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Longer Term InvestmentsFintech

Chief Investment Office Americas, Wealth Management | 10 April 2018 09:28 am BSTSundeep Gantori, CFA, CAIA, Analyst; Fabio Trussardi, Analyst; Michael Klien, CFA, Analyst; Bradley Ball, Financials Equity Sector Strategist Americas,[email protected]

• Driven by rapid urbanization, strong demand from millennialsand favorable regulations, we believe the global fintechindustry is at an inflection point and set to drive a major digitaltransformation in the financial services industry.

• We expect global fintech revenues to grow from USD 120bnin 2017 to USD 265bn in 2025, implying an average annualgrowth rate about three times faster than the broader financialsector's.

• Fintech's solid long-term uptrend offers investors above-average growth opportunities, in our view. Investors can takepart in this by investing in a diversified way in our themeof fintech companies, particularly leading payment players,platform companies and disruptors in emerging technologieslike blockchain and artificial intelligence.

Our viewDespite significant changes in the past few years, we believe theglobal financial services industry is at an early stage of a majordigital transformation powered by fintech, which is the confluence offinancial and technology-driven innovation.

The global fintech industry is at an inflection point due to bothdemand and supply factors. On the demand side, we believe rapidurbanization and the need for financial inclusion should drive demandfor fintech services that are centered around digital areas like mobility,cloud, analytics, social and emerging technologies such as blockchainand artificial intelligence (AI). Stronger demand from millennialsand favorable regulations are other supportive demand factors.On the supply side, the need for cost savings and the increasedefficiency of fintech services are forcing incumbent financials tolaunch fintech services, which, coupled with strong interest fromtechnology companies and a proven ecosystem, should increase theavailability of fintech services. We expect fintech revenues to morethan double from USD 120bn in 2017 to USD 265bn by 2025,implying an average annual growth rate around three times fasterthan the broader financial sector's revenue growth.

With double-digit earnings growth expected over the next eight years,we see fintech as one of the fastest-growing industries globally.

This report has been prepared by UBS AG and UBS Switzerland AG and UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures at the end of the

document.

Investors will be best rewarded by investing in a diversified wayin our theme, in our view, with a focus on payment industryleaders, technology companies launching disruptive fintech servicesand incumbent financial companies with a clear fintech strategy.Companies that are able to create platforms with network effectsaround emerging technologies like AI, blockchain and analytics arealso potential winners.

What is fintech?The term fintech should not be confused with the usual technologyspending by financial services companies on things like software,mainframes and data center expansions. Financial companies havealways been known as the biggest customers of many technologyfirms, as technology helps them to differentiate their services in highlycompetitive, service-oriented industries like banking and insurance.Financials on average spend 6–8% of their revenues on technologyalthough the share has been gradually declining since the 2008 globalfinancial crisis.

Ironically, the 2008 crisis is credited in large part for the surge infintech companies, as the focus of financials, particularly banks,shifted to comply with post-crisis regulatory developments and cost-cutting measures. This led to an innovation vacuum in the industry ata time when smartphones and corresponding disruptive forces, like e-commerce, social networking and mobile apps, were taking the worldby storm. Fintech companies appeared on the scene to initially fill thisvoid, but they later took off as standalone companies and as partner-ships with banks when the opportunities started to explode.

So, for the purpose of our report, we define fintech as the con-fluence of financial and technological innovation that facili-tates banking and financial services. Fintech, in our view, isabout digitalizing finance, which mainly takes advantage ofdigital services like social, mobile, cloud and analytics as wellas emerging technologies like blockchain and artificial intel-ligence (AI). For example, we view online banking as traditionalfinancial services IT, but consider mobile apps as fintech as theyleverage smartphone technology (e.g. the superior user interface,location-based services, etc.).

While fintech covers many technologies around these digital areasand emerging technologies, in this report, we divide the industry intoverticals and horizontals. Verticals are sub-industries within fintech,whereas horizontals are the key underlying technologies drivingthe digital transformation. For the purpose of our report, key ver-ticals include payments, insurtech, capital markets tech, wealth tech,online lending and other areas like regtech (regulation), real estatetech, etc. Horizontals include the four major digital technologies –mobile, cloud, analytics and social – and emerging technologies likeblockchain and AI.

Fig. 1: The fintech ecosystem

Source: UBS, as of March 2018. Note: Regtech = regu-latory technology

Longer Term Investments

Chief Investment Office Americas, Wealth Management 10 April 2018 2

Why fintech is at an inflection pointWhile technology has always been a key differentiator in the financialservices industry, whether solving major computing needs throughmainframes or setting up new banking channels like automated tellermachines (ATMs) or online banking, the unprecedented innovation inthe past few years has led to the emergence of fintech services. Webelieve the fintech industry is at an inflection point, as we see strongdrivers on both the demand and supply sides. This trend, we believe, isirreversible and will gain strong traction as the future financials land-scape is set to change significantly.

Demand driversUrbanization: Thanks to rapid urbanization globally, technologyinfrastructure has progressed swiftly over the past decade. Faster datanetworks like 3G/4G have extended wireless coverage greatly withthe rollouts of nationwide broadband programs. This has resultedin most of us being connected to the internet around the clock(24/7). The other notable development is the rise of the app economy.The mobile app developer, a job which was virtually non-existent adecade ago, is today one of the highest-paying occupations globally.Developers have built more than two million apps on both iOS andAndroid operating systems, and thousands of finance apps. With animproving technology ecosystem, and due to the proliferation of low-cost devices, smartphones have become ubiquitous in societies acrossthe world. Global smartphone penetration as a percentage of totalpopulation has almost doubled in the past five years, rising from 37%in 2012 to 70% in 2017 (see Fig. 2). With every incremental handsetsold being a smartphone, we are not far away from reaching universalsmartphone adoption or full smartphone penetration.

