The drive to digitise

A year as full of unexpected and potentially disruptive events as 2016 may lead banks to focus on downside risks as they look ahead cautiously to 2017 and beyond. As a born optimist, I take a slightly different view.

Notwithstanding its headline-grabbing political and macro-economic developments, last year confirmed many of the long-term trends re-shaping the finance sector, forcing banks and brokers to re-think their business models. 2016 witnessed a continued reduction in banks’ ability to commit capital, combined with greater commoditisation, fintech-driven disruption and emerging collaborative initiatives. Overall, these tended to emphasise the advantages enjoyed by scale players, but also point the way to toward sustainable growth for mid-tier and niche players. In 2017, these themes will be underscored by five ‘mega-trends’ that will accelerate the evolution away from existing models.

Some might look like risks or threats, but as an optimist I believe that a thorough understanding of the risks is a pre-requisite to taking full advantage of the available opportunities.

First, regulatory pressure will be maintained, in particular ensuring sell-side firms have the processes and policies in place to ensure clients’ interests are protected and prioritised. Conflicts of interest will be eliminated, corporate governance strengthened, best execution more clearly documented and product appropriateness fully evidenced. This will lead to better outcomes for clients, but the compliance costs of greater transparency are likely to be substantial, requiring firms to re-consider what they sell and to whom.

Regulatory change is one of several drivers behind the second mega-trend, the race to zero fees. Reforms are reducing the scope to profit from client facilitation, e.g. by sitting in the middle of the spread, and proprietary trading has all but disappeared. Simultaneously, pressure on fees will continue to intensify through product and technology innovation, often via non-traditional competitors, while prevailing low European interest rates still thwart historical revenue sources. In response, larger firms are looking to drive up volumes through global franchises, but all are exploring opportunities to reduce fixed costs. For mid-tier and smaller firms, I believe the best strategy is to stay close to the customer, providing differentiated services in the ‘last mile’.

A major reason for margin pressure is the pace and scale of innovation, my third 2017 mega-trend. From the application of artificial intelligence to cloud computing to API connectivity to the internet of things, technology is having a rapid and profound impact on many industries, including financial services. As Bill Gates said, we tend to over-estimate the change that will occur in the next two years, but underestimate the change that will take place in the next ten. The speed of change is such that no one can afford to think that one single large investment in technology will prepare them for the future. Banks should look to leverage collaborative utilities and partner with firms that can help them digitise their services and develop their value propositions on an ongoing basis.

The fourth trend that I expect to characterise 2017 – volatility shocks – is a function of economic and political uncertainty on the one hand, and regulatory constraints on capital, alongside related post-crisis reforms, on the other. As illustrated by the sterling flash crash in response to the UK’s EU referendum, the transfer of liquidity provision in the financial markets from banks and brokers to new liquidity providers  is increasing the number and scale of shocks. In a more uncertain and unstable world, the impact of these shocks will increase further, turning what were once highly speculative leveraged bets into existential crises for clients and / or counterparties. As such, I expect risk-taking activities will continue to decline in favour of more client-focused models.

Many of the changes described above are already finding expression in pockets of the finance sector, but I expect the digitisation of the wealth management industry in particular to take further significant strides in 2017. Robo-advisor platform operators are using cheaper building blocks to deliver performance and tailored functionality to clients, while coming to terms with underlying operational considerations such as transaction reporting, capital requirements and connectivity to market infrastructures. At the same time, traditional players with brand, distribution and expertise have a fast-growing awareness of the power of digital channels and the potential of APIs to develop a unique, highly differentiated user experience.

As a large but highly fragmented market, wealth management is ripe for those able to identify and seize the opportunity. But the dynamics that are changing wealth management are very evident in many of the lines of business across the financial services sector.

Whilst risk-taking is no longer as central to the business models of banks and brokers, perhaps the biggest risk to sell-side firms is the failure to adapt to the future and grasp the digital opportunities.