This is a presentation I gave to the N26 Product team on CORE Banking technologies.
A tale of two ecosystems: Square 10K
After some time I had the opportunity to go through another 10K analysis with my fellows of the Fintech product guild. This time we decided to analyze Square.
I heard a lot about Square in the news recently but, as I am not based in the US, I didn’t really perceive it as a consumer product and I expected to find a SMB-first company that eventually launched a retail product.
I discovered a much different reality. Square includes two very strong propositions: a Seller one, and a retail one – Cash App. They live under the same company umbrella, but they are solving two completely different problems.
Income Statement
Last year was pretty good for Square: the company grew a lot and managed to face COVID quite well: total revenue doubled (+101%) and the gross profit grew (+45%).
The operating costs grew in line with the revenues’ growth, especially on product development and sales and marketing: the company is betting on its growth and it is investing the extra revenues in acquiring new users and building new features.
Looking at the group Income Statement a few other elements caught my eye: first, the explosion of the ‘Subscription and service-based revenues’ (+45% yoy), which is mainly driven by the Cash App adoption and usage of Instant Deposits and Cash Card; second, the evidence that Hardware is a pure acquisition feature for Square Seller, with a loss of approximately 50M in 2020.
Being Square a transactional business, it is interesting to zoom in on the Transaction-based revenues: the Gross Processing Volume grew even though less than 2019, probably impacted by Covid; the Gross Profit went better, mainly due to the increase in card-not-present transactions [+26% vs -4% of card-present txs] which are more profitable for Square.
The ecosystem creation playbook
To fully understand Square it is very useful to analyze the different behaviours of the two sides of Square’s business: Seller and Cash App.
The Seller side growth was severely affected by COVID (especially by a terrible Q2-2020) that flattened its growth (Gross profit growth from +30% to +8%) but remained solidly profitable with over $1.5B of Gross Profit.
On the other side, Cash App exploded with 3 digits growth in each of the revenue streams: Transactions, Subscriptions and Services, and Bitcoin.
The Bitcoin feature was the hit of the year: 3 million users bought BTC through Cash in 2020, and 1 million in January 2021 only. Bitcoin revenue went up over 700% but so did Bitcoin costs, as the company recognizes as revenue the sale amounts received from the customers and as a cost the associated bitcoin cost – essentially neutralizing the impact on the IS.
What really jumps out is the impressive +125% of the Subscriptions and services-based revenue, made mainly through the wider adoption of 2 core features of Cash App: Instant Deposits and Cash Card. A strong usage pushed up by the massive growth in MAU of the app.
Overall, what seems evident from the analysis is that the core value that Square brings to the table is its mastery in building new ecosystems around an underserved customer base.
They really defined a playbook for ecosystem creation and they are applying it to the SMB customer and to the retail one. In my understanding this playbook works as follow:
- Identify an underserved user, who has a very fragmented financial experience based on stitching together products and services from multiple vendors (probably not digitised yet)
- Focus obsessively on a core pain point for this user: Card payments for SMBs, P2P transfer for consumers
- Use that core use case as an acquisition feature
- Build a constellation of profit generating services around to deliver a ‘cohesive, fast, self-service and elegant experience’
Seller and Cash App are nothing else than two iterations of the same playbook, only at different stages of maturity: Seller quite mature, Cash App still in exponential growth.
Looking at the future
The future looks brilliant for Square.
In the short run, the growth of Cash App is obvious and I believe they are only at the beginning of the journey: Cash App can become the dominant wallet in the US and, given its positioning in the crypto space, it also has the features and the sophistication to intercept new developments in the financial ecosystems – something very hard for traditional banks but challenging also for most of the consumer Fintech companies.
Also, the company just closed the Tidal deal which brings many opportunities in the music and creators space: creators can become another underserved user to build an ecosystem around – more in one of my latest posts.
Looking at the long term, I believe that Jack Dorsey’s vision is to connect the Seller and Cash App ecosystems to originate a new closed loop payment network – eventually based on blockchain rails – fully disintermediating Visa and Mastercard. The company has everything in place to do it: it is quickly ramping up the two sides of this 2-sided marketplace (sellers and consumers) and building two extremely solid customer bases that, once integrated, could create a financial giant very hard to compete against.
Resources:
How tokens could revolutionise the creators economy
Creators economy is the “new hit” in Fintech: all the main VCs are jumping on this vagon, new startups are raising millions trying to build for this underserved market, Square just bought Tidal and thus a creator base of millions of users and, impossible to forget, Non-Fungible Tokens NFTs are everywhere right now.
Much is indeed happening in the creator economy space, but I believe that the biggest impact will come from the interaction of these users with the wider token economy.
My thesis is that the sector’s structure and dynamics will be completely reshaped by the tokenization of the creators’ revenue stream and their sale to a plethora of investors/fans. And that this model will be potentially applicable to other categories (like solo-preneurs and SMBs).
The status quo
Imagine being a London-based musician with around 10M streams/year on Spotify, somebody like Tom Rosenthal, one of my favourite songwriters.
Considering that Spotify pays $0.00437 per stream to artists and that Tom generates around 10-12M streams/year, Tom will very likely earn in the range of 50,000$ to 60,000$ per year from this streaming service, and this cash flow will likely be stable, with some minor adjustments, over the years.
But imagine Tom entering his local Barclays branch to ask for a loan – he wants a new car. I doubt that Barclays will accept his Spotify future revenues (partially predictable by the Spotify stats) as a collateral for the loan. Yet, those stats are not really that different from my N26 employment contract: in both cases, it is a guarantee of cash flows that we will receive in the future. Yes there is always a measure of risk in the future, in this case that people will stop listening to Tom’s music on Spotify or that my relationship to N26 changes (they can fire me/I can resign/the company can stop operating).
The paradigm would be the same if you take a Youtuber, or an Instagram influencer.
Essentially, today’s financial life for a creator – unless they are in the star league – is not easy: the market is clearly underserved and the reason is that very few financial institutions have the sophistication to consider creator’s activities as a financial asset.
