Fault Tolerance: Investment Banks and Financial Technology

The noise around Financial Technology (“FinTech”):

There is no denying the attention and froth around the sector have grown at a record breaking pace. When we launched Conversion Capital in 2012, there were 4 companies that had a market value over a billion dollars within FinTech, one of them being Paypal. Those statistics have quickly changed, as there are now more than 1,500+ startups in the sector with over $19bn having been invested in 2015 alone. Furthermore, there has been a tripling of deal volume based on the subsequent demise of the Investment Banking sector. The transformation of the Banking industry back to a core “utility” has brought not only an influx of capital chasing money losing trends — and in turn creating false positives — but also a host of entrepreneurs with little understanding of how to build technology or companies solving technical and or structural issues.

The current landscape:

“Institutions will try and preserve the problem, to which they are the solution.” — Clay Shirky

We believe there is still enormous value in the future and redistribution of Financial Services. However, we believe the popular acronym “fin tech”, is crowded and has created an illusion of opportunity. As Lionel Barber (Editor, Financial Times) so eloquently put it: “Nobody wants to be in banking, everyone wants to be in FinTech.” There are currently dozens of “FinTech” focused VCs, Corporate Venture Arms, Incubators, “strategic” investors, and Merchant Banks all fighting for a piece of the pie. In addition, we feel the numbers being reported skew the overall size of the market, as many of the Investment rounds encompass both Debt and Equity. In doing so, the real number for total Financial Technology funding is actually much lower than what is quoted. All that being said, there is no doubt enormous amounts of money being deployed in the sector, and for good reason. Never before has the recomposition of Financial Services created so much opportunity across a variety of sectors. Led by four major macro factors including an increase in regulation, advances in technology, cultural shift in consumption (and global workforce), and lastly an organizational move from closed sourced intelligence to one of open sourced. As this recomposition continues to take shape, investment banks are pulling back from a variety of core business lines, leaving a seismic gap to be filled in their wake.

Reorganization of Investment Banks

Running an Investment Bank today is like captaining an icebreaker in the middle of the Antarctic. In order to change the direction of the ship, you need to change your entire environment. This is likely impossible due to a variety of factors, including but not limited to:

Macro Headwinds

  • Information is no longer proprietary
  • Increased regulation and enforcement are changing how employees communicate with clients
  • Challenged business models (regulation, resources and revenues)
  • Increased capital requirements effecting core business units
  • Decreased margins (bid/ask)
  • Decreased Origination volumes (IPOs, tradable assets in both Equities/FI)
  • Increased employment dissatisfaction and brain drain
  • Archaic technology infrastructure
  • Large bureaucratic employment structures without relevant domain experience

Micro Headwinds

  • Inexperienced talent pool
  • Increase in the number of clients (Record number of Hedge Funds managing more than $3 Trillion in assets)
  • More Data from more sources (closed to open operating environments)
  • Decreased relational understanding of this data and how to leverage it
  • Layered, outdated technology which does not conform to the paradigm shift in computing
  • Cultural differences in technology adoption vs. technology build (own everything)

Looking Ahead…

Role of open source architecture

Financial Services is one of the last verticals which has shunned open source technology. We believe it will be at its own peril, with huge consequences. Often you hear that the data being analyzed by Financial Services firms is too sensitive in order to use the public cloud, or the unstructured data on balance sheets is proprietary and can’t be used by third party companies (aka startups). As long as this is the case, Financial Services incumbents will lose large portions of their business model to new emerging startups. In order for full scale adoption to take place, and create an environment where substantial wealth can be created through innovation, Financial Services firms must stop being the paralyzed icebreaker; they must drastically change the course of their environment and approach to innovation. Much like NASAs collaboration with RackSpace, which birthed OpenStack Cloud infrastructure and changed the game of open source computing. We draw similar parallels between National Security apparatuses and Financial Services. However, the similarities end with the drastic changes that the US Intelligence community has undertaken to adapt to this changing environment. Such projects include the Open Source Center (OSC) in Virginia, which was built to provide the necessary tools and information for government verticals worldwide. Another example is the widely publicized contract given to Amazon Web Services (“AWS”) in 2014 to usher in a new era of collaboration across all the US Intelligence Agencies, in effect becoming a smarter and more efficient organization. Because AWS can build a better enterprise by servicing a global customer base, the natural conclusion would be that Financial Services firms would follow suit. Yet, that has still not been the case.

