FinTech is Revolutionizing the Capital Markets

Introduction

Financial service is a legacy industry dominated by the same few players for decades, but it is finally poised for disruption. With the entrance of modern financial technology (FinTech) companies, the industry will never be the same. FinTechs pioneered novel solutions to make processes and transactions more efficient, accessible and transparent. As customers become increasingly digital, traditional financial services players must adjust their product offerings. Given the hesitancy to build digital products in-house, many traditional players have opted to partner with FinTech companies, bringing them from the fringes to the frontline of the financial services revolution. FinTechs impact a variety of sectors, including personal finance, banking, lending, etc. The focus of this article will be on FinTech’s impact on capital markets, increasing its efficiency, degree of personalization, and transparency.

History and the Rise of FinTech

Broadly defined, fintech refers to essentially any technology integration that improves the delivery of financial services. Therefore, the first iteration of FinTech can be traced all the way back to 1866 with the first transatlantic cable by Cyrus Field, which allowed for instantaneous communications for global markets. The first wave of technology has the characteristics of being heavily centralized and capital intensive. This includes examples like Fedwire by the US Federal Reserve or SWIFT, which was established through an international governmental cooperation.

With the proliferation of personal computers, mobile devices, and the internet from 1980s to 2000s, traditional financial services have slowly shifted online. PayPal’s launch in 1998 signalled a transition away from the centralized financial giants to a new decentralized system. This transition was slow, as most people accepted the processes established by the financial services incumbents. Then 2008 arrived. The financial crises and the collapse of some of the world’s largest institutions put customers in disbelief, who began seeking alternative solutions. In the banks’ ashes, technologies like Bitcoin and a suite of startups such as Square, Stripe and CreditKarma were born.

Fast forward to today, FinTech has become an industry that is worth more than $250 billion with over 30,000 companies. These companies span a variety of sectors like capital markets, lending, payments, banking, wealth management, and many more. Many startups that were founded in the early 2000s have grown to be household names like Plaid, Robinhood, and Venmo. Despite a 40% decline after the COVID-19 funding frenzy, $55B of venture capital investments flowed into FinTech in 2022, which has increased roughly 17% year-over-year. Led by disruptive technologies, McKinsey & Company estimates that FinTech will grow around 15% annually over the next 5 years, which is almost 3 times faster than traditional financial services.

FinTech Market Map

FinTechs span across a huge variety of sectors with completely different use cases, as illustrated below:

Impacts of FinTech

As the market map demonstrates, FinTech impacts a variety of sectors in the financial services industry. For consumers, FinTech aims to democratize access to financial services and enable peer-to-peer (P2P) transactions. For example, PayPal allows customers to send money to each other directly instead of using wire transfers by banks, which are time-consuming and costly. Other examples include neo-banks like KoHo to onboard underprivileged groups and build credit or buy-now-pay-later (BNPL) services like Afterpay that allow consumers to pay hefty bills in installments.

More recently, there has also been an emergence of FinTechs that target businesses, helping them manage finances and transition into the digital age. For example, Toast offers point-of-sale systems for restaurants to manage their payments and improve operations. Many FinTechs also serve as partners to existing financial institutions instead of challengers. Companies like Thought Machine help banks migrate their core banking infrastructure onto the cloud, which allows banks to modernize and improve their customers’ experience.

FinTech for Capital Markets

Out of all the sectors impacted by FinTech, capital markets are one of the most interesting. We have seen a lot of innovation in the consumer-focused sectors like payments and money transfer, but legacy industries like capital markets have yet to be disrupted. Consumers adoption of capital market services is around 30%, which is far below sectors like payments at 75%+; however, capital markets represent the biggest area of VC investments at 23% from 2016 - 2021. This means that leading investors are betting heavily on capital markets, signalling that this may be the next sector for major disruption.

Capital markets include players such as investment banks, security exchanges, asset managers, and clearinghouses, which provide services like equity issuance, borrowing, savings, and investments. They also include major sectors such as neo-brokers like Robinhood, cryptocurrency exchanges like Coinbase, and alternative lending platforms like SoFi. It also includes niches such as trading efficiency, post-trade digitization, and AI and Analytics within investments.

FinTech has had a profound impact on capital markets by increasing the factors that promote ease of access, liquidity and efficiency. Furthermore, it has disrupted how investors trade, manage their portfolios and obtain market information. For venture capitalists, the capital market business is viewed as a preferable area for investing. This points to the sector’s dynamic nature, which can contribute to swift growth and innovation. The capital markets industry still has a relatively small footprint compared to other industries, representing a significant runway for growth. Investors are putting a lot of money into fintech companies that help with buying and selling stocks and planning trades before they happen. They've invested around $2.2 billion in trade facilitation and about $1.1 billion in planning trades.