Driven by a desire to stay connected all the time and the need toefficiently multitask throughout a busy day, most of us in today'surban world have become "digital omnivores" and see smart devicesas a prime necessity rather than a luxury. As a result, our bankingand financial transactions have increasingly shifted to mobile or socialdriven alongside the increasing trend of consumerization. There istherefore rising demand for fintech services: payments are increas-ingly being made through mobile; people are turning to socialchannels like crowd-funding for their financing needs; and investmentadvise is increasingly being based on big data analytics. The trendis even more apparent in emerging markets like China, whichleapfrogged to a "mobile first" economy. For example, according to aUBS Evidence Lab study in August 2017, the combined use of mobilewallets like Alipay and WeChat Pay has surpassed cash across keycities in China. Hence, we believe with the urbanization trend willdrive strong demand for fintech services in the years to come.

Strong demand from millennials: The financial, economic andsociopolitical prominence of the “millennial” generation, those bornbetween 1982 and 1998, is continuing to grow at a rapid pace.

Fig. 2: Global smartphone penetration is rising

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10%

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30%

40%

50%

60%

70%

80%

2012 2013 2014 2015 2016 2017

Global smartphone penetration

Source: UBS, as of March 2018

Fig. 3: Millennials – the global guardians of capitalGlobal private wealth of millennials (USD trn)

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25

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2015 2020

Source: UBS, as of June 2017



Accounting for 27% of the global population, they held USD 16.9trnof the world’s private wealth in 2015 (see Fig. 3), and by 2020,that could rise as high as USD 24trn – or roughly 1.5 times theUS’s national output in 2015. In our report published in June 2017,"Millennials – the global guardians of capital," we identified, amongothers, two unique characteristics of millennials: First, millennialsare digital natives, which means their high fluency with technologyshould drive increasing demand for digital services. Second, millen-nials call for a wide choice of content, conveniently delivered, thatmeets their varied affinities and needs. We believe these two charac-teristics make fintech services a natural fit for millennials. This group,which takes full advantage of digital technologies around social andmobile, should find fintech's unique features particularly appealing,such as the better user interfaces, integration with other financialapps/platforms and personalization.

A UBS Evidence Lab study in November 2017 highlighting thegrowing demand for fintech services from millennials found that they,on average, make 2.26 financial transactions per week on their smart-phones, versus 0.83 through a branch (see Fig. 4). With millennialsset to control an even greater share of global wealth in the future, asthey are positioned to benefit from one of the largest inter-genera-tional wealth transfers in history, their affinity toward fintech servicesshould be a strong growth driver of the industry.

Favorable regulation: In addition to strong demand from con-sumers in particular, regulators across the world are in support offintech services. From a regulator point of view, they bring much-needed competition to incumbent banks and financial companies,which should result in better pricing and incremental innovation.As seen in Fig. 5, according to the World Bank, the majority ofpeople in many emerging markets do not have a bank account.The success of mobile technologies like the M-pesa payment system,which reached 80% of households in Kenya within four years, hasmade many governments and regulators across the world realize thatthe disruptive and attractive pricing nature of fintech services facili-tates financial inclusion.

The G20 Financial Inclusion Action Plan (FIAP) 2010 laid out a fewprinciples to drive financial inclusion by using digital technologies.This has resulted in regulators becoming facilitators. The goals of theG20 FIAP include providing an enabling and proportionate legal andregulatory framework for digital financial inclusion, expanding thedigital financial services infrastructure ecosystem, and strengtheningdigital and financial literacy and awareness. Most regulators todayalso promote fintech innovation through the concept of sandboxes.A sandbox is an entity endorsed by regulators that enables temporary,limited-scale testing of a new product that may temporarily relax aregulatory requirement. The aim is to assess the potential benefits andrisks of a new product by easing its launch. Other demand drivers,from a regulatory perspective, for fintech include favorable (i.e. light)regulations for promising innovations, providing capital to upcomingfintech start-ups and cross-regional cooperation in promoting fintech.

Fig. 4: How millennials bank in IndonesiaPer week

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0.5

1

1.5

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2.5

Branch visit Use ATM Digital Banking

Source: UBS Evidence Lab, as of November 2017. Note:ATM = automated teller machine

Fig. 5: The need for financial inclusionAdults with an account in 2014 (%)

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East

Asi

aPa

cific

Euro

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Asi

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Latin

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eric

a&

Car

ibea

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sia

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Saha

ran

Afr

ica

Source: World Bank, UBS, as of March 2018



Supply driversStrong interest from technology companies: Thanks to forces likesmartphones, e-commerce and social networking, tech companieshave been able to disrupt many traditional sectors and industries.Fintech, as such, allows technology companies to disrupt financialservices, which, according to Bloomberg, generates annual revenuesof around USD 5trn. The strong interest from tech companies, bothsmall and big, is facilitating innovation and in the process causing thedisintermediation of many traditional financial services like payments,insurance, real estate and lending.

As a result, with tech companies only scratching the surface, wesee significant disruption opportunities in the financial services sectorthrough fintech as we see continuous interest from tech companies.fintech companies continue to attract significant financing, receivinga cumulative investment of around USD 60bn in the past five yearswith Asia contributing one-third.

Against this backdrop, we continue to see strong investment andinnovation in the fintech industry from tech companies over the nextfew years.

Strong interest from incumbent financial companies: While thethreat of disintermediation rises from fintech, incumbents know thatthe trend is irreversible and it is time to embrace innovation. Asthe popular saying goes, if you can't beat them, join them, andmany traditional financial companies have realized the benefits offintech which if leveraged with their existing loyal customer base andextensive distribution networks can help not only reduce costs butalso maximize revenues through new products and services. A UBSEvidence Lab study in 2016 predicted fintech can improve the cost/income ratio of global banks by 180bps (from an expected 49.6% in2016 to 47.8% in 2019).

