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Headline: Introduction - The long, long road ahead
Source: Euromoney
Date: June 2000
Author: Antony Currie
Wholesale financial services firms have made great play of their internet ventures in the last year, seeking to present themselves both as being internet-enabled and as pioneers in reshaping financial markets. Yet in reality few firms have done any more than take their traditional businesses and put them online. The true capacity of the internet to transform financial market structures has yet to be unleashed, although pure trading is changing fast. Maybe some of the self-styled pioneers want to hold this transforming power in check. They won't succeed for long, reports Antony Currie
When employees at JP Morgan arrived at work on June 14 they discovered a problem. All of them discovered a problem. Their e-mail system wasn't working, nor was their web site.
The cause of this complete shutdown was embarrassingly simple. The bank had neglected to pay its webservice registration fee to its site and e-mail provider, Network Solutions. The bill fell due in early May. Three bills were sent to JP Morgan, all them either ignored or misplaced. So Network Solutions did what any service provider does when not paid a debt: it pulled the plug.
It's an embarrassing incident for JP Morgan, the bank which has put itself at the forefront of the e-commerce revolution, creating LabMorgan as a separate unit whose raison d'être is to think of ways to cannibalize its existing businesses. It's also bad luck for the firm that it was singled out. A day later the head of e-commerce at another US investment bank admitted that it could have happened to any of them. "Of course it made us laugh, but the next thing I did was to make sure that our subscription was up to date. And I'm sure I wasn't the only one to do it."
Schadenfreude aside (who doesn't enjoy seeing a bank getting punished for failing to pay its debts?), this amusing little episode does have two rather more important messages for banks. The first is perhaps best summed up by the advertising slogan for DLJ's on-line share-trading arm, DLJdirect: "Putting our reputation on-line". In the past, if a bank had an internal problem, it might be able to keep it quiet, or it might gradually filter out. In the e-enabled world, a problem can be immediately visible to your entire client base and to your competitors.
Second, this is a small example of how an investment bank's business is not determined solely by what happens within its own walls anymore. Firms increasingly rely on outside providers, be it network providers for their internet and -e-mail, technology companies for their systems, or even former competitors now running parts of their business for them. The Bank of New York has positioned itself as a leader in custody, clearing and settlement, and will cover those areas for other institutions which want to focus on their own core businesses. JP Morgan Investment Management, for example, passed on most of these back-office functions to the Bank of New York last year.
As for JP Morgan's failure to pay the service provider's bill, perhaps better that it happen now rather than two years from now, when the bank's (and its competitors') reputation ought, according to its own estimates, to be so intricately linked to the internet that a day's failure could be hugely damaging.
Luckily for itwe're not at that stage yet. In fact, people are just far too overexcited by e-commerce. There is more hype than substance about the majority of what banks have been doing. Study the dozens of announcements made over the course of the last 12 months or more and you'll be hard pushed to find more than a handful that are ground-breaking.
Today, roughly a year after investment banking woke up to the potential threats and opportunities presented by e-commerce, the banks have created a complex web of investments in all manner of technology companies, start-ups and new business models. But a lot of these investments were little more than indiscriminate shots at a variety of targets. This time last year, for example, it was all the rage to be investing in electronic commission networks (ECNs), order-matching systems for trading Nasdaq stocks. They were growing, taking a 30% share in the market away from the traditional brokers, and had their sights set on the New York Stock Exchange. Investing in these, so the theory went, was a way to have a stake in a company stealing some of your business, and a seat at the table in case any of them managed to present a real long-term threat to the established exchanges.
Move forward to the start of 2000 and the emphasis shifted to the bond markets. The ability to be able to take orders and distributed securities online became the holy grail of the debt markets for a month or more.
Both are important in themselves, but hardly ground-breaking. Harold Bradley, senior vice president at US asset manager American Century will tell you, and tell you vociferously, that the market structure for stock trading is 30 years past due for a complete revamp. And anyone who feels that taking online an underwriting process for the debt markets which was previously done over the phone represents the zenith of e-commerce clearly won't have a job for much longer.
