The moats that fintech companies must cross

Traditional finance companies' competitive advantage operates like moats protecting mediaeval castles. Fintech companies must cross the moats of trust and regulation to break into the mainstream.

It started with a question which seemed simple enough when I first started investing in technology despite my training in years as a value investor: How do you invest in a fintech (financial technology) start-up with the potential to revolutionise finance, but which has not gained wide traction or turned a profit?

Cue the Oracle of Omaha with a question in response. To paraphrase legendary American investor Warren Buffett, investors of all stripes must first be able to answer this question: Is there any asset which deserves to be paid more for than the asset is worth? In the rapidly shifting sands of the disruption-prone fintech world, this fundamental question remains as relevant as ever.

How does one pick a fintech stock that might be priced below its worth? Let's consider the concept of moats. In mediaeval days when kings lived in castles, the moats surrounding these castles determined life or death during an enemy invasion. The larger the moat was (and/or the more crocodiles the moat housed), the more likely the castle would withstand an enemy attack. And just like kings in castles, businesses live and die by the size and durability of their competitive advantage.

This competitive advantage can stem from a multitude of factors, including economies of scale in which unit costs decrease with increased production, as well as network effects and branding.

Like a moat, the larger a business' competitive advantage, the more easily it can fend off competitors and the more likely its product will dominate the market. This will, in turn, lead to higher top-line growth which will increase the business' worth.

Conversely, just as the moats of mediaeval lore can be breached, business competitors and fickle consumer preferences actively erode businesses' competitive advantage. This is nowhere more evident than in the start-up world, where many fintech start-ups are leading the charge in revolutionising traditional financial services - or, as some put it, unbundling finance as we know it today.

Employees of fintech start-up N26 on a carpet with the bitcoin source code printed on it in Berlin. The key problem is not the start-up's technology stack, but the challenge of convincing people to entrust their money to it. PHOTO: REUTERS

They erode the defensive moats of these traditional financial services by offering a more convenient, efficient and secure alternative. In other cases, such as blockchain and peer-to-peer (P2P), they seek to transform the very nature of finance.

Blockchain, for example, is groundbreaking because it bypasses a central middleman like a bank, to make a transaction. Instead, it allows consumers and suppliers to connect directly, removing the need for a third party, as the World Economic Forum explains it: "Using cryptography to keep exchanges secure, blockchain provides a decentralised database, or 'digital ledger', of transactions that everyone on the network can see. This network is essentially a chain of computers that must all approve an exchange before it can be verified and recorded."

Employees of fintech start-up N26 on a carpet with the bitcoin source code printed on it in Berlin. The key problem is not the start-up's technology stack, but the challenge of convincing people to entrust their money to it.

This decentralisation means banks, remittance companies and financial intermediaries are not needed for such transactions, as people can transfer money, or make payments, to each other directly using this blockchain technology.

Then there is Funding Circle, a Britain-based start-up which provides a platform for investors to directly loan to accredited small businesses. This removes the need for banks as middlemen in the process, introducing transparency and increasing returns simultaneously. Using an online platform, investors can now self-select their loans based on their risk appetite.

Indeed, it is no wonder that start-ups tend to see themselves as the underdog, the David pitted against the Goliath of Big Finance. While that is analogous to a certain degree, start-ups should not forget that just as they are upending other businesses today, they themselves could be rendered obsolete with similar swiftness.

Prime Minister Lee Hsien Loong, in his National Day Rally speech, alluded to this when he discussed how ride-hailing start-ups Uber and Grab might experience disruption themselves as driverless taxis (and cars) are rolled out on the roads. No business can assume that its competitive advantage will remain intact forever. It is a matter of time before others start noticing the opportunity in its area of business. Mr Andy Grove, the legendary CEO of Intel, once said that "business success contains the seeds of its own destruction".

Regardless of the size of the company, entrepreneurs and businessmen have to think deeply and deliberately about how the trends of today will destroy their moats and eat into their profits. They have to honestly answer the question - What is the durability of the business' competitive advantage?

