When does a bank become a tech company?

It's a question with a seemingly simple answer.

When does a bank become a tech company? Or for that matter, when does any company become a tech company?

Today, every notable company runs on software, so the answer isn't as obvious as it seems.

Ben Thompson (Stratechery) tackles the question:

The question of whether companies are tech companies, then, depends on how much of their business is governed by software’s unique characteristics, and how much is limited by real world factors.

Thompson wants to know whether WeWork and Peloton are tech companies. Both have recently filed to go public, and investors have a lot riding on this question (though...there are a few more concerning questions).

WeWork rents office space. Peloton sells exercise bikes, treadmills and workout classes.

Just ten years ago, it would have been absurd to even consider them as tech companies. But today, it's an open question.

When we need to consider whether an exercise bike is a 'software platform', software has truly eaten the world.

Ben Thompson list five characteristics. If a company's software does some or all of the following things, it might be a tech company.

1. Software that creates ecosystems.
2. Software that has zero marginal costs.
3. Software that improves over time.
4. Software that offers infinite leverage.
5. Software that enables zero transaction costs.

I found Thompson's approach a deeply useful way to think about Kunai's work with financial services companies. I'm sharing it in the hope that it's also helpful to you.

Before we apply this framework to banks, let's establish a baseline through Thompson's analysis of WeWork, Peloton, and Uber.

The Five Point Framework

WeWork rents office space, and they use software to manage the process. Peloton sells bikes, and they use software to offer interactive workout classes that can be used with or without their hardware. At what point do these offerings tip the scales to thinking of them as full-scale tech companies?

Thompson begins with WeWork:

1. Ecosystems: WeWork claims it has a software-created ecosystem that connect companies and employees across locations, but it is difficult to find evidence that this is a driving factor for WeWork’s business.
2. Marginal Costs: WeWork pays a huge percentage of its revenue in rent.
3. Improvement: WeWork’s offering certainly has the potential to improve over time.
4. Leverage: WeWork is limited by the number of locations it builds out.
5. Transaction Costs: WeWork requires a consultation for even a one-person rental, and relies heavily on brokers for larger businesses.

1 out of 5. Based on this analysis, WeWork is still a real estate company; despite some semi-interesting software, they don't pass the tech company bar.

Here is Thompson's framework for Peloton:

1. Ecosystems: Peloton does have social network-type qualities, as well as strong gamification.
2. Marginal Costs: While Peloton is available as just an app, the full experience requires a four-figure investment in a bike or treadmill; that, needless to say, is not a zero marginal cost offering. The service itself, though, is zero marginal cost.
3. Improvement: Peloton’s product improves over time.
4. Leverage: The size, weight, and installation requirements for Peloton’s hardware mean the company is limited to the United States and the just-added United Kingdom and Germany.
5. Transaction Costs: Peloton has a high-touch installation process

2 out of 5. Also quite iffy, though there is more potential here than for WeWork. Thompson notes that Apple, as a hardware company, has some of Peloton's limitations.

Before we move into banks, let's take one more of Thompson's stronger examples, Uber:

1. Ecosystem: There is a software-created ecosystem of drivers and riders.
2. Marginal Cost: Uber reports its revenue as if it has low marginal costs, but a holistic view of rides shows that the company pays drivers around 80 percent of total revenue; this isn’t a world of zero marginal costs.
3. Improvement: Uber’s platform improves over time.
4. Leverage: Uber is able to serve the entire world, giving it maximum leverage.
5. Friction: Uber can transact with anyone with a self-serve model

4 out of 5. Clearly a tech company.

Are banks tech companies?

If you've worked at a bank, the answer is clearly no.

I'm trying to answer a different question: what it would take for a bank to one day be considered a tech company? More specifically, how do we identify the types of software projects that have a strong probability of making the shift?

I use Capital One as my example, because I spent three years there, working in various roles. I also believe that from top to bottom, Capital One clearly intends to become a tech company.

One: Software that creates ecosystems

• Capital One provides a limited set of open APIs that others can potentially use to serve their customers. Open banking is an incredible opportunity to create vast ecosystems, but most large banks (Capital One included) have responded with more enthusiasm than substance up to this point.
• Capital One provides private-labeled credit cards to a few large merchants and associations (which could be considered an ecosystem of merchants and customers), but this effort hasn't scaled dramatically or become an open platform.
• Like other banks, Capital One has attempted to work on a payments ecosystem, but have since moved to third party providers like Zelle.

Two: Software that has zero marginal costs.

Capital One's main business is credit cards. Therefore, the cost of bringing on a new customer is calculated in risk, rather than dollars. Software has already made the cost of bringing on new customers even more negligible, and new machine learning models may enable the bank to test algorithms that further reduce risk at every end of the market. Startups like Brex show us that there are dozens (if not hundreds) of credit innovations that take us far beyond FICO scores.

Three: Software that improves over time.

Capital One's customer apps can theoretically improve forever, and most banks are aware of several useful features they will be working on years into the future. These features are certainly compelling, but there are few barriers that prevent competitors from replicating them quickly.

Four: Software that offers infinite leverage.

Due to several limitations, servicing clients outside of the United States is an arduous task, so Capital One is more or less limited to the US market.

