The Great Fintech Con(version)

In the summer of 2013, you couldn’t swing a cat in Hackney without hitting a fintech startup. Fueled by an accommodating regulatory environment, piles of venture capital (VC) cash, and Friday afternoon office beer sessions, the future seemed bright for young and hungry financial technology companies, which saw it as their mission to disrupt—if not entirely replace—a financial system they regarded as creaky, stale and primitive in its use of technology.

Fast forward to the fall of 2017, and the picture is very different indeed. Far from disrupting the capital markets, fintech startups in the wholesale space have largely become institutionalized, and the tone is no longer one of disintermediation, but of collaboration with the very entities they were seeking to replace. “We saw all of the fintech firms appear, saying they were going to disrupt the industry, but in the end they’ve been bought by the banks and the people they were trying to disrupt,” says Michiko Matsubara, group manager of prime settlement services at the Nomura Research Institute. “So perhaps some people have now thought that being disruptive may not be the way to go.”

Of course, measuring fintech’s success by how many centuries-old institutions it has killed off is not a sensible barometer of the industry’s health. But the numbers do tell a story, and it’s not looking rosy for the fintech industry. While the VC tap is still open, it’s beginning to tighten—VC-backed fintech deals fell 40 percent in the second quarter of 2017, according to figures from CB Insights, while funding fell 32 percent, coming off the back of a couple of mega deals in the first quarter. 

Even in the sectors that have made big gains on paper, there are warning signs on the horizon—blockchain companies grew their investments by 100 percent quarter-on-quarter, according to CB Insights’ data, but 46 percent of this figure was attributable to bank consortium R3’s $107 million Series A funding round in May 2017.

The fintech revolution, it seems, has stalled, but did it ever get truly airborne in the first place? In payments, lending, consumer banking and retail investment, there has absolutely been a disruptive impact. But the story across the capital markets is far different. “In its first wave, there were a lot of fintech companies saying that they’ll disrupt banking, and that there will be no more banks in five years. I think that’s calmed down a little bit,” says Ivar Wiersma, head of innovation for the wholesale bank at ING. “Also, from the perspective of the fintechs, the new entrants, they’re looking much more toward a collaborative model.”

Captive Audience

What makes fintech in the institutional space different is that many of the “disruptive” startups are actually founded by industry veterans, and as such, this idea of collaboration is hardly a Damascene conversion. Most of the more successful entrants into this space have been happy to adopt the fintech label, but are less comfortable in being as brash as others in their sector, who are known for buying subway advertisements accusing banks of villainy, and for magnetic, lugubrious CEOs who wear polo shirts and speak at tech conferences, rather than investor days.

One example of the former is Algomi, which emerged as something of a darling of the UK’s sector after its founding in 2012, with executives accompanying government officials on foreign trade missions to show off the power of the UK’s burgeoning fintech industry. Algomi’s CEO and co-founder, Stu Taylor, is a former managing director at UBS, his senior staff are mostly alumni of industry giants, including Morgan Stanley, Nomura and Deutsche Bank, and his product is very squarely aimed at being collaborative rather than confrontational. “Certainly, in the business-to-business space, which is where we operate, being truly disruptive is at best hard, and at worst, maybe suicidal,” says Taylor. “In the retail markets, some of the more disintermediating strategies maybe have further to play, but we fundamentally believe that professional bond trading requires risk taking, and the risk taking is done by banks. For us, that just needs to be better educated, and that’s where the collaboration comes from.”

Other examples of bank or exchange executives forming fintech firms are widespread—Peter Randall, CEO of blockchain startup Setl, for instance, was one of the founders of Chi-X, while Blythe Masters, the CEO of Digital Asset Holdings, is the former head of commodities at JPMorgan—and this can be attributed, in many cases, to a simple fact: The capital markets are extremely complex, and their inner workings can often only be truly understood by those who have worked in them. “You need deep, deep product knowledge and domain understanding, so a lot of the successful fintechs in capital markets are all Wall Street or City, they’re all bankers,” says ING’s Wiersma.

