Fintech is entering the third wave and this will be a wild ride

 

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Disruptive change typically goes through three waves:

Wave 1: Everybody says that this is revolutionary. This is the initial hype wave. The basic ideas are right, but the timing is way off.

Wave 2: Everybody agrees that this is evolutionary. This is when realists point out that change takes a lot longer than the original promoters of change led us to believe and this leads to the Wave 1 ideas being discredited.

Wave 3: Everything changes. Some incumbents fail, some transform and thrive and a new power structure emerges with some new players.

The Internet went through these 3 Waves

Wave 1: This is revolutionary. From about 1994 to the peak of the bubble in late 1999.

Wave 2: This is evolutionary. From mid 2000 to around 2004. After the dot com bubble burst, everything digital was declared dead and the only tech was enterprise tech and that needed to be incremental and very low-risk. Remember Intranets and brochureware websites?

Wave 3: Everything changes. From 2004 to today, when the search and social era of GAFA and BAT emerged. The change envisaged in Wave 1 took longer than forecast, but the eventual impact was far bigger than even the most wild-eyed visionaries had forecast.

The 3 Waves look like this in Fintech:

Wave 1: This is revolutionary. After the Global Financial Crisis in late 2008 to the Lending Club IPO in December 2014 and an acceleration in VC funding in 2015.

Wave 2: This is evolutionary. This is what we saw in 2016, when Bitcoin became totally discredited and the bellwether Fintech stock, Lending Club, blew up. The key belief in this wave is that incumbents control the pace of change. Nobody debates that change is needed and change is good, but entrepreneurs are told to knock politely on the doors of the incumbents and sell technology to them.

Wave 3: Everything changes. From 2017 onwards. This post explains why.

 

Why Fintech is a big deal and will meet a lot of resistance

Financial Services is a big % of GDP, of employment and of corporate profits. Many big companies, that are not labelled as Financial Services, make a lot of their profit from Financial Services. By some estimates, Financial Services accounts for as much as 40% of corporate profits in the Fortune 500.

This article on Bloomberg does a good job describing how finance came to dominate-the US economy and you could write a similar story about the UK and Switzerland.

Almost all of this can be digitized and is therefore susceptible to disruption.

In short, there is a lot of money at stake.

That also means that a lot of money is spent to persuade people that nothing will change and the status quo will remain. Perception does impact reality (aka mindshare leads to marketshare).

However, this is PR. The reality is that incumbents can no longer dictate the pace of change. They can benefit from change or be hurt by change, but what they cannot do any longer is dictate the pace of change.

 

Why incumbents can no longer dictate the pace of change

Imagine Blockbuster saying “we will decide when and how streaming video will roll out”. Or Kodak saying that about digital photography or Borders saying that about book retailing. Disruption does not happen like that, particularly if it is Big Bang Disruption.

Straws in the wind indicating change

You can wait until the change is obvious, or you can try to get ahead of the herd. To do the latter, you need to get comfortable with incomplete data that I call “straws in the wind”.  It takes guts to see a few straws blowing about and bet that this is caused by an invisible wind, but that is what the best early stage investors do. The signs of change are far from obvious, but “the answer my friend is blowing in the wind”. We see 5 of these straws in the Fintech wind today:

  • Wells Fargo fake accounts scandal. This was what happens when organic growth slows because of a secular wave of change and managers pile on the pressure to maintain the illusion of growth.
  • Funding Circle raising $100m. This indicates that P2P Lending is alive and well. P2P Lending is a disruptive model where banks don’t dictate the pace of change.
  • Lending Club stock recovering. Since the ouster of the CEO in May 2016, the stock has recovered from a low of 3.51 to around 5.50 which is an annualized return of over 100% (which makes it one of the best performing stocks of 2016). Of course you can also measure from the peak (bad) or from the pre IPO early stage days (very good). The key point is that the P2P Lending bellwether is alive and well. Disclosure, I was fortunate to buy some shares at 3.51 after writing this post. You can get insights like this in your inbox every day – its free and all we need is your email.
  • Defections from the R3CEV blockchain consortium. This indicates that a bank-led consortium may not dictate the pace of change in blockchain deployment. An analogy would a consortium of camera makers doing something with digital photography. Looking at past waves of disruption it is much more likely that a startup harnesses the pace of change that consumers want and that individual banks figure out how to transform themselves for this new reality.

 

Expect a lot of PR that it is business as usual

During the evolutionary wave, the incumbents see an opportunity to slow things down and control the pace of change.  They do this through both acquisitions (buying and closing down a competitor or changing how they operate) and PR.

