Financial services business models are outdated and must be rethought if firms are to survive. In a DerivSource Q&A, Peter Farley, Senior Marketing Strategist, Capital Markets at Misys, speaks about what is driving the need for business transformation across both the buy and the sell side. Join us for a related webcast on the new post-trade.Q: What are the various market drivers behind business transformation today?
A: Complex legacy infrastructure and outdated silo business models are a massive drag on resources—most big banks spend up to three quarters of their annual technology budgets just keeping the lights on. This has been acknowledged as a problem for years, but there was not enough incentive to change the business models when profit margins were in the 15% range, or even after the crash, when bailouts provided significant relief.
Today, persistently low interest rates are drastically limiting banks’ and investment manager’s ability to make money. This could go on for some time, depending on when the central banks decide to raise rates.
New regulations have introduced far-reaching changes to the way firms calculate capital allocation and market risk, and firms today need to be able to look more horizontally and collectively across their organization, to better understand their balance sheet, profitability, and risk, in close to real time. In order to deliver that kind of analysis and intelligence, they need to change the way their IT infrastructure is set up. It’s a daunting task, and it’s not happening with the degree of speed that’s needed, because of a fear of change and a lack of IT expertise among senior executives.
Q: What might serve as that final catalyst to get the business transformation underway?
A: Partly, it will be driven by competitive pressures from firms that are unencumbered by the same legacy issues—be they startup FinTech companies, boutique investment banks, or buy-side firms, which are starting to encroach on traditional sell-side activities. Boutique firms with smaller overheads are picking up a lot of lucrative advisory business, while buy-side firms are investing heavily in technology and personnel, enabling them to circumvent the brokers that traditionally provided them with expertise and market access.
The sell side is losing revenues from the top end, incurring costs at the bottom, just as new technology is enabling a lot of new competitors to come in. They have to rethink their business models, but many are still focused on tactical projects rather than taking a longer strategic view. For example, many sell sides have focused on price, which is unsustainable and is killing their commissions. Both buy- and sell-side firms need to figure out where their niche or strategy will be going forward, and then restructure their business to make sure they are capable of being competitive.
Reports from top accountancy firms show that transformation is not happening at the pace it should be in capital markets because of a lack of IT knowledge at the board level. A very tiny percentage of executive board members at investment banks and investment management firms have sufficient IT qualifications to engage in strategic discussions about what their institution needs to be competitive.
Q: Would getting more IT expertise at a senior level be the catalyst they need to think more strategically?
A: The real catalyst will likely be shareholders demanding banks fix their balance sheets. Returns on equity have diminished from a reported 12%-15% five years ago to 6%-7% in the last couple of years, and further decreases are expected, while the cost of capital runs at 10%-12%. Banks are burning through shareholder capital and will simply go out of business if they continue.
Investment banks and buy-side firms need to decide where their focus is going to be. Many have already exited fixed income, and have also pulled out of certain geographies and sectors where they can no longer be competitive. Some have withdrawn from Asia and the Middle East due to weak revenue growth and as local competitors become stronger, more competent, sophisticated and agile.
They also need to figure out what non-core activities can be outsourced and moved off their balance sheets. Post-trade processing, for example, is labor intensive, offers no competitive differentiation and is essentially commoditised. To make middle and back-office processing more efficient, banks could move much of it to the cloud, buy-side firms can outsource these functions to an asset servicer or fund administrator. In future, collaboration through a utility model could replace independent back-office clearing and settlements activities. Blockchain technology might enable the industry to automate the identification work associated with the confirmations and settlement processes. Banks need to be able to free their balance sheets and focus on winning clients with creative trading ideas and strategies.
Q: What does business transformation look like on the buy side?
A: In addition to the disintermediation trend—where asset managers use technology to trade directly with one another—the buy-side continues to move into territory that was typically the domain of investment banks, such as providing custody services, prime brokerage, and securities lending. The buy side is not as heavily regulated as the sell side, because they don’t take on the same amount of risk. However, as they encroach further into these traditionally sell-side areas, their oversight is sure to increase.
Buy side firms have been investing heavily in both technology and talent, building out big data analytics tools and quantitative approaches, and picking up experienced traders and analysts who fell prey to cost cutting measures at investment banks. Focused on reducing costs, many sell sides have slashed headcounts, letting go their more costly—and experienced—employees, leading to what some have described as the “Juniorification” of Wall Street. With a growing sense that they are not being adequately served by the old investment banking model, buy sides are adding experienced headcount to help with strategy and building the capacity to do their own analysis, rather than continue to rely on third-party research and trading ideas.
On the flip side, some sell sides are branching out into traditionally buy-side areas like wealth management. Increasingly, there is a blurring of the lines between the buy-side and the sell-side, with the buy-side looking to become more active market participants and the sell-side looking to go more narrow and deep.
Q: Post-trade processing has undergone an overhaul of late due to market changes. What does the new post-trade business model look like and how are firms changing their business models?
A: New regulatory initiatives require banks and the buy side to be able to look at their whole balance sheet P&L across all asset classes, intra-day, and the volume of data firms are required to analyze has increased exponentially. Seven or eight years ago, firms would analyze 8,000 data points once a week to get a picture of their P&L. Today, regulators require intra-day calculations to assess the impact of new or potential positions on the balance sheet, requiring the analysis of 23 million data points two or three times a day.
Leveraging new open source technologies, Misys has integrated, cohesive intelligence to the front office in the pre-trade environment, while also allowing a seamless processing operation across asset classes at the back end. More sophisticated data management is at the heart of everything we are doing, whether it is to improve risk control, capital allocation or analyzing the potential impact of trades to the balance sheet pre-trade, as per FRTB. Once that data management capability is in place, it will be easier to improve the back office function, and eventually siphon it off into a more commoditised, utility-based outsourced operation.
Q: What are the main advantages for firms who do adopt a more strategic transformation for the business or for post-trade?
A: They will stay in business! Banks and the buy side are on a path of diminishing returns—the way their business model is currently operating is simply not sustainable. Nearly all of the established investment banks and asset managers are eroding capital on a regular basis. If you are only growing profits by cutting costs, you’ll go out of business in the end because you can only cut costs so far, and then you’ll find that the other guys have a competitive advantage and are growing their top line.
There are examples in different parts of the world of newer banks and investment firms—or newer restructured firms—that are operating at a higher healthy margin, and are able to grow because they launched using a greenfield site and as a result, have their costs bases under control, and their business model is more focused in terms of markets, asset classes, geography and so forth.
Q: How do you think this will evolve in 2017? Do you expect firms to finally take the jump and think more strategically?
A: 2017 is just around the corner, and people don’t take quick decisions. That said, there’s enough blood on the floor on people’s balance sheets and P&Ls that it is getting the attention of decision makers, and I sense that there will be more commitment to strategic transformation projects. There will certainly be more strategic discussions in banks and the buy-side community as to their business models, and hopefully they will have technology at the heart of how that new business model is going to work. It will be critical for them to use technology to their advantage, to get off balance sheet the things they don’t need to manage anymore—or make it more efficient and then move it off balance sheet—and make themselves smarter at the front end, where they can differentiate and be competitive.
Related webcast: “The New Post-Trade: How is Regulation & Market Change Impacting the Business”
