Heavily funded Neobanks market themselves as the future of finance – mobile-first and customer obsessed. We could all use less Wells Fargo in our lives after all. However, Neobanks (Chime, N26, etc…) are not the only threat that banks should be concerned about.
Less heavily funded and heralded are autonomous finance apps (Albert, Astra, Northstar, etc…). These apps manage assets where they already reside, spread across existing accounts.
Personal finance manager apps pose a serious threat to banks by turning the deposit holding bank (Bank of America, Wells Fargo, etc…) into commodity services differentiated only by their yield or fees.
The app manages funds according to the user’s rules.
Want to save $100 each month? The app takes $100 from your direct deposit account and moves it to a high-yield savings account.
A new savings account is introduced that offers higher yield. Great, the app manages moving funds so you maximize earnings.
No single bank is motivated to offer features that work across accounts. They want all your deposits in their bank, not others. Their mission is to bundle all the finance products you need in one place and keep your business.
By removing the friction of managing funds across banks, these apps change the nature of the relationship between the user and their money. This is the threat to banks.
Gradually, the user’s attention and relationship shifts from their primary bank to this app that manages their assets. When they think about how to save, get a loan or deal with their finances they open the autonomous finance app first, not the bank’s app.
If the app manages the flow of funds across accounts, does the user care which company offers the underlying accounts? As long as it carries insurance, the criteria becomes solely the lowest fees or highest yield, not the bank brand. That’s dangerously close to accounts and the institutions that offer them becoming commodities.
I came across Alice recently and love it. It isn’t only what the product claims to do, it’s how their business model aligns so well with their users and customers.
(FYI – I’m not involved with this company in any way. I don’t know the team or invested…although I wish I was an early investor!)
First, what it does.
It’s an app that employees connect to their credit cards which monitors their spending. When it identifies charges eligible to be reimbursed with pre-tax w2 dollars, Alice submits the deduction to the employer’s payroll system automatically.
This is ingenious because it requires no behavior change from anybody and makes money for everybody at the same time, including Alice.
Employees – It’s simple to connect an app to your credit card and you’re more than happy to find out that bus pass you bought is now being paid for with pre-tax dollars. That’s money in your pocket.
Employers – It wires into the payroll system to automatically submit deductions. Simple. Every dollar deducted pre-tax reduces the employer’s payroll tax burden (Medicare, Social Security, etc…). That’s keeps more money in company’s bank account.
Alice – This is where incentive alignment comes in. They save the employer money and the employer pays Alice back a portion of the savings. That’s money in Alice’s bank.
The last part may seem obvious, Alice takes a cut of the savings. But consider how powerful that is when compared to a service that negotiates on a patient’s behalf to lower their medical bill. The patient received a $10k medical bill. The company negotiates it to $2k and charges the customer 5% of what they saved them, $400.
Sounds great in theory, unfortunately the patient didn’t have the $10k to start with and probably doesn’t have the $400 to pay the service provider. Even if they are relieved the bill amount was reduced, the business model isn’t fully aligned with the customer.
In Alice’s case, the employer does have the money and is happy to pay a percentage to Alice. They were going to spend it anyway! And now they get to pay less.
It’s interesting to think why this product has emerged now. What makes it possible today versus 5 years ago? A combination of things:
Fintech Infrastructure – APIs to monitoring card transactions (thanks Plaid!) have made this 10x easier.
API Economy – Of course, the payroll providers all have an API. Try having done this even 5 years ago. Remove the benefit of auto-submitting the deduction and now you have to ask the employer to do work or change their processes. Much harder sell.
Consumer Habits – That fintech infra has made services that tap into your financial accounts so much more prevalent, resulting in more apps that do so. People have gotten used to it and are more willing to try.
They may sound very different, yet are driven by the same need for the lowest possible cost of capital. The cheapest money comes from you and I depositing our cash into the bank. From there, the bank lends it out and invests it, earning revenue from the deposits.