To even identify problems in the technology chain, let alone develop solutions to solve them, requires a deep level of affinity with not only the financial aspects of the trade lifecycle, but also the operational, the legal, the regulatory and technological concerns that are inherent to the markets, many of which are also idiosyncratic to the trading floor. “There are some difficult problems out there,” Wiersma continues. “If you’ve been working on a trading desk and encounter some of these problems, or you’ve been in risk and seen what it does to your capital consumption if it takes a long time to settle, then you understand this.”

As such, says Michael McGovern, head of investor services fintech at Brown Brothers Harriman, much of the “hot air” has left the room when it comes to fintech bravado. “That intimacy is required in order for the fintech capabilities to be relevant, and to be utilized by regulated institutions,” he says. “That’s what’s missing from the two engineers in a garage, or in a dorm room, creating the next fintech revolution—that intimate understanding of the meaning of financial data and how it gets utilized to support the activities that we’re seeking to automate.”

There is an argument that this can be learned, of course, without having to be a Goldman Sachs partner. But there is also a darker side to the markets that crops up time and again—once a certain size and importance is reached by a fintech startup, the real dangers of the jungle become apparent.

Soft Underbellies

More than fintech (or any other industry, for that matter), cyber-crime is the growth sector of the modern age. Hundreds of millions of dollars are stolen, extorted, laundered or scammed each year by increasingly sophisticated actors—no longer the Anonymous hacktivists of 2013, or the script kiddies of yore, which have far less importance than they once did, but nation states, organized criminal gangs, and often a blend of the two. “Clearly, these threats from state actors are not just from the state,” says Chris Mathers, a former undercover agent with the Royal Canadian Mounted Police. “They’re from organized crime, which in fact, in some countries, is the state, because the state is organized crime. The line between organized crime and intelligence services, in many countries, doesn’t exist.”

All of this presents a problem for fintech vendors, which have claimed the dubious crown of being the “soft underbelly” of the financial services industry in recent years, thanks to a growing reliance on outsourcing, cloud infrastructure provision and third-party services on the part of their clients, coupled with the need for sophisticated and continually evolving cyber defenses.

For any technology firm, cybersecurity is one of the pre-eminent challenges in modern operating environments. For a startup firm reliant on VC backing, with a threadbare staff in a WeWork office, the task of properly monitoring cybersecurity can be impossible. “Obviously, if you talk about where we spend our money, and the $350 million we spend each year on technology, a significant portion of that investment is focused on cyber, and on shrinking the attack surface we expose,” Brown Brothers Harriman’s McGovern says. “There’s no end game here—you have to assume that you’re under attack, and you have to put in place an evolving set of defenses that go beyond the traditional perimeter defense. That’s an area where, as the fintechs have gotten more engaged with larger clients and institutions, they’ve come to a realization of how risky the world is.”

Regulators, too, are aware of this possibility. Vendors and service providers are being increasingly considered in major pieces of regulation, such as Regulation Systems Compliance and Integrity in the US, or the revised Markets in Financial Instruments Directive (Mifid II) in Europe.

There has yet to be a major takedown of a fintech firm thanks to cyber-crime—outside of cryptocurrency exchanges, where such attacks are rife and well-documented—but most agree that it’s a matter of time. After all, if big commercial and central banks, ratings agencies, and even the Securities and Exchange Commission (SEC) can be successfully attacked, there’s little hope for the Silicon Valley startup weighing up a VC investment or a Kickstarter campaign for its next funding round.

Delivering the Goods

Yet another factor in the drawdown of activity within the fintech sector must be attributed to a more sober and rational analysis of the promises that these companies and technologies have made versus their ability to deliver them. In no other area is this truer than in distributed-ledger technology (DLT), or blockchain.

