When we look back at the first 3 months of 2023, one / five / ten years from now — the consensus will be that this was the period when modern financial services unraveled.

It feels like a breaking point for the industry — crypto exchanges & use cases not as prevalent, US banks collapsing or having to be bailed out, and fintech companies cutting costs as they struggle to survive.

No dominant players or winners. Uncertainty and unease across global markets. Banks, investors, infrastructure providers, and vendors are in a holding pattern — cautious of the next market event.

Here’s a state of the industry review:

BANKING

Out of these three sectors in financial services, only a few expected the fallout that took place in the last month for US banks. The turbulence from Silvergate, Silicon Valley Bank, and Signature Bank rippled throughout the world. Not only were crypto companies impacted (especially with Silvergate & Signature), but also startups and investment funds (with SVB). Executives and business operators struggled to access deposits, make payments, and establish new accounts at other banks earlier in the month.

The panic from bank clients in being able to access balances over $250K caused other regional institutions and credit unions to be impacted soon after. First Republic Bank and Bancorp were other banks caught in the cross fire of negative sentiment. No red flags or warnings had popped up before. Stock prices for mid-sized banks slumped in March due to fears that this ‘contagion’ would spread.

Outside of the US, concern spread to the European banking group. Credit Suisse needed an emergency rescue by UBS last week due to concerns of governance failures and liquidity risk. Deutsche Bank, which posted 10 consecutive quarters of profit, also saw its stock price decline as a result of fears with exposure to US commercial real estate.

Takeaway and Outlook for 2023: Depositors are worried about the liquidity risk of banks. The standard coverage of FDIC isn’t enough for high net worth individuals and companies that carry large balances in deposit accounts.

Multi-bank coverage in which bank clients have $1M or more in FDIC coverage is now a compelling need. Fintech banking providers (such as Mercury, Brex) have this type of coverage through deposit sweep networks (in which balances are spread overnight to multiple banks). As panic subsides in the sector, balances should stop moving in and out of accounts. The early beneficiaries from the events in Q1 are JPMorgan Chase and Mercury, who received the majority of balances from SVB customers.

For banks, concentration risk with types of clients (both having high balances and as part of an industry) will be looked at closely. Crypto companies struggled the most in the last year due to a declining market and rising regulatory restrictions.

Startups (not just in fintech) carry large deposits that start to dwindle over time based on operating initiatives and growth. From 2022 into Q1 of this year, many struggled to raise new funding rounds and are under pressure to shut down — no longer maintaining deposits or a bank relationship. For banks that serve these young companies, a dependency on the stability of these customer balances is a liability that must be mitigated by investment decisions and capital requirements. Poor strategy and lack of oversight leads to financial institutions unable to fulfill withdrawal requests (and needing to be bailed out).

CRYPTO

The downfall of FTX and other top crypto companies, plus a struggling digital assets market last year put this sector in a tough spot at the start of 2023.

The regulatory clampdown in the US finally came in Q1 as various agencies became vocal with guidance and enforcement actions. Regulators chose to first engage banks, who are licensed entities in the US financial system, and a critical link to fiat-crypto money movement. In January, there was a tri-party announcement from 3 of the top US regulators (Federal Reserve, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corp.):

“[there are] risks of “significant volatility in crypto-asset markets, the effects of which include potential impacts on deposit flows associated with crypto-asset companies and contagion risk within the crypto-asset sector resulting from interconnections among certain crypto-asset participants, including through opaque lending, investing, funding, service, and operational arrangements. These interconnections may also present concentration risks for banking organizations with exposures to the crypto-asset sector.”

The US Commodity Futures Trading Commission (CFTC) is responsible for oversight of commodities and derivatives markets, including for Bitcoin. Firms such as brokers that facilitate U.S. customers' trading of such products are required to register with the agency.

CFTC announced charges against Binance for ‘willful evasion’ of US law. The complaint specifically calls out from July 2019 to recently, Binance "offered and executed commodity derivatives transactions on behalf of U.S. persons." This follows an investigation from last December by the US Justice Department for money laundering violations that go back to 2018 for $10B in payments.

