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Happy new year 🥂. I hope you had a good break (or a quiet period if you've been building). Shout out to all of the founders I spoke to this break who have been heads down getting it done 💪.

Also, a huge thank you to every subscriber as we passed 10k! Considering this newsletter only really grows through word of mouth, its growth is astonishing. So grateful for all of you.

I have a funny feeling this could be Fintech's best year yet. Yes, the public market Fintech stocks are taking a beating as inflation rises, but watch the earnings, not the market caps. Fintech revenue continues to grow as it solves for the broken, analog industry that is finance. Let’s upgrade finance.

This week’s rant is long, so you might want to grab a coffee. But I really wanted to explore the interplay of what is DeFi, what are it’s actual benefits and where could it fit in Fintech. Would love your thoughts, do email them! :)

Weekly Rant 📣

DeFi is the infrastructure of the digital economy.

One theme stuck out when reading the Fintech 2022 predictions over the holidays: Fintech and DeFi are colliding. Whether it was FTT, a16z, or your favorite Fintech VC, about everyone seems to be pointing that way. Regular readers, too, will know I've been a fan of the DeFi Mullet principle for some time (although I originally called it Fintech 1.5).

But if we're ever going to get Fintech at the front and DeFi at the back, we need to figure out what problems DeFi solves for consumers, businesses, and the economy. It's not as simple as "cutting out the middle man = better." We have to look at what DeFi actually is today, where we can apply it.

What is DeFi?

At the most abstract level, I find it helpful to contrast DeFi to banking, so go with me here;

Banking (grossly oversimplified):

When you deposit a check at the bank, what you're doing is lending to that bank (but we call it deposits or saving).
Because you are lending to the bank, they pay you interest.
The bank can then take those deposits and lend them to other people (we won't go into fractional reserve, or how they can lend the same dollar 10x but here's a good summary).
The bank charges its customers (e.g., 10%) for lending but pays much less (e.g., 1%) to depositors.
The difference between its cost of capital (what it pays depositors) and the income it receives from lending is its revenue (or Net interest margin, this doesn't include other fees it might charge, etc.). So, 10% - 1% = 9%.
The bank's committees and management set these lending and saving rates.
The bank then has to pay for its infrastructure costs like staff, technology, branches, licenses, and more.
A bank's profit is its revenue minus costs (it's somewhat more complex than that but stay with me on this helpful metaphor).
Those profits are then often distributed by banks in the form of dividends to shareholders.

DeFi (grossly oversimplified and zoomed out):

When you deposit an asset in DeFi, it’s called lending to a "liquidity pool." But think of it as a deposit. (A liquidity pool is a wallet managed by a software algorithm with instructions baked in. In DeFi, a wallet, like a physical leather wallet, holds the asset itself, AKA "self custody").
Because you are depositing to a liquidity pool (LP), it “pays” you interest.
An algorithm (DeFi Protocol) and liquidity pool (LP) can lend those assets to borrowers (although it does not do fractional reserve in most cases, usually lending is 1:1).
The Liquidity Pool charges its customers for lending but pays slightly less to depositors. (e.g. charging 10% to borrow, paying 1% to depositors)
The difference between what it pays to deposit wallets and borrow wallets is delivered to depositors. e.g. 10% - 1% = 9%. (and a wallet that holds funds for future development of the DeFi protocol)
The DeFi protocol sets the rate algorithmically based on the perceived risk of borrowers vs. depositors.
The DeFi protocol has almost zero fixed costs (aside from algorithm maintenance and marketing.)
The DeFi protocol itself doesn't take a profit, but disributes most of it to depositors and returns a small surplus to a treasury wallet.
The treasury funds are then used to fund contributors (individuals or companies) to upgrade the protocol or make grants to benefit the community. The protocol doesn't have shareholders but has token holders, where things get pretty different.

Crucially, a DeFi protocol rarely (if ever) custodies (holds) the funds itself as a bank would. The protocol is setting the price, whilst individual depositors are collectively forming the liquidity pools.

