Don't Build Your Castle on Someone Else's Land
Why Blockchain Networks are the Ideal Foundation for Fintechs
Backstory
Three years ago, I was sitting in San Diego for a business leadership program with the lead investor in our startup. Among the many quips that passed through the slides during the two day event, the phrase “don’t build your castle on someone else’s land” lingered in my mind. At the time, I was working on a mobile app focused around NFTs for tokenizing real world assets (RWAs). I firmly believed the true magic of an NFT wasn’t in the current JPG heavy implementation but rather in the ownership itself acting as key to unlocking other data and information (often referred to as token gating).
About a year later, Apple changed the characterization of NFT wallets in the App Store to digital collectibles restricting NFTs from unlocking any sort of content in apps, banning external purchase links (ie links to marketplaces or collection’s websites), and requiring the in-app payment system which of course comes with a 30% fee. After several frustrating conversations with our contact at Apple, they insisted we couldn’t publish any updates to the App Store until we removed token gating and external links. What is the point of a consumer interface to interact with your tokenized assets if the interface can’t access any of the token’s utility? That’s like giving someone a key to a house but not letting them open the door and walk inside.
The AppStore isn’t the only network to enact sudden policy changes. Over the past year, many sponsor banks have changed their policies with regards to providing banking-as-a-service (BaaS) platforms for fintechs. These types of policy changes affected many businesses and developers, sometimes even ending the viability of a fintech.
Introduction
In the aftermath of that experience, I became much more attune to whether a project was building on top of land they owned or rented - and more importantly who it was rented from and what their incentives were. There are many networks, infrastructure providers, vendors, etc that you can use when building projects. This has a myriad of benefits including:
increasing the speed at which a project can ship
decreasing the time and costs it takes to build a project
delivering functionality that’s too regulated or cumbersome to do by the project
extending a project with specialized services
gaining access to audiences for distribution
In fact, it’s most often infeasible to build a project without some level of reliance on these networks. As an example, it’s usually not feasible to launch a native iOS app without relying on the Apple App Store.
Some common land rented by projects include:
Stripe for payment processing whether for subscriptions or single purchases
Instagram, TikTok or other social media following to drive traffic and awareness of the product
Amazon as the storefront
AWS to serve the application to users
The list goes on and on. In fact, most SaaS businesses create a reliance between their customer and their service. As I learned the hard way, these reliances create a systemic risk. At any time, the owners of these networks can change the rules and either damage or totally destroy the business.
Most often, these risks go unchecked especially in smaller startups. While some - and everyone should - have redundancy, there are far more people I speak with who rely exclusively on Stripe for card processing rather than offering it as one out of multiple payment options. Many SaaS startups go as far as to outsource the entire subscription management to Stripe through their whitelabel UI portal. The advantage of this approach comes in the form of decreased time and development complexity as startups can outsource the vast majority of billing but it comes at the cost of creating a single point of reliance in the entire revenue collection system in a company that could decide to, at any point at its sole discretion, deactivate your account. You trust that if you follow the rules you’ll be allowed to continue operating, however these rules could change at any time.
As companies mature, they often build out redundancy for their core vendors. This means integrating multiple card processing vendors, hosting critical application components in a multi-cloud strategy, and investing in diversified channels for customer acquisition. With infinite time and capital, all companies would certainly opt to have redundancy for any critical systems. That, however, is not the operating environment for any company so they must pick and choose where to invest their resources. Invariably, some reliances are much easier to mitigate than others.
Sponsor Banks are Rented Land
Fintechs rent land more than most other industries due to the heavy regulation that comes with banking and money movement. For most applications, the fintech exists as an interface to a sponsor bank which is the regulated entity actually performing the financial operations. In the US specifically:
Chime is an interface to Bancorp
Mercury is an interface to Choice Financial
Marqeta is an interface for Sutton Bank
Affirm is an interface for Cross River Bank
This isn’t to say fintechs are just a fancy user experience for banks - they certainly a lot of value on top of these banks - however it highlights a risk for smaller fintechs who rely on a single sponsor bank and an operational complexity of more mature fintechs who need to track, process, and reconcile across multiple sponsor banks. Some fintechs, such as Square, have acquired or created their own bank but usually the regulatory challenges, time, and capital requirements make this an ill suited strategy for most. The reason/excuse for many years has been that a sponsor bank brings a form of “adult supervision” to a fintech’s activities with supposed expertise in financial operations, compliance, reconciliation, and handling customer funds. Sponsor banks act as the regulated gatekeepers to banking and are ultimately responsible for the fintech programs run on top of them.
