Fintech in Capital Markets: A Land of Opportunity

Fintech in Capital Markets A Land of Opportunity

The Boston Consulting Group (BCG) is a global management consulting firm and the world’s leading advisor on business strategy. We partner with clients from the private, public, and not-for- profit sectors in all regions to identify their highest-value opportunities, address their most critical challenges, and transform their enterprises. Our customized approach combines deep in sight into the dynamics of companies and markets with close collaboration at all levels of the client organization. This ensures that our clients achieve sustainable compet itive advantage, build more capable organizations, and secure lasting results. Founded in 1963, BCG is a private company with 85 offices in 48 countries. For more information, please visit About Expand Research Founded in 2001, Expand Research is transforming the way the world’s financial markets make business and technology decisions by providing timely decision support and research services on business and technology strategies to leading financial institutions globally. In July 2011, Expand became an independent subsidiary of The Boston Consulting Group. It has offices in London, New York, and Singapore.

Fintech in Capital Markets A Land of Opportunity Philippe Morel, Charles Teschner, Valeria Bertali, Boris Lavrov, Kimon Mikroulis, Pierre Paoli, Will Rhode, Shubh Saumya, and Franck Vialaron November 2016

AT A GLANCE Enormous opportunity arises when established capital markets (CM) players such as investment banks collaborate with young financial technology (fintech) compa- nies—but the potential is far from being realized. According to our analysis using Expand Research’s Fintech Control Tower, the entire CM ecosystem, including banks, must take action now to gain considerable benefits. Capital Markets Fintechs Are Relatively Underfunded Of the roughly $96 billion in venture capital funding that has been raised since the turn of this century, only about $4 billion (or approximately 4%) has gone specifical- ly to CM fintechs. This is partly due to the highly specialized nature of the sector, which makes it harder to penetrate—even for brilliant startups—than either the retail or the commercial banking sectors. The Promise of Fintechs Fintechs can help build capabilities that enhance client relationships, reduce costs, and facilitate regulatory compliance. But to really take off, they must also overcome barriers. These include the complexity of many banks’ and asset managers’ IT landscapes, the lack of management bandwidth to both innovate and comply with myriad new regulations, and the need for standards to build effective solutions. 2 Fintech in Capital Markets

he financial technology (fintech) phenomenon first started to evolve in Tthe capital markets (CM) industry more than 40 years ago. Today, accelerated both by the electronification of trading in the 1990s and the subsequent thrust of the entire financial services industry toward digitization, fintechs—which we define as firms that use innovative technology at scale to either enable or compete with other financial institutions—have experienced exponential growth in the CM domain. The most prominent CM fintechs have been strongly supported and engaged by the CM ecosystem, which includes players such as investment banks, custodians, ex- changes, clearing-houses, and CM-focused information service providers. Such play- ers have been, and will remain, best positioned to pick the most promising fintechs for potential collaboration. Yet despite rapid growth, CM fintechs have been attracting less than their fair share Despite rapid growth, of venture capital (VC) funding. This shortfall is partly due to the highly specialized CM fintechs have and regulated nature of capital markets, which may hinder outside investors. In- been attracting less deed, when fintechs are backed by incumbent banks, they attract greater funding than their fair share and mature more quickly than when they are backed solely by VC firms. Incum- of VC funding. bents that invest actively can shape business models and help fintechs evolve into collaborative suppliers rather than disruptors. Moreover, the funding that CM fin- techs have received to date has been heavily focused on front-office initiatives with- in execution and pre-trade. Funding for post-trade activities has been much more modest, with investment concentrated in a select number of fintechs, resulting in the highest average ratio of funding per company. Simply put, fintechs focus on creating new value propositions or improving existing ones. They help build capabilities that can enhance client relationships, reduce costs through automation and simplification, and facilitate regulatory compliance. They also enable disaggregation of the value chain as they become more embedded in the supply chain. Nonetheless, in order for the fintech boom to realize its full potential, a number of barriers must be overcome in the way that fintechs relate to investment banks and the CM ecosystem as a whole. These hurdles exist in the areas of simplifying IT ar- chitecture, developing industry standards, improving collaboration among players, and mitigating the risks of working with vendors, among others. Moreover, inertia on the part of incumbents can have a dire consequence: the inability to compete with new entrants that use cutting-edge technologies to reverse banks’ traditional The Boston Consulting Group 3

