something that is not really, it’s not new, but it’s presented in a different way that really gives you like high NPS scores [Net Promoter Score, a metric used in customer experience programs] or really good user engagement and it doesn’t feel brand new, but it’s working really well.’ So, we’re paying attention, both to these foundational innovations – hey, that’s brand new, I’ve never seen it before – to also how people are going about combining things differently in a way that excites consumers.

Bigda: One other thing you mentioned, too, in just talking about the investment process was price. So many growth stocks have seen their valuations get stretched during the pandemic, as investors rewarded digital-first companies. Has it also been the case for FinTech?

McDonald: For sure, yes. One of the fun ways we think about this is looking at, I guess, income statement geography. And we want to keep ourselves grounded in cash flows; you know, value is the present value of cash flows, that’s not my definition of value, that’s the definition of value. So, we always want to keep ourselves grounded in cash flows. And we can think about price to cash flow as kind of a baseline, and then we move up to price to adjusted earnings, and then we’ll move to price to EBITDA [earnings before interest, taxes, depreciation and amortization], and then price to gross profit and then we’re talking about price to sales, and then you know, sooner or later the market’s talking about price to eyeballs and price to users. And the further we move away from price to cash flow, the more bubbly these valuations get. So, it’s certainly had, you know, along with very low interest rates and stimulus and COVID really accelerating and pulling forward a lot of these digital transitions, a lot of the space kind of got quite frothy. We can also see that with the level of, you know, SPAC [special purpose acquisition company] activity and IPO [initial public offering] activity, where a lot of these companies we’ve been friendly with when they were private and perhaps, we’re not ready to come public, but got their day in the sun around COVID and the elevated capital markets activity. So, we certainly are paying attention to, you know, what seems fair and what seems very optimistic.

Bigda: It’s interesting that you mentioned interest rates. In 2022, it looks as though rates are set to start rising for the first time in a while. Does that make FinTech companies more vulnerable because they are these long-duration types of assets?

McDonald: The answer is going to be yes. I mean a lot of these companies, as I mentioned, you know, their business model is evolving. They’re in the investment stage. We like the unit economics, again what is the lifetime value of a customer versus how much they pay to acquire them. But they could be money-losing and a lot of the value is in the out years. And obviously, the out years are very sensitive to the cost of capital and interest rates. So, businesses with a very long duration of growth are being, you know, are certainly being hurt by a higher cost of capital and higher interest rates. I do think that the majority of the FinTech stocks do not have interest rate exposure in a way that a traditional financial company would. So, their net interest income is not going up as rates rise. They’re really more fee-driven businesses, so there’s not an interest-rate lever for the FinTech versus traditional fins [financials].

And then the last part I’ll mention is the, there’s just enormous tailwinds that we think will for many of these firms overwhelm, you know, the interest rate component. If we had to think about, you know, how P/Es (price-to-earnings ratios) evolve, you know, down with higher rates, but then up with people becoming more comfortable with the moat around the business. There’s just some enormous opportunities for companies to go right through an interest-rate cycle.

Peron: And I think that’s a really important point, that the fundamentals here are so strong that I see the rates issue as presenting more opportunity than risk.

Bigda: Really?

Peron: Because you will see, sometimes, some of these companies will see their valuations compress, and that gives us the opportunity. And that’s why we want to be ready with our research, ready to pounce when those opportunities come up. There will be volatility in the market, and we’ll be ready for that.

Bigda: So there, it sounds like there could be near-term volatility, but there’s also good potential for long-term growth and the latter would outweigh the former, essentially.

Peron: That’s right.

McDonald: We had recently done an analysis of SMID [small- and mid-cap] stocks over the last three, five, 10 years that had done really well. And we were trying to characterize, you know, what can we learn qualitatively from, you know, why those businesses performed, those stocks performed so well. And there was a host of reasons, but one of them was, is does the industry have headwinds or tailwinds? And the tailwinds show up obviously on just about every one of those winners. And when Matt asked me to present a FinTech framework to the team, in the slide deck I used, the first page was actually just a copy and paste of the cover of Warren Buffett’s biography by Alice Schroeder. And the title is “Snowball.” And the reason for the snowball is Warren Buffett has a quote where he says, “What you really need is some wet snow, but you really need a really long hill to roll it down.” And so, we want to be paying attention to like, you know, how long is this hill and how steep is the hill? And for FinTech and software, we think the structural growth can kind of overcome some of the valuation hurdles we have.

Bigda: Okay, so let’s talk about another side of the financials sector, which is the traditional players. So, the banks and the credit card networks, you know, the companies that we might normally think of as the biggest players in the sector. How long is that hill now for those companies? Has it shrunk?

McDonald: I’ve been thinking quite a bit about this and, again, another framework perhaps for us to use. I’m thinking of an interview that Jeff Bezos did. When he was asked a question, something around disruption and what is changing and what’s not changing and how does Amazon fit in the evolving role of you know, retail. And Bezos actually inverted the question and said, I’d love to talk about what’s changing, but I really build my business plan three, five, 10 years on what is not changing. And so, I think of that quite a bit because with these legacy players, there’s certainly a lot of disruption happening, but then we sit back and say, ‘Okay, what is the foundational innovation, but what is not changing?’ And what Bezos’ answered with is, well people always want lower prices, and they want more convenience and selection. And by the way, they probably want their goods, you know, sooner than later. So, we’re going to build a lot of what we do around things that are not changing, and some things in payments, for example, are not changing. Payments is a good business. It’s still moving from banks to non-banks because scale matters. It grows, you know, it grows faster than the average business and some of these legacy players are priced as if they’re going away, and they’re not.