As mentioned in one of my previous posts, this is partially due to the fact that music assets are very illiquid: banks can hardly monetize the claim on the revenue streams in case the borrower defaults.
The issue is mitigated by some specialized firms (Royalty Advance, Sound Royalties, Lyric Financials or The Music Fund) but the experience is not optimal for creators. It is quite fragmented and very limited to the cash advance use case.
A new token-based model
Enter the Square-Tidal deal. A few weeks ago Square bought one of the most prominent music services around definitely the most popular in the artists’ community.
The Tidal acquisition makes total sense for Square from many point of views. First, it’s a great marketing strategy as it brings Square closer to many creators in a way that resonates well with its Cash app customer base. Then, it adds over 1M new potential users to Square. But, in my opinion, the most important reason for the acquisition is the opportunity to fix the financial experience for music creators: setup a new model that could reshape the financial dynamics around the music industries and, eventually, for other domains.
Imagine the following scenario: after being disappointed at the Barclays branch, Tom goes online on his Tidal account where he receives his streaming revenues in the form of a Tokenized money stream, without having to wait the end of the quarter/period. Tom could add all his artist accounts to Square and Square could then model the value of Tom’s future revenue streams, thanks to the streaming data provided by Tidal, and issue a `Streaming revenue token` that will entitle the owner to receive the next X months of Tom’s revenue flows.
This Streaming revenue token (SRT) could be sold to his fans on Cash App, who would probably pay a premium due to the emotional attachment to their music idol. Or the SRT token could be sold through Square to investors. (NOTE: This is not very far from what companies like Pipe.com are doing for SAAS Financing). Indeed, the SRT could even be used in a DeFi lending protocol as a collateral.
Imagine if Tom could easily create some unique perks directly from Tidal in the form of NFTs, in a way similarly to what Kings of Leon are already doing.
All these features would make Tom’s financial life much easier, he would have a single touchpoint to manage his professional/financial life, Square+Tidal would simply would become the center of gravity of Tom’s professional life. But, more importantly, his personal balance sheet would expand, because his asset side will be bigger – as all his future income could be included there. Thus, Tom would have a much higher disposable income, as people will be happy to extend more credit to him.
What I described above, resonates really well with the hyper-financialization of society always presented as the killer-application for DeFi. This is what happened during the 20th century with the most important socio-financial innovation of history, the mortgage, and this what eventually could happen again through the token economy.
If we zoom out from music and apply the same paradigm to other creators’ categories the model is fully coherent, and it would bring incredible value to these professionals.
A new industry standard?
At the end of the last century French political advisor Jacques Attali wrote a fantastic book: “Noise, The political Economy of Music“. In the book Attali goes through different phases of musical production and pushes a very strong thesis: music has a prophetic power to anticipate social formations and future mode of production that will then be adopted by the rest of society.
From the forewords of the book:
[Attali] is the first to point out the other possible logical consequence of the “reciprocal interaction” model—namely, the possibility of a superstructure to anticipate historical developments, to foreshadow new social formations in a prophetic and annunciatory way. The argument of Noise is that music, unique among the arts for reasons that are themselves overdetermined, has precisely this annunciatory vocation; that the music of today stands both as a promise of a new, liberating mode of production, and as the menace of a dystopian possibility which is that mode of production’s baleful mirror image.
Fredric Jameson
I believe that today all the premises are there for a new organizational model in the finance of the music industry, based on a more liquid market and a more sophisticated financialization of society.
Considering the widespread value that this new interaction model could bring, and the prophetic nature of the music industry, there are chances that a new hyper financialization paradigm will extend to many other industries: solopreneurs, artsy side-hustlers and SMBs.
Resources
- https://en.wikipedia.org/wiki/Noise:_The_Political_Economy_of_Music
- https://www.superfluid.finance/
- https://netinterest.substack.com/p/from-bowie-bonds-to-pipe-financing
- https://www.linkedin.com/pulse/fintech-food-8th-march-2021-simon-taylor-/
- https://lex.substack.com/p/long-take-why-square-bought-jay-zs
- https://aristake.com/the-music-fund
- https://www.rollingstone.com/pro/features/spotify-million-artists-royalties-1038408/
- https://www.rollingstone.com/pro/features/alternate-royalty-streams-music-business-988900/
The Apple moment for financial services
In the last 10 years the amount of money that was invested in Fintech startups was massive.
This produced a lot of innovation, many great companies were born and they significantly improved the way people interact with financial services. Their innovations took mainly two avenues: distribution/access and financial incentives.
Fintech startups essentially raised the UX bar in these two ways: providing a modern mobile interface to financial services and making their services/products cheaper than those of the incumbents. No one really excelled in terms of engagement or emotional attachment, changing the perception of financial service from a utility service to something cooler.
The argument of this post is that the Apple moment for financial services will come and the new generation of fintech startups will have to work on engagement first, building a very compelling and cool proposition in order to do to finance what Apple did to consumer technology.
The Apple Moment
Today Apple is arguably one of the coolest brands on Earth. Apple products represent a status symbol like no other brand in technology, but also more broadly speaking.
This coolness and luxury factor that Apple managed to create around technology products is something totally new for the tech industry. Before Apple, technology was perceived as a utility, essentially commoditized or easily commoditizable, definitely not as something beautiful that successful people would show off and be proud of.
Apple revolutionized this paradigm, reinvented consumer technology and destroyed many stereotypes in the process. The epitome of this groundbreaking approach is the famous ‘Get a Mac’ ad, where PC users are associated with the “unpopular nerd” cliché, while Apple Mac users are presented as young, creative, attractive, ultimately way ‘cooler’.
I believe consumer finance is ready for its Apple moment, and that consumer startups that really want to make a dent to traditional banks will have to go beyond access, financial incentives and utility, to actually become lifestyle products with high engagement and emotional attachment.
