Outlook 2023 - Fintech: Separating the chaff from the wheat
07 December 2022
Fintech innovation can't be stopped, becoming ubiquitous and having an even greater impact on our daily lives. Tomorrow’s financial leaders will not be the same as today. 2022 brought a focus on operational and financial efficiency that will help “new fintech” companies better grow through 2023 and beyond.
Reiterating our long-term views
Saying that 2022 has been challenging for fintech is a euphemism. More cyclical and consumer-oriented, impacted by multiples compression, and penalized by the end of Covid-19 incentives, our strategy went through an annus horribilis.
Despite such a year, our long-term conviction that new fintech companies are gaining market share over incumbents remains intact. In hindsight, our long-term thesis was challenged by short-term reactions. We dare to call these as "noise" unrelated to fundamentals.
A great reset has happened. The valuation metrics of challengers have retraced to levels comparable to those of the legacy players. The switch from growth-at-all cost to profitability is happening. And still, the market fails to capture the difference in growth and user experience between legacy and new fintech and bets on the idea that yesterday's leaders will remain tomorrow's ones. But history teaches that this never happens.
Alternative lenders originate more loans than traditional banks. Younger generations invest through apps. Blockchain is reinventing finance – and everything else. We reiterate our conviction that the companies behind these trends are here to stay. 2022 will be seen as an anomaly for the industry; the future can only be better.
Nearshoring trends and financial services
After years of progress, global standardization of financial regulations is no longer the main priority. At best, the political agenda tends to be a status quo, i.e., regionalizing the financial markets and protecting the local financial infrastructure. Leaders in specific geographies should not expect increased competition from the leaders of other markets, as the regulatory and license constraints represent significant barriers to entry. As a result, the few fintech companies that have decided to expand aggressively internationally may choose to exit some markets to reduce the rising costs of operating in too many jurisdictions.
A Chinese comeback?
Pushed by a "laissez-faire" approach to boost innovation and to harvest personal financial data, China leapfrogged payment cards to adopt digital wallets, QR codes, and super apps. It quickly became the country with the highest fintech adoption rate (>90% of the population use fintech services).
The absence of a regulatory framework led to excesses and forced the government to intervene. Alternative lenders were the first ones to be impacted. Then, the failed IPO of Ant Group brought the entire ecosystem into the unknown, compounded by the crackdown on Chinese Big Tech.
We believe the worst is now behind us. A fine will be announced to Ant Group in 2023, which we see as the trigger for a new cycle for all fintech companies. Regulatory uncertainty will go down. Consumer-oriented companies should benefit from a progressive improvement of Covid-19 measures and widespread e-CNY adoption. In parallel, financial reforms and the need to digitize the financial industry will boost local technology enablers. We favor domestic companies after the recent 20th CCP Congress.
Every company is a fintech company
Banking-as-a-Service, the plumbing of embedded finance
The recent announcements of Marqeta and Adyen to expand their product range (card issuing and payment solutions, respectively) to a new suite of APIs for banking solutions were not a surprise. Such companies provide the plumbing of the financial industry and play a vital role in the democratization of embedded finance. According to Bain, financial services embedded into e-commerce and other software platforms are expected to exceed $7tn by 2026, i.e., ~15% of all U.S. financial transactions, up from $2.6tn in 2021.
Tracking employee expenses
Companies are expected to pursue cost-reduction programs in 2023 aggressively. However, cost-cutting efforts can only be efficient if the expenses are correctly tracked. Dedicated software and add-on to payroll management software fulfill this purpose.
The use of virtual cards (online versions of debit cards) can also play a significant role in tracking employee expenses. Every employee can be assigned a unique card. Handling account payables is more straightforward and faster, and the protection against fraud or stolen funds is higher.
The expense market management software is expected to reach $8.0bn in 2026 (annualized growth rate of 11.7%). Juniper estimates that the volume through virtual cards will reach $9.1tn by 2027 (annualized growth rate of 30%), 72% of which will come from B2B transactions.
