Is this the future of digital banking? The rise of challenger banks and their legality from the perspective of EU regulators protecting the rights of end users of cryptocurrency services

Official announcements from financial market regulators in individual European Union countries confirm the legality of individual challenger and mobile banks as electronic money institutions. One example is Revolut Ltd based in the UK, whose legal status in Europe before BREXIT is that of an electronic money institution established in the UK. Prior to Brexit, receipt of a UK licence granted by the relevant regulator, the Financial Conduct Authority, authorised Revolut to engage in the business of issuing electronic money and providing payment services, including maintaining payment accounts and executing payment transactions. Under the EU freedom to provide services and on the basis of the so-called “single European passport”, challenger and mobile banks such as Revolut Ltd are entitled to operate on the territory of other EU member states, including Poland (according to the notification received by the Polish Financial Supervision Authority from the Financial Conduct Authority on 06 June 2016).

However, the legality of operations is not related to the possibility of proper control and protection of end users using the services of challenger and mobile banks. In view of the above, for example, the Polish Financial Supervision Authority does not have the legal and operational capabilities to identify potential improper practices or actions of such entities at an early enough stage to prevent infringements of the interests of their Polish customers.

Regardless of doubts whether the use of challenger and mobile banks is supervised and safe for customers, the legality of such cryptocurrency services is becoming an everyday reality.

What are challenger banks?

The rise and growth of challenger banks are not only linked with the development of new technologies but also with the global financial crisis, the alleged misconduct by many Australian banks, the Covid-19 pandemic and many communities being underbanked in different regions of the world.

Traditional banking is linked with having physical branches for the in-person banking. While the transfer towards digital banking can be seen in traditional banking, it’s challenger banks who lead the way. Challenger banks focus on the digital-first approach and prioritizing user’s experience. Oftentimes, they offer solely digital products with no physical branches to visit. It does not mean that the number of their products is limited to personal finance apps – one can find digital current accounts, debit cards, currency exchange apps, savings accounts, lending products, and so on. They also offer their services 24/7, making them very convenient to manage, and offer their customers transparent and low fees.

Challenger banks attract many investors – including global investment banks, such as Morgan Stanley. Other notable investors include Qatar Investment Authority, House Of Fraser, JTC Group, Fidelity Investments, Alianz X, Tencent, Insight Partners, DTS Global, and many more. They also enter partnerships with different banks, to launch new products and services.

As mentioned above, challenger banks oftentimes tailor their services to underbanked communities or small, specific groups. 70% of the Latin America population is underbanked or unbanked – while also 70% of the citizens own mobile phones. Compared with good regulations, the region is one of the best for this sector, even with its fierce competitiveness when it comes to products offered by different companies. Same rules apply for underserved minority communities in different regions of the globe. On the other hand, some challenger banks use demographic targeting to cater to more specific groups, like LGBT+ community members, high-net-worth individuals, women in business or young people without credit history.

Revolut is one of the companies that took this approach. It focused on a niche they though to be underserved, people who travel frequently, and offered them first a digital currency exchange app, establishing itself on the market. It has become the first challenger bank to break even on a monthly basis and, as of 2021, has 15M individual users and 500,000 business users.

Different routes and what current players can teach others

While it’s much harder to enter United States or Australian markets, many countries or organisations such as European Union create ample opportunities for challenger banks, which will be expanded upon further.

When it comes to six prominent United Kingdom and Germany-based challenger banks, they applied three different strategies of entering the market within the United Kingdom and European union (which happened before the United Kingdom left European Union). The first one was described when Revolut was mentioned – so far, this approach generated the best results, although good results cannot be explained by the chosen strategy alone.

Atom Bank, Tandem and Tarling Bank opted to take the traditional approach and decided to have a bank charter prior to launching their products. Although this route seemed safe, it had its drawbacks – the companies missed the first wave of early adopters, the approval process itself was time-consuming and the charter itself can be revoked (which happened in the case of Tandem).

Monzo and N26 took what the CB Insights report called a “semi-traditional approach”. While Monzo launched a pre-paid card first, before entering the market with a full account, N26 partnered with Wirecard before having their own bank charter. The first solution resulted in stopping the rapid growth, as Monzo stopped adding new customers while transferring the old ones from pre-paid cards to current accounts. When it comes to N26, they had to give Wirecut a cut from every transaction. However, the two companies still gained more users than Atom Bank, Tandem or Starling Bank.

Up took a similar approach to that of N26 and partnered with Adelaide Banks and Bendigo Bank before getting a license in Australia, which allowed them to establish a trusted reputation – which, in turn, shows that the semi-traditional approach has its perks.

Volt, the first challenger bank based in Australia also opted to build a name for themselves as a challenger bank before launching their savings account. Currently they have established themselves as a baning-as-a-service platform and have partnered with companies such as Microsoft.

Opportunities to grow

Apart from entering different markets and launching new products on their own, challenger banks have different possibilities for growth. One of them is bringing new products through acquisitions (which happened in case of Tandem and Alluminium). They can also contribute to embedded financial services, as they can offer their infrastructure to others.

Another opportunities to grow come in form of partnering with fintech and with bulge bracket banks. Partnerships are costly and create contingency risk but they can still be very valuable to challenger banks – for example, smaller challengers can launch new product categories while in partnership with other players. Partnership with other fintech companies can also result in launching new services. The new regulations from United Kingdom and European Union support such partnership in their new laws, helping challenger banks grow and expand their services.

New regulations

Different regulations within the United Kingdom and European Union have helped challenger banks to grow. To name a few, United Kingdom’s new banking standard required their nine biggest bank providers of personal and business current accounts to implement open standards for application programming interfaces (APIs). European Union’s Revised Payments Services Directive (PSD2) had the same results for the sector as the beforementioned act – namely, both standards allowed third parties to access customers’ account data at their request in a safe and secure manner, which in turn meant challenger banks and other fintech companies could build new services for customers.

On the other hand, Australian Prudential Regulation allowed challenger banks to operate in a restricted fashion for two years while they waited for their full ADI licenses.

1) The Challenger Bank Playbook: How 6 Digital Banking Upstarts Are Taking On Retail Banking by CB Insights