🧠🍣 - 26th June 2022 - Incumbents don't call it a come back. Carnage in Crypto & My take on Brex and SMBs

Hey everyone 👋, thanks for coming back to Brainfood, where I take the week's biggest events and try to get under the skin of what's happening in Fintech. If you're reading this and haven't signed up, join the 16,310 others by clicking below, and to the regular readers, thank you. 🙏

Hey Fintech Nerds 👋 

Hope you're doing ok out there.

Some how a silly little newsletter about Fintech doesn’t feel fitting when the world is tearing itself apart.

In times like this I don’t know what else to do other than focus on the things I can control. And maybe we can be a net positive if we change the incentive structure and how money moves.

For whatever reason I find excitement and hope in being able to change the world around us by changing how money moves. Maybe you do too.

I wanted to talk about the moment in the sun incumbent banks have as interest rates rise and Fintech companies stumble in the public markets. While I don't think Fintech as a category is dead (if anything, the precise opposite), the incumbents that get this right have a window of opportunity to meaningfully grow market share and attack cost.

Perhaps more interesting, the Fintech provider supplier base has a new buyer, but do they understand how to sell and execute with them? Selling to Fintech and growth companies is easier by comparison but not nearly as lucrative per deal.

Also missing a week, I'm a little behind on the news this week. So expect a view on FTX becoming the prime broker for the metaverse (with their Embed acquisition and BlockFi transaction).

I'm also toying with a bull case for web3.

We're at peak schadenfreude for web3 and Crypto. Only negative headlines and positive news gets ridiculed or ignored. We might be a ways off the bottom with Crypto prices, but the infrastructure is juuuuuuuuust getting useful. And the new business models? I have some theories there too. More next week.

PS. A massive thank you to everyone for love on the personal news last week. Now back to your regularly scheduled programming.

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Weekly Rant 📣

Banks - don't call it a comeback

… Don't call it a comeback, I been here for years

I'm rockin' my peers, puttin' suckers in fear

Citi hiring 4,000 tech staff in the same week Coinbase is laying off over 1,100 is the perfect encapsulation of this moment. 

The incumbents didn't go anywhere, but the market broke their business model. Narratives are powerful, and the market narrative was that banks are slow, can't innovate, and can't grow.

Now the tables are turning, and for the next two to three years (or however long interest rates stay above neutral), banks with a strong lending track record and have made the right strategic bets on tech and providers have a generational opportunity.

But there is a big difference between benefitting from macro trends and taking advantage of them.

So today's Rant covers: what factors will help incumbents grow market share in the coming years, and how do Fintech companies position to defend or be a provider in this new world?

1. Understanding incumbents: What betting on innovation looks like

2. Understanding incumbents: The power of balance sheets

3. The opportunities this market presents incumbents

4. How Fintech providers could react

5. And the options that will get left on the table to compete as a venture-backed B2C or B2B Fintech company

Understanding Incumbents: Betting on innovation - JPMC as a case study 📝

When JP Morgan Chase announced that they intended to double their tech spend in the coming 5 years, market analysts collectively vomited. Why would a fundamentally sound, profitable, big, but slightly dull yield stock go so deep on innovation?

Hiring people isn't cool.

Doing stuff with those people is cool.

JPMC has been busy.

Image from Whitesight

JPMC has been busy with investments and M&A (pictured above). In the past week, I also saw they announced they're launching a consumer shopping habit data service for merchants, that "winning in payments is a strategic imperative," and intends to bring hundreds of billions of assets to DeFi infrastructure through tokenization.

As an incumbent, they have a few things that I think others can learn from.

A track record of M&A: The history of JPMC looks like a family tree diagram of countless regional and national banks rolled together over decades, culminating in the merger between Chase and JP Morgan after the 2008 financial crisis. Why wouldn't it now look at Fintech companies to augment its offerings as providers or entirely new business lines?

Winning merchants: Chase drives a significant amount of revenue from merchants. However, companies like Square or PayPal have made a meaningful dent in this segment in the past decade with far better UX and integrated experiences. Effort here to defend and grow market share makes sense, although this shopping habits data alone might not cut it. (In the UK, Barclays has done this for a while, and it's handy, it just doesn't tip the scale in isolation). Still, it is the right focus. 

