In today’s insight – part four of our financial innovation series – we discuss open banking, open APIs and how the underlying technology has supported the rise of fintech competitors in the U.S., Europe and elsewhere. With Canada expected to introduce open banking regulations in the near to medium term, the topic is timely.
As we explore in this note, open banking and open APIs have been fertile ground for innovation in financial services lowering entry barriers for new entrants and supporting the rise of financial technology companies, particularly in the U.S. and Europe. In recent years, these companies have come to compete with incumbents in payments, banking, insurance, investing, and other financial services verticals. In Canada, we think it is likely that competitive trends elsewhere, including adoption of open banking, will increase domestic competition (including from big tech) and serve as a blueprint for digitization of financial services in the coming years. We present three use cases across payments and wealth management where open banking and/or open APIs have been instrumental in the rise of new entrants.
We launched the Hamilton Financials Innovation ETF (HFT) to provide Canadian investors exposure to “blue-chip” financials benefiting from powerful long-dated secular themes including the ongoing shift to a cashless society, digital banking, electronification of capital markets, and disruption in wealth management (including ETFs). Relative to most banks and insurers, HFT’s portfolio companies generate higher EPS growth and ROEs while also providing diversification from more traditional financial risks (namely interest rates and credit). As we will explain, open banking is a theme with large potential to support financial innovation across the globe, and HFT offers exposure to this theme directly and indirectly through many of its holdings.
What is Open Banking? Open APIs? What are their benefits?
In its simplest form, open banking allows bank customers to share their financial and transaction data with authorized third-party providers (including technology companies) through secure digital channels known as application programming interfaces, or APIs. These APIs can be publicly available (known as open APIs) or private.
Open banking and open APIs carry the potential to reduce customer switching costs and lower entry barriers in financial services by providing a customer’s financial data in a secure, easy-to-use, and customizable format to new entrants (including non-banks and technology companies). As we explore later in the note, this potential is already proving out, having reduced the cost and time for new entrants to market new products and services in many markets.
Currently, open banking regulations have been introduced in the European Union, United Kingdom, Australia, and Japan (see figure below from the Bank for International Settlements’ November 2019 “Report on opening banking and application programming interfaces”). Each of these markets grant varying levels of access, have different approaches to data privacy rules and regulatory frameworks. In countries where regulations are in place banks share must share customer data (following customer consent) with third-party providers (often fintech firms).
In other major markets such as the U.S and Canada, where open banking regulations are not yet in place, adoption has been consumer demand driven with popular fintech companies engaging in one-on-one agreements/tie-ups with banks for data sharing. This is especially true in the U.S., with its large and expansive banking system (~5,000 FDIC insured banks), as well as a large technology sector where open API usage by digital competitors has grown rapidly. Thus, in the absence of formal open banking regulations, open banking is making inroads though open APIs in the U.S.
Broadly, open banking has also pushed incumbents to invest and improve their product offerings often in partnership with fintechs.
In Canada, the government (specifically, the Department of Finance, DoF) is making progress on open banking policy, and we believe it is likely open banking will be formally introduced in Canada within the next 1-3 years. Once approved, we believe open banking and the underlying technology could reshape the competitive environment in Canada as they are already doing in the U.S., Europe, Australia, and other markets.
Open banking and open APIs in action: Three use cases
The fast pace of technological innovation and adoption in financial services imply that the competitive environment in oligopolistic markets such as Canada, Australia and others may not always remain benign. We believe open banking regulations and the underlying technology have the potential to lower barriers to all markets including Canada and Australia. Below, we present three use cases of open banking and open APIs from around the world.
- Open banking platforms: An open banking platform plays a critical role in the open banking ecosystem by acting as a secure intermediary between a customer, their bank, and the third-party application with whom the customer wishes to share their banking information. The third-party app can be a competing bank (often digital), a payment company, a wealth manager, or a non-financial entity (e.g., a food delivery app). Transactions occur through open APIs that are customizable based on a company’s requirement. The open banking platform earns revenues per transaction.These open banking platforms have proliferated particularly in the U.S. and Europe where the financial sectors are large but fragmented and where adoption of digital applications has accelerated in recent years, particularly since the pandemic. By acting as a bridge between big banks and start-ups, the networks have come to play an indispensable and central role in the fast-growing open banking ecosystem. See figure below.
- Payments – Buy Now, Pay Later (“BNPL”): BNPL companies allow consumers to split online and in-store purchases typically into four equal payments. If payments are made on time, there is no penal interest rate (like a traditional credit card) or fees (unlike a credit card). The service is subsidized by the retailer who pays a commission (% of transaction) and is compensated through higher sales volumes. In several key markets, BNPL applications are connected to customer’s bank accounts using open APIs.As evident by the figure below, BNPL adoption has grown rapidly, particularly in Europe which was an early adopter of open banking regulations. Generally, users belong to a younger cohort of consumers who are more likely to prefer debit cards. The category itself has also received a boost from the pandemic as: (i) eCommerce sales have grown and the large BNPL applications are integrated with major online retailers, and (ii) spending has shifted to debit cards over credit cards (typical in an uncertain economic climate).While the category faces increased regulatory and competitive risks, BNPL companies have at present captured a share of spending that might have otherwise taken place on credit cards thus effectively disintermediating a lucrative, high ROE business for incumbent banks and financial institutions.