Today traditional banks are highly commoditized products: they all offer the same functionalities and it’s very hard to distinguish them only based on their product offerings.
They typically tend to offer a prepackaged proposition, not really customizable on the users’ needs, which gives access to some fairly standardized sets of features.
Their data model is built around individuals, with no real space for different social aggregations and money management experiments.
The interaction model is identical for every bank: they all have very heavy apps and websites and many users are still relying on branches. Their competition is generally based on cost.
Neobanks are not so commoditized yet, but their features’ sets are getting more and more similar: most of the neobanks are building an ecosystem of mobile-first services, from checking accounts to lending to trading, targeting different demographics but with very similar experiences.
A new paradigm
To stand out from this crowd, a different approach will be needed: a new product concept that merges product and marketing together. Product people will have to come up with some unique product features that can contribute to build brand equity and that would help to find less saturated distribution channels.
Signs of this new trend are already visible: one of the assumptions that neobanks validated so far is that people are willing to pay more for a cooler credit card. N26 built a solid proposition around premium cards (which represent one of the main motivations for buying a subscription) though this alone is not yet enough to differentiate it massively from other neobanks…
Other startups are exploring different territories.
Step and Stir are building banking propositions for very specific niches (Teens and creators) developing a much closer and intimate relation with their customers. Step went even further, tailoring its search for investment on its brand identity, and managing to engage in this Charlie d’Amelio, a worldwide famous influencer extremely popular in their target audience. This can be initially written off as a marketing initiative, but in a world where the main distribution avenues are crowded and expensive, this is not a trivial move.
Bella is going even further: even though they don’t position themselves as a bank (look at the screenshot below), they are building a conversational banking experience blended with a strong sense of community for their customers, something that goes much beyond the current banking experience, even for neobanks.
Yotta is using the dream of making money effortlessly to acquire and retain new customers: every customer by default enters a weekly lottery and can win up to $10M, a super compelling incentive, more powerful than the classic 15/20$ referral rewards.
On the investing side, Commonstock and Public are building networks of investors that can be followed, contacted and mimicked. They are adding a social flavour to investing, something extremely powerful and engaging that we saw in an embryonic way through the WallStreetBets community, but that can be scaled up much further, especially in times of meme-stocks and stonks.
Both solutions are obviously trying to achieve network effect dynamics, something that doesn’t exist in current trading solutions.
Conclusions
The ones presented above are different propositions, but they all show a few common patterns: they are financial products trying to compete not just on easier access or better UX, but they are trying to build competitive advantage based on engagement and, at the same time, using their product to accelerate distribution and find effective alternative to cash-burning Facebook and Google ads.
Some of them might seem products relevant only for some niches, but also Apple started off as a brand for creators and creative professionals….
Beyonce and Monet: the first mass market app for DeFi
Over the last few months, the Decentralized Finance ecosystem has grown at an impressive pace: every single metric you can look at shows double digits growth on a month by month basis.
This is a great achievement, but it is a fact that so far speculation or high risk financial incentives have been the main adoption drivers for Defi (and the wider crypto space). This isn’t negative per se, as it led to the creation of interesting applications and facilitated the evolution of a proper ecosystem, but this is not enough to get to 100 million users. To get to 100 millions users a new set of use cases must be developed. The argument of this post is that DeFi has a great opportunity to build products in fringe alternative asset classes, in particular music royalties and art.
Fringe alternative classes today
In a world where interest rates are sub-zero, single digits return asset classes are extremely interesting for investors. In this scenario, music royalties and pieces of art – with a total asset base estimated north of $ 3T – are becoming more and more appealing for investors.
These “creative asset classes” are dominated by institutional or hyper-wealthy investors, with essentially no access for retail investors. A Robinhood for art and music asset classes simply doesn’t exist. Some marketplaces in these spaces (Masterworks.io for art or Royaltyexchange.com for music, Otis for collectibles) are live but they present some clear entry barriers: fractional ownership is not always guaranteed, their catalogue is limited, they are invitation-based and not open to the wider market.
Music, Art and Blockchain
Music and Arts are not new problem spaces for blockchain, as many projects have been focused on innovating those two domains using DLT applications.
On the music front, there are various companies that are re-imagining how the music industry can be improved. Noticeably among them is Paperchain – a payment solution that shortens the payment cycle for creators, based on their streaming stats.
On the art scene, NFTs are probably the hottest thing in crypto today. Non Fungible Tokens are unique and not interchangeable tokens, the opposite of cryptocurrencies where every token is interchangeable and not unique. NFTs have been used to create digital scarcity in several specific applications that require unique digital items like crypto art (Cryptopunks), crypto-collectibles (CryptoKitties) and crypto-gaming.
Over the last 6 weeks a number of incredible deals took place, with thousands of Eth (millions of $) spent to buy NFTs from groups of digital artists and the NFTs asset category really taking off (you can find an overview of the topic here).
These new projects are tremendously cool and highly innovative: they are exploring the concept of value in relation to physical objects and their ideal counterpart (ideal in Platonic terms), and are pushing the frontier of arts and capitalism to unexplored territories.
Anyway they are complex products: hard to discover and even harder to understand, far removed from our neighbours, the Joes and Janes on planet Earth. I’m sure NFTs will grow exponentially and will probably be the coolest thing in crypto in 2021, but they won’t drive mass market adoption – if not for other speculative reasons.
A mass market approach
Imagine a scenario where a popular crypto aggregation point with a wide distribution (an exchange/wallet like Coinbase or Argent) decides to onboard a new type of tokenized asset: the streaming royalties of the latest Beyonce album.
This token will probably be an ERC20 compatible token that can be traded over the Ethereum blockchain. Based on the number of Spotify streams the token will generate a steady cash flow over time, and the same asset could eventually be used on Aave, Compound, MakerDao to get a loan.
