The global fintech industry has expanded rapidly over the past decade as financial institutions ramp up their digital transformation efforts and consumers increasingly expect to access banking services online.

But what exactly is fintech and how is it reshaping the financial industry? Here is a rundown of everything you need to know about the market’s development.

When people think about fintech they often think about challenger banks – digital-only banking platforms that have snubbed bricks-and-mortar branches for mobile apps. But the Fintech market is far broader, incorporating sectors such as paytech, regtech, and wealthtech, all using technology to make the provision of financial services faster, cheaper, and easier.

The growth in the market has been driven by a combination of factors involving traditional financial institutions, investors, fintechs, and consumers, says Joe Channer, CEO of financial services consulting, managed services, and technology firm Delta Capita.

“It all started with the underinvestment over the years by financial services firms in their technology platforms,” says Channer. “We’ve all seen the increased burden of regulation since 2008 and lots of budgets being spent to patch up legacy systems to meet those regulatory requirements.”

That meant that what limited resources were left over were diverted from long-term projects such as digital transformation to those offering an immediate and obvious return on investment.

“That created an opportunity for fintechs to focus on solving specific problems in a creative way, focusing absolutely on the customers’ needs, and that really allowed them to fill the gap in the market,” says Channer. “At the same time, consumer trust in banks was at an all-time low, while record-low interest rates made it easier for start-ups to access capital, giving them cheaper funds to grow.”

A regulatory sandbox

For Nikki Worden, who leads the financial institutions group at law firm Osborne Clarke, there have been two key triggers that have supported the market’s growth: first, the European Union creating a legal framework for payments in 2007 and, later, the introduction of a legal framework for open banking in both the UK and the EU.

“What the Payment Services Directive 1 (PSD1) did, after the financial crisis, was reduce the amount of time that payments were hanging in the air. You used to have to wait up to five days for payments to clear but under PSD1, everything had to get from A to B the next day,” she says. “That enabled payments to happen in a more efficient way, and, once you have more efficient payments, you can develop more efficient services. PSD2 in 2016 further evolved the regime with the specific intention of enhancing competition.”

In the meantime, the advent of open banking, which allows customers to share their financial data with third parties, has given smaller players access to the kind of customer data that was once only available to retail banks and has made it easier for consumers to use, compare, and switch financial products, Worden says.

“All of that has helped the UK’s fintech sector in particular to grow very quickly,” she says.

Since fintechs offer a broad spectrum of services, there is no dedicated regulatory framework that governs them. For instance, if the fintech is a challenger bank, it will fall under banking regulations. If it is a payments organization, it will be subject to payments regulations.

Legal framework for open banking

In the UK, the Financial Conduct Authority set up a regulatory sandbox in part to enable businesses to test their products but also as a way to engage early on with fintechs that might have been unsure how regulations applied to them, says Tom Bull, Head of Fintech at EY.

“The sandbox was a really good way to start a dialogue with those companies and help them learn,” he says.

The rapid growth of the industry is also a challenge for regulators, in part because technology changes quickly but also because certain fintech activities fall outside traditional regulatory boundaries.

“Regulators are always playing catch-up,” says Worden. “For instance, some ‘buy now, pay later’ lenders, which provide short-term ‘point of sale’ credit to consumers, are not covered by existing regulations, so regulators are trying to change the law to get certain types of lenders regulated who aren’t at the moment.”

But while some fintechs are spared regulatory oversight, others are burdened by red tape.

“The cost of compliance for start-ups and even scale-ups can be quite prohibitive, and there are so many ways things can go wrong, which can result in fines or even criminal sanctions,” she says.

While the fintech industry remains nascent compared to traditional financial services, there are several early success stories – and the one thing that unites them is their ability to identify areas where legacy processes can be redesigned from scratch, says Phil Weisberg, EVP of Strategic Planning and Partnerships at fintech company oneZero.

“There are two paths to success – one path is to just be a supplier of technology to the financial industry, and the other is to operate in a niche area and apply a different business model,” he says. “If you look inside a large financial organization, many of the technologists they employ don’t really build stuff; they just integrate things that other people build. So building technology solutions that will replace the legacy systems at these financial institutions is one path to success.”

Cheap and cheerful services

The other route – to pick a niche and apply new thinking to make services cheaper or more efficient – has also created winners: think businesses such as Paypal, Robinhood, or Transferwise (recently rebranded Wise). 

Weisberg warns, however, that fintechs competing against traditional financial institutions are always vulnerable to those institutions using their size to regain their market share by becoming more competitive.

“If a large bank like JP Morgan wanted to reduce the fees they charge to their clients, they could turn a couple of dials and those fintechs would have a tough time ever getting to profitability. So the race depends on whether they can build a unique set of services that wouldn’t be exposed if a large bank turned the dial down on fees more rapidly,” he says.

For Channer, the fintechs that are more likely to succeed over the long term are the ones that collaborate rather than compete with existing financial institutions.

“The way the market has evolved is that it has moved from this disruptive threat to an enabling partner, so it’s become a more symbiotic relationship,” he says.

Governments around the world are eager to embrace the potential of the fintech industry as a way to drive domestic growth. In the UK, the recent Kalifa Review into the country’s fintech sector outlined recommendations for policymakers to ensure that it continues to attract investment. Some of those suggestions include setting up a fintech growth fund and changing share ownership rules so that founders can still retain control even if they sell a majority stake in their business.

Innovation and embracing fintech

Other countries have also embraced the fintech sector. Take Singapore, for example. It has set up incubator programs partially funded by the government to try to steer businesses into areas considered to be strategically important for the country.

In some countries, such as India and China, fintech has leapfrogged traditional financial services in part because their existing financial infrastructure was less well developed than in the West –  meaning fintechs in those countries could move more nimbly and expand faster since they weren’t held back by legacy technology and processes, says Worden.

The billion-dollar question in the fintech market is to what extent Big Tech will embrace financial services. For some market watchers, their entry is inevitable.

“If you want to know the answer to that, the best market to look at is China, where the Big Techs absolutely have been involved,” says Weisberg. “If you look at Alibaba or Tencent, those firms leveraged a critical mass of users and created products that previously didn’t exist, such as building a money market fund that leveraged idle cash balances. China has been a really big source of innovation.”

The scale of this potential change is already causing incumbent firms to rethink how they will interact with customers and provide services in the future.

“The Big Techs are really good at getting close to their customers at their point of need. This is prompting banks and fintechs to accelerate building APIs, so they are able to adopt ecosystem strategies that allow their products and services to be consumed within the customer journeys or propositions of others like the Big Tech players,” says Bull. “The Big Techs tend to like building global platforms, and maybe that has slowed them down a little bit, but it means that, when they come, it will be in a big way.”