A cyclical perspective on European venture capital, Fintech and Blockchain (part II)
Updated: Mar 9
This is the second part of a two-part series of articles which looks back on the dynamics of venture capital, Fintech and blockchain under the assumption that we are currently transitioning into a new economic cycle. If you have not done so, I encourage you to read the first part to get a full picture of my line of reasoning.
In any case, following is a summary of the findings of the original article, which looked into venture capital as an asset class and how it fared in Europe. Its conclusions were fairly rosy:
European Venture capital “finally made the map” in Europe, boasting healthy ecosystems, dynamic investment volumes and hefty valuations.
The only thing missing for European VC to be complete was a bulk of successful exits but I hypothesised that since European VC really took off towards the middle of the decade and since it takes on average eight years from founding to exit, it was too early in the cycle to be able to truly judge Europe on its exits.
The current late-stage VC environment (where abundant capital is readily available for pre-IPO startups) delays exits but also provides liquidity opportunities to early stage fund managers, who should be able to crystallise returns for their investors and hopefully stimulate VC fundraising from European institutional investors as a result.
Now, let’s talk about Fintech and Blockchain.
What is Fintech?
First things first, there’s no good story without setting the stage. Contrary to popular belief, the term was first coined in the early 1990s by the “Financial Services Technology Consortium”, a project led by Citigroup aiming at fostering collaboration with its peers on technology subjects (it rings a bell…).
If reading research papers on the evolution of technology dedicated to financial services is your thing, have a look at this research paper published by the University of Hong Kong and the University of New South Wales in 2016, aptly named “The Evolution of Fintech: A New Post-Crisis Paradigm?”. I will try to summarise it in a few sentences to help us get our bearings.
Note: For the sake of this article I will completely ignore Asia and Africa. The evolution of Fintech in those geographies is nothing short of fascinating but would require an article of its own. This article focuses on the US and Europe, where the history and dynamics driving financial innovation were roughly the same.
Fintech 1.0: infrastructure (1866–1967)
Although the term became popular in recent years, it merely refers to the commingling of technology and financial applications, which is nothing new. The authors of the paper date the first signs of Fintech to 1866, which corresponds to the year when the first transatlantic telegraph cable was successfully put in service, effectively connecting Newfoundland in Canada to Ireland. The telegraph, along with the other technical advances of the era (e.g. railroads, canals and steamships) facilitated the rapid transmission of financial information, leading to a period of financial globalisation which lasted until the world wars.
Fintech 2.0: digitalization (1967–2008)
The London borough of Enfield was to make history in 1967, when an odd machine invented by Scotsman John Shepherd-Barron was installed at one of the branches of the Barclays Bank: an Automatic Teller Machine (ATM). The same year, Texas Instruments started selling its handheld calculator machine, probably receiving orders with a fax machine, which started to become widespread around that period.
As you will have understood, the acceleration of advances in communication, electronics and information technology triggered a second wave of financial globalization and digitalization, creating international organisations still active to this day such as the NASDAQ in 1971, the Society of Worldwide Interbank Financial Telecommunications (SWIFT) in 1973 or Bloomberg’s Innovation Market Solutions (IMS) in 1981.
“By the late 1980s, financial services had become largely a digital industry, based on electronic transactions between financial institutions, financial market participants and customers around the world, with the fax largely having replaced the telex. By 1998, financial services had become for all practical purposes a digital industry.
By 2001, eight banks in the US had at least one million customers online, with other major jurisdictions around the world rapidly developing similar systems and related regulatory frameworks to address risk. By 2005, the first direct banks without physical branches emerged (e.g. ING Direct, HSBC Direct) in the UK.”
Fintech 3.0: disruption (2008 — ?)
I do not use the word “disruption” lightly as it has become completely void of meaning, usually followed by a sentence along the lines of “the Uber of [place your industry here]”. There is, however, hardly another way to describe the phenomenon that most probably originated from the Global Financial Crisis.
The research paper cited above suggested that the birth of Fintech 3.0 was due to “an alignment of market conditions supporting the emergence of innovative market players in the financial services industry. Among these factors were: public perception, regulatory scrutiny, political demand and economic conditions.
[…] The financial crisis has had two major impacts in terms of public perception and human capital. First, as its origins became more widely understood, the public perception of banks deteriorated. For example, predatory lending methods directed at disenfranchised communities not only breached the consumer protection obligations of banks, but also severely damaged their standing.
Second, as the financial crisis morphed into an economic crisis, an estimated 8.7 million American workers lost their jobs. Two sets of individuals were impacted. On the one hand, the general public developed a distrust of the traditional banking system. On the other hand, many financial professionals either lost their jobs or were now less well compensated. This under-utilized educated workforce found a new industry, FinTech 3.0, in which to apply their skills.
