June 2016

No large respectable financial institution seems to not have Fintech ambitions these days, as the Fintech craze sweeps an otherwise conservative industry. In the global information age, where information and trends spread at a greater pace than ever before, a certain level of herd mentality is hardly surprising. However, the current intensity of Fintech makes you wonder whether it is a temporary trend that will fizzle out after a while or indeed a revolution of the financial services sector. 


We believe it is the latter for the reasons explained in this article. 



Why now?

Although the causes of the global financial crisis were many and complex, including macro-economic trends, the crisis undeniably had its roots in, and greatest impact on, the financial industry. Arguably, the image and self-perception of the financial sector has not fully recovered from the crisis, and this may be one of the drivers behind the Fintech movement. By teaming up with the technological and entrepreneurial community known for its youth, energy and innovation, the financial sector in general and banks in particular are hoping to change public perception. But Fintech is not just driven by the desire of banks and other financial institutions to improve their image. 

In the aftermath of the financial crisis, many banks have struggled to regain the revenues and earnings of previous days. Their business model is under pressure. As banks have been less willing to lend money to, for example, the SME sector and projects with a higher or more unusual risk profile, other players such as lending funds, insurance companies and pension funds offering direct lending as well as crowdfunding platforms have moved swiftly into this space, while new disruptors are looking to gain further momentum by challenging the core business of banks. At the same time, technological development has caused banks to shut down branches which has limited the interaction between the bank and its customers, thus weakening customers' loyalty to banks. To exacerbate the issue for banks in adapting to a new and more technology-driven economy and consumer pattern, their IT-systems often suffer from significant legacy issues.

Further, it is important to bear in mind the rapid changes in consumer behaviour that we are currently witnessing and have witnessed over the last decade. By way of example, it took eight years before 1 million Danes used internet banking, but only 18 months and 6 months for the same number of Danes to use mobile banking and MobilePay (a Danish app for mobile money transfers), respectively. Such an adaptability to new behavioural patterns indicates that, if the right idea emerges, Fintech could potentially quite rapidly disrupt the traditional banking model.

The new technological opportunities obviously serve as a contributing factor for the rather sudden rise in Fintech projects. The development and maturity of cloud computing and big data etc. forms the technological basis for Fintech.   

The concept of the sharing economy is not new, but a wave of initiatives within this space seems to have taken off in recent years. Initially, such initiatives were confined to non-financial services such as Uber, Airbnb, car2go, DoorDash etc. However, the combination of a trend towards increased activity in the sharing economy and a need to rethink the offerings of the financial sector, particularly in respect of consumers after the financial crisis, meant that conditions were perfect for Fintech to emerge and develop as a driver of change in the financial sector.


Perspective

It is important, though, to keep a sense of perspective. 

There is a mixed basket of players present in the Fintech space. The disruptive start-ups create a great deal of stir when successful, but in reality, established players such as banks, payment service providers and insurance companies spend significantly more money and resources than the start-ups.

As illustrated below, the impact of Fintech on the traditional banking market is still quite limited. 
 


In a recently published report on marketplace lending, Deloitte concludes that peer-to-peer lending platforms "…do not have a sufficiently material source of competitive advantage to threaten banks' mainstream retail and commercial lending and deposit-gathering businesses".1 

The report goes on to say "…that banks will have a structural cost advantage over MLPs [i.e. peer-to-peer lenders] if and when the credit environment normalises".

The report offers a refreshing alternative view on the impact of Fintech on the banking sector going forward.

That being said, Fintech's share of the total banking market is increasing, especially in Asia Pacific, as illustrated below:
 



Traditional players vs. start-ups?

The traditional financial institutions have significant advantages over many of the Fintech companies, particularly start-ups. Obviously, they have the manpower and financial resources to invest in Fintech. 

Further, the traditional financial institutions have a large pool of customers and if they are able to activate them and offer appealing new services that meet their changed needs, the prospects for these institutions are promising. Given the size of their customer pool, the existing financial institutions have access to big data which can be used to create exciting new products and services offerings. 

While the above description of the differences between the traditional financial institutions and the upcoming Fintech start-ups may serve as an explanation of why Fintech has suddenly taken off, we think it is important not to perceive Fintech as the battleground for the incumbent financial institutions and the challengers (disruptors) in the form of start-ups. The Fintech movement is about innovation by way of collaboration and partnerships. There is an acknowledgement that in order to meet the future needs of customers, companies offering financial services and products must have a more open approach compared to the more proprietary approach of past times.


What are the initiatives?

When investing in Fintech, financial institutions often pursue multiple parallel strategies such as (i) acquiring or investing in external, independent Fintech start-ups, (ii) creating their own internal Fintech labs or autonomous innovative Fintech units, and/or (iii) partnering with Fintech companies or other established service providers on Fintech initiatives, etc.

