The 2008 global financial crisis was easily the most destructive economic crisis since the Great Depression. And yet, it's still ironic that without it we wouldn't have a thriving startup ecosystem.
In an attempt to restart the global economy, central banks cut interest rates to near zero, ushering in an era of cheap money.
This gave two relevant results. First, it incentivized investors to fund promising (and, in many cases, not-so-promising) young tech companies. But it also allowed the emergence of business models that, under any other circumstances, would be completely unviable.
To see examples of the latter, you only have to look at the fintech world. Over the past decade, a dizzying array of new banking models, e-money services, digital wallets, and more have achieved a large market share far from regulatory and historical holders.
They achieved this by offering a product that, from the consumer's perspective, was undoubtedly higher.
Consumers were easily swayed by these slick apps, low or non-existent fees, and higher rebates or interest rates. But they didn't think about whether the business fundamentals of these fintechs were sustainable in the long term or whether they could weather a broader change in macroeconomic conditions. It was not necessary.
But now fintechs face a reckoning. Over the past two years, central banks have raised interest rates from their COVID-era lows to the highest levels in a generation. And now the business models that won consumers' affection look increasingly weak.
It is only a matter of time until this house of cards is corrected or collapses.
The Achilles heel of fintech
For countless fintech providers, the main source of revenue comes from interchange fees. These are, essentially, the commissions paid to card issuers, payment networks and schemes and the banks themselves every time a consumer buys something.
Many fintech companies rely on interchange fees to varying degrees, although in each case they represent a significant portion of their revenue. For example, the American neobank Chime made $600 million from exchange fees in 2020 alone. From a consumer perspective, the exchange is completely invisible, although for many fintechs it is a financial lifeline.
Ultimately, fintechs must remember that they are, first and foremost, technology companies.
There are two things you need to know about this point: first, although interchange fees vary depending on the type of card, for example whether it is a debit or credit card, and the jurisdiction where the payment was made, they are limited to a percentage fixed transaction price.
The second point is that interest rates, by their very definition, are not. They are set by central banks and the percentage rate is mainly influenced by external economic conditions. When times are tough, like a recession or a once-in-a-lifetime pandemic, they decline to stimulate spending and bolster consumer confidence. When inflation rises, so do interest rates, as central banks try to slow down economic activity (and therefore demand).
This alone presents a serious dilemma for fintechs that rely wholly or primarily on interchange fees. While your earning potential is limited to a fixed percentage of your customers' purchasing activity, your borrowing costs can get dangerously out of control.
This problem is further exacerbated by the fact that, in many cases, these fintechs do not keep the interchange fees. As we've seen over the last decade, one of the most valuable barometers of a startup's future prospects is its customer acquisition rate, and the easiest way to take advantage of this metric is to offer generous rebates or interest rates.
And so, to stay with the lights on, they are burning through their resources or seeking financing through equity or debt deals. But resources do not last forever, and as the overall macroeconomic situation worsens, additional financing has become more difficult to obtain and is likely to be smaller or on less advantageous terms.
Lack of flexibility
It is worth noting that this crisis is shared almost exclusively by fintech startups and not, as perhaps one might expect, by standard market financial institutions. One reason, although small, is that these companies do not have the same pressing need to acquire new customers. A bank with a hundred-year legacy does not have to rely on records to demonstrate its long-term viability as a business.
But the biggest advantage these pre-entities enjoy is the fact that, as companies, they are incredibly diversified. Time has allowed them to offer a wide range of services, from loans and insurance to credit cards and mortgages. This diversification offers a degree of insulation from changes in interest rates and is why the notoriously top-heavy traditional financial sector will hold up for years to come.
In addition, banks have traditionally enjoyed the cheapest forms of financing, because they store and hold deposits, and often pay interest rates to their customers much lower than those set by central banks.
By contrast, most fintech startups that have challenged the traditional market lack that degree of product diversity. They may rely solely on interchange fees for revenue or, if they have alternative products, they have not yet reached any level of critical mass or adoption. Often this is because they have not yet registered and regulated, or have voluntarily chosen to focus on a particular segment of the market.
