What happened

Shares of three recently public fintechs -- cryptocurrency platform Coinbase (COIN -2.74%), AI-based lending platform Upstart (UPST 0.33%), and Brazilian digital bank Nu Holdings (NU -1.87%) -- all fell on Monday, down 8.2%, 6.5%, and 1.9%, respectively, as of 12:30 PM EDT.  

The Federal Reserve has been raising interest rates to tame inflation, and, as of September 15, has accelerated its quantitative tightening. That means it's letting a lot of Treasury bonds and mortgage-backed securities roll off its balance sheet. That should have the effect of increasing longer-term interest rates, as those securities will now need to fetch a price that is attractive for private sector buyers. In fact, the 10-year Treasury bond yield touched 3.5% earlier today, briefly exceeding its June highs.

It had been a popular thesis that higher interest rates would benefit financial stocks, as they can earn more net interest income as they charge higher rates on loans. However, what we're seeing with these three fintech stocks is actually the opposite. Here's why.

So what

As a cryptocurrency brokerage, Coinbase earns most of its revenues from trading cryptocurrencies. Therefore, when cryptocurrency asset prices go down, it's heavily affected. And when there's a crypto bear market like the one we're in now, scared traders tend to pull back on trading as they wait for things to shake out. In that light, it's no wonder Coinbase is down again today.

Some thought Bitcoin (BTC -0.79%) would be a hedge against inflation, but it has turned out to not be the case over the past inflationary year. Bitcoin prices are actually down some 70% since last fall, when inflation began to take hold on the economy. Bitcoin prices took a big leg down in early trading today before recovering to a more mild loss. Unsurprisingly, Coinbase's stock traded down in sympathy.

What exactly happened to the Bitcoin-as-inflation-hedge thesis? It could be a question of several factors. First, although Bitcoin is over a decade old, cryptocurrencies are still a new asset class. Additionally, cryptocurrencies don't throw off cash in the form of dividends or repurchases, as other stocks and bonds do. So when liquidity is drained from the system, many investors -- especially older investors -- may need cash coming in now and be unable to hold securities that don't pay out dividends or interest income.

That's the same fate affecting all growth stocks that don't pay dividends, including Upstart and Nu Holdings.

Nu is also affected by higher U.S. interest rates, but for a different reason. Nu is an up-and-coming digital bank with operations in Brazil, Colombia, and Mexico. Rising interest rates in the U.S. could strengthen the dollar against other world currencies, a trend that has been going on for all of 2022. If the dollar strengthens, that means Nu's revenue and earnings in these other currencies would be worth less to U.S. investors.

Additionally, Nu Holdings is a very high-growth stock that's reinvesting in growth and doesn't have any current earnings. Its overall results have been quite strong of late, as it grew revenue 230% in local currencies. That's probably why it's down less than the other stocks.

However, longer-duration assets, such as growth stocks, also tend to be hit harder than other stocks when long-term rates rise, as higher yields lead to higher discount rates on future earnings. Therefore, the further in the future profits are, the less they are worth today in present value terms. So as a high-growth stock, Nu wasn't spared, in spite of strong results.

That phenomenon is also affecting Upstart, another growth stock. Upstart actually made profits over the trailing 12 months, but revenue declined, and the company swung from a profit of $37 million in net income in the year-ago quarter to a net loss of $30 million in the second quarter of 2022.

Upstart is a unique case in which rising interest rates have actually put pressure on the underlying business model. Upstart positioned itself as a pure lending platform entering this year: It would sell its loans to third parties, then recycle the cash into more growth. However, this year's rapidly rising interest rates have caused loan buyers to slow down or pause their purchasing. Obviously, if rates go much higher, these buyers don't want to be stuck holding a lower-yielding loan that has lost value.

Therefore, Upstart has had to slow its originations and has even begun to hold more loans on its own balance sheet. That increases the company's risk should those loans go bad. These compounding problems are why Upstart tends to plunge when interest rate concerns come to the fore.

Now what

The current risk-off sentiment amid rising interest rates generally means investors are eschewing "risky" assets. Unfortunately, that means just about every fintech stock is getting slammed even more than the average stock.

Fintech stocks have a bad combination of duration risk, since most are profitless or low-profit growth stocks, and underwriting risk, since they also make loans. Even Coinbase makes loans against its clients' crypto assets, though it maintains it has not lost any money on its client financing activities.

Yet just as rising interest rates have hammered these types of stocks, a reversal in trend could reignite them. If inflation starts falling and the Federal Reserve stops tightening conditions, these stocks could very well have significant upside, given that they are down so much over the past year.

However, it's hard to know when these trends could reverse, and this fintech bear market could last for some time. That said, those looking to position themselves aggressively for a market recovery -- perhaps younger growth investors -- should definitely be looking at the fintech sector.

For those looking to make bets on a sector recovery, you should make sure that any fintech stock you choose has conservative leverage and will survive the current downturn, and that it is well positioned to recover relative to competitors.