Many banks today have innovation labs to promote fintech and havealso adopted a partnership approach with the startups, leveragingeach other's strengths. In addition to developing in-house fintechsolutions, with many financial companies either investing or nurturingstandalone fintech companies, there will be no dearth of fintechofferings from incumbent companies in the future. The initial resultsare impressive, with increasing penetration of mobile banking acrosskey markets (see Fig. 6) , according to a UBS Evidence Lab study inSeptember 2017.

A well-established ecosystem: The fintech industry is well past itspeak in the hype cycle as we believe the ecosystem is now well-estab-lished, with clear monetization strategies and growth visibility. Withmultiple stakeholders across technology, financing, regulation keenon supporting the fintech trend, we believe growth in the industry ismore sustainable as we believe there are more companies now thanin the past with proven business models and monetization in manyareas.

Fig. 6: Mobile banking penetration across keymarkets (in %)

0% 20% 40% 60% 80% 100%

ChinaTurkey

IndiaGlobal

South AfricaBrazil

MexicoSingapore

Hong KongRussia

USAAustralia

UKBelguim

FranceJapan

Mobile banking penetration

Source: UBS Evidence Lab, as of September 2017

How fintech is helping incumbent financials - Acase study

As highlighted earlier, many traditional banks todayfully embrace fintech. While we believe fintechcontribution continues to rise for many of theseincumbent companies, in our case study, wehighlight an Asian bank, DBS which is fully takingadvantage of fintech and digitally transforming.

In November, 2017, DBS held its DigitalTransformation Investor Day articulating its digitalstrategy. As management highlighted the companyhas been able to successfully transform itself from"damn, bloody, slow" to one of the global digitalleaders by fully leveraging key digital technologieslike mobile, cloud, social and analytics and in theprocess significantly improve its efficiency. Forinstance, DBS highlights that as part of its digitaltransformation, the company had only 11.2% of itsapplications in the traditional data centers in 2017compared to 90.3% in 2014 as the company hasbeen able to successfully transition into its optimizedcloud. The following data shows how digital todayplays an important role on its financials andperformance.

The rising digital influence on incumbentsHow digital plays a vital role at DBS

Superior returns from Digital segment

Total Traditional DigitalCustomers (m) 5.9 3.6 2.3

5.1 2 3.12.2 1.1 1.12.9 0.9 2

0.9 0.6 1.343% 55% 34%24% 19% 27%

2017 profit and loss (SGD bn)

Key indicatorsProfit before allowances

Cost-income ratioReturn on equity

CostsIncome

Income per customer (SGD '000)

Source: DBS, UBS, as of March 2018



While the industry initially suffered from severe talent shortages, con-tinuous investments in skill development programs across the globehave narrowed the gaps. Finally, as we discuss in the next few sec-tions, with strong growth expected in the coming years, the industryis in a sweet spot in terms of key supply factors like capital, talentand innovation.

Against the backdrop of strong demand and supply drivers, we believethe global fintech industry is at an inflection point, with industryadoption expected to take off. With likely more fintech public listingsexpected in the next 12-18 months, we believe fintech as a trendshould gain more investor traction.

How big is the fintech market?Today, clear industry projections on fintech is missing. We believe afew industry observers have significantly underestimated the oppor-tunities by accounting for the revenues of only unlisted companies orby including every technology spending at financial companies.

Based on our calculations, the combined fintech revenues for all thefintech companies stand at USD 120bn, or low-single digits as a per-centage of global financial revenues, which we believe is plausibleas fintech today accounts for 0-5% of the global financial sector'srevenues. We expect the industry size to reach USD 265bn in 2025(see Fig. 7), implying fintech as a percentage of overall financial rev-enues will reach mid-single digits, which we believe is reasonable. Insummary, we expect the fintech industry to report an average annualgrowth rate of 10.5% or 3x the broader financial services sectorduring 2017-25. Our estimates may prove to be conservative if fintechadoption is stronger than expected in emerging markets.

In the next few sections, we highlight the key growth segments offintech.

Fig. 7: Fintech revenues expected to post CAGR of10.5% during 2017-25Figures in USD bn

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2017 2025Fintech revenues (in USD bn)

Source: UBS estimates, as of March 2018

PaymentsFintech is transforming clearing, settlement and point-of-salepaymentsThe payments landscape has been transformed by the applicationof technology both behind the scenes (clearing and settlement) andat the point of sale (POS). Technology is impacting the payments"ecosystem" in profound ways and capturing ever greater volumesof payment flows for both banks and non-banks alike. Fintechplayers span a broad spectrum and include card networks, merchantacquirers, POS players, digital payment platforms, person-to-personcompanies, bill payment companies and money transfer companies.

The application of fintech to payments, clearing and settlement is low-ering barriers to entry and elevating the role of data as a valuable com-modity. Traditional security and customer relationships still matter;however, the value of long-term reliability and trust is increasinglysurpassed by ease of access, speed and accuracy. While winners andlosers will likely take several years to sort out, it is becoming clear thatincumbent payment service providers will have to modernize and dig-

Fig. 8: New opportunities for digital payments

P2P· Increasingly shifting to electronic and mobile payment

models· Deliver real-time, seamless experiences

G2C· Prevents misuse of funds, expands financial access, serves

as effective disaster relief instrument

B2C· Real-time disbursements of funds, especially powerful for

the "gig economy"

B2B· Still largely based on check and ACH / EFT· Multinationals seeking cross-boarder solutions

Source: Visa, UBS, as of March 2018

Note: P2P- Person to person; G2C- Government to con-sumer; B2C- Business to consumer; B2B- Business tobusiness; ACH- Automated Clearing House; EFT- Elec-tronic funds transfer



itize to keep pace with technological changes and customer expecta-tions.One fintech transformation that is already widely visible is in creditcard transactions where issuers, networks and merchant acquirers areleveraging digitization to enhance convenience and efficiencies acrosstheir product offerings. Meanwhile, other applications that have beenless evident so far, are in real-time payments (RTP) where the likelyearliest and largest use-case will be in business-to-business (B2B)and eventually spread to business-to-consumer (B2C), and person-to-person (P2P), (see Fig. 8).