The E-Trade numbers are particularly interesting. Trading commissions are approaching zero, a trend started by RobinHood and accelerated by Schwab. In reality though, E-Trade doesn’t make the bulk of their money from that trading fee.
As Morgan Stanley offers a fuller suite of retail finance products, those deposits are the zero cost capital they can use to finance them.
As LendingClub expands their product lineup, the Radius deposits offer them the same benefit.
Would you want to be a fintech carrying capital at 3% trying to compete with others who have an almost zero cost? Easy question. With almost no bank charters being created, expect to see more and more of these deals.
How Varo’s bank charter will help prove or disprove the Neobank thesis.
Varo, a Neobank, announced this week that the FDIC approved their banking charter. This is a first for Neobanks, enabling them now to hold customer deposits and lend that money out.
You know, like a regular bank.
This will be a fascinating experiment, one that could make or break the thesis on the potential value of Neobanks.
To understand why, it’s worthwhile to explore the challenges Neobanks (Chime, Stash, etc…) face and how this charter potentially differentiates Varo.
The Problem With Neobanks
First, let’s understand what a Neobank actually is. You don’t deposit your money with a Neobank. Your money is actually held (and subsequently lent out) by a traditional bank.
It looks a little something like this.
That API between what the Neobank controls and the deposit holding bank introduces a set of challenges. It means the Neobank:
Can’t earn money by using the deposited funds to lend out at a near-zero cost of capital
Is limited in their product development by the API’s available from the underlying bank (or infrastructure provider that sits in the middle).
The bear argument for Neobanks is that they are novel UX layers and marketing channels, which can easily be replaced, to bring deposits in for the underlying bank.
On the bright side, Neobanks do not have the compliance overhead of holding customer’s money. The bull case treats Neobanks as modern finance companies with incentives aligned to their customers.
For example, Neobanks protect you from overdraft fees with warnings and quick loans because they make their money from a monthly SaaS fee as opposed to the penalty fee itself. A traditional bank has no incentive to offer the same protection, it just hurts their bottom line.
The Varo Bull Case
With their charter, Varo is betting that owning the entire stack, from UX to deposits, will enable them to:
Better anticipate, qualify, cross-sell and serve customers than banks today and at a lower cost of capital and less friction than other Neobanks.
Offer API driven banking infrastructure that others can build on (note: this one is something I’d like to see, not what they’ve publicly stated)
Can Varo do this and challenge incumbent banks in scale and market cap? Maybe.
The charter gives them a unique weapon in their arsenal. Considering it has taken them almost 3 years to get the charter issued it doesn’t appear there will be any fast followers. And with it, we’ll finally see what the value of a fully digital bank is.
Software has replaced relationship banking as the best way to acquire customers and sell new financial products.
This bodes well for the land and expand strategies of tech companies and not so well for the mythical personal relationship banks have with customers.
Changing customer attitudes and bank’s antiquated tech stacks are killing relationship banking, leaving banks vulnerable to competition from tech companies.
Fintechs have built modern and integrated tech stacks to better serve customer segments more economically.
Others (Uber, Shopify, etc…) are leveraging their vertical solutions to sell financial products.
Relationship Banking Test
Relationship banking posits that customers select products from banks they already use and presumably trust. And that these banks are best positioned to understand and serve their customers because of their relationship.
This just isn’t true.
Consumers, particularly younger ones, don’t discover and choose financial products based on their bank relationship. In truth:
~70% bank digitally because they don’t want to visit a branch
~50% don’t think banks are that different from one another
3x more likely to close accounts and switch than older cohorts
Let’s skip the “next generation changes everything” argument. Instead let’s use Frank Rotman’s excellent rubrik (highly encourage reading his full post for more detail).
Is it easier or more economical for current customers to access other products from you? Are you able to qualify customers because of your current relationship that others can’t?
Are you proactively suggesting and moving customers into the best products based on what you know about them?
Ever applied for a mortgage with a bank where you hold an account to find that you are filling out same information that a brand new customer would?
