Damned if you do, damned if you don't

In 2007, Estonian management consultant Kristo Käärmann moved to London to work for Deloitte.

Kristo still had a mortgage back in Estonia and every month had to send money from a British bank to his Estonian account to cover the payments. And every month, the bank charged him about 5% in foreign transfer fees.

With the price of a mortgage, those fees can quickly add to thousands of euros. Not great.

Luckily for Kristo, there was another Estonian living in London facing the exact same problem, but in reverse.

Taveet Hinrikus, who became the first employee of Skype, moved to London in 2006. He often needed to transfer money from his Estonian bank account to the one in the UK to pay the bills, facing the exact same high commission problems.

Estonians are smart people so they figured out that Käärmann could use his British account to send payments to Hinrikus while the latter could pay off Käärmann’s mortgage with his local Estonian account. By simply transferring money locally between each other to avoid cross-border payments, they were able to save thousands of euros.

This looked like a million-dollar idea so they decided to explore the concept further. They figured out the regulations, paid €1,500 to a Russian guy in Omsk to develop an MVP and then threw an extra €500 for some good Estonian design.

In January of 2011, TransferWise was launched as nothing more than a website and a €2,000 MVP with a TechCrunch article.

Kriso Käärmann, now CEO of Transferwise, explains what happened:

"Fifteen minutes after the article was published, the first person sent us 2,000 GBP to convert into euros and send it back to Germany. Another ten minutes and another 1000 EUR came in — that’s when we knew we were on the right track."

In its first year of operation, TransferWise moved over $13 million in transactions between British Pounds and Euros (the only corridor available).

Fast forward a decade, TransferWise processed £67 billion in customer payments during the last fiscal year, an 80% year-over-year increase, and generated £302.6 million in revenue and £20.4 million in profits.

TransferWise is an incredible business. 2020 is the fourth consecutive financial year in which they've been profitable whilst continuing to scale fast.

Most people credit their remarkable product and their SEO-and-referral-powered SEO loop as the main drivers. But the key to TransferWise's success is not the business per se: it's their position with respect to incumbents.

But before diving into why, we need to understand how TransferWise works.

The TransferWise magic

Every year, people from all across the world transfer an estimated $10 trillion to each other. Most of these transactions are handled by traditional banks – you log in to your online banking, do an International Wire, your bank does some dark magic on the backend and money shows up somewhere else.

Problem is bank networks are local, which makes international transfers slow, expensive and obscure. As of March 2020, the World Bank put the global average total cost of remittance at 6.79% of the transfer value.

This is an age-old problem. But it is also a money printing machine for banks, who take a cut of the transaction. Over $200 billion annually is lost in fees (and earned by banks) every year.

TransferWise does what Taveet and Kristo did a decade ago, but at an incredible scale: to transfer a customer’s money, TransferWise uses their own accounts to do so.

For instance, when sending money from Australia to Canada, the user will first transfer the money to TransferWise’s bank account in Australia. TransferWise then transfers the money from their Australian to their Canadian bank account. Afterwards, the money is transferred to the user’s bank account in Canada.

Almost every cross-border payment corridor has its unique cost structure due to regulations and digital ecosystems on each end point, but TransferWise’s general strategy is to make a slight gross (not net) profit on every transaction.

For that, TransferWise charges (on average) 0.68% of the transfer value and contrary to traditional banks, their pricing is always transparent, with the full cost of the transaction shown upfront.

Got it? Great. Let's move on.

TransferWise and counter-positioning

TransferWise has been cannibalizing the banks' customer base for over nine years now. That's because, for consumers, their business model is superior to the incumbent’s model due to lower costs, which can then be passed (transparently) to customers.

But TransferWise's business isn't rocket science. Banks always had the capabilities to do what TransferWise was doing since before Kristo had to pay his mortgage: (1) bank licenses or partnerships in multiple countries, (2) a technical team to build the solution, and what TransferWise lacked until recently, (3) the public's trust.

So if it's such a great business, why didn't banks build a TransferWise-equivalent back in the late 2000s? Or when TransferWise entered the market in 2011, why did banks decided to not build a clone to compete?

