Three Layers of FinTech

Article was originally published in Caijing.


Fintech has become the darling of the VC world over the past few years including a number of technologies such as crowdfunding, blockchain, and robo-advisory. At the same time, it is an all-encompassing term that has eluded definition. Worse, industry participants tend to conflate finance and the technology behind it. The article seeks to clear the cloud and provide a framework to think about fintech as three layers: user experience (UX), alternative financing and financial infrastructure:

While technology can drive changes in the infrastructure, the true challenges lie in governance. Understanding these three layers can clear up confusion over business models and avoid conflation of the fin and tech parts of fintech.

Financial technology, also known as fintech, has become the new thing of VC investment circles and the financial industry in recent years. According to a report by KPMG, the total investments in the sector topped USD 25 billion in 2016 alone.[1] But curiously, from the so-called “internet finance” a few years ago to “fintech” today, the fundamental nature of this sector seems to have eluded definition. P2P, big data, robo-advisors, blockchain… these buzzwords only compound the confusion.

But finance is finance, and technology is technology. No matter how intimate or how intertwined the interactions have become, differences in their fundamental nature prevent the two from merging into one. The impression that fintech is sometimes fin and sometimes tech originates from ulterior motives. The fundamental nature in the fintech sector can be seen through three layers: (1) user experience; (2) alternative financing; (3) financial infrastructure. The three layers operate at different levels of the financial system but are not mutually exclusive. Every startup or institution claiming to be in fintech is involved with at least one layer. The innovative or “revolutionary” features of fintech fall cleanly into fin or tech without confusion if we look at the sector from this perspective.


User experience is often called by its shorthand: UX. This is the most conspicuous layer of fintech. It basically means offering financial services on a mobile app. The mobile device, usually a smartphone, is the main medium. It delivers financial services for a new generation that has grown up with social media and online games by putting the user at the center.

An often neglected fact of UX innovation is the breakthrough in design concepts, particularly interface and service design. Originally at the forefront of the design community, these concepts found their way into engineering and technology through the efforts of firms such as Apple, the design studio Ideo and various game developers.

Interface design refers to human machine interaction, such as how a mobile app flows from page to page. Smart phone touch screens have completely altered the thinking in interface design. Service design is even broader, encompassing online and offline integrated service flow. It can be understood as crafting the entire experience. In China, such user-centric design thinking is sometimes called “internet thinking”.

Note that impressive UX is not unique to fintech, nor is it a prerogative of fintech firms. It just so happens that financial institutions in the traditional sense tended to neglect retail or SME user experience, thus coming across as stand-offish and bureaucratic. This stands in sharp contrast to user-centric UX design. Over the past few years, fintech startups, particularly in China, with impressive UX such as all kinds of wealth management and stock picking apps grew extremely popular with younger users as well as VCs, and often hailed as “innovative”.

In reality, many so-called fintech startups provide plain old-fashioned financial services under the guise of impressive UX. In China, this was commonplace from 2012 to 2015. But after a few years of disruption, financial institutions have slowly mastered the UX advantage. Now mobile apps from some big banks can hold their own against startup products. At the end of the day, UX is not financial innovation, but rather a pathway to it. Its importance lies in acquiring and retaining customers, but a financial firm cannot make this its primary business. And as the Chinese experience shows, those fintech firms relying too much on “internet thinking” or UX sugar coating have run into financial difficulties.


Alternative financing (or financial services) is the actual business of many fintech firms. It is “alternative” because advances in hardware, data science, cloud computing, machine learning, etc. have enabled non-financial institutions to provide financial services. Many regulators around the world, keen to avoid the label of “stifling innovation”, have played along by introducing “regulatory sandboxes” (effectively a trial environment) so that firms can provide financial services under specific circumstances without having to go through the normal license applications. Examples include P2P lending, robo-advisor, crowd-funding, and electronic wallets.

Image result for p2pFintech firms in alternative financing more than often blur the lines between finance and technology, with plenty of them sounding the revolutionary trumpet of “tech changing finance” or spelling the doom of banks. Silicon Valley style offices, entrepreneurial passion, T-shirt and jeans attire, ever higher valuations…everything seems to point to a Silicon Valley takeover of Wall Street.

But after the fundraising party, reality hits. Technology may be the indispensable agent, but if a firm provides financial services, it cannot deviate from the nature of finance – the pricing and trading of risk. The first principle of finance is the time value of money. When there is time there is a future. When there is a future there is uncertainty. Where there is uncertainty there is risk. Taking risk demands reward. This reward ultimately is afforded by the party selling the risk, albeit after changing many hands on the way, and so completes the financial transaction, though what is exchanged is not physical. The price of the transaction is the price of risk. Now any shrewd merchant can tell you that the price of any transaction is not completely driven by rational valuation. Emotions, market conditions, negotiation psychology, liquidity of funds etc. – all irrational drivers – play a big role. Such is human nature, which is not easily disrupted by swapping suits for T-shirts and jeans.

For example, look at P2P lending and robo-advisors. The former is ultimately a lending business, while the latter is ultimately an asset management business. Lending makes money from spread (or net interest margins) – the higher the leverage, the higher the spread, and so is the risk. Asset management earns management fees – the larger the asset base under management, the higher the fees. Under client consent, asset managers could also earn a portion of the excess returns (i.e. carry). These are basic facts of the financial services business, but just temporarily drowned out under the mantra of “technology changing finance.” Who could make spreads or fees on returns under which conditions is ultimately determined by licenses. In other words, the fundamental revenue model of financial services is determined by specific licenses. Hence, fintech firms pursuing alternative financing would ultimately find their place by transforming into licensed financial institutions. The dilemma is that it may imply a departure from the halo of technology and the associated valuation. That many fintech firms in the United States choose acquisition by financial institutions – those very monsters to be disrupted away, supposedly – as an exit strategy is the best proof.