Filing taxes for free
The Inflation Reduction Act is the largest bill aimed at reducing carbon emissions in history. Lost in the text, the Internal Revenue Service will receive $15mn to study the feasibility of providing Americans with a free tax filing option. Tax software providers like Intuit would obviously lose some of their retail business. The tax filing market is expected to reach $17bn by 2026 (9% annualized growth).
Anticipating a rebound
2022 will close as a record year for digital payments, with industry growth of ~12%, slightly above the long-term average. But the market anticipates another story, as shown by the price action of the last 12-15 months. A recession is around the corner, and U.S. consumer sentiment reached an all-time low in June 2022.
Valuations have plunged to pre-Covid levels, representing opportunities for long-term investors. Industry insiders will not say the opposite, as the third major consolidation wave of the payment industry started during the Summer of 2022. Leading companies are trying to boost their revenue growth.
Sooner or later, probably once inflation settles and has less impact on consumer sentiment, investors will return to the fundamentals and notice that various payment challengers can still grow their activities at >20% in a recessionary environment. By then, all planets will be aligned for a rebound of the payment industry.
Real-time payments in the U.S., finally!
Paying has never been so easy. But the payment infrastructure has never been so complex. Each payment flow (domestic or cross-border) and type (P2P, wire transfer, payment cards, etc.) has its own payment rail exploited by various players (e.g., traditional banks, local payment processors like GMO Payment in Japan, international players like PayPal, etc.).
The U.S. Fed is about to release one of its most important infrastructure upgrades, FedNow, that will allow real-time payment 24/7. The commercial deployment is expected in mid-2023. At first, only banks will have access to the system. This confirms our old thesis that fintech firms with a banking license must be favored. FedNow tastes like revenge for traditional banks, as it will close a bit of the technological gap compared to fintech companies. This payment method could also be adopted for e-commerce.
To be exhaustive, we can note that The Clearing House has been offering an instant payment rail in the United States since 2017, the RTP Network. But FedNow is expected to be more cost-effective and have a greater reach than the RTP Network, used by only ~250 institutions.
Biometric payments, round 2
Biometric payments have been under development for years. Recognizing the iris, the voice, or a vein pattern to confirm a payment offers more security and speed. Amazon led the way in the United States to mass deploy hand payments in its Whole Food stores.
But suddenly, Covid-19 appeared, slowing down all penetration of such technology. In China, where Alipay and WeChat already offer facial recognition payments, users thought masks were an issue in processing payments (in reality, algorithms can correctly identify masked people). Similarly, the fear of the virus discouraged people from touching any payment terminal or recognition device.
As a result, contactless cards were the big winners of the digital payments boom during Covid-19. Payers will change their habits only if the substitution means of payment offer a seamless and improved user experience. This is the goal of biometric payment. Visa is currently conducting a facial payment experiment at selected coffee shops at the World Cup in Qatar. We expect such trials to spread quickly.
Ethics and privacy will remain a concern. But by 2026, up to 3bn payment devices worldwide could be biometrics-friendly.
The importance of being selective
The challengers' challenges
Less than 5% of the >400 neobanks are profitable. Fintech is disrupting financial services, and challengers are gaining market share over traditional banks. But not all challengers will be able to navigate through an uncertain macroeconomic environment. For this reason, we remain very selective with pure neobanks and favor companies that are already profitable or on the verge of being profitable (e.g., with a positive EBITDA and a strong user network).
A framework for open banking in the U.S.
Open banking is the promise to give back control to users over their data. There have been two approaches to this objective: forcing financial institutions through regulations (like in Europe or Australia) or letting market forces act (like in the United States or Japan). The United States is slowly moving towards the first approach, as a proposed new rule (to be issued in 2023 and implemented in 2024) will require financial institutions to share consumer data upon request.
This change will create a more decentralized financial market structure. There will be more competition, especially for traditional banks, resulting in better products and services. Financial institutions offering deposit accounts, credit cards, digital wallets, etc., will have to develop data-sharing methods. This will be an opportunity for technology enablers to gain new customers, especially for the companies that provide the plumbing to the fintech ecosystem (like the API developers).
Will Musk disrupt banking?
