Fintech and the Digitization of Financial Services — An Introduction
We are currently in the midst of the fintech revolution. Fintech, which we can define as the intersection between finance and technology, has experienced 67% growth in investment in the first quarter of 2016, with investment reaching US $5.3 billion. PwC reports that 83% of financial companies believe specific aspects of their business are at risk of being lost to various fintech startups.
It is evident that technology is significantly transforming and disrupting the financial services landscape. This presents both significant opportunities and challenges for incumbents, startups, and regulators alike. Fintech is rapidly evolving, moving well beyond the realm of startup disruptors, with many incumbents now making significant R&D investments and collaborating with startups. Furthermore, consumers are increasingly willing to adopt emerging fintech technologies such as AI-driven robo-advisors, which provide financial advice or portfolio management online with (depending on the model) reduced or no human intervention. As evidence of the trend, Accenture research found that “Forty-six percent of North American bank customers say they’re willing to bank using computer-generated advice and services independent of a human advisor.”
While financial services organizations are certainly interested in the promise of robo-advisors, it is distributed ledger technology (DLT)/blockchain that is the hottest topic in financial services R&D at the moment. A blockchain is immutable, meaning transactions can’t be changed/deleted once added to the blockchain. This allows blockchains to act as a reputable source of unchangeable, verified, and valid information. In the past 18 months, there has been a significant increase in interest in blockchain among financial services companies, and 2017 will be a critical year, as organizations seek to move beyond exploratory use cases and proofs of concept toward scalable pilot and operational systems.
Already, big financial services players are supporting a wide range of blockchain initiatives, both company-specific and consortium-based. For example, R3 has established a consortium of over 50 of the world’s leading banks and technology companies to collaborate on advancing blockchain research for possible adoption within financial services. On New Year’s Eve 2015, Nasdaq enabled the first-ever private securities issuance on its new blockchain technology platform: Nasdaq Linq. Nasdaq believes that blockchain “holds potential for 99% reduced settlement time and risk exposure in capital markets.” Other institutions researching blockchain technologies include State Street, BNP Paribas, and Goldman Sachs.
While blockchain has the potential to transform certain aspects of financial services, the question arises as to how organizations should engage with it. Should this happen in an inhouse context, as part of a consortium, in partnership with other financial services organizations, or in collaboration with technology companies? Business leaders are now looking beyond blockchain as a standalone technology, considering how it can be combined and integrated with other technologies to create the next generation of financial services platforms. Such fintech platforms will incorporate emerging technologies and standards, including semantic technologies, which bring structure and meaning to information. Semantic technologies remove many of the complications presented by legacy information systems and their inflexible and siloed data.
One possible use case where there is significant value in combining and leveraging blockchain and semantic technologies relates to business contracts. In financial services, contracts are ubiquitous, and they have traditionally been complex, manually exchanged, paper-based instruments that are time-consuming and costly for all parties involved. In domains with significant transaction volumes and value exchange (e.g., financial services, insurance, trading), the time and cost involved in handling such contracts can be substantial.
Smart contracts — which use a computer-based digital protocol to execute a legally enforceable agreement — could well redefine how business is done. In financial services, for example, smart contracts have all the covenants and conditions of a traditional security written into them, including interest rates and maturity dates. Smart contracts are expected to execute as designed, without any possibility of downtime, fraud, or third-party interference. Proponents of smart contracts outline many benefits, including removing the need for manual processing, increased transparency, reduced settlement time/cost, and reduced counterparty risk.
One of the reasons blockchain is potentially so powerful is its inherent ability to enable smart contracts. In terms of transporting these smart contracts between counterparties and recording transactions, the blockchain is the network upon which these contracts are exchanged. Facilitating the permanent recording of these contracts in a transparent and auditable way is one of the chief advantages of applying blockchain technology in this context.
A key aspect for enabling smart contracts is shared meaning, a pillar of the Semantic Web. Standards are required for “meaning” to be held in common across institutions, processes, and jurisdictions. The Semantic Web is an extension of the Web in which information is given well-defined meaning, better enabling computers and people to work in cooperation. Yet the biggest challenge is to develop a method that lets computers simulate humans’ capability in understanding the meaning. This is where semantic ontologies have significant business value.