Ever gotten a maintenance charge on a checking account when the bank offers a free option that you also qualify for?
Then you know the answer to these questions is a resounding NO.
Banks are playing a tough hand. Their tech stacks are a mess, cobbled together over 30 years, making it difficult to serve customers across products. It also makes it expensive for them to support the niche segments that tech companies can profitably serve.
How Do Fintechs Stack Up?
Using modern tech stacks, low opex and a technology-driven mindset, fintechs focus on acquiring the best (i.e. most profitable) or underserved customers as wedge into the market. Solving one customer segment’s problem enables them to move into adjacent products and/or customer segments (‘land and expand’).
Their entire business plan is predicated on being able to answer yes to those questions. Let’s look at one of the test questions.
Is it easier or more economical for current customers to access other products from you? Are you able to qualify customers because of your current relationship that others can’t?
Remitly’s core product is an international money transfer service and many of their customers are thin file immigrants who have difficulty getting a bank account or many not have a SSN. No problem, they released a bank account that using international identification documents and no SSN to KYC a user.
How do you think these users will send money internationally from their new bank accounts? The virtuous cycle spins. It’s easy to imagine Remitly growing into loans and other products as well, all to an ignored customer segment deemed too expensive (i.e. risky) by the legacy bank tech stack.
What About “Regular” Tech Companies?
It’s not only Fintech companies the banks need to worry about.
Increasingly, tech companies that you don’t think about as finance businesses are leveraging their customer data to offer financial products more economically than a bank could. It makes sense, it’s getting easier to roll out a finance product and it’s a margin lift for their businesses.
That’s a business loan, the same kind you can idealize is taken by a hopeful entrepreneur in the lobby of their local bank. Instead it’s delivered by a technology company that makes data-driven decisions based on the businesses use of their software platform.
Technology is the new relationship banking.
Everybody Becomes a Bank
You could imagine a Shopify competitor giving away the storefront for free to attract businesses and then earn money from loans and payment processing.
We are seeing this happening already in some verticals. Divvy is an expense management platform that is free for businesses. Completely free. They earn money from the interchange fee via use of their issued credit cards and soon through loans issued to business customers.
The permutations are endless depending on the market and pressure points. This is great for customer, not so great for banks.
Early stage financing options have evolved radically, giving founders more choices to optimize for company/investor fit.
Early stage financing has evolved radically, everything from the amount of capital available to the types of funds and their return targets.
It’s critical that founders think about company/investor fit as they choose financing partners, particularly in the earliest stages.
Choosing for company/investor fit enable founders to authentically build the company they envision. It also avoids misalignment between founders and investors along the way as critical decisions are made.
Early Stage Capital Explosion
A few trends have converged, creating an explosion of both capital (3x as more in the last 10 years) and types of funds managing that capital focused on early stage.
Yield Chasing – We’ve lived in a zero and negative interest rate environment for years now. 15+ countries offer negative returns on their sovereign debt. Capital managers are chasing yield in riskier sectors and stages.
Software Ate the World – The importance of tech in our lives grow and their market cap dominance does also. Early stage tech is a good place to chase yield.
Software is Cheaper to Build – AWS has made software 10x cheaper to build, meaning companies can do more with less capital.
The amount of capital focused on the seed stage from traditional venture capitalists has exploded, ~500 firms at last count. These are “traditional” in that their goal is to return 3x+ of funds invested (net of fees) to deliver top decile results to their LPs.
The growth in number of firms and capital gives founders options of personalities and operating styles to choose from, if they believe their business has the potential to fit their return profile.
Let’s focus instead on the emerging class of alternative capital sources for early stage tech that offer founders other options.
Shared Earnings – (Indie.vc, Earnest Capital) These firms invest provide between $75K to $1M to companies on a shared earnings model. This is a novel approach for software business that aligns the returns the fund targets (~6%) with revenue generated by the company over a given time period.
