Investing in the digital economy

published 13 June 2022

As the digital economy continues to grow exponentially, the financial technology providers with the specialist expertise to help people participate in it are moving centre-stage. These fintechs provide the infrastructure that underpins the way in which digital technologies are changing the way we work, live and play.

In the UK alone, fintech businesses attracted $11.6bn of investment last year according to the CBI – a 217% increase on 2020 – and the number of billion dollar “unicorn” businesses in the sector more than doubled. And this is a global phenomenon – because the digital economy is expanding fast all around the world, so too are the fintechs that support it.

Given the achievements already made by fintechs and the prospects for further growth, many investors are excited by the returns potentially on offer from getting in at an early stage. But investing in this aspect of the digital economy is not always straightforward, with pitfalls that could catch out the unwary. Take three areas of the market where investors’ interest is coalescing:

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Managing cryptocurrency risk UK investors have become increasingly enthusiastic about cryptocurrency assets, prompting the Financial Conduct Authority, the UK’s chief City regulator, to publish a cautionary note last month. Investment in these assets is not regulated in the UK, the FCA point out, as market volatility hit the value of many investors’ holdings.

Cryptocurrencies, for the uninitiated, are digital currencies that are secured by sophisticated cryptography; the best-known example is Bitcoin, but there are many more. Many cryptocurrencies run on decentralised technologies, making use of blockchains – effectively ledgers of transactions maintained by huge networks of computers.

As recent months have shown, cryptocurrencies can rise and fall with alarming speed, but that is not to downplay the fundamental value and usefulness of digital currency. It provides a means to electronically exchange value with anyone, anywhere, and to do so instantly, with no need to use traditional intermediaries such as banks. The potential is to fundamentally reshape the global financial system.

How, then, do investors explore these ideas? One option could be to look at those companies leading the cryptocurrency charge, rather than the assets themselves. That could include, among others, companies directly involved in crypto mining, payments, finance, and infrastructure. All of them are supporting the use of digital assets and their associated networks as the foundation for a digital economy.

Profiting from payments Consumers have got used to being able to settle their bills in new ways that offer greater convenience and reduced stress. Contactless payment is one example: the total value of contactless transactions in the UK increased to £166bn last year according to UK Finance, a 46% increase on the previous year. The growth of buy-now, pay-later financing is another; harnessing new technologies, innovators in this industry are able to offer consumers personalised financing plans at the point of payment. And then there are mobile payments, with millions of people now using their phones to pay for goods and services, dispensing with bank cards and cash altogether.

All these payment capabilities require innovation and infrastructure from payments companies focused on facilitating communication, commerce and collaboration. It is easy to start taking them for granted very quickly given their mass adoption, but they wouldn’t exist were it not for the disruptive influence of fintech businesses that have developed the necessary technology.

These include businesses that have become household names, such as digital payments processor Paypal or the British challenger bank Revolut, as well as newer entrants such as Coinbase, one of the most popular cryptocurrency exchanges.

Switching to digital first Traditional businesses in the financial services space are naturally keen to play their part in innovation – and to offer their own customers new digital products and services. However, while these businesses have launched initiatives in areas ranging from online banking to mobile apps, these have to be bolted on to their legacy technologies and systems; inevitably that holds them back.

Digital-first businesses in the fintech sector, by contrast, have been able to develop their products and services from scratch. They’ve been able to build networks, protocols and other infrastructure specifically for the purpose of delivering digital economy products, rather than having to retrofit systems that were developed for an analogue age.

From an investment perspective, these digital-first businesses feel particularly alluring. The digital economy will feature a broad range of financial institutions, including incumbent providers, but newer fintechs are likely to benefit from greater agility and flexibility.

Against this backdrop, the key for investors will be to think about which companies are best-placed to power the transition to the digital economy – and the right way to secure exposure to those businesses.

“The digital economy represents a fundamental reimagining of the global financial system to a new paradigm that harnesses the speed, convenience and capabilities of modern financial technology,” says Michael Sonnenshein, CEO of Grayscale Investments, an asset manager focused in this area. “Our own Grayscale Future of Finance UCITS ETF is one product that aims to capture these themes in a single convenient fund, but there are many ways for investors to receive exposure to this global megatrend.”