Financial services has already been disrupted; we believe outdated legacy financial technology companies are next in line to face competition from a new wave of startups.
Wave 1: Disrupting legacy financial services
Over the past decade, an influx of startups has attempted to disrupt nearly every facet of the financial services industry that consumers and businesses have traditionally relied on, from banks and lenders to advisors and asset managers.
This wave was driven by a simple truth — incumbents were really bad at serving their customers! They overcharged and hid fees. Their processes were archaic and confusing. Perhaps to their greatest detriment, incumbents were also slow to innovate in the face of growing customer desire to transition to digital channels and products. These shortcomings presented opportunities for startups, and we saw a wave of tech-enabled, digital financial service providers take advantage by going after incumbents’ customers and profit centers. Companies like Robinhood, Chime and Lending Club reached multi-billion dollar valuations by providing financial services faster, cheaper and with a modern user experience.
Wave 1 in a nutshell:
What began with startups targeting the “unbundling” of more narrow business areas has now turned into head-on competition with even the largest incumbents. The digital financial services startups that reached scale now offer a broad suite of financial products similar to that of any bank, and often do so with a better user experience. This new wave of digital financial services has also broadened to cover almost all corners of incumbents’ businesses, as well. What started in consumer lending and wealth management now reaches everything from life insurance to commercial banking. As new entrants have gained critical mass and expanded across the financial services landscape, the impact has been dramatic:
- Financial services are becoming more democratized: Startups are using better data and technology to make it easier for more people to access financial services and reach historically-underserved customers.
- The cost of financial services is falling dramatically: Whether it’s removing overdraft fees, increased interest savings, or brokerage commissions going to zero, competition is shrinking incumbents’ profit pools to the benefit of customers.
- Incumbents are being forced to catch up: Digital innovation and a modern customer experience is no longer a nice-to-have or something on the roadmap. It’s a priority for incumbents or anyone who wants to survive this wave.
Time will tell what the overall success of the digital financial services wave looks like. As competition intensifies, product offerings converge, and incumbents improve their digital capabilities, the underlying economics of these new providers are being tested. Investors are also questioning whether these are technology companies or financial services companies, and therefore how they should be valued long-term. Regardless of the ultimate outcome for many startups in this first wave, one thing is clear — competition from new, digital financial services providers has been a huge net positive to customers and the industry overall.
Financial technology: the status quo
So why didn’t incumbents do a better job of serving their customers in the first place? As the rest of the economy was innovating, driven by the rise of new technologies like cloud and mobile, why did the financial services sector appear to give modernization a hard pass?
Part of it was likely risk aversion — financial services is highly regulated and inherently slower-moving when it comes to modernizing. Certainly, there was an element of “if it ain’t broke, don’t fix it.” Those legacy business models were highly profitable; why mess with a good situation?
But it wasn’t just lack of desire that held back incumbent financial services providers, it was also lack of capability. Incumbents, and even many financial services startups, are reliant on an older generation of financial technology providers to operate key elements of their businesses. And whereas financial services have seen disruption, competition and innovation grow over the past decade, that has largely not been the case when it comes to financial technology.
What do I mean by financial technology? Financial technology is the tools, enabling technologies and underlying infrastructure that financial services providers need to build, deliver and maintain their products. Most financial services providers don’t build or operate their own technology, but instead rely on a relatively small group of long-standing incumbent technology vendors. These vendors power everything from banking to wealth management to capital markets and have been doing so for decades.
These are the technology companies powering the financial services industry. Most of them are older than I am! They have predominantly driven growth and scale through acquisition, which is rarely accompanied by technology integrations. As a result, financial services providers are left to rely on disparate, legacy systems (and engineers old enough to know how to support them).
Nonetheless, these giants dominate the industry. They benefit from strong brands, deeply-embedded technology and long-term relationships (and contracts) with their customers. They are hard to rip out and replace. They’re also safe. Just as “nobody gets fired for buying IBM”, at most banks or credit unions, no one is getting fired for using FIS.