In principle, a DeFi protocol is performing true peer-to-peer lending. It never holds the asset; it just sets the price between borrowers and lenders. It serves the core function of lending at ultra low cost because it has almost zero fixed costs. In essence, we DeFi could* cut out the middleman.

*(We'll come back to this)

I should note here too, that most if not all DeFi protocols are over collateralized. This means for every $1 borrowed there’s more than $1 held in deposit. Contrast this with banks where for every $1 deposited, up to $10 could be borrowed.

How DeFi Protocols are Run

Most bank shareholders have almost no say in how the company runs (unless they're a massive hedge fund / activist investor). Most bank shareholders have never voted on company issues at the annual general meeting (AGM). 99.9% of bank shareholders are simply holding the stock for the dividend yield. The role of management is critical in a bank, and as such senior management in banking is a heavily regulated job.

The closest equivalent in DeFi is governance tokens (e.g., UNI, SUSHI). Nearly every governance token holder can influence how DeFi protocols operate. Tokens may grant token holders direct voting rights on every significant change to a DeFi protocol (for example, Uniswap and AAVE use a platform called Snapshot to allow their token holders to vote on proposals).

There are also countless reasons why someone might hold a token. To speculate on the asset's price in the future, lend it, vote on the protocol's future, and more.

When you deposit your assets (e.g., ETH / USD) into a liquidity pool, you receive LP tokens in return. But the LP tokens are much more than a receipt; these tokens track your share of the pool and allow the protocol to pay you a proportion of the fees it generates.

What's more, the LP tokens can also be seen as an asset with tradeable value, and they can be deposited or borrowed. In many cases, DeFi protocols have (especially in their early days) rewarded LP token holders with governance tokens (as an incentive to stay or as marketing).

That would be like a bank issuing shares to customers who deposit with them 🤯.

What has any of this got to do with Fintech?

As Matt Harris elegantly described, Fintech (at the highest level) is solving two major issues with financial services.

Better products (in UX, price, audience, or execution): This would include consumer Neobanks like Chime and Nubank, who solved an unmet need for a consumer the large banks ignored. B2B fintech companies like Ramp or Brex built way better business products and experiences.
Contextual products (sometimes embedded finance or banking as a service): New infrastructure providers made it possible to place payments, lending, or cards at the point of need. Almost the entire finance value chain is now available API first from companies like Stripe, Unit, Treasury Prime, Alloy (and everyone whose name I didn't mention here).

Fintech filled the gaps in product and experience, then abstracted the underlying infrastructure, but it never remade the infrastructure.

In his essay, Matt Harris describes Fintech 3.0 as the move from centralized to decentralized. Decentralization is just one aspect, I actually think Crypto, DeFi, Web 3, and insert your own buzzword here is upgrading the infrastructure of finance, the back end, the very rails themselves.

We’re upgrading finances infrastructure to be global by default and digital by default and that could bring a ton of value to the entire economy.

What value does DeFi bring to Fintech?

Early Fintech / DeFi products have focussed on high yield deposits (e.g., 5% on USD), and indeed in a low-interest-rate environment, that's a great feature. But there are questions about how sustainable those rates are given they're founded on ever-rising crypto prices and endless token emissions (the minting of new tokens). This feature could be temporary.

DeFi is currently operating like a bank whose share price keeps going up, so it keeps printing new shares to give them away to customers as marketing. So I suspect rate won't always be the key (or only) benefit, even if over the long term, it could be more competitive than banks because there are no fixed costs (assuming regulation doesn't kill that idea).

*(This is the cut out the middleman bit I promised to come back to earlier)

Many will suggest the goal is to cut out the middleman and pass more back to the customer, and that's not wrong; I think it just misses the point. I don't think we'll live in a world with no middlemen (they're already evolving in the DeFi landscape). But I do believe we are building an alternative economic backbone for the digital economy.