Market Map: FinTech Companies Disrupting Capital Markets

CB Insights identified a suite of technology providers in capital markets. They divided the companies into 3 categories: front-office, middle-office, and back-office. The front office covers customer-facing areas like sales and trading, which aims to create more access to primary and secondary markets or alternative exchanges for assets trading. Middle-office covers support functions like investment risk, research, and analytics platforms. This sector aims to provide better information for investors to make more informed decisions through using technologies like big data or machine learning. Lastly, the back office covers administrative functions and includes clearance & settlement, risk & compliance, and information technology broadly. Companies aim to improve efficiency and mitigate the risks with post-trade settlement and general operations for capital markets.

It is also important to note that there are many consumer-facing capital market FinTechs as well that reduce barriers to investing and democratize access to more asset classes. Examples include neo-exchange platforms like Robinhood with low trading fees, platforms helping small investors access IPOs, or private markets like PrimaryBid and Seedrs. The advent of capital markets FinTech has significantly improved the efficiency and quality for incumbents and opened up more investment opportunities for individual investors.

Future Outlook: AI Improving Front-End User Experience

AI (Artificial Intelligence) may be used to enhance the user experience in the front-end of capital market software. To improve client satisfaction and end-to-end customer experience, capital market FinTech businesses are using AI technology to provide intelligent trading algorithms, intelligent portfolio management tools and interactive customer support services. Predictive analytics, natural language systems and recommendation engines are among the AI-powered features that facilitate user engagement and decision-making by offering personalized revelations and user-friendly interfaces. For example, Robinhood uses AI to recommend personalized investment opportunities based on the customer’s past trading history, risk appetite, and proprietary insights.

Furthermore, front-end service providers like portfolio managers or trading platforms can use AI to enhance their insights. AI enables firms to process and extract insights from a massive database coming from diverse formats and sources. AI can also leverage advanced analytics to analyze real-time financial data and predict potential risks. Many platforms have integrated machine learning algorithms to identify and analyze patterns within large datasets, like detecting credit anomalies to recommend appropriate risk management strategies for investors. Overall, with the enhanced intelligence that AI provides, users should witness an improved experience with more insights and data when interacting with the front-end FinTech capital markets platforms.

Future Outlook: Blockchain Improving Back-end Core Infrastructure

This is one of the most popular trends from the FinTech revolution, as blockchain technology can improve speed and transparency for post-trade settlements or equity issuance. Blockchain technology can create a decentralized environment without the need to trust an intermediary and uses smart contracts to execute transactions automatically. To put it simply, the current equity issuance or trade settlement processes require a lot of data and information changing hands between a lot of different parties. As such, the processes occur slowly, and each party needs to verify the information received to prevent fraud. However, with blockchain, these processes can automatically be executed through smart contracts, eliminating the need for trusting and verifying information from middlemen since they will no longer be required. This can improve the efficiency of capital markets, save costs for firms, and prevent risks from fraud or cyberattacks.

Blockchain can also help with financial reporting and regulatory compliance. Given that data on the blockchain is immutable and public, regulators can easily see the transactions that occurred. Smart contracts, enabled by blockchain, can automate compliance procedures, ensuring adherence to regulatory standards and reducing the need for manual intervention. Moreover, the transparent and auditable nature of blockchain transactions facilitates real-time reporting, providing stakeholders with timely and accurate information. By streamlining processes and enhancing transparency, blockchain technology can foster trust among investors and regulators, ultimately improving the efficiency and reliability of the capital market ecosystem.

Conclusion

The arrival of FinTech has invited a new era of innovation in the financial services industry. We have already witnessed significant disruptions in consumer-facing services, with players like PayPal becoming household names. We believe the next area of disruption will occur in the capital markets sector. With innovative new technologies like AI and blockchain, the entire customer journey for capital markets could be improved to become more efficient, effective, and transparent. Incumbents in this space must adapt to this changing environment caused by the new entrants driving innovation with disruptive technologies. Most importantly, FinTech companies will continue to improve customers’ experiences and unlock more financial opportunities for more people.

Sources: Accenture, The Payments Association, McKinsey & Company, Redpoint Ventures, Boston Consulting Group, CAIA, CB Insights, OMERS Ventures, Broadridge, Ernest & Young, Celent Securities, Pitchbook, World Financial Review, Oliver Wyman