SoFi: Next Steps for the Original FinTech Darling
In light of SoFi’s announcement of their plans to go public via a SPAC backed by Chamath Palihapitiya’s Social Capital I’m sharing some background on the company and some analysis on where it may be going next. Special thanks to my co-authors Brian Mongeau & Bryant Seaman.
Executive Summary
In September of 2015 SoFi, under the leadership of then CEO Mike Cagney, finalized a $1 billion round of financing from leading tech investor Softbank. At the time, it was the largest financing round for a Financial Technology (FinTech) company ever and cemented SoFi as a leader in the burgeoning category with a valuation of nearly $4 billion.
SoFi’s market position has shifted dramatically since then. Competition in the FinTech space has intensified with a bevy of vertical and horizontal digital challengers building better and more broadly adopted financial services across the core checking, savings, personal finance management, lending, and investing product categories. Incumbent financial institutions have made significant investments towards modernizing their products, even partnering with Big Tech super platforms in some cases (Google, Apple, Amazon, and Facebook), drawing a daunting new competitor into the category. Financial infrastructure providers have built better, cheaper, and more accessible APIs lowering the barriers to entry by making it easier than ever for consumer financial services targeting specific user niches to quickly get off the ground and service customers in a cost effective manner.
All together, SoFi’s once meaningful head start in the consumer financial technology space has all but evaporated. While SoFi has bolstered its initial student loan-centric offering with checking, mortgage, and investing products, it has failed to convert its early beachhead into a meaningful broad based multi-service customer relationship. We see three potential paths forward: (1) continue to invest in building out a complete consumer financial services product suite; (2) make further investments in infrastructure to attempt to vertically integrate; and (3) leverage institutional first-hand knowledge and recently acquired Galileo assets to become a “picks and shovels” infrastructure provider to other neo and challenger banks. SoFi’s best path forward is the third option, focusing on becoming a best-in-class Financial Technology infrastructure provider by embracing the industry sea change toward multi-homing.
A Brief History of SoFi
SoFi was founded in 2011 by business school students looking to save on the cost of their education. The initial business model was predicated on interest rate arbitrage in the archaic student loan market, where rates were set well above prevailing risk free rates without consideration of underlying borrower risk. The significant savings SoFi offered fueled rapid customer growth, reaching $2 billion of loans issued 4 years after launch.
However, as with most great arbitrage opportunities, the market caught up, competition entered, and loan interest rates fell precipitously from ~8% at SoFi’s founding to 3% — 4% by 2017. As the student loan TAM shrank, SoFi needed additional revenue streams to fuel growth. The company pursued wallet share expansion aggressively, targeting their coveted “Henry” (high earners, not rich yet) customer base and utilizing advanced internal analytics to determine customer attractiveness across personal loans, mortgages, wealth management, checking and savings. See Exhibit 1 for a full product timeline.
Today, SoFi faces increasing competition across product lines from neobanks and incumbents. Its strategic moves over the next 2–3 years, including bold expansions like the $1.2 billion acquisition of Galileo, will dictate the company’s success or failure.
The NeoBank & Challenger Market
Neobanking Overview
Neobanks seek to leverage technology to offer internet-only banking services to customers using mobile apps. In contrast to traditional consumer banks, neobanks’ use of mobile apps rather than physical branches enables decreased operating costs, helping to offer above-average interest rates, reduce or eliminate fees, and expand services to underbanked consumer segments. Typically, neobanks also differ from traditional physical and online banks in that they do not have a state or federal banking charter. The result is that many neobanks often form partnerships or alliances with existing chartered banks, enabling them to offer FDIC insurance to customers. The value of the neobank market has also been growing rapidly. One market research firm estimates that the industry will grow at a CAGR of 48.1% from 2020 to 2027, with a value of $471 billion at the end of that timespan.
Regulatory Openings
The Durbin Amendment in the 2010 Dodd-Frank Wall Street Reform Act set thresholds and regulations governing interchange fee structures. Per the new regulation, any bank with over $10 billion in assets is considered a “regulated” bank, while those with less than $10 billion are considered “unregulated” or “exempt” banks. Under these definitions, Durbin Amendment regulations set an interchange fee cap for debit transactions with regulated banks of 22 cents plus 0.05% of a transaction. Conversely, exempt banks are able to charge highly variable interchange fees, which can be dependent on factors including transaction size and merchant category codes. Exempt banks are enabled by the amendment loophole to charge interchange fees approximately 10x that of regulated issuers. Neobanks have capitalized on this regulatory edge by staying under the $10 billion asset threshold through distributing deposits across partner banks, enabling them to claim less assets than if the deposits were concentrated on their own balance sheets.
