Straddling the Old and the New – Fintech in the Capital Markets

We are sitting at an extraordinary inflection point in the capital markets. The competitive landscape is in flux as competitors find their way through a maze of constraints. The constraints are well known-increasing regulation, rapidly changing market structure, liquidity challenges, and difficult macroeconomic conditions. There is also a feedback loop with the broader economy; many of the same forces that are constraining the capital markets are creating an unusual political landscape. We have seen this playout with Brexit, and the world awaits the outcome of the US presidential election. These then feedback into the capital market as uncertainty around managing volatility, risk and whether regulation will proceed as expected will be delayed or, radically altered.

For many capital market incumbents: the investment banks, broker-dealers, asset managers, and infrastructure firms are also saddled with extremely complicated legacy systems that are highly siloed, very expensive to run and even more expensive to change. While many are rationalizing systems, in certain areas it is just not possible. In many cases, ancient systems are running broad swaths of the back office, and sit under decades of add-ons, fit-ins, force-ins, and integrate with countless systems internal and external. Capital market firms are often in the habit of creating an abstraction layer above systems to tie more and more data and systems together. This creates a kludgy infrastructure, but it can, and does work.

Given that there are so many challenges, and hence opportunities, we have seen a slew of fintechs increasingly offering capital market solutions. There are those that come from the capital markets and speak the language of the markets. They have grown up in the space and see an opportunity to solve a particular pain point in investment process, trading or operations. There are other fintechs that have entered the vertical from another and are leveraging their data processing, analytical, machine learning, and hardware acceleration prowess in the capital markets.

We have seen fintech disruption in banking, but in the capital markets, so far, it has been much more collaboration than disruption. Fintech firms are bringing unique data, analytic, technology solutions into a highly regulated business. Fintechs that partner with existing firms are offered scale, legitimacy, and clients in a highly risk averse and regulation heavy business. For the brave incumbent firms who are providing capital and nuanced expertise to these innovators, there are rewards: new ways of looking at their business, but more importantly, ready built solutions that they can scale. Overcoming the fear of engaging these firms effectively is a path to finding better and more cost-effective solutions.

In my report, From Financial Technology to Fintech: Trends in Capital Markets, I look at the areas in which the rate of change is greatest, the nature of fintech partnerships in the capital markets and how they are evolving. I look at the pain points in KYC, liquidity, trading, liquidity, collateral and operations. I investigate the growing acceptance of cloud, the importance of leveraging data correctly and analytics and tie these to specific providers with solutions in InvestmentTech, MarketTech, RegTech and AltData. I also look at emerging technologies such as distributed ledger technology, AI, and business models that are looking to remap the capital markets at its core.

Yes, we are at an inflection point and some of the systems out there are kludgy, but in the short term, solving specific business pain points is the key to solving some of the industry’s thorniest problems.

Post-Brexit questions loom over Europe

The post-Brexit environment is still quite hazy, but the politicians and regulators in the EU are trying to lay markers for future discussions and negotiations. There have been several comments that betray a fear of further demands for exits from  the EU by the politicians and citizens of other countries that have high levels of Euro-scepticism, such as the Netherlands, France and Greece. 
The French president recently stated that clearing for Euro-denominated securities would no longer happen in London and this "could serve as a lesson" to those who are questioning the need for the EU. Strong words indeed for a market that currently gets jittery at the drop of a hat. In a similar move, the president of the German financial regulator, BaFin, has  also expressed doubts on the possibility of the LSE-DB merger if the resultant entity is based in London. The exchanges themselves have mentioned their intention to go on inspite of the added complexity due to Brexit, but I am sure they are keeping an eye on the political headwinds that are developing around them.
On their part, the British politicians and regulators are trying to calm the markets down and lull them into believing that little has changed in the aftermath of Brexit. The desire to delay invoking Article 50 to officially confirm UK's demand for exit is an example of this strategy, although EU leaders are opposed to this move. The claim by the politicans who supported Leave that there would not be any major and immediate economic or financial change after the referendum is another attempt of this nature.
While both these parties would probably be interested in discussing the issues that have arisen behind closed doors, in public they have to make the right noises to ensure damage control. There is also anger and resentment in the EU at the UK's decision and this shows from time to time in some of the comments. The German Chancellor Angela Merkel has a very balanced attitude to Brexit, but she has also conceded that the UK cannot enjoy access to the EU single market the same way as it did earlier, something that was suggested by Boris Johnson. There is a genuine concern in the EU to prevent cherry-picking in this regard. 
The various questions that have arisen post-Brexit will take a while to be answered. But what is clear is that there is going to be a significant parting of ways and the separation is going to be less than amicable, at least in public. For capital market professionals, in this landscape the discussion ends up being about political rather than economic or financial issues, in spite of trying otherwise. The latter have to take a backseat at time like this and this might continue for the weeks and months to come.