Several recent trends have accelerated the erosion of moats as well. One is the democratisation of ideas and information. The financial world is driven by information - just ask Bloomberg. Yet, both the supply and demand of these ideas and information, which have long kept traditional financial institutions at the forefront, are increasingly being democratised.

For instance, Smartkarma, based here in Singapore, is aggregating and identifying the best sell-side research - previously sequestered in the equity research departments of banks. This allows analysts or experts who are truly good at their craft to submit pieces of original research unhindered by their management or company policies.

Despite all this talk of "creative disruption", however, a very wise man once said that there is nothing new under the sun. Ideas take on new forms, but fundamental human nature does not change. Traditional financial institutions capture this well with their twin deep moats of trust and regulation; both are equally important for fintech start-ups to surmount. Trust: Indeed, finance has been around for a long time, and the force that has always undergirded finance was that of trust. Why do people hand their money over to the bank for safekeeping? Because they trust the banks to keep their money safe. How do creditors know that their borrowers will repay their loans on time? Because there is an implicit trust in the borrower to repay, or the financial system to guarantee, the loan.

Why would an investor choose to invest in one company but not another? Because we invest only in people who we trust can grow their company and make our investment worthwhile. Mr Jack Ma himself asserted that Alipay was created to address a trust deficit and became a huge driver of e-commerce in China.

Gaining the trust of stakeholders and end users remains a critical moat which many fintech start-ups have to breach, to truly disrupt the financial giants of today.

Perhaps, then, it is no coincidence that the fintech revolution really started to take off post-global financial crisis where there was a deficit of trust in many financial institutions . Today trust in the traditional financial system is low and we need to make a social case for the value of finance. Clients are not looking for more products to buy from banks; they are looking for solutions for their needs.

The key problem is not the start-up's technology stack, but the challenge of convincing people to entrust their money to it - even if its product may not handle transactions directly. This is why traditional financial institutions strive hard to win and retain the trust of their customers - they are continually deepening and solidifying their moat. Regulation: Additionally, another key hurdle that start-ups have to crack is that of regulation. Start-ups in Singapore have to think deeply about this challenge, given the fragmented nature of financial regulation around the region. Localisation to reach customers around the region has been a perennial challenge (and opportunity) for start-ups based out of Singapore.

Fintech start-ups have an added layer of regulatory requirements to consider. They should consider fully leveraging on the Monetary Authority of Singapore's FinTech Innovation Lab to learn from industry experts and work with traditional stakeholders to co-create adaptive solutions.

In a recently released World Economic Forum report on the state of blockchain technology, it highlighted "an uncertain regulatory environment, lack of standardisation efforts, and the need for a formal legal framework" as some of the key challenges to the technology. It is thus the fintech start-ups' imperative to educate not only their users but also regulators on the potential risk and reward of each new technology.

Despite having these two deep moats, traditional financial institutions are not going to get off easily either. In the same speech, PM Lee spoke about the disruptive effect of online e-commerce on brick-and-mortar retail stores. Similarly, retail banks have to consider the impact of online and mobile banking on their retail strategy. Traditional brokerage firms have to be cognisant of the competition posed by start-ups, such as Robinhood, which have no brokerage or transaction fees. These advances could be made possible only by start-ups which leverage technology, consider new business models and exploit inefficiencies in the current way of doing things.

To return to the initial question - of how to identify companies that are priced below their worth - the answer lies in picking companies that are leveraging technology to drive efficient operations; and that are invested in building trust and engaged in shaping regulatory frameworks for the banks and financial companies of the future.

It is thus with a certain degree of irony that I am writing this as an active investor. Who knows what the future holds - with the growing plethora of artificial intelligence- driven wealth management products and learning algorithms to optimise investment accuracy and improve the rate of return, a totally different set of features may prove to be the most important metric for businesses to flourish.

Yet, until then, the time-tested strategy of building deep and lasting moats will give companies that extra edge to thrive in the economy of tomorrow.

  • The writer is the Asia-Pacific CEO of a global company and a member of the Monetary Authority of Singapore's financial centre advisory panel.
A version of this article appeared in the print edition of The Straits Times on August 30, 2016, with the headline 'The moats that fintech companies must cross'. Subscribe