The trend that some refer to as "Amazon-ification" of commercehas attracted a lot of market attention, but Amazon-related e-com-merce represents only a small fraction of the overall online paymentmarket. In fact, consumer transactions executed online span broadcategories in addition to pure online retail, including omni-channelretail and specialized online retail. Moreover, commercial paymentscan be divided among commercial cards (P-card, Fleet card, and T&E[travel and expenses] card), other points of interaction (checks andcash) and accounts payable (Automated Clearing House [ACH] andchecks).

All of these consumer and commercial "addressable markets" rep-resent an enormous volume of payment flows that could one daybe captured by fintech offerings. By Mastercard's estimation, thetotal market size of consumer and commercial payment flow is USD225 trillion (see Fig. 9), including carded (10%), ACH or automatedclearing house, a network used to clear electronics payments ormoney transfers (51%), and cash and checks (39%). The applicationof technology by all market participants aims to capture a growingshare of the as yet untapped 90% of payment flows that still ride onslower rails.

Technological trends are accelerating payment volumes

Cards over cash. The shift toward card-based payments instead ofcash and checks is accelerating due to the growing adoption of elec-tronic payments. The secular trend of cash-to-card conversion hasbeen a key driver for legacy rails including Visa, Mastercard, AmericanExpress and Discover for decades. While this trend has mainly influ-enced credit and debit card-based payments to-date, other areas ofbanking are increasingly impacted by the shift to digital, includingbranch-banking, treasury (custody, clearing and settlement) and othercorporate banking services.

Re-imagining the branch. The utility of the traditional brick-and-mortar bank branch is changing from transaction-based to sales-and-advice-based. This means branches will not only shrink in numberbut they will likely also become smaller, more digitized and efficient.They will also play an ever smaller role in cash processing with lowerteller and ATM costs and greater security. Branch evolution may befurther impacted by blockchain (distributed ledger) technology whichis increasingly disrupting banks' traditional function in the clearingand settlement of financial transactions.

Fig. 9. Market size by payment flowVolume in USD trillions

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2

225

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49

114

17

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11

86

PCE B2B P2P / B2C TotalCarded ACH Cash & Check

451 120 60 2251,2

90%

10%

Notes: Figures may not add up due to rounding. 1Includesabout USD 4trn non-purchased personal consumption.2Includes non-PCE card spend.

Source: Mastercard company presentation, Oxford Eco-nomics, Euromonitor International, Kaiser Associates,McKinsey Payment, UBS, as of 2016



Omni-channel takes off. Travel booking was an early adopter ofthe online channel with the introduction of Priceline and Expediain the late 1990s. Recognizing the ease of use and efficiency ofonline booking, airlines, hotels and other travel-related providers hasembraced the internet channel (Delta.com, Hilton.com). Amazon andother retailers have also caught on, as more and more establishedbrands drive increasing volumes online (Walmart.com).

Penetrating new markets. Consumer bill payment is anothersizeable market that is growing exponentially as adoption increases.Regular payments such as utilities, insurance and mortgages areincreasingly moving to the online channel. Consumers' comfort withbanking online or with smartphones and institutional acceptance ofdigital payments should get an even bigger boost from the launch ofreal-time payments in the US and Europe later this year.

Expanding beyond just retail. The growing convenience of digitaland mobile payments in business-to-consumer (B2C), business-to-business (B2B) and person-to-person (P2P) transactions continues todrive adoption and growth. Payment volume growth is spurred onby in-person-to-online purchase conversion, proliferation of low costacceptance infrastructure and increased usage of prepaid and com-mercial cards. In B2B payments, the main driver of digital adoption ofaccounts payable will likely be the widening availability of fast ACH.

Real-time is a reality. Real-time payments and fast ACH should be acatalyst for acceleration of digital payments. Real-time payments willbecome a reality this year in the US with the planned launch of TheClearing House (TCH), including real-time messaging, real-time set-tlement, and 24/7 processing. This new, fast and safe technology willlikely be quickly adopted by a variety of financial services companiesseeking to improve payment-related offerings to business customers.

Internet of payments. With the growing appeal of convenientonline and other forms of digitized shopping, the use of technologyin payments is continually evolving. Emerging trends involve the useof automated intelligence (AI) and internet of things (IoT)-based pay-ments. The IoT has increasingly become a part of everyday life withthe advent of the Amazon Echo and other in-home devices that havespurred home appliance companies, car manufacturers, and paymentservices providers to explore ways to integrate into the IoT mix goingforward.

Disruptors are good… New entrants have generally been goodfor incumbent networks, relying on existing rails for secure, fric-tionless execution. The so-called disruptors, including Apple, Google,Amazon and Square, are actually positive for existing networks asthey have generally partnered with incumbents and help drive cash-to-card and offline-to-online conversions. These newer players alsohelp force traditional players to invest in enhancements to keep pacewith expanding technical requirements.

…but still pose challenges. Incumbent payment companies arestill facing threats of disruption to their traditional business from

Fig. 10: Total global retail spendSpending is increasingly shifting from physical to digital

9% 15%

91% 85%

2016 2020

Digital Physical

4% CAGR

Notes: Total global retail spend excludes travel and eventticket sales

Source: Visa, UBS, eMarketer, as of March 2018



new entrants (telcos, startups and digital providers). Increasingly, thethreats of new entrants are coming from social media and emergingmarket players that have the ability to tap into previously untappedproducts and markets. The growing disruptive threat of the future istherefore not from a new attack on existing client bases where incum-bents still have scale, but rather disintermediation of the sizeablefuture market opportunity.Legacy rails still matter. Several mobile wallets like Apple Pay,Samsung Pay, Google Wallet, MCX and Android Pay compete forin-person payments. These "in-app" wallets address the lion's shareof in-person-mobile payment volume today, but they all still dependon the rails provided by Visa and Mastercard and their issuing bankpartners as the primary funding source. Meanwhile, online checkoutvia PayPal Express, Visa Checkout, Masterpass and Chase QuickPay allbenefit from legacy relationships/brands.

