Banking to be defined by technology

The global banking industry is at crossroads and evidence of change is more tangible than ever. Banks’ fixed income and equity trading businesses have been major casualties of the past few months, a result of both secular and cyclical trends; a decline further exacerbated by lack of investment in trading technology.

There are many drivers to the bank restructurings we are seeing, including rising cost of capital, declining profit margins, litigation risk, rising technological complexity and costs. The universal banking model may be threatened as a result of these changes, but it’s too soon to write its epitaph.

Nevertheless at this juncture the future viability and profitability of banks will be determined by the choices banks make around innovations and investment in technology. Once a bank has made the decision about which businesses it wants or can still afford to be in, the decision about how it participates in the intermediation and the trading process becomes crucial.

A good understanding of how the market infrastructure is evolving will be essential to making informed decisions. In my view, the new market structure that is emerging will have five key pillars:

• First are the global exchanges. They have survived the liberalisation and fragmentation of trading, innovating to meet the needs of a growing and more diversified customer base. They have also been able to turn regulations to their favour by expanding and diversifying their revenues. The same can be said about other infrastructures such as clearing houses and securities depositories. These entities will not only survive but will remain key to the market structure of the future, as long as they continue to adapt their business models to the market and retain scale.
• Second are the large broker-dealers. They will continue to exist despite the trend towards declining margins and profitability. However, there will be fewer players that have the scale and the liquidity needed to facilitate trading in key asset classes like derivatives. To the extent that they can break their own internal silos, and invest to replace their legacy technology, these select few players will survive and thrive.
• Third are the global banks. While broker-dealers are at the forefront of product innovation, global banks play a key role; in the distribution of financial products through their retail arms; managing wealth through their private banking businesses; and protecting and segregating assets through their custodian businesses. The breadth of these services will inevitably lead to an ‘arms race’ to achieve scale and efficiency, driving further specialisation by client type or asset class.
• Fourth are the market makers who have managed to carve an increasingly important role for themselves in today’s market structure. They are big clients of exchanges, and increasingly take on execution of trades that have been outsourced by many of the broker-dealers. They have revolutionised the world of equity trading. Their recent move into other asset classes such as foreign exchange is a sign of their ability to continue to disrupt the status quo.
• Fifth are the technology and software providers which do not compete with any of the above, but develop tools for other market participants. Players such as regional banks and brokers, private banks and wealth managers are increasingly outsourcing their trading technology to software houses to give them the ability to build scale and make the process of client intermediation and trading more efficient.

Mapping this market structure of the future, I am reminded of the so-called ‘creative destruction’, a term first coined by Joseph Schumpeter in the 1940s to denote the destruction of the old by the creation of the new. A term perhaps overused by dotcom era enthusiasts, but which holds some truths for today’s banking industry.

We are entering an era of high specialisation driven by consolidation towards a five-pillar market structure. Once this overcapacity in the system is removed, market participants will increasingly have less choice per type of client or asset class, and will rely on companies who aggregate different services.

In an environment in which technology is creating change, complacency and efforts to protect the status quo will only lead to destruction of value and loss of market share. It is market participants that understand their strengths, establish which markets they want to be in, and then use technology to achieve scale, that will remain profitable in this new era.

Matteo Cassina is Member of the Global Executive Commitee at Saxo Bank Group

This article first appeared 30 June 2014 in the Financial Times