How disruptive is FinTech really?

A few days ago, I again came across this one article about how most FinTech isn’t deserving of the status of ‘disruptive innovation.'

How disruptive is FinTech really?

A term coined by Harvard professor Clayton Christensen in 1995. I decided to more thoroughly investigate the article’s conclusion to understand what exactly is disruptive about FinTech and what qualifies as merely incremental. I carried out a broader analysis distilling FinTech into its subcategories and assessing them in turn with regard to the disruptive innovation variables. But first, let me provide a short introduction of the theory around disruptive innovation, a theory which to this day is one of the most influential in management.

In a few words, for a product/technology/business model to be disruptive, it has to fulfil the following criteria:

  • Originate in low-end or new market.
  • Follow an upmarket trajectory to serve mainstream customers.
  • Its initial customers are deemed unprofitable by incumbents.
  • Has low quality (relative to criteria important to mainstream customers), low margins for the incumbent seller, and comes at a lower price point than the incumbent’s offering.

As it turns out, many of the FinTech categories are not disruptive at all. I list them below:

  • FinTechs in remittance simply target the same customers of Western Union/Money Gram at a lower cost via an improved process.
  • Merchant payment solutions (such as Square) merely provide merchants with an electronic channel for payments, replacing the original channel (cash).
  • E-merchant payment solutions (such as Stripe) just make it easier for e-retailers to accept payments over the internet.
  • Consumer payment solutions (among others, Apple Pay, Klarna, PayPal) make the payment process more frictionless, but essentially it’s the same customers they’re targeting.
  • Insurtech only improves the traditional underwriting processes. It is to be noted that while due to more effective underwriting processes a significant portion of the uninsured can now join the market, this wasn’t the initial origination point of insurtech, and as such cannot be considered disruptive.
  • Institutional investment tools make easier the lives of wealth advisers, asset managers, fund managers, and so on.
  • Digital banks by and large digitised the processes of brick and mortar banks. I do, however, need to make a note about Secco Bank, a bank whose business model I don’t yet have a full understanding of and as such cannot comment on.
  • Personal finance management doesn’t in any way target new customers.

However, a few notable categories do qualify for the disrupter status. I outline them below, and elaborate on why they’re disruptive.

 The first one is marketplace lending, a sector that represents 19% of the $25.8bn total invested in FinTech. Marketplace lending originates in a new market, as it originally was targeted at consumers/businesses who were not eligible for bank loans due to their credit risk. Secondly, they arguably follow an upmarket trajectory; as marketplace lending becomes increasingly popular with early adopters and acts as a ‘proof of concept’ for the business model, mainstream borrowers should join in (there should be no reason not to). Moreover, the initial target customers of marketplace lenders were massively ignored by high-street lenders due to perceived unprofitability. With regard to margins, while they are very attractive for marketplace lenders, adopting such a model for banks would under no circumstances generate similar returns due to their legacy infrastructure, and in terms of price (where price fundamentally is the interest rate) marketplace lenders are obviously winners. Lastly, marketplace lenders actually have higher quality products relative to mainstream customers’ criteria, which would disqualify them from the ‘disruption race’, but I personally regard this factor as insignificant and still deem them worthy to be classified as disruptive innovators.

 Second comes the robo-advisers segment. Firstly, the robo-advisers segment originates in a low-end new market: consumers who would for various reasons (such as minimum required balance) not be able to invest. Secondly, it’s easy to see how robo-advisers follow an upmarket trajectory; as technology adoption increases and more advances are made in AI, human advisers will be replaced by robo-advisers, or hybrid models will become more pervasive. Furthermore, as stated above, the initial target customers of robo-advisers were indeed overlooked by incumbents as they were deemed unprofitable. Lastly, robo-advisers provide low quality relative to criteria important to mainstream customers; these typically want to be involved in their investments and are interested in strategic risk-taking, while portfolios managed by robo-advisers tend to be heavily invested in conservative products such as ETFs.

 Thirdly, crowdfunding. (Note that in this context, I consider customers to be the companies that are to be invested in.) Firstly, crowdfunding opened the funding market to companies that would, due to various reasons (such as lack of network), not otherwise have access to funds. Secondly, crowdfunding is definitely moving upmarket; we have seen companies such as Mondo that could easily have secured funding from world-renowned VCs, but have instead opted for crowdfunding. In Mondo’s case, the underlying reason was customer engagement and brand awareness building, but I predict this strategy to be pursued in the future for other reasons too, such as minimising the amount of control VCs exert. Thirdly, the original targets of crowdfunding were firms not being able to secure funding in any other way and as such were deemed unprofitable by the usual funding sources. Lastly, crowdfunding is lower quality than competing sources of funding such as VCs, as it doesn’t come with additional services such as advice provision or network.

So at least three FinTech segments are disruptive to the market, but what are the implications? What lessons can be drawn from disruptive innovation in FinTech? In order to answer these questions, I looked at what these three segments have in common in banking terms

Of course, companies from these segments use latest-generation technologies such as big data, analytics and artificial intelligence, but this isn’t what sets them apart. All of the non-disruptive FinTech companies use quite similar technologies. What’s unique about these companies is that they provide services to the underbanked/unbanked. Thus, while the billions poured in FinTech have mostly been targeted at developed countries, disruptive innovation in FinTech is much more likely to come from developing parts of the world, where a large proportion of the population is unbanked. A notable example that comes to mind is M-Pesa in Kenya. Via its innovative business model, where airtime could be employed to pay for goods, M-Pesa has in a very quick fashion contributed to the financial inclusion of millions in Kenya. This is a truly important aspect because of the societal impact disruptive innovation has.

Disruptive innovation vs disruptive FinTech

Disruptive innovation is empowering: it transforms products that historically have been complicated, costly, and unavailable to the masses, into cheaper ones available to many. This in turn leads to job creation for people who build, distribute, sell and service these products. At the other end of the innovation spectrum, we have sustaining and efficiency innovations, which most of FinTech fits within. These replace old products with newer ones and reduce the cost of making and distributing existing products and services, respectively. Sustaining innovation has a zero-sum effect on jobs and capital, and efficiency innovation almost always reduces the net number of jobs in an industry by means of allowing more work to be carried out employing fewer people.

In numerical terms, roughly 20% of all FinTech creates jobs and contributes to economic growth, while the rest either has no impact or stifles growth. Should we then look at the developing world, where most of disruptive innovation will likely come from, and attempt to apply the disruptive business models to the developed world? No, not really, because FinTech disruptive innovation in the emerging world is based on an utterly distinct set of variables, which are not necessarily fitting to mature markets.

Let’s consider M-Pesa again. A key success factor for M-Pesa in Africa was the continent’s lack of infrastructure, which is not to be found in the developed part of the world.

Disruptive innovation theory says (quite counterintuitively) that FinTech will not lead to massive creation of societal benefits in the key VC target markets, and may even lead to loss of jobs in these. It’s quite a paradox, isn’t it, that although consumers do enjoy better/more convenient lives as a result of using incremental innovation-derived products, at the end of the day no societal benefit is realised.