The PR works, because people have an instinctive reaction to believe that the status quo will remain. Banks have not fundamentally changed for hundreds of years, so it is really hard to imagine a world where Banks are not at the center of Financial Services.

For example, read this view by Goldman Sachs that the third wave of Fintech will be all about “partnerships between big banks and startups.  

I don’t mean to pick on Goldman Sachs, but I think this is PR and not reflective of reality. Some incumbents will make the transition after Big Bang Disruption and I think Goldman Sachs will be one of them. From personal experience of selling technology to them, I know that they were Fintech before it was called that and that they fully understand the level of disruption that is coming.

Partnerships between Banks and Tech Startups are real and a key feature in how Fintech evolves, but what is different this time is how the world has changed from Traditional Fintech when Banks controlled the pace of change.

Today , both Banks and Tech Startups need a reality check before a real partnership can be negotiated.

 

Partnerships require a reality check by both parties

When Banks and Fintechs first date, it is a Venus and Mars story. If the relationship continues, it goes through three levels of maturity:

  • Level 1: Incomprehension. The other party just looks strange and it is hard to imagine a productive conversation. Whether the emotion is fear or disdain, the reaction is the same – inertia. Banks seek to overcome the incomprehension problem by funding Accelerators and Hackathons.
  • Level 2: Funding. Banks take minority equity stakes in Fintech ventures through their Corporate Venture Capital (CVC) unit. This is the level that most relationships have reached. Funding while still in Incomprehension mode is clearly dangerous.
  • Level 3: Strategic. This is where the relationship drives needle-moving revenues and profits for both parties. This may or may not include an equity relationship; the strategic relationship comes first.

As Fintech entrepreneurs and Banks seek strategic win/win relationships, they will move beyond Level 2. The Corporate VC wave of funding into late stage Fintech that we saw in 2015 was a classic sign of an overheated market. The real win/win deals will be at Level 3 and equity will not be a primary feature of those deals; they will be straightforward revenue share deals. Big Banks will have to gain the trust of entrepreneurs who might worry that Big Banks want to learn from them and then build in house or buy a struggling competitor. In other words, Big Banks could be competitors or partners. Smaller Banks don’t have an option to be competitors; they are partners that entrepreneurs can feel comfortable with.

A real partnership only happens when both parties have a clear answer to one strategic question:

  • The one question that banks need to answer is where in the stack do you want to excel? Do you want to be a platform for consumer-facing businesses? Or do you want own the customer experience? Both are great strategies, but it is a choice – it’s very, very hard to be both.
  • The one question startups need to answer is do you want to market direct (B2C) or via channels (B2B2C)? The answer can be “both”, but only if the startup is getting real traction in B2C. Without that, startups are really doing B2B, meaning they are selling technology to Banks (aka Traditional Fintech).

The difference between inevitable and imminent

During wave 2, realists point out the difference between inevitable and imminent. This has killed many startups. They understood what change was coming and how to position for it, but underestimated how long it would take – and that means running out of cash and that is the end for a startup. That is one reason startups are so hard. However, that is no consolation for incumbents. They face a relay race where the runners who give up exhausted can pass the baton (IP & team) to a new runner. Investors lose money on one runner and invest in the next one.

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The Daily Fintech Top 10 Fintech Predictions for 2017

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First, how did we do on last year’s predictions? Here are our predictions from last year with a yes, no, maybe self-assessment score:

  1. Bitcoin price will be volatile (no duh) but will end 2016 not much different from 2015. Bitcoin will fall deep into the slough of despond and entrepreneurs will avoid any mention of Bitcoin when fund raising. No. Got that one totally wrong about price (but right about slough of despond).
  2. XBRL will start climbing out of the slough of despond but won’t be recognized yet as moving into the plateau of productivity. Maybe. Saw a lot of real progress, but it is certainly not on most people’s radar. Maybe 2017 will see a breakout product.
  3. Momentum Capital (short term hype chasing) into Fintech will slow down but Innovation Capital (funding long term value creation) will increase because the reality of the opportunity is not impacted by the hype cycle. Yes. This was triggered by the Lending Club meltdown. You can pretty much track VC flows into Fintech based on Lending Club stock price. VCs liked the price decline as they could get into good companies at better prices
  4. More investment will flow into Underbanked as investors see the scale of the opportunity.Yes.  The biggest beneficiaries are in India (eg Paytm) and China (which overtook the US for VC funding into Fintech).
  5. Consolidation will start in Lending Marketplaces. There will be a fierce battle for a winner takes most network effects market (similar to what we saw in ride sharing in 2015).No. This may still happen in 2017 as the market globalizes.
  6. The strange inversion we saw in 2015, when private companies were valued higher (on paper at least) than public companies, will end in 2016. The headlines will refer to Unicorpses. Yes.This will reach an ugly finale in 2017 with Uber (see 2017 Predictions).   
  7. Analysts covering Banks will start referencing Fintech disruption when referring to a drop in profits at a major bank. No. I believe Fintech disruption was the root cause of the Wells Fargo scandal, but this is not a commonly held view. 
  8. Moves by Big Tech and Big Retail into Financial Services will eclipse moves by Fintech startups and will worry bankers a lot more. Lots of talk about moves by GAFA (Google, Apple, Facebook Amazon) and BAT (Baidu Alibaba Tencent).
  9. Calls for regulating Fintech startups more intensely will follow at least one high profile blow up. Yes. Happened after Lending Club CEO ouster in May. But the reverse happened as well – easier Bank Charters in many jurisdictions.
  10. The Great Convergence between Banks and Fintechs commences, as both get judged on the same metrics by consumers,regulators and investors.   Yes. We can see this in analysis of both Lending Club and Goldman Sachs Marcus.

Our predictions for 2017

  1. The end of the bank-driven phase of blockchain. The attempts by banks to coopt blockchain were like music CD retailers getting together to run MP3 music sharing sites or Post Offices setting up email services. Disruption means pain for some. Blockchain is disruptive to the current Financial Services world. The defections from the R3CEV consortium signals the end of this phase.
  2. We will see blockchain based real time settlement in equities markets move from R&D to live deployments. This may appear to contradict #1. However the disruption will come from a startup, not an existing Bank or consortium of banks. Banks will do well from the move to real time settlement (lower post trade costs) but they won’t drive this change.
  3. The InsurTech funding surge will slow down. This is because the early pioneers have to prove real customer metrics to get Series B & C rounds and as it becomes clear that Insurance incumbents are not asleep at the switch.
  4. Bitcoin price will go past its all-time peak of $1,242 (from 2014).. It will then settle back just below $1,000 for most of 2017. Unlike 2014, we won’t see a major price crash because of # 5 below.
  5. Bitcoin moves from its Darknet phase (illegal) to the early adopter Clearnet phase. This is when legitimate people charge in Bitcoin for legal transactions. This will start with cross border digital products. Because this brings new bitcoins into “circulation” with owners who also then want to pay in bitcoin, this starts a sustainable move to mainstream use which supports the price.
  6. Analysts covering Banks will start referencing Fintech disruption when referring to a drop in profits at a major bank. Carried over from 2016. I believe Fintech disruption was the root cause of the Wells Fargo scandal, but this was not a generally held opinion.
  7. Uber will not do an IPO and may do a private down round. This will signal the dramatic end of the public private valuation inversion (private higher than public valuations). This started in 2016 and will have its dramatic end in 2017.
  8. VC Fintech Funding in China, India, Africa and Latin America (the Rest) will be double VC Funding in America and Europe (the West). Even deals in the West will highlight growth in the Rest. Growth is the prize and growth is supported by a) middle class income growth b) no legacy technology constraints (“leapfrogging”).
  9. Most startup digital banks (“challenger” or “full stack” or “neobanks” will fail to get follow on financing. Investors will see more Incumbents get traction with their digital only spin offs and so they won’t see digital innovation as such a competitive moat.
  10. This one left blank for the big surprise. The big surprise may be triggered by macroeconomics and politics (as if we didn’t have enough of these in 2016), but will have a bitcoin element to the story.

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Regtech thrives on change: welcoming Trump, Brexit and China

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Heraclitus, a Greek philosopher of the 5th century BC, is quoted as saying

“Change is the only constant in life.”

His doctrine was around change being central in the universe. This has also been translated to “the only constant is change.” And this exactly why Regtech, the cross-sector Fintech category, thrives and will continue to do so.

Whether one regulatory body is becoming lighter or stricter, change is what Regtech needs to be able to serve. A modular Fintech design of Regtech services, is key in both of these cases. For example, if the US changes its strict and complex multi-layer regulatory structure as a result of the Trump administration, the Regtech sector will not be affected; neither the size of the sector, nor its significance in the multi-carriage train of financial innovation. The train has left the station and there is no turning back. In every compartment, there is a place (albeit a moving target) for Regtech and this will not change.