The focus on payments: If you own the payments, you have the best shot at cross-selling and owning the customer. As a global bank, JPMC is a major player in domestic and international payments but sees well-funded Fintech companies coming for its market share. Also, domestic payments rails may change or even switch to open banking, DeFi, or central bank digital currency. If the core of your business is payments, no amount of R&D here is too little. 

Playing for DeFi: JP Morgan's Onyx platform has quietly, consistently been building token-based payments infrastructure. The real prize for banks now is to be the most efficient way to tokenize "real world" assets and bring them into DeFi protocols. Many have recognized what the IMF did in their April 2022 update: DeFi is a much more efficient infrastructure for global finance. Banks that get this right could be the link between the world's existing assets and that new world.

In addition to making tech bets, another macro force benefits incumbent banks.

Understanding Incumbents: The Balance Sheet is Power. 💪

Large banks have balance sheet power.

Balance sheet power is a law of finance that has to be understood.

Those with the lowest cost of capital win. 

And banks have the lowest cost of capital because they're the only type of lender who can fund their lending from deposits. Every type of lending except bank lending must support its lending by borrowing themselves.

The fees a lender pays to the supplier of its capital is its "cost of capital." 

So when you see "x Fintech has raised $10m in equity and $100m in debt finance," - that second bit is the borrowing the Fintech has to do to be able to lend. When interest rates were low, and lots of capital was looking for a yield getting this capital was relatively simple.

Now Fintech is correcting that capital may not be so cheap or available. Lenders need a supply (capital) to be able to lend in the first place. If there is no supply, they can't lend, and if they can't lend they will generate no revenue. 

We saw this movie with the P2P lenders in ~2010, and those that survived have gone on to get charters (e.g., SoFi, Lending Club, and Zopa in the UK). To reduce their cost of capital.

Financial physics.

Having more deposits and diverse sources of deposits builds a balance sheet.

Balance sheet is power in a cost of capital game. 

And the cost of capital goes down the bigger the balance sheet. 

So assuming incumbents have 

1. A willingness to bet on innovation

2. Balance sheet power

What are the opportunities?

I'm glad you asked.

The incument opportunities 🚀

Attack structural cost: The Achilles heel of incumbents is their long-term operational, marginal, and labor costs. Much of this comes from high-cost infrastructures like branches and multi-decades-old technology. Add to this the mission-critical nature of the systems and their role in the national and global economy, and you can see why change is all kinds of hard.

Change requires a long-term commitment and sometimes big-spending if going deep into the core of what a bank does. But the Fintech boom created a whole ecosystem of new providers that take the previously unloved non-differentiated bit of a bank and make it best in class. Enter, Fintech, the supplier.

Fintech the supplier: Fintech providers can attack cost and improve UX across almost the entire banking supply chain. And the consumer and B2B Fintech companies have helped those providers hit the scale banks need to get confidence before they can buy from a supplier. During the pandemic, we saw banks adopt e-KYC and digital onboarding instead of relying on branches. But now, the opportunity is to go into core operations. Core banking, payments processing, fraud, AML, underwriting, and even regulatory reporting and management can be significantly upgraded.

Finance Embedded Finance: Bank and Fintech companies' "partnerships" have been asthmatic at best. The biggest Fintech companies use the largest banks to access infrastructure and manage their operations, but for the most part, this happened to the banks rather than it being some grand strategy. The partner banks or smaller bank ecosystem in the US had filled that gap. Still, those with the most balance sheet power could strategically deploy lending to the B2C and B2B Fintech companies struggling with their capital cost at smaller partner banks. 

Corporate VC / M&A: The down rounds and layoffs have already started. Talented teams and good products in the market are being rapidly re-priced. Companies with exceptional consumer engagement but had not yet hit profit fit well for incumbents with the opposite problem. Banks haven't acquired consumer Fintech companies well historically, so they may need to tread carefully here. The potential for acqui-hires is also high, especially if incumbents can create space for genuine autonomy without the big machine grinding down these teams.

DeFi as new infrastructure: I've found myself citing the IMF April 2022 Global Financial Stability Report almost daily because it has this incredible chart.

Current DeFi protocols have near-zero marginal, operational, and labor costs.