Security is key. Security remains a significant challenge for thepayment industry and must be at the forefront of any new and/or updated solutions. For example, in-store and online POS transac-tions that used to rely on a simple signature or magnetic strip havebeen replaced by EMV-chips and tokenization for authentication. Theemerging challenge is to ensure protection of data from cyber-securitythreats across POS as well as all new devices and channels.

Other services are emerging. Participants across the paymentfood chain increasingly demand additional services beyond simplefulfillment. Adjacent services include funding flexibility, consulting,data analytics and loyalty solutions. For example, digital wallets aregenerally reloadable using multiple channels (ACH, cards, Zelle andVenmo) and can help consumers manage funding methods. Thus,banks are increasingly required to offer these digital payment capa-bilities as part of basic account offerings.

InsurtechAs was the case for our definition for fintech in general, we also regardinsurtech as the confluence of financial and technological innovationthat facilitates how insurers do business.

The insurance industry has the potential to be materially changed bynew technology. As such, insurtech will drive greater divergence inearnings growth and profitability in the industry. A host of differenttechnologies, such as artificial intelligence, machine learning, Internetof Things (IoT) or blockchain, can help modernize the entire valuechain and even the business model. This results in a myriad of benefits,more accurate risk assessment and pricing, more personalized solu-tions, more efficient operations and processes, and, most importantly,an improved customer experience and greater satisfaction. In someareas, revenue potential should be enhanced and cost savings for theindustry are significant. Insurers can benefit from new product intro-ductions as well as improved operational efficiency, fraud preventionand more targeted marketing and cross-selling.



WealthtechThe wealth management business is theoretical one of the easiestfinancial services that can be disrupted by fintech companies as it is acapital light business. Banks conversely have a significant advantagein more capital intense products and services (i.e. corporate and com-mercial lending).

However, we do not expect fintech innovation to significantly disruptthe wealth management business, particularly with regard to theoffering to ultra high net worth individuals (UHNWIs). This is becauseUHNWIs generally have sophisticated needs and therefore prefer per-sonal interaction with relationship managers. Conversely, more dis-ruption has been noticeable in the mass market segment and withthe "millennials", mainly through robo-advising, where we think thatthe fintech offering will continue to gain market share.

However, it will be a very gradual process. In fact, several fintech com-panies just offer a cheaper while similar service compared to the estab-lished companies, leaving the price as the major differentiating factor.We think that these business models will take a long time beforemaking noticeable market share gains; this gives time to the incum-bents to optimize their costs in order to provide a similar competitiveoffer. Robo-advising is the main fintech proposition to enable com-petition in the wealth management business (for e.g. Nutmeg in theUK). We think it will not be a game changer, but will enhance com-petition in the form of reduced margins over time for the incumbentcompanies. The prices of robo-advisor-based companies can be up to75% lower than the ones of traditional asset managers; this partiallyexplains the constant price pressure affecting the industry, which isalso confronted with extremely low interest rates.

Currently, robo-advising has an almost negligible market share in theindustry, well below 1%, while investment houses (BoAML, Barclays)think that it may achieve a low single digit percentage market share inthe coming years. This "optically" limited market share target can beexplained by the very high fragmentation of the wealth managementindustry.

The ongoing reduction of bank branches in Europe (for e.g., Nordicand Dutch banks have cut their branches by roughly 50% from peaklevels over the last 5-7 years) will probably favor fintech companiesin the sense banks will have fewer physical human interaction capa-bilities with their clients, somehow equalizing the service with thefintech offering in the geographical area. However, branch networksare still growing in Asia, where the bulk of the net new money isachieved, favoring traditional bank services in that region and conse-quentially in a global context.

Fig. 11: Assets under management of majorrobo-advisers (in EUR bn)

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VanguardPersonalAdvisors

SchwabIntelligentPortfolios

Betterment Wealthfront Nutmeg ScalableCapital

Moneyfarm

AUM ( EUR bn )

Source: Barclays, UBS, as of March 2018



Looking at the differentiation among existing traditional players, wenotice that all the major banks are heavily investing in digital tech-nologies and we think that any cost savings will then be transferredto clients through lower prices, therefore diminishing the differenceamong competitors even further. Only early adopters will benefit ini-tially from savings related to digital technologies.

To conclude, we do not see fintech applied to the wealth man-agement industry as a game changer, while some disruption is visiblein the mass market sub-sector, which has standard needs and is themost sensitive to pricing, and in the "millennials" age category.

Capital markets techFintech or digital penetration in capital markets industry is still in itsinfancy. However, it is worth considering progress in related areaswhere today online penetration is promising and the seeds are poten-tially sown for digital technologies like mobile or emerging tech-nologies like AI. These include 1) online platforms where clients candirectly execute trades of securities and investment funds in themarket; 2) algorithm trading; and 3) crowd-funding platforms.

Online trading platforms are becoming increasingly relevant, particu-larly for private individuals interested in execution-only services at thelowest possible price. As we think that the majority of the investorsvalue advice highly, the main consequence we foresee from the dif-fusion of the online trading platforms is a pressure on trading feesin favor of clients, while they are unlikely to attract professionalinvestors, at least with their current offering. Given the trend is mainlydriven by consumers, we consider the area as a low-hanging fruit formobile technologies within fintech.

