1. Introduction: FinTech in Germany
FinTech is all around, although it is far more than a trendy buzzword. In Germany, particularly in the financial centres of Frankfurt, Berlin, Hamburg and Munich, the FinTech market has grown steadily over recent years. In the ongoing transformation from classic banking models financing Germany’s global players to making financial services available to everyone with ease, the FinTech sector is seen as one of the key drivers of this transformation and is expected to continue to be in the upcoming decade. However, a bubble is far from being in sight.
1.1 FinTech Definition
It should not be surprising that there is no legal definition of the term FinTech except for the well-known fictional neologism combining the terms financial services and technology. As probably in every other market, in Germany a FinTech is commonly understood as a company providing financial services and adding modern technologies to those services.
In Germany, we have recently seen FinTechs mostly combine emerging internet-based platforms resulting in a wider range of (cross-border) participants with decentralisation and privatisation of data and its documentation. In this context, decisions are transferred from a few thought leaders to algorithms and artificial intelligence based on blockchain and distributed ledger technologies.
These services are often provided by startups. In the German financial services market, however, we also see grown-ups, i.e. large and well-established banking institutions putting more and more effort into the FinTech sector.
1.2 Market Overview
FinTech in Germany emerged in the millennial and post-dot-com age. The trend was driven by established banks transforming from counter banking to direct banking business. All well-known German banks got involved in this transformation, e.g. Deutsche Bank with Deutsche Bank 24, Commerzbank with comdirect, Frankfurter Sparkasse with 1822direkt – just to name a few.
What we see almost 20 years later is a trend from direct banking to digital banking. Other than counter banking, direct and digital banking services are being provided through the internet whereas direct banking services use far more sophisticated technologies than direct banking services. This trend, obviously, gives us an idea of why the FinTech market is often referred to as being disruptive.
In the German private clients market, one of the key drivers is the idea of banking the unbanked, or rather the unbankables. Whereas the unbanked represents clients not using financial services yet (except for, say, a simple deposit account), the unbankables are the potential client group that would probably get rejected by established banks. Since, in Germany, a large part of the population is already banked at least in some way, the target group to focus on is more the unbankables rather than the unbanked.
The other key driver in the FinTech sector is the extension and inclusion of financial services into everyday life, be they payment services, account information services or new ways to both invest and borrow money. For the longest time, German market participants lacked confidence in digitisation and they are still comparatively sceptical about modern banking solutions. In a challenging environment threatened by the corona pandemic, there is at least hope for the FinTech sector to benefit from this change in banking behaviour. Fuelled by the current crisis, the abolition of cash money finally found its way into German payment behaviour.
This recent development can be seen in more and more cooperations between established banks and FinTechs. Such cooperations are being concluded in order to move towards more digital and thus more promising business models. This trend recently became very apparent in the German savings bank environment as well as in the disruptive market of payment platforms such as paydirekt, Giropay, VPay or Maestro. Nevertheless, compared with our European neighbours, Germany still seems far behind.
As we look at the German market, the biggest concern when structuring financial services business models, e.g. in a cooperation with an established banks, is meeting the regulatory requirements while, at the same time, boosting efficiency and maximising the customer experience. This gets more challenging due to the fact that regulatory standards across Europe still vary, although the European legislator and the European Banking Authority have put remarkable effort into establishing a level playing field.
However, there is no reason to despair when looking at German FinTech endeavours. FinTechs continue to represent a dynamically growing and highly innovative segment of financial services on the market. The German FinTech market grew by approximately 120% over the past five years. Furthermore, the overall market volume of 2016 had increased by the factor of six at the end of 2019. In April 2020, approximately 700 FinTech companies were deemed active in the German market.
Apart from pure numerical growth, it can be assumed that the FinTech market in Germany, not least by strict consumer protection and risk mitigation requirements, developed also in terms of reliability and credibility.
2. Hot Topics
In the following, we briefly summarise the topics that, in our view, might be worth considering when trying to predict where the German FinTech sector is developing to.
2.1 Crypto Assets and Crypto Currencies
Drawing the attention to crypto assets and particularly crypto currencies, two main trends will lead the way: the recently established licence requirement for crypto custody business on the one hand and initial thoughts and discussions on digitising our good old currency, the euro, on the other.
