Last year saw a number of investments in fintech firms offering FX technology. Galen Stops takes a look at the rationale behind this trend and examines the broader investment landscape.

The more eagle-eyed Profit & Loss reader will have noticed that there was a distinct spate of investment deals involving FX-focused fintech firms in the second half of last year.

In November, TickTrade got investment from SVB Financial Group, Capitolis secured $40 million in funding from five different investors and MarketFactory got bought out by Ion. Prior to that, TradAir completed an $11 million funding round in July, oneZero announced it had secured private equity investment in June and, looking a little further back, Singapore Exchange (SGX) bought a 20% stake in BidFX in March, with an option to buy a controlling interest for $25 million further down the line.

“There are selective dialogues going on. From where we sit, we do actually see a fair bit of interest from a variety of players that are not in FX that want to expand into this asset class. Broadly speaking, FX remains an asset class that people who are coming from equities, futures or other more mature asset classes look at as the next destination for them,” says Vikas Shah, managing director at Rosenblatt Securities.

Of course, Shah is no stranger to the world of FX-focused fintechs, having been part of the team that advised Euronext on its acquisition of the trading platform FastMatch, which has subsequently been rebranded as Euronext FX.

But what is making the FX market so attractive to these investors right now?

Yes, the latest Bank for International Settlements’ (BIS) survey shows that the FX market has grown 30% in notional volume terms over the past three years, but this generally does not seem to have translated into larger profits for many in the industry.

The FX trading platforms that publicly report their volumes showed that activity was muted in the spot market last year, with volatility at rock bottom levels for most of it. Banks generally continued to reduce their FX headcount, semi-frequent articles appeared in the press about currency funds struggling to make money and new regulations and capital requirements appear to have increased cost pressures for just about everyone in the industry.

Jeremy Philips, Spark Capital

Thinking differently

But according to Jeremy Philips, a general partner at venture capital firm, Spark Capital, it is precisely this environment that makes the FX market so ripe for investment right now.

“Market participants are looking for industry-wide software solutions to increase returns, reduce risk and mitigate pain points in their businesses, which have only increased due to regulations and capital requirements over the last decade. So I think there’s a huge opportunity to address these pain points,” he says.

Within the fintech sector, Spark already has invested in firms like Coinbase, e-Toro, IEX and Plaid, the last of which was recently bought by Visa for $5.3 billion. The firm is also an investor in Capitolis, where Philips now sits on the board of directors.

Likewise, the private equity firm Lovell Minnick Partners (LMP) sees recent market conditions as a reason why investing in an FX-focused fintech firm is a good idea right now, having been behind oneZero’s investment last year.

“Although we don’t consider ourselves to be market timers, you have to look at how the asset class has performed in the preceding years leading up to your investment,” says Steve Pierson, managing partner at LMP.

He points out that the Deutsche Bank Currency Volatility Index (CVIX) was, on a historical basis, so low last year that it would be impossible for it to go materially lower. In addition, the carry trade has largely not been working for major currency pairs as interest rates have tended to move in lockstep in recent years. While Pierson doesn’t see a lot of incremental trading activity coming from interest rate disparities anytime soon, he notes that down the road divergent rates could eventually provide some upside for the market.

Hence why Pierson feels comfortable about LMP’s entry point to a market which, as he points out, is at a high level seeing good growth relative to other asset classes.

Meanwhile, Gil Mandelzis, CEO of Capitolis who also founded the fintech firm Traiana back in 2000 which subsequently got sold to Icap for $250 million in 2007, insists that there are reasons to be optimistic about the FX market and its potential to grow further.

“If you’re able to think about the FX market differently, then I think that there is actually a lot of room for growth in the future. For example, if firms think differently about capital utilisation, optimisation, etc, then they can make much more money from their existing flow. So we are terribly excited about the opportunity in FX because of the current size of this market, which is humungous, and because we believe that with the right tools it can continue to grow and firms can find ways to become more profitable,” he says.

B2B opportunities

Within FX there are, of course, many firms that would welcome additional outside investment, and so the next question naturally becomes: why are fintechs such an attractive prospect?