competitive advantage. Market structure changes brought on by technology, regula- tion, and shifting client needs make it critical for incumbent banks to take action now. In addition, as banks begin to think of themselves more as data and technology companies, they need to start managing their IT stacks, and the data and analytics within them, as assets that can be commercialized. Banks can leverage the experi- ence gained in such areas as execution algorithms, direct-market-access connectivi- ty, and securities services, and explore opportunities for unconventional partner- ships. In order to move forward efficiently and effectively, however, banks must fully grasp the history and scope of the fintech domain. In this report’s analysis of the rapidly evolving CM fintech landscape, we used the Fintech Control Tower pro- prietary database of Expand Research, a BCG subsidiary. The database covers more than 8,000 fintechs. The Fintech Landscape Since the establishment of Instinet as the first electronic communication network in 1969, and the creation of Nasdaq as the first electronic exchange in 1971, there have been three major fintech waves. (See Exhibit 1.) The first occurred mostly in the 1980s and 1990s and featured roughly 100 CM fintechs, predominantly en- Exhibit 1 | Three Major Fintech Waves WAVE 1: TRADITIONAL FINTECHS WAVE 2: FINTECH MILLENNIALS WAVE 3: FINTECH BOOMERS ~19% ~25% ~56% Number of companies founded SETL 60 Orchestrade Development SunGard SmartStream Symphony Intercontinental Exchange Communication Mysis Services Currenex 50 Broadridge Financial Solutions 46 47 45 Bloomberg Ion IHS Markit 38 40 OpenLink 35 Murex Calypso 29 31 30 21 23 19 18 17 15 13 13 15 14 15 10 77 55 4 55 6 333 22 0 1974– 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 1984 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 Sources: CB Insights; DealRoom; Tech in Asia; Expand Research; BCG analysis. Note: The 551 companies included were active as of the first half of 2016. The total includes neither the 16 fintechs that did not disclose founding dates or were founded before 1974 nor the two that were founded in 2016. 4 Fintech in Capital Markets

ablers, that focused on market data, news distribution, risk management, and core processing. Most of these players are now embedded in sell-side and buy-side firms. Market electronification accelerated with the introduction of the Financial Informa- tion eXchange protocol in 1992, and by the late 1990s, electronic venues, such as Electronic Broking Services, had become the primary trading vehicles for interdeal- er foreign-exchange transactions. The second wave took place from 2000 to 2007 and comprised just under 140 fin- techs that focused more on e-trading. These players included business disrupters, such as high-frequency trading, and execution platforms, such as Currenex. Starting in 2008, the post-crisis wave of about 310 fintechs evolved to mostly com- The potential gains prise enablers designed to fix the post-crisis challenges of falling revenues, high are much larger than costs, complex legacy infrastructures, and fragmented liquidity and data. One such those currently being player was the buy-side-to-buy-side venue Luminex. Today, many of these firms are realized. emerging startups with regulation built into their DNA. They use cutting-edge tech- nologies, such as machine learning, which are often delivered as a service. It is worth noting that the latest wave of digitization is being fueled by incumbent banks’ rapid digital transformations and is characterized by paradigm shifts in tech- nology instigated by the proliferation of cloud hosting, artificial intelligence, peer- to-peer computing, and distributed ledger technologies. Regulation has been a key driver of the latest fintech explosion, as CM players have moved toward low-capital- intensive business models that require enhanced technologies. Capital Markets Fintechs Have Received Less Than Their Fair Share of Funding. Of the roughly 8,000 fintech startups that we track globally across all business lines, only 569 are active in the CM space. And of the roughly $96 billion in VC funding that has been raised since the turn of the century, only about $4 billion (or approxi- mately 4%) has gone specifically to CM fintechs. (See Exhibit 2.) Thus, it is clear that the potential gains are much larger than those currently being realized. Indeed, the 2015 CM revenues of $330 billion (excluding those related to asset management) represent 9% of the total financial services revenue pool of $3.67 trillion. Therefore, the CM equity funding ratio, relative to the revenue pool share, is skewed at 1:2, with CM fintechs attracting less than half their fair share. If we use the broader definition of the CM ecosystem, which includes asset management, the ratio is even more pronounced, at 1:3. The vast majority of fintech disruption in the banking industry is happening on the retail and corporate fronts, where technology provides a way for companies to serve large, diverse client bases while still reducing the cost of customer acquisition across a number of distribution channels. The prospect of mass adoption makes equity financing readily available, with numerous VC firms on the lookout for the “Uber moment” of finance. As a result, there is a large imbalance in the amount of VC investment going to retail and corporate banking versus the amount going to CM firms. The handful of CM-focused startups that do exist have not only generat- ed fewer VC funding rounds than their retail- and corporate-focused peers, but they have also attracted significantly less funding per round: roughly $11 million in CM in 2016, compared with about $14 million in retail and corporate banking. The Boston Consulting Group 5