Non-Dilutive Working/Growth Capital – (ClearBanc, Lighter Capital, Capital, RevUp) These firms offer capital to grow and run your business with fixed terms (~1%-20%), no equity warrants or conversions. These models are more efficient today via real-time data the company can provide the lender. For example, ClearBanc can inspect your ad spend and conversions to asses the health of your marketing spend to base a loan decision.
These alternative funding sources have vastly different return needs than traditional venture capital. They provide new, and in some cases more efficient path, for founders building businesses that fit the profile.
Why Company/Investor Fit Matters
Imagine you’re running a business that is doing $5M in ARR and growing steadily with healthy margins. You can either pocket the free cash flow or reinvest for growth. Odds are you’re probably happy.
Except…if you’ve taken early investment from a fund that needs you to hit $100M in revenue in the next 3 years to meet their return expectations. Oops, instant misalignment in the decisions to be made about how to grow the business.
Raise another round, build a risky new product line with 10x possibilities or incrementally grow your existing one? Easy decisions when the company and investor share the same expectations. Nightmares when they don’t.
Pick the investment source that aligns most closely with the business you plan to build. Then adjust on the fly because nobody’s business goes according to plan!
Banks need a regulatory push to make our data more accessible and transportable.
Regulation could help here…gulp.
Particularly in the US, our financial data should be more easily accessible and transportable. This would make it simpler for more applications to be built to give us views into our financial life (bank account, brokerage, etc…). That in turn would allow different segments of the population to be better served for their needs. Worried about overdrafts? Remittance fees? There’s an app for that.
Wait. Doesn’t Plaid make financial data easy for developers to access $5.3B different ways? And didn’t Mint begin this trend over a decade ago? Yes and yes.
Notice I said improve in the title though, not enable.
First a quick background on how Plaid, Yodlee, and others work today. Primarily they compile your financial data via screen scraping. They access your account using the credentials you provide and parse the interesting data (account balance, tx dates, etc…) to share through a formal API to an app developer. For the app developer it saves time and allows them to focus on their unique business value rather than plumbing.
To be clear, I’m not condemning screen scraping. I’ve used it in multiple companies to structure data that resides in unstructured formats on websites or PDFs.
It does have serious problems though. For one, it’s brittle. The underlying site changes often and when it does your scraper breaks. So access to some banks is constantly under repair and there is no way to know when. Also, it can break completely when the provider of the website wants to break your scraper. And they have multiple reasons to want to do this.
So what can be done? Why don’t banks adhere to a standard format of making data available? It is your data in the first place. Unfortunately, they have no motivation to do so. They prefer you live within their universe of products and not easily manage finances across banks or have simple access to products elsewhere that would compress their margins.
Europe offers a roadmap to solve this with their PSD2 initiative. Among others things, PSD2 requires banks to adhere to a standard API for data access. Unfortunately, there probably isn’t another way to make this happen among banks that aren’t motivated to do it on their own. More unfortunately, we probably won’t see a similar rule in the US.
This wouldn’t negate the value of Plaid and similar services (see Tink for proof). It would serve to make their APIs more robust and reliable. The winners would be end users benefiting from more ways to manage their financial health. And we should all want that outcome.
More importantly, though, is the power of inertia: as long as it is hard to move money around, the more likely it is that that money will stay in the bank, collecting minuscule interest; or, if customers need value-added services, the path of lowest resistance will be simply getting them from their bank.
An API-based world could change this dramatically: suddenly consumers could commission robo-advisors to move their cash to whoever is offering the best rates, or to automatically refinance debt. Value-added services from multiple vendors would be equally easy to access, meaning they would have to compete on price or terms. In other words, much like the open Internet, banks fear that profits will be rapidly transformed into consumer benefit.
Plaid’s founders, team and investors are huge winners obviously. The secondary effect is the rising tide this will provide to the next wave of fintech infrastructure players like Astra, Alpaca & SynapseFi.
…many of the companies we think of as cryptocurrency exchanges were actually brokerages, exchanges, custodians, and clearing houses bundled into one….I think we’ll see the cryptocurrency market structure evolve to more closely resemble the traditional financial world, with these functions being separated out…
Brokerages are an inevitable evolution of crypto-finance, abstracting investors from exchanges.