Steve Pierson, Lovell Minnick Partners

“If you want FX exposure, there’s lots of different ways to play this. You can go for a real money, business-oriented, FX currency conversion type of play which a number of our peers have done you can play in the exchange space, you can play in the liquidity provision space. As I said, there’s lots of way to play it,” says Pierson.

But as an investment philosophy, when it comes to financial services LMP doesn’t like to make investments into firms that are involved in risk bearing or balance sheet trading, preferring instead to focus on firms offering software products that are agnostic to market volatility.

According to a senior figure at one fintech firm, this is not an uncommon approach amongst investors these days.

“Yes, yes, yes, no one wants to invest in risk-taking companies,” they say. “I can’t tell you how many meetings I’ve had with potential investors who appear incredibly enthusiastic until they understand that our business model fundamentally involves us taking at least some risk and at that point the conversation shuts down.”

For his part, Philips says that Spark sees plenty of scope for good investments in the fintech sector, but says that the firm skews towards firms operating in the business-to-business (B2B) side rather than business-to-consumer (B2C) firms.

“We’re generally very bullish about the opportunity in fintech, and we probably see a broader set of opportunities within this segment than the consumer market, which has gotten the lion’s share of attention from entrepreneurs and investors recently. I think that there are interesting opportunities on the consumer side for sure, and we’re invested in some of those, but there’s also a lot of me too products and ones that seem to have a high risk of commoditisation. This is where we’re probably a little different to some firms out there we’re more interested in business-to-business infrastructure and enterprise investment opportunities, as well as consumer,” he says.

Finding the right people

What’s interesting is that when talking at a strategic level, broader industry trends are cited as a reason for investing in FX as an asset class and fintechs as a business segment, but when pressed on why they invest in specific firms, both Pierson and Philips are quick to explain that it is the individuals at these firms that are core drivers of their decisions.

“The management the fit, the culture, the philosophy, the capabilities we put that at the top of the list,” says Pierson. “The management has to want to work with us and they have to be open to input, which not everyone is.”

“What we’ve found is that the quality and experience of the team is always key,” says Philips, noting that Spark spent about two years in dialogue with Capitolis before deciding to invest in the firm. “That, combined with a compelling product and market structure, leads to a strong opportunity to create value for all stakeholders, not just the investors but all the market participants.”

As previously noted, Philips sits on the board of Capitolis following the firm’s latest funding round, but he emphasises that while he works closely with the Capitolis management, he remains conscious of the fact that he is not part of it.

“As a board member one needs to really understand the difference between being part of day-to-day management and helping to support day-to-day management,” explains Philips. “My main role is to support the management and bring some of the knowledge that our firm has gained from prior experiences with other firms businesses in our broader portfolio to the company. Because there are often a lot of principles that apply across companies, but when you’re working day-to-day, head-down in your own business, you’re not as exposed to them. Then I think it comes down to providing support and sometimes asking the hard questions to challenge the team and drive the thinking.”

Patience (and investment) required

It’s worth pointing out though that for fintech firms it’s equally important to find the right investors to partner with. Although for some fintech firms it might be tempting to partner with any firm holding a big enough cheque out to them, Mandelzis is at pains to emphasise that these firms need to be thinking longer term if they are going to ultimately be successful.

Gil Mandelzis, Capitolis

“For us, the most important thing is truly finding the right investors. When you’re bringing an investor in, you have to know that this is a team that you’re going to be working with for the next decade, and that during this decade there’s going to be ups and there’s going to be downs. So you need to find people who have conviction about the opportunity and the firm, but also experience, valueadd and understanding of where we are now and what the challenges are going to be. From our perspective, it’s certainly not just about getting that investment cheque or the evaluation, we’re thinking much more long term about building the company,” he says.

From a fintech’s perspective, patience is an important virtue in an investor, says Mandelzis, and this is especially true in the B2B segment where winning business, getting integrated into systems and then building up scale can take a long time. And a lot of investment.

As Shah explains: “For B2B, fintech is a much longer gestation cycle. In B2C fintech, you can demonstrate growth very dramatically and very fast. By contrast, in B2B it’s much harder to do this because they’re dealing with regulated entities and many of them may need to push any third-party technology through their vendor approval process, which can take 9-12 months in some cases. So it’s not easy for younger fintechs because it can take a very long time to acquire large customers, even though some larger banks are trying to fast-track the onboarding of some of these technologies.”