The existing global financial infrastructure wasn’t designed for the digital world, it was built for analog. To date, Fintech has abstracted it with better APIs. But. despite great abstractions, the infrastructure still creates a massive drag for anyone trying to build in Fintech. (Ask anyone who's dealt with random file errors in payments as just one example).

What value would a new decentralized financial infrastructure bring? So far, I've boiled down to 8 benefits Crypto offers as infrastructure vs. the existing.

(Each one of these warrants several thousand words but stick with me)

Global and 24/7: Perhaps the most obvious benefit of this infrastructure is that it's always on. There's no downtime, closing for weekends, or significant friction transacting globally.
Assets with Functionality (programmable assets): AKA "Programmable money" or "Programmable Assets," bake in the rules about the transaction to the asset itself. For example, a US Dollar automatically deducts tax in the transaction. Or art that manages its royalties every time it's transferred.
Broader ownership/participation: Anyone (outside China) can own a piece of the network or project and access the project or network. The lack of a central operator means the individual owns an asset and can take their asset to any marketplace.
That creates new forms of engagement (consumer and business): Ownership of the network (in the form of a token) rewards early supporters and allows them to show conviction in a project if they don't sell. It allows them to vote on the project's future and benefit from its long-term growth. (This may mean projects that wouldn't have been funded by venture, corporate or government (e.g., upgrading the internet) get funded. AKA, a business model for open source.
New economic models: Digital and physical items can now be monetized and traded in new ways. For example, selling land or items in a digital world or royalties to music in a global marketplace. Suddenly, everything is tradeable, interoperable, and programmable if it uses this new infrastructure.
Feature composability: Any project can be a building block for another. For example, one DeFi protocol can use another to price its assets. Imagine if Citi built a capability, and Wells Fargo could immediately use it. This dramatically increases the pace of innovation as ideas compound.
Auditability / Transparency: Transactions are a public record by default and are near impossible to edit. The existing financial system has countless copies of records but no golden source globally. This makes understanding and agreeing the "truth" incredibly hard. One globally consistent record of agreed facts enables surprising sub benefits (like performing airdrops or monitoring for fraud).
Anti Fragility: The open networks can be attacked by anyone 24/7 and have built-in incentive mechanisms that maintain consistency and robustness of the network. While many points at perceived weaknesses in Bitcoin (or other) network security, the fact is they remain a giant public target. For example, successfully hacking Bitcoin would (in theory) be a trillion-dollar prize for the hacker. Many of the services around Crypto are vulnerable (as are the users) but rarely the entire networks.

(These benefits apply to all Web 3 projects beyond DeFi too)

These benefits compound. As we broaden ownership, we can issue more assets with functionality. Assets with functionality create new economic models. Feature composability reduces time to market, increases creativity, etc.

In summary; We're upgrading finance. Dramatically.

But DeFi and Crypto are far from perfect.

For a handful of reasons

Users aren't ready to be their banks: The problem with being your bank is dealing with the criminals. True DeFi has the consumer manage their assets, like storing cash in the mattress and art in their house. Few consumers have the level of sophisticated operational security (opsec) to do this well in the mass market. This has (and will continue to) lead to countless hacks. It's a matter of time until something goes majorly wrong here, and we have a public outcry.
The frontier is full of scams: There are countless scams for every world-changing Crypto project. It can be challenging to tell a good project from a bad one for the untrained eye, especially when weird dog coins have minted more millionaires than any lottery in the past year.
The UX is awful: There are great wallets, and better UX is coming, but the core concepts of Crypto are just confusing. Finding a decentralized exchange and "connecting your wallet" is still a bit unfamiliar. This is changing as NFTs bring millions into Crypto, but the language and experience are still very niche.
It's all a bit speculative and circular: The Crypto rich in a crowd all swam together on the next big thing, as a new protocol creates a new market that works with the existing DeFi protocols. If you're not in this DeFi world, a common (and quite fair) complaint is, "what real-world problem does this solve." Now I'd argue there are many, but we have to admit so much of what's happened so far looks like speculation for speculation's sake.

