Consolidation of Financial Services Among Vertical Software Platforms to Redefine Industry Roles

Removing Layers Of Complexity

For decades, payment systems have become increasingly digital but improved very little with regards to structuring. If anything, they have become more complex, with online payment processors adding another layer of complexity between the customer and the sellers, adding to multiple banks, card networks, and online merchants.

Source: Ark Invest

This structure might change radically with the rise of digital wallets. Increasingly, consumers are using these wallets not only to pay for services online but also to store their money, pay in person in a shop thanks to their smartphone, etc.

This creates a massive opportunity for financial services companies and digital wallets to become “closed loop” payment systems, bypassing banks and card networks entirely.

The Rise Of Digital Wallets

In 2023, digital wallet transactions rose to almost $2T, more than tripling since 2018. ARK Invest estimates this trend might continue, and digital wallet transaction volume will rise to $7T by 2030, making up 25% of  PCE (Personal Consumption Expenditure).

This would represent a solid 20% CAGR. This same forecast sees closed-loop transactions becoming an important part of the growth story starting in 2026.

Source: Ark Invest

For industry leaders like Block's Square, Shopify, and Toast, this would result in a 29% CAGR in US payment revenues.

Source: Ark Invest

Closing The Loop

While more usage of digital wallets by customers is expected, a trend that markets have not fully realized is the “closed loop” effect. When merchants receive payment from a customer, they can keep it in their digital wallet instead of sending that money to their bank accounts. This has the result of keeping the money in the network of the fintech company instead of just passing through.

This money in the merchant's digital wallet can be used for other purposes. For example, paying their employees into their digital wallets, or buying supplies and services from other companies, themselves using digital wallets.

Source: Ark Invest

Exponential Connections

The key characteristic of this transition is the network effect. The more digital wallets exist, the more useful they become. Employee digital wallets alone represent a $25B revenue opportunity for digital wallet providers (and still only 2.5% of the addressable payroll opportunity).

This would represent a 123% CAGR between 2023 and 2030.

Source: Ark Invest

The deeper market penetration of digital wallets and online payment also provides service providers with plenty of data previously locked in the IT systems of bank and card networks. This, in turn, can be an opportunity to expand the offering, including business and consumer loans, factoring, employee payments, etc.

Finally, the extra potential is providing a complete payment ecosystem, including software. If the digital wallets can already be used for payroll, it is best if they integrate with payroll software.

Source: Ark Invest

Investing Outlook

Will this spell the doom of banks and card networks? Probably not. However, it is likely to rebalance the relations between them and online payment & digital wallet systems. This could redefine the industry's roles, where everyday traffic of money and small transactions become mostly done through digital wallet ecosystems, and only larger financing like mortgages and bonds stay the protected domain of large financial institutions.

It is also likely that each service provider will become dominant in their industry vertical, like, for example, restaurants, e-commerce, etc., as the more specialized an offer, the deeper market penetration will be.

And, of course, all these changes might happen in the context of increasing adoption of cryptocurrency & public blockchains, which might prove transformative for the financial industry.

Financial Services Stocks

1. Block

Block, formerly known as Square, was founded by Jack Dorsey, co-founder of Twitter. Its first product, Square, was focused on helping small and medium businesses accept credit card payments using tablets as payment registers.

It also has a Cash App for directly transferring money from person to person; Afterpay, a buy-now, pay-later service; Weebly, a web hosting service; and Tidal, a music streaming service.

This full array of apps makes Block a good candidate for becoming one of the first closed-loop digital wallet ecosystems.

The company's expanding list of services has helped it grow its revenues and gross profit, with most of the profit coming from Cash App and Square. The company has been recording a positive net income since 2019.

The company's largest opportunity is with mid-sized companies, with less than 0.5% market penetration today. By comparison, market penetration was 13% for micro and 4% for small companies.

Cash App is used by only 20% of Gen Z and 17% of millennials, leaving much room for growth to Block. Nevertheless, it was the number 1 finance app in the App Store for the last 5 years and 8^th most downloaded app in 2021.