The financial services industry first reached fever pitch regarding the potential for blockchain around 2014 to 2015, when it was proposed by consultants, industry experts and early evangelists that the technology would replace everything from reconciliations through to stock exchanges and vital market utilities. “You’re seeing more and more fintechs coming back to banks and intermediaries to accelerate their business models, rather than disintermediating them,” says Todd McDonald, co-founder at blockchain consortium R3. “There’s a joke that when we first started this, we did a trip out to the Valley in the fall of 2013, and the number of business plans I saw that said ‘and then we will eliminate the need for the Depository Trust and Clearing Corp.’ was incredible. You can raise five bucks on that, but they didn’t realize that you need a billion-dollar balance sheet to execute on the problem.”

While consortia such as R3, which has embarked on an ambitious program of development across payments, capital markets, trade finance, supply chain and other areas—a program which, McDonald says, is now being reined in and refocused—have continued to thrive despite high-profile departures, the tone of conversation around DLT has become more muted in recent months. Nowhere was this more obvious than in the recent Sibos conference, held from October 16 to October 20 in Toronto. Organized by Swift, the conference is the flagship event for the more serious end of fintech, and the part of the sector that has, perhaps, been most institutionalized over the years. There, industry experts were still passionate about DLT, but were far more cautious in their predictions. “Is blockchain the future? I’m sure it is,” said Alexis Thompson, head of global securities services at Spanish bank BBVA, speaking on a panel during the conference. “How long is it going to take? For me, at least, that’s the big question. But at least in the custody space, we’ve made a lot of big investments [in recent projects] that have to be paid off before we can move on to other things.”

That attitude has filtered down into the projects currently under way, which are no longer concerned with replacing vital pieces of post-trade infrastructure, but are now seeing more targeted applications in relatively obscure areas. Indeed, executives are far blunter than in previous years about blockchain’s prospects. While some cite its potential in niche areas, most find the idea of entire markets powered by blockchain in the near term to be ambitious at best. “The best thing we can do now with blockchain is take very discrete elements of our settlement ecosystem—like secured loans, trade finance, or the gold settlement market—and try to solve for those in a blockchain pattern,” said Tom Castelyn, head of product management for custody, cash and foreign exchange at BNY Mellon, on the same panel.

On a wider scale, too, fintech is now being forced to react to some of the changes it has prompted in the industry it initially sought to disrupt.

Decaying Orbits

Taken as a whole, while fintech continues to exert its influence on the minds of technologists, VC investors, and indeed regulators—in a recent proposal to expand the powers of market watchdogs, the European Commission included an odd provision stating that regulators must “consider fintech” in all of their rulemaking activities—it’s clear that some of the wind has left the nascent industry’s sails. This may not necessarily be a bad thing for the industry as a whole—a number of acquisitions this year have seen innovative fintech firms snapped up by incumbents, which has validated their approach, the most noteworthy of which were Nasdaq’s purchase of Sybenetix in July, and Trading Technologies’ acquisition of Neurensic in October.

However, on a macro scale, this could be unwelcome news for countries such as the UK, which was an early backer of fintech and has seen interest wane since its vote to leave the European Union in 2016. The departure of major banks from London for Frankfurt, coupled with a declining fintech sector that employs 60,000 people and contributes £6.6 billion to the economy, but saw a 34 percent decrease on capital inflows during 2016, according to figures from trade body Innovate Finance, could be bad news for the country’s financial sector.

Some redrawing of this optimism was, perhaps, inevitable. There has been a general failure of fintech to recognize the key factors that have been driving change in financial markets, not all of which are attributable to legacy technology or an inability to adapt quickly. Regulation, consumer behavior and the natural evolution of financial products have all factored in to how banks have begun to change their practices and their offerings, and that can’t always be solved with something new. “The structure of the financial services market is changing, irrespective of the fintech phenomenon, driven by economics, customer needs and regulatory responses to market failure,” said Julian Skan, senior managing director, and Eve Ryan, banking research lead at Accenture, in a May 2017 research note titled, Fintech—Did Someone Cancel the Revolution? While fintech has a part to play in this future and in making the current system into a “better version of itself,” the researchers concluded, it won’t replace the existing system on its own.

What this does do, however, is provide a salutary lesson for future startups to perhaps consider—if you can’t beat ’em, join ’em.