Twitter is not part of our fintech non-listed universe. At least not yet. This could change with the vague plans announced by Musk to transform the platform into an "everything app". Super apps have made the success of Chinese Big Tech companies, but they must still successfully reach the masses in developed markets. Payments and other financial services, like the high-yield savings account mentioned by Musk, would be critical elements of such an app. Twitter must regain people's trust to be involved in personal finances. But Musk, PayPal's co-founder, understands how the payment industry works. Turbulences for Twitter are likely to last for a while, but the banking industry should not draw definitive conclusions too quickly on Musk's chances of success and competitive threat.
Crypto is far from being dead
The crypto ecosystem will long remember 2022. The crypto winter is here with its lot of failures (e.g., the stablecoin TerraUSD), liquidity mismatch and excess leverage (Celsius Network and the hedge fund Three Arrow Capital), and more recently, fraud (FTX).
The blockchain world is still in its early days. It goes through its own cycle where growth encourages talents to join. Then, new ideas are launched until too many projects coexist. As a result, a cleansing of the ecosystem is required before starting again. We are in the latter phase. It is not the first time it has happened, and it is probably not the last.
Despite all these events, we reiterate our conviction that blockchain is here to stay and has the potential to disintermediate the world. The death of crypto has been greatly exaggerated. Web 3.0 will happen. The tokenization of assets will grow exponentially. Transacting will be faster, cheaper, and more transparent.
The perplexity expressed by conventional wisdom reminded us of the mid-1990s when people struggled to understand the potential of the Internet. The upcoming recession and this crypto winter could provide the inflection point needed for the ecosystem to boom.
Ethereum and its roadmap
It will take time to restore trust, especially in the humans running this ecosystem. This year's issues do not come from the digital assets themselves; the code does what it is told to do. Two things will come out of this crypto winter for sure: (1) More regulation, as poor risk management or non-segregated assets, will not be possible anymore (see Regtech), and (2) technological upgrades.
The change from proof-of-work to proof-of-state for the Ethereum network was a real success. With its powerful community, Ethereum will likely be part of the backbone of the Internet of tomorrow. In 2023, the next big update for the protocol will be the possibility of withdrawing staked assets. Then, a series of changes will make the network more scalable.
No problem for Bitcoin, a turnaround for miners
We reiterate that Bitcoin will keep its status of "digital gold". Bitcoin ticks all the boxes of the perfect digital asset: decentralized, permissionless, open source, transparent, traceable, secure, etc. Scalability solutions exist. Should an economic crisis spiral out of control, all these attributes will make Bitcoin the perfect alternative hedge to traditional assets.
Bitcoin miners have had a challenging year. Surfing on the highs of 2021 and the institutionalization of this activity, miners ordered massively new hardware to gain market share. The fall in Bitcoin price and the rise in electricity costs forced them to look for new equity, raise debt, or sell their mined Bitcoin. The weak will vanish, and the strong will rule. We favor miners with realistic expansion plans, low production costs, and a sound balance sheet.
"Not your keys, not your coins"
With all the issues that surfaced this year, adequate storage solutions to hold digital assets have become more critical than ever. The demand for cold storage solutions will remain high. Exchanges that are not domiciled in regulated markets and unable to prove to hold customers' assets on a 1:1 basis must be avoided. Whether all cryptos will be considered securities in the United States could also be a game changer that would eventually benefit traditional exchanges with new business opportunities.
Facing their first existential test
AI-based credit models come with a simple promise. By eliminating human bias and using large and unusual data sets, alternative lenders can either reduce their risk for a constant amount of loans originated or increase their amount of loans originated for a constant level of risk.
Will their promise hold if the economy enters recession? After >10 years of economic growth, AI-based credit models may lack the training of a challenging environment. The recent troubles of Upstart, among the most vocal companies about its superior credit models, tend to prove it.
On the positive side, incumbents will reduce the volume originated in case of a recession. This will be a unique opportunity for challengers to gain additional market share. But betting on the right horse (ideally with a banking license, assets and collateral of high quality, low credit risk, etc.) will be more important than ever, as an increase in defaults from borrowers is more than possible.