Again, louder for the people at the back.

Imagine being able to operate a global, 24/7 infrastructure with almost no marginal, operational, or labor cost? 

Despite the price volatility in Crypto lately, the DeFi protocols and rails continue to work perfectly. Yes, there are risks of fraud, scams, hacks, and regulatory uncertainty. 

But a well-funded patient incumbent thinking long-term could unlock this market opportunity in unique ways. If, if they can manage the risks and truly understand the space (and not try to copy + paste today's business onto tomorrow's reality).

The risk of doing nothing for the banks is that their competitors are already moving.

And innovators are hard to bet against.

The mood may have turned against Fintech companies in public markets, but they still have millions of deeply engaged customers worldwide, much lower operating costs, and some even have charters.

How Fintech providers can react 👟

The Fintech provider ecosystem that has primarily sold to the growth Fintech company now potentially has to learn a new Go-To-Market motion. "Up and to the right" should show revenue and profit, not just usage. 

Partnering with other Fintech Providers: Everyone was a competitor when the next funding round was always available. Their product was your growth opportunity. With less funding available, revenue matters, and maybe that product you wanted to launch is burning cash but not getting traction. Perhaps partnering with someone great could bring you a ton of revenue, while you can offer your customers something new and make revenue without much cost. Great partner managers are going to be worth their weight in crude oil.

Focussed innovation: DeFi projects need better risk and fraud management. The Fintech providers that react fastest here to where the pain has moved can do really well. Well-funded, massive Fintech companies have to find profitability. How will you help them do that? The cost message also plays well with some incumbents.

Selling to incumbents: We've already started to see this with companies like Marqeta partnering with Marcus by Goldman and JP Morgan for virtual cards. Incumbents like to sign long contracts, and one deal can bring massive ARR. However, it's easy to sink time with incumbents and get nowhere with innovation theatre and PoCs. Banks have many budget holders and many people who can say no. It's a long cycle, but if you know their pain and processes a huge opportunity. 

Just survive: The number one rule of entrepreneurship is don't die. This may be a long cold winter, but the cold makes you strong. It is forcing focus and discipline on where the market opportunity is. 

Consumer and B2B Fintech Companies 📱

The truth is rarely as exciting as the peak of the bubble or the trough of the bubble bursting. Headline writers are scrambling to say PayPal is dead or Affirm will be killed. That's obviously hyperbole to drive clicks, but the fundamentals that made those businesses popular still apply.

The daily active users on the most popular Fintech apps still dwarfs what an incumbent bank would expect. Fintech companies are motivated to seek out customer problems and build much better experiences.

This focus on product and customer over the long run means not just survival but thriving.

Solving a customer problem drives engagement. 

You win the customer's trust if you solve that problem well enough.

And businesses that have customers' trust and engagement are best placed to sell them new products or services.

I have a massive conviction that:

• Fintech is not dead; it's getting stronger.

• Fintech companies are the best at Finance product R&D

• DeFi is the new infrastructure of finance (eventually)

• The entire value chain of financial services now has a provider who does that piece of the value chain as an API with incredible efficiency.

But that:

• Balance sheet power matters

• Incumbents have a window to make strategic moves

• And a new supplier mix that has sold primarily to Fintech companies but is ready for scale

• Who can help manage the unique risks in areas like DeFi

The threat of banks becoming "dumb pipes" is still very real.

But perhaps those pipes that change their posture from competing with Fintech to strategically partnering aren't that dumb.

The future of Fintech is smart pipes, enabling better products and experiences built by innovators.

The incumbents that use the next few years to build those smart pipes can win.

ST.

4 Fintech Companies 💸

1. Treasure Financial - Cash yield optimization for growth companies

• Treasury Financial identifies "idle" cash in a company bank account, allowing the finance team to quickly deposit this in FDIC-insured high yield accounts (e.g., 3.25%). Treasure is an SEC-registered investment advisor that helps its clients select mutual funds like an RIA for growth company finance teams.

• 🤔 Great timing. In this market, especially for companies that raised big growth rounds, having the capital in their bank account generate a return makes excellent sense. This is the kind of product the megabanks always offer to global corporates (who often have entire treasury teams dedicated to maximizing yield, FX, etc.) But bringing this to the growth stage company in a modern package is attractive. But how does this make money if they're just the advisor? This is a way better bank feature, but is it a business?