Looking at how Silicon Valley builds its moat around innovation, it has less to do with the actual technology and more with the application and culture of their operating environments. Facebook, which boasts over 3.5bn total active users (which includes Instagram, Messenger, and WhatsApp), operates in perpetual development mode, tasking engineers to continuously develop new features and make them available directly to their users. The combined market cap of the top 4 technology companies has grown to over $1.7 Trillion over the last few years, vs. the combined market cap of the top 4 US Banks which has collapsed to ~$700B over the same time period. In rare cases, Financial Services firms have released innovations to the open sourced community; the last being AQRs unveiling of Pandas (software library), which revolutionized the large scale adoption of Python. While other companies like GitHub have been at this for many years, Financial Services firms must change the core psychology in running their businesses. In addition, they must do this hand-in-hand with leveraging their distributed operating platforms. As a point of contrast, WhatsApp now has 1bn active users who send 42m messages a day, with 57 engineers. The ability to scale at minimal costs has never been so accessible, and with increasing regulatory reform, Financial Services is in dire need of this transition.

Building a FinTech company, and the avoidable Rabbit Holes:

Entrepreneurs too often make the mistake of confusing interest in their product with a potential revenue stream. It’s a so-called rabbit hole with perilous consequences that should be avoided at all costs. When building any company in Financial Services or its periphery, you must have a clear vision of exactly what you want the future to look like, and how your business plays a role in that world. It’s often best to think outside the box vs. building a solution to an existing problem (more on this later). Entrepreneurs need to remember that Investment Banks are often not early adopters of technology. They are Institutions which service clients across a broad array of assets, and are migrating back to their initial core utility function of facilitating customer transactions, an area which is ironically being cannibalized by the very clients they service. Historically, Investment Banks profited from information asymmetry and access to balance sheet. That information is no longer proprietary, and is readily available in the open domain. Culturally, they tend to have a myopic view of technology as the “IT” department, which in the past has spent millions of dollars on development with very few projects ever getting fully released or deployed to their clients. Why, you may ask? Because there is a critical breakdown between the understanding of the role technology should play in creating sweeping efficiencies and relating to the functions of the front office (production). The culture of an Investment Bank was built on increasing ROE and client wallet share, while carefully managing against near term volatility. This stands in great contrast to the culture which is required to build a world class software company, one that takes years of patience, imbued by a deep mission to be fully monetized. You can look at everything from the compensation structure of Financial Services firms — where the starting salary pay gaps favor near term profit instead of long term equity creation — to the never ending search for solution driven innovation vs. actual technical innovation. Everywhere, the writing is on the wall: it’s time to change.

Engage at your own peril: false positives:

Investment Banks (incumbents) don’t care that you’re a startup. They don’t care that you’re operating with a super thin capital base or that you’re in a constant state of fundraising, hiring, pivoting and building. Much like Colonel Jessup in the movie “ A Few Good Men”, they have a luxury which you don’t have: capital. So while someone may have suggested you need to have more customers, and pushed you in the direction of an Investment Bank, unless you have a product that they desperately need, you most likely want to close your demo and walk out of the office. All that is assuming you have made it to the right office with the right person, and that person has decision making authority, let alone a budget. If you go down this path, you will engage in a series of meetings which will likely last upwards of 6 months. If you haven’ t run out of money yet waiting to sign this illusive customer (POC, on boarding, security, data cleansing hell), you will likely be building a product for the very customer you are looking to displace. When dealing with incumbents remember two things: 1) Incumbents, by the very nature of their business model, are not at the forefront of innovation and 2) you must be so good that they can’t afford to ignore you.

The Rise of Analogous Markets:

“We need a CTO, because I need them to solve or fix this problem,” said a non technical founder. This phrase usually demonstrates the true level of ignorance in an organization. If you are a non technical leader instructing your CTO on what software or products to build, you probably have a target on your back (in rare cases there is exception). The greatest innovations of our time have come from analogous markets, or, said differently, “the greater the conceptual difference from the problem, the more novel the solution.” One example is Improbable, out of the United Kingdom, which developed a distributed simulation platform for Virtual Reality and Gaming. Their newly released Operating System called Spatial OS, is now at the center of mapping for Autonomous Vehicles, Financial Services, Smart Cities, Health Care, Security and Energy. Another example is RedOwl Analytics, a software whose early vision was developed and deployed to detect and deter possible bad actors during military conflict analyzing changes, patterns, and anomalies in behavior. This very same software is at the core of RedOwls initial product called “Reveal” which is being used by various Investment Banks, Hedge Funds and Private Equity firms globally in a similar capacity.

As Steve Martin said, “Be so good they can’t ignore you.” If you believe you can build a more efficient and scalable business model through collaborative work environments and distributed computing, then the opportunity before you is enormous. Once you have built a business which can be developed, deployed and grown in a different test environment, then its time to enter Financial Services. You will find less procurement periods, shorter POC lead times, and a smart development environment which will help you reach max productivity, while most likely also helping you write the future.

All the best,

Christian Lawless
Founder & General Partner
 Conversion /IO is a division of Conversion Capital Group, and focuses on proprietary research and analysis of financial technology related market trends.

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