Something disruptive this way comes

IFR Review of the Year 2016
13 min read
Alex Chambers

Fintech start-ups have mostly played around the edges of investment banks’ core activities – but not for much longer. The global financial full-service model was already creaking, but an Uber-style disruption to front-office activity is no longer a distant threat.

Have you heard the one-liner about banks being badly run technology firms with a sideline in finance? It may be a poor joke but many a true word is spoken in jest.

Investment banks spent an estimated US$32bn in 2015 on front to back office IT services, according to Boston Consulting Group’s Expand Research. The scale of their spending is far larger once activities such as trade processing and tech development are included.

But there are few smiles from the bankers signing off on these budgets. This is not discretionary spending on new commercial initiatives that help the finance sector be at the cutting edge of the business economy, and compete with the likes of Google and Facebook in the hunt for the smartest talent.

Instead it feels much like a sunk cost: money that simply has to be spent, maintaining or fixing legacy IT systems but for which there is little tangible incremental return.

A technology revolution in finance is taking place, however. It just happens to be outside the traditional bastions of Wall Street and the Square Mile. Instead, these specialist financial technology (or, to use the now widespread term, “fintech”) firms are operating in (relatively) cheap innovation hubs such as London’s Tech City or Silicon Alley in the US.

BCG tracks 8,000 fintech start-ups but most of these target retail and commercial banking – only 570 are in capital markets. The consultancy firm argues that this disparity means the opportunity in core investment banking is substantial, all of which points to the word bankers dread most: disintermediation.

The last time bankers were worried about the tech sector was around the turn of the millennium but that was down to FMO – fear of missing out. Then the dotcom bubble burst and laid waste to hundreds if not thousands of start-ups. Now it is the banking industry that is struggling to come to terms with a burst bubble, and the wave of regulation designed to keep it in check.

It has become increasingly obvious that disintermediation is no longer a distant threat.


The problems facing the banks are well known: they are burdened with poor quality legacy assets, greater compliance costs and increased capital requirements. According to data and analysis provider Coalition, the return on equity of the 12 largest investment banks in the first half of 2016 was just 8.1%, including non-core assets – well below their cost of equity.

Fintech could allow banks to buy in innovation – to do the kind of thing that is hard to do within large global institutions that are subject to tremendous forces of inertia but also struggling to find their way in the post-financial crisis world.

Little wonder then that blockchain – or distributed ledger technology – has been pursued with such vigour as a mechanism to allow banks to cut costs via streamlining back-office operations. Anything that can shorten the time taken, and the costs incurred, in clearing and settlements could save billions. Since last year nearly half a billion dollars has been invested directly to develop DLT, according to IT consultancy Celent.

The risk facing banks is that if they fail to embrace the change they could be left behind as others do. BCG argues that front-office innovations may be easier to implement as they can be deployed one bank at a time, while back-office change may require industry-wide collaboration to fully reap the rewards.

Banks have already been subjected to disintermediation in various parts of capital markets. Secondary shares and most derivatives no longer trade face to face on exchange floors. In fact, cash equites mostly trade away from traditional exchanges entirely. With the rise of the algorithmic, high-frequency traders, banks’ market share of this business has collapsed, even if they remain a key constituent.

Market failure

Conditions are near-perfect for disruption in many other core investment banking activities, whether by fintech start-ups, long-established technology players (such as exchanges) or a combination of the two. The chances of success are much greater where incumbents or strategic players can partner with fintech and where there is a clear market failure, such fixed-income trading.

One example of a joint venture came in November, when Euronext announced a tie-up with Algomi – a bond market information network – to create a centralised market for pan-European corporate bond trading.

Despite long-running illiquidity in corporate bond trading, this is only the second big exchange to attempt to become a provider in this area since Deutsche Boerse’s brief tie-up with Bondcube failed after just a few months in 2015.

Front office in play

Fintech experts say start-ups have a greater chance of success in the businesses that banks are not actively protecting, are failing to innovate in or are not very good at. So where will disrupters prosper?

Already there has been an explosion in peer-to-peer and online lenders. These have met a growing need, since the financial crisis, where banks have struggled to lend efficiently to individuals and small and medium-sized enterprises.

Celent says P2P, or marketplace lending, has moved on from just providing funding for obtaining car loans and crowdsourcing for equity investments, and is becoming increasingly institutionalised.

Marketplace lenders have become regular users of the securitisation market in the US, and have also begun to issue asset-backed bonds in Europe.

“Marketplace lending is bringing something new – not only direct access to origination but the assets are digital – so it is a very transparent flow between the assets and the end product,” said Yann Ranchere, partner at Anthemis Group, a venture capital investment and advisory firm.

According to Ranchere, all front-office investment banking activities are now in play. He cites the rapid pace at which alternative primary capital markets are being created across equity, debt and loan markets.

