Fin-tech: Sleeping with the Enemy — Informilo

Square, the first start-up to enable self-employed professionals and small merchants to accept card payments via smartphones and tablets,processed payments of over $10 billion in 2012. Its phenomenal success did not escape the attention of Banco Santander, the leading bank in the Eurozone by market cap and the largest financial group in Spain and Latin America.

But the bank, which also has a significant presence in the UK, Portugal, Germany, Poland and the northeast U.S., did not try to develop a competing system in-house. Instead, it invested in and partnered with iZettle, a Square competitor. Such alliances are part of a growing trend: banks are realizing that they can’t do it all and if they are to retain the millennium generation as future customers they will have to partner with nimbler start-ups in order to develop the types of services that are attractive to digital natives.

While the small army of fast-growing start-ups across the payments and foreign exchange (FX) landscape aren’t yet a significant threat to financial services institutions, there’s little doubt that they will forever change the nature of banking. For example, Google Wallet, which enables customers to send money using Gmail to friends and family in the U.S., and Dwolla, which replaces “hidden” bank transaction charges with low, flat fees, are gaining traction with consumers. So are a growing number of consumer mobile payments services such as Square, iZettle, Stripe, mPowa, SumUp, payleven and others which target small and medium-sized businesses. Cross-border payments companies such as TransferWise, a peer-to-peer service that allows people to transfer money more cheaply; B2B international transfer services like The Currency Cloud and Earthport; as well as direct debit processor GoCardless, which enables smaller merchants to set up interbank transfers for customers, are also disrupting the market.

By forging strategic partnerships with such start-ups financial institutions are hoping both to piggy-back on start-up innovation and to counter the threat to their future market share.

“The model of the market used to be hierarchical so the payments systems were part of the hierarchy — they were like building blocks and owned by the same people: the banks,” says economist and technologist JP Rangaswami, chief scientist at” But now there are new entrants in their market, doing things [the banks] used to do, faster, cheaper, better. Before our eyes the hierarchy is morphing slowly into a much more adaptive ecosystem, into a network of small pieces, loosely joined, and not all those pieces will be [controlled by the banks]. The way you deliver a service now is not by full vertical integration, but by the right partnerships and alliances ± and we’ve only seen the beginning of that trend.”

As Square, PayPal and other U.S. companies gear up to expand internationally, iZettle announced, in February, a strategic investment of €5 million ($6.6 million) from Banco Santander. The deal enables self-employed professionals and small merchants to accept card payments via smartphones and tablets using iZettle’s Chip & PIN reader. For Banco Santander the interest is clear: in Spain alone there are more than one million self-employed professionals and micro-companies that need an option that is more flexible than conventional card terminals, according to the bank.

Others have announced similar arrangements. In October 2012, UK-based mobile payments firm mPowa signed a deal to supply its devices and payments infrastructure to First National Bank in South Africa. It has also signed an agreement with Portugal Telecom. mPowa’s CEO Dan Wagner says further, similar deals will follow. “We’re in negotiations with many banks and telcos around the world right now and we have plenty of opportunities that are under negotiation globally,” he reveals. Meanwhile, another Square competitor, SumUp, which enables merchants to take debit and credit card payments with their smartphones or tablets, announced a Series B investment round led by American Express and Groupon in May. That was followed by news, in July, that BBVA, which provides financial services in more 30 countries, had also invested in SumUp to help the company’s planned rollout into the South American market.

“All the banks have checked the box for things like mobile apps and P2P but there is a difference in checking the box and truly living and dying it and putting your resources behind it,” says Jay Reinemann, executive director at California-based BBVA Ventures, which recently announced that it has set aside $100,000 to take minority stakes in start-ups in payments and other related spaces. So far the bank has invested in two venture funds and four start-ups. Looking ahead, he says, the bank plans “to rely on the start-up community to help us to bridge the gap in product or marketing in any areas they can help.”

It’s taken start-ups to shake up the industry because banks have plainly had no incentive to disrupt themselves, says Tyler Sosin, a London-based associate with venture capital firm Accel Partners. Sosin works closely with the GoCardless team, in which Accel led a $1.5 million investment round last year. “It’s one of these innovator dilemma issues: why would you disrupt an existing business model that’s worked so well for you?” he asks. “The new players in the space, who don’t have the fixed costs of the banks, can come in and offer something that’s focused on one area and be able to provide much better value.”

iZettle’s CEO Jacob de Geer says that while banks, such as Santander, have been very effective at servicing mid-tier and larger companies with payment solutions, they have been rather less adept at finding ways to reach merchants and more mobile small businesses. “That’s where companies like iZettle are really disruptive,” he says. “We can reach out to these smaller companies. There are still 20 million companies across Europe which still don’t accept card payments, and typically they account for 20%-30% of GDP of any given market. Then if you look at a market like Mexico, you can see almost all companies are SMEs and they account for about 70% of all employment, so they are very significant, but very hard and expensive to reach for a traditional bank, given their set-up and sales methods.

“So why this cooperation is so exciting for Santander, and us, is being able to reach out to a totally new target group in a very cost-efficient way. It’s also a fantastic way for them to leverage their installed base of issued cards in the markets. The infrastructure’s already there and they can boost their revenue by bringing more acceptance devices to the markets.”

