Fintech and the Future of Money

As the crypto winter continues, with the price of Bitcoin recently dropping below $20,000 and Ethereum sliding under $1,500, we are going to look at the current state of the U.S. monetary system and how the rise of Fintech could revolutionize not only the way we transact but even the way we think of money.

Money and Transactions

Money is the lubricant for the engine of commerce; as the nature of commerce evolves, so must monetary systems. The value of any form of currency is intrinsically tied to its utility and stability. If a currency is difficult to give or receive, or if its relative value fluctuates wildly, its utility is low. As the economy becomes increasingly digital, its monetary system must adapt, which has been one of the driving forces behind the desire to shift to a native digital currency such as cryptocurrencies or a central bank digital currency (CBDC).

Today, while the U.S. dollar is not natively digital, most transactions occur in the digital realm. In the United States, the vast majority (68%) of transactions are cashless with cards (both debit and credit) the leading form of payment in volume terms. According to the Federal Reserve, between 2012 and 2015 card payment volumes grew at a 6.8% annual pace, accelerating to 8.9% between 2015 and 2018.

Data for 2019 showed a similar pace of growth, but in 2020 the number of card payments declined, driven by a large drop in in-person payments (thank you, pandemic), the first such decline recorded in a Federal Reserve Payments Study. Conversely, first-time use of bank-sponsored peer-to-peer (P2P) payments spiked in Q2 2020, and the first-time use of digital wallets hit its highest level in Q3 2020 when in-person shopping restrictions were lifted in the U.S., likely because digital wallets provide a low-touch option for in-person payments.

When thinking about the viability of non-state backed currencies like a cryptocurrency, consider that 90% of U.S. currency, as measured by M2, does not consist of Federal Reserve notes or U.S. Treasury notes or coins, but is rather created by privately issued bank deposits, made possible by the fractional reserve banking system.

M2 is a measure of the money supply that includes physical cash, checking and savings deposits, money market securities, and other one-time deposits under $100,000. In short, M2 is liquid currency as well as those assets that can be quickly converted into cash or checking deposits.

That percent is even higher if we look at just the U.S. domestic economy, because around 60% of Federal Reserve notes are held outside the country. That means that over 90% of “money” in the United States is created by private-sector banks, even though we don’t think of it that way. These banks are authorized by the U.S. Federal Reserve to effectively create money through loans that are backed only fractionally by their customers’ deposits.

This brings us to the realization that we really cannot talk today about money or monetary systems, without talking about lending and payment systems or Fintech in general. The term "Fintech" includes tech solutions in the areas of payments, banking, digital lending, wealth-tech (investing), insurance, and capital markets - basically, all the ways in which money can be used.

Early-stage Fintech

Venture capitalists and angel investors saw the spike in digital wallets adoption and P2P payments in 2020, which drove Fintech funding to skyrocket by 180% in 2021 to $138.8 billion from just $49.4 billion in 2020, $49.1 billion in 2019, and $40.5 billion in 2018, according to CB Insights. With the challenging equity markets in 2022, funding has decreased by 1/3 in Q2 of 2022 from Q1, but funding for the first half of 2022 is still higher ($50.7 billion) than for all of 2020.

The top investors in the space during the first half of the year include Tiger Global Management, Global Founders Capital, Gaingels, Coinbase Ventures, and Accel. From a regional perspective, the U.S. continues to lead the world, ranging from 34% to 38% of global investments in dollar terms over the past four years, with Asia and Europe each accounting for low to mid-20s percent of global investments.

The top equity deals in Q2 2022 give us insight into how the economy is evolving and how Fintech is responding. The biggest deal in Q2 was Coda Payments series C round which closed in April at $690 million. The company, recently valued at around $2.5 billion, helps digital content providers monetize their products and services in more than 26 emerging markets. Here we see the increasingly powerful creator economy join forces with Fintech.

The second largest deal was the series B round for Velocity Global which closed at $400 million. Here we see the intersection of labor market challenges with payments systems in a company that facilitates compliantly hiring, managing, and paying workers anywhere in the world. The pandemic showed both employers and employees that remote work could be highly productive, and with many countries facing low growth in their workforce, companies are more willing to hire talent regardless of geography but hiring and paying employees in foreign countries is cumbersome. The easier it can become, the more opportunities there can be for both potential employees and employers.

The third and fourth largest equity deals both use blockchain infrastructure and highlight some of the biggest challenges facing the current monetary and financial systems. Circle, with a $400 million venture capital raise in April, uses the blockchain to send and receive payments globally, moving digital money while leveraging traditional payment rails. Bloom, which raised $378 million in its A round, is a blockchain solution for secure identity and credit scoring, giving consumers ownership over their identity and financial data.