“We’re seeing companies staying private for much longer as there is [alternative] liquidity available to them,” said Ranchere, highlighting the multi-year decline in equity IPOs.

“One of the reasons you would IPO is to provide liquidity to your investors. Now there are ways to provide liquidity without going public – you have less pressure to IPO.”

Fintech developments in data and infrastructure provision are playing a role here. Firms like eShares, an equity management outfit and marketplace for start-ups, provide services which make it easier for these companies to remain private, or entertain other routes for growth capital and liquidity. Having a digital footprint of a company’s stock options and warrants, for instance, is key to understanding the relationship between the different asset classes. Furthermore, it makes it easier to buy and sell – and for the company to monitor.

Debt capital markets next?

Observing the P2P development in debt for SMEs and individuals, bankers in the booming new issues market are becoming concerned that the wholesale primary debt markets may be next.

This is an area ripe for change, not least because, arguably, there has been no truly innovative development for 15 years – since electronic bookbuilding became widespread.

They worry about developments such as Ipreo’s Investor Access, which allows buyside traders to input orders directly into IssueNet, Ipreo’s syndicate-to-syndicate platform for the new issue market. The rationale behind Investor Access – which a number of banks support – is that technology can free-up front-office salespeople from the manual process of taking orders. Instead they can engage with clients on higher value trades and investments. But bankers see a risk, at some point in the future: they could be cut out of the bond syndication process almost entirely. The technology is there, even if there is not yet the will.

There is no evidence that Ipreo wants to move from its information and tech solutions mission. Nor would it be easy for it to attempt to disintermediate banks as they would quickly act to defend their new issues turf.

“There would be significant challenges for Ipreo,” said one DCM banker. ”You need hundreds of investors signed up. They may have the biggest but you can’t do deals with just the biggest. The ’backfilling’ with smaller investors is really important.

“It takes an awful lot of time to onboard people. You cannot underestimate the rollout challenges.”

Nontheless, a number of experienced bankers think it will not be long before some other form of fintech entity tries to take them on in DCM syndication.

Celent argues that big-data technologies are having an impact in driving efficiencies in post-trade activities like reporting, compliance, and risk management. But bankers also know that having the right data can give firms a kind of leading edge with clients, which is why some fear tech firms so much.

“This is a market waiting, primed for someone who is super-organised, and is able to combine good technology with a thorough understanding how the market functions,” said one long-standing market practitioner.

Origin of the (debt) species

Origin is a fintech startup that wanted to improve pricing efficiency for frequent issuers in the medium-term note market. These are very sophisticated borrowers, who use bilateral funding for as much as 60% of their funding. They do not really need investment banks to tell them where their curve is.

Then you have the buyside, flush with capital and looking for liquidity. Connecting borrowers and investors directly together on a platform seems an obvious opportunity for an enterprising technology company.

But in primary debt markets banks have maintained their leading position due to their heft. Their ability to source liquidity, leverage balance sheets, use long-standing infrastructure and their understanding of the regulatory frameworks are a powerful set of obstacles for disrupters to overcome.

The first two advantages – abundant liquidity and readily available big balance sheets – are no longer apparent. But an ability to deploy substantial infrastructure remains an important strength. Settling trades is a mundane aspect to selling bonds, but it is a key to success, as is the ability, explicitly or implicitly, to underwrite transactions on settlement day. Many issuers will not deal with an intermediary that cannot underwrite.

Regulatory moat

Start-ups also face regulatory hurdles. Over-regulation is the biggest complaint from bankers but if regulation makes bank returns challenging, it also acts to keep out nimbler competitors from various parts of the business. This regulatory moat is a significant barrier to entry for fintech start-ups. Know-your-client and anti-money laundering rules are two of the more obviously onerous rules that indirectly protect incumbents. There are also broader regulatory infrastructure concerns, such as having a full understanding of legal entities and what they are licensed to do.

Faced with all this it is hardly surprising that Origin – now in beta testing – ended up shifting to a symbiotic business model, one aimed at delivering cost efficiencies for dealers to help them do more with fewer people. Nevertheless, it could help those banks it is partnering with to cut costs and become more efficient by doing something they would not otherwise do.

There are bound to be fresh attempts to take on the banks. The provision of films, books and now taxis has been completely transformed by technology. Sometimes new technology will see incumbents’ practices changed rather than completely disrupted. Thanks to regulation and other infrastructure it is unlikely that wholesale banking will be entirely overhauled by fintech disrupters, rather that the best players will be react to embrace the change.

Management consultants say the successful incumbents will be those that deploy a business strategy that enhances user experience, data, technology and customer success. Banks will have to become a lot like the best technology firms to succeed.

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Something disruptive this way comes