What is the sexiest area to invest now? RegTech
Five months after the arrest of Wirecard’s CEO, the ripple effects of this giant fiasco are still felt across the financial services…
Five months after the arrest of Wirecard’s CEO, the ripple effects of this giant fiasco are still felt across the financial services industry globally. The main question in the wake of such disasters is always the same; “How do we make sure this doesn’t happen again”. As German regulators unveiled plans to prevent another Wirecard, the lack of recommendations for the industry to leverage digital tools is pretty surprising. Considering the exponential growth in business complexity, using the same old playbook relying on better engagement models to solve circumvoluted global issues seem pretty naïve — if we can ever accuse a German finance regulatory body of naivete.
Broadening the perspective above and beyond Wirecard, recent leaked documents from the U.S. Treasury Department show that “the biggest banks in the world are moving vast amounts of money for drug cartels, corrupt regimes, arms traffickers and other international criminals”. This can seem surprising considering that you can walk the corridors of any global bank (or at least pre-COVID one could) and, without fault, come across entire floors of employees working on AML remediation files. So how could it be that so many resources have been allocated to this problem with such poor results? Very simply; for decades, financial institutions have done what they do best when new regulations come up, which is “throwing bodies at the problem”. Unfortunately having armies of staff manually processing files is getting less and less effective — if it ever was — on top of being a major irritant for clients. It is clear that using technology is the only way for the financial services industry to abide to the governance, risk and compliance directives appropriately and efficiently. Accordingly, regulators of all breeds in North America and Europe have been inviting comments in relation to AML and more broadly RegTech.
On the back of my October article on Cybersecurity, Dennis Smith, Founding Managing Partner at Evolution Equity Partners commented about the “dreaded AML/KYC” as another security issue for global financial institutions and investment intermediaries globally. On the bright side, some financial institutions are waking up to the value RegTech companies can bring in terms of improved compliance to regulations and efficiency; COVID-19 and the latest revelations from the FinCEN files are without doubt fueling that increased interest. In an interview with Remonda Kirketerp-Moller, Founder and CEO of RegTech Muinmos, it became clear that the appetite for RegTech from U.S. banks has grown tremendously in the past few months. This shift makes total sense; consider for a moment the instant global KYC/AML capability rooted in sophisticated AI/ML offered by Muinmos, no homegrown solution mixed with human interactions will ever be able to compete. And it is scary to think that most FIs are actually relying on this mishmash of people, process and internally-developed tools to address such important issues that KYC/AML are.
Mindbridge.ai is another RegTech leveraging advanced AI/ML to detect potential fraud via automated audit solution; with errors that are 20 to 900 times more likely to be uncovered, once again it is difficult to justify the current manual way to audit companies. This would have been a useful tool in the context of Wirecard! CEO, Eli Fathi, and Founder, Solon Angel, share their thoughts on the New Normal in Financial services in a couple of interviews (Eli’s video, Solon’s video) outlining the importance of trust in the industry.
Strong Tailwinds
Lines have been blurring between AI, Enterprise Software, Cybersecurity, RegTech and Fintech, with many startups and scaleups straddling between the different categories. Behavioral biometrics BioCatch is a great example of that, leveraging advanced AI to offer ID verification to financial institutions; the company also supports regulatory requirements. BioCatch raised $145M earlier this year in a Series C led by Bain Capital Tech Opportunities Fund. In the same vein than Refinitiv, Trulioo and Alloy, RegTechs such as Biocatch benefit from strong secular trends buoying valuation in the space — increase in regulations, cyber-attacks, and digitization, combined with a need for cost reductions. In some instances, these secular trends are feeding of each other creating a virtual circle for these businesses and their investors.
I strongly believe in investing in companies benefitting from favorable structural tailwinds and riding the biggest wave. This is definitely the case with companies whose business models are supported by regulations. In the early 2010’s, I was leading a finance and technology team whose main responsibilities was to allocate the annual ten-figure technology budget amongst the different groups and projects for a large Canadian bank. As there were never enough funds, I will leave to your imagination to determine how unpopular I was in the organization; more interesting is how this budget was consistently allocated. First at the door was ~60–70% of the budget to “run the bank”, think sexy bug fixes and software upgrades; the second tranche was systematically related to regulatory and compliance projects, usually crowding out ~15–25% of the budget; the little that was left was allocated to transform and grow the bank. Even if technology budgets increased significantly in the last 10 years the pecking order is still the same…hence my endearing love affair with companies providing technology solutions in the GRC space, as they are consistently first to be funded.
Savvy institutional investors recognize the value of these tailwinds and are flocking to RegTech. The fact that these businesses can fall in multiple categories, (the aforementioned AI, Enterprise Software, Cybersecurity, RegTech and Fintech) allow virtually any VCs to stretch their investment thesis to participate in these deals.
In addition to healthy valuations and growth rates, we will see consolidation happening between some of the players; going from point solutions to platforms. This dynamic is very similar to the one we previously discussed in the context of cybersecurity.
Real-life implications
It is paramount to remind ourselves that, above and beyond the outsized financial returns that can be generated from RegTech investing, there are real-life implications behind the non-respect by financial institutions of regulations such as AML/KYC; enabling bad actors to live long and prosper being the main one. Timea Nagy, founder and CEO of the social enterprise Timea’s Cause, gave an enlightening interview sharing insights on the link between financial services, AML/KYC and human trafficking. Her company provides trainings to North American regulators, law enforcements and financial institutions on red flags detection related to human trafficking. Timea’s Cause has been working with institutions such as Capital One, Bank of America, American Express, CIBC and Verafin. Verafin being another fantastic RegTech offering multiple RegTech solutions to the financial services industry. Their human trafficking detection solution tagline reads “Fight back against one of the world’s most lucrative and detestable crimes”… these are words to live by that hopefully financial institutions will soon embrace.
Key Takeaways:
- Fraud linked with KYC/AML is omni-present in large global banks; RegTech offers the only alternative for FIs to comply with regulations efficiently,
- Blending of categories is happening for companies at the intersection of AI, Cybersecurity, Enterprise Software, Fintech, Regtech,
- Strong secular trends support Regtech’s valuation and growth (digitization, regulatory pressure, cyber-attacks, margin compression),
- M&A in the RegTech space will accelerate to enable the transition from point solutions to platforms,
- Savvy institutional investors have been directing more capital to RegTech to benefit from the space’s tailwinds — Bain Capital Tech Opportunities Fund, Blackstone, Evolution Equity Partners,
- Great investment opportunities are available at any stage and geography — companies to watch; Alloy, Mindbridge.ai, Muinmos, Refinitiv, Trulioo, Verafin,
- Real life implications of fraud linked with KYC/AML are devastating, enabling activities such as human trafficking and terrorism — social enterprise to watch; Timea’s Cause
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