2.1.1 Licence Requirement
Under the cover of anti-money laundering regulation (i.e. the German implementation of Directive (EU) 2018/843, the so-called 5th EU Money Laundering Directive, “AMLD5”), crypto assets found their way into German law. As of 1 January 2020, crypto custody business is qualified as financial services regulated by the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, “BaFin”). Furthermore, crypto assets and most prominently crypto currencies qualify as financial instruments.
Taking crypto assets into the circle of regulated financial services might mark a milestone for the FinTech industry and is likely to significantly impact crypto assets trading activities. The new regulation obliges crypto assets to meet the same regulatory standards as those already applicable to traditional capital markets for years. For the industry, this could initiate a competition for the most efficient, customer-friendly crypto services promising protection, legitimacy and security to market participants (a so-called “race to the top”). The flipside could possibly be a regulation arbitration between European legislators that makes market participants search for the jurisdiction providing the least regulatory requirements (a so-called “race to the bottom”). In this expected competition, FinTechs and established banks possibly face a new competitor: foreign crypto exchanges. FinTechs need to consider that it is not (yet) possible to passport a crypto assets licence. As a consequence, crypto assets service providers need to obtain the German crypto assets licence in order to approach the German market.
What is really new for the German regulatory horizon is the fact that the legislator was the first to implement the EU crypto assets requirements into national law. For sure, Germany will not remain the only state, but, nevertheless, being the first opens up at least the opportunity to put German crypto assets FinTechs in a favourable position in the European crypto assets market.
2.1.2 Euro 2.0
Initiated by "FinTechRat", an advising committee to the Federal Ministry of Finance (Bundesfinanzministerium), discussions on future digital concepts for currencies are expected to intensify in the next couple of years.
One of the main benefits desired by introducing digital currencies is the efficiency increase of payment transactions. Furthermore, from ongoing discussions we expect a major push towards innovating the digitisation of the payment services industry, first and foremost shaped by FinTechs.
What efficiency increases of payment transactions can be expected? Nowadays, payment transfers from one established bank to another currently often take a few days. With the currently discussed Euro 2.0 based on blockchain technology, payment transfers could be executed within, if at all, seconds. In this context, transaction costs charged by the respective service provider might decrease significantly. From this development, we expect a boost for cross-border payment transfers which then opens up the opportunity for German industry to approach foreign markets and increase its international competitiveness. Germany’s nature as an export nation highlights just how important such a development would be for our markets.
Putting all the enthusiasm aside and taking a realistic look at current discussions, there are some issues remaining to be considered before inventing a digital, blockchain-based crypto euro. Euro member states seem to be aware of these issues and mutually agree that particularly data protection and cybersecurity aspects need to be taken into proper consideration. Digitising a currency issued by state authorities requires significantly more effort than the issuing of crypto currencies by FinTechs.
However, for the next couple of years, we expect a growing discussion on the Euro 2.0. The continuing corona pandemic significantly pushed digitisation and did not let payment transfer aside. So, the pressure is on for finding a stable coin meeting all regulatory requirements and therefore qualifying as a potential digital currency.
2.2 Electronic Securities
Thinking about the way securities are traded, it is almost inconceivable that in Germany, securities cannot yet be traded electronically. Following the invention of online banking in the late 20th century, securities still need to be genuinely linked to reference certificates that need to exist physically. Following the AMLD5 implementation, the Federal Ministries of Justice and Finance (Bundesjustiz- und Bundes-finanzministerium) recently proposed a digitisation of securities by drafting the Electronic Securities Act (Gesetz über elektronische Wertpapiere, eWpG).
The eWpG, once it has entered into force, would allow the issuance and trading of securities without a physical securities certificate. In simple terms, the draft eWpG replaces the issuance of a physical (i.e. paper-based) securities certificate by recording the issuance in an electronic securities register. Such electronic securities register can be based on blockchain technology. In order to do so, the draft eWpG provides for a new financial service in addition to those already established in the German Banking Act, the crypto securities registry management (Kryptowertpapierregisterführung). This leads to a licence requirement for service providers intending to manage a crypto securities register. The comparatively high requirements for obtaining the intended licence for crypto securities registry management make one thing very clear: crypto securities registry management is designed for the grown-ups.