A New Black Swan

So the latest Black Swan was spotted in the last few days in the UK when the outcome of the Brexit vote took everyone by surprise. While many are still trying to make sense of the whole situation and figure out what it means for the future, the only thing that is certain at this moment is there will be a lot of uncertainty in the coming weeks, months and possibly years.

In question is the constitutional and political arrangement of the United Kingdom and broader EU, but how is it going to impact the financial services industry? The future of the “bank passport” that allowed financial institutions to do business easily across Europe will be a topic of much interest. Restrictions in ease of doing business might result in them moving out of the UK, and some have already started the process. This would not only result in shifting (if not loss) of banking jobs, but could also balkanize the markets. Technology requirements, for example hosting of data centers within national jurisdictions, could similarly balkanize operations. This would also impact adoption of centralized operations, like cloud services, and slow down the growth of start-up culture and innovation. Balkanized operations and restricted market access would deter or slow down smaller players in designing and launching innovative solutions, and help larger incumbents.

Then there is the question of pan-European regulations and initiatives like Target2 Securities. T2S entailed firms with significant European presence to restructure their operations across Europe. While UK never decided to join the T2S project, firms with European operations were so far busy designing their optimal operational mix within continental Europe. If the UK vote now requires further restructuring that may force them to rethink their current plans and impose additional resource constraints. Also of interest would be the LSE-DB merger; even though both parties have said the deal is not threatened by the vote, politicians might have other ideas.

The political negotiations in the coming weeks would therefore be closely watched as market participants look to navigate their way through the latest developments. All in all the level of complexity and uncertainty in the system has suddenly grown manifold. All blame the Black Swan.

How do you say “Brexit” auf Deutsch?

I was in Frankfurt a couple months back to host a client roundtable and there was a palpable rubbing of hands in anticipation of a possible Brexit. It reminded me of the time I had spent in Frankfurt in the late 1980s, right after university, back when the only real skyscrapers in town belonged to Deutsche Bank. There was a real sense in that era that with the coming together of the European Union in 1992, Frankfurt stood to emerge as a global financial hub.

Obviously, London was to usurp that role. For reasons of language, geography, regulation and infrastructure, that ascendance seems in retrospect to have been inevitable. And yet now, with the UK vote in favor of Brexit, London’s preeminence appears to be at risk.

Jangled announcements of redundancies by a few large banks belie the fact that once the dust settles, financial institutions will shift into a wait and see mode. Yet to say that much remains to be determined is as interesting as saying that the original Star Wars movies were better than the litany of duds that followed.

I hate to fault my friends in Frankfurt, who have fostered the growth of a robust fintech sector and capital markets businesses, for seeing opportunity in the UK decision to step away from the Continent. Schadenfreude is after all, a German word. But I believe that Frankfurt’s aspirations are overdone. Wasn’t it just a few months ago that HSBC and a few other institutions were threatening to decamp Britain for Hong Kong and Singapore? Wisely, they decided to stay. The acquisition of the London Stock Exchange by the Deutsche Börse was another vote of confidence in London.