Besides, legacy businesses, such as banks and telcos, find it hard to innovate, argues de Geer. Their scale, history, heritage and hierarchical systems all mitigate against rapid technological change. “[Innovation] is not really in their DNA,” he claims. “It’s extremely hard to innovate from within an organization. The payments industry right now is being disrupted from many angles. Every part and aspect of banking will be challenged in the next few years; just look at what [online social trading and investment network] eToro’s done for trading — it gives a pretty good indication of what’s to come in banking services. So the combination of the incumbent and innovator is extremely dynamic.”

Another underlying reason for banks partnering with start-ups is speed. In an age of disruption, says mPowa’s Wagner, first-mover advantage is critical. “[Banks] recognize that market entrants could come into their space and capture a large chunk of customers before they’ve had a chance to get their act together. That gives an opportunity to new market entrants like us, who are providing a service to them, to say you don’t need to build this yourself, we’ll build it for you. In fact we’ve already built it for you, we just need to integrate it into your … infrastructure and then you’re off to the races.”

In FX, too, start-ups, including TransferWise, which strips out the hidden fees banks and others levy, and the cloud-based cross-border payments service Earthport, which enables users to pay money into almost any bank account in the world — are snapping at incumbents’ heels. “The banks have two choices,” says Hank Uberoi, Earthport’s executive director and a scheduled speaker at Sibos 2013 in Dubai. “Either they can try to do everything themselves, in which case they’ll never be able to solve [the challenges they face] because they can never move fast enough relative to other nimble players. Or a solution like ours will allow banks to solve a difficult problem, and then they can focus their efforts on what the consumer and their clients actually want, in which case they can move pretty fast.”

FX companies are, in fact, already forging strategic partnerships with banks. The Currency Cloud, for example, has already done deals with Fidor and Sofort banks in Germany and CEO Mike Laven says the company is currently in discussions with three other medium-sized European banks. “Our thesis is that in the cross-border payments area, people pay too much and it’s too difficult. Our intention is make it easier and cheaper — and if we can help a bank to do that instead, then in some ways we’ve achieved our purpose as well.”

Accel’s Sosin foresees a landscape in which banks and start-ups operate alongside one another. “Banks and start-ups will be able to coexist, but banks will just not be able to generate as much profit on some of these smaller customers, like SMEs and consumers, as they have in the past,” he says. “They will be important providers in the space, they’ll still work with much larger businesses and their FX needs, and they’ll still be partners to a lot of these end FX companies, in terms of providing them liquidity in the market. It’s just that instead of the banks dealing with end consumers, companies like TransferWise and [Accel-backed] OzForex will aggregate a lot of demand and be able to negotiate better with the banks and go into the exchanges with a lot more leverage.”

Stripe Co-Founder John Collison On Why Banks Are Not Leading In Payments

Stripe, whose investors include Peter Thiel, Max Levchin, Elon Musk, Sequoia Capital and Andreessen Horowitz, IS AVAILABLE IN the U.S., CANADA and the U.K. and is in private beta in Ireland and France

Innovation in the payments space is harder than in most markets: it requires pushing boundaries from both a technological as well as a regulatory standpoint. Naturally, as we look at less technologically-oriented companies (like major banks), this problem becomes more pronounced. Because they focus on providing services to well-established businesses, not a fast-moving base of startup clients, they aren’t required to challenge the status-quo or relentlessly root out inefficiencies in existing systems.

Ironically, while major banks have significant clout in discussions with regulators, it’s becoming increasingly clear that start-ups, not banks, are the ones driving changes in regulation to accommodate innovative products. In 1999, PayPal changed the face of online commerce and drove the direction of much of the online payment regulatory landscape. Today small but fast-growing companies such as Square and, my own, Stripe are challenging areas traditionally dominated by large financial institutions.

Innovation comes from the ability to respond quickly to changes in the market and environment. While talking to companies in the collaborative consumption space, we learned that much of their operational overhead came not from accepting payments, but from disbursing funds to the supply side of the marketplace: Lyft, a ridesharing app, needed to send funds to drivers, while Postmates, a mobile delivery app, wanted to send money to couriers. So in less than four months, we developed and launched our Payouts product. Rather than undergo a time-consuming and error-prone process of sending manual payments through their banks, marketplaces could now manage multi-party payments with a few lines of code.

Banks have seemed wanting in agility and innovation in financial technology, especially when it comes to that used by sellers. Why is this? We think these banks are in the doldrums thanks to a lack of emphasis on technical expertise (including reliance on outsourced technology). They are ignoring the very telling leading edge of the market and failing to empower the types of people who drive progress.

Stripe has benefited from living directly in the center of a generation of entrepreneurs, who are pushing technology boundaries. In order to understand the developments of the market and build products that solve needs and drive change, you need two-way interaction with fellow disruptive businesses. By narrowly focusing on existing big players and large accounts, banks have lost the connection with those who inspire innovation.

–Jennifer L. Schenker contributed reporting to this story.

This article was first published on on 16th September, 2013 and in the Sibos print edition.