Exhibit 2 | CM Fintech Is a Small but Growing Portion of the Overall Market INVESTMENT IN CM FINTECHS COMPARED WITH TRENDS IN CM FINTECH EQUITY INVESTMENT IN OTHER FINANCIAL SERVICES SEGMENTS FUNDING BY CLUSTER, 2000–2016 (H1) Share (%)1 Cumulative funding ($millions) 100 9 7 1 4 5,000 Total funding: $4 billion 3 4 Total number of fintechs: 569 7 6 75 7 4,000 $115 million 47 55 35 45 3,000 $591 million 50 50 2,000 $2.2 billion 184 25 $1.1 billion 42 40 43 1,000 240 $96 million 0 0 40 Financial Number Cumulative services revenue of fintechs, equity funding, 2000200120022003200420052006200720082009201020112012201320142015 pool 2015 2016 (H1) 2000–2016 (H1) Retail banking CM Asset management Primary Post-trade 2016 (H1) Corporate banking ecosystem CM Pre-trade Support Wealth management Execution Sources: CB Insights; DealRoom; Tech in Asia; Expand Research; BCG analysis. Note: The CM ecosystem revenues include asset management of $263 billion and investment banks, custodians, exchanges, venues, clearing- houses, and CM-focused information service providers of $330 billion. This results in a total of $593 billion. 1Because of rounding, not all percentages add up to 100. Such differences are partly attributable to the perception of a higher risk of failure in the CM industry, which is highly specialized, heavily regulated, and dominated by a few incumbent players. This reality discourages VC investors who are not in- dustry specialists. In light of this, many CM players have taken up the dual role of investing strategically in new tech ventures as well as representing their traditional client bases. An Attractive Investment Opportunity. Indeed, despite perceptions to the contrary, the overall CM ecosystem has thrived in recent years, generating a sizable revenue pool that is expected to markedly increase over the next five years. (See Global Capital Markets 2016: The Value Migration, BCG report, May 2016.) Given the size and growth of the industry, as well as the less crowded landscape, the CM fintech space is an attractive market for both investors and entrepreneurs. In addition, as we have seen, evidence shows that fintechs supported by banks or other strategic players, such as exchanges, tend to reach maturity faster and be- come more successful than those that are not backed by such players. (See Exhibit 3.) They also attract much greater funding, because VCs tend to follow strategic players in their investment allocations. The presence of such investors in fintechs signals that they are high-quality companies with credible business models and good prospects. On average, industry-backed fintechs reach the exit stage in six 6 Fintech in Capital Markets

Exhibit 3 | Industry Support Is Key to CM Fintech Success FINTECHS BACKED BY THE CM INDUSTRY ATTRACT HIGHER FUNDING… … AND MOVE FASTER TO MATURITY Average size of funding round ($millions) Average number of years to event 60 56 9 ~7 years 45 ~6 years 6 30 28 24 7.1 6.7 3 5.7 5.6 13 5.3 15 11 4.5 8 9 10 3.1 3.4 6 5 7 2.9 2 4 1.8 1.5 1.7 1 0 0 2010 2011 2012 2013 2014 2015 2016 Backed by VCs only Backed by the CM industry (H1) Backed by VCs only Seed Round A Round B Backed by the CM industry Round C Round D M&A Sources: CB Insights; DealRoom; Tech in Asia; Expand Research; BCG analysis. years, compared with seven years for firms backed only by VCs. Also, the average funding for industry-backed fintechs in the first half of 2016 was $24 million, com- pared with less than $11 million for those backed only by VCs. Investment banks, however, have been facing revenue headwinds that are far more powerful than those faced by other players in the CM ecosystem. Indeed, informa- tion service providers are growing strongly and commanding price-to-earnings (P/E) multiples as high as 30 (compared with an average of 10 for investment banks). Banks have also been constrained in redistributing cash to shareholders because of recapitalization and deleveraging. Equity investments, therefore, provide avenues to reinvest retained earnings in projects with high returns on investment, helping to deliver long-term value to shareholders. Fintechs can help investment banks across the value chain by monetizing existing assets, such as data and algorithms, as well as by mutualizing industry costs. So-called know your customer (KYC) tasks, market data, client-reference data, and trade surveillance currently amount to $4.4 billion in annual IT and operations costs. And the opportunity will be even larger where efficiency is a primary goal, such as in the automation of trade processing. (See the sidebar “Blockchain-Based Solutions.”) Execution and Pre-Trade Take Center Stage. Investors have been choosing fintechs that focus on enabling execution and pre-trade activities (with funding of about The Boston Consulting Group 7

