Innovation: Unlocking value through fintech

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 havedone to the transport and accommodation industries. The journey towards trueinnovation in capital markets, however, looks much harder because of theentrenched technologies, processes and regulatory obligations that compriseglobal financial markets.

Capital markets today

In the wake of the financial crisis, we'rewitnessing the inception of an entirely reshaped industry driven by the twinpressures to demonstrate relevance whilst ratcheting down cost to reflect thenew economics of market participation.  

Combine this with the fact that regulatorseverywhere are pushing for even greater transparency, and it is no longerviable for the sell-side simply to intermediate between its customers andsources of liquidity. Buy-side firms are also on the hook to demonstrate totheir own investors how they procure research, allocate costs and get the bestpossible 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'scapital markets, and the increasing cost of capital, mean that firms of allsizes have to scrutinise every aspect of their operations. They need todevelop creative ideas to solve, simultaneously, both the cost and therelevance problems, defining which of their activities are necessary butnon-differentiating and which can add demonstrable and differentiatingvalue.

Innovation can add differentiating value todemonstrate relevance ('Type R' innovation) or help reduce cost('Type C' innovation). Each has its own very specific set of characteristicsand challenges but the same approach can be used to improve the outcome forboth.

Examples of Type R and Type C innovation

Obvious examples ofType R innovation in the sell-side include algos or smart routers, but a newclass of more exciting applications is emerging in the battle for relevance andvalue-add. Providing context to any particular trading situation, theseintelligently bring together multiple sources of structured and unstructureddata to help the user understand the why rather than just the what. Other examples of Type Rapplications are those that help traders interpret the trading landscape moreefficiently. Both can help the sell-side offer demonstrable value to theirclients.

The buy-side can benefit from understandingcontext better too. Today the problem isn't about getting data to support aparticular trading thesis, it's about filtering out the noise, effectivelycurating what is left and using that information more imaginatively. Tools areemerging that allow portfolio managers to look intraday into back officesystems to help drive better decision making. Similar tools are helping thesell-side better understand historical trading shapes that allow them to offergenuine insight to their clients.

Type C innovation seeks to solve a differentproblem set and is all about efficiency and driving down cost. With frontoffice approaching a point of diminishing marginal returns in terms of furtherautomation, there is an increasing focus on other areas of the workflow -post-trade in particular. Firms may boast very low breakage rates inaffirmation processing, for example, but in an area dominated by legacytechnology and often characterised by inefficient work practices, the cost ofgetting there is exponentially high. Applications that automate exceptionhandling through standardised workflow are good examples of Type C innovationthat can really drive down cost. Type C innovation is also being driven by thegrowing realisation that firms are unlikely to get to an acceptable cost levelon their own; they're looking at how pieces of workflow can be standardised andoperated on a collective basis. This works well for those areas that arenon-differentiating, such as trade reporting, affirmation processing or datastandards.

Blockchain technology, for example, has thepotential to collapse the cost of clearing and settlement to almost zero, butit will only work if everyone adopts the same blockchain technology.

Barriers to innovation adoption

Assimilating new innovations is never easy, butfintech and capital markets throw up some distinct problems for would-bedisruptors. Many innovators (especially the Type Rs) can struggle to convincelarge market participants that they meet the mark in terms of resilience,security and regulatory compliance. Also, many new innovations only really workif they can be embedded in the trader's existing workflow and operatedynamically so as to reflect what the trader is actually trying to do. Only bybeing tightly coupled with existing workflow can Type R innovation gainmainstream appeal.

Another challenge forType R innovators is the cost of selling and delivering their technology.Cloud-based delivery reduces the cost, but many firms are reluctant to allowtheir sensitive 

trading data to be stored in the cloud. Thisbarrier is built upon well-placed concern about cyber security and infosec, anda political agenda that is determined to avoid systemic risk.

Any new idea only really works in practice onceit is widely deployed, so Type C innovators face an additional hurdle. Wherecomplete end-to-end trading workflow depends upon the collaboration of multiplecounterparties, achieving uniform momentum across enough parties concurrently canbe a significant barrier to new technology adoption. What is needed is themeans to co-ordinate, lead and execute upon initiatives.

Innovation ecosystems

An ecosystem approach to innovation facilitatesthe interaction between old and new technology (Type R) and the bridge betweenold and new work practices (Type C). This interconnected network is empoweredby elegant organisation which allows each member to be more successful thanthey would otherwise be. Examples from other industries abound, with perhapsthe most famous being Apple’s App Store. The problem with the App Storeapproach in capital markets, however, is that the demands from financialinstitutions are such that any 'store owner' would either have to abrogate allresponsibility for its apps or spend almost its entire time vetting andmonitoring its app providers. 

Whilst thefintech incubators can provide valuable guidance (and money) they can do littleto help new firms execute.

What is needed is something far more controlledand based upon a genuine partnership between a proven, established providerthat can cover areas such as workflow and resilience, and the newcomers thatare now free to innovate in areas such as context and visualisation. The formertakes full responsibility for the overall outcome to their mutual customers -commercially, technically and legally - and ensures that the newcomer’stechnology is elegantly embedded within its platform to avoid poorly integratedor even conflicting parts. Doing this right takes time and money, but ifsuccessfully executed the outcome is likely to be way more certain andimpactful.

Ecosystems can alsowork well for Type C innovation. Competing firms need to be encouraged to worktogether and share ideas, and this is more easily achieved when organised by atrusted, neutral third party. This needs to extend beyond just theestablishment of technical standards, though, to include defining the newworkflow and then building and operating any resultant innovation on a utilitybasis at a fixed margin. By way of example, the specification for using FIX inpost-trade affirmations has existed for over ten years and yet it is onlyrelatively recently that a standardised workflow has been defined and is nowbeing rolled out across the industry. This underlines the point that if thesame organising party also has distribution across 

the buy- and sell-side, then the result in termsof driving industry change can be extremely powerful.

The road ahead

Capital markets will continue to reshapethemselves and, in so doing, drive the need for the buy-side and the sell-sideto innovate, both to demonstrate relevance and to reduce cost. Fintechinnovation that isn't clearly solving one of these problems or the otherwill struggle to gain traction. Even those that do will still face some uniquechallenges in crossing the chasm into mainstream success. The elegantorganisation that well-developed ecosystems can provide bridges the journeyfrom the old to the new. Those firms that can help the buy- and sell-sideassimilate new technology in this way will come to dominate.