My sense is that a number of elements could make this feature a mass market one:
- Better UX: considering the amounts of barriers to entry to the art/music marketplaces presented above, it would be much easier for Joe or Jane to download Coinbase and buy the Beyonce album token in a few taps. This token would promise higher returns than the vast majority of asset classes today, it would be much more liquid than an investment on Royalty Exchange and could be used to get access to other financial products (it could be a potential collateral).
- Better distribution: Coinbase is a fairly popular app, so it wouldn’t be too problematic for the average investor to get the news that it is possible to buy a Beyonce token.
- Emotional attachment: fans would be in a unique position to show their affection and support to their favourite artists, this would create a bondage with the product that cryptocurrencies will never achieve at scale. This feature would move crypto beyond arbitrage and utility, towards a more popular movement (not far from what happened two weeks ago with Gamestop and r/Wallstreetbets)
Conclusions
What DeFi and the decentralized finance movement achieved so far is incredible, but this is still a tiny fraction of what traditional finance moves every day. To attack the traditional financial system I believe that a typical strategy of the classic startup theory should be followed: optimise for an underserved niche, dominate that segment and then move on to the next one, one by one till conquering the entire financial space.
Especially in a post-pandemic world that craves owning emotions, Arts and Music could be powerful hooks.
Thanks to my friends Angelo Min Tagliabue and Luca Cosentino for their kind and extremely valuable review of this post.
Resources
- https://lex.substack.com/p/long-take-non-fungible-tokens-and
- https://www.coindesk.com/artwork-ethereum-hashmask-650k
- https://www.thehashmasks.com/overview
- https://news.bitcoin.com/rick-and-morty-creator-sells-nft-art-collection-for-over-1-million-in-ether/
- https://cryptobriefing.com/digital-art-auction-raises-record-million/
- https://medium.com/paperchain/how-we-worked-with-centrifuge-and-the-maker-foundation-to-advance-60-000-worth-of-spotify-revenue-a3b6b31299aa
- https://news.ycombinator.com/item?id=26073970
- https://en.wikipedia.org/wiki/Non-fungible_token
- https://www.masterworks.io/
- https://www.royaltyexchange.com/
- https://www.thehashmasks.com/gallery
The Amazonization of retail payments
The phenomenon of “Amazonization” refers to the wholesale disruption occurring across retail and eCommerce thanks to the leviathan-like presence of Amazon.com. Considering the platform shift happening in the retail payment space, I believe the same phenomenon of ‘Amazonization’ that happened to eCommerce will eventually happen to the retail Payments space.
In this post you will find an analysis of the trend and its main consequences.
The dominant payment interface
Paying for things is a universal need and human beings adopted different technologies throughout history to satisfy this need (I won’t elaborate more on this here but if you want to dig deeper you can refer to these two amazing titles on the history of money: The Ascent of money by Prof. Niall Ferguson, Money changes everything by Prof. William N Goetzmann).
During the 20th century, cash payments remained the dominant interface to pay for things.
The general financial habit of the average western citizen was the following: open up a bank account, eventually get a card linked to that but use the bank account as your payment hub. Bank accounts were essentially the acquisition channel for the payment service and cash transactions were still the most common form of retail transactions.
With the new millennium, mainly due to the Internet taking off, things started to change and the % of cash transactions started to fall.
A new interface has clearly taken over the retail payment space from cash: card. Similarly, the bank account lost its acquisition channel nature for the payment services. It’s not a coincidence that the most important consumer fintech unicorns around today (Monzo, Revolut, N26) started as a debit card services (there are also regulatory and operational implications to them starting up as cards and not full bank accounts, but I believe the main rationale was commercial – today it is much easier to attract users with a card than with a bank account).
More recently, another payment platform has been launched: Operative System Wallets.
Wallets are not that new, but they struggled to take off due to complexities in distribution and then adoption problems. Making the wallet a native feature of your smartphone, a key component of your OS experience, is solving these distribution and adoption problems.
Considering the symbiotic relation that each individual has with their smartphone, I believe there are the conditions for a new paradigm shift in the payment behaviour of users: in 10 years the main entry points for payment services will be your OS wallet – Apple pay, Google pay or a proxy – not your bank’s card.
The first signals of this theory are emerging: the adoption of OS payments wallets is growing more than 50% y/y and the trend will relentlessly be reinforced as more people upgrade their smartphones to newer versions that support wallets.
Amazonization of retail payments
As the entry point for retail payment services will be the OS wallet and there are currently only two OSs in the market, the logical consequence is that aggregation theory will be applied to the retail payment space as well.
Apple pay and Google pay will do to payment what Amazon did to ecommerce and Facebook did to news/content: they will be the only acquisition channels for payment services and all the ‘technical’ service providers will be battling on these platforms to get the users’ attention.
When such a strong gatekeeper emerges, it is very unlikely that it will not try to capture some of the market itself, exactly as Amazon did for e-commerce. My expectation is that many basic payment needs will be sorted out through one of these providers (Google or Apple) and it will be essentially impossible to compete with them, especially for basic needs very close to the platform level, as these (Apple and Google) will have operational efficiencies exponentially bigger than any other payment provider.
These basic payment needs will comprise a set of basic payment products and probably including also the identity of the user – I won’t be surprised if Apple will start KYC-ing users and then allow seamless switching between payment providers (similar to Apple SIM model).
PAAS (Payment-as-a-status) and the new payment scenes
There will be a second level competition, similar to the Amazon Marketplace model, where a group of brands, old and new, will be offering premium payment products and compete on top of the main wallet platforms for user attention. This is where neobanks will battle with incumbent banks, but also non-financial brands, to get their market share.
I expect that payment methods will converge towards being a status symbol of your social position, becoming a differentiator of your personality. The main value that they will provide to users will be social positioning, not very differently from brands like Rolex or Ferrari.
Users will be acquired through Apple pay or Google pay by Brand X, and then Brand X will upsell a better service, convenience or status (eventually through a physical card).
In this context, Payment products will essentially be very similar to fashion products, they will appeal to different socio-economic demographics, focusing on specific niches and use cases, and their ultimate differentiator will be their brand.
