When FinTech meets DeFi đź’•
One of the common criticisms that can be levelled against fintech platforms is that they’re really just a superficial improvement. Yes, lots of work and thought has gone into designing the user experience and using a modern fintech banking app is infinitely more pleasant on the eye than the idea of queueing up in a branch to get a transaction done.
Nonetheless, digging just beyond the depth of a fintech app’s UI, we typically find the same old behemoths sleeping underneath. Robinhood, for example, turned out to be built on the rails of Citadel, settling stocks the same way as everyone else, with a business model that was less than friendly towards the retail end-user – turns out free trading does come at a price, and if you can’t find a product in the business model, chances are you are the product.
The same can be said for many of the UK’s leading fintech banks, which have wonderfully intuitive app interfaces but which have built their businesses on the custody and payment functions of the incumbent banking system. Ironically, because of their relative “newness”, fintech banks also appear to be under much more scrutiny from regulators. Many of them also combine multiple functions from different segments of the regulatory regime, offering bank accounts, payments, trading and savings, for example, from one single app. However, because they are more Tech than “Fin” in their nature, the typical approach involves taking advantage of existing infrastructure and building a nice user interface on top of it.
As a result, multiple regulated entities become intertwined within a single business – not the best news for transparency. And certainly, a massive complication for regulatory reporting. From our experience, small transactions are fine – paying for office supplies from Amazon, no problem. Receiving a relatively large invoice payment of fees? Red alert in compliance – payment queries pop up all over, with the risk that payments get reversed.
Thus the sad reality: no serious business would bank solely with a FinTech bank. A serious business needs a proper bank – like Barclays, Lloyds or Natwest. Proper = incumbent = old school.
More importantly, if FinTech is just a jazzed up, pretty version of the existing system, how far can it really go towards being a disruptor when the target for disruption also provides the underlying pipes that make the business viable?
Short answer: not very far.
But we think there’s an obvious pairing that might turn into a marriage made in heaven – where FinTech meets DeFi.
The economics of piggybacking
Before we go any deeper, it’s worth working out at least in principle how the economics could work for a “digital”/”fintech” bank – the general idea would likely apply to other forms of fintech e.g. insurance, broking, payments etc. insofar as the fintech company in question doesn’t control the full set of infrastructure rails and regulatory permissions needed for its business.
Most of the time it’s not particularly obvious whether a “bank” is true bank (i.e. receives deposits and makes loans) or a “bank” in that the services it provides are similar to that of a bank. These structures vary across the globe depending on the regulatory jurisdiction but using examples from the UK, we can broadly categorise these businesses into two buckets.
The first is new age banks like N26 and Starling Bank which are real banks – in that they have full licensing, regulatory capital and permissions to undertake all of the activities of a bank, and are solely responsible for client deposits the same way any other bank is. In essence, they are no different from the likes of global behemoths like Barclays and HSBC, although they have certainly done a much better job of making the process of interacting with them much more pleasant, and are proving to be much more creative and innovative in allowing access to their underlying infrastructure.
For example, Starling Bank offers “banking as a service”, allowing other institutions to make use of its banking license to offer white-labelled bank accounts to clients. Complete with a plethora of automated API access to open banking protocols, it is quite possibly one of the most innovative banks in the UK – with a great reputation for customer service as a bonus.
But at the end of the day, it’s a bank. While customer deposits totalling about £1bn+ as of the end of 2019, a respectable amount by any measure, being a bank is hard: the consolidated group accounts reported a loss after tax of -£52m, despite net interest income and fees/commissions totalling £14m for the full year, more than offset by administrative expenses which were -£83.2m, mostly salaries and wages. There’s a lot of work to be done to be a bank, and taking a new approach by trying to expand revenues in creative ways is certainly one way to disrupt.
Added to more than £51m of regulatory capital required to be held in reserve, Starling bank has a long road ahead to even delivering a positive return on equity for its shareholders. With total shareholder equity at group level sitting at £67.9m, they’re looking at an ROE of -77%. How high can it go? JP Morgan Chase and ICBC, the largest banks in the US and China respectively, clocked in an ROE of about 12% last year – that’s probably the best case scenario.
Sources: Starling Bank Limited Annual Report, YE 30 Nov 2019; Starling Bank Limited Pillar 3 Disclosures 30 Nov 2019
The other category of financial institution contains the likes of Revolut and Tide, which offer banking services through interesting, dynamic user interfaces but which are not true banks per se. In the UK, they are regulated under the Electronic Money directive, allowing them to create and issue electronic money vis-Ă -vis the deposits put in by their customers.
In terms of capital requirements, the rules are slightly less onerous, although they remain relatively demanding. But as laid out on Tide’s FAQ page, the business becomes quite tricky if we think about it a bit more deeply:
Likewise for Revolut in their FAQ:
The reason it’s tricky is not because client money isn’t safe. It’s because both these businesses rely on other institutions (banks) to provide them with the services that they subsequently pass on to their clients. We could call it piggybacking, or we could call them the middlemen – either way, the business model becomes just a spread business, a tiny margin but access to many new clients, minus the cumbersome nature and capital intensity of being a bank.