Fintech fixes this.

The DeFi Mullet, putting Fintech at the front, can help with these issues (and already is in many cases). Companies like Coinbase already offer a DeFi wallet that plays to their UX strengths, and we've seen countless Fintech companies come to market that offer "DeFi yield" (like Eco, Juno, and Linus).

In 2022 we'll see this expand both in breadth (more Fintech companies will do the basics) and depth (some Fintech companies become guardians of DeFi, opsec, preventing users from being scammed). We may see a world where services emerge for insurance, where if you're scammed, you're made whole because you're a user of Fintech company ABC.

But where Fintech & DeFi could excel is in lending.

Lending on the surface feels like a great business model, you're giving away money (who doesn't want that), and you make a % as consumers or businesses pay you back. In a good market, new lending businesses grow; suddenly, they all start to shrink or disappear in a down market.

We can learn a lot from the first wave of Fintech companies like Lending Club who have bumped into the many challenges of being a lender. These businesses appeared after the financial crisis and filled a gap left by the banks, who refused to lend to society's higher-risk segments. But, not being banks and having little to no history in lending meant they faced two challenges all lenders eventually face.

Getting good at underwriting risk (through the cycle): Underwriting risk when the market is doing well is easy; everyone pays you back. Only in market downturns do you find out who really can't payback. Market cycles can take 10 or even 15 years to play out, so building that data set takes time. It doesn't matter how sophisticated your AI is; unless it has 15 years of training data, it's probably wrong. DeFi may help in this area (by bringing a transparent record of someone's activity to lenders), but it doesn't solve it.
Funding lending activity (through the cycle): Most Fintech lenders don't have a banking charter, meaning they can't take deposits and lend against those. So Fintech lenders have to fund their balance sheet through debt capital markets. The Fintech company sets up a desk to package and sell a tranche of their loans (often via a broker like a bank or directly to an asset manager or private equity). In good times there are plenty of buyers of this risky debt, but in bad times that funding can dry up. If a lender can’t fund their lending, they have to turn off the revenue.

The entire back office of lending is complex, manual, and ripe for disruption. It's no surprise we're seeing Fintech companies appear to help abstract this pain for US-based lenders.

DeFi currently relies on being over collateralized (at least $1 held for every $1 borrowed), which may not supply the amount of lending the market needs. However, maybe that’s not the point, it’s not supposed to displace consumer and SMB lending directly.

When it comes to funding real-world lending activity, DeFi may excel.

Imagine I'm a Fintech lender in Brazil (where there's a very weak debt capital market), and a bank in the US wants to buy my loans. That process sucks for the Fintech company and the bank. It's slow, expensive, and just moving the capital can be obscenely expensive. I think DeFi can help here.

If we had a shared (KYC’d) liquidity pool, that used a US Dollar stablecoin to move value between the buyer of the loans and the Fintech company, that would make it so much easier for capital to flow.

Maybe DeFi is supposed to create a market infrastructure where moving value across borders becomes lower cost because we’re all using the same, global, liquidity pools to do so?

And it’s starting to happen.

One of my criticisms of DeFi is that it had been circular. Most lending is to traders who want to speculate on Crypto in some form, but I think that's started to change.

Several projects have started to focus on Real World Assets ("RWAs," not to be confused with banking's risk-weighted assets, which share the acronym).

Centrifuge is a project that lets businesses "tokenize" their receivables (e.g., invoices) and sell those to DeFi investors.
AAVE recently announced a partnership with Centrifuge to price the lending of USD stablecoin DAI to borrowers.
AAVE does this using KYC'd or "permissioned" liquidity pools, making the lending compatible with institutions.
Credix (write-up coming next week) is a startup that helps Fintech companies in Brazil fund their lending via DeFi rather than traditional analog rails.
Goldfinch (BF May 23 2021) deploys lending to microfinance lenders in Africa by building a liquidity pool for investors.