In the past, this is something that only Amex was essentially doing, using its brand as a socio-economic status symbol, making it very appealing to corporate westerns. The differentiation, that was before an Amex monopoly, has been replicated for different target audiences, mainly millennials, by a plethora of new neobanks that are building differentiated consumer payment services for specific niches.
Examples include: metal card by N26, Wooden card by Treecard, Wooden card by Tomorrow, Crypto-backed card by Bitwala, Gold-backed card by Glint. Even though their main product today is still a physical card, they are selling something else: a status-symbol (Metal card by N26), a financial service (Gold-backed card by Glint), a political statement (Wooden card by Treecard or Tomorrow).
Their proposition, that today is embodied by the card, goes obviously beyond a pure payment one.
In this model, leveraging the wealth of financial infrastructure businesses emerging, many non-financial payment providers will join the bandwagon and will successfully compete against old payment providers: if people are willing to pay thousands of $ for a Louis Vuitton bag, why won’t they activate a LV card on Apple pay and then upsell to a luxury Louis Vuitton diamond card to exhibit every time they pay?
Traditional banks will suffer: as hybrid organizations, that are not tech companies and are not marketing-driven companies, they won’t necessarily have the flexibility and the user understanding to become fashion brands, and they won’t have the technological capabilities and the strategic positioning to build competing wallet platforms. Traditional banks will share the fate of newspapers in the Facebook era – they will compete against so many providers that only a handful of them will manage to profitably stay in business.
Conclusions
I believe that OS wallets have the potential to fundamentally change the Payments landscape over the next decade. I’m convinced that general purpose payment services belong to the past and they will entirely be captured by a handful of global tech platforms.
Leveraging the huge wave of financial infrastructure services, payments will probably become a business of branding and it will be crucial for anyone willing to stay in the retail payment space to fully understand the type of user they are catering to and focus on serving them much better than anybody else.
Resources
A neobank stack
Over the last few years I’ve spent a lot of time building lending and banking stacks. What used to require vast resources only 10 years ago, is today a much simpler and more inexpensive job, thanks to the enormous number of financial infrastructure businesses born in the last decade.
The goals of the following 2 posts are: to highlight which are the key functional components of these stacks, to point at who are the main providers around and, more in general, to share what are some of the key learnings I gathered working hands-on on their development.
An overview
The core assumption behind this architecture is that a retail bank is not in the business of making mobile apps, nor it is in the business of issuing debit/credit cards. A bank operates in 2 problem spaces:
- the business of trust (liability side) – a bank is an institution selling trusted repositories where users can store their value. It must convince people that it is a trustworthy institution.
- the business of selling liquidity (asset side) – a bank must make a profit out of the funds it gathered, correctly setting the price of the liquidity, based on the risk profile of its clients – on the asset side
The average banking product is simply an interface optimised for the current state of the technology: today it is a smartphone application, in the past it was a branch, in the future it will likely be a different interface. What won’t change are the fundamental problems that a bank will solve, as shown in the architecture designed below.
Banking channels
This module includes multiple elements: from domestic payments to branches, from ATMs to cryptos. These apparently very different pieces have one core characteristic in common: they enable the movement of money inside and outside of the user account. Each one is a different touchpoint which covers different use cases for different demographics, but they all ultimately enable money movement.
I believe this module is probably the most affected by the modern banking evolution, putting together today things that were completely different in the past, such as Cards and Branches. Take branches, for example. As the retail banking space evolved, the branch-centric approach has been totally surpassed and branches pushed to the margins of the banking architecture.
Branches today are to banks what CDs are to songs: once the physical embodiment of the service, now they are nothing more than a nice accessory, interesting to some, but definitely not a central component of the related business model.
In the banking channel alone, there are literally hundreds of companies trying to build more modern API-based experiences which requires minimal effort to integrate with and guarantees adequate support.
Fincrime
The Fincrime module is in charge of filtering out potential fraudsters and money-launderers from the flow of total movements. It is logically a clear extension of the banking channels component, because it operates on top of those transactions.
It is a fairly recent innovation which became necessary when banking lost its personal touch and became a machine-first, more than a person-first, business.
Fincrime is one of the spaces where artificial intelligence and machine learning techniques are seriously delivering value: it would be inconceivable for a modern bank to manually or semi-manually scan all the transactions.
Products engine
The product engine is probably the flagship element of modern core banking platforms. It is a product configurator where a bank can easily configure standardized products like overdraft, checking account or loans and immediately distribute them to its customer base.
It is usually bundled together with other modules in a wider core banking offering (ledger).
NB. In my abstraction, the product engine does contain the creation of the loan, credit line and overdraft products, but doesn’t include the decision lending stack, which I’ll present in a future post.
Ledger
Ledger technologies have been the foundation of any banking businesses since the northern Italian city states invented banking just after the Middle Ages. A ledger is nothing more than a glorified database, and it represents the ultimate source of truth on the account balance and, in general, on any banking activity within the company.
A ledger must be extremely reliable, secure, easy to integrate with and easy to query.
Being blockchain a ledgering technology, this domain is constantly mentioned as being a domain ripe for innovation. My opinion is that blockchains, before being ledgers, are primarily systems to align incentives and I’m very skeptical about the real benefits of permissioned chains. For this reason I believe that DLT doesn’t really make sense today as a ledgering technology for a bank, especially in a permissioned context and without a proper ecosystem built around it.
API Aggregator
API aggregators are new-comers to banking. Before open banking took off, this element wasn’t even a theoretical concept in banking ecosystem.
Today, almost every bank is integrated to at least one banking information aggregator which shares data about customers gathered from other financial institutions.
The role of API aggregators is still in its infancy but, being banking a business of information, I believe that their role will become more prominent over the next years.
Identity hub
I decided to aggregate Onboarding, KYC and CRM because they represent to me different phases of the same user’s lifecycle, as they all build different aspects of the identity of the user in the bank’s eyes.