2. Augie - Build credit through paying your bills

• Augie is a free credit card that provides cash back and credit to consumers who demonstrate they continue to pay their bills on time. Consumers link their bank accounts to show their bill payments (and streamline onboarding) and can apply with no credit history. 

• 🤔 I love using cash-flow and behavior data to help consumers build credit, but we're living through a history lesson in why lending businesses take time to build. This is an experienced team, so hopefully, they're thinking that through and taking it slow in the early days. I'm not aware of any mainstream banks offering this level of an innovative product to bring in the low-credit / no-credit consumer base. So if this works, they could prove a market segment exists. If it doesn't work, we learn again that lending is hard.

3. Quolum - The SaaS buying concierge

• Quolum helps companies manage SaaS spending with an expenses card and spend management suite. Storing all contracts as structured metadata helps manage expenses, renewals, trials, and cancellations. Quolum also aggregates multiple invoices into one to help accountants and finance teams.

• 🤔 Quolum is in a crowded market but selling itself on its product results. To competitively position itself vs. Brex or Ramp, Quolum talks up its feature depth like software spending compliance, invoice aggregation, or trialware management. While this definitely plays to a particular type of buyer, I have two questions, especially for the segment Quolum is after. First, how many companies get their corporate card before the finance team is a major buyer (I'd posit many). Second, how many clients of Brex or Ramp actually churn, and what are the switching costs? This looks like a great product, a finance person's dream.

4. Hola Hipo - The Mortgage concierge for Mexico

• Hola Hipo users can compare rates at the largest lenders in Mexico, "simulate" their credit and get advice by talking to a financial coach. Users instantly chat via Whatsapp with Hola Hipo to connect with the team.

• 🤔 Chat as the default call to action is something I think we will see more of as LATAM Fintech goes increasingly mass-market. Chat is an ultra-low-cost way to communicate but also a great way to directly start building a CRM of customers.

Things to know 👀

1. Crypto Markets Capitulate as Celsius halts withdrawals

• Celcius, one of the largest lenders in digital and DeFi yield, has prevented users from being able to withdraw funds from their platform. Some users fear they may never be able to withdraw funds or will only receive a fraction of what they invested, according to Coindesk. Celcius had lent more than $8bn and claimed $12bn of assets under management in May of 2022.

• Celcius offered a "17% yield," Many observers claim they used on-chain sources like Terra, Lido, and curve to generate these returns. Celcius is distancing itself from on-chain activity, but its messaging to date has been vague. In recent weeks net outflows have been in the $800m range, which raises long-term solvency questions for the lender. 

• 🤔 Celcius isn't some weird DeFi project; it is a centralized lender regulated by the FCA under its temporary Cryptoassets regimen. These products and providers looked like banks with better rates to consumers. The problem has been that Celcius may have managed its funds terribly. Irresponsible lending and balance sheet management are fine in a bull market but horrible for everyone, especially consumers who are harmed when the market turns. CeFi using DeFi needs to be better (and some folks have been).

• 🤔 This market will have more casualties. This all comes as three arrows capital (3AC) confirmed major losses in the wake of the Luna collapse; there are also rumors that lenders like BlockFi and Genesis have liquidated 3AC. The old saying goes, everyone is a genius in a bull market. Watch for those sensibly exiting positions and announcing it vs. those staying eerily quiet or worse, vague. 

• 🤔 Overall, this is good for the ecosystem, as lousy business models and ridiculous leverage get washed out. Leaving sensible risk managers standing. The sad part is the consumer harm; we must do better.

• 🤔 The critical point here is that despite all the volatility, the DeFi infrastructure didn't break; a centralized lender did. The protocols all work; they're humming along. 

• 🤔 This could be a great time to be a well-funded incumbent with a long-term and patient view of web3 and DeFi. If DeFi is materially lower cost and is robust in extreme market conditions, that's a valuable signal for incumbents. 

2. Brex is exiting (Brexiting?) SMBs

• Corporate spend management scale-up Brex says it is now "less suited to meet the needs of smaller customers." This means tens of thousands of SMBs have until August 15th to find somewhere else to place their money. This follows announcements of "a big push into software" and rolling out IRL advertising in some cities to win SMBs.

