The emergence of fintech “super apps”
Traditional payment processors are moving beyond their core transaction processing businesses to offer a much broader range of financial services. For example, in China, Ant Financial utilises AliPay’s 1bn user base to sell a broad array of financial services, from loans and insurance contracts, to asset management products. Its digital finance business accounted for 56% of the group’s revenues in 2019.1 While concerns around regulation and anti-trust derailed the company’s initial public offering (IPO) last year, we believe Ant Financial is leading the way, and others will follow.
We expect the convergence between payments and financial services to gain traction in developed markets, too. Unlike China, digital payment wallets are not yet widely adopted in the US and Europe, where Visa and Mastercard ecosystems remain dominant. In this context, we believe that only a few companies seem to have the user base, brand power and ecosystems needed to become fintech “super apps”.
With close to 350m users and 30m merchants on its network, Paypal is one of the few names that stands out for us. The company has launched many new products and services in the last couple of years around online lending, digital banking and cryptocurrencies. These new services are already showing in its numbers, with the company now expecting 19% year-on-year revenue growth this year, despite tough competition.
1 Ant Financials IPO prospectus (2020102600165.pdf (hkexnews.hk))
Figure 1: Fintech platforms have gained a large audience in China, and to a lower extent in the US and Europe
Source: Visa, company data
AI will be a key enabler of financial innovation – and inclusion
More than three quarters of financial institutions believe that Artificial Intelligence (AI) will become essential to their businesses within the next two years.2 The lending space, in particular, is likely to be profoundly disrupted by AI.
Traditionally, banks with lending activities would filter potential borrowers based on their credit history. Then, a loan officer would manually assess the merits of each individual applicant. There are several issues with this model, however. Credit scoring only works well for people with a bank account and credit history, and the cost of the underwriting process means small loans often tend to prove uneconomical. Overall, this leads to poor access to credit. In the US, for example, while four out of five people have never defaulted on a loan, less than half are eligible for the best interest rates on offer.3
We believe AI will make it possible to improve the accuracy of credit scoring through complex models that consider thousands of data points, including a borrower’s education background and employment history. AI will also likely be leveraged to automate the underwriting process, thus rendering small loans much more profitable.
From a societal standpoint, AI has its benefits too. We believe it should ultimately lead to more affordable credit and thus better financial inclusion. Furthermore, for companies that are successful at adapting, the addressable market is massive – for example, in the US alone, commercial banks issued $15trn of new loans in June 2020.4
For fintech companies, the opportunities AI presents are two-fold, in our view. First, fintech companies can directly engage in activities like personal and micro lending, often in partnership with traditional financial institutions that provide funding for loans. In the US, for example, fintech companies controlled close to 39% of the US unsecured personal lending market in 2018 – up from just 7% in 2013.5 Second, in other sub-segments of the lending market like auto or mortgage origination, fintech providers, while having less of a direct presence, can drive innovation by selling modern AI solutions to traditional financial institutions like banks and credit unions.
3 Upstart’s IPO prospectus (Amendment No. 2 to Form S-1 (sec.gov))
4 Upstart’s IPO prospectus (Amendment No. 2 to Form S-1 (sec.gov))
5 TransUnion Industry Insights report (TransUnion FinTechs Continue to Drive Personal Loan Growth | BIIA.com | Business Information Industry Association)
Figure 2: Fintech has made major headway in the US lending market
Source: TransUnion, Experian, McKinsey
Digital currencies are here to stay
Crypto and digital currencies are becoming increasingly popular, as evidenced by the sharp increase in the price of bitcoin in 2020 and this year to date. The total value of crypto currencies reached close to $1.5trn in February. Crypto Fund Research also estimates that the cumulative Assets Under Management of cryptocurrency funds rose from $5.6bn in Q1 2018 to $25.1bn in Q3 2020.
Unsurprisingly, we are cognisant of the risks associated with cryptocurrencies – they are volatile, and the underlying price drivers can be difficult to identify. However, we also acknowledge that they present advantages for businesses and consumers – in terms of lower trading fees, secure and real time transactions, universal accessibility across countries – as well as investors, due to low correlation with all other asset classes. To some extent, cryptocurrencies can be viewed as having started to become an alternative for diversification purposes.
Figure 3: The total market cap of cryptocurrencies has reached $1.5trn
Source: TransUnion, Experian, McKinsey, February 2021
The saying “in a gold rush, sell shovels” can apply to digital currencies as well, in our view. These currencies will require an entire ecosystem of financial services and financial technology providers to trade, insure and store them. Indeed, these ecosystems are already starting to emerge, with a handful of quality companies offering indirect exposure, such as Square and Paypal, which have allowed their users to pay in bitcoins. Mastercard also announced this year it will start supporting cryptocurrencies on its network. On the institutional side, JP Morgan launched its digital currency and blockchain house Onyx last year; and the InterContinental Exchange also has a digital currency house, Bakkt, which is expected to IPO in the next few months.
Exciting long-term opportunities
A powerful cocktail of stimulatory forces should enable a very robust recovery, in our view. This recovery will likely be accompanied by higher inflation and higher bond yields, though we believe this is a price worth paying, as full employment remains the Federal Reserve’s number one priority. The tug of war between stronger economic growth and higher bond yields will be the defining battleground of 2021. We believe remaining adaptive, flexible and proactive will be key.
We have been gradually increasing our allocation to traditional financials since November last year, in areas including European banks. Consensus-beating capital returns, earnings per share (EPS) upgrades and an improving revenue outlook from 2022 are all potential catalysts for a sector that is still trading in the middle of its historic range, despite recent upgrades. UBS and Nordea – both held in the strategies – have some of the most significant capital-return plans (dividends and share buyback policies) in Europe.
Furthermore, we expect the shift in behaviours and the acceleration in financial innovation brought on by the pandemic to persist. The long-term opportunities remain massive, even though one should not overlook the fact that technology stocks may be negatively impacted if we see a durable increase in interest rates.
Electronic and online payments were the first thematics we identified in the financial innovation universe, and we see plenty of room for continued growth there – in Italy, for example, close to 70% transactions are still settled in cash. Going forward, we also expect to increasingly look to emerging sub-segments such as fintech platforms, AI, online lending, and crypto and digital currencies. Our strategies invest in companies that we believe are set to benefit hugely from these trends.
Figure 4: New sub-segments in financial innovation are emerging around digital banking, digital currencies and fintech “super apps”