- Digital Investing: Around the world, open banking and open APIs have been critical to the rise of robo-advisors by allowing for a faster onboarding process, secure fund transfers and account aggregation from various bank providers to present a fuller financial picture. The space has seen rapid AUM growth off an admittedly small base as most new competitors at present are small and sub-scale. It is likely that over time, a few larger competitors consolidate the market to gain scale and emerge as the go-to for financial advice especially as their customer base ages and accumulates wealth.
Goldilocks backdrop for open banking driven innovation in Europe, U.S.
As open banking spreads around the world, it will influence the market dynamics and competition in the global financial services sector. We believe three factors have been crucial to digital competitors’ success in the U.S., Europe, and other major markets:
- Fragmented banking sectors, especially in Europe, where the banking sector’s profitability remains structurally constrained by the post 2008 stricter regulatory climate, higher core capital requirements, and a low interest rate environment.
- Supportive regulatory backdrop: The EU was a first mover introducing open banking regulations in 2018 with the aim of increasing competition and innovation. The UK’s competition authority followed soon after with the goal of increasing customer choice and control over customer data. By comparison, in the U.S., open banking adoption has been driven by growing popularity and adoption of digital financial services applications by consumers (in the absence of formal approval).
- An attractive fund-raising environment, globally for high-growth companies in a low rate/low return post GFC investment environment.
In contrast, we believe oligopolistic banking sectors remain one of the most powerful barriers to entry for a new entrant, digital or otherwise. Two examples of countries where adoption of open banking could take longer are Canada and Australia, both with dominated oligopoly banking sectors.
Moreover, we believe that regulators in both Australia and Canada remain more risk averse than peers elsewhere when it comes to open banking. The success of their banking sectors, including during the global financial crisis (where both sectors led the world), seems to have engendered a more cautious regulatory approach to open banking with implementation either delayed (Canada) or measured (Australia). In our view, this may have given incumbent banks in both markets a multi-year head start to adapt and invest for a progressively digital and open financial services sector. That said, industry feedback suggests that regulators in both countries are hoping over time open banking will create new competitors and increase competition for the incumbents.
Open Banking Driven Innovation is Here to Stay
We believe open banking and the innovation from the underlying technology are here to stay. As the three use cases above highlight, open banking continues to create new, disruptive revenue streams and global competitors by lowering entry barriers to financial services. Parts of the financial sectors already benefiting from this technology include digital payments and investing.
With exposure to 30+ global financial technology companies, Hamilton Financials Innovation ETF (HFT) offers Canadian investors “blue chip” exposure to innovation within the financial sector where firms are generating materially higher EPS growth and ROEs, while providing diversification. While only a small part of HFT’s portfolio exposure at present, we believe open banking will continue to drive growth and support innovation, especially in portfolio holdings that operate in large economies where either open banking regulations are already part of the prescribed regulatory framework (like Europe) or where adoption is driven by consumer demand (like the U.S.).
Moreover, we believe HFT’s exposure to this fast-growing theme will expand as other countries, including Canada and the U.S., provide definitive regulatory direction/frameworks, complementing the ETF’s current exposure to other themes in financial innovation benefiting from powerful secular trends.
Part III: Market Data M&A Accelerates Pivot to a Digital Future (February 10, 2021)
Part II: Four Themes Driving Innovation in Global Financials (January 25, 2021)
Global Financials: The Most Attractive/Important Investment Themes in 2021 (November 16, 2020)
Hamilton ETFs Launches Hamilton Financials Innovation ETF (June 1, 2020)
A word on trading liquidity for ETFs …
Hamilton ETFs are highly liquid ETFs that can be purchased and sold easily. ETFs are as liquid as their underlying holdings and the underlying holdings trade millions of shares each day.
How does that work? When ETF investors are buying (or selling) in the market, they may transact with another ETF investor or a market maker for the ETF. At all times, even if daily volume appears low, there is a market maker – typically a large bank-owned investment dealer – willing to fill the other side of the ETF order (at the bid/ask spread).
 APIs, or Application Programming Interfaces, are the software intermediaries between different applications and services that allow for the exchange of information.
 This is done through a practice known as “screen or data scraping” and increasingly using APIs. Screen scrapping is the predecessor technology to open APIs and is common in markets, products where open APIs may not yet be available. Screen scrapping technology allows consumers to give 3rd party applications permission to access their transaction and payment data but is generally thought to be less secure.
 This is in contrast to platforms that gather information via screen or data scrapping.
 Younger consumers across several major markets are likely to prefer debit cards over credit cards. For instance, in Australia, according to data from the Reserve Bank of Australia (RBA), 36% of consumers aged 20-35 owned credit cards compared to 59% in 2002. In the U.S., this preference is partly attributable to the 2009 CARD Act which imposed stricter rules around marketing to younger people (under 21). In a recent industry roundtable, the CEO of BNPL firm Sezzle referred to BNPL as “training wheels” for credit.
 Open banking regulations called Payment Services Directive (PSD2) came into force in the EU on January 13, 2018. In the UK, the regulatory initiative is called the ‘Open Banking Standard’ and was introduced in 2018.