a16z Podcast - Every Company Is a Fintech Company

Episode Date: July 7, 2020

"Why Every Company Will Be a Fintech Company -- The Next Era of Financial Services and the 'AWS Phase' for Fintech" by Angela Strange.You can also find and share this essay at a16z.com/fintecheverywhere  

Why every company will become a fintech company, the next era of financial services, and the AWS phase for fintech by Angela Strange. You can also find and share this essay at A6.Z.com slash fintech everywhere. There are two banking systems in the world today. One for people with money or good credit, and another for people without. But neither of these systems work well. People with money have gotten used to clunky user experiences and low expectations. for everyone else, and that's most Americans and billions more worldwide, banks don't serve them well or sometimes at all. Not only that, but the current system actually extracts from the very people who need financial services the most. The poorer you are, the fewer options you have, and the more you will pay. The system is clearly broken. No one has been able to fix it

despite many attempts to do so. Big financial institutions already spend billions of dollars a year simply to maintain the existing systems and comply with regulations, leaving little room for new product development. Meanwhile, compliance regulations and infrastructure complexity make it challenging for new companies to even afford to enter the market. But what if software could address these hard structural problems, enabling even non-fintech companies to provide financial services for their customers? What if, as a result, people didn't just put up with, but actually loved their banks? now, despite how often people use financial services, few would list their bank as a beloved brand among their daily products. But the next bank does not have to start out as a bank.

I believe the next era of financial services will come from seemingly unexpected places. Just as Amazon Web Services dramatically lowered the cost and complexity of launching a software business, unleashing thousands of new companies, the AWS phase for FinTech has arrived in banking. Before AWS, it could cost upwards of sales. several hundred thousand dollars a month to run a business just for compute and storage. It now costs roughly a tenth of that. In much the same way, we are nearing the point at which any company can start or enable financial services.

Consumer apps across multiple categories, home screen fixtures highly valued by users, are becoming banks. It's not as crazy as it might sound. Many drivers already consider Lyft and Uber their de facto bank. These ride-sharing companies didn't even exist a decade ago. nothing happens for years and then when things change they change suddenly how did we get here why couldn't all this happen through incremental improvements to the current system and why haven't more startups been able to scale to fully understand why we're seeing such a dramatic change

it's worth unpacking how we got here in the first place the popular narrative for why it's expensive to be poor is that large banks are to blame for high fees and lack of product innovation And to some extent, that's true. But classic financial services institutions also face structural problems due to legacy tech and a burden of a large physical footprint. Banks have been under pressure for some time, especially as consumers have moved online. Most of these institutions have existed for decades, or centuries in some cases, by acquiring customers in physical branches.

The banks then own that person's full financial life cycle, from the first checking account, the first credit card, first brokerage account, first mortgage, and so on. But in the age of e-commerce, banks no longer have that same relationship with their customers. Instead, consumers can choose their financial services from several different providers online. Then the financial crisis hit. Well-intended regulations such as the Durbin Amendment, part of Don Frank, limited transaction fees on debit swipes. The theory being that if merchants paid less in interchange, they would pass that savings onto consumers in the form of lower prices. These regulations were meant to help merchants and to spur economic activity, but they significantly

reduced revenue for large banks. Some estimated a revenue drop of over $6 billion a year. No small hit to absorb no matter your size. So to make up for these losses, many banks banished free checking, increased minimum balances, and raised overdraft fees. Ironically, the Durbin Amendment had an adverse effect on the consumers it was intended to help. For banks, banks, raising fees was much easier and faster than lowering the hard, fixed cost of physical branches and associated staff. On top of that, existing software infrastructure can seem like a bottomless money pit. Banks keep incrementally adding and patching fixes for new compliance rules on top of older, harder to change systems, leading to a tangled spaghetti-like mess

of software. At some of the larger banks, 75% of the IT budget goes just towards maintenance. And then beyond software, there's a large manual labor force. 10 to 15% of the workforce of larger banks can be devoted solely to compliance. Citigroup alone had 30,000 of its over 200,000 employees working in compliance last year, largely devoted to tasks like manually reviewing alerts triggered by the anti-money laundering or AML systems and filing suspicious activity reports. Many of these maintenance and compliance costs are passed along to consumers in the form of higher fees. And those costs leave little room in the budget for innovation.

In other industries, startups could typically come in with fresh approaches and better technology. But in financial services, getting a fintech company going under the current conditions is hard, requiring multiple partnerships, entrenched financial industry insider knowledge, and often establish connections in capital. Here's what it would take to launch a new bank that offers just two basic financial services products, checking account and a debit card. The new bank obviously needs to comply with regulation. In the U.S., this is most often achieved by finding a sponsoring bank partner. This tactic is much faster and has a higher likelihood of success than applying for a license. A regulated bank agrees to lend the new bank is license in exchange for a financial

cut of whatever the new bank is offering. Typically, that means the sponsoring bank gets more deposits without having to pay to acquire those customers. But for a startup, finding the right sponsor bank partner is difficult. There's no directory of these banks to identify potential partners and contacts. And while sponsoring bank does get the benefit of more business, i.e. more deposits, it also carries additional risk. It must ensure that the startup properly complies with KYC, know your customer, AML, anti-money laundering, and so are. So given this risk, when approached by a potential fintech startup, how does a bank thought, thoughtfully and efficiently evaluate a startup partner. After a startup decides to partner,

there's still more time and effort involved to build out the rest of the product. There needs to be a card processor, more negotiation, more costs, a card issuer, a relationship with a card network like Visa or MasterCard, a card printer, more back and forth, some way to hook into the bank accounts for data, a way for consumers to make payments, vendors to help with compliance, and so on and so on. Under this system, it's hard for existing banks to get better. It's hard for new banks to get started, and it's even hard for them to partner with each other, even when the incentives are aligned. There has got to be a better way. Today, technology allows innovative new companies to be created and enables existing banks to better serve the needs