As user onboarding moved from a branch-based approach to remote, KYC providers acquired an enormous space and there are a lot of companies doing KYC cheaply and very reliably in the vast majority of geographies.
Identity is surely a banks’ key asset but its value still remains largely untapped, as no bank built a business on top of the constellation of information gathered on the users, nor on facilitating dedicated identity services to other providers.
Treasury
Putting the capital gathered in its deposits to a more productive use is one of the key activities of a bank. This is a crucial activity for bank profitability, but this also requires skills completely different from the ones typically available in a consumer-focused neobank. All the recently funded neobanks tend to be very user-centric and customer-service focused: they are 21st century technology companies more than traditional financial companies, therefore scaling up this function can be extremely defocusing in the growth phase, when the goal of the bank is to create a solid customer base of depositors.
In this scenario, many of these companies can outsource their treasury investing/activities to some of the many investment vehicles around or can, more traditionally, use softwares to internally manage their liability side.
RegTech
The financial industry is one of the most regulated industries in every country and a tremendous amount of resources is spent on this activity. Lots of companies are working in this space.
Conclusions
In this brief post I wanted to present some high level modules that I believe are essential elements in building a modern bank.
All the brands and companies mentioned are only a small subset of the incredible number of good solutions in circulation and most of them cover more than one aspect, but this is not factored in in my architecture.
In my next post you will find a similar exercise for the other crucial stack of a bank: the credit decision stack. Stay tuned.
Bank runs in the 21th century
We live in very special times, from many points of view. Essentially any aspect of our life is being disrupted and this wave of unusuality is impacting banks as well: banks are seeing their deposits going up, they are getting a lot of money, but, for once, that isn’t necessarily a good thing.
The usual way: bank runs
Usually people put their money in banks confident that they are safely stored, easily accessible and ideally producing some sort of returns. In the large majority of cases, things go well.
Unfortunately, sometimes they don’t: banks can collapse. Every time that a bank is even rumored to be in bad waters, a large number of depositors immediately ran out and queue up outside bank branches hoping to withdraw their money and secure them before a possible collapse.
This run to the branches would then cause even more troubles to the bank, ultimately resulting in the actual collapse of the institution.
This phenomenon is defined as a bank run, and it has been a fairly common occurrence in banking history. Wikipedia provides a very interesting page with the list of the most significant bank runs.
The covid-way: reverse bank runs
In 2020, after Covid-19 hit, things are going differently. Many banks are today suffering from the exact opposite problem: they have too much cash and are reluctant to accept more deposits.
Today depositors are keeping their money in bank accounts. This is due to various reasons: less opportunity to spend money, a desire to save for uncertain times, but also the lack of profitable investment opportunities around. The latter applies especially to financial institutions themselves, as interest rates at central banks are exceptionally low and COVID-19 has increased the risk of lending to most of the companies. Therefore all these fresh deposits end up being stashed as bank reserves.
This phenomenon is especially true for neo-banks like N26, Monzo or Revolut, because their loan-book is pretty thin, if non-existant at all, and thus the cash of their users is ultimately not reinvested in loans, ending up in the neo-banks’ accounts in central banks.
Usually, this extra reserve wouldn’t be a big deal: yes, there is a sort of ‘ethical’ issue because banks should channel capital from households to investments to put it at more productive use; but, to be honest, it is also very hard to find productive use for all the capital that is around today.
Besides this, the extra capital wouldn’t be a big problem if banks were not regulated by the Basel III framework. But they are. Basel III actually introduced a new non-credit risk ratio, the leverage ratio.
Leverage-ratio = Tier1 Capital/Total Asset > 3%
In simple terms, the leverage ratio wants to make sure that the leverage of the bank is not too high, so that the activities of the bank are not overly funded by debt positions.
This ratio is highly impacted by the reverse bank runs, because the bank capital that was optimized for a lower deposit base before the pandemic, is likely insufficient to guarantee a much larger asset base post-pandemic.
How are banks reacting?
There are essentially two ways to solve this problem: add extra capital or optimize the Asset side – shrink it and make sure you don’t get other reserves.
Adding extra capital would be seamless to the depositors, but it’s not easy to ask your shareholders to put extra capital in a banking venture that is extremely cyclical, on the verge of a global recession caused by the pandemic. Therefore, the only feasible alternative for many banks is balance sheet optimisation, which concretely means stopping the creation of new accounts (as Goldman Sachs did in the UK with Marcus’ accounts) or, even more radically, disincentivizing extra deposits.
In the end, banks don’t want people’s money anymore, at least for now. What a time to be alive.
Resources
- https://en.wikipedia.org/wiki/List_of_bank_runs
- https://www.bloomberg.com/opinion/articles/2020-05-21/too-much-money-can-be-bad-for-banks
- https://www.bloomberg.com/opinion/articles/2020-04-02/banks-have-too-much-money-now
- https://www.theguardian.com/business/2020/jun/10/goldman-sachs-closes-marcus-account-to-new-savers-coronavirus
- https://www.bis.org/bcbs/basel3/b3summarytable.pdf
- https://www.riskquest.com/wp-content/uploads/2016/09/whitepaper_basel_iii.pdf
- https://www2.deloitte.com/content/dam/Deloitte/sg/Documents/financial-services/sea-fsi-basel-III-framework-noexp.pdf
- https://www.investopedia.com/ask/answers/062515/what-minimum-capital-adequacy-ratio-must-be-attained-under-basel-iii.asp#:~:text=Under%20Basel%20III%2C%20the%20minimum,economic%20systems%20throughout%20the%20world.
