Since the development of the fintech industry, banks have been the primary competitors to startups. But now the industry has become more competitive. Today, fintech has never been more crowded, funded, or better tooled.
During my time at Adyen, I’ve seen how dynamic the competitive landscape is, how quickly a fintech company can build powerful and enduring products and relationships, and ways in which the industry is finding its maturity.
Network effects are researched and productized everywhere else in the technology industry. They’re the cornerstones of product and process design and development. If fintech wants to beat tech’s encroachments, and if your company wants to win your market, it’s time to embrace the concept of network effects.
Pull up a chair and let me share what networks effects are in fintech using three best-practices from leading companies: Adyen, Square, and Lending Club.
But first, some myth busting.
📣 Economies of Scale and Network Effects are not Identical
Aren’t network effects the same as economies of scale? Actually, no. Economies of scale are when the cost of production decreases as demand rises; the downward pressure on supply-side costs from the upward pressure on demand. Manufacturers of physical goods will see the average cost of production decrease as revenue increases. You can think of economies of scale as the supply-side benefit of compounding value.
So what’s a network effect? At its core, a network effect is the result of additional users of a product or service, wherein each one adds value to the current and future users. Because the benefit accrues for users, network effects become the demand-side benefit of compounding value. Commonly, network effects occur in technology and software industries, like fintech. But what makes a network effect work?
🚀 Flywheel: a Network Effect’s jet fuel
The flywheel is the jet fuel for any network effect. It’s the active mechanism by which value is generated and compounded; the effect of a product or service offering that benefits existing users and accelerates adoption from prospective users. For a fintech company, it’s critical to understand how flywheels work to get your users creating value for themselves, their peers, and, ultimately, your business. Let’s see flywheels in action.
Network effect #1: 🧠 Knowledge
No two regulatory bodies, consumers, or markets are the same, so a fintech must be a flexible expert. A fintech, to be successful, should understand the nuances of its product and market, achieving a competency in which its products’ many use cases are explored and understood. Merchants and users are coming to fintechs instead of banks for a reason: distribution (no brick-and-mortar office, but instead an app and/or website) and sophistication (a VC-backed startup with a board of ex-fintech and bankers vs your local community bank). Winning on sophistication comes from making your flywheel spin.
Serving new users, be they consumers or businesses, brings into your teams’ purview a whole new set of use cases, interactions with your product, and business environments. Each is an opportunity to approach these moments and those responsible with an inquisitive mind, and improve the product offering for the next customer who fits that particular, learned use case. You build a catalog of previously-experienced use cases that colors how you can work with new users. This is especially helpful in the B2B space; here’s a good example.
🔎 Knowledge at work:
Adyen is a global payments company, processing for merchants in Asia, Latin America, Europe, and North America. They’re also my employer. The variety and complexity of merchants’ business models, consumer bases, and regulatory guide rails which Adyen must understand and succeed in servicing only compounds the ability for Adyen to turn around and support merchants with identical or comparable use cases. When a merchant wants to launch a new subscription product or e-commerce payments in Malaysia, Adyen’s knowledge-sharing and documentation of use cases provide first-class service to the merchant, all thanks to prior experience and knowledge.
During my time at Adyen, I’ve analyzed trends on card testing, one of the most common types of e-commerce fraud (‘A $12 Billion Problem’) — even more pervasive and costly as COVID has increased the size and penetration of the internet economy. We leveraged custom rules around distinct number of cards, BINs, purchase frequency, etc. to thwart fraud for one of America’s largest electronics manufacturers. Guess what? After I shared the findings, solutions, and calculable value, I presented the story to our global risk team who implemented the same solutions for hundreds of similar merchants (for any fraudsters reading this, I am on to you).
🚧 Watch out for:
- Identification Risk: if a fintech can’t distinguish one use case from another, they are bound to repeat the same mistakes as before. They also will not recognize an issue’s nuanced solutions to avoid a one-size-fits-all method.
- Documentation Risk: the inability to document previous use cases and train current and future employees makes it exponentially more difficult to learn and provide quality service and products to future users.