Debit transactions have thus increasingly become unprofitable for large, regulated issuers, while remaining highly lucrative for exempt banks. This has been most noticeable among the high-dollar transaction business debit card segment. A study by Oliver Wyman, 2012 Debit Issuer Study, notes that pre-Durbin Amendment revenue per business transaction averaged $2.10, significantly higher than the $0.52 for consumer signature debit transactions. This dropped precipitously for regulated issuers after the Dodd-Frank Act, however, falling to $0.26 per business debit transaction. The upshot is that exempt issuers, a category in which neobanks can and do feature prominently, are much better situated to monetize from debit transactions profitably. This has proven to be a key and sustainable competitive edge for neobanks.
Current Neobank Strategies and Leaders
Neobanks have so far adopted a strategy centered around establishing a beachhead around a specific product or feature, using that to expand customer relationships over time. Most have offered “freemium” models for their core product, charging for additional features, but other neobanks have utilized multi-tiered subscription options. This reliance on freemium models centered around checking and savings accounts has led to a rapid accumulation of users, but has prevented profitability with a monetization strategy reliant on interchange fees, leading to a focus on expanding services to areas that will likely challenge SoFi in short order. Currently, the average neobank loses $11 per user. Neobanks currently focus on improved user experience as a way to attract customers. Customer acquisition costs have increased over time, as Fed rates were cut (making it harder to offer high yield accounts), traditional banks adapted to online-based challengers, and competition increased. This has led many neobanks to start charging fees or introducing business model innovations. Lending, in particular, is a difficult area for many neobanks to move into, given their comparatively low credit quality. The best positioned neobanks, however, are those that have achieved stability and maintained lower CAC by targeting typically specific, often underbanked, customer segments, as well as those who built brand trust and direct deposit relationships with customers from the start, enabling more spending capture and cross-sell potential.
Chime is the current leader in the U.S. neobank market with a 59% market share of mobile app MAU as of April 2020 (Exhibit 2). Chime is now planning for an IPO within 12 months with a current valuation of $14.5 billion after raising a Series F in September 2020 worth $485 million. This is a valuation increase of 900% compared to its Series E in December 2019. Chime has focused its attention on a 25- to 40-year old customer segment that earns $30,000-$70,000 a year and partners with Bancorp and Stride Bank to offer checking and savings accounts that are FDIC-insured., , Chime has also attempted to ease customer transitions from other banking accounts, introducing CardSwap to automatically swap out current account details for customers on bill pay websites, automatically substituting Chime card information. Since 2018, Chime user accounts have grown from one to eight million, as of February 2020, attracting attention as the neobank also claims to have reached profitability during the pandemic through the tripling of its transaction volume. This transaction increase is crucial, as the company’s business model is centered on revenue from interchange fees. Other data suggests that most of Chime’s customers are not using it as their primary account, however, with the total number of individuals banking with the neobank estimated at 25% of the total accounts as of December 2019. This multihoming challenge helps highlight a central issue that has bedeviled multiple neo- and challenger banks. Chime intends to introduce personal lending and investment services in the future, putting it in direct competition with SoFi.
Another leader in the industry, Varo, has pursued an alternative path by obtaining a banking charter. The charter will enable Varo to move beyond a reliance on interchange fees for monetizing no-fee checking and savings accounts by expanding services to include lending. Varo is in the midst of purchasing its two million customers from its partner Bancorp to make this transition. In this strategy, Varo demonstrates that some neo- and challenger banks may opt to move closer to traditional banking in seeking profitability.
The Incumbent Response
As FinTech players have captured mind and wallet share across a range of financial services, incumbent banks have responded vigorously. The response is warranted: a PwC survey of incumbent banks shows FinTech threatens market share (~70% of survey respondents), pressures margins (~65%), and increases customer churn (~50%). The incumbent response spans multiple strategies, pursued simultaneously and aggressively.
First, incumbents are lobbying in Washington to prevent SoFi and other neobanks from obtaining Industrial Loan Company (ILC) charters. Such charters would allow neobanks to receive FDIC insured customer deposits directly, rather than utilizing typical partner bank relationships, drastically reducing their cost of capital and enhancing competitiveness in the highly-profitable loan market. While lobbying is principally performed by banking industry groups like the Bank Policy Institute and the Independent Community Bankers of America, those organizations are backed by industry stalwarts including Bank of America, Goldman Sachs, UBS, Citibank, JP Morgan Chase and many more. Despite the daunting hurdles, a few select FinTech companies are seeing progress: Varo Money was the first neobank to officially receive a national bank charter in July 2020 and SoFi has received conditional approval for a similar charter., The approvals open a path for the select few neobank recipients to be true competitors across the range of consumer banking products.