Regtech companies will continue to serve the huge market need of integrating legacy systems of the incumbents and at the same time offering these services in a dynamic (quick and cheap time to market) way as regulations change. Regtech will always have new clients and areas to serve, as a result of regulatory changes. The recent announcement of the Office of the Comptroller of the Currency (OCC) in the US to offer an opening to the US federal banking system to Fintechs; is an example, of how new clientele will be flocking to Regtechs can serve the new business needs of Charter Fintech Banks.

“A top regulator said Friday that his agency would for the first time start granting banking licenses to “fintech” firms, giving them greater freedom to operate across the country without seeking state-by-state permission or joining with brick-and-mortar banks.” By  WSJ Regulator Will Start Issuing Bank Charters for Fintech Firms.

The US Regtech Fintechs have been different than the European in two main ways. First, the number of European fintechs is much larger basically because of there are more regulations (e.g. MIFID, EMIR, MAR, CRDIV, PSD2, REMIT etc) that apply to all EU countries and second because in Europe bootstrapping and growing businesses without strong VC support, is more common than in the US. On the other hand, in the US the complexity of regulations is mainly due to cross-state differences and incumbents have tried to find other ways to circumvent these frictions; plus, entrepreneurs prefer naturally to pick naturally businesses that have a higher probability of being funded by VCs. Regtech overall hasn’t been the favorite baby of VCs.

The US Regtech sector will not be hurt, in case of lighter regulations by the new US administration, simply because any type of change will create new opportunities and clientele. Regtech Fintechs have an advantage compared to the Regtech offerings by incumbents (and there are many) like Thomson Reuters, Bloomberg, IBM, Oracle etc. only because they can adapt faster. Whether they will able to execute on this advantage is yet to be seen. We will be monitoring how the acquisition of Promontory by IBM plays out, what market share Accenture and Bloomberg gain as they all have no procurement issues, which is an important friction for Fintechs. FundApps, the UK based Regtech focused on serving the investment management sector, just announced that they will be opening a NY office in the Flatiron district. This is the first international Regtech move from Europe over to the US. Regtech is less local than it looks at first site. I foresee, more moves from Europe towards the US in 2017, rather than in the other direction.

“The only constant is change, in regional and cross-border Regulations”.

The increased fragmentation and complexity, resulting from Brexit, will also open up more opportunities for Regtech services. The pain points are simply changing.

Similarly, in Switzerland and the East, we are seeing new regulations that will also need to be served. All these changes, are great opportunities for Regtech companies to show incumbents especially, that Regtech should be seen as an enabler rather than an expenditure.

Regulations lighter or stricter, new regulations, more or less complex, fragmenting or integrating; are great market opportunities for Regtech Fintechs and for incumbents with Regtech services. The biggest threat to Regtech Fintechs is rather the incumbent Regtech offerings.

Daily Fintech Advisers provides strategic consulting to organizations with business and investment interests in Fintech & operates the Fintech Genome P2P Knowledge Network. Efi Pylarinou is a Digital Wealth Management thought leader.

Banks can learn from how Fintech Startups do Business Planning

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For a long time, startups had to learn how big companies do business planning. Now the flow is reversing and we see management consulting organizations pitch methodologies to big companies that have come from the start up world.

Now that software is eating the world, big companies seek to understand how such tiny young companies can have such big impact so quickly. 

I am deliberately using the word Business Planning rather than Strategic Planning because Strategic in a corporate setting has all too often had the connotation of being divorced from near term business priorities. Startups who need to hit KPIs in order to close the next funding round or meet payroll from revenue cannot afford to take their eye off near term priorities for long. Business Planning must have a long term view and a near term view – which brings us to Zoom Out Zoom In methodology. 

Zoom Out Zoom In methodology

When I heard Zoom Out Zoom In methodology being described at a conference, my instinctive reaction was:

This is how startups think.

Having been a startup guy for a much of my career, it just seemed intuitive and real. 

The problem with any methodology is that it quickly degenerates into a fad with magical thinking as in “all we need is a bit of Zoom Out Zoom In methodology”. So I hesitate to talk about methodology; it is the thinking behind it that matters and the integration with execution. 

The startup mantra is:

Focus on today and the big picture future, ignore the rest. 

It is a barbell approach. 

At one end of the barbell is today. Today is about the immediate stuff you have to get done to grow the business, to deliver to clients, collect cash and so on. In corporate term this means this quarter and next quarter.

If the next quarter looks bad, investors can dump your stock and you will be taken over – a strategic plan then gets thrown into the “round filing tray”.