- https://en.wikipedia.org/wiki/Standardized_approach_(credit_risk)
- https://www.bundesbank.de/en/tasks/banking-supervision/individual-aspects/own-funds-requirements/credit-risk/credit-risk-standardised-approach-622822
- https://capital.com/standardised-approach-credit-risk-definition
- https://www.bis.org/publ/bcbs128b.pdf
- https://en.wikipedia.org/wiki/Basel_III#Liquidity_requirements_2
- https://www.investopedia.com/terms/r/risk-based-capital-requirement.asp#:~:text=Risk%2Dbased%20capital%20requirement%20refers,regulatory%20capital%20for%20financial%20institutions.&text=These%20requirements%20ensure%20that%20each,a%20safe%20and%20efficient%20market.
The backbone of cross border transactions: correspondent banking
A few weeks ago, while preparing my 10k analysis for Adyen, I came across a very interesting McKinsey report on Payments and stumbled into the following table on cross-border transfer flows and revenues:
What really surprised me, even more than the huge revenue chuck of the B2B segment, was the disproportion between consumer and business segments and, at the same time, the opposite trend in startups. Here is why, I thought, I see so many startups trying to build in the C2C payments space, even though in B2B there is a 5x bigger opportunity. Trying to get to the bottom of this, I started investigating, together with some fellow guilders of the Fintech Product guild, on the fundamental piece of infrastructure that powers these transactions: correspondent banking.
The goal of this post is to go through the process of sending money through correspondent banking corridors and to look at how new technologies might change it all.
What is correspondent banking?
Correspondent banking is defined as “an arrangement under which one bank (correspondent) holds deposits owned by other banks (respondents) and provides payment and other services to them.
In order to fully get the concept and the implications of this banking model, it is very useful to contextualize it in the wider bank transfer ecosystem.
Sending money through your bank to somebody else is a fairly standardized process nowadays: based on the recipient destination you might have to fill in in your app few or less fields – but ultimately the complexity is totally abstracted away from the bank user. In reality, sending money to somebody with an account in your bank or in your country (economic area) or in the rest of the world, it’s a very different process.
If your recipient is in your bank – the money will be transferred in a matter of seconds, it’s just a change in the liability side for your bank.
If your recipient is in your same country or economic area – the transfer will take some more time but it will essentially be guaranteed by a ‘national’ payment scheme (SEPA).
If your recipient is in another part of the world, things get trickier: unless there is a specific agreement between your bank and the recipient bank, there is no common scheme that is connecting them, because a common global scheme that connects all the banks in the world doesn’t really exist. To send your money to your destination, your bank will have to be part of a global network that regulates correspondent banking (the SWIFT network) and a correspondent bank will have to act as an intermediary.
As shown in my example, It is possible that more than one correspondent bank will be necessary to get to the destination, but due to the hierarchical structure of the SWIFT network, the delivery of the payment to the counterpart is essentially guaranteed.
PS: Just to be clear, the financial mechanics of this transaction are more complex than a simple money transfer, because the correspondent bank will also provide currency exchange service, thus it will have to hedge the currency transaction in some form, but this complexity is external to the pure corresponding banking process and thus I will not explore it in this post.
SWIFT, the most critical telecommunication company in the world
As briefly anticipated above, the core of the correspondent banking model is represented by SWIFT, the Society for Worldwide Interbank Financial Telecommunication.
SWIFT was created in the 1970s by a consortium of banks, that still owns the company, to facilitate cross-border banking interactions. Since the 70s, SWIFT has been the essential monopolist in cross-border payment infrastructure.
As suggested by the name, SWIFT is a telecommunication company that supports financial applications: it essentially delivers billions of messages every year to make the cross-border monetary flow happen. An important thing to note is that SWIFT is a pure telecommunication company: it can deliver your messages to anyone fast and securely, however, it doesn’t provide the legal framework for settlement that banks often establish on 121 basis.
The volume of transactions processed is staggering:
The data around the monetary volumes of these transactions is not clearly presented but numerous sources reports around multiple hundreds of $ trillion per day.
Going back to the example presented above, how does SWIFT concretely work to move money?
SWIFT doesn’t physically move money, and the transactions are not settled at SWIFT level or on SWIFT balance sheet. SWIFT is a telecommunication company that propagates messages containing financial transactions’ details between origination and destination. This is done essentially through two methods: serial or cover.
The Serial method is simply a chain of single transactions between each bank in the chain with each bank having an account at the other bank. The payment information and the settlement instruction travel together in the MT 103 message (the most common SWIFT standard).
The Cover method decouples the settlement from the payment information. On one side, the MT 103 with the payment information is sent directly through the SWIFT network from the originating bank to the receiving bank; whereas the settlement instruction (the cover payment) is sent via intermediary banks through the path of direct correspondent banking relationships – through an MT 202 message.
The cover method is theoretically cheaper, because banks do not take any additional fees from processing an MT 202 message, while they do it for an MT 103. In reality there are other cost elements involved in the equation to be factored in.
The cover method is also faster because the destination bank is aware of the incoming message and can investigate if the payment is stuck somewhere upstream, something that isn’t possible for the serial method, where the destination bank becomes aware of incoming transactions only when they are at destination.
The next step in correspondent banking
Over the last decades multiple attempts of disintermediating have taken place: multiple players have attacked one by one multiple use cases that were once served by SWIFT, but the Brussels-based consortium remains the core infrastructure of the vast majority of the cross-border payment volumes.
The latest attack is mainly coming from Ripple, a company that built a blockchain based technology which claims to be cheaper and more efficient than SWIFT.
Due to the nature of the problem, I believe that blockchain technology can be extremely promising in the B2B cross border space, but due to various reasons, network effect being the first one, so far nobody has not cracked the SWIFT domination.
Anyhow, the future of SWIFT and correspondent banking is a very fascinating but also very articulated topic and it definitely deserves a stand-alone post. Stay tuned.
Thanks to my friend (and former SWIFT employee) Alex Eliseev for his kind and extremely valuable review of this post.
