Peter Misek is a partner at the Business Development Bank of Canada's Venture IT Fund.
The financial system has really had its share of shocks in the past decade. Traditional financial institutions have suffered through bailouts, flameouts and public scorn since the credit crisis. The Occupy Wall Street crowd has been unable to dent the banks in any serious way, but there are more insidious rivals that might: startup financial tech companies.
Fintech is one of the hottest startup subsectors in the technology world right now, with more than $1-billion a week flowing into these startups globally. Fintechs offer traditional financial products, such as payments and loans, but their services are delivered with the help of sophisticated, disruptive software.
With this kind of funding and focus, there are growing fears that they could start to eat the traditional financial institutions' lunches. But do the banks, and their investors, really have anything to worry about?
In the past 12 months, I've looked at more than 100 fintech firms for potential investment as a venture capitalist. It is a fascinating and gruelling process, meeting startup after startup, pitch after pitch. After a while, you start to see certain patterns, and can almost end sentences for keen young entrepreneurs.
So is the threat they pose real? Yes and no.
The biggest pattern emerging is that, with their software, fintech startups often have superior information to traditional financial institutions. These startups have more access to customers' personal information, often in real time. Users are willing to part with this information in order to get free services, better rates or some other kind of utility.
These fintech firms have no trouble giving away something for nothing, whereas traditional financial institutions rarely do free. While some would question the sustainability of free (or "freemium") models, the reality is that the margins on financial products are often so high that 80- to 90-per-cent gross margins are still possible at scale.
As more users link more of their lives to the Internet, the usefulness of a centralized banking system may come into question. Traditional financial institutions will be forced to rethink their value propositions, with significant risks attached to any decision.
That said, the risks for startups are even higher. Will the average consumer trust them with their financial and personal information? Is the value being provided enough to cause people to change their behaviour? Would I let a piece of software see everything I buy or see my bank account to get free coffee? Hell, no. But I'm not the client these firms are targeting.
What else have I seen? A potential bubble in robo-advisers. Some will ask, what is a robo-adviser? One simple example is an app or piece of software that allows any investor to determine appropriate investments and management strategies based on a series of programmed questions.
What's the problem with this situation? Since barriers to entry are relatively low, almost anyone can set one up. But now there are literally hundreds of them, almost all with relatively low asset bases but big promises for growth. The landscape has become confusing to some investors, especially in the United States, and sifting through them all is difficult for venture capitalists.
Without a clear, unique, differentiated and defensible value proposition, most of these startups will fail to scale and ultimately disappear. But that rationalization process is likely to take years, and could surface regulatory issues or concerns if the custodians of these assets aren't stable.
I would still encourage investors to explore robo-advisers, but I would caution them to understand the team behind the technology and ensure that the custodian responsible for holding these securities is a viable and well-capitalized entity that can stand behind your investments.
If you are considering starting a robo-adviser, my advice is to think long and hard about it. Even then, think again, because sooner or later, the capital will dramatically slow down or disappear, leaving the startup – and any uninformed or ill-prepared investors – in the lurch.
So what's working?
New, successful fintech companies are using big data – sophisticated analysis and a very low-cost delivery model – and leveraging the Internet to out-think, out-manoeuvre and out-price the traditional financial institutions in areas where the barriers to entry are higher.
This means these fintech startups' cost structure can be much lower; they can scale quicker and price more efficiently with better information. This makes the rates they charge and the services they offer potentially much more economical.
In payments, startups are using big data to offer merchants who accept credit cards to pay between 1 and 2.9 per cent for each transaction, versus the 2 to 4 per cent charged by the larger banking players. They do this by preventing fraud more effectively, having a lower cost structure and avoiding the embedded system and regulatory costs faced by the traditional financial institutions.
Now, imagine a mortgage or line of credit that analyzes your spending and income patterns to determine not only what you can afford, but what you are very unlikely to default on, and price those products based on near-perfect information.
That means mortgages or lines of credit could be 10- to 50-per-cent cheaper than traditional channels. That is potentially game-changing. The hundreds of startups and the research clearly point to a major disruption.
What's ultimately at stake is how we bank in the future, and who provides us with the products and services we use every day to pay, get paid and consume.
In the near term, market-share and profit erosion are the real risk facing traditional financial institutions. In the long term, the entire system could be upended.
The views expressed are the author's alone.