The other end of the barbell is the big picture. The big picture is looking at how the world might look like 5-10 years from now and start building towards that. This is what Daily Fintech refers to as skating to where the puck is headed (not where it is now). 

The medium term external view that big companies have traditionally focussed on is tough to envisage. Another startup mantra is:

Change takes longer than we think but the eventual impact is bigger than we think.

That is the lesson we learned from the Dot Com era. Projections made c 1996-1999 were far too optimistic on timing but the eventual impact of the Internet going mainstream has been bigger than even the most wild forecasts from that era. It is the same with Blockchain technology – it will probably take longer than many think but the eventually impact will be much bigger than envisaged.

Zoom Out is not just Scenario Planning

A conventional strategic planning tool is Scenario Planning. The leader was an oil company – BP. Oil is a market where both demand and production are clearly understood. It is like post war manufacturing companies – you could easily forecast demand so then you could plan the manufacturing process. There are external factors influencing the price of oil (such as macro cycles and how cartels behave), but this is only one variable. 

In markets that are being disrupted (or facing digitization or undergoing a big shift or at an inflection point or whatever language you want to use), Future Scenario Planning is too rigid. 

John Hagel, one of my favorite management thinkers (who I finally got to meet in person at SIBOS in Geneva) describes this as planning based on trajectories not terrain.

During Zoom Out, one seeks answers to two questions:

 1. what will your current business look like in that future world?

 2. what does the profile of a market leader look like in that future world?

If profile of a market leader in that future world look looks like a minor evolution of your current business, then no strategic action is needed, it will be business as usual. If however, the profile of a market leader in that future world look looks fundamentally different to your current business, then the business needs to look at strategic options.

Zoom In, looks at the immediate things that could be done that a) bring in near term revenue and b) move towards the profile of a market leader in that future world.

Strategy every day
Startups don’t see strategic planning as a one time activity. They do a bit of strategic planning every day. The plan is constantly being evaluated based on market feedback. Every action is seen as an experiment on the market. There is no success or failure in an experiment on the market. You might have a thesis, but you are not attached to that thesis. Like a scientist running an experiment, you seek truth even if it invalidates a thesis. From that truth, you adapt the plan.

Your Zoom Out thesis has to be correct, but that can be totally vague in terms of timing and scope. It can be something like “at some point in the future”:

– people will shop online to save money and time
– people like to communicate with each other online
– people will exchange value online in real time using Blockchain technology

As you grow, the experiments become bigger and have more impact. The problem for big companies is that any experiment has to be on a massive scale and the cost (in terms of brand damage and management bandwidth more than financial) of getting your thesis wrong is too high. That is what leads to plans that take 6 months and a Minimum Viable Product that takes 2 years and only then do you find that the market is not interested. In those 30 months, the market has changed and some startups have got to Product Market Fit and are starting to scale.

The only way for big companies to fix that is with skunk works type intrapreneurial ventures within the company that operate without brand or other company resources other than small amount of capital (which increases as the startup hits metrics). The big capital decision is when to use the brand (at the scaling phase).

Daily Fintech Advisers provides strategic consulting to organizations with business and investment interests in Fintech & operates the Fintech Genome P2P Knowledge platform.

Goldman is leading the “Sell-side empowers the Buy-side” movement.

The Daily Fintech founders are at SIBOS in Geneva; reporting every day, snippets of insights on the Fintech Genome. Stay tuned on all SIBOS Insights conversations.

For years the Sell side was the incubator of financial innovation and the marketplace where products and services were designed and the platforms where market making and execution took place. The Buy side, were the institutional clients!

The buy side players have always included at hedge funds, asset managers at institutionsmutual funds and pension funds. Despite the fact that individual investors are technically on the buy side, the term has usually been reserved for professional money managers. Only recently, maybe, with the explosion of Fintechs democratizing the investing space that has been traditionally only available to professionals or HNW; we can broaden the definition of the Buy side.

For all kinds of asset classes (equities, fixed income, derivatives, structured products, ect), we all understood that the Sell Side was the service provider and in the driver’s seat or the power position; whereas the Buy side was the client. It was traditionally, a Sell-side market. The competitive advantages were on the Sell Side, the proprietary algorithms were mostly on the sell side. The Buy Side was captive (partly or wholly) to the Sell Side, in ALL the phases of the trading life cycle. Starting from portfolio construction, research, product discovery, execution, and post-trade monitoring.

Fast forward, to our customer centric era and ask yourself:

Is the Sell Side, still the Sell side and the Buy side, still the Buy side?