Fintech Trends

These four companies illustrate two of the biggest problems that Fintech and next-gen monetary systems look to address:

• Low-to-no transaction fees. Traditional financial services involve a heavy layer of often expensive middlemen, creating friction and higher transaction costs. Think about the costs involved in selling a home or wiring money internationally. For decades, middlemen and transaction fees have been slashed across a wide range of industries and now financial services, which are heavily loaded with both, are in the crosshairs of disruptive tech. The emerging creator economy creates yet another tailwind as the consumer of content and the creator of content are increasingly able to connect directly.
• Zero-knowledge identity. Where there is valuable information, there will always be someone trying to get their nefarious hands on it. Zero-knowledge identity takes away those incentives because it allows a business to ensure their customers are who they say they are without obtaining any sensitive information about the customers that would need to be protected. By using a zero-knowledge solution, companies may be able to save money by reducing the cost of confirming identity and by removing the liability of having and protecting sensitive information.

Some Fintech models are eliminating or materially reducing fees with the idea that innovation and scale will make these new business models viable and much more attractive than traditional providers. We are also seeing collaboration of Fintech with traditional institutions. The OGs are able to leapfrog their offerings in a cost-effective manner and the new fintech companies face reduced regulatory headwinds by riding on the rails established by their OG partners, but this also opens up the opportunity for the newcomers to acquire customers from their bigger counterparts in full.

Today’s Public Fintech

While the 2021 explosion in Fintech investing, and in online shopping and payments in particular, was breathtaking, the implosion in tech-driven payment companies in 2022 has been equally stunning. However, the current valuation headwinds aren’t stopping Apple (AAPL), which is reportedly (but not officially confirmed) developing its own payment processing technology and infrastructure to support future financial products to reduce its reliance on outside partners, including Goldman Sachs (GS), over time. The suite of planned offerings is said to include payment processing, risk assessment for lending, fraud analysis, credit checks, and additional customer-service functions such as the handling of disputes.

The excess exuberance of 2021 met with the reality of people so happy to get out of the house that brick-and-mortar shopping recovered from the pandemic restrictions more than was expected. That said, the longer-term trend towards online continues and valuations in this area are much more attractive today than they were towards the end of 2021.

Fintech Challenges

While business models that remove middlemen and reduce transaction costs have a long history of being successful, the road to industry disruption is never smooth and the bumpiness is often correlated to the magnitude of change. Fintech and blockchain technology have the potential to revolutionize financial services to a degree that would make the music industry of the 90s think that the impact of Apple wasn’t all that bad, so one would expect the challenges facing such disruptors to be commensurate with their potential impact; they are.

Many of the business models in Fintech are looking to reduce transaction costs, increase availability, and allow for greater customization. When a product has high friction, it lends itself to standardization to minimize costs, but as fintech removes friction, customization becomes increasingly viable, particularly when the solutions involve decentralized finance or “DeFi.” DeFi uses cryptocurrencies’ core innovation, the ability to validate peer-to-peer transactions or to provide financial services without intermediaries, through the use of smart contracts. The potential here is immense, but there is some pain to get through first.

According to research from the Federal Trade Commission (FTC), over $1 billion in cryptocurrency was lost to fraud since the start of 2021. Chainalysis, a blockchain analysis firm, found that 37% of crypto scam revenue in 2021 was driven by “rug pulls” which involve developers listing a token on an exchange, pumping it up, and then vanishing with the funds.

In response, the House Committee on Oversight and Reform sent a series of letters in late August to four agencies – Department of Treasury, FTC, CFTC, and the SEC - and five digital asset exchanges — Coinbase, FTX, Binance.US, Kraken, and KuCoin — to provide the committee with information and documents concerning their consumer safeguards against scams and cryptocurrency-related fraud by September 12th. Getting more clarity on regulatory oversight will help bring in more investment to the space, so while it will limit a level of creativity, it will also give investors greater comfort.

The crypto world was rocked by the recent high-profile bankruptcies of lenders Voyager Digital and Celsius and the related-party hedge fund Three Arrows Capital (3AC). It is important to note, however, that these companies were not DeFi companies, but were rather traditional firms that used DeFi token or protocols. When the asset prices of its holdings fell dramatically, 3AC was unable to meet its margin calls and defaulted on loans, just like many traditional hedge funds have done in the past.

Its lenders, which included Voyager and Celsius, faced the double-whammy of withdrawals by depositors on top of 3AC’s defaults, pushing them into insolvency. The failure here was not an indictment on DeFi, but rather one of risk management. One could argue that the volatility of cryptocurrencies was at fault, but if you think back to the Great Financial Crisis of or the LTCM debacle, rapidly falling prices causing insolvency is not unique to crypto.

Fintech's Future

The bottom line is that blockchain, DeFi, and digital currencies will upend today’s monetary systems and financial services to a degree that is at least commensurate with the changes seen in music and video entertainment over the past two decades. But as is always the case with enormous change, it takes longer than you think and ends up being even bigger than imagined.

For investors, this means being attentive to the process and timing of the change because having the right vision of where things are going to go isn’t enough. Remember that both Webvan and eToys had the right idea, but they were probably too early and had flawed implementations. On the other end of the spectrum, Amazon (AMZN) is up over 23,000% and Netflix (NFLX) is up nearly 19,000% (after having been up as much as 57,700% in 2021) since the start of 2002, the year following the spectacular crash of Webvan and eToys. Both Amazon and Netflix have continually adjusted their offerings as consumer adoption and preferences evolved.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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