Meanwhile, equity markets are already predominantly electronic, witha high percentage of transactions executed automatically (see Fig.12). Trading is considered automated when machines decide, basedon algorithms, whether to buy or to sell securities. Investment gradebonds are probably the area with the lowest full electronic execution(roughly 20% of the total) as the agreement is mainly made over thephone, but things are changing and this segment is moving towardfull electronic trading. Of all the markets, automation is highest inthe currency market; in some cases, more than 80% of FX trades areautomated (source: Bank of America, Haynes & Roberts, 2017).

The push toward automation also came from regulators after scandals(such as the Libor one) that showed how human-executed tradescould have been manipulated by fraudulent bank employees. Elec-tronic trading is hardly influenced by fraudulent wrongdoing andtherefore guarantees a higher ethical standard.

The market consequences of these trends are a structural decline incommissions and fees, which favor clients, and frequent periods ofhigh volatility generated by high-frequency automated trading basedon algorithms. The relatively high share of algorithm-based trading inthe equity markets could be one of the reasons for the recent suddenresurgence of volatility.

Fig. 12: Investment bank trading which isalready electronic at leading banks (example JPMorgan, in %)

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80%

100%

120%

Equities Macro Spread

Tickets %electronic Notional %electronic

Source: JP Morgan, Barclays, UBS, as of March 2018



In fact, many algorithmic strategies focus on momentum andvolatility. In particular, they tend to increase market exposure withlow volatility, or falling volatility, and vice versa. Because of theirlarge presence in the market however, they can become pro-cyclicaland somewhat a driver of the market with their behavior. At timesof confined volatility, they would increase market exposure but, indoing so, they would also further compress volatility. Conversely,rising volatility could trigger a domino effect, with many algorithmicstrategies selling, and therefore putting more pressure on equities.We still view high frequency algorithm-based trading as part of legacytechnologies; but thanks to significant progress made in AI, we arenot far away from AI bots taking control of electronic trading.Crowd-funding platforms today fit into the definition of fintech asthey provide support for small/medium capital raisings that are usuallybelow venture capital sizes. While industry prospects are improving,by just leveraging on technological improvement, we think these plat-forms can compete with banks across every transaction - for e.g.medium-sized deals and in the profitable IPO (initial public offer)segment - where the banks operate. Therefore, we see them onlycompeting with banks for small and typically risky loans as in the caseof start-up companies. To conclude, we do not think that they willpresent a major threat to banks' market share in the lending and IPObusinesses.

Online lendingBy the term "online lending", we refer to lenders which utilize onlineplatforms to match the needs of borrowers and lenders usually moreefficiently than traditional banks (see Fig. 13). The advantage for bor-rowers is to benefit from lower rates on loans than otherwise appliedby traditional banks, while lenders benefit from higher returns thanwhat they would have achieved with traditional investments at thesame risk level. There are many platforms in the US, China, the UKand other major markets. Some more mature platforms have alsostarted to provide loans directly, taking direct credit risk, though thisis not the bulk of the business (which is based on fees collected fromthe involved parties). Online lending currently generally accounts forless than 1% of total bank lending in the countries where the plat-forms operate, except in China where the online lending market shareis already above 5% of bank loans, leaving ample room for furthergrowth across the globe (see Fig. 14).

The size of the target market, theoretically equal to all the banks'lending, would allow very fast growth rates for several years tocome. However, we believe several barriers, ranging from capitalrequirements to credit-risk expertise, will limit the success. We seeproblems arising during periods of economic recessions, when tradi-tional banking, which depends on expertise on credit risk and lendingcriteria, might make a huge difference on the quality of the loans pro-vided. Given the platforms are relatively new, their ability to lend hasnot been tested during periods of very difficult economic conditions.

Fig. 13: Traditional banks vs. Online lendingbusiness model

Traditional banks business model

DEPOSITORS BANK

Online lending business model

LENDERS Online lenders BORROWERS

Savings Loans

Loans

Loans repayment

Fees Fees

BORROWERSLoan's interestand repayment

Interest onsavings andrepayments

Online lending platforms match lenders andborrowers needsThey make money from fees & commissions fromborrowers and lendersThey do not need to hold capital to absorbpotential losses as they usually do not lend directly

Traditional banks operate as intermediary betweendepositors and borrowersThey generate income managing the interestspread on the loansThe risk on the loan requires banks to own capitalto absorb potential losses


Fig. 14: China's P2P finance cumulative lendingFigures in CNY bn

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

1Q14

2Q14

3Q14

4Q14

1Q15

2Q15

3Q15

4Q15

1Q16

2Q16

3Q16

4Q16

1Q17

2Q17

3Q17

4Q17

Source: Citibank, UBS, as of March 2018



Similarly, we do not see online lending platforms being able to takesignificant market shares in the corporate business, where the needfor ad-hoc credit expertise is high in order to keep the lending businessprofitable. Conversely, disruption may take place in the consumercredit (usually with above-average risk borrowers, where current plat-forms mainly operate) and mortgage businesses, where standardlending procedures may be successful and they will allow gain ofmarket shares.

Given that economies of scale and trust among customers are keyin banking, we envisage few successful platforms in the respectivemarkets being able to remain profitable across the economic cyclesand to provide good cash dividends.

While we expect online platforms to continue to gain market shares,mainly in niche segments as described above, their growth ambitionsmight face a less favorable economic environment going forward. Inthe last decade, online platforms benefited from the synchronizeddecline in global interest rates, which has significantly boosted creditquality, while simultaneously investors’ risk appetite had to increase inorder to achieve noticeable returns. We do not know if such a benignenvironment will continue in the future and online platforms will beequally successful in attracting investors. Ultimately, market platformswill have the option to refer to banks or other institutional investorsfor their funding needs, which would likely reduce profitability but itwould allow growth to continue.

Other fintech verticalsWith most traditional financial areas set for disruption, digital tech-nologies could be implemented across industries and functions, suchas real estate, compliance or regulations, and remittances. The othertypes of fintech, like regtech (regulation) and verticals based on digitaltechnologies should help financials understand and comply with reg-ulations.