BLOCKCHAIN-BASED SOLUTIONS The main promise of blockchain based on private blockchain imple- technology in capital markets lies in mentations are the only acceptable the full automation of trade process- alternatives to bitcoin-like public ing across asset classes. The greatest chains for financial institutions. expected impact is on products such as syndicated loans, foreign exchange Of all the tech clusters, blockchain- for currencies not covered by continu- based fintechs have experienced by ous linked settlement, and over-the- far the highest compound annual counter derivatives, whose back-office growth rate over the past three years. processes remain largely manual. Yet disclosed funding for such projects is still significantly behind Blockchain-based solutions are other areas of innovation, such as currently being developed through data and analytics (a ratio of 1:4). two approaches: industry collabora- Cross-industry settlement of billions tions that involve multiple players, of daily trades among globally such as the Hyperledger Project, and dispersed counterparties, although efforts led by individual players (SETL, theoretically feasible by using block- NASDAQ OMX Group with Chain, chains, represents one of the toughest UBS with Clearmatics Technologies, use cases for a technology still in its and the Depository Trust & Clearing infancy. Automation of more simple Corporation). However, although processes, such as recording client prototypes exist, there is still minimal data on decentralized ledgers for KYC traction within the industry because and for anti-money-laundering of the relative immaturity of the purposes, is likely to emerge first. technology and the fact that solutions $2.2 billion and $1.1 billion, respectively), at a combined ratio of about 6:1 relative to post-trade activities. (See Exhibit 4.) Moreover, post-trade and support remain the least mature segments of the value chain, with early rounds up to series B represent- ing 82% and 64%, respectively, of the total funding they have received since 2000. For investment banks, this dynamic partly reflects an effort to revive the age of rev- enue growth, notably by increasing the share of client wallet. Although there are areas in which banks could create new products and increase trading volumes, the pursuit of market share in a stagnant environment is a zero-sum game for the in- dustry as a whole, because competitors can improve their relative positions only by capitalizing on market share dislocations. Also in play are reactive strategies to maintain positioning in a market with increas- ing electronification. With front-office compensation representing roughly 40% of to- tal costs, banks recognize the benefits of moving toward more cost-efficient service models with lower front-office headcounts. Most important, banks may be finding it easier to apply front-office technology, which can be deployed one bank at a time, rather than back-office initiatives, which could require significant industry collabora- tion to fully realize any benefits. Moreover, although explicit post-trade costs repre- 8 Fintech in Capital Markets

Exhibit 4 | CM Fintech Investment Has Focused on Execution and Pre-Trade Activities Funding CAGR, 2013–2016 (H1) (%) 200 Blockchain High growth Algorithms, smart order routing, Client data analytics and pre-trade risk Collaboration, communication, 150 & KYC1 and connectivity Primary market intelligence Pricing & 100 OMS/EMS3 Electronic brokerage Alternative 2 funding and HFT platforms Trading-market data, Risk, Core trading technology, analytics, and research 50 collateral infrastructure, and user experience Clearing, management, reconciliation, and trade and settlement surveillance Mature Venues/platforms Shared services 020406080 100 120 140 Primary Pre-trade Execution Post-trade Support Number of fintechs Sources: CB Insights; DealRoom; Tech in Asia; Expand Research; BCG analysis. Note: Bubble size represents cumulative equity funding since 2000; the execution bubble includes brokerages. 1 KYC = know your customer. 2 HFT = high-frequency trading. 3 OMS = order management systems; EMS = execution management systems. sent 15% to 20% of the total cost base, the implicit costs arising from cash flow ineffi- ciencies, such as excess collateral for clearing, can weigh down capital resources. Ultimately, data and analytics underlie the entire value chain, and investment banks have started to recognize data as a strategic asset that offers differentiation opportunities. (See the sidebar “The Focus Is on Data and Research.”) The Fintech Value Proposition Banks are constantly in search of measures that can help them restore ROE. In ad- dition to monetizing existing assets and mutualizing costs, fintechs can come to their aid by building capabilities to improve existing client relationships and experi- ences, streamlining front-to-back costs, and optimizing regulatory compliance. Improving Client Relationships. Fintechs can help prioritize profitable clients and optimize pricing and sales strategies. For example, transaction cost analysis can help establish a complete internal view of client profitability through rigorous analytics, allowing banks to raise their game on pricing, increase hit ratios, and capture client flow. Such initiatives can shield banks from increased competition, as client flow is expected to become more price-sensitive with the advent of the second Markets in Financial Instruments Directive (MiFid II) and its best-execution requirements covering nonequity asset classes. In addition, banks can provide more coverage and high-touch resources to clients that have a more profitable flow. The Boston Consulting Group 9

THE FOCUS IS ON DATA AND RESEARCH The data and analytics niche is one of sometimes deployed on top of the largest for CM fintechs: approxi- existing data silos to meet short-term mately 150 companies are active goals, with few improvements in the within the space, and they have underlying core data architecture. To received $670 million in funding. avoid amassing an ever greater Another 950 companies, with technological burden within the $11 billion in funding, offer solutions organization, therefore, deployment to CM players as well as to the wider must be accompanied by efforts to financial services market. Such improve data governance standards. proliferation of fintech firms is not surprising, considering that the The value migration happening today efficient processing and exchange of has been aided by a reduction of information underpins the CM information asymmetry, as exchanges, industry. Moreover, the explosion of information service providers, and the available data means that the larger buy-side players hold informa- opportunity for harnessing it is both tion that is comparable to that of urgent and critical. broker-dealers. Moreover, the regula- tory drive for unbundling is causing Historically, broker-dealers were the providers to price research on a principal accumulators and gatekeep- standalone basis and to find new ers of data, deriving power from their ways of monetization. The intellectual market-making role in the order flow. property within research can be used But poor data governance and too to launch indices and systematic many silos have led to significant strategies, in line with the move of underutilization and undervaluation investors toward low-cost index funds of this asset. and smart beta investing. Today, the financial services industry When it comes to distribution, some treats data management as a primary fintechs, such as the research aggrega- function. And while the role of the tor Visible Alpha, can enable the chief data officer has become relative- delivery of research in new ways. This ly established, the position will includes access to the underlying ana- continue to evolve as data begins to lytical models, semantic search, and be monetized. This increase in sentiment scoring capabilities, so that importance has been enabled partly research consumers can mine the by the regulatory push for transparen- large daily output in unique ways. cy and standardization in the mar- Also, licensing agreements can kets, as well as by recent technologi- provide revenue sharing opportunities cal advancements in aggregating and from the rise of alternative data. The analyzing both structured and Chicago Board Options Exchange, for unstructured data. example, has partnered with Social Market Analytics to launch dynamic Despite this progress, however, issues indices that track stocks with high with data management are far from sentiment scores and facilitate resolved. Big data solutions are options trading based on social media. 10 Fintech in Capital Markets