Currently, the main frontier of the battle for global supremacy in Fintech is the payment services industry. Long a relatively conservative industry without much innovation or focus from the banks, the scale of a successful payment services business in itself makes it lucrative for banks or other payment service providers. The SEPA and EU harmonisation of the regulatory framework for payment service providers has worked as a catalyst of this development. Non-financial services companies such as Apple, Samsung, Amazon and AliPay have made a push to develop alternative payment platforms through which a sizeable and rapidly growing number of payment transactions are processed.

Besides payment services, banks are also being challenged in other parts of their core business. Niche banks are trying to set up shop with a new and more focused value proposition free from the IT legacy issues of the more established players, especially within the SME sector where the more established players have often found it difficult to make money from their customers. 

Examples are vast, but a few should be mentioned. “OnDeck”, for instance, provides SME owners in the US, Canada and Australia with an alternative to banks when it comes to lending. They provide a specially developed method to evaluate a potential customer's creditworthiness enabling the SME owners to process loans within a day – by comparison, banks can take weeks to make such a decision. Another example is ”Udenombanken”, a peer-to-peer platform for mortgage lending where professional investors are bidding to provide a mortgage instead of the customer using a traditional bank or mortgage credit institution.

And it's not just the banking and payment services sector: technological advancements have also started to try to disrupt the insurance business (known as Insurtech). In 2014, Insurtech received less than $800 million in funding, a figure that more than tripled in 2015, when insurance tech start-ups received around $2.6 billion in funding. One example is ZhongAn (ranked #1 in KPMG's Fintech 100 innovators list for 2015), an innovative online property insurance company, which uses big data technology to assist with product design, automatic underwriting, auto claims, precision marketing and risk management. The company, a joint venture involving, among others, the Alibaba Group Holding, is the first in China to be issued an internet (online) insurance license.2 Another example is Oscar Health Insurance’s (ranked #2 in KPMG's Fintech 100 innovators list for 2015) partnership with Misfit, where biometric information sent from a wearable device makes it possible to reward fit customers on their health insurance3


A global phenomenon

Fintech is a global phenomenon, but it is hardly surprising that the majority of Fintech investment is currently focused on North America, although investment in both Asia-Pacific and Europe is gaining traction. 

 
Source: Indian Association of Investment Professionals



Copenhagen as Nordic Fintech hub

Denmark is generally perceived as a country with a high technology penetration ratio, and is, together with the other Nordic countries, among the countries moving fastest towards a cashless society. So it is hardly surprising that Copenhagen has set the ambitious goal of becoming the Nordic Fintech hub. In pursuit of this goal, the city, the Danish Bankers' Association and many industry participants have joined forces to sponsor, host and participate in a number of events focused on Fintech. The Danish Bankers' Association is also the initiator behind the non-profit organisation Copenhagen Fintech Innovation and Research (CFIR) as well as the "Copenhagen Fintech Hub", a Fintech lab established at the offices of the Financial Services Union Denmark (the union for employees in the financial sector). The purpose of "Copenhagen Fintech Hub" is to offer start-ups within the Fintech industry office space at a minimal rate in an environment with kindred spirits from whom they can get inspiration, critical feedback, etc. 

The report ”Copenhagen as a Nordic Fintech Hub” - prepared at the initiative of, and sponsored by, the City of Copenhagen, the Financial Services Union Denmark, the Danish Bankers Association, CFIR, Saxo Bank, Nets, DJØF, BEC and Tryg - has uncovered the potential for Copenhagen to become the Nordic Fintech hub and has identified the following criteria necessary to accomplish that goal:

  • A vibrant Fintech community.
  • Active established players.
  • Access to risk capital.
  • Political support and a friendly regulator.
  • Access to talent.
  • A brand as a Fintech hub.

The culmination of Copenhagen's efforts to become the Nordic Fintech hub was the decision by Money 20/20, the world's largest payment services conference, to hold its first European conference in Copenhagen in April 2016.


The legal side of it

Fintech as such is not subject to a specific legal framework, neither in Denmark nor in the EU. So as always, the law is trailing commercial and technological developments. Often, Fintech companies are able to avail themselves of certain exemptions from the existing regulatory framework. Ironically, the regulation which in some sense has served as an entry barrier to the financial industry has now become a cost of doing business which impedes the financial undertakings from competing with their unregulated Fintech counterparts. 

Navigating this often unprecedented and complex legal minefield requires a good understanding of the motivation behind the regulation. Accordingly, legal advice from seasoned financial regulatory lawyers and a constructive and open dialogue with the competent regulator (in Denmark, the Danish FSA) is pivotal.

However, it is not just financial regulation that Fintech companies need to take into account when designing a new business and their products/services. IT security and the protection of personal data should also be at the top of the agenda. Issues such as whether a financial institution has appropriate insurance coverage for cybercrime will be highly relevant in the Fintech era. 

Perhaps the greatest challenge faced by lawyers and regulators alike is the task of bridging the gap in understanding between the regulatory and technological experts who traditionally have not had much interaction. 

