Banks and fintechs need to converge, or crumble

PAYPAL'S US$2.7 billion acquisition of Japan's Paidy, which offers "buy now, pay later" services to online shoppers, is just the latest example of big money being invested in bringing financial services to consumers via the platforms where they spend their digital lives.

But this dynamic also throws up some difficult questions. Who is going to provide the payments, credit, investment and other products? How will they make money? And how will consumers be protected?

Judging by the headlines - and valuations - fintechs and blockchain-based decentralised finance players are stealing away the future of finance from banks. The regulatory system continues to be built around established banks, though, and they remain profitable - unlike many fintechs. If financial services are going to balance inclusion, innovation, user experience, profitability and consumer protection, these apparent competitors will need to converge - or else they will crumble.

SHOW ME THE MONEY

Fintechs' slick user experience and free or low-cost services have enabled them to capture market share and command impressive valuations. Revolut, the UK-based European neobank recently closed an investment round that values it at US$33 billion - up six times in little more than a year. Klarna, a Swedish buy-now pay-later online payments firm, is worth even more at almost US$46 billion, up from US$5.5 billion in August 2019. US-based Chime, an eight-year-old neobank, is reportedly nearing an initial public offering (IPO) that could value it at US$30 billion, double its valuation in a 2020 fundraising.

Compare that to traditional banks that must work with legacy IT systems and are often subject to analogue-era regulation. Even star performer JP Morgan can only show a 230 per cent jump in valuation over the last five years - not bad at all, but a far cry from the racy fintech gains.

The Economist said that the fintech industry is now valued at US$1.1 trillion, equivalent to 10 per cent of the value of the global banking and payments industry, and up from 4 per cent in 2018.

But while it seems investors expect fintechs to run away with the prize, matters are more complicated than their heady valuations suggest. Many virtual banks and some of the biggest fintechs - including Revolut and Klarna - don't turn a profit. Revolut's operating losses topped £200 million (S$369 million) in 2020, while Klarna reported a pre-tax loss of US$92 million in the first quarter of 2021.

Fintechs have proven an ability to build large user bases by offering free or low-cost digital payments. This gives them market share and user data, but doesn't always make money in its own right. When fintechs have bundled other, more profitable products into their platforms - as Ant Financial did in China - regulators have become concerned that they are effectively becoming banks, asset managers or insurers while benefiting from lighter supervision, creating systemic risk.

Banks, meanwhile, continue to turn a respectable profit and many are accelerating their investment in digital transformation. Research by JP Morgan showed that banks like Citi, BNP Paribas, Santander, BNY Mellon and Societe Generale spend 20 per cent or more of their operating costs on IT, versus 12 per cent for Amazon and 20 per cent for Alphabet.

Big finance is also investing in its potential disruptors. In just the past two months, JP Morgan has bought UK wealth manager Nutmeg and sustainability-focused Californian startup OpenInvest, while Visa has acquired Swedish payments platform Tink for US$2.9 billion.

Many of today's biggest fintech unicorns aim to streamline, rather than reinvent, existing financial infrastructure. But there is also a new generation of blockchain-based decentralised financial projects with the potential to upend the way that finance has always been delivered, recreating traditional financial products but enabling users to transact directly with each other and reduce costs.

These "DeFi" projects are also attracting growing amounts of funding. Venture capital investment in the market is accelerating and public markets are getting in on the action, too. Bullish Global, which plans to operate a decentralised market for digital assets and has been valued at US$9 billion, will list via a combination with a special purpose acquisition company (SPAC). DeFi may be the new kid on the block, but it's gaining momentum fast.

WHEN THREE BECOME ONE

The truth is that we need all three components: banks, fintechs and DeFi. Drawing on their respective strengths is how we build a modern financial system that gives customers what they want on the platforms that they actually use, protects consumers and expands financial inclusion.

Users expect the slick interfaces and smart data-driven products offered by fintechs. Economies need the stability and consumer protection that exist when regulated institutions provide financial services, drawing on their strengths in product development and risk management. And all parties can benefit from the efficiency of blockchain and decentralisation - particularly as central bank digital currencies catch on.

The future, then, is hybrid. It will involve the combination of banks, fintechs and DeFi. It would be logical for banks to lead this dance; they have the financial resources and operational nous to acquire and integrate fintechs as well as DeFi projects. Indeed, they are already doing so. But the soaring valuations of fintechs and - in time - some DeFi players, could give them the ammunition to make inroads into traditional finance too. Circle's ambitions to become a "national digital currency bank" in the US is an early example of this.

Whoever takes the first step, governments will be called upon to update their approach. Give and take will be required. Financial regulators will need to accelerate the development of regimes that allow banks to offer user experiences that can compete with fintechs. At the same time, fintechs and DeFi must embrace regulation, accepting that there is no route to the mainstream - and profitability - without it.

Forging new combinations can allow safety, convenience, inclusion and reduced cost to come together in business models that can create value and make money. It's going to require regulators to be bold, but it's the only way forward. For banks, fintechs and blockchain ventures alike, the choice will ultimately be to converge or crumble.

• The writer is CEO & co-founder of Episode Six