“The megatrend in financial services is neither Fintech nor Blockchain, but the shift from batch to real time.”
Many people would agree that technology and new digital tools are disrupting finance –among many other industries – through new actors (i.e. Fintech), new technologies (i.e. Blockchain), and new regulations (i.e. PSD2). However, is disruption actually taking place?
To address some of these issues, I interviewed Tony McLaughlin, Managing Director at Citi’s Treasury and Trade Solutions (TTS). His views regarding the future of finance and its interrelation with the current technology changes are definitely worth reading.
Q: Fintech: hype or disruption?
It is often reported that Fintech firms are disrupting the banking system, but are we dealing with a discontinuity or a natural evolution in financial intermediation? Financial intermediation is an information processing business, and it has always used the best available technology, commencing with marks on clay tablets.
When people look at banks, they see the business units or product types – consumer banking, credit cards, corporate banking, etc. but in a sense, these business units are artificial constructs. The central reality of banking is the balance sheet, which the business units only exist to populate with assets and liabilities.
Some Fintech companies seem to be focused on relatively peripheral aspects of financial intermediation. For example, behind slick user interfaces we sometimes find old-fashioned FX brokers. We have to wonder whether customer interface is the source of a sustainable competitive advantage for Fintechs if there isn’t also innovation in the middle and back office. It is also valid to wonder how far Fintechs can move the needle without balance sheets.
Q: This opinion is very much aligned with that of our [Kantox] CEO Philippe Gelis, and that’s why we are mainly focused on developing sophisticated tech-driven products. But regarding those Fintech firms that mainly provide a better user experience, don’t you think they add value too?
It’s true that a good customer interface adds value to the customer experience, but such interfaces may be relatively easy for traditional players to replicate. Better design is welcome in banking, but good design in one domain does not necessarily transfer to another. Consider the number of banks that have set up branches to look like Apple Stores; while Apple Stores are filled with customers, their banking counterparts are often noticeably empty.
The design of the user interface and interaction is a real focus area, but fundamental change comes from asking and answering fundamental questions. For example, how is value added in financial intermediation businesses?
We can compare value added in finance with manufacturing and note some stark differences. A car manufacturer starts with a few thousand dollars’ worth of raw materials. Once these pass through its value-adding processes you can end up with a vehicle worth $50,000. The value creation mechanism is tangible – it is easy to see how the finished product is worth more than the raw materials.
In financial intermediation, all of the inputs and outputs are information. The inputs, outputs and value creation mechanism are intangible and therefore harder to grasp, but they are real nonetheless. It is worth pondering how financial intermediation information processing turns one set of information inputs into a higher-value set of outputs.
When finance is seen as an information processing business, the Fintech label loses some of its meaning. In the mainframe age, banks were the biggest buyers – we have always been the biggest consumers of the best information processing tech available at the time. Finance is information processing wrapped around a balance sheet, so creating a separate category of player called Fintech might not be very meaningful.
The transformative power of technology in finance is unquestionable and that transformation will be brought about by an ecosystem of bank and non-bank players. Marc Andreessen said that ‘software is eating the world’, and a subset of that is certainly true: ‘software is eating financial intermediation’… But which part of financial intermediation to point your software at? That is the question.
Q: And what implications can we derive from this?
Financial intermediation as a whole will continue to grow as economies develop. There will be more wealth, more securities, more credit, more e-commerce, more transactions by volume and value of all types. And, of course, there will be more competition for slices of this larger pie.
If you accept that financial intermediation is an information processing business, then we have to imagine that there will be a significant impact on the number of people who work in financial services and the type of jobs they do. Information processing functions performed by people in the glass towers of the world’s financial centres will in all likelihood migrate to data centres. There has already been one huge wave of outsourcing and offshoring of processing work to low-cost locations. The next great migration is for that work to move to cyberspace.
There will also be more innovation, which is welcome, but let’s not set up this false conflict between Fintech disruptors and the banks. The Fintech barbarians are not storming the gates of financial services; often they are to be found inside the castle walls in dialogue with their banking partners over tea and biscuits.
We can all work together to deliver better forms of financial intermediation and this is a good thing. Financial intermediation and globalisation drive economic progress and higher living standards, albeit unevenly. When we stand atop skyscrapers and look out over our great cities, each of us sees different things, but the banker sees capital at work and feels the buzz of a billion invisible transactions. The better we collectively make financial intermediation, the better capital can be deployed and friction removed from transactions for the benefit of everyone.
Q: So, beyond Fintech, what is the biggest technology trend affecting banking?
The real megatrend in financial services is not about Fintech nor Blockchain but around the transition from batch processing to real-time processing. Much of the banking world is built on batch processing but everywhere we look there is a transition to real time.