This is the new battleground in crypto and the winner holds the key to serving users with a full suite of financial products.
Coinbase faces a classic innovator’s dilemma. Their exchange business is a cash cow today, but a liability in the battle to own the brokerage layer and winning the next phase in crypto.
The $100B opportunity over the next decade is to own the brokerage layer in crypto.
Let’s assume Brian is right and crypto-brokerages emerge. The key to appreciating the importance of this trend is that brokerages, not exchanges, own the end user relationship. And owning that relationship is critical.
That relationship is the key to cross-selling banking, savings, borrowing and investing products, crypto or otherwise. Winners in finance offset high CAC by serving all your finance needs. The brokerage has the customer touch points to understand their needs and market other products.
Coinbase’s strength today, their exchange, may be severely impacted in the battle to own the brokerage layer.
Brokerages execute customer orders at the best price, thus they operate across exchanges tied to no single source of liquidity. A healthy market for crypto-brokerage products would deteriorate Coinbase’s pricing power and volume.
Today all Coinbase retail orders are funneled directly to their exchange. Competing with other high-quality brokerage products would require Coinbase to provide best execution for customers, distributing their order flow across competing exchanges.
This begs the question, will they sacrifice short term revenue for the longer term prize. It’s easy to say yes in theory but hard to do in practice, even for a private company.
Consider that they just raised trading fees! It’s less expensive for them to offer this service over time, but they chose to offset declining volumes by raising fees. Does that sounds like a company ready to sacrifice short term revenue?
Brokerages make the market more efficient in general which reduces cost. So even if Coinbase doesn’t compete directly with other brokerages, they will feel their emergence via reduced margin.
Are you thinking that Coinbase is the 100 lb. gorilla of crypto and will naturally dominate every layer in the stack? Consider though that only ~50M people hold crypto today. A rounding error. The billions of new users will choose their onboarding path via crypto-native brokerages and banks, not directly with exchanges. So Coinbase’s dominance is far from certain.
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If you’re building a bank today, you’re in luck. Much of what you need is available via API so you can skip the months of legwork to find bespoke banking and compliance partners.
If you’re building a bank
today, you’re in luck. Much of what you need is available via API so
you can skip the months of legwork to find bespoke banking and
You can start building on day 1.
Here’s a few of the things you can start building quickly by standing on the shoulders of g̵i̵a̵n̵t̵s giants-in-the-making.
offer most financial products you’ll kneed to abide by Know Your
Customer (KYC) and Anti Money Laundering (AML) rules. This will involve
asking the user for personal and financial information and verifying
it’s authenticity. These providers automate much of the work required to
verify the information collected.
ID Verification — Is that picture of their passport or driver’s license they uploaded authentic and actually of them? Trulioo and Jumio will handle that check for both USA and international applicants.
& Watchlist Scans — Is the address they provided really theirs? Is
their legal status free of flags for money laundering or international
watchlists? Blockscore handles those checks via its API.
onboarding the customer, you’ll often want to confirm and connect with
financial accounts they own. Perhaps you’ll want to confirm balances or
offer to ACH funds into their new accounts.
Perhaps you’ve got a spin on the traditional credit card and think you can get into the flow of interchange fees. Maybe a card for teens or one to control your spending?Avoid the upfront fees and convincing card issuing partners and use one of these APIs instead.
that you’ve got millions of people direct depositing their paychecks
and spending using your credit card, let’s offer them some investment
tools to put their money to work. Sure, they could open an E-Trade
account, but wouldn’t it be easier to do this in the same account they
already use for their personal finances? You could start the
multi-month, multi hundred thousand dollar process to launch a
Broker-Dealer, or leverage one these APIs to get started immediate.
These APIs are serving as the infrastructure anybody needs to get finance products to market quickly. The end result will be more products tailored to more market segments and hopefully better finance experiences and outcomes for all of us.