Buy now, pay later: regulation is coming
Buy now, pay later, the fastest-growing digital payment method, will have to deal with new regulations (spanning from the U.S. to Australia). Regulation is expected to be similar to the rules applied to credit card companies. This would imply appropriate supervisory examinations, proper disclosures to individuals, the development of credit reporting, etc. But actually, this is a positive development, as it will reduce regulatory uncertainty.
End of the student debt moratorium
Biden wants to fulfill one of his campaign promises: tackling the $1.7tn student debt problem. A forgiveness plan for ~$450bn and impacting >40mn eligible borrowers is in the hands of the Supreme Court. Judges have to decide on the legality of the plan.
Suppose the forgiveness plan gets the green light. In that case, the Biden administration will likely stop the moratorium on all student debt payments and interest initiated due to the Covid-19 pandemic, which has, for the moment, been extended until the end of August. With the end of the moratorium, thousands of American student loans that will not benefit from the forgiveness plan will likely consider refinancing options, an opportunity for specialized alternative lenders.
Make or break
Insurtech challengers have been struggling to convince that their technological superiority is an advantage. Investors only focus on profitability which will still take years to materialize. While challengers are still building their track record, investors need concrete results. 2023 will be the pivotal year to demonstrate whether they can compete with historical leaders – or not.
Challengers must leverage their technology now. AI-based models must yield reduced expense ratios (marketing, support) and loss ratios (fraud, claims). Personalized insurances and pricing have to become the new standard. As challengers expand their product range, cross-selling activities have to increase. The market is large and highly inefficient. As an example, users of Lemonade only spend on the platform 10% of what the average American pays per year on insurance.
Building tomorrow's digital infrastructure
As for the banking sector within the open banking framework, the use of APIs is rising for insurance companies. Third-party developers can leverage the open architecture of modern solutions from software companies like Guidewire or Duck Creek. For instance, APIs are used to improve the time-to-market of new insurance products, provide real-time quotes, or make premiums and claims payments. Lemonade claims to sell 98% of its policies thanks to its suite of APIs, while incumbents still sell 95% of theirs through humans.
Technology to reinvent insurance models
The $260bn auto insurance market is being shaken out! Usage-based insurance, or "pay as you drive", relies on telematics (technology of sending information to control remote objects) to reward people who drive well. The car sends information about the distance traveled, the speeding, or the time of day it is used. The better one drives, the lower the insurance premium one pays.
In need of a consolidation
The risk and compliance functions have become significant actors in the financial industry. While financial institutions globally spend ~$780bn on compliance activities, only a fraction is devoted to technology solutions. Regtech remains composed chiefly of small and private companies that struggle to integrate with banks' legacy systems. A lack of global standards and local financial regulations may partly explain this fact.
More consolidation in the sector is needed for regtech to play its expected role in knowing your customer ("KYC"), anti-money laundering ("AML"), or regulatory reporting. More prominent players would mean financial institutions could contract with a single provider for a comprehensive package.
Proper data governance
Data has become a vital and strategic asset with the digitization of the financial industry. However, not all financial institutions have embraced this reality and lack a proper approach to data governance (storage, management, aggregation, security, destruction, etc.). Financial institutions focus on the clients or the transactions in silos and often lack a proper understanding of the comprehensive data generated by their business activity. The value that can be derived from the data themselves is still untapped. New regtech tools are being developed to improve control over this strategic asset.
The governance debacle of FTX will accelerate the finalization of new regulatory rules for the crypto space. This will bring fantastic opportunities to the regtech industry, as the new regulation is the primary driver of regtech.
The primary compliance functions for traditional financial institutions (like KYC or AML) will have to be widely deployed and adapted to the blockchain ecosystem. Moreover, developing solutions to track and monitor on-chain data will accelerate. Blockchains offer a massive amount of data that needs to be structured to make actual use, e.g., detecting fraudulent behaviors.
Navigating through troubled waters
After years of appreciation, the housing market is slowing down. For instance, in Canada, volume is down by a third, and the average selling price is down 20% from the February peak. Large banks' economists anticipate a 5-10% correction in the United States for 2023. A sluggish real estate market has an impact on proptech companies.