Admittedly, the eWpG only covers bearer bonds (Inhaberschuldverschreibungen). Nevertheless, the legislative efforts in this sector can be seen as first step towards changing the securities market in general and gives a brief estimate of where this trend is heading to. In any case, the FinTech market will be curious as to whether the eWpG will find its way into applicable law and how it will be adapted by market participants.
2.3 Regulatory Sandbox
The German regulatory market is known as strongly regulated and setting high requirements for participants. This could, however, be detrimental for startups as they are not (yet) able to meet those high standards. Both regulator and market participants therefore are discussing a so-called regulatory sandbox for such startup FinTechs. Such sandbox could provide a playing field where FinTechs are given the opportunity to test their business models in the market without the obligation to meet all regulatory requirements like their grown-up competitors. Obviously, these exceptions should not be applicable to all startup FinTechs, but only for those FinTechs offering innovative services that need to be tested in or close to the market and where such testing would not be feasible with the regulatory requirements in place.
On the one hand, a regulatory sandbox could boost the motivation of FinTech startups to make effort on the German market which could consequently have a positive impact on its attractiveness in the regulatory competition between EU member states.
On the other hand, regulatory requirements and the importance of a service being tested in the market would become subject to discussions with the regulator. Nowadays, German supervisory practice by BaFin is determined not only by regulatory requirements set out by law but also by assessing the respective risk profiles of the FinTechs. This assessment by the regulator considers both the scope of service as well as the business model and its risk complexity. Furthermore, a level playing field for all participants, whether startups or grown-ups, avoids competitive disadvantages.
BaFin and the legislator currently deny the introduction of such a regulatory sandbox in Germany. However, it will be interesting to see how German FinTech market can attract startups despite, or because of, the regulatory environment.
2.4 New Refinancing Models
One of the key services offered by German FinTechs is refinancing models. As of today, most FinTechs mediate loans from cooperation banks to its customers and sell those loans to investors. In this regard, loans are not entirely sold to one investor but sliced and sold to several investors. As a consequence, each investor is obliged to comply with regulatory provisions, in particular KYC and anti-money laundering provisions.
Investors typically seek attractive refinancing models without time- and cost-consuming administration. As FinTechs and their refinancing engagements are growing, new refinancing models meeting the expectations of investors and cooperation banks as well as FinTechs are expected to be developed. In the German market, securitisation models are recently emerging. These securitisation structures typically provide for eligibility criteria meeting the investment and regulatory standards of investors, e.g. banks, pension funds or life insurance companies. Alternating securitisation models, a refinancing model can be set up through a fund structure. In such a structure, customers participate from a fund that is financed by a major loan from a cooperation partner.
Apart from these models, further structures are expected to emerge in the German market in order to meet all participants’ expectations of refinancing opportunities.
2.5 FinTech and Corona
It should not be surprising that the corona pandemic is seriously affecting the FinTech sector. Regarding the German consumer market, these effects are resulting in a change of lifestyle which accelerates digitisation. These trends are not limited to payment behaviour and the (re-)birth of contactless payments. Furthermore, we see everyday lives shifting more and more from the real world as we knew it to a digital world. This shift is changing the way we collaborate and work together, how we socialise, organise, consume – and also how we invest.
The ongoing crisis involuntarily led to the widespread testing, use and adoption of innovative technologies. It also made clear that our economy as we knew it will necessarily reach its limits without immediate digitisation.
Despite (or because of) the current challenging environment, many FinTechs have increased their capital since commencement of the crisis (e.g. Auxmoney EUR150 million, N26 EUR85 million, Scalable EUR50 million, Trade Republic EUR40 million). This proves that German FinTechs are aiming high. However, many players are expected to vanish from the market or to merge with other players. This trend could possibly be fuelled by the fact that many business models are quite similar to those of competitors and the vast majority of FinTechs are not yet profitable.
In the competition between FinTechs and established banks, FinTechs benefit from their ability to rapidly adapt to changing customer needs. One possible gateway could be the financing business. Whereas many SMEs are facing serious liquidity threads, finance (e.g. factoring) FinTechs could at least present a swift and flexible alternative to conventional bank loans.
As the corona pandemic is not expected to end in 2021, it remains to be seen whether the current crisis will not only substantially but rather sustainably change the FinTech sector.