Five: Software that has zero transaction costs.

It costs little to nothing to bring on a new customer. In that respect, transaction costs are extremely low (again, partly because money itself is essentially a virtual good).

Beyond on-boarding, many of the transaction costs in banking are artificial. It costs very little to enable a merchant to accept your credit card. It shouldn't cost much to enable an overseas wire transfer. Innovative fintechs are figuring out how to reduce these costs, by maneuvering around large banks and government regulations, putting pressure on banks to eliminate artificial costs.

A loose 3 out of 5. Much more than I expected when I started this thought process, but as noted, this is partly because money is essentially a virtual good.

We will now follow Thompson into most important step of his framework: understanding a company's capacity for disruption.

Banks and Disruption

The true mark of a tech company is whether or not their technology is disruptive.

For example, Uber's ecosystem of drivers and riders was fundamentally disruptive. The ecosystem simply didn't exist before Uber. Moreover, creating this ecosystem gave Uber a winner-takes-all or at least a winner-takes-almost-all advantage - meaning that once the network scales to a certain level, it is extremely difficult for another incumbent to enter the space.

Here is how Clayton Christensen characterizes disruptive technology in his classic work, "The Innovator's Dilemma":

Disruptive technologies bring to a market a very different value proposition than had been available previously. Generally, disruptive technologies underperform established products in mainstream markets. But they have other features that a few fringe (and generally new) customers value. Products based on disruptive technologies are typically cheaper, simpler, smaller, and, frequently, more convenient to use.

Ben Thompson makes the same point, in reverse:

...if adopting technology simply strengthens your current business, as opposed to making it uniquely possible, you are not a (disruptive) tech company.

From this perspective, it is obvious that banks are not tech companies. Banks have gone online, they have developed apps, and they are playing with technologies like artificial intelligence. However, in each case, the technology is strengthening the bank's ability to conduct business as usual, rather than pushing it into uncharted territory.

We can look back over the last twenty-five years and make the point definitively. Since the advent of the Internet in the 90s, no bank has achieved a disruptive advantage over its competitors.

The Disruptive Bank

Where will you find the most potentially disruptive projects at a bank?

I'll discuss two of my favorite examples below, and I'd love to hear yours in the comments.

Software that Creates Ecosystems: Open Banking & Real-Time APIs

In the 1970's, a young executive named Dee Hock convinced the leaders at Bank of America to let him spin out its credit card business, so that other banks could leverage its system. The result was Visa, which became the foundation for the modern credit card ecosystem.

Banks have a similar opportunity today: Open Banking.

Large banks sit on a massive trove of data. They have also spent years cleaning their systems, refining their data and customizing their processes to satisfy regulators. This combination represents an insurmountable moat for even the most well-funded startup companies.

Fintech startups are springing up all over the place, and they have their own clear advantages: innovative services and better customer experiences. Their services could be enhanced significantly (and in many cases, be made possible) with access to large bank data and processing.

Banks are beginning to realize the power of Open Banking, but their APIs continue to be limited and historic, rather than open and real-time.

Fintech startups are just the beginning. Retailers, tech companies, schools, and countless other organizations could leverage banking data to provide financial services to their customers. The disruptive advantage starts at home: Open Banking would make it possible for banks to integrate their own data across products, making it possible to offer better services and more consolidated customer experiences.

The disruptive advantage belongs to the first large bank to develop and market a standard that others are then asked (forced) to use.

Open Banking is also a minefield. The business risks and regulatory constraints are concerning. Of course, that is also true of....every other innovative banking idea ever.

Software that has Infinite Leverage: Bitcoin

Yes, it's that time again...time to talk about cryptocurrency. No matter how much banks insist on closing their eyes and ears (and sorry, doing one random blockchain project in your innovation lab does not count as opening your eyes and ears), Bitcoin offers more potential leverage than any idea in financial services during the last 50 years.

For the purposes of ideation, I want to focus on the feature-set that Bitcoin and other cryptocurrencies represent. Bitcoin may eventually crash and burn, but now that it has existed for a decade, its feature-set will have an indelible effect on banking.

Bitcoin breaks Thompson's framework, because it turns the good itself into software. Bitcoin is programmable money. Peloton can't build a software version of a bike; WeWork can't build a virtual office space. Bitcoin turns money itself into software (of course, as I've noted above, money is a fairly virtual good in the first place).

Because it can be transferred without needing to be converted, Bitcoin has worldwide leverage. People can send money across borders and oceans without incurring significant transaction fees, even in cases where their government is crumbling and openly hostile.

If I were still working at a bank, I'd be lobbying to work on any project relating to Bitcoin. Yet, in the absence of that, there are many opportunities to emulate the enhanced monetary features of Bitcoin, such as payments.

Most of the transaction costs involved in remittances, inter-bank transfers, and merchant fees are artificial: they are not accurate representations of the labor or computing power involved in executing the transfer. With alternatives such as Bitcoin becoming viable options, large banks will need to respond. The first one to create an alternative standard that becomes ubiquitous will have a disruptive advantage.

Find the disruptive pockets

This article started as a note to self. I wanted to figure out how Kunai could target potentially disruptive opportunities at large banks, and I found Ben Thompson's framework to be a helpful tool for a thought experiment.