Second, incumbents are launching competing products organically or acquiring consumer-facing FinTechs to bolster their digital-first offerings. Incumbents are banking on their existing customer base, brand recognition, and extensive existing infrastructure to take share in the rapidly growing FinTech universe. Importantly, their offerings are typically not innovated or differentiated; incumbents are flooding the market with more commoditized lending and savings products.
Marcus, by Goldman Sachs, is arguably the most successful of these initiatives. The service offers high-yield savings accounts, personal loans between $3,500 and $40,000, credit cards via its Apple partnership, and business credit lines via its Amazon partnership. Since launching in 2016, Marcus has amassed $92 billion in customer deposits across 5 million customers, generating $1 billion in annual revenue. In addition to internal development, Goldman has bolstered the offering through acquisitions, such as its $100 million acquisition of Clarity Money in 2018. Other notable digital-only offerings by incumbents include HSBC’s First Direct (with 1.45 million customers), Santander’s Openbank (1.2 million), and Customers’ BankMobile (2 million).
However, many other incumbents have not been successful in their digital-only efforts, highlighting the high degree of competition in the commoditized universe of consumer-facing products. JP Morgan Chase shuttered its digital offering Finn after one year of operation after attracting only 47,000 customers. Wells Fargo closed its Greenhouse mobile-first offering to new customers after 3 years of operation (membership figures were not disclosed). The list goes on with other notable failures: RBS shut down its Bo unit, UBS sold off its SmartWealth offering, and Citizens’ Citizens Access only has 60,000 customers.,,
Finally, given the positive momentum neobanks have in the regulatory sphere and difficulty of launching competing digital offerings organically, incumbents have turned to partnerships with successful neobank offerings from startups and existing Big Tech players. Such partnerships provide incumbents with access to the high-growth digit market while providing neobanks with critical services to fuel their growth. The most recent and notable of such relationships is Google Plex. The service has partnered with 11 incumbent financial institutions to provide checking and savings account infrastructure, including behemoths like Citibank. Many partnerships take on similar structures: FinTech businesses provide access to digital-only customers while incumbents provide core services in the most regulated, hard to access areas of the market. The list of such partnerships is extensive, outlined fully in Exhibit 3.
Despite the perceived attractiveness of the partnership route (symbiotically solving critical issues for both incumbents and neobanks), the alternative will likely be fraught with challenges over time. Not only are participants sacrificing margin versus vertically integrated solutions, but frictions will arise as one side of the platform gains dominance (e.g., will Google ultimately seek a banking charter to displace existing incumbent partners if its Plex offering is wildly successful?). As a result, there are critical issues with every avenue of incumbent response today, leaving the door open for vertically-integrated neobank new entrants.
The Galileo Acquisition
In April 2020, SoFi acquired payment platform Galileo for $1.2 billion in cash and stock. SoFi’s stated intention for the purchase was to take advantage of “Galileo’s APIs to power consumer and B2B financial services like direct deposit, ACH transfer, IVR, early paycheck direct deposit, bill pay, transaction notifications, check balance, and point of sale authorization as well as dozens of other capabilities.” More importantly, Galileo’s API infrastructure layer already powers many of today’s leading consumer financial services challengers including Chime, Transferwise, Robinhood and Monzo. Noto has publicly stated that the “companies will continue to operate independently.” This dynamic means that the merger might help these SoFi competitors launch new product lines such as lending.
Facilitating financial payments, whether consumer or business, is not simple, nor is the technology behind it. Galileo enables neobank and digital banking partners to create financial products from scratch. FinTech infrastructure companies are transforming the technology and financial services industries through APIs, which enables software companies to offer financial products directly to their end customers . Three popular use cases for these APIs are: (1) Launching digital banks like Chime by providing accounts, physical and virtual cards and mobile apps; (2) Enabling consumer payments for companies like Transferwise through fraud prevention and analytics; (3) Helping delivery service companies like Shipt pay their gig workers through instant/near-instant payments. Galileo’s other APIs power commercial payment, investing and lending solutions.
Neobanks and digital banking alternative providers focus on providing best-in-class customer service and innovative financial products. Rather than develop these financial services capabilities organically, innovation in fintech infrastructure has led to the rise of Banking-as-a-Service (“BaaS”). Galileo’s Bank-as-aervice platform serves as the back-end that integrates seamlessly with existing back-office infrastructure of traditional banks. This allows non-banks to launch additional financial products and expand into additional markets in a timely, efficient and cost-effective manner (Exhibit 4 exemplifies BaaS stack).