He adds: “Ultimately, it’s much harder for B2B fintechs to scale up compared to B2C, but the cost of client acquisition is less for them and the stickiness of their clients is much greater.”

Avoiding fintech pitfalls

Although fintech has gathered some hype in recent years, it is of course nothing new. Financial technology has always existed and firms have always been around to create and sell it. As the CEO of one fintech company once observed to Profit & Loss, the stereotypical assumption is that fintech firms are populated by young people wearing casual clothes and dreaming up a way to “disrupt” traditional finance from atop a bean bag chair. By contrast, they argued that in reality at least on the B2B side fintech isn’t a young person’s game because, as they put it, “you have to try things and get them wrong a whole load of times before you get it right”.

Mandelzis is certainly candid about his experiences on the fintech front line in this regard.

“What lessons have I learned? I could speak for the next 24 hours straight about all the lessons I’ve learned and the mistakes I’ve made!” he quips.

Focusing instead on mistakes that he’s seen firms in the fintech space make more generally, if only for the sake of brevity, Mandelzis says that focusing too much on valuation and raising money can often cause businesses to struggle. He adds that while raising money is important for fintech businesses, there can be a danger of spending too much time doing that and not enough time building the company.

Mandelzis adds: “I would also say that in the fintech industry, and specifically in the world of capital markets, I think that people undervalue

Vikas Shah, Rosenblatt Securities

what I would refer to as the ‘Smart Silicon Valley Type’. Building companies, financing companies, growing companies this is a profession and it’s a state of mind and it’s something that these Silicon Valley types excel at. Taking money from them is not like taking money from anywhere else, it’s the most expensive money on the planet, but I think it’s incredibly worth it.”

From the investor’s perspective, Pierson says that one of the most common mistakes that he sees firms make is spending money on marketing and advertising spend in order to acquire customers while de-prioritising profitability until later. However, he adds that this tends to be a mistake made by venture capital firms focused on the B2C side who perhaps have less experience in the fintech space.

An expanding universe

Looking ahead, it seems that fintech investment is likely to continue at a healthy clip, and fintech firms with an FX focus, or at least an FX product, will be beneficiaries of this. For example, although Pierson says that it has become harder to invest in this space because it is increasingly tough to find quality assets that LMP considers worth investment, the firm is already keen to find additional business that can be combined with the companies that it already has a stake in, such as oneZero.

“For most of our portfolio companies we always look for bolt-on M&A opportunities. There are peers of oneZero in the market that we have the capacity, the firepower and the interest to buy. M&A is a big part of our thesis,” he adds.

Looking back to his experiences in the fintech space 20 years ago, Mandelzis sees cause for great optimism regarding the investment environment today.

“When Traiana was first starting, fintech didn’t exist. When you went to Silicon Valley as a startup, back then ‘financial services’ was like a bad word, everybody thought you couldn’t build a big company and that you couldn’t make money. It was a real struggle. So it’s a huge delight that people have actually discovered the fintech world and are excited about it, and it’s not just investors, banks and hedge funds and other financial services firms are much more open to working with fintechs now. The whole ecosystem is thriving,” he says.

Mandelzis continues: “It’s definitely easier than 20 years ago to get investment as a fintech and I think that’s a really positive thing because now you have the best people and the best minds and the best money excited about trying to revolutionise this industry. We’ve already seen some amazing successes in the fintech space and I think there’s more to come. For me, there is competition and there is vibrancy and so I think the fintech environment is great right now.”

Philips is thinking even bigger though, arguing that the fintech investment that the FX industry is seeing today could pave the way for much more money flooding into different areas of the markets.

Summing up why he’s so optimistic about the future, he says: “I think that what we’re seeing right now is a huge investment in the underlying infrastructure of financial services. This in-turn opens up a whole world of investment in all the things that are being created on top of this infrastructure, which includes what we think of as fintech, but also a whole range of other software companies where financial services is becoming a core part of their business. Without meaning to ‘gild the lily’, it’s sort of analogous to the Internet or the iPhone where an underlying technological change led to an explosion of subsequent opportunities. So we see this fintech universe expanding dramatically going forward and so I think it’s a really exciting time to be investing here.”

Galen Stops

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