Now, I’m not arguing that sponsor banks are some sort of deficient entity that does nothing but destroy fintechs - that’s also untrue. Sponsor banks bring many tangible benefits to fintechs outside of the licensing and operations usually focused on protecting consumers such as FDIC insurance to protect user’s funds, continuity in the event of a failure, and regular audits and examinations on their financial condition, operations, and compliance programs.
However, banks are far from perfect and especially over the past year we’ve seen massive cracks where sponsor banks haven’t been the strong and stable foundations they’ve been marketed to be.
Silicon Valley Bank (SVB)
Signature Bank
Silvergate Bank
Evolve Bank
These are just the notable collapses. Far more sponsor banks have sunset sponsoring certain programs which doesn’t create national headlines but deeply impacts any fintechs built on those programs leaving them scrambling for a new sponsor bank to save their business. There are a wide variety of reasons for sunsetting a program ranging across risk concerns, underperforming revenue/margins, and broader regulatory initiatives as the most common. It’s challenging for fintechs to truly depend on commitments made by sponsor banks when those commitments are made by a deep stack of different people all of whom can be replaced, overruled, or change their perspective.
A Better Model for Fintech
What if there was a financial infrastructure layer that made strong commitments through code rather than through people? That’s what a blockchain network does. Instead of relying on people’s decisions, a fintech can evaluate a blockchain network based on the commitments it makes through the technology itself as well as the far more distributed governance structure. Instead of being controlled by one corporation who can change the rules at any given time, changing the the rules for most blockchain networks requires approval from the majority of the community - a community that the fintech itself is also a part of.
These strong commitments made by the network in its design creates the ideal infrastructure for most companies who run the risk of building their castles on someone else’s land, especially fintechs who face existential threats renting land from sponsor banks. In fact, this is likely one of the reasons why financial applications of blockchain including currency and money transfer have gained significantly more adoption that other applications in areas such as social media and supply chain tracking.
Chris Dixon from the venture capital firm Andreessen-Horowitz (a16z) explains the upside of these commitments in his book “Read Write Own” noting that companies and developers can add features and applications to these sorts of networks without fear that the networks will “change the rules, undermine them, and extract their profits later”. He goes on to say that while many developers may offer services like Square or PayPal as a payment option, most aren’t willing to become reliant on them for fear of unknown changes that could be disastrous to their applications.
Blockchain networks can’t be unilaterally bent to the will of any single individual (assuming a properly decentralized governance structure) which allows for significantly more investment of time, capital, and other resources to developing applications. These commitments create another core advantage of composability. Instead of having to build everything themselves, a founder of a fintech built on blockchain based networks can focus their efforts on delivering value to their customers, their user experience, and the problem they’re solving while using existing puzzle pieces already developed by others.
This composability replicates a very common development pattern from the open source community which has two core advantages:
Individual components are scrutinized and contributed to by a much larger group of developers which increases quality, security, and reliability. As more enterprises use a given component, it’s now in more people’s best interest for the component to perform well. As more people improve it, it now becomes used by more enterprises accelerating the cycle.
Development costs in both time and money decrease which allows for more and faster innovation. Enterprises don’t need to develop each and every piece of technology themselves which allows them to bring more applications to market and serve more customer needs.
These two factors, among others, have led to extremely rapid growth in blockchain based components including blockchains themselves, tokens such as stablecoins that represent fiat currencies, and structured products that underpin lending and yield. Fintechs - due to the vast scope of their applications - need composable, dependable, and predictable components. Blockchain networks are best positioned to deliver those components and will continue to drive strong capital investment over the long term further accelerating their capabilities.