Experts point to two primary BaaS business models that have emerged (Exhibit 5 further explores the market):
- “Pure BaaS providers: these fintechs offer banking infrastructure APIs to customers and partner with banks (typically 1–3) on the back-end. Examples Galileo, Synapse, Bankable, and Marqeta.
- BaaS providers with B2C operations: this includes both legacy (e.g., BBVA, Goldman, GreenDot) and digital-first banks (e.g., Cross River, BankMobile) offering APIs through BaaS platforms.”
The pricing for BaaS APIs is quite complicated and operates on a variety of revenue modes. Directionally we see the following in the fintech infrastructure space: For payments the API is free but each transaction is charged based on a percentage of transaction value. This could be up to 1.99% for larger businesses. Data APIs (eg. credit score) are charged a flat fee per million API calls. Account creation or loan origination has some revenue sharing agreement in place. Consent/identity (eg. KYC) APIs are charged on a fixed fee per API call basis.
Interestingly, the fintech infrastructure industry operates on a spirit of “coopetition” as banks providing services to their potential competitors unlock new monetary revenue streams and help keep them ahead of technological trends.
Strategic Options
Double Down on Membership
SoFi has thus far responded to intensifying competition by expanding its product portfolio in an attempt to own more of each customer’s financial services wallet share. Since 2015, SoFi has gradually expanded beyond initial Student Loan refinance products to offer checking, credit card, personal finance management, investing, secured loans (mortgages), insurance, and even small business finance products. It has wrapped these diverse offerings into the “SoFi Membership” product and augmented its nuts and bolts product with a smattering of non-financial service-based benefits like career coaching, offline member perks and experiences, and estate planning.
To consider the logic of this strategy it is important to first examine the strategic dynamics of the consumer financial services space. Neo- and challenger banks without banking licenses are fundamentally platforms that aggregate and connect consumers with a fragmented array of licensed financial institutions. SoFi, Wealthfront, Chime, and other players like them rely on chartered partner banks to hold deposits and assume credit risk by purchasing loan portfolios. It is the partner bank capital and balance sheet that underpins the neobank branded financial service that the consumer purchases.
While neo- and challenger financial service companies are platforms, they do not meaningfully benefit from network effects. Same side network effects are non-existent. A SoFi deposit account, borrowing, or investing experience is not made better by an additional member joining the platform. SoFi has attempted to create network effects by facilitating member-to-member interaction through events and experiences, but these are largely orthogonal to the core consumer and platform value proposition. Neo- and challenger banks like SoFi do benefit from weak cross side network effects: financial institution capital providers benefit from a concentration of customers which enables them to pursue fewer partnerships, while customers benefit from an amalgamation of BaaS providers bidding and vying for their deposits and loans.
Given the limited network effects in the space the purpose of the Membership strategy seems to be to reduce multi-homing, and expand customer wallet share through product breadth and cross selling. For this strategy to be effective, the neobank and consumer relationship will ultimately have to eventually mirror the bank and consumer relationship of the offline world. Traditionally, consumers banked with a single institution and purchased the lionshare of their financial services from that institution and rarely switched banks. With online user experience improvements and payroll APIs making it easier than ever to simultaneously maintain multiple relationships with an assortment of financial service providers it remains to be seen if the customer loyalty dynamic of consumer bankings past can really be recreated.
Vertical Integration
The Galileo acquisition, coupled with a pursuit of a national banking charter, gives SoFi the tools needed to own a larger portion of the value pool from the most popular and broadly adopted financial services in their portfolio. While the “Membership Strategy” prioritizes breadth and user growth, the “Vertical Integration Strategy” prioritizes depth and margins. Challenger banks have worked with infrastructure providers and partner banks to quickly release and scale new financial service offerings. Though enabling challengers to grow briskly, it has cost them on margins by trading low fixed costs for higher variable costs. Challengers pay a meaningful supplier “tax” on each consumer deposit account and loan because they are dependent on these partners. With lower per customer margins, challengers are incentivized to aggressively pursue growth to compensate, often resulting in price wars in the form of above market savings rates and below market loan interest rates.
SoFi could use judo strategy to avoid being drawn into a consumer acquisition tit for tat, choosing to instead focus on expanding product margins by vertically integrating. Tactically this would involve obtaining a banking charter to reduce the cost of capital (commensurately increasing their loan product profit margins), and using the recently acquired Galileo technology to bolster the core product stack, reducing the supplier tax paid out on each financial service sold. For this strategy to ultimately be a sustainable competitive differentiator, SoFi would likely have to shift the mandate of Galileo away from its B2B FinTech infrastructure BaaS mission and towards becoming a proprietary part of the consumer business. Gradually over time new infrastructure features would be reserved for SoFi’s products, instead of shared more broadly with the ecosystem.
