Musings on Full Stack Financial Services startups

(This post has been long in the making). One of the posts that sparked my interest in the last months is a post by Chris Dixon, Full Stacked Startups. In it, Chris highlights several startups such as Nest, Uber, Tesla, Warby Parker as companies that have gone after the market as full-fledged businesses instead stacking on top or in partnership with other players. Notably the …

[…]  full stack approach lets you bypass industry incumbents, completely control the customer experience, and capture a greater portion of the economic benefits you provide.

Recent transactions, such as Twitter’s acquisition of Gnip, are also showing, in my view, the business tension by any tech startups to move vertically upstream or downstream to find the right mix of economic models.

There have also been more conversation around the idea of changing at its core financial services. Marc Andreessen has jumped in the discussion with the idea of building a full new bank: http://qz.com/175512/to-disrupt-banking-do-you-need-to-own-the-bank/.

@infoarbitrage @cdixon @JackGavigan @Kwdmiller @aweissman All software top to bottom + exposes API for thousands of financial apps.

— Marc Andreessen (@pmarca) February 9, 2014

Note 1: Bitcoin is a strong factor here, not so much from a direct technology perspective, but more from bringing into the public’s mind that the financial services sector can be disrupted / affected in its own core. 
Note 2: API banking has been at the center of what we are building at Anthemis and a personal passion of mine: http://tekfin.com/2012/04/10/the-core-of-the-machine-banking-as-a-utility/  http://tekfin.com/2010/08/16/banking-as-a-platform-coming-soon-with-banksimple/ , 

Jack Gavigan answered with this excellent post on a blueprint for a new disruptive bank: http://jackgavigan.com/2014/04/14/disruptive-bank/.

A system blueprint is a great way to start but is one of the views of a fractal of perspectives that needs to be taken when considering financial services (I highlighted in red what I think is one of the key area). Another important one is the financial view. A full stack financial services startups is, in my view, a balance sheet driven startup. Balance sheet driven startups are a bit of an exception in the world of technology startups. In the past years, a lot has been made to make these less and less driven by balance sheet. From renting infrastructure to outsourcing functionalities to other companies, most tech startups have been driven at first with little focus on balance sheet. However in the world of financial services whether banking or insurance, balance sheet driven startups are the default structure for full stack startups.

That makes them more difficult to be considered from a venture capital perspective:

– First, they require capital, much more than a typical tech startup. Oscar’s minimum capital requirement for operating as a health insurer in the state of New York is USD 45M : http://www.dfs.ny.gov/insurance/exam_rpt/x9475o13.pdf , most/all of which will need to be kept aside. That’s a $45M raise just for the right to play. Additional funds will be required for development, marketing, …

– Second, they are very difficult to grow hockey stick. Think of balance sheet driven financial services startups as the weird cousin of multi-sided marketplaces startups. Taking the example of a new bank, for every new customer that will subscribe and deposit, a matching capital will need to be added following Basel III or another local capital requirement rule, invested in secure products. In parallel, you will want to deploy your customers’ deposits in money-making investments with risk profiles compatible with your capital requirements. Either you run your own lending / investment business which adds further complexity or you look for partners to deploy. Low risk with relatively good returns investments are chased by investors and your new bank is a small fish in that pond. All of this contributes to make growth more difficult than in a typical startup.

Even for a simpler version of balance sheet driven startups, say a lender with little/no prudential ratio, every growth in customers will need to be matched with an increase in available capital. Kabbage debt raise is a good example of that: ~$53M raised in equity for ~$345M raised in debt.

So why are full stack financial services startups interesting?:

– From an operational point of view, these activities are enormously inefficient in existing banks. The software they are using (Core Banking Software) is old, batch based and difficult to replace – understandably, once you have built a full balance sheet, something that can affect its management is high risk. Anything build on top of this software base is affected, from your customer front end to your risk management software to your lending activities. This leads to more operational margins being taken to ensure you are operating within regulation. A new player will have tremendous opportunities using the flexibility that current software allows. I am playing our book here (Anthemis) but Fidor Bank‘s ability to connect to P2P lending platforms, virtual currency exchanges or to manage multicurrency /commodity accounts is a good example. This is an incredible opportunity space.

– From a business point of view, once you are past the more difficult early stage balance sheet growth phase, you have built a resilient, flexible company. Flexible is not an adjective often used for banks, but with the right infrastructure and API layers I think modern banks will have the opportunity to open themselves to many business models. Built in-house or in partnership with others. This is also the case in terms of their capability to deploy assets. Financial products, liquidity providers, exchanges are evolving at a rapid pace. New platforms appear to access private companies equities, alternative debts (P2P but also factoring, data driven SMB debt). Non banks are becoming investors as well, investing in their own supply chain to guarantee its performance. And these platforms are becoming more and more digital, creating new opportunities for a bank to connect and invest.

Note 3: This is also where the evolution around contracts in the blockchain such as Ethereum, or distributed open ledger such as Ripple (which recently partnered with Fidor Bank) are really important. Making transactions fully electronic and real-time has massive implications for banks in terms of their investments as well as their risk monitoring.

There are a lot of additional perspectives to consider and I will gladly take additional insights, critics, comments. However if you are working on building a full stack financial services startups, whether in banking or insurance, I am really interested in talking with you. There are very few now but I am betting we will see more and more people try in the coming years.