A 35,000 feet look

The Buy Side is still using the ubiquitous Bloomberg terminal or the Eikon Thomson Reuters tools.

Fintechs wanting to become the alternative ubiquitous interface for most of the phases of the trading cycle, continue to popup despite the fact that VCs and accelerators don’t recommend this subspace (“Forget about creating the next Facebook or Bloomberg terminal; look at AI and ML and Big Data and pick your focus”).

All the Fintechs that can potentially be part of the next generation platform that is mostly used by the Buy Side; are directly or indirectly empowering the Buy Side.

The Sell Side was into market-making, proprietary trading, brokering, and investment banking. Expensive and proprietary tools were developed in-house to support the lucrative businesses of running large books, taking risks, and market-making. All these businesses have been shut down by the regulators and the otherwise perceived competitive advantages, i.e. the proprietary software tools, have lost their resale value and their potential to generate revenues.

The Sell Side, has a Treasure in their vaults that is worthless for them (at least as used in the past) and is valuable for the Buy Side (it always was). The Sell Side can and should empower the Buy Side. Much like Google empowered me and you, and all the relevant B2B users, by offering its open source solutions on its platform.

Goldman Sachs is leading by example: “The Sell side empowers the Buy Side”

Gain a perspective from one of the many web-based applications, SecDB, that Goldman Sachs has developed in house:

“Securities DataBase, also known as SecDB, allows users to test out potential trades and assess the risk of those positions. Up until now it was so guarded that chief operating officer Gary Cohn said he wouldn’t sell the rights to use the technology for $1 billion—maybe for $5 billion, the Journal reported.” Source

SecBD, was initially developed to manage inhouse complex derivative positions. It grew into a sophisticated risk management tool, that professionals can use to integrate new information or change parameters for their decision making. It became the Risk management Bible, on your smartphone. Deutsche bank and the likes were salivating in the previous era, to license such a system.

Fast forward to today! Goldman says : “Just take it, for free” to its Buy Side clients.

So, what has happened that led GS to offer SecDB for free to its clients instead of of some sort of revenue sharing agreement with them.

Goldman Sachs is empowering all its trade-prone customers, the Buy Side!

Goldman has publicly confessed that they are sharing for free with their Buy Side clients not One but Three applications.

SecBD has already been mentioned. SecDB is able to calculate 23 billion prices for 2.8 million positions and 500,000 market scenarios (Source: FX Magnates). Marquee (maybe in honor of CIO R. Martin Chavez, known by everyone as “Marty”) and Simon (Structured Investment Marketplace and Online) are the other two. Simon is focused on structured products and helps clients design products based on their hedging needs or investment views; instead of spending hours on the phones between with Sales and Trading. Goldman Sachs aims to increase their equity-linked note business and to become a platform for brokers or other distribution channels that have access to a broader Buy Side segment. Marquee is the software that integrates Goldman Sachs technology for the entire trade cycle.

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Source: Business Insider

The Sell-side is empowering the Buy-Side. Goldman Sachs is leading the pack. In five years, we wont be using these terms anymore, as the platforms that can integrate all the parts of the trade cycle, will be what matters. Whether they originated from what we called “The Buy-Side” or the “Sell-Side” or the from the “outskirts” of the Wall, won’t be of essence.

The digitization of the Sell-side will be synonymous to becoming a platform empowering the Buy-Side.

The Sell-Side maybe the biggest threat to the vendors or the platforms traditionally serving the Buy-Side.

It will be a Buy-side market rather than a Sell-Side market.

Daily Fintech Advisers provides strategic consulting to organizations with business and investment interests in Fintech & operates the Fintech Genome P2P Knowledge Network.  Efi Pylarinou is a Digital Wealth Management thought leader.

The Convergence of Traditional & Emergent Fintech will enable more fruitful conversations

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In a few weeks time, about 8,000 bankers and their vendors fly into Geneva for SIBOS (the annual “gathering of the tribes” that is organized by SWIFT each year in a different city around the world).

The bankers who fly in want to understand technology. The Traditional Fintech vendors want to sell them technology.  In many ways, SIBOS is not much different from decades ago when I attended with my Misys hat on.

Thanks to the tremendous efforts of Innotribe, Emergent Fintech (aka disruptive  Fintech aka the exciting stuff) has increasingly taken center stage at SIBOS. Sessions about Blockchain were oversubcribed.

However as we discovered at SIBOS in Singapore last year, it was mostly two different echo chambers. Traditional Bankers and their vendors spoke to each other and Emergent Fintech ventures and their investors agreed that disruption was coming.

