Fintech’s future is in the back end

Google searches for "fintech" are hovering at an all-time high, suggesting that the conversation about the digital transformation is peaking. But while the discussion has increased, the dollars have decreased. Total global fintech venture funding and fintech-related M&A deals together appear to be slumping, having fallen by nearly 50% between 2015 and 2016, to $25 billion.

Unicorn companies that launched and then exited the market in recent years focused on consumer-facing products. The decrease in investment suggests that the low-hanging fruit in consumer products is gone, and that simply iterating on the massive disruptors — like Lending Club, SoFi, Betterment and Credit Karma — will no longer have an impact financially or substantively.

Yet the longer-term objective of the fintech revolution — to improve the financial consumer’s experience — is still important and requires more work. A key step to getting there is fixing the mechanical flaws in the financial system. The excitement that had surrounded new consumer-facing products may give way to the critical yet less sexy discussion over how fintech can improve the financial services infrastructure.

Dimitar Marinov - Fotolia

Banks worldwide spend about $241 billion annually on technology across risk and compliance, business intelligence and analytics, and trading and data infrastructure. But today, banks still run mostly on mainframes that are often three to four decades old, and operate in overnight batch processing cycles. Further complicating matters, a financial institution usually starts its business specializing in one primary product, and then expands over time into others. With this modular progression, it has been nearly impossible to develop a good consumer experience because banks don’t have a comprehensive, real-time view of their customers.

Customer experience in financial services continues to lag significantly below other verticals, and the opportunity to invest in the underlying infrastructure is massive.

But historically, investors have avoided deploying capital here for three reasons.

One, investors often view the sales cycle of infrastructure software to a large financial institution as unmanageably long. Yes, this is true and always will be true on a relative basis. However, the urgency for a software refresh throughout large financial institutions is higher than ever.

Servicing existing infrastructure without looking at new systems upgrades is expensive. The cost of maintaining the aging and unwieldy systems now accounts for a 75% of banks’ annual tech investment. That leaves only 25% ($60 billion per year) to spend on new technology to keep up with the rapidly emerging threat from startups trying to steal customer mind share.

Fear that their money would ultimately be spent on on-premise, and therefore nonscalable, technology has been another reason investors have shied away from the opportunity. This fear arises from the tendency of institutions to want to keep a new technology “in the institution” because of security concerns.

However, technology has matured enough to meet the reasonably strict security requirements banks impose on partners and vendors. Just six years ago, only 64% of global financial firms had adopted a cloud application, according to research from Temenos. But now, security has dramatically improved in cloud applications and banks are willing to adopt the technology at scale. This is evidenced in both cloud solution adoption and also the industry’s growing willingness to embrace an open banking framework.

Finally, investors have avoided infusions for technology infrastructure because regulations in this area are complex and potentially expensive.Investing in infrastructure requires engaging regulators and filling compliance roles immediately. But in this regard, global regulators have shown more interest in engagement. European policymakers have led the way, with European Union-backed data sharing legislation, the regulatory sandbox initiative advanced by the United Kingdom’s Financial Conduct Authority and the EU-wide banking licenses. Regulators in the U.S. seem to be responding, albeit slowly, most notably with the Office of the Comptroller of the Currency’s new fintech charter.

Here are three key areas of opportunity for venture investment in the infrastructure of financial services technology.

Compliance

Compliance is today’s biggest fintech infrastructure opportunity. With large fines and massive headcounts (roughly 6,000 compliance analysts work at some of the largest banks), compliance costs financial institutions$70 billion annually. Even so, ancient anti-money-laundering systems produce a 99% false positive rate. The good news: new machine-learning technologies are equipped to improve the status quo. Large pools of data are available for the AML application, and the transactional nature of banking yields near-immediate feedback loops. Banks will be able to improve the customer experience through faster account approvals and payments, and reduced fraud. Some startups are in the early stages of tackling this opportunity, including ComplyAdvantage, CCOBOX and IdentityMind.

Data infrastructure

PSD2 (the revised Payment Services Directive) in Europe mandates that banks give third parties access to financial data, which they can use to transact on a customer’s behalf. U.S. banks have aggressively battled this type of arrangement and consumers have been forced into a terrible user experience via two avenues: a bare-bones app delivered by a big bank or a broken experience on a fintech app that is given limited data and routinely logs users out due to poor permissioning. Data underpins a great consumer experience and third-party data aggregators are crucial to this effort. Without Yodlee, Quovo, MX and Plaid providing the secure infrastructure for hundreds of fintechs, consumers would have far less choice and control.

API

Underpinning many of the fintech products making waves has been the technology allowing them to interface with an incumbent institution’s system.

The technology favored by third-party providers for allowing this integration is application programming interfaces, which has already been deployed by some of the most successful fintech leaders. But API technology will undoubtedly need improvements over time if — as startups hope — banks open their systems more and the interfaces become more commonplace.

To invest here, you must believe that big banks will never be able to rebuild their own products in a way that does not require APIs, and that it will be years before they’re able to white-label their products in any kind of scalable way (hence why nonbank companies are rebuilding products with an API-first approach). Companies like Synapse, Dwolla and Cross River Bank are leading the way in this category.

And so, we have a $241 billion opportunity that, to date, the venture community has almost completely ignored. The irony is that while the first wave of fintech focused on consumer facing products, the real innovation for consumers will come from back-end improvements.