A second category of front-office fintechs is focusing on enabling banks to increase retention by improving the client experience and helping banks embed themselves into their clients’ workflow. Indeed, until recently, most front-office applications were built in-house, available only on specific platforms, and siloed under a thin layer of integration at the level of the user experience. Today, driven by the adop- tion of a suite of HTML5 technologies, this situation is changing as the industry moves toward a more flexible user experience model. Fintechs can now enable banks to create a smooth and unified client experience that tracks behavior across different platforms. Moreover, new fintech offerings such as multi-issuer structured product platforms allow banks to match products with investors’ risk preferences, thus shifting product governance to more client-driven, self-service solutions that avoid inappropriate selling. The reality is that many investment banks lag behind organizations in other indus- tries when it comes to tracking customer satisfaction, at a time when customer ex- pectations have increased substantially. Banks thus have an immense opportunity to leverage predictive-modeling solutions that blend financial-market and client transaction data to understand and anticipate client needs. Use cases vary from es- tablishing client profiles and predicting demand for certain products to forecasting the propensity to issue equity or debt or to perform block trades. Partnerships with fintechs can also reduce the time to market for proprietary prod- Partnerships with ucts and services and increase revenue. For example, Goldman Sachs collaborated fintechs can reduce with Motif Capital to issue structured products that express the unique thematic the time to market for views of clients. proprietary products and services and Streamlining Costs. Most fintech enablers in the CM ecosystem have a lower-cost increase revenue. component in their value proposition and can thus provide investment banks with an alternative route to additional efficiency gains. Consider the modern trading desk, for example, which is evolving to adopt a unified communication approach that merges channels, such as voice and electronic (including digitizing voice trading through speech recognition). Services that enable trading from any location, while leveraging cloud-computing services, could become ubiquitous in the future. Such software could eliminate large portions of legacy systems and costly private- communication lines, as well as improve overall asset productivity. By moving to internet-based cloud-computing services, investment banks can rent computing power and hardware in a way that efficiently meets fluctuating demand. In addition, mutualizing costs in post-trade and support is a particularly attractive opportunity, the benefits of which have yet to be fully realized. Current utility play- ers are still nascent, and adoption is slow because the market remains fragmented. Meanwhile, process automation is expected to maintain momentum across both front- and back-office activities as machines continue to replace human workers. Some of the most promising areas are intelligent processing, which can be found in functions as varied as robotics and machine learning systems, and the application of distributed ledger technology for settlement, confirmation, and reconciliations. Other potential areas to realize cost efficiencies include connectivity and order management systems in fixed-income and trader communications. The Boston Consulting Group 11

In many of the above cases, the potential for cost reduction on the respective func- tions can be significant (greater than 50%). However, the transformation should start from the ground up, with the infrastructure layer, to avoid leaving fundamen- tal IT architecture problems unresolved. Furthermore, to become credible as a viable substitute, fintechs must offer high standards of service and reliability. To be sure, a major challenge in adopting inno- vative solutions today is building trust. The potential for regulatory accreditation can quickly raise fintech credibility. Fintechs must offer Overall, up to 75% of sell-side IT costs are nondifferentiating, according to Expand high standards of Research. A large proportion could be externalized to fintechs over the next 15 service and reliability. years, leaving the remaining 25% to be built and managed internally as a competi- tive asset—such as by developing systems that provide pricing sophistication, client analytics, and execution. Optimizing Regulatory Compliance. Regulations have been a huge burden for investment banks since the 2007–2008 financial crisis. In investment-banking technology functions alone, around $3 billion is spent annually on regulatory and compliance IT, which includes only officially reported regulatory projects. So-called regtech firms, which have received about $200 million in funding, have stepped up to help banks navigate the evolving regulatory maze. Currently, there are more than 400 sources of regulatory information, with many regulatory tasks (such as KYC and trade surveillance) requiring extensive manual efforts. Regtech companies, deploy- ing technologies such as natural-language processing and machine learning, prom- ise to automate these processes while reducing duplications caused by regulatory requirements that overlap across jurisdictions. In addition, behavioral technologies, such as Behavox, can analyze employee actions and provide risk warnings for possible noncompliance, helping banks proactively deal with any conduct issues that could cause incidents. Implicit in the efficient use of any regtech tool is maintaining a certain level of data standards. Regulatory harmonization and convergence require international coordi- nation between the private sector and the official sector. The regulatory goal of de- veloping a more robust financial system must involve developing and adopting data standards, such as the Financial Industry Business Ontology common language, and finding ways to nurture the regtech ecosystem. Four Factors Are Critical to Getting the Most Out of Fintechs The value that can be delivered by CM fintechs is often diluted by certain industry barriers that need to be understood and overcome. These barriers exist in areas such as simplifying IT architecture, developing industry standards, improving collaboration among industry players, and mitigating the risks of working with vendors. Simplifying IT Architecture. Over a period of years, many banks have been adding IT infrastructure without consolidation, resulting in excessive complexity. That complexity, in turn, has required banks to deploy middleware to provide interfaces among their fragmented applications. In addition, dealing with a large number of 12 Fintech in Capital Markets