Verticals: payments, consumer/business lending, insurtech, regtech, cybersecurity
Network effect #2: 💰 Enrichment
A fintech that offers capital to its users, whether they’re an SMB or you or me, is able to do so because of the revenue and profit they take in from their other users or products. The more revenue and profit generated by the other users or products, the more capital that’s available to Bob’s Bakery, you, and me. And, even better, the more capital that’s deployed (effectively, of course), the greater the opportunity for expansion and growth. More expansion and more growth — well that means more revenue and profit for the fintech. Back to the beginning….It’s an exciting flywheel that can be explained with an example.
🔎 Enrichment at work
As the number of the merchants using their products and their volume and frequency of usage grows, Square Capital can offer more loans to merchants, who in turn use these loans to attract new customers, offer new products, or expand to new markets, repaying the loans and, via their growth or expand, allow Square to offer more loans to more merchants.
Here’s something cool — according to Square’s 2020 Capital Report, SMB confidence is high (indexed at 79) and 68% SMBs surveyed were confident sales would grow. But many, actually 47%, saw access to funding as their top issue. So Square created a proprietary model which, after analyzing over 400 data points including payment volume, provides SMBs access to funding in minutes. The SMB pays back the principal plus interest through a % of each payment Square processes. More business means more access to more capital- scaled across the entire Square SMB ecosystem, SMBs are fueling the growth of one another via their paybacks to Square Capital.
🚧 Watch out for:
- Financial risk: the more liabilities on the balance sheet, the more risk a lending or insurtech company is exposed to. The failure of a borrower to pay back a loan affects loan availability — at scale, this is can be a problem.
- Regulatory risk: because of these liabilities, fintech companies must grapple with regulation scrutiny and regulation requirements. Changes in rules and enforcement can ratchet compliance costs and jeopardize a fintech’s ability to provide an enriching effect.
- Quality risk: the more users/merchants serviced, the greater the risk of a dip in quality. If the ratio of low-quality to high-quality borrowers trends poorly, the overall ecosystem becomes unhealthy as high-quality borrowers are harmed by low-quality borrowers.
Vertical: consumer/business lending, insurtech
Network Effect #3: 🤝 Aggregation
Any fintech company that runs a marketplace should know about the Assembling network effect. When you are connecting buyers with sellers, or borrowers with investors, your goal is to make the marketplace benefit both sides; buyers/borrowers like seeing all the sellers/investors offering different products and their particular value, and vice versa.. When there are more buyers/borrowers with the cash and willingness to buy/borrow more, there is an incentive for more sellers/investors to offer quality goods and services at the right price. It can be a bit of a chicken-and-the-egg situation…who comes first? That’s for you to decide, but, most importantly, be able to articulate the value your marketplace and/or fintech company offers to both sides.
🔎 Aggregation at work:
Lending Club is a P2P loan marketplace. To provide value, Lending Club attracts investors by recruiting borrowers seeking loans with favorable interest rates. As the pool of borrowers increases, each offering their own investment opportunities via differentiated principals, interest rates, and payback periods, the more investors are attracted. The more borrowers, the more investors, and vice versa.
Lending Club has seen their loan originations grow from $4.3B in 2019 to $12.3B in 2020. That’s an impressive growth rate of 186%! Something is bringing in returning investors — and that’s having a large and growing populating of attractive borrowers. But there’s more at play. For investors, Lending Club is adding more tools, like a high-yield savings account, to generate returns on investments that keep investors coming back.
🚧 Watch out for:
- Quality Risk: just like the Enriching effect, more sellers/investors attract more buyers/borrowers, accompanied by ranging quality. Similarly, more buyers/borrowers attract more sellers/investors and their spread of quality. In the main, a quality dip (vs a bump) is more probable. It’s the fintech’s job to audit and moderate buyer/borrower and seller/investor quality.
- Competition Risk: the success of one marketplace inspires competitors who iterate on benefits and products that can conquest buyers/borrowers and sellers/investors. Migrated buyers/borrowers incentivize sellers/investors to take chase and vice versa.
Verticals: consumer/business lending, insurtech, social investing
To make the most of your company’s opportunity, it’s imperative to embrace network effects and the concept of flywheels. Adyen, Square, and Lending Club show us knowledge, enrichment, and aggregation done right — follow their example.