The ties between the UK and Europe are thick (London is home to second largest community of French citizens after Paris) and mutually beneficial. They are unlikely to be undone by this plebiscite. Yes, the vote will give heart to seccessionists elsewhere in Europe, and increase the fissiparous tendencies (look for another Scottish independence referendum) already present in the UK.

But it’s important to take the long view. The UK has survived, even thrived, in the wake of greater challenges, including strikes, war and the loss of global empire. It is a mature democracy that hosts a financial services hub unrivalled in the world history. Surely it can work through this Brexit.

To Brexit and beyond!

So the Brexit has finally happened. The equity, forex and bond markets are still reeling from the news, the volatility probably caused as much by the fact that Brexit was unexpected as of yesterday night in the UK as by the event itself.
While the overall impact will reveal itself over the next several years, in the next few months the capital markets would have to deal with issues such as the future of the LSE-DB merger. Does it make sense anymore, and if yes, how do the two parties proceed? One would expect that now there would be political pressure to ensure that trading and jobs do not move away from either London or Frankfurt. Keeping all stakeholders happy would be a more complicated affair, although it could still be done.
EU wide market infrastructure regulations such as T2S and MiFID II would also now be seen in a new light. London was seen as the financial capital of Europe. The EU would now have to proceed with these significant changes at a time when the UK is preparing to exit, and is weighing its options in terms of how best to deal with the rest of Europe. It could take a middle ground as Switzerland has taken, or position itself even further away with more legal and policy independence but less overlap with the European capital markets.
In an earlier blog that considered the possibility of Brexit, I stated that technologically this might be the best time for an event such as the Brexit. Technology is more advanced and we are better connected than ever before across nations and continents. However, undoubtedly there will still be significant impact from an economic, financial and demographic point of view. As always, there will be winners and losers. As a neutral, one hopes that the people in the UK are able to achieve the goals they had envisioned in making this decision.

Is this the best time for an event such as Brexit?

It is difficult to read financial news at present without coming across extensive coverage of the Brexit referendum in the UK and its possible impact. As part of the financial sector, capital markets could be at the forefront in terms of bearing the impact of any likely change. There are already widespread claims of how London could lose its position as the premier European financial center. Of special relevance is the advantage that London has due to the 'passporting' principle, which allows leading U.S. or Asian banks and other firms to access the Europan market without any restrictions. Certainly with regard to these firms, if the UK leaves the EU, US and Asian banks that have based their teams in London while serving the European market will have second thoughts about doing so. Different alternatives have been touted, including Paris, Frankfurt and even Dublin. Some believe that all of these cities, and some other European financial centers as well, would benefit from the departure of the leading global banks from London, but this could lead to fragmentation in the European financial industry and reduce the effectiveness and competitiveness of European firms. 
There are various views and opinions that have been expressed during the run-up to the referendum. Many of these hold water. But in my humble view, when it comes to competitiveness, if the departure of the UK from the EU does lead to a fragmentation of the European financial industry, then this is the best time for it to happen. Technology has today advanced to a level that to an outsider, there would be little tangible difference if a thousand people in a bank are based across four difference financial centers in Europe instead of being in one place they were earlier, namely, London. There would certainly be a one-off rise in cost due to such as move, but the industry should be able to take that in its stride. Furthermore, a more fragmented industry in Europe would also have the ability to address national and regional requirements better than a single leading financial center. So financial creativity and innovation might get a boost across Europe. One would expect that London would continue to be a leading financial center globally, but it might be forced to reinvent itself to continue to be relevant for global banks and financial firms from outside the UK. Therefore, as a neutral and a student of capital market technology trends, Brexit does not necessarily hold many fears and might even lead to some interesting outcomes. Whether people in the City of London or the rest of the UK or indeed Europe have the same view, is of course, another matter!