For example, digital technologies can help automate mundane com-pliance requirements, such as monitoring for fraud, by leveragingbig data analytics, for example, to correlate and analyze employeebehaviors. According to CB Insights, regtech start-ups have sealed585 deals worth more than USD 5bn in financing over the last fiveyears (see Fig. 15). Real estate and remittance tech are other promisingdevelopment areas, which should significantly disrupt their respectivefields in the next few years, in our view.

Driving the progress of these key fintech verticals are two major hor-izontal markets – emerging technologies like blockchain and AI; webelieve they will provide both opportunities and threats to existingfinancial companies.

Fig. 15: Global financing to venture capital-backed regtech companiesFigures in USD mn

0

200

400

600

800

1,000

1,200

1,400

2013 2014 2015 2016 2017VC-backed regtech financing (USD mn)

Source: CB Insights, UBS, as of March 2018. Note: 2017data is annualized

Fig. 16: Blockchain could generate an annual eco-nomic value of USD 300–400bn globally by 2027Figures in USD bn

020406080

100120

Fina

ncia

ls

Man

ufac

turin

g

Hea

lthca

re

Publ

icse

rvic

es

Util

ities

Shar

ing

econ

omy

Low-end High-end

Source: World bank, Bloomberg, UBS estimates, as ofOctober 2017



BlockchainBlockchain is a secured ledger shared by all the parties in a dis-tributed network, which records and stores transactions in an irrev-ocable manner. Blockchain, the core technology behind cryptocur-rencies, is a foundational technology that is set to transform manyindustries in the future, in our view.

In an industry that relies on intermediaries to conduct transactions,the distributed nature of blockchain could be seen as a major threat tofinancials. But it also has the potential to yield significant cost savingsfor incumbents and could be a key transformative technology forfinancials. Four out of five banks will have adopted blockchain tech-nology in some form by the end of this year, according to the WorldEconomic Forum. Based on our cryptocurrency report published inOctober 2017, we expect blockchain to generate annual economicvalue worth USD 300–400bn globally by 2027 across six major indus-tries, led by financials (see Fig. 16).

We have identified six areas where blockchain can create a significantimpact in the financial industry.

Post-trade services: While typical stock exchange transactionshappen in real time, post-trade services like settlement, custody, stocklending and collateral management may take days. Blockchain canhelp reduce reconciliation and other operational risks. The DTCC(Depository Trust and Clearing Corporation), a central bookkeeper fortrades in New York that processes almost USD 1.6 quadrillion worthof trades annually, is currently rolling out blockchain solutions for itspost-trade services.

Compliance: Blockchain can significantly improve the current know-your-client (KYC) and compliance processes across banks by creatingdigital identities for clients that are inter-operable across multiple plat-forms and institutions. The process would also allow clients to controlthis information and keep track of authorizations.

Trade finance: Blockchain can greatly enhance trade finance servicescurrently offered by banks by leveraging smart contracts, which canautomatically trigger contingent payments. This would help free upcapital and boost efficiency, particularly among small businesses andin emerging markets, where the bulk of transactions are still doneon paper. Even today in China, almost three-quarters of trade or billfinancing transactions are carried out on paper-based platforms.

Foreign exchange (FX) transfers: In early 2018, the Bank ofTokyo-Mitsubishi UFJ teamed up with six major banks from the US,Europe and Australia to start cross-border remittance services usingblockchain. In doing so, blockchain could help improve remittancespeeds and reduce transaction costs, relative to current processes.

Insurance claims: A major bottleneck in the insurance industry is theclaims management process, where often there are disputes betweencustomers and insurers, and between insurers and reinsurers.

Fig. 17: Blockchain should disrupt many tradi-tional functions of the financial services sector

Financials

Posttrading

Compliance

Tradefinance

FXtransfers

Insuranceclaims

DigitalCurrencies

Source: UBS, as of March 2018. Note: FX = foreignexchange

Fig. 18: Evolution of Artificial Intelligence




Blockchain technology can solve the problem by time stamping andauditing insurance documents, and by embedding smart contractsthat could automate payments once a payment-triggering eventoccurs.

Digital currencies: Blockchain technology can be used to improve theinter-bank settlement system for existing mainstream currencies. Earlylast year, a few global banks decided to join a group to create adigital cash system that would make payments via a ledger-basedtechnology, known as the utility settlement coin.

Artificial intelligenceArtificial intelligence is a set of tools and programs that make software"smarter" in a way an outside observer thinks the output is generatedby a human. In essence, one can perceive AI, at least in its currentform, to be like a normal human brain with functions like common-sense reasoning, forming an opinion or social behavior. AI, however, isan umbrella term used to cover a confluence of multiple technologiessuch as machine learning (which includes deep learning), cognitivecomputing, natural language processing, neural networks, etc. AIoffers significant cost savings to financial companies through highscalability, the elimination of both omission and commission errors,and the ability to instantaneously document and optimize processes.

The low-hanging fruit for AI within financial services is to leveragevirtual assistants, chatbots or speech recognition software for regularcustomer interactions, thereby lowering the dependence on tradi-tional banking channels like branches. Additionally, banks should geta major boost to risk management, which is traditionally an area ofchallenge, as AI can help better manage credit-risk assessments andanti-money laundering programs. In the longer term, as robo-advisersbecome more sophisticated. Banks can further utilize the technologyin product marketing and after-sales. Insurance is another area withinfinancial services where AI can have a long-lasting impact. AI, throughdeep learning, can elevate the region’s insurance industry throughbetter products and pricing, underwriting, target marketing and sales,claims management, and overall data mining.

The risk, which other industries face but more so with banks, is that AIwill level the playing field for emerging players from other industries,like the technology sector, to compete against incumbent financialgiants. It is therefore imperative that existing banking and insurancefirms take AI seriously and invest to maintain their differentiation.