If technology cannot change the fundamental nature of finance, then what does it really transform? Simply put, fintech has fundamentally altered, or disrupted, the cost structure of operating a financial services business, and the impact cuts deep.

Take lending as an example. Suppose we ignore, for the moment, losses due to non- performing loans. The operating cost base alone is exorbitant. This includes the costs of risk management, liability and funding management, compliance, IT systems, document processing, etc. If we put non-performing loans back into the calculations, the profit margins of lending (without artificial interest rate controls) remain embarrassingly thin. This was the precisely the motive behind dismantling the Glass-Steagall Act in the 1990s by the banking lobby, so that commercial banks could enter the far more lucrative investment banking and capital markets business.

But the emergence of advanced data sciences (big data, deep learning, etc.) makes it possible to dramatically reduce the operating cost base of lending. The shrinking of risk management staff and smarter processes have increased operating efficiency. If we add an impressive UX, the cost of client acquisition also falls. And that barely scratches the surface of the potent magic between data science and mobile UX. Mobile devices can obtain social media, GPS data, etc. in real time. Smart UX design could reveal hidden user preferences. New types of data enrich the customer profile, making it possible to risk manage client segments that previously thwarted such efforts. By removing geographical constraints with mobile, previously underserved client segments can now access credit. The same applies to insurance and many other financial services. This is why fintech is often associated with financial inclusion. The implications are especially relevant to developing nations. From the deserts and snow-capped mountains of Central Asia to the archipelagos of South East Asia, operating costs have challenged delivery of financial services through physical branch networks. By disrupting the operating cost structure of financial businesses, fintech has enabled the previously unbanked millions to become mobile users of financial services.

However, the prerequisite to all this is still running a financial services business (be it lending or insurance) properly with a license. The business is only sustainable if the profits come from a legal and compliant revenue model under its permitted business lines. Large institutions tend towards bureaucracy and stifle innovation. It is a perpetual management challenge. Financial institutions can invigorate themselves with innovation through strategic investments or acquisitions, such as Blackrock acquiring the robo-advisor firm Future Advisors. Fintech firms, on the other hand, can become financial institutions through license application, such as Xinwang Bank which was granted permission to operate in China late last year. License is not the obstacle to innovation, and no inherent conflict exists between the two. Even P2P lending now falls under a licensing regime in many different countries, and will transition into a licensed financial business. The real conflict comes from managing and selling financial services as technology products. In China, perhaps the spread from financial services is so alluring that fintech firms selling only tools are not as common as in the United States.

So far, one flagship fintech that has not been mentioned is mobile payment. Technically speaking, the payment business (excluding interests and wealth management products on balances) is not a financial business, but a service to financial services. It does not price risk, does not incur risk exposure, and does not profit from spread or capital gain related to risk pricing. Payment earns only fees, but it is a highly regulated business it involves the transfer of money. Payment fundamentally belongs to the area of financial infrastructure. This is the least understood part of fintech, but perhaps the most important part since it lies at core of financial system infrastructure.


Image result for financial infrastructure

Financial infrastructure can be simply described as the service to financial services, broadly falling under either clearing & settlement or fundamental data. Clearing & settlement comprise many parts such as cross-border settlement, securities and financial instruments clearing, but the most fundamental of which is the core banking payment system. Fundamental data includes credit bureau data, tax data, etc. Infrastructure is akin to public utilities such as water and electricity where some degree of monopoly is necessary for efficient delivery. Infrastructure is typically barely noticed until something goes wrong. Often called “the plumbing of the financial system”, users often take infrastructure for granted and fail to grasp its technological and strategic implications.

The payment system is arguably the most critical piece of financial infrastructure. Like all infrastructure, the more developed the country, the more antiquated it tends to be. For example, US payment companies, despite pioneering advanced NFC technology and superb UX design, often fail to move funds in real time because the underlying system is outdated and fragmented. US payment system still relies on technology from the 1970s and 1980s scattered over several networks. It never built a UK style Faster Payments for inter-bank settlement or a Chinese style Union Pay. Developing nations without the burden of legacy systems can position themselves to leapfrog. China’s sophisticated third-party payment business is the clearest testament.

Financial infrastructure itself is not a financial business. At its core is indeed technology, but it demands robustness of a very high degree. More than just innovation, it requires highly effective operational management and technical governance including setting rules, standards, procedures, etc. Imagine an electric power supply system without government standards –  all hell would break loose. Therefore, all technology touching financial infrastructure must first develop proper governance before implementation. Blockchain, crypto-currency and other similar frontier technology have yet to be widely adopted precisely because setting up a proper governance system is not a simple matter. Globally, blockchain consortia often struggle to reach consensus due to conflict of interest between corporations. The regulatory, policy and international collaboration issues would easily overwhelm a start-up or a band of hackers hailing disruption. If developing nations wish to exercise late mover advantage in these areas, government involvement is indispensable. Financial infrastructure evolves hand-in-hand with national data efforts. Effective government leadership can set the tone.

From the perspective of the three layers – UX, alternative financing and financial infrastructure, the fin and tech of fintech are intimately connected but distinguishable, and certainly not to be confused. Even though fintech firms are leading the new wave, a true transformation of the dynamics of the financial system requires the combined efforts of financial institutions, regulators and governments. In an era that celebrates entrepreneurship and innovation, “revolution” and “disruption” have almost become the norm. History, however, reminds us that those revolutions that aspire to disrupt all would ultimately spell their own end.

[1] KPMG Pulse of Fintech 2016