The financial technology market is heating up. With a string of successful exits and funding at an all-time high, fintech is the poster child for the startup community. This year has already seen record investment in the sector, with Q2 marking the largest funding quarter to date. So what’s driving this flurry of investor activity — and is it sustainable?

Investment in the fintech market

According to CB Insights, $30.8 billion of venture capital was invested across 657 fintech deals globally in Q2 — shattering the previous quarter’s record by almost a third.

This has been driven by a surge in ‘mega-rounds’, deals worth over $100M, which accounted for 70% of total funding in the sector. The boom cements fintech’s position as the dominant category for unicorns, and goes some way to explaining the peak in investor interest.

While we’re likely to see continued investment in neo and challenger banks, only a handful will be successful. After all, the Revoluts of the world are the exception rather than rule. In this particular instance, the investment case goes beyond pureplay financial services, to a superapp strategy that could prove Europe’s answer to the likes of Alibaba and WeChat.

Nevertheless, the growth opportunity remains sizable. We’re only scratching the surface of what’s possible, and there are two key areas within fintech that are continuing to grow rapidly.

The first is the nascent fintech-as-a-service category. At the vanguard of this is Mambu, Solarisbank and Marqueta, helping anyone to enter the financial services space. This emerging market has been given a significant boost during the pandemic, as consumers have come to expect access to financial services whenever and wherever they need them.

The second is the provision of digital financial services itself. Neo bank success stories, such as Monzo, N26 and Chime, have all proven the growth potential in this space. Still, only a fraction of the global population currently uses these services. Those able to follow in the footsteps of Revolut will be the ones that break into these underserved markets.

The growth trajectory for fintech, then, is comparable to Google back in 2004 versus Google today.

Bringing the future forward

But banking is an industry notoriously slow to change. So, what’s making investors double down in the hunt for the next fintech success story?

The impact of Covid-19 shouldn’t be understated. The pandemic has been a force majeure like no other for financial services, bringing broad-ranging impacts for both banks and their customers.

Health and safety measures have accelerated the shift to a cashless society, increasing the provision of online and digital banking services. With banks under pressure to deliver contactless experiences, digital attackers were at a significant advantage — better able to balance business decisions while responding quickly to customer needs.

Meanwhile, lack of job security and the prospect of indefinite economic turmoil saw consumer confidence plummet. Out of this adversity has sprung financial change. With the pandemic continuing to affect buying power, demand for personal lending and flexible payment options, such as point of sale (POS) lending and Buy Now Pay Later (BNPL) services, has risen dramatically.

Square’s recent acquisition of Afterpay for $29 billion in August is an indication of just how lucrative the market has become. At the end of 2020, Afterpay had more than 11 million users in the US, with 7.5 million of these having made a purchase in the preceding year.

This demand for financial products outside of traditional ecosystems has accelerated the rise of embedded finance. With this market set to be worth $7 billion globally by 2030, non-financials are beginning to realise the growth potential for their businesses.

More than ever, banking is becoming about financial infrastructure. Something that’s reflected in the increasing funding rounds and successful exits in the investment space. While traditional banks have long looked to third-party providers and tech leaders on digital transformation, there’s always been a question mark over whether fintech is a friend or foe to the industry.

The pandemic has brought the future forward, along with an acceptance of fintech’s role within it. This has significantly increased the appetite to partner among incumbent players and the B2B side of the market has growing appeal for the investor community.

The role of big tech

This shift in mindset may also reflect the threat of a looming player in banking. Specifically, big tech. With Apple set to launch its own BNPL offering with Goldman Sachs and Facebook poised to unveil its long-awaited digital wallet, speculation on the tech giants’ appetite to encroach on financial services is rife.

Still, the threat to incumbent players has to be qualified. The potential for big tech to acquire a majority share of the market is certainly there, and the opportunity is huge. If Facebook got 10% of its users to adopt financial products, that’s 300 million customers — ten times more than the world’s largest banks. But it’s difficult to picture this in the current regulatory environment.

There’s growing consensus globally that big tech already has too much power. In Europe and the US, these firms are navigating a calculated game of brinkmanship with lawmakers and politicians in the shadow of regulation. It’s hard to imagine them being allowed to consolidate their monopoly in new markets — especially one as tightly controlled as financial services.

Then, of course, there’s the question of whether the tech giants want to become banks. Yes, Apple can embed BNPL into its user experience. And, yes, this could majorly disrupt the lending and credit industry. But Apple offering POS credit is very different from it becoming a bank. It’s not clear whether tech leaders want to embrace this level of risk and if this represents a distraction from their core business.

In the end, it doesn’t really matter. What sets big tech apart is its laser-like focus on the customer experience, and how well these firms leverage data to provide tailored services. So long as their services are the most convenient and accessible on the market, customers will use them — regardless of whether or not they come from a bank.

Change is the only constant

As financial services increasingly become embedded in the user experience, the fintech community has to address what the future looks like, and how banking will change in the next two, five and ten years.

This means thinking about the competition incumbents face at a business line rather than wholesale level. The problem is these business lines rarely operate independently, running on monolithic systems and legacy tech, which creates a bottleneck in the delivery of new services.

As an industry, banking has to stop looking for the next big operating system, when what’s best now might change in six months. The only thing banks and the market can be certain of is change.

That’s why forward-thinking players are building highly adaptable composable architectures. By partnering with software-as-a-service (SaaS) providers, banks can deliver incremental change, at scale, as well as bring products to market quickly in line with consumer demand.

Estimated to be worth $123 billion globally, the SaaS industry offers businesses a desirable alternative to big, in-house ‘rip and replace’ projects that are doomed to fail.

Core to this is a customer-centric approach. Something the tech giants know all too well, but a concept that’s less well understood in the banking world. Banks talk a good game when it comes to the customer experience, but only 1 or 2% are actually changing the stakes.

The channels people use to manage their money have changed. Digital challengers have provided online alternatives to traditional banking. But the underlying experience is too often the same. A one-size-fits-all model that lags behind the personalisation seen in other sectors, and falls short of customer expectations.

Only by building flexibility into core systems can banks truly respond with the speed and agility required to meet changing user needs, while future-proofing their operations in the process.

Looking forward

With SaaS set to blur the lines between fintech and banking, the smart money is on those businesses that tap its potential to solve a clear and identifiable user need — not reinforce bank-centric models or the dream of the next big thing.

While there’s been a shift in the power balance between banks and customers in recent years, this hasn’t happened hard enough or fast enough. Rather than fearing the influence of tech giants, banks must adopt a customer-centric mindset of their own. One that brings value to end users through hyper-personalised services they can’t find anywhere else.

But the market’s red hot for a reason. Whether it’s the next wave of challenger banks or the growing B2B community powering innovation from behind the scenes, fintech is solidifying its appeal for modern investment portfolios.

With the pandemic accelerating its acceptance among the wider banking community, the record investment of the last few months is just the tip of the iceberg.