Drivers of financial innovation

Disruptive forces in financial markets have been noticeable over the last 10 years with the introduction of new digital payment methods such as contactless cards and mobile phone payments. However, the disruption caused by the Covid-19 pandemic in 2020 accelerated some of these changes with technological innovation across the industry. We identified three main pillars that facilitate financial innovation: the current macro environment, the ongoing demographic shifts and the advances in technology.

Macro environment

Central banks adopted large accommodative monetary policy regimes worldwide in response to the economic disruption from the pandemic, but even before these measures, banks had been faced with increased regulation, high capital costs and a low to a negative interest rate environment. Years of low rates has impacted revenues and reduced margins for financial institutions. More recently, the economic recession has left financial institutions exposed to increased default risks as a result of a pick-up in unemployment, corporate defaults and for the consumer segments, a reduction of consumer spending. Insurance companies make lower returns on fixed income investments, and asset managers fees have been brought down to reflect that absolute returns are lower, due to lower nominal fixed income yields. Additionally, in recent years asset managers have also faced the competition of passive strategies, offering new investment products at even lower fees. As a result, embracing  digital transformation and adopting new trends becomes a matter of survival for incumbent companies in this sector. This requires firms to reduce costs, increase efficiency and adapt to new consumer trends.

The pandemic also accelerated the shift to online shopping, with companies and consumers increasingly adopting digital forms of payments. New payment methods such as digital wallets, which are a software-based system to store customers payment information to complete purchases from a mobile device, currently represent 44.5% of global e-commerce transactions, growing by 6.5% between 2019 and 2020. In the US, the use of digital wallets for e-commerce has now equalled that of credit cards, representing 30% of transaction volumes.¹ Overall payments with digital wallets currently represent 26% of global point-of-service payments and are expected to represent a third of payments by 2024.

Consumers’ adoption of new technologies prompted governments to adapt regulation to capture these rapid changes in trends. Regulation has accelerated the transitions into new technologies, creating opportunities in underserved markets with low banking penetration, but also triggered concerns over cybersecurity. These new threats resulted in financial institutions increasing their investment on security as the number of cyber-related crimes increased by 160% since 2018.² According to a survey from the Centre for the Study of Financial Innovation, cybercrime has increased as a result of the pandemic as more staff work remotely, making it the number one risk to the banking sector.³

The increase in popularity of digital currencies, which are a specific form of money which is only available in electronic form, have also questioned the future of monetary sovereignty. Digital currencies are secured by an encryption method that prevents them from being counterfeited or duplicated. However, despite the rapid increase in the price of these so-called cryptocurrencies, they still represent less than 1% of global registered e-commerce transactions⁴. Notwithstanding the slow adoption of cryptocurrencies for everyday payments, 70% of central banks have explored the possibility of issuing their own digital currencies to complement their existing fiat currencies⁵. However, a digital currency issued by a central bank and used for settling payments globally could threaten the monetary sovereignty of countries with weaker currencies, increasing the possibility of tighter regulation of this space.

Demographic shift

As well as consumers’ willingness to use digital services being accelerated by the pandemic, this also reflects the underlying demographic shift. In 2020 the wealth of US millennials totalled USD 5.9 trillion, increasing over ten-fold from a decade earlier.⁶ While in comparison to previous generations millennials are still behind in amassing wealth. This growth signals that greater attention should be paid to catering to their habits and requirements around digital banking. The number of bank branches across the US has been in decline, with the sector seeing a wave of consolidation, given a more favourable regulatory environment and a greater need to scale efficiencies. Banks are now seeking out digital solutions to lower acquisition costs and accelerate revenue growth. Indeed, there are a number of challenger banks with no physical branches at all, being purely app based.

At a time where the current financial leaders are expanding and enhancing their digital offering and innovative new companies are emerging, consumers are faced with greater choices. As awareness increases, consumers will inevitably be more demanding and selective with the services which they require. The costs of switching products is also low, meaning that companies will need to offer differentiated products to stand out and retain customers. Most US banks now offer digital apps however the quality greatly varies. While some large banks have been able to draw on their resources and knowledge of the high-quality experience demanded by clients, others have struggled with legacy vertical systems.