In financial services, the Financial Industry Business Ontology (FIBO) is a business conceptual ontology developed by members of the EDM [Enterprise Data Management] Council. FIBO provides a standard semantic representation of a financial instrument with precise meanings of the asset and the relationships that exist with all other assets. A derivative, for example, will have a clearly specified relationship with the asset from which it is derived. It’s possible, through applying an ontology, that forwards, futures, options, and credit default swaps can all be identified as forms of derivatives. This is incredibly useful if you wish to, say, gain a comprehensive insight into the risk exposure of a particular party. In situations where parties use different names to refer to financial instruments with similar characteristics (e.g., credit default swaps), semantic ontologies can help reduce counterparty risk by applying reasoning and inference techniques forefficient search, analysis, and reporting.
For business leaders in financial services, the next generation of digital platforms represents a very significant and possibly lucrative opportunity. Yet beyond the hype, blockchain models remain little understood by many managers, and actual adoption of blockchain technologies in the financial services domain remains low. Significant obstacles must be overcome to ensure that users will accept the changes blockchain could bring to financial services processes. Business technologists need to start by educating themselves about the value proposition of these technologies. A key objective of this special issue is to help with this education process.
In This Issue
In such a fast-changing landscape, many managers are suffering from information overload in terms of trying to identify and evaluate opportunities (business and technological). It’s a continuous challenge for organizations to determine what is potentially significant and distinguish that from mere marketing hype. This fintech special issue of Cutter Business Technology Journal (CBTJ) will assist managers in gaining an understanding of the emerging business opportunities and technologies in the financial services domain.
Offering an introduction to the emerging fintech scene, Bjorn Cumps’s article discusses the impact that technology will have on key financial services functions, specifically payments, insurance, deposits and lending, capital raising, investment management, and market provisioning. Cumps sees the future of financial services as a landscape characterized by collaborations between some combination of digital giants, established financial services organizations, and fintech startups. He argues that the biggest threat to banks is a lack of agility, emphasizing that their ability to strategize and adapt quickly to a changing landscape will be key to their future success.
To assist managers in achieving a greater understanding of blockchain, we are fortunate to have two complementary articles in the special issue that explore different facets of blockchain. In our first blockchain article, Steven Kursh and Arthur Schnure introduce the dynamics of blockchain and provide an overview of how the technology works, while comparing public and private blockchain architectures. The authors also offer a critique of the current state of the art and the potential business advantages of adopting the technology. They conclude with some key takeaways for organization leaders, including exploring how blockchain could impact upon business functions.
Next, Dorota Zimnoch shares excellent insights on how emerging digital technologies are disrupting and reshaping the insurance industry (“insurtech”). An important point she raises is the fact that consumer expectations no longer come just from within an industry but from digital giants (Amazon, Google, Uber, etc.) that have become central to individuals’ lives. Zimnoch highlights a number of emerging use cases and gives helpful advice to senior managers within the insurance industry (indeed, any established industry facing digital disruption) who are trying to understand how they can effectively respond to the possibilities and threats being brought about by emergent digital technologies and fintech startups.
Returning our attention to blockchain, Karolina Marzantowicz and Maciej Jedrzejczyk present a detailed discussion of DLT, specifically focusing on the consensus mechanisms that enable digital trust. These are among the critical design aspects that organizations should consider when developing a blockchain-based system so as to find the optimal balance between scalability and transaction performance.
Our final article in this issue focuses on the rapidly evolving world of payments. When one considers payments exemplars, Asia leads the way, and there are many lessons that can be learned in terms of successfully embedding payments as a seamless experience within the digital business ecosystem. In his article, Andy Yee applies a three-layered network model to show how “networks, devices, and applications drive and support each other in a virtuous cycle” of payments innovation. Among the benefits of such innovation, Yee claims, are economic growth, inclusion of the previously unbanked, and reduction of the “shadow economy.”
We hope the articles in this issue of CBTJ will advance the state of the knowledge for all readers, regardless of your specific area of interest in fintech. Whether you wish to gain an overview of the emerging fintech themes, broaden your knowledge of blockchain technology, or understand the impact these technologies are having on the insurance and payments industries, there are learnings for you here as you continue on your fintech journey.