Fintech growth fueled by venture capitalWith fintech companies still mostly in the startup stage, privateinvesting through venture capital (VC) funds remains the purest wayto invest in the sector. Such funds are best equipped to identifypromising companies and provide the necessary capital to help fin-techs grow revenues and achieve profitability, before exiting theirinvestments via an IPO or a sale at higher valuations. They also offeraccess points to a company's technology life-cycle, with the flexibilityto invest at an early, mid or late stage.

Fig. 19: Global VC-backed fintech deals

0

4

8

12

16

20

24

0

200

400

600

800

1,000

1,200

2012 2013 2014 2015 2016 2017

Number of deals (left hand side)VC-backed fintech financing (right hand side)

USD bn

Source: CB Insights, UBS, as on March 2018

2017 data in annualized



Since 2010, VC managers' appetite for fintech companies has beenstrong. Using data from CB Insights , we estimate that the sectorattracted more than USD 60bn of VC capital over the past five years,making it one of the fastest-growing funding segments of the techindustry. Managers have largely been focused on US startups. But inrecent years, funding of Asian fintech startups has increased, espe-cially in China and India. Europe has lagged so far, but activity ispicking up. For instance, Europe VC fintech funding grew over 120%year-on-year in 2017. Managers have also started to finance dealsin more frontier markets such as Latin America and Southeast Asia.Companies developing payments and lending services have tradi-tionally attracted the majority of VC fintech-based investments. Since2015, however, insurtech has been gaining more traction amonginvestors. Blockchain is also garnering more attention.

Using VC investments to gain direct exposure to fintech can provideaccess to high growth potential companies across all stages of theirdevelopment, with the potential for high returns. But such invest-ments naturally come with risk. Besides the inherently higher failurerate of startup companies, VC investments differ significantly frominvesting in listed shares on the stock exchange. VC is essentially anopaque and illiquid market, in which the same amount of informationis not available to everyone. Financing usually consists of multiplerounds of private financing by investors who purchase newly issued,unlisted securities. Each round triggers a capital increase and raisesthe risk of ownership dilution. Also, shareholder rights such as voting,veto, exit or liquidation rights can differ greatly between founder-entrepreneurs, angel investors, independent or corporate venturefunds, and other industrial or financial groups.

Securing access to the best fund managers to mitigate these risksis paramount to maximizing the chances of success. Competitionamong VC managers to fund the best companies is also very high.Investors should seek partnership with managers who are activelysourcing deals and taking a leading role in the company in whichthey invest, as opposed to employing a follower strategy and focusingsolely on unicorns and bigger deals. Manager selection matters, but sodoes portfolio construction. Investing in one VC fund has historicallyproved to be a rather inefficient way to access the asset class. Investorsshould commit to a long-term plan and build exposure across vintageyears, geographies, managers, etc. Importantly, VC exposure shouldbe considered within a global private market portfolio diversifiedacross various private equity and debt strategies, and sized accordingto an investor's risk appetite and goals.-Karim Cherif, Strategist



Investment implicationsWith strong growth seen across fintech verticals over the next fewyears, we are still in the early stages of rising fintech adoption.Our estimates of rising fintech penetration from low-single digitsto mid-single digits by 2025 may be very conservative, given thepotential upside risk of strong uptake in emerging markets. Fintechprovides both opportunities and risks to existing incumbents. Com-panies that embrace technology and are flexible at adjusting theirbusiness models should outperform their peers, in our view. Withmore than 10% revenue growth annually and moderate marginexpansion due to rising scale benefits, we expect our fintech themeto report low-double-digit earnings growth over the next few years.Fig. 20 shows the strong earnings growth potential continuing for ourtheme. Given our forecast of double-digit earnings growth over thenext eight years, fintech should be one of the fastest-growing indus-tries globally. Investors, in our view, will be best rewarded by investingin a diversified way in our theme of fintech companies, with a focuson payment industry leaders, technology companies launching dis-ruptive fintech services and incumbent financial corporations with aclear fintech strategy. Additionally, companies that are able to createplatforms with network effects around emerging technologies like AI,blockchain and analytics are also potential winners.

RisksKey negative risks include, but are not limited to:• Tighter regulations around fintech that could slow down industry

growth. As highlighted, favorable regulations are a key growthdriver for the industry, as the need for financial inclusion isforcing governments to promote fintech. A tighter regulatoryenvironment may therefore worsen fintech's growth prospects.

• Deflationary pricing continuing for longer than expected,resulting in margin pressure.

• Data privacy and consumer protection concerns. As fintech com-panies leverage data to provide a wide range of financial ser-vices, any potential data breach or cyber crime is a risk. Still, ourother Longer Term Investment theme "Security and safety" high-lights opportunities from the broader trend of rising spend oncyber security. Additionally, lower consumer protection comparedto traditional products can also slow down adoption.

• The emerging nature of fintech, which means the potential listof winners will likely be more dynamic and should continue toevolve. Hence, investors need to pursue a diversified approachwhen investing in fintech.

Key positive risks are accelerated M&A transactions, which wouldpromote the valuations of the industry, and more favorable regula-tions, which would likely facilitate fintech adoption, particularly inemerging markets.

Fig. 20: Strong earnings growth expected tocontinue for fintech companies (in %)

-10%

-5%

0%

5%

10%

15%

20%

25%

2015 2016 2017 2018 2019Fintech MSCI World

Source: Factset, UBS, as of March 2018



Appendix

Terms and AbbreviationsTerm / Abbreviation Description / Definition Term / Abbreviation Description / DefinitionA actual i.e. 2010A bn BillionCAGR Compound annual growth rate COM Common sharesE expected i.e. 2011E EmV Embedded value = net asset value + present value

of forecasted future profits (for life insurers)Shares o/s Shares outstanding UP Underperform: The stock is expected to

underperform the sector benchmarkCIO UBS WM Chief Investment Office

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