of customers. Specifically, this is happening through one, new financial services infrastructure company providing APIs. Two, new distribution channels that enable better differentiated products to spread more easily and at a lower customer acquisition cost. And finally, three, better data that allows companies to assess and assign risk more precisely. First, the infrastructure. We are at the beginning of a growing ecosystem of banking infrastructure companies, an API economy that both startups and incumbents can draw on. These Lego-like companies specialize in building and providing specific building blocks for banking,

for instance, KYC-AML compliance. By providing APIs to their services, these companies democratize their expertise. This means that any one company doesn't have to know every single thing there is to know about complex regulations. Another company that specializes in that area has created an API for others to use. It also means that it's easier to create new financial services companies of all sizes and all kinds. Rather than having to build or maintain regulatory systems themselves, they can just plug in to that expertise. Not only your new entrance using the software infrastructure to get started faster and more cheaply, incumbents are beginning to augment or even replace some of their legacy systems. Instead of

going the way of other brick and mortar retailers, many of which either went out of business or became glorified showrooms for e-commerce. The beauty of the API economy for banking is that it lets everyone participate, play to their strengths, and concentrate on their core offering. The demand for better and more inclusive financial services is big enough that there's room for many players in the market to succeed as large, standalone companies. All of this results in better products at less cost serving a wider range of consumers. This also means that almost any company can offer banking services, whereas existing consumer services used to have only two options to monetize, either charge for the product or sell advertising. Now, companies can layer on financial products.

What if your ride-sharing app became your bank, and you can pay for goods as frictionlessly as you hop in a car? What if your favorite gaming company or streaming service or consumer product becomes a beloved financial services company thanks to tech? Or what if your toothbrush company could offer you dental insurance? Seem far-fetched? It's not. The thing that excites me most about this future is that it can unlock new services for banking the underbanked, built by entrepreneurs who come from the very communities they are trying to serve, whether geographically or through personal experience. The people who understand the problems in their communities will likely build better products to serve them. Who better to build banking services for those on food stamps than entrepreneurs

who grew up on food stamps? The key is that today, better products can spread more easily and cheaply thanks to new distribution channels, like messaging, social media, as well through non-fintech brands you already use, resulting in lower customer acquisition costs. a product that is exponentially better than a status quo could spread by referral, creating an organic growth cost advantage for the company. If the company doesn't have a high fixed cost structure, then they don't have to recoup their costs through high fees, thus expanding the range of customers that it can serve. Luckily, the bug that limits better service in the legacy system, in which banks are incentivized to recoup their customer acquisition investment

through higher fees, becomes a feature for newer companies, which have low, cost structures and more efficient distribution strategies. Great technology shifts aren't just about fixing existing problems, though. They're also about opening access to help more people. This is where data is the last piece of the puzzle. Through sophisticated data science and machine learning, we can now unlock more data sources to better assess risk for people who lack sufficient data or a credit invisible in the current system. Today, almost 80 million Americans have credit score is below 680, the point at which rates can dramatically increase or sometimes credit can be less available, and 53 million don't have enough data to even generate a FICO score.

Most banks will assume that those people are high risk and charge them higher interest race or not serve them at all by default. Yet we're swimming in much more and far superior data than when those credit assessment systems were invented. Data science and machine learning can also help us understand the best thing. for determining one's willingness and ability to pay. New experiments in assessing creditworthiness, such as monitoring rent and cell phone payments,

as well as cash flow underwriting, have been promising. Globally, companies are using even more creative data types to effectively predict loan repayment, such as how up-to-date is your smartphone operating system, the number of friends you message with regularly, and even whether or not you fully charge your phone at night. People who were previously hard to gauge now become new customers. When more people have access to fair credit, income inequality declines, sparing opportunity

and economic growth. Such data shifts affect not only how money flows around debt, but around income too. What if people could get paid sooner instead of having to wait two weeks? Reliable workers, whether salaried or hourly, who are falling short on cash before payday, should be able to get access to their earnings for work they've already completed. With data, we know where you've worked, what you've already earned, and can offer this service. The current model disproportionately punishes the poor. A shortfall before payday means they have to engage with more sometimes pernicious payday lenders. Some states try to solve this problem by using lending caps to discourage payday lending at usurious rates. But the unintended outcome is that people who need it the most now have access to nothing. It's another example of good intentions misapplied. But software can flow around the hard limits of legacy models better. aligning intentions and desired results. So where does this leave us today? The first wave of fintech companies 10 years ago proved that physical locations aren't a requirement for banking.

The next wave is unlocking the rest of the infrastructure required to build a better financial services system, banking licenses, payment processors, regulatory compliance, and so on. Previously, companies would have had to painstakingly acquire or partner, both slow and expensive, Build from the ground up, also slow and expensive, and figure out a patchwork of compliance in IT, very slow and expensive. New financial services companies now can leverage best-of-breed infrastructure, creating differentiated products to help lower customer acquisition costs drawn better data sources to serve many, many more people. Software not only lets us bypass hard structural problems, it lets us build entirely new kinds of companies and services. All of this to say is

fintech is eating the world. The banking system today favors the privileged, while large swaths of the population have no options at all. Technology lets financial services players of all kinds innovate beyond the constraints of the existing system to better reflect the world we live in. Instead of chipping away at deeply ingrained inefficiencies, we can use its very structural limits to build new kinds of companies from the ground up. We can do better than a two-tiered system. It shouldn't be expensive to be poor. And as more people enter the economy by getting plugged into better financial services, everyone wins.