Fintech comes of age: invest in the future of finance

The world’s first cash machine was a key milestone in the history of financial technology

(Image credit: © Tom King/Mirrorpix/Getty Images)

published 31 July 2020

“Fintech”, short for financial technology, is often dismissed as yet another buzzword – a way for companies to market themselves and raise money. But there is a great deal more to it than that. Think of it as a sector bringing together money and new technologies to improve financial services. It is closely linked to major technological advances in several other areas.

One is artificial intelligence, which can help financial services companies make decisions about loans, for instance, or help customers by installing robo-advisers to answer questions. Blockchain, the electronic ledger that underpins bitcoin, can help manage transactions more efficiently; data storage and processing advances help companies achieve more scale for less cost; and internet connectivity, through cloud computing, means they can embed their services in everyone’s daily lives across all their devices.

Equity investors certainly see plenty of potential in the sector. It has generated near-10% returns this year while some markets, such as the S&P 500 in the US, are just breaking even. This is due to both the compelling long-term outlook and short-term factors. In lockdown, people were forced to change their habits and turn to online shopping, payments and e-commerce to get by. Many won’t go back. All these areas of fintech were already growing; what the virus has done is accelerate the take-up. Throw in the structural tailwinds from various technologies and no wonder more and more investors think the fintech sector is a smart place to be.

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An online presence means reaching a market without investment in bricks and mortar. And platforms can be built using other providers who can offer the transaction management, the data processing and the joined-up infrastructure. It is becoming increasingly straightforward for new players to enter the sector. A good example of an early disruptor is mobile-payments company PayPal, while online, “virtual” bank Monzo offers accounts in the UK without a single branch.

Fintech can be hyped as a “David versus Goliath” battle between small, plucky upstarts armed with attractive deals and services fighting to free us from the tyranny of evil bricks and mortar banks. This narrative has been tarnished this year, most notably with the financial scandal unfolding at German payments company Wirecard. While it would seem its demise is a case of fraud rather than faulty technology or a flawed business model, it’s a warning to investors and regulators. Visionary entrepreneurs, start-ups and disruptors are all well and good, but the desire to encourage them should not come at the expense of supervising them effectively.

It’s all a far cry from the fintech of old. In June 1967 nobody waiting in the crowd outside the Barclays Bank on north London’s Enfield High Street could have imagined they were about to witness a major milestone in the long history of financial technology. For them, the attraction was an appearance by Reg Varney. He is still just about remembered today as the star of ITV’s sitcom On the Buses. He was there to launch what was the world’s very first automated cash machine. And now, more than 50 years later, there are 3.25 million more cash machines globally.

The first cash machine built on previous advances. In 1866 the first reliable transatlantic cable was used to send foreign-exchange price data (hence the term “cable” to denote the exchange-rate between the pound and the dollar). The US Federal Reserve’s Fedwire system launched in 1918 and used the telegraph and Morse code to transfer money. Credit and charge cards were appearing in the US in the 1950s, while Barclays launched Britain’s first plastic card – the still surviving Barclaycard – in the 1960s.

It’s not just retail banking. Finance everywhere was sped up by the major breakthrough of the handheld calculator in the late 1960s (previously they were big and generally built into desks). Electronic share trading arrived in the 1970s with the world’s first digital stock exchange, America’s Nasdaq. The Swift system, a name that will be familiar to anyone who makes international payments, came soon after. This international code remains a very common way in which banks talk to each other as they move funds around the world. The 1990s saw online banking, and hence e-commerce, take off.

Despite fintech’s rich past, the sector today is often associated most closely with innovations in how people pay for goods, especially online, and pay each other outside the traditional banking and financial system. Digital payment is a major theme globally and a significant driver of fintech. The world is shifting away from cash. Covid-19 has accelerated the trend. Suggesting people avoid cash to limit potential transmission of the virus has been a boon for traditional banks and credit-card companies, as well as other payment-system providers. According to the British Retail Consortium, even before the pandemic cash payments were in third place behind debit and credit cards. Retailers handed over £1.3bn in fees to payment companies in 2018. No wonder, then, that the share prices of PayPal and Square are up by 65% and 100% respectively this year.

Sweden, with a young, tech-savvy population, provides a glimpse into the cashless future. Cash usage has declined rapidly as people embrace paying electronically. At least 4,000 Swedes have even had microchips inserted under their skin allowing them to make payments with the wave of a hand. Italy, on the other hand, where cash payments are still relatively high at 86%, is actively promoting the use of cards in a bid to reduce tax evasion totalling an estimated €100bn a year by offering tax cuts for users of plastic.

When it comes to profiting from digital payments, the best opportunities are likely to lie among the bigger companies building scale that brings with it greater business efficiencies and better margins. These firms should provide the strongest returns from the favourable underlying digital trend. We like the payment processor Visa, for example. The pursuit of scale is a theme that has already been playing out in the US, with a series of significant mergers involving firms such as Worldpay, First Data and Global Payments. The European landscape remains much more fragmented as individual countries adjust to digital payments at varied speeds, but the wave of consolidation in the US is likely to be repeated in Europe, particularly as some companies’ funding has dried up owing to the pandemic.

Beyond digital payments, another attractive theme within the sector is fintechs bolstering established financial services providers’ technology. A good example is Britain’s high-street banks, which, owing to underinvestment and several mergers, are sitting on dated and cobbled-together software applications and processes dating back to the 1970s. IT shutdowns are frequent, with customers sometimes locked out of their accounts.

Fintech companies can also help big banks plug gaps in their IT capability. They can offer a system to run current accounts, for example, which a bank could buy and offer on its own website platform. Robo-advice is becoming more common, while artificial intelligence can help make lending decisions because such systems can absorb the relevant information and apply it. Many insurance and asset-management businesses would now find it very hard to operate without fintech support. Of course, with money – and especially money on the move – comes fraud. Fake emails, credit-card fraud and the theft of customers’ data are all becoming more common. This means plenty of opportunity for companies that can stop hackers, protect data and contain viruses.

Fintech has already developed quite strongly in China and India, two huge countries with populations making and earning more money. In China, making digital payments is much more common than using cash or even credit cards. In 2011 only 3.5% of payments were made on mobile phones; by 2019 the figure had risen to a staggering 85%. There are big players such as WeChat (China’s equivalent of WhatsApp) that offer these services and there are also several smaller companies poised to enter the market. India, meanwhile, is capitalising on digitalisation to offer financial services to its rural population. Eye and fingerprint recognition technologies help get accounts up and running quickly.

And beyond these two regions offering significant growth opportunities there are around two billion people in emerging markets who haven’t got bank accounts. Fintech is helping countries get them included in the financial system more quickly, with mobile-phone payments key. Many of these countries are essentially building nationwide banking infrastructure without the need for a widespread branch banking network and unencumbered with a legacy business that needs modernising.

Fintech investors should be on their guard, however. Incumbents can be unexpectedly hard to topple (there are plenty of “old guard” businesses still in profit in spite of intense competition), while start-ups can be immature and untested, moving from being a disruptor to becoming outdated in no time. Transformation takes many iterations before settling. But the gains and successes outweigh the failures. Selecting where to invest is tricky and our preference tends to be larger businesses with strong positions and unique offerings, or a funds-based approach: diversification might blunt returns, but the overall sector is doing so well that it is still easily ahead of the wider market. We list our favourite ideas in the box below.

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Stephen Connolly is the managing director of consultancy Plain Money. He has worked in investment banking and asset management for over 30 years and writes on business and finance topics.