vendors places significant strain on internal resources. Ultimately, investment banks need to avoid creating additional application layers and work to become more agile in order to integrate fintechs and transform the IT architecture uninhibited by legacy issues. The agile method delivers iterative, minimum viable states that continue to communicate with the existing infrastructure and allows for gradual migration to the new platform. Agile involves rapid prototyping to identify use cases and develop solutions that help a company adapt its IT operating model more quickly. Developing Industry Standards. Although CM players can play a significant role in developing common assets, regulators can act as a catalyst for technological innova- tion by promoting standardized solutions. For instance, the European Securities and Markets Authority decided to use International Securities Identification Numbers as identifiers for derivatives under MiFID II in order to expedite implementation. The industry is still grappling, however, with a common standardized approach for describing all facets of the CM universe, such as reference data for distributed ledger technology, given the complexity of the financial instruments, entities, and processes involved. Improving Collaboration Among Industry Players. Governance frameworks within industry-owned fintechs can foster better collaboration among industry players, increase adoption rates, and promote goodwill on the part of incumbents because they have a stake in ensuring their fintech partners’ success. In addition, initiatives such as Project Neptune, launched by a group of banks and investors to facilitate the exchange of fixed-income inventory information among participants, demon- strate the benefits that accrue to both the sell side and the buy side as a result of unifying their efforts. Indeed, the current lack of interoperability and open innovation among fintech and CM players hinders new business and sourcing models. The adoption of open inno- vation principles can drive cocreation across firms by combining enterprise assets Reducing the risk of in new ways. Some of these assets could be monetized by individual firms. Applica- working with vendors tion programming interfaces (APIs), for example, have become a prominent feature will be critical to drive of the digital economy and constitute a core capability of technology leaders such innovation. as Uber, Twitter, Google, and Facebook. Moreover, third parties can develop appli- cations that leverage enterprise assets though APIs, thus connecting firms, develop- ers, and end users. CME Group, for instance, has partnered with Dwolla to make real-time margin payments on behalf of CME’s customers. Mitigating the Risks of Working with Vendors. The advent of multiple startup firms supplying solutions to the market has led to the perception of an increase in risks when working with vendors. Reducing these risks will be critical for the industry to drive innovation. At the same time, in light of regulatory capital constraints, the appetite for operational risk has diminished. For fintechs, many of which have yet to attain the necessary maturity to displace es- tablished practices, knowing how to build solutions that both minimize integration costs and enable the firms to work alongside other industry vendors in a seamless manner is crucial. Fintech clients will need to analyze and mitigate both contractu- al risks and operational risks, such as reliability and security. To help in these areas, The Boston Consulting Group 13

