By Steve Grob, head of group strategy at Fidessa
Barely a day goes by without a financial technology start-up claiming it is going to do to capital markets what Uber and Airbnb have done to the transport and accommodation industries. The journey towards true innovation in capital markets, however, looks much harder because of the entrenched technologies, processes and regulatory obligations that comprise global financial markets.
Capital markets today
In the wake of the financial crisis, we're witnessing the inception of an entirely reshaped industry driven by the twin pressures to demonstrate relevance whilst ratcheting down cost to reflect the new economics of market participation.
Combine this with the fact that regulators everywhere are pushing for even greater transparency, and it is no longer viable for the sell-side simply to intermediate between its customers and sources of liquidity. Buy-side firms are also on the hook to demonstrate to their own investors how they procure research, allocate costs and get the best possible execution quality from their brokers. Both buy-sides and sell-sides, then, now have to demonstrate the real value they bring to the party.
The regulatory hurdles of operating in today's capital markets, and the increasing cost of capital, mean that firms of all sizes have to scrutinise every aspect of their operations. They need to develop creative ideas to solve, simultaneously, both the cost and the relevance problems, defining which of their activities are necessary but non-differentiating and which can add demonstrable and differentiating value.
Innovation can add differentiating value to demonstrate relevance ('Type R' innovation) or help reduce cost ('Type C' innovation). Each has its own very specific set of characteristics and challenges but the same approach can be used to improve the outcome for both.
Examples of Type R and Type C innovation
Obvious examples of
Type R innovation in the sell-side include algos or smart routers, but a new
class of more exciting applications is emerging in the battle for relevance and
value-add. Providing context to any particular trading situation, these
intelligently bring together multiple sources of structured and unstructured
data to help the user understand the why rather than just the what. Other examples of Type R
applications are those that help traders interpret the trading landscape more
efficiently. Both can help the sell-side offer demonstrable value to their
The buy-side can benefit from understanding context better too. Today the problem isn't about getting data to support a particular trading thesis, it's about filtering out the noise, effectively curating what is left and using that information more imaginatively. Tools are emerging that allow portfolio managers to look intraday into back office systems to help drive better decision making. Similar tools are helping the sell-side better understand historical trading shapes that allow them to offer genuine insight to their clients.
Type C innovation seeks to solve a different problem set and is all about efficiency and driving down cost. With front office approaching a point of diminishing marginal returns in terms of further automation, there is an increasing focus on other areas of the workflow - post-trade in particular. Firms may boast very low breakage rates in affirmation processing, for example, but in an area dominated by legacy technology and often characterised by inefficient work practices, the cost of getting there is exponentially high. Applications that automate exception handling through standardised workflow are good examples of Type C innovation that can really drive down cost. Type C innovation is also being driven by the growing realisation that firms are unlikely to get to an acceptable cost level on their own; they're looking at how pieces of workflow can be standardised and operated on a collective basis. This works well for those areas that are non-differentiating, such as trade reporting, affirmation processing or data standards.
Blockchain technology, for example, has the potential to collapse the cost of clearing and settlement to almost zero, but it will only work if everyone adopts the same blockchain technology.
Barriers to innovation adoption
Assimilating new innovations is never easy, but fintech and capital markets throw up some distinct problems for would-be disruptors. Many innovators (especially the Type Rs) can struggle to convince large market participants that they meet the mark in terms of resilience, security and regulatory compliance. Also, many new innovations only really work if they can be embedded in the trader's existing workflow and operate dynamically so as to reflect what the trader is actually trying to do. Only by being tightly coupled with existing workflow can Type R innovation gain mainstream appeal.Another challenge for Type R innovators is the cost of selling and delivering their technology. Cloud-based delivery reduces the cost, but many firms are reluctant to allow their sensitive trading data to be stored in the cloud. This barrier is built upon well-placed concern about cyber security and infosec, and a political agenda that is determined to avoid systemic risk.
Any new idea only really works in practice once it is widely deployed, so Type C innovators face an additional hurdle. Where complete end-to-end trading workflow depends upon the collaboration of multiple counterparties, achieving uniform momentum across enough parties concurrently can be a significant barrier to new technology adoption. What is needed is the means to co-ordinate, lead and execute upon initiatives.
An ecosystem approach to innovation facilitates the interaction between old and new technology (Type R) and the bridge between old and new work practices (Type C). This interconnected network is empowered by elegant organisation which allows each member to be more successful than they would otherwise be. Examples from other industries abound, with perhaps the most famous being Apple’s App Store. The problem with the App Store approach in capital markets, however, is that the demands from financial institutions are such that any 'store owner' would either have to abrogate all responsibility for its apps or spend almost its entire time vetting and monitoring its app providers.
Whilst the fintech incubators can provide valuable guidance (and money) they can do little to help new firms execute.
What is needed is something far more controlled and based upon a genuine partnership between a proven, established provider that can cover areas such as workflow and resilience, and the newcomers that are now free to innovate in areas such as context and visualisation. The former takes full responsibility for the overall outcome to their mutual customers - commercially, technically and legally - and ensures that the newcomer’s technology is elegantly embedded within its platform to avoid poorly integrated or even conflicting parts. Doing this right takes time and money, but if successfully executed the outcome is likely to be way more certain and impactful.Ecosystems can also work well for Type C innovation. Competing firms need to be encouraged to work together and share ideas, and this is more easily achieved when organised by a trusted, neutral third party. This needs to extend beyond just the establishment of technical standards, though, to include defining the new workflow and then building and operating any resultant innovation on a utility basis at a fixed margin. By way of example, the specification for using FIX in post-trade affirmations has existed for over ten years and yet it is only relatively recently that a standardised workflow has been defined and is now being rolled out across the industry. This underlines the point that if the same organising party also has distribution across the buy- and sell-side, then the result in terms of driving industry change can be extremely powerful.
The road ahead
Capital markets will continue to reshape themselves and, in so doing, drive the need for the buy-side and the sell-side to innovate, both to demonstrate relevance and to reduce cost. Fintech innovation that isn't clearly solving one of these problems or the other will struggle to gain traction. Even those that do will still face some unique challenges in crossing the chasm into mainstream success. The elegant organisation that well-developed ecosystems can provide bridges the journey from the old to the new. Those firms that can help the buy- and sell-side assimilate new technology in this way will come to dominate.