Last but not least, there is also the newer generation of highly educated, fresh graduates facing a difficult job market. Their educational background has often equipped them with the tools to understand financial markets, and their skills can be applied to FinTech 3.0.”
As a result, while financial institutions were busy restructuring and adapting to new regulation, thousands of brilliant minds were at work figuring out how to use technology to fill the empty spaces left by the institutions, giving birth to neobanks (some call them challenger banks), P2P crowdfunding and lending platforms, insurtechs, etc.
From zero to hero
How did that translate into VC investments? While some VCs were already investing in Fintech without calling it Fintech, the investment theme became popular among investors and grew from virtually non-existent to represent a large chunk of total VC investments in 2019: 13% in the US and 20% in Europe.
Yes, that’s right, Europe loves Fintech. From just €100 million in 2010, European VC investments in Fintech grew at an annual rate of +61% until 2019, higher than US Fintech investments (+45%) and well above the growth rate of total European VC investments (+18%).
Albeit higher than average at the beginning of the period, the ratio of US investments to European investments (which in general averages 4x) was only 3.1x on average from 2015 to 2019. It even reduced further to an average of 2.6x for the last three years of the period.
Fintech is quite special in the sense that incumbents are inherently digital innovators (see above) and generally most of their activity consists of executing and managing investments, for themselves as well as for their clients. Under these premises, you would expect a high participation rate from financial corporates, right? Well, yes and no.
In the US, corporates’ participation in Fintech VC broadly followed the trend of other VC categories; if anything, they were slightly more active. In Europe, however, two periods clearly contrast each other: from 2010 to 2015, financial incumbents’ participation was generally lower than average, before reversing the trend from 2016 and becoming hyperactive.
Too bad. From 2010 to 2015 European entrepreneurs created 13 unicorns with an aggregate value of c. €28 bn. Let’s have a look at the characteristics of the “heroes” (unicorns and exits ≥ $1 bn) that were born during this period, both in Europe and in the US (you can get a detailed view here):
I previously hypothesised that it was too early in the cycle to judge European exits and this analysis tends to prove me right. The Fintech investment theme started roughly at the same time both in Europe and the US and the differences in the exit dynamics are not huge: at the end of 2019 (actually a little later since Visa’s acquisition of Plaid closed in early 2020) 12% of American heroes had seen an exit vs ~8% for Europe.
Another interesting point of comparison; in absolute terms, the difference in value between regions seems dismal (€105 bn for the US vs €28 bn for Europe) but it does not account for the fact that US fintech startups received c. 4x more financing than their European counterparts. If we divide the total value of the heroes of each region by the amount of VC investments received from 2010 to 2015 the result is surprising: every Euro invested by VCs generated exactly 6.5 Euros of value, both in Europe and in the US.
Solid proof that, for Fintech at least, European startups supported by VCs are capable of delivering similar value than in the US.
However, something happened in the US after 2015 that did not happen in Europe: four more heroes were born. Dave, a Neobank founded in 2016, became a unicorn three years after incorporation. Brex and Devoted Health, active in respectively Payments and Insurance and both founded in 2017 became unicorns after one (!) year of existence. Lastly, Figure Technologies, a lending startup, was founded in 2018 and raised €92 million ($103 m) just before the close of 2019, propelling it to a valuation of c. €1.1 bn.
Figure Technologies is an interesting company. It was founded by Mike Cagney, a founder of SoFI (American hero #7 with a valuation of €4 bn), first raised $20 million via a security token offering and uses its proprietary blockchain (and AI) at its core to approve home loans in less than 5 minutes and deliver in less than 5 days. I believe that Figure is the precursor of a new breed of non-infrastructure Fintech startups that use AI and blockchain to deliver better and faster services. Actually, blockchain is well represented among our list of American heroes: three blockchain startups — Ripple (#2 with a €8.9 bn valuation), Coinbase (#4, €7.1 bn) and Circle (#13, €2.7 bn) — make up almost 20% of the total value of the US Fintech successes.
This raises the question:
What are blockchains and why are they important to the financial services industry?
Note to the expert reader: What follows has been written about time and again and published countless number of times under many forms but is a necessary piece to the full articulation of my line of reasoning. If you are already convinced that blockchains are a cornerstone of the evolution of financial services, I encourage you to jump to the next section, where we come back to our original subject: venture capital.
What are blockchains?