Financial institutions rely on these providers for everything from their core systems to risk management to customer communications, and this status quo isn’t good for customers. A 2019 Bank Director Survey found that a majority of banks, regardless of asset size, felt their core banking providers were slow to provide innovative solutions or upgrades, and made it difficult to implement new solutions. In the fintech equivalent of Stockholm syndrome, most surveyed banks that held under $10 billion in assets also noted that they rely on their core providers to introduce innovative solutions. No wonder it’s been hard for the industry to evolve!
Wave 2: Disrupting legacy financial technology
The legacy financial technology industry has lacked competition and therefore provided limited incentive for the dominant incumbents to change. As a result, the financial services industry has suffered. We believe that this dynamic is starting to change and that we are in the early innings of an equally large and important wave — the disruption of legacy financial technology. This wave will accelerate the technology capabilities of both incumbent and startup financial services providers. It will enable them to launch new products faster, improve their operations and provide a better experience to their customers. In short, it will move the financial services industry forward.
For one thing, the attitude of incumbent financial services providers is changing as they see new competition on the horizon. A growing number of banks and credit unions view financial technology startups as an important means of improving customer experience, creating new capabilities and reducing operating expenses. For another, the universe of financial services providers has expanded and become more tech-forward. A startup neobank or wealth management platform is basing its value proposition on the use of modern technology and the ability to innovate. It can’t be held back by an outdated, inflexible technology vendor for something as critical as its core system or payments infrastructure.
These changes were already underway, but the Covid-19 pandemic is accelerating this wave. Financial services customers have shifted usage dramatically toward digital as a result of the pandemic and are unlikely to go back to the prior status quo. We’ve also seen that those financial services providers dependent upon legacy technology have struggled to adapt to new government initiatives and requirements from regulators. The government-sponsored Paycheck Protection Program (PPP) exposed the inflexibility of legacy loan and digital banking systems, as many incumbents struggled to even create digital versions of PPP forms and capture the customer data required for the program. Government-mandated mortgage forbearance (along with the loan modifications that are sure to come) are exposing the inflexibility of legacy mortgage software and historical reliance on manual, Excel-based workarounds. The payment delays and website crashes that banks have suffered as they tried to manage government stimulus checks highlighted the issues in legacy payments infrastructure and mobile banking.
The pandemic has made it clear to financial institutions that modernization needs to start now, and that legacy financial technology is inadequate for the current digital age. For financial services providers, innovation is now at the top of the agenda. Digital transformation initiatives previously expected to take two to three years are now being given 12- to 18-month timelines. The need for modern financial technology has never been greater.
The financial technology landscape
Luckily, as demand is increasing, so is supply. There is a new crop of financial technology companies built with modern infrastructure and providing new means of integration and interconnectivity. They are changing the way that both incumbent and new financial services providers operate their businesses and serve their customers. These startups operate at every level of the financial technology stack, from infrastructure to operations to financial product creation, all the way through to customer experience. What financial services companies used to rely on one “full stack” incumbent technology provider for, they now have a growing ecosystem of individual building blocks that enable them to have best-in-class solutions at any level within it.
For incumbent financial services providers, there is also a large number of startup technology companies focused on enabling a modern, digital customer experience similar to that of startup digital financial services players.
Whether it’s at the customer experience layer or core systems, we believe that this next wave of innovation will do to legacy financial technology what the first wave did to financial services. It will create competition and force innovation. It will enable financial services providers to reduce expenses and be more efficient. It will improve the customer experience for all consumers, as everyone from neobanks to community banks get access to modern technology. It will further democratize access to financial products and enable the consumption of financial services in new places and ways. It will move the financial services industry forward.
Point72 Ventures invests in companies that are solving the most critical issues in the manufacturing of, distribution of and access to financial services globally. We could not be more excited about the second wave of fintech and the opportunity to partner with this new generation of companies.
We recognize that this landscape is by no means complete. If you would like to add a name to our list of disruptive financial technology companies, please drop us a line.