The integration of technology in the financial services industry these years makes a basic understanding of technology imperative for any lawyer advising on Fintech. This is the reason why Kromann Reumert has formed a Fintech focus group with specialists from various practice groups within the firm. 

The regulators are faced with the same challenge. Crowdfunding is a great example of how different offices within the Danish FSA need to work together to form a joint view on the legal aspects of a new business model. 


The role of the regulator

Given that the vast majority of the financial regulation is based on EU directives and regulations, there is a concern that the Danish FSA will not be as open to flexible solutions out of fear of overstepping its authorities under the EU law and/or that different constructions of the EU directives and regulations among the various EU Member States may risk creating an uneven playing field amongst European Fintech companies. 

The UK FCA has introduced the so-called Regulatory Sandbox where Fintech start-ups are allowed to experiment by testing innovative products, services, business models and delivery mechanisms within a safe regulatory environment. The idea is to allow start-ups to undertake such testing without immediately complying with the relevant regulatory requirements. In order to qualify for membership of the Sandbox, a Fintech company must meet the following criteria4

  1. Is the firm in scope: Is the planned new solution designed for or supports the financial services industry?
  2. Genuine innovation: Is the new solution novel or significantly different to existing offerings?
  3. Consumer benefit: Does the innovation offer a good prospect of identifiable benefit to consumers? This criterion needs to be met throughout the period of Sandbox testing. 
  4. Need for Sandbox: What is the objective of testing? Does the business have a genuine need for testing within the Sandbox framework? 
  5. Background research: Has the business invested appropriate resources in developing the new solution, understanding the applicable regulations, and mitigating the risks? 

Many industry experts in Denmark have encouraged the Danish FSA to introduce a model similar to the Regulatory Sandbox. 

However, it is also important for start-ups in the Fintech space to create a legally robust business model. As tempting as it may be to not concern oneself with the regulatory implications of a new and exciting business idea, the future consequences may be dire, e.g. that you cannot obtain or subsequently maintain a required license, that you experience a loss of reputational value from customers and the broader public or a loss in confidence from business partners, or that you are unable to create a viable business model, procure the necessary financing, or secure an attractive exit.

Whereas the regulatory scrutiny of some Fintech companies at this stage may be limited, there will inevitably be increased regulatory focus as businesses and indeed the industry gain further momentum and scale in the sector. 

The EU will also need to consider introducing regulation of the Fintech industry as it continues to grow. Our financial stability, the need to protect consumers and the need for regulated financial undertakings to be able to compete with the Fintech companies without the uneven regulatory burden and cost of doing business will dictate a push for such regulation.


Securing financing as a Fintech start-up?

With the historically low cost of capital, there appears to be sufficient financing available for Fintech start-ups. As illustrated by the graph below, there has been a quite dramatic increase in private investments in Fintech companies globally.



Indeed with the capital that, among others, seed capital providers, business angels, venture capital funds, incumbent financial services firms, etc. have committed to Fintech, one is left wondering whether there are a sufficient number of solid, innovative business ideas available for all these capitalists to efficiently place their money while appreciating the significant risk that will always be associated with such investments.

Of course, there are also alternatives or supplements, such as financing from crowdfunding, family and friends, Vækstfonden, incubators, etc.

While attracting capital from seed capital providers, business angels and venture capital funds may appear relatively easy (provided that the start-up has the right business idea), it comes at a price; and not just a monetary price, but also in terms of loss of control. In addition to anti-dilution protection, these investors will typically be rather active and require board representation and veto rights with respect to certain reserved matters, including when and at what terms an exit may be carried out. 

That said, these types of investors - besides often providing crucial financing - also often contribute greatly to the professionalisation of a start-up and its organisation. It is no myth that many innovators do not have a strong interest in the administrative side of their business, but are more focused on creating and developing a superior product and customer experience. An active and professional investor can, among other things, help to keep management on track and prepare it for an exit within a time span of 3-5 years. However, when the time for an exit does come, the founders and the investors may not necessarily have aligned interests.

When preparing the financing documentation, it is important to try to foresee and take into account most of these future dilemmas in order to avoid any hidden surprises for both the start-up, its founders and investors.


What does the future hold in store?

Of course, nobody knows, but we believe that Fintech is here to stay and that this market will continue to grow for the coming years, although perhaps at a slower pace. We think it is a genuine game changer rather than a fluke. We also believe that it is not yet a mature market and that there is still a huge potential for both newcomers and more established players to make their mark

Potentially, Fintech represents a new world order where it may become easier for entrepreneurs or existing financial undertakings in smaller countries to become a global success. Only time will tell.

NOTES:

1 Deloitte, Marketplace lending - A temporary phenomenon?
2 KPMG's report on Fintech innovators 2015, p. 7.
3 Accenture's report Fintech and the evolving landscape, p. 7.
4 The Regulatory sandbox report, November 2015 from the UK FCA.