A lot has changed in a year. Both Traditional and Emergent Fintech have changed and there is some convergence in the middle. That change is leading to more productive conversations. As both parties reach the same Level 3 of Partnership maturity, fruitful conversations can take place.

Level 3 of Traditional Fintech partnership maturity

1.0 was selling Perpetual Licenses. It was a great way to bootstrap a business as you got cash upfront. All the risk and all the reward went to the customer/bank.

2.0 was SAAS, priced per seat per month. VCs loved SAAS because a) the revenue visibility was better and b) it was very hard to bootstrap. This took away technical implementation risk but left business execution risk.

3.0 priced on a transactional revenue share basis. This is genuine risk/reward sharing. Traditional Fintech vendors are looking at this model as a) it could enable better revenue scalability – their revenue grows as their customers grow – and b) they can become a platform for consumer facing Fintech ventures. Many Emergent Fintech ventures are also moving to this model as they want distribution; to them, this is B2B2C.

Level 3 of Banks partnership maturity

1.0 Incomprehension, disdain and fear. This looks scary and strange. Either banks think that “its just hype and will soon pass”, or they think “this will destroy our business”. In both cases, the result is inaction.

2.0 Engagement via Corporate Venture Capital, Hackathons, Sponsored Accelerators and Innovation challenges. This is a safe way to engage and understand Emergent Fintech, but is only a prelude to doing a real deal and the actual deals banks do today are mostly at Level 1&2 of the Traditional Fintech partnership maturity.

3.0 Partnerships on a transactional revenue share basis. The vendor really becomes a partner, sharing risk and reward. Banks can move into new lines of business without waiting for IT to build something or a big capital budget to be approved.

When both vendors and the banks get to Level 3, productive conversations can take place and real deals get done.

Disconnect between Labs and Reality

Many big banks tell a great story in their Corporate Venture Capital, Hackathons, Sponsored Accelerators and Innovation Challenges, but then some of their real customers (who maybe Fintech savvy) contrast that with the actual experience they get in the real world. Banks who respond honestly say “these things take time”, but the pressure from Neobanks and other Emergent Fintech is increasingly taking away that luxury of time.

Daily Fintech Advisers provides strategic consulting to organizations with business and investment interests in Fintech & operates the Fintech Genome P2P Knowledge platform.

Real time banking

Unstoppable

What happens when an unstoppable force meets an immovable object? The unstoppable force is customer expectation of real time, which we get from using email, text and social media.  We are instant gratification junkies, like Veruca in Willy Wonka “I want it and I want it now”. The immovable force is the batch legacy that derived from IT 1.0 moving from paper systems to computers about half a century ago.

Expect a loud noise! 

Personally I am betting on the unstoppable force. You don’t go far wrong by serving customer needs. If Veruca wants it now, find a way to sell it to her!

First we look at the 5 batch hangovers from paper. Then we look at the responses of different players in the ecosystem.

The 5 batch hangovers from paper

  • LIBOR & other “Fixes”.
  • Quarterly Financial Reporting
  • Daily Accounts Close
  • T+2/3 Securities Settlement
  • Regulatory Reporting

 

LIBOR & other “Fixes”.

Quick word association – LIBOR = scandal (if you want to understand the LIBOR FX scandal, go to this BBC explainer). Another batch “fix” (when a price is fixed for the day in a process dating back pre computers) is for Gold (and other precious metals). The gold fix used to happen in the physical offices of Rothschild and then, in a classic bandaid move, became updated by moving to a teleconference system (this Wikipedia article explains the history). The point is simply that when 21st century real time global trading in FX and precious metals meets a Victorian batch hangover from paper, there is a lot of room for collusion and other illegal activity. The regulatory response so far has been to layer more processes on the banks so that their compliance people can catch the bad traders while they are colluding via phone, email or trading terminal messaging system. Lets apply more bandaid! Bandaid vendors vote for this response.

A more radical response would be to replace the fix with a computed “daily price”. This is technically simple. There are multiple methods (eg. trade weighted average) and banks that need a daily closing price (eg to value a portfolio or an index) can choose which algo they use (all of them would be open source). If one algo gets gamed too much, they can switch to a different one (which will reduce the value of gaming the system). Our trading systems will cope with this quite easily. The problem is which regulator in which country can make this change? This is difficult because it will affect banks and traders in every country.

Quarterly Financial Reporting

Our systems record transactions as they happen. It would be technically simply to apply a filtering process in order to issue an abstract of that data (not so much that it gave away trade secrets) to investors in real time. Instead we have layers of processes to produce a report for investors and regulators on a quarterly basis. Plus we have a whole industry of analysts and media whose job it is to guess the numbers and to manage investors expectation of those numbers.