So, there’s certainly opportunity where the theme of disruption has kind of blended together with COVID. COVID has made, you know, some numbers, you know, whether it’s travel or cross-border or, you know, physical point of sale, those businesses are still suffering and haven’t recovered. And so COVID can be masking some of the underlying strength when we come back to a more normal economy or reopening, and the market has kind of confused disruption with poor COVID numbers. So, there’s opportunity across the board for both the FinTech companies and some of the discounted legacy players.

Bigda: So, yes, because those legacy players aren’t going away anytime soon, like you mentioned. There’s still a lot of demand for the services they provide.

Peron: There certainly is, but I think there are pieces of them that really are vulnerable here. I think Ian’s laid that out in his roadmap. For example, midsize banks potentially are more vulnerable than a larger money center bank. So, there are pieces of the of the existing legacy players that are certainly vulnerable, and we’re mindful of that.

Bigda: So, it sounds like you need to be a little more selective now when looking around that area of the sector at this point.

McDonald: Sure. As I kind of described it earlier, you know, the idea of the changing distribution of financial services, moving from analog to digital, it was okay to own digitally forward incumbents because the distribution channel hadn’t changed. And now we’re in a spot where disruption is much hotter, so we need to pay quite a bit more attention.

Bigda: Okay, so we’ve talked a lot about the first phase of FinTech and then where we are now in terms of its evolution. Maybe now let’s turn to where we’re headed. One thing that comes to mind for me is that China is about to host this year’s Winter Olympics, and visitors there will be able to make purchases with the country’s new digital currency called e-CNY. And for those who don’t know, e-CNY is a type of sovereign digital currency, which is technically known as a central bank digital currency, or CBDC for short, and China is the first country to launch one. So besides being another acronym from the world of FinTech, what is a CBDC and how is it different from cryptocurrencies? And is this all part of the next phase of FinTech?

McDonald: Well, a CBDC stands for a central bank digital currency, eCash or electronic cash is also another way to understand it. And there’s really two or three motivating factors behind the issuance or potential issuance of CBDCs. I think the defining feature of a CBDC is that it’s going to be just like legacy cash. It’s going to be a liability of the central bank. So, broadly speaking, we have two types of money. There’s deposit money, money in my checking account that’s a liability of a commercial bank, and then we have cash and coins, which are a liability of the central bank. So, I do think there is a practical reason to issue a CBDC. It makes sense for a central bank to issue eCash for the digital economy, just as it had issued bills and coins for the legacy economy.

There’s also the threat that the eCash void, if you will, as physical cash is drained from the system, could be filled with a non-bank issuer of money-like assets. And here, I’m thinking about Facebook and its Diem project. So, Facebook looks to issue a stable coin, which would allow the 1.7 billion people that are unbanked right now to enter the digital economy with a phone and an app and no need for a bank account. So, I think there’s some urgency for central banks to make sure that they have an eCash offering as opposed to a non-bank having a money-like asset or stable coin, which then could interfere with monetary policy. So, some urgency on that front.

There’s also the potential for a CBDC to take advantage of what they call programmability of blockchain coins where you can have automated transactions via smart contract that have use cases in B2B payments and cross-border. I think that’s probably a mouthful and it gets quite complicated. But for now, one thing is clear: The winners from a CBDC or eCash are going to be the consumer-facing tech brands, both big tech and FinTech because it lessens their dependence on commercial banks. And one of the things we hear over and over again from developers is that the user interface of their app degrades once it touches money because it becomes subject to the data exchange and clearance activities of banks, which are really slow and expensive. So, eCash provides a workaround from that, that I think would be a boon to quite a few FinTech companies.

Bigda: So, is it inevitable that we’re going to see more of these CBDCs in countries around the world? It almost sounds like it’s, you know, it has to happen.

McDonald: I believe so. You know, the CEO of Goldman Sachs said CBDCs are on their way. I think he said for sure or something like that. So, we’re certainly going to have, we have the pilot stages in China right now, but we’re likely to see quite a few more.

Peron: And now we’re talking FinTech 3.0, right, where we’re off the payment rails, so to speak; the traditional ways that we move money around. That’s a whole new paradigm, and that is really going to be very impactful to how we conduct business.

Bigda: Are there other new paradigms that we should be prepared for going forward?

McDonald: Well, like we scratched the surface on kind of crypto with a central bank digital currency. But we’re paying very close attention to blockchain and crypto developments, both kind of like the bridges that are being built from existing fin structure to cryptocurrencies and the potential for an entirely new, what would be a decentralized ecosystem to develop. So, stay tuned there.

Bigda: Man, I don’t know how you keep up, Ian. This is crazy. So, Matt from a market perspective, do you think the financials sector could soon rival the tech sector for innovation and growth? I mean, is it going to be even possible to separate the two sectors when you’re looking at the market?

Peron: Well, I think to your first point on the innovation, yes, I think we’re already there. We’re seeing that the innovation coming out of the FinTech sector is just mind-blowing and that’s set to continue. So, I do think yes to that question. I think the traditional, there will always be, as Ian touched on this earlier, there’s always going to be a role for traditional credit, extension of credit at the heart of the economy. And how that’s done might change, but that I see will stay the same. But the whole ecosystem around it really is set to change.

Bigda: Well, we’ve covered a lot of ground today and it sounds like, amazingly, we have a lot more ground to go. So, Ian, thank you so much for joining us. This has been a really enlightening conversation.

For more bottom-up analysis of market and industry trends, tune into future episodes of Research in Action. I’m Carolyn Bigda.

Peron: I’m Matt Peron.

Bigda: Thanks for listening.

 

NPS scores refers to Net Promoter Score, a metric used in customer experience programs.

EBITDA refers to earnings before interest, taxes, depreciation and amortization.

SPAC refers to a special purpose acquisition company.