For this strategy to make sense, aggressive competitor customer acquisition tactics must be unsustainable. With lifetime value to acquisition cost ratios shrinking, consumer financial services providers will eventually reach a breaking point where profitability again becomes the priority, at which point SoFi’s strong, vertically integrated product stack would leave it well positioned to compete and win. This strategy is an opportunity to zig while everyone else is zagging.
Pivot to Infrastructure
In a competitive space defined by a lack of strong network effects, SoFi has the opportunity to leverage its Galileo acquisition to move to a more defensible part of the consumer financial services value chain.
As the neo- and challenger bank space has evolved, a new layer has emerged: Fintech infrastructure. This layer, which connects neobanks and the financial institutions which provide them with capital, has proven to be notably more attractive than the two sides of the market that it serves for two key reasons. The first is high barriers to entry; building effective financial technology APIs is a complicated and capital intensive endeavor. The second is that multi-homing is rare. Due to the technical complexity of implementation on the neobank side, and the subsequent investments in building features on top of the platform, it is unwise and uncommon for neobanks to use multiple infrastructure providers at once, or to switch providers frequently. While it is more common for partner banks to work with multiple infrastructure providers, the partner bank side of the market is highly fragmented and commoditized, reducing the likelihood of sustainable value accrual.
It appears as though the FinTech infrastructure category has the characteristics to support an innovation platform (Exhibits 6A and 6B), similar to the kind Amazon Web Services (AWS) built for the cloud category. Just like Amazon, SoFi has the opportunity to be their “own best customer” for this innovation platform, as their consumer business gives them the insight and experience needed to create relevant and sticky features.
Recommendation
SoFi should pursue the ‘Pivot to Infrastructure’ strategy. Ultimately, this perspective is grounded in how the consumer financial services world will likely evolve over the next 5–10 years. Looking forward, a few key trends are expected to shape the category.
Consumer multi-homing can be expected to accelerate and eventually become the new normal. The internet as a distribution vehicle for financial services removes the most important driver of customer centralization: the physical bank location. With bank branches becoming increasingly irrelevant, and digital experience flows becoming consistently more user friendly, customer switching costs are plummeting. The benefits reaped by sticking with one provider (customer service continuity) pale in comparison to the benefits of multihoming (more relevant and competitively priced products). This has, and will, continue to lead to a world where consumers comfortably embrace a variety of financial service providers on a product-by-product basis.
As customers embrace multi-homing, digital consumer financial service providers will likely respond by becoming even more specialized with offerings: Consumer checking for elementary school teachers. Unsecured loans for firefighters. Automated sustainable investing for yoga instructors. Each of these hyper-niche companies will aim to differentiate via user experiences and product pricing customizations, while leveraging a powerful centralized toolkit of APIs and balance sheets to outsource the building blocks. This will lead to a cambrian explosion of hyper-targeted consumer financial services companies.
Reasoning back from this future, there is little sense in fighting the tide and attempting to recreate the “one bank, many financial services” relationship that consumers are primed to move on from. Instead we see an opportunity to utilize judo strategy to leverage their opponents (financial service incumbents) competitors (niche digital financial service providers) to achieve success. By becoming the financial technology AWS equivalent for these companies, SoFi can bet on the trend of neobanking without having to take the risk of fighting on the front lines. Instead, SoFi should leverage Galileo’s existing assets, and first-hand experience as a consumer financial services player, to build a best-in-class innovation platform that underpins the next 5–10 years of neobanking innovation. In the process SoFi will move from a market where network effects are sparse to one where they are plentiful and centered around the company.
SoFi can make this bold stroke without betting the company by maintaining its core consumer business as it builds and expands its infrastructure business. By continuing to operate its consumer business, SoFi will stay plugged in to the problems facing the customers for whom it aims to build. Additionally, these investments will benefit SoFi’s core business, allowing the company to reap many of the cost savings benefits described in the “Vertical Integration” strategy path. If the financial technology world fails to evolve in the way described above, and the “one bank, many financial services” model wins out online, SoFi will still have a legacy consumer business to fall back on, minimizing the potential downside. There is precedent for this kind of “co-opetition” as Amazon has competed with Netflix via Amazon Prime Video, while also serving as their infrastructure provider through AWS. While SoFi faces more competition than it did in 2015, it is well positioned to become one of the major winners of the consumer financial services industry wide digital evolution.
