Disrupting Financial Services

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Is traditional banking as we know it over?

While the small but fast-growing army of start-ups isn’t yet a significant threat to financial services institutions, there’s little doubt that it will forever change the nature of banking.

Google Wallet, which enables users to send money using Gmail to friends and family in the U.S., and Dwolla, which replaces “hidden” bank transaction charges with low, flat fees, are gaining traction with consumers. So are a growing number of consumer mobile payments services such as Square, iZettle, Stripe, mPowa, SumUp, payleven and others which target small and medium-sized businesses. Cross-border payments companies such as Index-backed TransferWise, a peer-to-peer service that allows people to transfer money more cheaply; B2B international transfer services like The Currency Cloud and Earthport; as well as direct debit processor GoCardless, which enables smaller merchants to set up interbank transfers for customers, are also disrupting the market.

Meanwhile, following the financial crisis, banks have retreated from the unsecured loans market and requirements that they hold more capital against riskier forms of lending. Peer-to-peer lending platforms have filled the gap. But they don’t have to be competitors.

The message to banks is “partner with us,” says Lending Club’s Renaud Laplanche. “We have proven we can originate loans at a lower cost than the banks. The banks should benefit from it and become investors in our platform and capture the extra spread.”

Even the staid worlds of wealth management and insurance are being impacted by Big Data plays. Index-backed Novus, a portfolio analytics company founded by technologists and data scientists, enables top hedge funds, pensions and other institutional investors generate higher returns. And Addepar, co-founded by Silicon Valley serial entrepreneur-turned-VC Joe Lonsdale, a scheduled speaker at Web Summit, is building a digital platform to make private wealth management more efficient.

Against this backdrop financial institutions are starting to piggy-back on start-up innovation to counter the threat to their future market share.

“The model of the market used to be hierarchical so the payments systems were part of the hierarchy — they were like building blocks and owned by the same people: the banks,” says economist and technologist JP Rangaswami, chief scientist at Salesforce.com and a scheduled speaker at Web Summit.  “But now there are new entrants in their market, doing things [the banks] used to do, faster, cheaper, better. Before our eyes the hierarchy is morphing slowly into a much more adaptive ecosystem, into a network of small pieces, loosely joined, and not all those pieces will be [controlled by the banks]. The way you deliver a service now is not by full vertical integration, but by the right partnerships and alliances — and we’ve only seen the beginning of that trend.”

As Square, PayPal and other U.S. companies gear up to expand internationally, iZettle, which has launched in nine markets, including Brazil, announced in February, a strategic investment of €5 million ($6.6 million) from Banco Santander, the leading bank in the Eurozone by market cap and the largest financial group in Spain and Latin America.

The deal enables self-employed professionals and small merchants to accept card payments via smartphones and tablets using iZettle’s Chip & PIN reader. For Banco Santander the interest is clear: in Spain alone there are more than one million self-employed professionals and micro-companies that need an option that is more flexible than conventional card terminals.

Others have announced similar arrangements. In October 2012, UK-based mobile payments firm mPowa signed a deal to supply its devices and payments infrastructure to First National Bank in South Africa. It has also signed an agreement with Portugal Telecom. mPowa’s CEO Dan Wagner says further, similar deals will follow. “We’re in negotiations with many banks and telcos around the world right now and we have plenty of opportunities that are under negotiation globally,” he reveals. Meanwhile, another Square competitor, SumUp, which enables merchants to take debit and credit card payments with their smartphones or tablets, announced a Series B investment round led by American Express and Groupon in May. That was followed by news, in July, that BBVA, which provides financial services in more 30 countries, had also invested in SumUp to help the company’s planned rollout into South America.

Such alliances are part of a growing trend: banks are realizing that they can’t do it all and if they are to retain the millennium generation as future customers they will have to partner with nimbler start-ups to develop services that are attractive to digital natives.

It’s taken start-ups to shake up the industry because banks have plainly had no incentive to disrupt themselves, says Tyler Sosin, a London-based associate with venture capital firm Accel Partners. Sosin works closely with the GoCardless team, in which Accel led a $1.5 million investment round last year. “It’s one of these innovator dilemma issues: why would you disrupt an existing business model that’s worked so well for you?” he asks. “The new players in the space, who don’t have the fixed costs of the banks, can come in and offer something that’s focused on one area and be able to provide much better value.”

iZettle’s CEO Jacob de Geer (pictured on Informilo’s home page) says that while banks have been very effective at servicing mid-tier and larger companies with payment solutions, they have been rather less adept at finding ways to reach merchants and more mobile small businesses. “That’s where companies like iZettle are really disruptive,” he says. “We can reach out to these smaller companies. There are still 20 million companies across Europe which still don’t accept card payments, and typically they account for 20%-30% of GDP of any given market. Then if you look at a market like Mexico, you can see almost all companies are SMEs and they account for about 70% of all employment, so they are very significant, but very hard and expensive to reach for a traditional bank, given their set-up and sales methods.

“So why this cooperation is so exciting for Santander, and us, is being able to reach out to a totally new target group in a very cost-efficient way,” he says. “It’s also a fantastic way for them to leverage their installed base of issued cards in the markets. The infrastructure’s already there and they can boost their revenue by bringing more acceptance devices to the markets.” The next step will be for payment providers to start offering value-added services based on customer analytics.

Legacy businesses, such as banks and telcos, find it hard to innovate and develop such services, argues de Geer. “[Innovation] is not really in their DNA,” he claims. “It’s extremely hard to innovate from within an organization. The payments industry right now is being disrupted from many angles. Every part and aspect of banking will be challenged in the next few years; just look at what [online social trading and investment network] eToro’s done for trading — it gives a pretty good indication of what’s to come in banking services. So the combination of the incumbent and innovator is extremely dynamic.”

Another underlying reason for banks partnering with start-ups is speed. In an age of disruption, says mPowa’s Wagner, first-mover advantage is critical. “[Banks] recognize that market entrants could come into their space and capture a large chunk of customers before they’ve had a chance to get their act together. That gives an opportunity to new market entrants like us, who are providing a service to them, to say you don’t need to build this yourself, we’ll build it for you. In fact we’ve already built it for you, we just need to integrate it into your … infrastructure and then you’re off to the races.”

FX companies are also forging strategic partnerships with banks. The Currency Cloud, for example, has already done deals with Fidor and Sofort banks in Germany and CEO Mike Laven says the company is currently in discussions with three other medium-sized European banks. “Our thesis is that in the cross-border payments area, people pay too much and it’s too difficult. Our intention is to make it easier and cheaper and if we can help a bank to do that instead, then in some ways we’ve achieved our purpose as well.”

Start-ups are clearly benefiting from pent-up demand from corporates and individuals alike. “Today’s tech-literate customers expect transparency, multi-channel access and specially-tailored rates. Businesses that cannot offer those services — whether taking or accepting payments, extending loans, or providing insurance or wealth management products — are doomed to lag behind and eventually fail,” Jan Hammer, a partner at Index Ventures, argues in a blog. “Against a backdrop of such far-reaching upheaval, two things are certain: no aspect of financial services will be immune. And this is just the start.”

Jennifer L. Schenker contributed reporting to this story.

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