This transition is happening elsewhere – look at messaging, which has moved from store-and-forward email systems to real-time systems like WhatsApp. This is a space ripe for innovation in banking as there are still many batch processes to tackle through the front, middle and back office.
What is emerging is a real-time world that is hyper-connected through APIs. Every bank, clearing system and every corporate customer will have an API. Every government will expose its services and information through API.
This is a world in which great innovation can take place. For example, if you are a corporate customer and you want to get your bank statements from ten different banks, in today’s world you get a SWIFT MT940 from each of them. These are end-of-day batch statements. In the API world, you will have the API keys from those ten banks in your Treasury Management System (TMS) and will call on the data in real time over HTTPS.
This is a tiny example at the foothills of a Himalaya of innovation that stands before us. Thinking about the possibilities of a real-time, hyper-connected, API world is much more interesting than trying to find use cases for Distributed Ledgers, which seem to garner a huge amount of attention.
Q: PSD2 is also supporting this shift from batch to real time. What other implications does this piece of legislation have for the industry?
PSD2 is part of three global trends that are going to have profound effects:
- Banking infrastructure will be opened up to non-bank players.
- Real-time credit and debit capability will come to bank accounts everywhere.
- All banks will offer their services through API channels, leading to an environment of hyper-connectivity.
Real-time payments and collections systems will become ubiquitous. In a few years, every major country is going to have a faster payments scheme, and the bank account will be accessible in real time for both credits and debits. This changes the world of payments profoundly. If your bank account is instant, do you need a virtual wallet? Do you need a card product?
Think about the Japanese tourist who comes to London and buys a luxury watch. This transaction is currently effected through a card product. The merchant pays a percentage fee to accept the payment. The tourist suffers a poor retail exchange rate, again a significant percentage of the purchase value. In a world of bank accounts that are accessible in real time, this tourist will present their phone at the merchant, their bank account in Japan will be debited in real time, and the merchant will be credited in real time. The merchant will pay a fixed fee, and the FX rate will be fair and transparent.
This future is as certain as the emergence of self-driving electric cars. It may seem like hype, but all of the foundations are being put in place to bring about this future state.
Q: But replacing the global network of trust built over decades by card schemes doesn’t seem to be an easy task…
Financial intermediation of all sorts will continue to grow. The pie will become larger, and there will be space for many players, traditional and new. We do, however, have to try to understand the impersonal, technological forces that shape the competitive landscape that we operate in.
For those interested in commercial discontinuities it is worth going back to the 2011 annual report of Research and Motion (RIM). The company was on a high, reporting record revenues, shipments and users. BBM was the coolest messaging app on the planet. Their tablet was being launched in response to the iPad. 2011 was their apogee, but the seeds of their downfall were planted much earlier.
One can argue that the bullets that felled RIM were fired in 2007/2008 with the launch of iPhone and Android. In business you can be dead and not yet know it. This is a salient lesson for many players in financial services. We all need to read the runes as best we can and prepare for a real-time, hyper-connected and open future.
Q: Talking about Blockchain, what are your thoughts around this technology and its application in the payments sphere?
Blockchain may have applications in many domains, but in the payments space, we need to break things down into their component parts and examine potential benefits. Payments systems consist of two primary layers – messaging and settlement. Any new payment system has to be superior in one of them.
In the messaging layer, ISO 20022 seems to be an afterthought in some Blockchain payment solutions. These messages may be too large to be written to DLs as it is computationally inefficient to do so. Also, people say that Blockchain is faster, but electrons move at near light speed, whether they are Blockchain or not.
In the settlement layer, it is not clear how trading in and out of cryptocurrencies is a good idea in a payment system because each trade in and out of any asset has a bid/offer spread. It does not seem obvious that banks will want to keep cryptocurrencies on their balance sheet, what their worth will be in a crisis situation, or how easy they are to secure from theft. It may be possible for governments to issue national currencies in cryptographic format, but they will have to be careful not to create an instrument that facilitates bank runs. Why would governments issue a cryptocurrency that means I can easily remove my bank balance and store it on a USB at home?
Blockchain may be useful in situations where there are lots of counterparties who don’t know or trust each other, and they are all bad at record-keeping, but these two activities (managing counterparty risk and good record-keeping) are absolutely core in the banking system.
Enormous innovations are happening in the world of financial intermediation, and I would encourage people to take a first-principles approach and try to cut through the hype.
We can learn from each other as we innovate new solutions in the growing market for financial intermediation. ‘Fin’ folk have lots to learn about ‘tech’, but ‘tech’ folk can also have gaps in their understanding of ‘Fin’ when we go beyond the customer interface… so it is encouraging that in reality there is not an ‘us against them’ situation and that there is a huge new industry developing to make financial services better for everyone and hopefully a more effective driver of economic growth and progress.