The consistent theme here is DeFi isn't changing the front. It's changing the back.

DeFi has a long way to go before it's "mainstream," but if its major first advantage is cross-border, then the skills needed are immense. You need local compliance knowledge in the markets you're taking capital from and lending to. You need to understand debt capital markets and be up to the minute with the changes in DeFi protocols.

Folks with that particular kind of mullet look rare.

ST.

4 Fintech Companies 💸

1. Buratta - Digital Identity and KYC for Web 3

Burrata mints "identity tokens" to allow Fintech and Crypto companies to "KYC," otherwise anonymous Crypto wallets operating in DeFi. The personally identifiable (PII) data sticks in the individual user's wallet, and Burrata's "identity tokens" allow the user to pass through KYC gates without sharing their underlying data.

🤔 I got so excited when I saw this for two reasons. First, it allows DeFi projects to continue decentralized and not hold consumer data while still checking that everything is kosher and compliant. Remaining decentralized enables the protocol to be lower cost, efficient and composable. If we expect every protocol to "know its customers," they suddenly need a back office, and the advantage of the tech dies. The second benefit is finally allowing the consumer to control their data and only have it "checked" in an assured privacy way. This solves many problems in our digital economy; we would dramatically improve everything from hacks like Sony and Equifax to basic digital privacy if we adopt this model. Plenty has tried to build a "decentralized identity" before, but the simplicity of Burrata is to mint a token for wallets people already have.

2. WhenThen - Payments automation for eCommerce

WhenThen allows users to build custom payment workflows with its no code editor and smart ledger. For example, when collecting a payment, an e-commerce merchant has to check which country the card is coming from, run fraud rules, authorize the payments, send SMS's and emails update their ledger, update their bank, and possibly more (and that's a simple use case). WhenThen is essentially the no code version of the non-differentiated work every merchant has to string together. They've also pre-baked many workflows so customers can use a "here's one we made earlier" version to get moving quickly.

🤔 Payments automation providers are coming to market with different levels of opinion in their offering. Modern Treasury's core focus is money movement and reconciliation, broadly applicable. Primer or WhenThen have deeper, more opinionated products for those accepting payments. Fragment.dev (and their integration with no code service retool) is fascinating because it has almost no opinion about how you use it. The market likely needs both specialists and generalists. As a specialist sector, consider Fintech or Crypto companies with complex ledgers and rules to manage; they might welcome a more opinionated product.

3. Wert - Crypto payment gateway

Wert allows developers to quickly add a "top-up your crypto" feature to their app or service. Like Moonpay or Ramp network, Wert has focussed very tightly on the fiat to the crypto onramp.

🤔 The simplicity of this offering is compelling, but there are now some very well-funded competitors out there. The "buying" buttons gained massive traction in a market bull run, but as we correct and people rush for the exit, will people think more about the payout or off-ramp space?

4. Wisetack - Point of Sale (~BNPL) lending as a service.

Wisetack allows merchants to embed lending at their point of sale. Unlike Affirm, Klarna, or Afterpay, it doesn't include a branded button but rather carries the merchant logo and can include terms from 3 to 60 months.

🤔 I usually don't cover something as late as Series B, but I hadn't covered Wisestack before, and they're worth mentioning for the insights they provoke. They have a different target audience to BNPL. Its customers are smaller (e.g., home services, veterinary, dental or automotive). The lending amounts are larger infrequent large transactions instead of lots of small ones. There is absolutely space for this type of embedded lending, but it made me think of two things. 1) Wisestack is doing a soft credit check like BNPL providers, but this is a potentially higher risk for higher ticket items than a small ticket. 2) Hatch bank is the partner here (a relatively small/innovative challenger in the partner banking space, expect to see that name pop up a lot more). PS. What's Wisetack's moat here?