Blockchains are a kind of distributed ledger in which new entries are stacked in “blocks” before being appended. Distributed ledgers (we are going to refer to them as Distributed Ledger Technologies or DLT from now on) are databases set up and maintained by multiple entities, called nodes. At any time, the nodes synchronously maintain the latest version of the database. The database is append-only and all the new entries are cryptographically linked to the previous ones. Deep dive here if you like.
The first blockchain was Bitcoin, a peer-to-peer electronic cash system created in the wake of the Global Financial Crisis that used an ingenious way to solve the double spending problem and make transactions immutable without having recourse to a centralised third-party. It allows any two strangers to transfer value to each other, almost instantly, in a trustless manner. Quite the disruptive Fintech!
In 2015, six years after the Bitcoin blockchain registered its first transaction, the first release of Ethereum went live. Relying on the ingenuity of the cryptographic algorithms introduced by Bitcoin, Ethereum introduced the ability to execute smart contracts in a trustless manner.
Smart contracts basically allow the automatic execution of a set of actions (usually a transfer of value) upon the completion of certain conditions, without relying on a non-digital third party that would need to execute the contract (theoretically). Code becomes law.
The implications of running smart contracts on DLT are deep: they allow us to safely automate the transfer of value, exponentially enhancing the possibilities offered by the internet, which first allowed us to automate the transfer of information.
To summarize and without entering into details, DLT are important because:
Their architecture and distribution among multiple nodes make the data they contain virtually immutable;
They enable standard ways to share information and processes, making them ideal for organisations which require a single source of trust shared between various stakeholders;
They are programmable and enable the automation of the transfer of value.
Why are DLT important to the financial services industry?
I see DLT as a tool that enables the removal of human intervention from the processes required for the smooth functioning of the world’s financial infrastructure.
DLT not only allow the freedom of human capital from tedious, low value-added tasks, they contribute to cost savings and accelerate the speed of execution of transactions.
Let’s pragmatically explore some examples where DLT impacts financial services providers.
1. Payments and remittances
The optimization of payments and remittances was the main driver that led to the creation of bitcoin and subsequently of all DLT that derived from it. The benefits of using blockchain for payments and remittances are obvious: 24/7 availability, quasi-instantaneous settlement, no intermediaries and low cost. Information attached to payment instructions are richer than the typical messaging systems used nowadays, allowing the inclusion of thorough KYC and AML documentation. Ripple (payments network using its own cryptocurrency: XRP) and Circle (programmable US dollar) built businesses of respectively €8.9 bn and €2.7 bn in this field.
2. Know Your Customer (KYC) and Anti Money Laundering (AML)
DLT enable financial services providers to share certain certified customer information (or only their state with zero-knowledge proofs) with other stakeholders in their network while keeping full ownership and the right to revoke information. Doing so reduces costs by avoiding repetitive KYC and AML checks that have already been done by another entity in the network. The immutable properties of DLT make them ideal to certify / timestamp electronic documents, replacing certified hard copies and wet ink signatures. As the developments of digital ID and sovereign identity progress, DLT may be able to help financial services providers manage their GDPR risks by removing the need to hold their clients’ identity data while still remaining compliant with AML regulation.
3. Commercial Banking
In the context of lending, sharing a DLT-based record of clients and transactions with other financial services providers allows banks to seamlessly generate credit scores, reduce fraud, facilitate syndication, automate loan events (drawdown availability, collection of interest, reimbursements, etc.). The programmability of both the value in which the loan is denominated and the digital representation of the collateral opens up innovative loan designs. DLT can be used in the context of intra-group cash management services for large international firms.
DLT can securely streamline data verification, claims processing and disbursement, reducing processing time significantly by automating low-value claims with smart contracts, build insurance products with pay-outs dependent on the event of digitally verifiable risks (weather conditions, delays, etc…) and digitalize insurance policies to facilitate reinsurance. The progress of digital identity initiatives and/or the adoption of DLT best practices by healthcare institutions may facilitate the assessment of risk for health insurance policies.
5. Digital securities
Digital securities are the digital representation of ownership rights to any kind of asset: equities, debt real estate but also art, collectibles, etc. As such, traditionally illiquid assets become available for investors to buy or sell 24/7 in minutes. High unit cost assets can be fractionalised, making them available to a broader number of investors. Lastly and maybe most importantly, the programmable form of digital securities allows the complete automation of compliance. Financial services providers can benefit from digital securities in many ways:
· Offer a broader, fractionalised range of assets to clients looking for innovative investments · Offer a greater choice of options for the management of family assets belonging to HNW clients · Allocate and rebalance portfolios (including private assets) with greater ease and speed · Automate fund and trust administration and management, etc.