2.6 FinTechs vs Neobanks vs Established Banks
With all the focus on FinTechs, there is another species on the German finance market: Neobanks. Neobanks are digital banks that often started as FinTechs and emerged to become fully-fledged and therefore licensed banking institutions. Defined as such, there is no clear distinction between FinTechs and Neobanks. The most prominent example of a Neobank in Germany is N26 with its European competitors such as Revolut or Monzo.
The corona pandemic might on the one hand be fruitful for FinTechs, but on the other hand detrimental for Neobanks. German Neobanks have recently been shaken by negative publicity. Some critics see excessively poor cost management and strict internal regulations leading to increasing losses. Compared with established banks, Neobanks are significantly less engaged in lending business. This means that alongside deposit business, the contrasting business line that could compensate for lacking commissioned income is more and more neglected. The downturn possibly gets accelerated by a decline of innovative power. As pointed out, these topics currently identified as hot are mostly driven by FinTechs rather than by Neobanks.
Another challenge Neobanks probably face lies in their names: the word “Neobank” contains “bank”. From a German regulatory perspective, this leads to increased regulatory requirements comparable (or even equal) to those for established banks. Is the regulatory gap between FinTechs and Neobanks growing larger, even though regulatory requirements increase for FinTechs as well?
2.6.1 What are the chances?
Putting all the challenges and differences between established banks and FinTechs aside, what are the chances for both systems?
Well, it is not only in dealing with the current crisis that FinTechs are ahead of established banks. They also offer many other advantages. When it comes to the actual product of financial services, however, established banks can certainly keep up. Could these different strengths together be a new route to success? As recent studies prove, the amount of cooperation between banks and FinTechs is constantly increasing. Such cooperation typically addresses regulatory concerns – i.e. the FinTech is not planning to obtain a licence for the services it intends to offer and the cooperation bank enters into the business model as a licensed participant.
But what are the main challenges to face in such a cooperation? Banks are concerned about their processes not being agile enough for a cooperation and also fear poor returns. FinTechs seem to be frustrated over in-house processes of banks preventing them from entering a cooperation.
Nevertheless, this trend is expected to continue in the next couple of years. Such cooperation will be necessary to remain competitive – for FinTechs as well as for banks. It seems like the task lying ahead for market participants is to find a solution for a successful cooperation that satisfies both cooperation partners.
2.7 Wirecard – not again!
Wirecard, one of the biggest – if not the biggest – fraud cases in German history, was spread all over the news for months (and still is), and everyone might agree that another Wirecard story is not supposed to be told.
Alongside the considerable reputational damage for the German FinTech market, it is not only Wirecard that has suffered from the scandal but also its former business partners are starting to struggle, considering that the corona crisis does not at all improve their situation and the chance to leave behind the scandal without significant reputational damage.
Furthermore, the case of Wirecard as a once ambitious, innovative and highly successful German FinTech company unprecedentedly shows the challenges that supervisory authorities face. The Wirecard case is expected to substantially change the German financial supervisory environment. Supervisory authorities, formerly known as strict and conservative, certainly need to reconsider their approach to new business models and their structuring. Building trust in upcoming business models and new players on the FinTech market might therefore take even longer and demand more effort than before.
3. Legal Challenges and Outlook
As can be expected from these topics considered as hot, a major challenge for the legislator as well as for supervisory authorities will be the reduction of regulatory blind spots. The German Banking Act (Kreditwesengesetz) makes a distinction between financial services providers on the one hand and banks on the other. Since FinTechs cannot always be undoubtedly qualified as one of either, the applicable regulatory requirements are not clearly determined beforehand. Triggered by the invention of new products in the FinTech market, German authorities face a constant race to identify associated risks and the regular adaptation of legal and supervisory requirements.
Drawing attention to customers' behaviour, there will possibly be a significant change in the financial services business. Typically, German customers stick to their current bank (we call it the Hausbank) even if they are somewhat or even very dissatisfied. Taking into consideration that the German population is facing a major generational shift from baby boomers to millennials, this shift could lead to a fundamentally different behaviour in choosing their payment services providers rather than sticking to established customer relations with unattractive Hausbanks.
FinTechs in the German market have recently evolved from 'troublemakers' to grown-up players. Now it is crucial for established banks to see FinTechs not only as competitors but also as necessary partners in order to meet the increasing expectations of their customers.
In a nutshell, it seems like one thing is for sure: there is more to come in the German FinTech market.