• 🤔 This announcement is about focusing on a competitive but valuable segment. The founder later clarified they are concentrated on SMBs who had "raised outside capital" like venture capital or angel investment. Mom and pop stores and smaller SMBs tend to have lower deposits, transact less and don't grow nearly as quickly as a venture-backed company would. Growth companies may start small but are often primarily digital and have similar requirements. 

• 🤔 Did I mention it is competitive? Doubling down on "growth companies" means Brex is competing more head to head with Ramp, Mercury, Jeeves, and Stripe offering corporate spend cards. 

• 🤔 The segment focus makes sense in the backdrop of the chase for profitability. The cost to acquire a smaller company and run its account is similar. However, the profit potential for Brex in a customer with $400m deposited and 200 employees with expenses card is very different from $100k, and one card is very different. 

• 🤔 Big banks have had sector focus for a long time; they often organize their larger "cash management" or transaction banking divisions along industry lines. In 2022 as venture capital has diversified the type of company it invests in, there are now many "segments" of growth companies, but their operating models all look similar. I wonder about the switching cost for corporate spend management cards once a company scales. Did Brex do well with an early vintage, or is this a game of the best software wins?

• 🤔 Complete aside: Why do none of the US corporate spend cards have tap-to-pay (AKA contactless)?! Apple Pay and Google Pay don't count. As someone who lives in the UK, this is baffling to me. I find US point-of-sale terminals are generally a gauntlet of shit UX (honestly, even Square is a bit rubbish). In most of Europe, it's just, tap, done. But that's no excuse; tap-to-pay means being top of the wallet and more transactions, which matters when card interchange is a significant revenue source. 

• PS, this extra crunch piece by Mary Ann Azevedo is fantastic.

🥊 Quick hit: Backbase raises $128m. 🤔 Motive Partners was the sole investor in this round, and they usually take a private equity view rather than a YOLO fintech VC view. But as incumbents come roaring back, Backbase, with 150 clients and a market looking to go all-in on digital, could be well placed. Motive are also ex-FS folks themselves, so they understand the opportunity better than many. This might be perfect timing.

Good Reads 📚

1. A better taxonomy for Stablecoins

• The market has chosen to categorize Stablecoins as one of three types. Fiat backed, asset-backed, or algorithmic. Fiat backed should have currency (e.g., Dollars or equivalents) held securely 1:1 for every Stablecoin issued. Asset-backed or over-collateralized Stablecoins should have more of the assets they hold than the Fiat currency they are offering (e.g., for every $1, carry $2 worth of Eth at the current price). Then Algorithmic Stablecoins "use algorithms" to maintain a peg. In the shadow of the Terra TUSD collapse, many quickly blamed the fact that it was an algorithmic Stablecoin

• Luca argues you cannot blame the algorithm for what happened. The key risk comes from how the money is secured, either from external (exogenous) or internal (endogenous) capital. Terra relied almost entirely on future profitability or "intangible assets," this allowed it to scale rapidly when markets went up but unwound just as fast. We could have more automated (algo) Stablecoins that rely on capital and money external to the system that would, in theory, be more economically sound than a dumb stablecoin that relied almost entirely on its own future growth.

• 🤔 This post is required reading for anyone building a CBDC, Stablecoin, or watching DeFi more broadly. If the big issue with the recent DeFi Yield implosions had been nobody "understood the risks," this is the perfect primer. Crypto folks always say DYOR, do your own research; here's the ideal opportunity for you to do just that.

• 🤔 When something goes wrong projects understandably try to distance themselves from failure, but algorithms run the world. We just need to get to a point where the smart folks writing algorithms struggle to do so with billions of dollars of consumer capital until they've passed some level of first principles standard. Such a standard would balance "allows new innovation" with not destroying capital in entirely predictable ways to those with a first-principles understanding of finance.

• 🤔 In Crypto, it's now normal for smart contracts to be audited; the community has found ways to solve hacks and technical risks but not financial risks. What would a community-driven, standards approach to good financial practices look like?

Tweets of the week 🕊

That's all, folks. 👋

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