6. Capital Markets
DLT can help automatize post-trade processes with quasi-instant clearing, settlement and reporting. Risk management processes can be enriched by directly interacting with programmable securities and their collaterals. Programmability of DLT paves the way to new structured products and synthetic derivatives. DLT enable seamless digital asset (today, mainly cryptocurrencies but in the future any kind of asset represented in a digital form using DLT) transfer on secondary markets, neatly improving the liquidity of private assets. Coinbase, a digital assets exchange and custody provider was last valued €7.1 bn.
7. Trade Finance
Supply chain financing is complex as it involves numerous parties in numerous jurisdictions: corporates, (general and correspondent) banks, facilitators, public authorities, etc. Each transaction relies on a stack of (paper) documentation difficult to analyse to assess risk. As a result, financial services providers cannot close a $1.5 trillion financing gap, mainly suffered by SMBs, due to compliance costs being too high, low profitability or high risk of fraud. The digitalization of the whole process with DLT allows trade finance providers to seamlessly share the transaction documentation among all parties, automate compliance, automatically build profile scores and facilitate the calculation of risk and eliminate fraud.
8. Other applications
As technology incites technology new ecosystems will emerge, generating new use cases that by definition cannot be known in advance. Such a phenomenon is currently unfolding with the Decentralized Finance (or DeFi) movement. DeFi “is the movement that leverages open source software and decentralized networks to transform traditional financial products into trustless and transparent protocols that operate without unnecessary (sic) intermediaries.” The movement started gaining traction in 2018, on the back of the maturation of technology developed on Ethereum and, as of today, mainly consists of decentralized protocols and applications revolving around crypto-collateralized stablecoins, lending and derivatives. The amount of value “locked” (i.e. held as collateral) on the platforms grew from virtually nothing in mid-2018 to c. €1.1 bn at its peak in February 2020. Not much, you would say, but DeFi is a pure concentrate of innovation unhindered by any kind of legacy model or infrastructure. Interesting to have an eye on it to say the least.
Back to you, venture capital
Little was heard about Bitcoin until 2011, when on June 8 the price reached a high of $31.50, 105x the price it started trading at the beginning of the year. Those ludicrous returns attracted interest from the mainstream, for the cryptoasset itself as well as for the potential of the underlying technology.
In late 2012, the next year, Coinbase (backed by Y-combinator) and Ripple raised their seed rounds of respectively $600k and $200k, principally from angel investors.
In 2013 our usual suspects (Coinbase, Ripple and Circle) kept on raising further rounds from established VCs (USV, Accel et. al.) while Bitcoin attained a new all-time-high of $1,163, 87 times higher than the yearly open. Those price fluctuations again put the spotlight on cryptoassets and blockchain technology and in 2014 serious money started pouring in.
Back then everything was about infrastructure: one or two-year old startups active in mining, custody or trading of cryptoassets started routinely raising $20+ million Series A rounds, propelling total VC investments in DLT well into a 9-figure total by the end of 2014.
2015 was a pivotal year: financial institutions (until then waiting on the side lines to monitor the evolution of the technology and its potential for their core businesses) started making strategic investments. Notably, in January BBVA Ventures, USAA and the NYSE participated in Coinbase’s $55 million Series C and Goldman Sachs led Circle’s $50 million Series C in April.
In September, nine financial institutions took the matter into their own hands and came together as a consortium around R3, a software development startup founded a year earlier by a Wall Street executive, David E. Rutter. By the end of the year, 33 more financial companies had joined the circle to develop together a DLT especially tailored to their needs. Enterprise blockchain was born.
In 2016 and 2017, VC investments in DLT continued to grow steadily at a rate of +43% per annum. Meanwhile, Ethereum (which was released in July 2015) drastically reduced the barriers to entry to set up so-called “Initial Coin Offerings (ICOs)” (the method Ethereum used itself when raising funds in 2014), allowing virtually anyone to quickly and cheaply design multi-million fundraising campaigns available to anyone in the world without having to let go of any equity.
The word spread quickly and by the end of 2017 $10.1 bn were raised through ICOs, 9x more than what VCs had poured in during the same year. The world was reinvented many times over, fortunes were made and naïve investors got ruined. Millions of investors hoping for a better tomorrow flocked to ICOs and by doing so sent Bitcoin and Ether (Ethereum’s native cryptocurrency) to all-time highs. Crypto was everywhere. Even after the market crashed hard during the first quarter of 2018, investors who arrived late to the party still wanted to secure their piece of the pie and poured another $11.6 bn into ICOs that by then, unfortunately, were mostly scams.
