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Digital Disruption: “This Time is Different”

by internationalbanker

By Mat Newman, Executive Vice President, FIS

Technology and regulatory change mean industry disruption is here to stay, says FIS

“This time is different”. The four most dangerous words in investing are normally whispered at the peak of a bull market. Said as a caution on a downswing they are not quite so dangerous, and amid regulatory, market and technological disruption, banking really is changing markedly in a way from which we see little prospect of a return to the earlier status quo.

The market backdrop is a tough one: many investment banks are seeing value diminish for investors, with returns on equity falling below the cost of capital. Regulatory Balkanization, meanwhile, is being mirrored by market fragmentation as challenger financial service providers carve out market share, unhampered by legacy issues; either legal or technological.

Regulation has been the biggest cause of the turmoil: it has been nearly a decade since the financial crisis, but regulators have not stopped pushing banks to formalize their capital-planning and stress-testing processes, driving a dramatic increase in infrastructure costs.

The regulatory checklist is increasingly onerous, if arguably well-intentioned: Dodd-Frank; Basel III; MIFID II; MIFID III; EBA Governance Guidelines; FSB Principles; European Market Infrastructure Regulation; Foreign Account Tax Compliance Act et al all have ramped up the cost of compliance in terms of both time and effort. And the newest wave of regulations, such as the FRTB, is even more comprehensive than those released shortly after the crisis.

As a result, middle office compliance teams in many institutions are still growing, despite much of the workload being repetitive and prescribed and cost pressures mounting as margins fall across the board. Automation is set to be a major game changer as a result.

From (a)utomation to (b)lockchain

Technology that makes it easier to automate and outsource compliance obligations will help save firms substantial amounts of time, money and effort as they respond to demands for trade transparency and we see them increasingly being adopted. IT spend has been driven by compliance requirements; but the investment can also be leveraged to drive better results in areas that are critical to business and customer experience, as well as regulation.

FIS’s latest survey of nearly 500 sell-side executives from around the world revealed that a massive 84 percent expect increased automation to impact their businesses, with automated data collection, processing and reporting all likely to play critical roles in helping firms to cut their costs, comply with regulations, satisfy clients and remain competitive.

A significant 79 percent of respondents meanwhile expected algorithms to take an increased share of trading and transactional activities. This can be seen as threat or opportunity. Digitalization of many currently manually handled processes means more sophisticated services can be made available to new markets and there are also significant digital opportunities in the deal management area. M&A, IPO, and private placement for example all require heavy analysis, coordination, documentation and communication between multiple internal and external teams that delay the deal management process and security. Automated end-to-end deal management processes are going to change this markedly.

Blockchain is another example. What might initially have been viewed as a technology solution in search of a problem, now holds real potential to underpin next generation contracts; for example allowing derivative instruments like interest rate swaps to automatically respond to events and seamlessly automate coupon payments.

Blockchain may well yet prove a game changer and fundamentally transform the way transactions are conducted, verified, reconciled and reported, even if it is still several years away from dominating securities settlement. A report by Santander, for example puts the potential infrastructure cost savings at $15-20 billion per year by 2022. Regulatory and technological immaturity will continue to act as a headwind for blockchain technology use in currencies, asset registries and application stacks in the short term, but not for ever.

The risk of not adapting

Without adaptation, major banks risk disintermediation, getting put out of business by nimble start-ups who can think freely about the positive potential from technological innovations, without the legacy infrastructure to consider. Such challengers can offer services at a much lower unit cost than established players. Robo advisers for example are managing growing portfolios, funnelling client money into ETFs with low fees. As the underlying passive funds most are parking their clients’ money in have among the lowest fees in equity funds, the costs are even lower. This is clearly not for everyone on the buy side. The levels of sophistication at play are rising however and so will the popularity.

Business-as-usual is not going to be an option for the banking industry. The onslaught of regulatory and operational risks being faced not just by commercial and investment banks but by brokerages is being compounded by the need to keep up with a genuine wealth of disruptive new technologies coming to market, whether that be open APIs, mobile computing, artificial intelligence or distributed ledgers. Big opportunities exist for lean, agile and highly automated new banking firms that can successfully harness the latest technologies to attract clients. What’s happening meanwhile is a blurring between research data science and the software that investment banks use.

Examples include logic like that used by digital dating agencies being deployed to help match buyers and sellers in the illiquid, off-the-run corporate bond market; electronic networks that allow investment banks to attract investors, and cognitive intelligence that lets investors make their own trading decisions driven by data mining.

Established banks don’t necessarily have to add another layer to already heterogeneous internal IT systems to take advantage of the opportunities: they can partner with technology vendors and challenger financial service firms to get the best of both worlds, outsourcing functions, unlocking value, realizing latent opportunities, and incorporate advances that cannot currently be managed in-house. In future, every duplicative effort in front-office as well as middle-office systems, regulatory compliance and post-trade processing may be digitized and managed within a common industry utility for example. The changes the industry is facing, this time, really are different.

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