Resources
- https://www2.swift.com/knowledgecentre/publications/us1m_20190719/2.0?topic=mt103-guidelines.htm
- https://www.swift.com/sites/default/files/documents/swift_annual_review_2019.pdf
- https://www.investopedia.com/terms/c/correspondent-bank.asp
- https://www.investopedia.com/ask/answers/071715/what-role-does-correspondent-bank-play-international-transaction.asp
- https://en.wikipedia.org/wiki/Correspondent_account
- https://www.bis.org/publ/qtrpdf/r_qt2003g.htm
- https://www.bis.org/cpmi/publ/d147.pdf
- https://www.wellsfargo.com/com/correspondent-banking/
- https://efinancemanagement.com/international-financial-management/correspondent-banking
- https://cib.db.com/insights-and-initiatives/flow/correspondent-banking.htm
- https://www.ecb.europa.eu/home/pdf/research/Working_Paper_412.pdf
- https://core.ac.uk/download/pdf/6608801.pdf
- https://cib.db.com/insights-and-initiatives/flow/correspondent-banking.htm
- https://www.youtube.com/watch?v=U05APPEawDM&feature=youtu.be
- https://www.bis.org/cpmi/publ/d173.pdf
- https://www.mckinsey.com/~/media/mckinsey/industries/financial%20services/our%20insights/tracking%20the%20sources%20of%20robust%20payments%20growth%20mckinsey%20global%20payments%20map/global-payments-report-2019-amid-sustained-growth-vf.ashx
- https://miro.com/app/board/o9J_ktZUdCw=/
Shopify, e-commerce eats finance
The last session of the Fintech Product Guild `10k-a-month club` was centered around one the most interesting companies in circulation: Shopify.
Shopify was established with the goal of making e-commerce very simple for anybody: the company provides a set of tools to bootstrap an online shop and essentially remove a lot of technical hurdles from the setup of an e-commerce, letting entrepreneurs focus on the commercial side of the venture.
Recently, they started adding a comprehensive set of financial features to their product, embodying the paradigm of embedded finance that I already touched in one of my previous posts.
The goal of this post is to deep-dive into these features and analyse their strategic impact.
Financials analysis
Income statement
Shopify grew massively in the last 12 months, reaching over 1 million merchants on the platform and a GMV (Gross Merchandise Volume) of more than $60bn.
This is obviously an insane number, but it’s still less than a third of what Amazon generates through its Marketplace business, and less than 20% of Amazon’s entire GMV .
That GMV translates into $ 1.5 B revenues split between subscription and merchant solutions.
The subscription product is essentially the access to the e-commerce platform and was crucial to jumpstart the company, but the merchant solution is where the company is investing more and where they probably expect to build a moat.
Merchant solutions now accounts for 59% of Shopify’s revenues, and counting. This line includes a constellation of extra services that support the merchant in many non-commercial activities, such as:
- Shopify Payments
- Shopify Shipping and Fulfillment
- Shopify Capital
Balance Sheet
Shopify’s balance sheet is really a fortress with minimal leverage and a lot of cash available.
Statement of Cash Flows
Shopify’s statement of Cash flows is very insightful, as it really shows a company in its growth phase: the financing flow started to go down but is still very strong, the operating flow starts to take off and the investing one is diminishing but still deeply negative.
Leveraging the platform: embedding finance
The last Shopify Reunite saw a number of announcements with Money and Financial features at the centre of the stage. Many of their products pose a direct threat to many incumbents and pure Fintech startups:
| Feature | Threat to: |
| Shopify balance: A business banking account and loans for merchants. No fees or minimum balances. This will include a Shopify customized virtual and/or physical debit card and cash-back cards | Retail banks, neobanks for SME. Any new e-commerce will probably use either Shopify or Amazon. They will easily be acquired also on the banking side. |
| Shopify Capital: The company expanded their lending infrastructure. Lent $1 billion to merchants so far, in ticket sizes ranging from $200 to $1 million. | Retail banks, SME lenders. See above, only for lending (with better underwriting opportunities). |
They also announced some customer-facing features that want to rival with more customer facing brands:
- Installment payments via Shop Pay, with the option for users to break purchases into 4 even payments at 0% interest.
- Shop App: Less fintech and more Amazon competitor, with better merchant features and 16 million users so far.
To be honest, I’m very skeptical about this consumer-facing twist: first, building a consumer brand that rivals Amazon or even Facebook is extremely complex and defocusing for a platform company; second, and more important, this also introduces a mismatch of incentives between Shopify and its customer base: the merchants.
One of the perceived value of Shopify over Amazon, is the fact that Shopify is considered a tech partner that doesn’t want to screw you up because it doesn’t consider your margin its opportunity. This partnership narrative may be at risk in a more prominent D2C role.
Looking ahead
Shopify is an extremely solid company, with a great outlook for the future. They are placing themselves at the center of the future of commerce, providing a comprehensive infrastructure that makes the life of the merchants much easier, and let the company focus on serving customers better and with minimal financial and logistic hussle.
Their focus on financial features is the nth signal that embedded finance is a key trend that also other platforms are embracing (see Amazon partnership with Goldman Sachs).
In this world, incumbents and pure fintech startups have to find a way to clearly define themselves, but I’ve already tackled this point 🙂 .
Resources
- https://investors.shopify.com/financial-reports/default.aspx
- https://www.marketplacepulse.com/articles/amazon-gmv-in-2019
- https://www.forbes.com/sites/gulnazkhusainova/2020/05/21/shopify-has-a-plan-for-e-commerce-domination-and-it-just-might-work/#668f05c58d1e
- https://www.shopify.com/partners/blog/shopify-reunite-announcements-2020
- https://techcrunch.com/2020/05/20/shopify-balance/
- https://stratechery.com/2020/platforms-in-an-aggregator-world/
- https://stratechery.com/2019/shopify-and-the-power-of-platforms/
- https://www.cnbc.com/amp/2020/06/10/amazon-and-goldman-sachs-unveils-small-business-credit-lines-up-to-1-million.html
- https://www.shopify.com/partners/blog/shopify-reunite-announcements-2020#money
- https://www.shopify.com/reunite?itcat=partner_blog&itterm=shopify_reunite_2020_announcements