Coinbase is also caught in the crosshairs of regulators — receiving a Wells notice from the Securities an Exchange Commission (SEC) last week. This is a formal declaration that SEC staff intend to recommend an enforcement action. The potential actions will be tied to specific products (Earn, Prime, and Wallet) offered by Coinbase; staking programs in particular (like Earn) are being scrutinized due to lack of registration. Staking offers crypto customers high-yields for volunteering to help validate blockchain transactions.

Takeaway and Outlook for 2023: The campaign from US regulators to narrow the cryptocurrency sector is succeeding. The number of startups operating with a crypto program is dwindling. It’s unclear if any financial institutions still support crypto use cases. Even the topic of stablecoins (especially for cross-border money movement) seems to have vanished.

Partner banks are removing affiliations with all platforms that offer or market crypto services. Any type of adjacency (in this regulatory environment) is an immediate red flag. Taking custody of crypto is not acceptable. Working through an external crypto provider is no longer an option.

Without a breakthrough regulatory announcement of a compliant path forward, crypto will continue to hang in the balance for the rest of this year. Crypto startups will need to decide on a pivot towards a fiat product OR shut down completely. Without a product to offer or a US bank to partner with, these companies are stuck.

FINTECH platforms

The drop with investment activity from 2022 carried over to Q1, especially for mid-stage and late-stage opportunities. Early-stage companies have become more popular with VCs & funds due to the smaller size of rounds and ability to cast a wide net. Even so, these smaller firms are still struggling to obtain seed funding and get a product to market.

As companies deplete funds, they must decide whether to shut down or be acquired (if there’s a interested buyer). This consolidation in the sector isn’t a total surprise. The market was crowded with neobanks, card issuers, and investment platforms — all competing for limited wallet share in an economic downturn that has seen layoffs, inflation, and banks collapse. The startups with the most stable operating model and differentiation are expected to rise as industry leaders.

Less funding and consolidation with startups also means less fintech-bank partnerships in launching financial services. There’s a fixed cost to build and maintain a banking program through a partner bank. These licensed entities must cover their own overhead costs for due diligence and oversight — no room to defer or waive these expenses for companies that are pre-product.

Third-party risk oversight is still top of mind for bank partners. Regulators are concerned that fintechs partnering with banks lack proper risk management and controls. Most partner banks tend to be smaller financial institutions, which may struggle in monitoring multiple fintechs. Minimal rigor with ongoing compliance makes banks, fintechs, and customers susceptible to fraud, losses, and program suspension.

Takeaway and Outlook for 2023: The trend throughout 2023 is for banks and service providers to move upstream towards enterprise firms (with established brands and user bases). There needs to a clear ‘north star’ for these companies to commit to a new banking program, especially if there’s existing experience with financial services. Expanding to new markets & geographies, secondary products for existing users, lowering current operating costs, and widening the funnel for new users are all compelling.

For Banking-as-a-Service vendors and platforms, this year will be a ‘gut check.’ Startups were the most eager to launch new banking programs. Lack of investment has hit these firms hard and delayed initiatives to work with banks. Bank partners are also extending review & approval periods for new programs, which can impact timing to launch and increase costs in getting started.

Established companies offer stable partnership opportunities, but lack urgency in adding new products. There’s no clear timeframe of when these larger companies would be ready. New revenue opportunities (especially for young BaaS platforms) will be minimal going forward.

THE industry outlook for 2023

Not great. Modern financial services — by sector, geography, participant — is facing the largest challenge since the Financial Crisis of 2008-2009.

There’s no niche or wedge in the industry to point to and say, “this area will see growth over the next year.”

Regulators, banks, vendors, startups, and enterprises all face uncertainty with how to approach the next three quarters. Caution will be the theme in the short-term. Action will depend on regulatory trends, economic conditions, and investment activity.

The platforms that weather this storm and emerge as industry leaders will do so based on their ability to adapt and launch a differentiated banking program. A few fintechs were able to capitalize on the recent fallout of banks — similar opportunities may pop up in 2023 for new or existing companies.

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