All the while, venture capitalists, driven by a mix of FOMO and sound intentions, invested almost 3.5x the amount they invested in 2017. Proof that the madness had at least brought one positive element: many entrepreneurs and developers became aware of the potential of the technology during this period and started building new legitimate ventures, capitalising on the maturation of the recently developed infrastructure.
2019 saw a decline of -35% in VC investments in DLT, which I interpret as nothing else than a healthy return to the mean. If anything, the fact that VCs still invested more than €2.5 bn is a clear sign that DLT are now widely recognised as a high potential technology and investment theme.
Blockchain, not crypto
While the crypto world was on fire, Enterprise DLT (defined as software for enterprise processes excluding the management, custody, or trading of cryptocurrencies) continued receiving modest investment from VCs (13% of total investments in DLT over the five-year period). Three reasons to explain this:
Firstly, DLT-focused US funds (mostly from Silicon Valley) jumped straight into the crypto rabbit hole, supporting open, decentralised projects and ignored their semi-open (permissioned) or closed counterparts.
Secondly, for many investors who got burned or who were waiting on the side lines, anything “blockchain” resonated in a negative way after the burst of the crypto bubble in 2018, blindly shunning the technology as a result.
Lastly, and maybe most importantly, Enterprise DLT is extremely recent:
R3, the financial institutions’ consortium that I mentioned earlier was established in 2015 and released the first stable version of Corda, their DLT, only in October 2017 (raising $107 million from their base of consortium members a few months earlier). Corda Enterprise, the “premium” version of Corda aimed at large corporations, was launched in July 2018.
In December 2015, the same year that the R3 consortium was formed, the Linux Foundation announced the creation of the Hyperledger project, an open-source project destined to “advance cross-industry collaboration by developing blockchains and distributed ledgers, with a particular focus on improving the performance and reliability of these systems […] so that they are capable of supporting global business transactions by major technological, financial and supply chain companies.”
As a member of the project, IBM contributed their “OpenBlockchain” codebase which was combined with contributions from two other companies (Digital Asset and Blockstream) to become Hyperledger Fabric, a leading DLT for enterprise use. The first stable version of Hyperledger Fabric was released in July 2017. Version 1.4 (the first LTS) and 2.0, which each brought multiple needed enhancements to put Hyperledger Fabric on par with comparable non-enterprise DLT, were respectively released in January 2019 and January 2020!
Finally, the Enterprise Ethereum Alliance, a consortium of Enterprises supported by Consensys (a for-profit company created by one of the co-founders of Ethereum which mission is to promote the development of Ethereum software and related ecosystems) was formed in March 2017. (JPMorgan started working on an enterprise version of Ethereum called Quorum in late 2016 but decided in February 2020 to spin it off and merge its development unit with Consensys)
Fintech has been an active theme of venture capital investments, reaching 20% in Europe, where the performance of VC-backed startups is on par with the US.
DLT have the potential to have a deep impact on the different verticals of financial institutions. The technology (magnified by AI and IoT) is an essential catalyst to the evolution of the world’s financial infrastructure.
I would like to suggest that after Fintech 1.0, 2.0 and 3.0, we are entering into a new phase of financial technology, Fintech 4.0, driven by both automation and disruption (or disruption by automation!).
DLT allows to minimise the need for human intervention in low value-added tasks such as KYC/AML verification, reconciliation, reporting, etc. They unlock value by slashing costs and opening low-margin markets.
Thanks to the standardisation and interoperability brought by DLT, barriers to free and instant transfer of value are falling, driving costs to zero.
The embedded programmability of units of value opens avenues to radical innovation: creation of new financial products, broadening of risk management strategies with more diverse portfolios, novel ownership models, interoperable assets, etc.
DLT are extremely recent (even more so for Enterprise uses) but early use cases have already proven their utility and potential. Generalist investors are still skittish in making significant investments at early stage and there is a large unserved demand for startup financing.
I believe that market factors are favourably aligned for investing in early stage enterprise DLT projects (in Europe and in the US) which will unlock value by contributing to the evolution of the financial services industry by removing redundant human intervention from its infrastructure.
About Schema Capital:
Schema Capital is a venture capital investment and advisory company dedicated to supporting European fintech founders from inception to seed.
We focus on “deep fintech”, where emerging technologies (blockchain, AI, IoT, quantum) are revolutionising the infrastructure of financial services and enabling entirely novel ways of creating and consuming financial products and services.
We also run The Drawing Board, a rolling advisory programme destined to help entrepreneurs hit the ground running and raise an institutional seed round.
The programme offers hands-on assistance with business strategy, product design and development, business development, investor documentation, pitch preparation and all things finance until a CFO steps in. The Drawing Board is open to Fintech startups only.