some fintech offerings have emerged to provide so-called know-your-third-party ser- vices that simplify vendor due diligence. Taking an Engagement Approach Incumbent banks need to find the optimal engagement mix for interaction with the fintech community and actively select individual companies to acquire, invest in, or partner with. A recent BCG report described five potential innovation models. (See Global Capital Markets 2015: Adapting to Digital Advances, BCG report, May 2015.) The models are as follows: • Business incubation and acceleration can provide support for, and coopera- tion with, startup companies in the early stages of development. • Venturing allows banks to make equity investments in order to assess and take advantage of new growth opportunities. • Strategic partnerships allow banks to explore joint ventures that drive incre- mental revenue and extend market potential. • Mergers and acquisitions can act as fast-to-market solutions when investment banks acquire developed companies. • Internal R&D has a significantly longer lead time and a considerably higher total cost of ownership, but it allows banks to maintain full control. Our analysis of fintech engagement shows that incumbents’ preferences for the mix they choose varies according to the nature of their strategic growth plans (organic versus inorganic), their degree of innovation momentum, and their digital maturity. CM fintechs are (See Exhibit 5.) mostly engaged through M&A and VC CM fintechs are mostly engaged through M&A and VC funding rather than through funding rather than incubators or accelerators. This may be owing to the sophistication and high value of through incubators or their intellectual property (IP), making them attractive acquisition targets. Challeng- accelerators. ing market conditions, including regulatory and cost constraints, have also meant that many CM players have preferred inorganic growth, taking advantage of consolidation opportunities and external innovation channels rather than internal development. Information service providers have the most aggressive inorganic strategy, using mostly M&A to acquire fintech assets. Such providers also use strategic partnerships to extend their offerings. Exchanges and venue operators are the second most ac- tive in M&A, as they diversify into multiasset trading and nontransaction business- es. These players have been expanding into software segments that command lofti- er P/E multiples owing to higher expected growth. Favorable revenue prospects have also spurred these players to become active in internal R&D with new product launches and services. Some banks have shown a balanced approach that includes the use of incubator and accelerator programs. These programs can afford such banks the first pick of 14 Fintech in Capital Markets

Exhibit 5 | CM Players Have Varying Preferences for Their Fintech Engagement Mix INCUBATORS AND ACCELERATORS ARE PREFERRED FINTECHS FOCUSED ON CM ARE MOSTLY FOR ENGAGING WITH FINTECHS ENGAGED VIA M&A AND VC 0 Incubators Incubators and 44 161 20 5 and 2 accelerators accelerators 2 Venturing 10 124 13 7 Venturing 19 1 Strategic 4612 29 13 Strategic 15 partnerships partnerships 1 M&A 7 19 15 33 6 M&A 53 R&D 47511 3 R&D 17 065 130 195 0612 18 24 30 36 42 48 54 Total number of fintech engagements by type, 2010–2016 (H1) CM-focused fintech engagements by type (%) Clearing-houses Custodians Exchanges Banks Information service providers Venues Sources: CB Insights; DealRoom; S&P Capital IQ; Tech in Asia; Expand Research; BCG analysis. Note: Based on an analysis of the fintech engagements and internal R&D initiatives of 40 CM players: 14 banks, 11 information service providers, 8 exchanges, 3 custodians, 2 clearing-houses, and 2 venue operators. promising businesses, the opportunity to cost-effectively outsource experimental R&D, and the ability to discover budding tech talent. Internal innovation labs, meanwhile, can help attract IT expertise. Moreover, investment banks have been registering patents to protect and monetize the IP they have been developing inter- nally. For example, Goldman Sachs has filed patents both for a virtual settlement currency called SETLcoin and for swap futures contracts to secure recurring reve- nues from third parties. Regulators and central banks have launched their own ac- celerators with the potential to help fintech companies achieve authorization. An Urgent Need for Action Though the overall CM ecosystem has been thriving in recent years, the industry is facing a perfect storm of multiyear revenue declines on the sell side, an exodus of technical talent (partly toward fintechs) that requires banks to look outside their own organizations for resources, an expanding supply of fintechs brought on by the growing need to replace legacy IT architecture across the industry, and a wealth of maturing technologies (such as cloud, machine learning, and big data) that are ready to be applied to the CM industry. Banks must take action now both to protect their own interests and to boost the CM fintech ecosystem as a whole. These actions include: • Focusing on standardization The Boston Consulting Group 15

• Opening the banking framework to reduce integration costs • Improving strategic principal-investment capabilities to overcome the lack of VC funding Banks also need to manage their technology stacks as investors do and quantify the value of their portfolios. For example, investment banks can identify potential ven- tures by leveraging their current IT assets, much the way Goldman Sachs has done by forming a joint venture with Synchronoss to begin monetizing its IP in mobile communication technologies. Overall, the shifting competitive landscape has heightened the urgency for CM play- ers to proactively explore fintech adoption. Nonbank players have already broken into traditional fortresses of investment banking, such as market provisioning. Ca- pability gaps between nonbanks and banks have been decreasing, while investors have been growing impatient in the face of chronic underperformance. A wait-and- see approach is no longer viable. Banks that defer their options will lose significant value by not participating in the innovation process. They face the risk of disinter- mediation by competitors. Ultimately, fintechs are introducing new paradigms that CM players can exploit to their advantage. (See the Appendix.) Proliferation in innovation means that the landscape is complex and difficult to navigate. By establishing labs to focus on early- stage, novel technologies that are core to their principal activities, and by systemati- cally pursuing adjacencies that have synergies with their existing portfolios, invest- ment banks can position their businesses for a bright digital future. 16 Fintech in Capital Markets

