Fintech and investment banking: Knowing fintech to know the effect
Financial technology, or fintech (FT), will affect investment banking (IB) by affecting the various lists of services that they offer. However, two concepts need to be clarified before these effects can be analyzed in detail. First, the scope of FT needs to be defined by the most recent technology. Such a definition is important because FT is not a new term in the field of IB. FT has been a part of retail and investment banking since 1867, when Mr. Edward Calahan invented the telegraph printer, which was used for printing stock prices. However, the following discussion will assume FT to consist of: artificial intelligence (AI), mobile technology, quantum computing and big data. This narrowly defined FT is expected to be used by investment banks, their customers and players in secondary financial markets.
After limiting the scope of FT, the second concept that needs clarification is the level of difference between FT firms and traditional IB firms. This distinction was necessary before because “non-banking” FT firms were not required to have banking charters, which come with their own sets of obligations. While this distinction may have been relevant in the past, this is no longer the case. According to Gina Primeaux from Deloitte, the two types of financial firms are beginning to resemble each other. This is a 50/50 effort on the part of both firms. IBs are acquiring FT firms or generating FT services in-house. At the same time, FT firms are considering banking charters as part of their long-term strategies. Due to this convergence, the following discussion will not differentiate between FT and IB firms. Instead, the following analysis will investigate the effects of FT services on IB firms.
IB structure and types of effects: shaking IB to the core
FT’s effects on IB will be determined by the changes in the various services offered by FT. In their essence, investment banks provide a number of services that help their clients maximize financial returns. These services can be grouped into three broad categories. They are: mergers and acquisitions (M&A), risk management (RM) and management of financial assets (MFA). MFA can be further grouped into private wealth management and private client services. The structure of these services is graphically represented in the following diagram.
FT will affect each of the above boxes, and these will change the IB experience for the firms as well as their customers. The grouping of these effects naturally flows from this structure, where FT will affect M&A, RM and MFA. These effects will support both Red Ocean (cost-minimizing) and Blue Ocean (market-creating) strategies.
M&A and FT
FT’s effects on M&A include reducing time and cost for due diligence, improving speed and efficiency of legal work, and aiding calculations for receivables. AI-based FT will allow IBs to create value for their M&A clients via improving calculations of accounts receivable (AR). This is a challenge under normal circumstances because of the different accounting standards and product portfolios of M&A customers. Similarly, due diligence is also a very difficult task. Mistakes in due diligence can be some of the most expensive mistakes for an acquiring partner. Skeptics can be pointed towards Hewlett-Packard (HP). In an ill-fated deal, HP acquired Autonomy for $11.1 billion. It later found out that Autonomy had been “cooking its books”. That was a painful realization, considering that Autonomy was acquired at a 64-percent premium. The key to conning a multinational corporation (MNC) such as HP lay in overloading the due-diligence team with gigabytes of data. Today, AI-based software could have run through the data within days and detected the discrepancies. Such software is already being used by giants such as KPMG and Deloitte. These systems have been successful in detecting asset-reporting discrepancies in M&A acquisitions.
Apart from due diligence, processing legal contracts—to check for conflicting clauses, often over multiple jurisdictions—is also one of the slow and laborious tasks in the M&A process that opens the space for oversight mistakes. Apart from being error-prone, legal work is also expensive. Legal expense can form up to 30 percent of the billings for M&A customers. FT is expected to change this cost structure via cognitive systems. Cognitive systems can go through thousands of these contracts to find conflicting clauses or other such legal complications. This speeds up the process while at the same time reducing expensive billable hours. It is pertinent to mention that a single cognitive system software can reconcile data from multiple languages. Through these three effects, FT is expected to improve the M&A services of IBs.
Risk management and FT: better, cheaper, faster and immortal
FT will revolutionize RM in IB by aiding actuarial science. Actuarial science has many uses, which include assessing risks in M&As and initial public offerings (IPOs). Previously, human actuaries used complex statistics to accomplish this important task. Now, these humans are being replaced by AI. Such replacements can reduce costs while at the same time providing a faster and more accurate service. AI-based actuarial systems have high retention rates, because unlike human actuaries, they don’t die. Furthermore, AI-powered actuarial software gets better with experience.
Management of financial assets and FT
MFA entails maximizing the return on customers’ assets by issuing stocks and bonds and providing wealth-management services. FT will affect initial public offerings and wealth management by changing the prices of stocks and bonds. These changes in prices will occur via the introduction of robo-investors, tapping into small investments and blockchain solutions for small and medium-sized enterprises (SMEs).
Robo-investors allow AI-based algorithms to make investing decisions for individuals. These robo-investors offer lower fees and better control because of their digital nature. These advantages are being reflected in the behavior of the market. According to a report from Statista, the global assets under management (AUM) under robo-advisors grew to $400 billion in 2018. This growth is expected to be maintained into the future with an annual growth rate (AGR) of 38.2 percent. Conversion from old techniques to new ones will be the key to this AGR increase. A McKinsey & Company report from 2015 noted that 40 to 45 percent of wealth-management customers shifted to digital-led firms. Such robo-advisors are more resistant to human heuristics, such as availability bias. This, in turn, will reward the customers of IBs that have strong fundamentals.
After netting the big game, digital FT is also targeting small customers by introducing new features such as automated investments and blockchain-based stock trading. According to a Fidelity Investments benchmarking study, Millennial youth remarked that they would use a financial advisor if costs were not so high. Seeing this demand, firms such as Acorn are offering unique solutions, including offering to invest a customer’s spare change into the market. Such an increase in investments can add new money into secondary markets. If the flow of new funds into secondary markets is significant enough, it could affect stock markets. Similarly, FT is allowing small SMEs to invest via blockchain. Such an effort is being taken in Italy at Borsa Italiana, where blockchain-based records will replace paper certificates. Without FT, these small firms would not have been able to tap into organized credit structures. Access to these credit structures will catalyze the growth of SMEs into big firms. These big firms can all be potential clients for IBs.
It can be concluded that FT will continue to change the market for IBs. This change will happen throughout the length and breadth of IB services. IBs offer a range of services, and FT will affect all of them. These services can be broadly categorized as M&A, RM and MFA. These changes are all positive, as they result in increased speed of processing, decreased cost and increased accuracy. Some of these changes are well underway. What remains to be seen is how FT will affect the structure of the market.