The entire key is that TransferWise is counter-positioned relative to incumbents, the banks.

Hamilton Helmer in 7 Powers: The Foundations of Business Strategy describes counter-positioning as a situation where "a newcomer adopts a new, superior business model which the incumbent does not mimic due to anticipated damage to their existing business."

Jon Kol explains:

Blockbuster’s main business was video rentals via brick and mortar stores, and a non-trivial portion of its revenues came from late fees. At one point Blockbuster had about 9,000 stores and collected as much as 16% of its revenue from late fees¹. When Netflix opened for business with its DVD-by-mail business in 1997, and a bold promise of ‘NO LATE FEES!’, it was counter-positioned to the video rental powerhouse Blockbuster.

Blockbuster could easily have launched a DVD-by-Mail service themselves, and launch one they did, albeit a mere seven years past the founding of Netflix. It wasn’t a technological barrier that caused Blockbuster to delay their decision to follow Netflix’s business model, rather it was likely the result of sound management. For Blockbuster, which made its money by renting DVDs through myriad retail stores and charging late fees on those rentals, any gains from a Netflix’esque ‘DVD-by-Mail’ business would have come at the expense of their large businesses.

International transfers are a BIG source of revenue for banks. They charge fees, take the spread on the exchange rates and use that to finance physical locations and under-pay their Customer Support.

This puts incumbent banks in a position where, no matter what they do, they'll end up losing to TransferWise.

So just like with Netflix, Blockbuster and late fees, if a bank decides to compete with TransferWise and adopt the new superior business model, it will see collateral damage for the decision because they'll immediately lose a considerable percentage of their revenue. But if they don't do it, they'll see TransferWise slowly eat out their customer base, one transparent cross-border transfer at a time.

Now, bank executives are not stupid. It's not like banks or whoever didn't see this coming. They are paid a few million a year to know what's going. And they do. They just, rationally, decide to milk the existing business model as much as possible until the opportunity disappears, even though the new model is what customers want.

From The 7 Powers:

The incumbent’s failure to respond, more often than not, results from thoughtful calculation. They observe the upstart’s new model, and ask, “Am I better off staying the course, or adopting the new model?” Counter-Positioning applies to the subset of cases in which the expected damage to the existing business elicits a “no” answer from the incumbent. The Barrier, simply put, is collateral damage.

TransferWise put banks in a position where the logical decision was to not compete against them, and let them take their customers because the other alternative is even worst. That is why TransferWise's winning.

When the cow dries out

The only problem with counter-positioning against an incumbent who is forced to milked their model is that, eventually, the cow dries out.

As TransferWise cannibalizes the banks' customer base, (a) the banks original business shrinks, and (b) the uncertainty around TransferWise's new business model diminishes.

At some point, what's left to milk is not attractive enough for the incumbent who, after paying a couple million to McKinsey to make the decision for them, decides to enter the market.

But TransferWise knows this. So instead of waiting for banks to decide that entering the market is a good idea, they are working with the banks.

TransferWise for Banks allows other banks to plug into the company’s system (via the API provided) to offer their customers cheap exchange rates and money transfers. Connecting to TransferWise’s API is free of charge, but just like with their other products, a fee is being charged whenever an international transfer is made.

From their 2020 Financial Report:

We’ve also seen increasing demand for TransferWise for Banks, with 8 integrations live to date. Banks recognise that delighting their customers with faster, cheaper and more convenient payments by TransferWise, but offered through the bank’s own app, means they keep their customers in their ecosystem whilst gaining a competitive advantage. The last financial year saw the expansion of the product into the US, Canada and Australia.

It's not that banks "recognise that delighting their customers with faster, cheaper and more convenient payments by TransferWise". What banks recognized is that their cross-border payments business is approaching zero AND that building a TransferWise clone is expensive.

This is a win-win. Banks can now connect to TransferWise for free and offer a better service to their existing customers, thus reducing churn. And TransferWise now gets the volume from banks who are OK giving it up because, well, there's nothing there anymore.

Damned if you do, damned if you don't.