At least that’s what it would look like on paper. Unfortunately, despite reliance on third parties to provide core banking services and infrastructure, being an electronic money firm isn’t without its regulatory obligations: it has regulatory capital requirement obligations under the law too, in addition to the costs of software development, sales, marketing and headcount that is par for the course for any tech company.
Furthermore, when the value proposition made to clients is that services provided are cheaper and better, there’s not much room on the upside for pricing. On the other hand, there’s a minimum return that the underlying infrastructure provider will need to make – and with profitability a challenge for newer institutions like Starling, the parameters under which a “new” fintech can operate while playing by the rules of a more conservative, less adventurous “old” bank are likely to be less than liberal.
No surprise then that the burden of proving that nothing wrong has happened in terms of KYC and AML does appear to be higher for Fintech firms.
Is Fintech a profitable venture? So far, the numbers don’t seem to suggest so. Revolut reported a loss of -£206m in 2020, just under -50% ROE on its equity base of about £417m in its 2020 Annual Report. Tide in its 2019 accounts filed with Companies House reported a loss of -£13m, on shareholder equity of £8.5m, clocking in at a -153% ROE.
Turns out Fintech is equally hard.
A win-win proposal
For most financial institutions, revenue comprises net interest income and fees, and it is the former that offers the greatest room for operating leverage, simply because any expansion in the net interest margin is magnified by the size of the institution’s customer-facing balance sheet (deposits vs loans).
While spreads in the world of TradFi are low thanks to years of interest rate compression, the world of DeFi still enjoys juicy spreads. Even as deposit yields on platforms like Yearn have “collapsed”, to borrow the often-dramatic jargon of crypto twitter, from mid-high teens % to mid-single digit levels currently, a 3.45% deposit yield on say DAI stablecoin, effectively a USD deposit, is still 30x the rate of return on a standard savings account. Anyone like a spread on that? Even splitting the difference halfway yields 1.6% of extra yield to depositors, and 1.6% to the Fintech access provider.
For a “new” bank, being able to access that amount of yield and offer some of it to their depositors would likewise be a real differentiator – a game changer that puts them on a different level from the incumbents they’re trying to stand up to. Bigger deposits, bigger scale, bigger earnings.
Building a deposit base on top of these protocols can be a potentially lucrative way to draw in new deposits and properly challenge incumbent banks.
Ironically, the only thing that is stopping most people from going directly to the likes of Yearn to take advantage of these still-advantageous (at least relative to traditional banking yields) rates is the complication of setting up a wallet like Metamask, getting funds from a bank into crypto form and pulling the levers of Ethereum to get a deposit in.
And of course, there wouldn’t be a need to wait minutes for transactions to clear on Ethereum or even Bitcoin, nor worry about high gas fees – an elegant solution would be for each Fintech shop to put together a sidechain or a scaling solution like Arbitrum, aggregate transactions within its own ecosystem as much as possible (as is already the case) and clear those that need to be cleared on-chain when necessary.
With the likes of Coinbase and Compound launching corporate treasury solutions (even if Coinbase doesn’t really count as DeFi), the doors are open. The new kids on the banking block just need to step in.
That’s the edge – a combination of the slick, easy to use UI/UX of Fintech and the nascent but already highly liquid credit markets of DeFi would be a match made in heaven.
All the magic in the background
On top of that, there’s the education that needs to be done, so that users know what they’re depositing into. Or is there? How many people know how the interbank liquidity system works? (Our guess: maybe only Zoltan Pozsar at Credit Suisse REALLY understands it inside out) Or even the Eurodollar system? Or SWIFT, BACS, Fedwire, ACH, Visa/Mastercard or Faster Payments in the UK?
Ultimately, understanding the ins and outs of the plumbing behind the financial system, TradFi and DeFi alike, isn’t necessarily a prerequisite for using it. We would argue that the DeFi system is actually easier to understand than the TradFi one – though the reason more people are comfortable with TradFi is not because they understand, but because they have confidence in the institutions that stand in front of those pipes. It is the brand that they relate to and draw comfort from, in addition to the regulatory status and compliance that comes with it.
To be clear, we aren’t arguing for an unregulated financial wild west. Rules and regulations need to be in place to make sure that good behaviour is incentivised, and bad behaviour is punished, so that everyday users of the system can use it with full confidence. But those rules and regulations must not stifle innovation, and this is an opportunity for regulated financial services entities to drape their beautiful UI/UX interfaces on top of infrastructure that represents the future, not the past.
For DeFi, having a regulated front-end that takes care of “dealing with clients”, compliance and marketing, as well as providing snazzy “UI/UX for normies” might also be a source of great relief, leaving devs to focus on the back-end innovation. Most importantly, clothed with the rubber stamp of regulatory approval confers the comfort that needs to be in place for mass adoption to happen.
If Fintech and new banks alike step up to the plate and apply the regulatory authorisation given to them to interact with clients and, where possible, handle client money, embracing this still-booming ecosystem of DeFi would be the biggest win-win outcome they could hope for.
The best part of it all: no magic needed, just code.