Francis Richard Pereira

The rapidly evolving landscape for fintech and digital assets opens up opportunities for financial institutions to evolve their business models.

Global venture capital (VC) funding achieved a new high of $621bn in 2021, up from $294bn in 2020, with the number of unicorns (private companies valued over $1bn) reaching a record 959, according to CB Insights. Mega-rounds (VC funding exceeding $100m) raised $361bn in 2021, another all-time high.

Fintech, the sector with most unicorns, attracted a record $132bn of VC funding, compared to $49bn in 2020, with 67% funded through mega-rounds. Fintech exit deal values in 2021, driven largely by initial public offerings (IPOs) and special purpose acquisition companies reached a record $490bn, according to Dealroom.co, surpassing the combined total of the previous five years. The US Nasdaq and New York Stock Exchange accounted for 34% of global capital IPO proceeds compared with just 4.7% on the London Stock Exchange, according to EY. In December 2021, the Financial Conduct Authority confirmed an overhaul of the UK listing rules aimed at making London more attractive to list fast-growing fintech companies.

However, the record-breaking year revealed concerning market signals for fintech investors regarding IPO valuations and technological capabilities. Most fintech companies that went public in 2021 recorded double-digit falls from their debut valuation, according to Dealroom.co. The misalignment between private and post-IPO valuation has increased scrutiny on why valuation metrics in pre-IPO funding rounds differ to public markets.

Successful post-IPO performance is crucial to underpinning investor confidence and enhancing access to further ‘scale-up’ funding. Late-stage private company financing from non-traditional VC investors in ‘crossover rounds’ could help transition companies beyond the VC stage and bridge the valuation gap between private and public equity.

The collapse of lender Greensill Capital, once extolled as a fintech unicorn, exposed claims about the company’s capability in deploying proprietary artificial intelligence (AI) and machine learning. It now transpires that Greensill’s technologies were not pioneering and their application of machine learning actually promoted speculative financing. The UK House of Commons Treasury Committee report Lessons from Greensill Capital (July 2021) noted “the claim that Greensill Capital was a fintech appears doubtful” and whether fintech business “claims about the ‘tech’ are not hiding a ‘fin’ problem”.

Regulatory underpinning

Fintech companies lacking superior technology-driven solutions to disrupt financial services will struggle to achieve a strategic competitive advantage, scale up profitably and generate cash flows to justify valuations. Viable business models should incorporate regulatory and compliance frameworks to build confidence in their technological innovation for regulated financial markets. Fintech company risk-based regulatory frameworks should satisfy prevailing ‘activity-based’ rules. For risks arising from a combination of activities, incorporating complementary ‘entity-based’ rules would ensure regulatory alignment with established financial institutions.

The demand for technological change to improve financial services has spurred fintech innovation and the adoption of crypto technology applications in digital finance solutions. In 2021, payments and crypto/decentralised finance (DeFi) were two notable areas attracting significant fintech investment.

Payments, worth an estimated $1.4tn, is the most valuable area in the fintech ecosystem; the segment raised $32bn in 2021, making it the largest destination for VC funding. The European Payment Services Directive 2 (PSD2) open banking regulations helped accelerate innovation and integration of tech-enabled payment solutions. PSD2 allowed for customer-permissioned data sharing by banks with third-party providers through application programming interfaces. Open banking benefits customers and empowers incumbent banks to become disruptive themselves by partnering with fintech innovators to create new business opportunities and access competitor banks’ customers.

Pressure on margins through commoditisation of payment processing has increased fintech focus on adjacent opportunities. Areas include commerce enablement services to small and medium-sized enterprises (SMEs) and merchants, as well as financing solutions and payments performance data analytics to improve risk management, security standards and fraud reduction tools.

Cross-border payments is another strong growth opportunity. Global corporates incur transaction costs of over $120bn annually to make roughly $24tn in wholesale cross-border payments, according to Oliver Wyman. In 2020, the G20 endorsed the cross-border payments roadmap developed by the Financial Stability Board (FSB) and other international bodies to prioritise making payments across jurisdictions cheaper, faster, more transparent and more inclusive while maintaining security.