In the United States, a prominent driver of fintechs, banks are the only institutions that can retain depositors' funds. They have more freedom in the types of products they can offer and therefore have greater opportunities for diversification. But the formal process to become a bank is long, tedious and expensive, and it is harder every time. For fintechs, it is simply not worth the effort or, rather, it is a problem they must overcome by partnering with a bank close to the fintech movement.
Becoming a bank also comes with some serious disadvantages. It involves a high degree of supervision, which many startups may find too much to bear. And what happens if a fintech changes its mind? Then things get complicated.
Giving up a banking charter is a logistical nightmare and carries a degree of stigma, as it is often the result of some form of fracaso or misconduct. That's not to say it doesn't happen or that there aren't legitimate (and even strategically sound) reasons to do it. Utah-based Marlin Bank gave up its state charter to merge with a larger investment fund. But these divorces (for lack of a better term) are never easy. There's the thorny issue of what to do with customer accounts or products you can no longer sell or manage. The transition requires time, effort and money.
A difficult road ahead
The original sin of many startups (including, but not limited to, fintech companies) is believing that the rosy macroeconomic conditions of the 2010s would continue indefinitely. That inflation and interest rates will stay low forever and that they will never run out of affordable, easily accessible capital.
That there would be no pandemic or war in Ukraine. Nothing that could shake the foundations of their businesses.
For many companies, this myopia will be their downfall. They have locked themselves in, either by offering a limited line of products or by offering incentives that their customers will be reluctant to give up. This is especially true for those companies in the corporate card market that rely primarily on interchange fees but give most or all of their revenue to customers in the form of rebates and interest rates.
This fear is shared by McKinsey, which, in its Global Payments Report 2022 where he warned about the impact of rising interest rates and fixed interchange fees on fintechs, noting that the business models of many fintech startups (particularly companies in the buy now, pay later, BNPL sector) still have to demonstrate its viability in such turbulent macroeconomic conditions.
One thing is clear: persistently high inflation rates are not a temporary problem, as once thought, but something that will be with us for a long time.. This means we are unlikely to see low rates at central banks for several years, the secret sauce that allowed these fundamentally precarious business models to last so long. The fintechs that survive this period will be those that adapt, whether by making difficult decisions about the incentives they offer customers or expanding their product portfolio.
They can achieve this without fundamentally undermining their value propositions. As some of the most successful fintech companies demonstrate, the best way to drive volume is to offer a customer experience that is unequivocally better than traditional alternatives.
Ultimately, fintechs must remember that they are, first and foremost, technology companies. And the way to win is to create powerful, solid and relevant software and experience.
Good software gives consumers a reason to pay instead of using a free alternative. Unlock new revenue models beyond relying on interchange fees or other commission-based payments. By thinking of your business as one that tries to identify and solve problems, rather than focusing on customer acquisition and transaction volumes, it becomes much easier to identify new opportunities, whether they are new features to distinguish your business from the competition or new products that can increase sales to existing customers.
Crucially, by treating software as a first-class citizen, fintechs can license their software to other organizations, unlocking an additional revenue stream. If the biggest threat to existing fintech companies is an over-reliance on interchange fees, the easiest way to achieve resilience is to aggressively pursue diversification.
This is not an inherently novel concept. For example, Microsoft makes money from various sources: operating systems, office software, cloud computing, game consoles, and laptops. The same could be said for Google, Apple, Amazon and many others. Although the highly regulated nature of the financial services sector makes expansion a complicated and often bureaucratic process, it is by no means impossible.
Obviously, it takes time to build new features and unlock additional revenue models. Great software, truly great software, requires talent, money, and a roadmap that extends beyond a single quarter. For many organizations, achieving this sustainability is a long-term ambition. But it's worth remembering that we're still in a difficult macroeconomic environment and that profitability is no longer a dirty word for investors, or at least secondary to growth.
Demonstrating that you are serious about long-term sustainability and have a path to profitability will go a long way in the next funding round.
Finally, it is important to consider whether the incentives still on offer make sense, given the turmoil seen in the financial services sector. The year 2023 has already witnessed three major bank failures and the collapse or acquisition of countless smaller suppliers. Given the current dismay, stability and, most importantly, the ability to project an image of stability, diversification can be a useful marketing tool.