Block has also been known as a Bitcoin enthusiast company, notably putting 1% of its assets in Bitcoin in 2020. With TBD, it is building an open developer platform to facilitate access to Bitcoin and blockchain in general while bypassing financial institutions.

2. Shopify

Since early on, the e-commerce industry has been split between 2 segments: platforms like eBay, Amazon, or Etsy, and website builder and services providers like Shopify.

The first one provides a merchant with the ability to scale and a preexisting base of customers. The second one provides total control and ownership of the client base.

Currently, Shopify represents 10% of the US e-commerce market and expects to keep growing its market share. No less than 561 million unique online shoppers used Shopify in 2022.

From an online website builder in 2006, Shopify has evolved into a full-service provider, able to handle sales online (including on marketplaces), in person, on social media, in B2B (Business-To-Business), or for pop-up shops.

Source: Shopify

It is also one of the most powerful e-commerce platforms available, with integration into most important websites and channels and software companies. It also embraces the AI revolution with Shopify Magic and Shopify Sidekick, providing easy integration of AI into e-commerce owners' work and product management.

The company was also early in providing additional financial services, with the launch in 2016 of Shopify Capital, which funded $5.1B in 2023. After all, who but Shopify could have a clearer picture of the financials, risks, and prospects of an e-commerce company using Shopify for all its transactions and inventory management?

Source: Shopify

The deep presence of Shopify in the e-commerce industry makes it a rather obvious candidate for the emergence of closed-loop digital wallets. It is also very active internationally, bringing extra network effects into play.

And the network is still growing very quickly, with revenues up 21%-86% yearly, depending on the year, from $1.1B in 2018 to $5.6B in 2022.

Source: Shopify

3. Toast

Toast is a payment provider and digital wallet focusing on the restaurant industry. With $900B in sales (4% of GDP) and 12 million employees in the US, this is a very large market to address.

Source: Toast

Because of its narrower focus, Toast can provide unique services adapted to the needs of the restaurant industry beyond just payment processing (like tipping, takeout, online catering, time clock, scan-to-pay, gift cards, etc.). It also provides payroll management, recipe costing, or ingredient price tracking, encouraging restaurant owners to use Toast to manage their entire business, not just process payment like a card network.

The company makes most of its money from payment processing (financial technology solutions), with subscription services being a growing activity.

Source: Toast

Other service providers are looking to penetrate multiple industries, which provide them with a solid scale. Instead of competing straight with them, Toast is becoming the leading provider of the restaurants' financial and software needs.

This could help it build a solid closed-loop digital payment network, including vertical integration of B2B transactions.

4. Paypal

When the Internet was still young, payment processing was an unsolved problem. People lacked trust in online payments or sellers to put their credit card data online.

To solve these issues and make payment seamless, Elon Musk and Peter Thiel worked tirelessly to build payment processing companies. They would put aside their differences and merge their respective companies to form the so-called PayPal mafia. PayPal employees would later start LinkedIn and YouTube.

PayPal today has lost a little of its early days' luster, being seen as a “boring” payment company. This is rather misleading, with PayPal still a central keystone of e-commerce. The company also owns Venmo and Braintree, both acquired in 2013.

PayPal has 400 million active customer accounts and 35 million active merchant accounts in 200 countries in 150 currencies.

PayPal is also quite shareholder-friendly, with $19B in share repurchases since 2015.  Contracting margin, rising rate, and inflation have created anxiety among investors about PayPal's future, leading to a severe decline in share price back to 2018 levels.

PayPal is also innovating, notably launching a dollar stablecoin in August 2023, aiming to “Build the bridge between fiat and Web3 for consumers, merchants, and developers”.

Even if it lagged in innovation for a while, PayPal should not be too easily dismissed, as its massive pre-existing network could be quickly turned into its own “closed loop” ecosystem, especially regarding international transactions.