Technological advances

Recent technological advances have allowed financial institutions to create better customer experiences and improve their online presence through innovation. The development of artificial intelligence (AI) has created a new way of dealing with customers. According to one US insurance company, its AI handles new policies and 30% of claims. AI enables companies to reduce the number of manually processed tasks, reducing time and minimizing errors. On the investment side, companies have developed automated investment services, driven by algorithms  that has no human intervention, designed to optimize passive indexing strategies at lower costs to investors. Assets in this space have grown by USD 160 billion in 2020 to an estimated USD 987 billion, expecting to reach USD 2.9 trillion worldwide by 2025.⁷ Developments in big data and analytics have allowed companies to have more complete information on their customers to create customized products that better suit their needs. This allows companies to understand their customers at the time of conceding loans, understanding their willingness to take risks or detecting potential frauds.

Additionally, cloud computing has changed the way companies store and share data, reducing time and costs. Small companies have benefitted from outsourcing some of their operations and IT departments, so that they can  keep up with technology trends and updates. Faster and more reliable connectivity through 4G and 5G technologies have allowed businesses to develop better payment systems, allowing e-commerce businesses to reach customers in areas with low banking penetration or poor financial infrastructure. However, despite these technological advances, application software penetration in the banking sector currently covers less than 30% of the banking sector, which is significantly behind the 70% registered in other more mature industries such as industrial goods and energy.⁸

Finally, blockchain has the potential to become a disruptive force in the sector. The technology behind crypto assets could contribute to the efficiency on clearing and settlements of payments as well as data storage.

This is truly an immense time for great innovation in financial services and is likely to be persistent for the foreseeable future.

Footnotes

¹ WorldPay Global Payments Report, 2021.

² III and Internet Crime Complaint Center.

³ Banking banana skins survey 2021. The Centre for the Study of Financial Innovation. No 137. March 2021.

⁴ WorldPay Global Payments Report, 2021.

⁵ Proceeding with caution – a survey on central bank digital currency. BIS Papers. No 101, 2019.

⁶ US Federal Reserve and EFGAM calculations

⁷ Statista

⁸ Temenos

Important Information

The value of investments and the income derived from them can fall as well as rise, and past performance is no indicator of future performance. Investment products may be subject to investment risks involving, but not limited to, possible loss of all or part of the principal invested.

This document does not constitute and shall not be construed as a prospectus, advertisement, public offering or placement of, nor a recommendation to buy, sell, hold or solicit, any investment, security, other financial instrument or other product or service. It is not intended to be a final representation of the terms and conditions of any investment, security, other financial instrument or other product or service. This document is for general information only and is not intended as investment advice or any other specific recommendation as to any particular course of action or inaction. The information in this document does not take into account the specific investment objectives, financial situation or particular needs of the recipient. You should seek your own professional advice suitable to your particular circumstances prior to making any investment or if you are in doubt as to the information in this document.

Although information in this document has been obtained from sources believed to be reliable, no member of the EFG group represents or warrants its accuracy, and such information may be incomplete or condensed. Any opinions in this document are subject to change without notice. This document may contain personal opinions which do not necessarily reflect the position of any member of the EFG group. To the fullest extent permissible by law, no member of the EFG group shall be responsible for the consequences of any errors or omissions herein, or reliance upon any opinion or statement contained herein, and each member of the EFG group expressly disclaims any liability, including (without limitation) liability for incidental or consequential damages, arising from the same or resulting from any action or inaction on the part of the recipient in reliance on this document.
The availability of this document in any jurisdiction or country may be contrary to local law or regulation and persons who come into possession of this document should inform themselves of and observe any restrictions. This document may not be reproduced, disclosed or distributed (in whole or in part) to any other person without prior written permission from an authorised member of the EFG group.

This document has been produced by EFG Asset Management (UK) Limited for use by the EFG group and the worldwide subsidiaries and affiliates within the EFG group. EFG Asset Management (UK) Limited is authorised and regulated by the UK Financial Conduct Authority, registered no. 7389746. Registered address: EFG Asset Management (UK) Limited, Leconfield House, Curzon Street, London W1J 5JB, United Kingdom, telephone +44 (0)20 7491 9111.