Core Banking Daily Accounts Close

Little known fact – CORE stands for “centralized online real-time exchange”. What we think of as those old-fashioned legacy systems were disruptive in the 1970s when we moved from paper in bank branches to branches that were connected via a network to a head office where all the accounts were processed by a computer. This allowed branches to exchange account data in real time. The paper systems had been processed quarterly (try doing it any quicker with paper). Core banking systems speeded that up massively by going to daily close. It is still batch – just much faster batch.

In an era when we debate the value of branches vs mobile phone banking, this automation of accounting between branches seems rather quaint.

T+2/3 Securities Settlement

This is where the Ferrari meets the Donkey. We measure trading in fractions of a second. That is the Ferrari. Then we move to Settlement which takes 2 or 3 days (T+2/3 Securities Settlement). This is starting to change, enabled by Blockchain technology (for an analysis of three projects in this area read this post).

Regulatory Reporting

Regulators demand data from banks and traders. In order to not be too intrusive, they only ask for that data in predefined periods – days, weeks, months, quarters, years depending on the data. Banks have to reconcile what they send with what goes to investors and internal management. Any mistake and the fines come pouring in. Pity the poor compliance officer.

What if all the data was streamed in real time (after a suitable filter to protect customer confidentiality and trade secrets)?  Regulators, investors and internal management could all parse the feed to get what they need for their decision support systems.

Responses from different players in the ecosystem

The reason change takes so long is that no single entity can make a decision in isolation. There are too many moving parts and as any deal-maker knows, when there are too many moving parts, nothing happens. Each of these players in the ecosystem have a different response to the unstoppable force of real time.

  • Incumbent Financial Institutions
  • StartUp Neobanks
  • IT Vendors

(Regulators also need to respond but mainly to get rid of the vestiges of Victorian days via daily fixes as described above).

The Incumbent Financial Institution Response

When banks study their legacy systems, which they are maintaining at huge cost, they discover massive overlap with many systems serving exactly the same need. The sensible reaction, to get rid of the overlap, gets crushed by a business group telling IT that their business is utterly reliant on that legacy system and suggesting that any glitch in the conversion would be career suicide for the project manager.  In one case, a system had only one user!

This has to change. The question is how. There are two corporate responses:

  • Lets do a total core system revamp, move everything to real time. It will take years and cost millions but the effect on our agility and sustainable competitive advantage will be a game-changer.
  • Lets bypass the old legacy systems (let IT move them to “end of life maintenance” when the time comes) and simply buy the startups when they get to reasonable scale or partner with startups or other Banks by using Open APIs on top of utility platforms.

The Response of StartUp Banks

StartUp Banks (aka as “challenger banks” or “full stack startup banks” or “neobanks”) are fully regulated Financial Institutions that don’t have any legacy. Its that simple. They can meet Veruca’s demand for real time, because everything they do is in real time. They still need some batch jobs that are designed to serve the needs of investors and regulators, but those batch jobs are simple after the fact reporting; the cart does not drive the horse.

As these StartUp Bank start to get actual market share, it will impact the Incumbent Financial Institution Response (decisions where they assumed they had plenty of time now become a lot more urgent).

IT Vendors

Traditional Fintech is a huge business (see this report, its a few years old but this is not an area of rapid change). It may not be “exciting” but today it is bigger than Emergent Fintech and, done right, it is hugely profitable.

There are three responses:

  • the Banks are locked into our legacy systems and its a massive cash cow, lets milk it for everything it is worth. Private Equity loves this approach as it can service big debt loads.
  • lets be the vendor of choice when the Banks need a transformational move to real time. This is only possible for a few very big vendors. There are not that many deals like this but they are huge.
  • forget about the legacy systems, we are about new systems that “sit on top”. That has been the de facto response for decades. The problem now is that we are reaching the limits of what we can do on top. If we offer a real time response to the customer but the transactional processing is batch, there is room for a lot of error and liability.

Most IT Vendors have a mix of these three responses, but the emphasis and mix varies a lot.

Expect this subject to be debated vigorously in a few weeks time in Geneva when 8,000 bankers and their vendors arrive for the annual gathering of the tribes known as SIBOS. See y’all there.

Daily Fintech Advisers provides strategic consulting to organizations with business and investment interests in Fintech & operates the Fintech Genome P2P Knowledge Network. Bernard Lunn is a Fintech thought-leader.