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FinTech Innovators vs. Incumbents: Understanding the Odds

FinTech startups and investors must run through an unforgiving gauntlet to get an edge on incumbents. Morgan Stanley offers a framework for assessing the risks and opportunities.

Technology is transforming nearly every aspect of financial services—from mobile payments and peer-to-peer lending to the emergence of “robo-advisors.”

For entrepreneurs and early-stage investors, financial technology (a.k.a. FinTech) is an opportunity to roll out new platforms and service models ahead of established players, tapping into a market with trillions of dollars in revenue. Yet, whether newcomers will succeed at taking market share from the incumbents remains to be seen.

Established financial services firms are likely to take a more meaningful role in funding and developing new technology.

The slow pace of change of behavior in financial services, relative to other sectors, coupled with intense capital requirements for financial products, pose considerable hurdles for FinTech upstarts. “In short, it is more marathon than sprint, and it is hard to stick around long enough in FinTech to scale and be truly disruptive,” says James Faucette, who covers the U.S. communications systems and payments sectors. Of the more than 450 FinTech firms launched during the dotcom boom, for example, only five disruptors have survived as standalone entities, notes Faucette, citing McKinsey.

How can investors navigate this next chapter in FinTech? In a recent global collaborative report, “FinTech: A Gauntlet to Riches,” Faucette and his colleagues offer an investment framework for understanding where FinTech companies are likely to disrupt—and where established players are poised to get ahead.

Indeed, the pace of venture capital funding in FinTechs has slowed recently, suggesting that early-stage investors are coming to grips with the challenges of this space, and that established financial services firms are likely to take a more meaningful role in funding and developing new technology. “We think financials and payment incumbents are going to be emboldened to step up R&D and take the investment lead,” says Betsy Graseck, who covers large-cap banks. “This represents a paradigm shift that could translate to better return on investment for incumbents.”

VC Investments in FinTech Startups Fell in 2016

Source: Pulse of Fintech Q4 '16, KPMG, CBInsights, PitchBook, Morgan Stanley Research

On the whole, rising incumbent investment will skew returns to the biggest and most entrenched, Graseck notes, “but whether the final prize goes to incumbents or disruptors depends on a number of factors, including existing infrastructure, consumer behavior and government involvement.” To understand which trends favor startups and which bode well for incumbents, investors should ask some key questions:

1. What is the existing infrastructure?

Innovators have the best shot at success in areas that lack established infrastructure. “There is more opportunity to add value, and incumbents are less likely to notice a small disruptive threat,” says Faucette. This is one factor working against FinTechs focused on U.S. mobile wallets, which have yet to show value against a well-functioning system for card payments. On the other hand, digital payments have benefitted from a dearth of trusted and frictionless options for online transactions and electronic payments.

One area that is particularly poised for growth is B2B payments, a large and underserved corner of the market, with roughly 50% of payments still made via checks. “With ACH being the last major innovation, B2B electronic payment options are lacking, particularly for smaller businesses that don't get as much attention from banks,” says Graseck.

FinTech Investments Are Concentrated in Payments & Lending

Source: Pulse of Fintech Q4 '16, KPMG, CBInsights, PitchBook, Morgan Stanley Research

2. Is consumer behavior changing?

Consumers’ appetite for stability or change is the key to success. Early adopters in a nascent market tend to be more receptive to a new technology or provider, giving innovators a first-mover advantage. This bodes well for FinTech disruptors focused on small-business insurance (a.k.a. InsurTech). “We estimate that 15% to 30% of the total small-business insurance market will be sold digitally by 2020, up from 4% today,” says Faucette.

3. Does government help or hinder innovation?

Government mandates can be a catalyst for adopting new technology, as has been the case in India, where the government is pushing to increase electronic payments, which account for less than 20% of personal transactions today. Likewise, FinTech providers often aren’t subject to the same regulations as incumbents. On the other hand, navigating a changing regulatory landscape requires resources, and some promising FinTech start-ups simply may not have the depth of resources to stick it out.

4. How important is access to data?

Investors should take note of the role of data, which can limit a small firm's ability to scale without partnering with a data owner. “We think that the availability and accessibility of data is necessary to rapidly disrupt most financial subsectors,” says Faucette. Even so, a lack of data isn’t a deal breaker, as an innovator can succeed by building out a disruptive business that accrues data on its own.

5. Does success hinge on collaboration?

In any business, it's important to get buy-in from multiple parties, but in finance especially, establishing trust and partnerships is critical. Robo-advisors, for example, are benefiting from undeveloped infrastructure, changing consumer behavior and new emphasis on fees. Even so, “we think robo-advisors will be most successful if they collaborate with established players, by sharing their technology, while benefitting from brand and network,” notes Graseck.

6. How important is access to capital markets?

Companies that require continuous access to capital markets are subject to a high degree of market volatility, which can put an entire business model in jeopardy if still early in its formation, says Faucette. For fledgling U.S. marketplace lenders (a.k.a. peer-to-peer lending) and mortgage originators, access to capital markets could be a limiting factor, especially now that established players are investing in the space.

7. Is the industry concentrated?

“Simply put, we believe the complete disruption of a highly-concentrated industry is all the more challenging because incumbents have the ability to respond in concert to any serious, growing threat,” says Faucette, noting that industry concentration isn’t an issue for B2B payments or InsurTech, but poses a threat to mobile wallets and blockchain financials, among others. “In a fragmented free-for-all market, meanwhile, partnerships don't offer much benefit, and a superior product, if scalable, is unlikely to be quashed by the combined resistance of incumbents,” he says.

For more Morgan Stanley Research on the outlook for FinTech and its impact on financial industry incumbents, ask your Morgan Stanley representative or Financial Advisor for the full report, “FinTech: A Gauntlet to Riches,” (May 17, 2017). Plus, more Ideas.