When Sustainable Future meets proptech
Despite the current environment, the long-term drivers behind proptech remain intact. Big data, widely used to automate valuation models, is getting enriched with new data sets related to ESG. With the energy security crisis, sustainability is becoming a key factor, especially in commercial real estate. Tenants will avoid renting spaces in buildings that are not energy efficient and with too high emissions. ESG is having an impact on how real estate valuation models are fed.
Propagating proptech to the Finverse
Metaverses and "Finverses" are made of (usually) limited pieces of land in virtual worlds. Like real estate, these pieces of land, represented by non-fungible tokens (NFTs), can be acquired, developed, leased, or used as collateral. Gaming, advertising, and shopping are among the use cases of these digital worlds. At the time of this writing, the cheapest land on Decentraland costs around ETH 1.3 (or ~$ 1'500). This price has been impacted by the crypto winter. But if tomorrow the number of monthly users goes from a few thousand to millions, then the land price will increase.
These projects are still "experiments", but 2023 could be a year where international brands significantly develop their presence in these worlds (like they did on the social media platforms in the 2000s).
Change in monetary policy. The rise of interest rates has been a killer for the ecosystem. Investor appetite for high-growth stocks will return once we have clear visibility about where and when the Fed will stop raising rates.
Failure of non-listed firms. There are >15’000 private fintech companies. Many of them struggle to reach profitability. Raising funds will be a challenge in 2023. Some will fail, reducing competition pressures on established fintech firms and incumbents.
Bitcoin ETF. We stopped counting the number of ETFs for spot Bitcoins rejected by the SEC. But a favorable decision regarding an ETF backed by Ark and 21Shares listed on the Chicago Board Options Exchange could be released in January. Sufficient to end the crypto winter?
Economic slowdown. Most of the fintech ecosystem was born in the ashes of the global financial crisis of 2007-2008. They have never gone through a recession and will face a first real test.
Complex partnerships. Fintech companies not getting a banking license mostly opt to partner with traditional financial institutions. The Office of the Comptroller of the Currency has difficulties seeing where the bank stops and where the fintech firm starts. More regulation is in sight.
Tether scam. We reiterate, again and again, our concerns around the stablecoin Tether (USDT). We fear a bank run causing a liquidity mismatch, knowing that the protocol holds ~20% of non-cash or T-Bills notes.
Companies mentioned in this article
Adyen (ADYEN); Duck Creek (DCT); FTX (Not listed); GMO Payment (3769); Guidewire (GWRE); Intuit (INTU); Lemonade (LMND); Marqeta (MQ); PayPal (PYPL); Twitter (Not listed); Upstart (UPST); Visa (V)
- Bain & Company
- Ernst & Young
- Fingerprint Cards
- Juniper Research, Virtual cards
- McKinsey, Global Payments
- Simon Kucher, The future of neobanking
This report has been produced by the organizational unit responsible for investment research (Research unit) of atonra Partners and sent to you by the company sales representatives.
As an internationally active company, atonra Partners SA may be subject to a number of provisions in drawing up and distributing its investment research documents. These regulations include the Directives on the Independence of Financial Research issued by the Swiss Bankers Association. Although atonra Partners SA believes that the information provided in this document is based on reliable sources, it cannot assume responsibility for the quality, correctness, timeliness or completeness of the information contained in this report.
The information contained in these publications is exclusively intended for a client base consisting of professionals or qualified investors. It is sent to you by way of information and cannot be divulged to a third party without the prior consent of atonra Partners. While all reasonable effort has been made to ensure that the information contained is not untrue or misleading at the time of publication, no representation is made as to its accuracy or completeness and it should not be relied upon as such.
Past performance is not indicative or a guarantee of future results. Investment losses may occur, and investors could lose some or all of their investment. Any indices cited herein are provided only as examples of general market performance and no index is directly comparable to the past or future performance of the Certificate.
It should not be assumed that the Certificate will invest in any specific securities that comprise any index, nor should it be understood to mean that there is a correlation between the Certificate’s returns and any index returns.
Any material provided to you is intended only for discussion purposes and is not intended as an offer or solicitation with respect to the purchase or sale of any security and should not be relied upon by you in evaluating the merits of investing inany securities.