The roadmap acknowledged the potential for new cross-border payment infrastructures to incorporate innovation in distributed ledger technology (DLT); multi-currency central bank digital currency ‘mCBDC’ arrangements; and crypto-assets, e.g. regulated stablecoin arrangements. Improving the efficiency of cross-border payments would boost international trade, global development and economic growth.

The crypto realm

Crypto and DeFi, with an estimated ecosystem value of $332bn, experienced the highest VC fintech funding growth, raising $19bn in 2021.

The cryptocurrency market capitalisation experienced significant volatility in 2021 surging from $750bn to circa $3tn, and is now around $1.7tn. Stablecoins represent around 5% of all cryptocurrencies and are primarily used to facilitate crypto trading and lending activity. The value of stablecoins in issue increased five-fold in 2021 to $144bn, with stablecoins Tether and USD Coin dominating issuance volumes.

The crypto-asset value locked in DeFI protocols grew from $18bn to over $250bn during 2021, largely driven by decentralised trading, lending and investment activities. Crypto-assets valuations are still small relative to total global financial assets ($468.7tn). However, 95% of crypto-assets are ‘unbacked’ and increasing links to the regulated financial system has led to greater regulatory scrutiny.

The FSB recently warned that ‘emerging risks’ from ‘fast-evolving’ crypto-asset markets could pose a threat to global financial stability. As the crypto ecosystem continues to expand rapidly, the vulnerabilities arising from crypto leverage, volatility, stablecoin risks and deeper interconnectedness with traditional finance will warrant continuous supervisory monitoring to evaluate threats to global financial stability.

Future expectations

The prospects for broader adoption of digital finance and crypto and DeFi markets will be strengthened by progress in three key areas.

First, digital finance regulation is necessary for successful adoption of crypto technology. Regulatory certainty would encourage traditional financial institutions to engage in crypto-asset market activity and increase competition. Legislative proposals are evolving to regulate markets in crypto-assets (including stablecoin arrangements and crypto trading); DLT market infrastructure; prudential treatment of crypto-asset exposures; and strengthening crypto-asset investor protection, market integrity and competition. Greater global regulatory coordination is required to develop consistent principles across jurisdictions for crypto-asset regulation and taxation of digital assets.

Second, resolving the ‘blockchain trilemma’ to achieve an appropriate balance between decentralisation, security and scalability within blockchain architectures. Developments in ‘Layer-1’ (main blockchain) and ‘Layer-2’ (off chain) scaling solutions offer the potential to improve decentralised networks scalability, security and sustainability (energy efficiency). Attaining the correct balance would promote wider commercial use of ‘trusted’ DLT financial market infrastructures and blockchain-based ‘smart contracts' that meet digital operational resilience regulatory requirements for financial services.

The Depository Trust and Clearing Corporation has enabled digitisation of private markets by adopting DLT connectivity, and enables issuers to create tokenised securities in its Digital Securities Management platform expected to launch in 2022. Scalable blockchain solutions could be deployed in areas essential to foster economic growth and sustainability. Opportunities include mobilising finance for SMEs, climate finance, scaling up carbon markets and new climate fintech solutions for net-zero transition.

Third, the EU’s Digital Finance Strategy includes plans for ‘open finance’ legislative proposals. Open finance could transform banking, insurance, pensions, investment and wealth management. Data-driven innovation, especially artificial intelligence applications and predictive data analytics, can support personalised consumer and business open finance solutions. The proposed European Digital Identity Wallets will allow individuals to digitally identify themselves and exercise full control over their data.

Digital identity solutions incorporating the Financial Action Task Force guidance would ensure the digital identity is reliable for customer due diligence, anti-money laundering, countering the financing of terrorism and promoting financial inclusion. Trusted digital identity solutions and big data analytics are crucial for successful scale up of digital finance.

Fintech innovation is shaping the digital transformation of financial services. It presents an opportunity for financial institutions to evolve their business models and embrace new fintech solutions to improve financial services.

Francis Richard Pereira is an investment actuary with institutional expertise in fintech investment, crypto-assets and DeFi.

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