Appendix The table below provides a value-chain-oriented overview of the various fintech categories, along with brief definitions of different types of players. VALUE CHAIN FINTECH CATEGORY DEFINITION Alternati­e €ning lat€orm‚ Pri­ate tock iance ƒ„A an cro…€ning marketlace connecting intittional roct e­eloment in­etor an ri­ate comanie Primary ynication an trctring E‡cange trae €n ro­ier trctre roct itri‰tion Primary market intelligence Plat€orm ro­iing ata an analytic on rimary market incling ƒ„A acti­ity IPO an ri­ate tock iance Algoritm mart orer Tool €or otimi†ation o€ orer e‡ection fining te ‰et rice ­ene timing roting an re trae rik meto an Šee o€ a trae Traer‹ ­ie… o€ real time market rik an rofit an lo Alication an ar…are €or trae colla‰oration an commnication incling Colla‰oration an liŠiity orcing lat€orm an traing trret Pre-trade commnication‚ connecti­ity Connecti­ity to market ­ene incling e‡cange mltilateral traing €acilitie interealer ‰roker e‡ternal ark ool an croing net…ork ‰roker connecti­ity financial in€ormation e‡cange connecti­ity engine an lo… latency oltion ro­ier Tool €or aggregation analyi an ­iali†ation o€ trae an market ata incling Traing market ata analytic tranaction cot analyi an reearc Hig le­el reearc ro­ier incling reearc management Žgeneration itri‰tion an content management“ Pricing orer management Engine e to atomatically calclate te market an €air ­ale o€ ecritie ytem an e‡ection an eri­ati­e in real time‚ alication to manage an monitor ifferent tye o€ management ytem orer c a to orer an limit orer an ot tem to te market ‘rokerage Intermeiarie tat el connect to a ­ene or lat€orm Ž‘’C“ Execution Vene an lat€orm Comanie c a e‡cange tat allo… er to e‡ecte trae Comanie tat ro­ie trae catre an ‰ooking ytem incling trae oition Core traing tecnology management an creit limit cecking in€ratrctre an er •ey ro­ier o€ market ata an trae commnication e‡erience Deign an imlementation o€ te er e‡erience €or te trae ytem Tool to manage creit an market rik calclate rik e‡ore an ot collateral Rik an collateral €or trae acro mltile conterartie management‚ trae ƒonitor to enre €air ealing an te ‰et e‡ection o€ trae‚ reort an re­ent r­eillance te e‡loitation o€ inie in€ormation‚ re­ent €ralent traing acti­itie an o on Post-trade Clearing reconciliation Generation o€ clearing intrction €or clearing oe clear trae caing an an ettlement litigation management‚ reconciliation ‰et…een te ‰ank an market or oter artie‚ ettlement o€ trae oition ‘lockcain Comanie tat e itri‰te leger tecnology €or ecific alication in caital market Žreominantly trae an ot trae er­ice“ Tran­eral ort €nction” finance €ra management ecrity HR internal –are er­ice reglatory an comliance €nction not relate to te trae li€e cycle Ž€or e‡amle reglatory monitoring“ Support Comanie tat allo… te tracking an analyi o€ client ‰ea­ior an er€ormance Client ata analytic an c a trog CRƒ kno… yor ctomer Client on ‰oaring ‰ackgron ceck an e iligence on creit rating icio acti­ity an anti money lanering The Boston Consulting Group 17

About the Authors Philippe Morel is a senior partner and managing director in the London office of The Boston Con- sulting Group. He is the global leader of the capital markets segment within the firm’s Financial Institutions practice. You may contact him by e-mail at [email protected]. Charles Teschner is a senior partner and managing director in the firm’s New York office. He leads the North American capital markets segment within the Financial Institutions practice. You may contact him by e-mail at [email protected]. Valeria Bertali is a capital markets knowledge expert in BCG’s London office. You may contact her by e-mail at [email protected]. Boris Lavrov is a project leader in the London office of Expand Research. You may contact him by e-mail at [email protected]. Kimon Mikroulis is a capital markets senior knowledge analyst in BCG’s London office. You may contact him by e-mail at [email protected]. Pierre Paoli is a partner and managing director in the firm’s London office. You may contact him by e-mail at [email protected]. Will Rhode is a principal in BCG’s New York office. You may contact him by e-mail at rhode.will Shubh Saumya is a director in the firm’s New York office. You may contact him by e-mail at [email protected]. Franck Vialaron is a partner in Expand Research’s London office. You may contact him by e-mail at [email protected]. Acknowledgments The authors would like to thank their BCG colleagues, as well as Emily Chapman and Esther Gross of Expand Research, for their valuable input and insights. The authors would also like to thank Philip Crawford for his contributions in writing this report, and Katherine Andrews, Gary Callahan, Lilith Fondulas, Kim Friedman, Abby Garland, and Sara Strassenreiter for their assistance in its editing, design, and production. About the BCG Fintech Control Tower The BCG Fintech Control Tower is a research framework developed jointly by BCG and Expand Research both to identify initiatives, technologies, and companies that matter most in today’s fin- tech ecosystem, and to assess their impact. It currently tracks over 8,000 companies and initiatives worldwide. 18 Fintech in Capital Markets

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