Thing to know 👀

1. Indian Neobank Jupiter raises $86m at $711m valuation

The round led by Tiger, QED, and Sequoia India comes just two years after Jupiter launched. Jupiter claims more than "half a million" customers to date and adds 5k customers a day with less than $1m of monthly burn. Today Jupiter offers 100% digital onboarding, servicing, and a debit card + app. Their differentiator is the "delight factor." Jupiter intends to use the funds to add lending, savings, and wealth management to its offering.

🤔 That's a heck of a cap table. Sure, Tiger are everywhere, but QED rarely leaps without looking. QED was also an investor in the freshly-IPO'd Nubank (as was Sequoia and Tiger, but I see QED as a sign some serious mental horsepower has been burned to do a deal). And, you can see the pattern recognition potential: the Indian market has some similarities with Brazil. High base interest rate (4% in India, 9.25% in Brazil), traditionally lazy but profitable incumbent banks

🤔 The Indian competitive landscape for Neobanks is interesting because it's not just the incumbents they're battling for attention. Although the sheer volume of the population has been underserved in lending and savings products for decades, the market could be massive; Jupiter sized even 😶. Outside of China (and even there), we rarely see big tech companies displace banking; at best, they distribute it.

🤔 Long India: India has so much talent, and as companies like PayU and PayTM acquire smaller fintech companies, we see that talent cycle into their 2nd or 3rd venture (e.g., the founder of Jupiter sold his last company to PayU). Also, the sheer volume of highly educated, talented engineers means large investment rounds go much further than they would if all of the talent was trying to afford to live in SF or NY.

Good Read 📚

1. Messari Crypto Report

The unstoppable Ryan Selkis has penned the ultimate summary of Crypto in 2021, covering everything from top 10 narratives, top 10 people to watch to thoughts through to policy, Defi, NFTs, and even DAOs. If there were a way to place an entire person's brain on 165 pages, this would be it. I can't possibly do justice to the report in summary here, but I will provide a couple of additional observations and thoughts it triggered for me below.

To try and summarize: Ryan points out that consumers' trust in institutions that politicians and businesses have traditionally seen as "trustworthy" is collapsing; this makes Crypto and "Web 3" inevitable. Crypto has its own dedicated VC firms that have now had such massive returns; they can go very long on game-changing projects. Ryan has no doubt we're in a bubble, and there is a crash coming (and it may have started).

Ryan's advice for the crash is sage: don't leverage yourself unless you're a pro trader. Remember to account for taxes. Taking short bets is dangerous and is very likely to blow up again unless you're super sophisticated. WAGMI is fun when coins are up, but who's left standing when they're down 80%? Because those folks will make it.

🤔 The narrative in Crypto is dominated by US policy, but much of the adoption will be non-US. We've seen massive APAC and Africa adoption in the past year, Binance all but locked out of Europe, and enormous growth in LATAM. Just like Fintech is now a global story, Crypto is one too, and that's getting far too little air time.

🤔 Crypto faces growing pains at the off-ramps back into fiat, a massive opportunity for Fintech / DeFi Mullets. Imagine you're a Crypto exchange, and you have millions of global customers who suddenly want to exchange their Crypto for fiat and pull it into their bank account. You'd need to maintain relationships with 30, maybe 40 banks, manage all of their compliance quirks, and ensure your customer received their money within your own rules and thresholds. This is the type of "payment ops" pain that every Fintech company has, but Crypto particularly struggles with.

Tweets of the week 🕊

Jake Chervinsky @jchervinsky

In 2022, let's get serious about ending class discrimination in the federal securities laws. Every American should have equal opportunity to invest & grow their wealth no matter how much money they have. The securities laws protect the rich by design. It's time for that to end.

p.mirror.xyz (🪞, 🪞) @patrickxrivera

i luv airdrops but token incentivizes aren’t a replacement for: * core product value * engagement / retention * organic growth * intrinsically motivated community * active dev ecosystem (especially in consumer apps)

That's all, folks. 👋

Remember, if you're enjoying this content, please do tell all your fintech friends to check it out and hit the subscribe button :)

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