Yet both cases show how the ready availability of technology is finally shattering the resistance to change old, inefficient processes. The challenge is to realize that once this takes effect, it will fundamentally change the way we perceive what a bank is, and how it conducts business. What e-commerce is doing is raising the barrier of differentiation. Which is a polite way of saying that many of the things investment banks do for their clients really aren't that difficult or unique. Certainly that holds true for almost all of the trading businesses.
The US Treasury market, the most liquid debt market, has already made a successful transition to electronic trading, be it through proprietary sites such as Deutsche Bank's Autobahn system or the bank conglomerate TradeWeb, which has steadily built up a 30% share in ticket volume. It's only a matter of time until the rest follow.
It will take more time for some of the more complex products to go electronic, and for those trades which are more sophisticated, such as block trades or multiple trades made to alter the structure of a large portfolio.
But the ability to trade is no longer a question of who knows whom or what. It is a commodity which needs to be serviced by a utility. Take the announcement in mid-June of BondBook. This is a would-be exchange for trading agency, corporate and municipal bonds, jointly set up by Goldman Sachs, Merrill Lynch and Morgan Stanley Dean Witter. In some respects it's a response to MarketAxess, set up in January by Bear Stearns, Chase Manhattan and JP Morgan to provide a soup-to-nuts website for research, buying and trading debt products. But BondBook goes a step further: by making anonymity a central plank of the offering, the three banks are handing back one of their biggest advantages to the market, namely their ability to watch and gather information, and use it for their own purposes.
This is a gripe investors make for debt, equity and foreign exchange: banks see what their customers are doing, and trade against them, or use the information to advise other clients.
Consider how much the traditional trading methods benefit the investment banks. First, and most obvious, are trading revenues, which can make 40% or more of profits for a bank. Second is the information gathered from being a player in the markets. Once trading becomes a commodity transacted over a utility the banks lose both the revenue and the information.
The search for new businesses
Scott Moeller, chief administration officer for e-GCI, Deutsche Bank's e-commerce unit, outlined this point at a Euromoney seminar back in March. Traditional businesses where margins have already been falling due to competition, he said, will migrate to the web, where margins will most likely continue to fall because "the lower cost of doing business over the internet will not be fully offset by the increased volume". The only way to replace these revenues will be by getting into new businesses, be they vertical or horizontal marketplaces, perhaps applying their technology outside of finance. And these businesses could represent from one-third to one-half of a bank's revenues.
And that does not necessarily allow for effect of non-traditional players. CFOWeb.com is mentioned by several e-commerce heads and management consultants as a business model which could further erode investment-banking revenues, and possibly even their traditional role. As the name implies, it is a web site designed to offer better risk and operational management tools to chief financial officers. Banks then bid for services so driving down prices. And it allows smaller players access to clients previously out of their league.
The non-traditional companies with the best advantage may well be the telecoms companies. Wireless application protocol (Wap) is still in its early days, but already you can trade stocks and download information using mobile phones and hand-held computers. In Europe and Asia especially many analysts regard such devices, rather than personal computers, as the main way of connecting people to the internet.
Let's assume that you use your internet-phone or Palm Pilot to order a coke, or a takeaway meal, and by pushing a button you charge it to your phone bill. Bank and credit card are disintermediated from all but maybe the last step of paying the phone bill. It effectively makes your phone company another bank facility. What happens if telecoms companies can find a way of bringing similar ideas to wholesale finance?
The response, as Moeller has outlined, is for investment banks to find new revenue streams themselves. For some the choice is obvious: Lehman Brothers last June announced a strategic alliance with the biggest fund manager in the world, Fidelity, which also has a significant retail individual investor business. The venture helps a pure investment bank such as Lehman to get access to the retail market, and allows Fidelity to add investment-banking research and access to deals which it formerly lacked. Each partner is able to benefit from the other, and without having to undergo a painful merger process.
Deutsche Bank has followed a similar path in the US, where it has no retail presence, but a better investment-banking division since the acquisition of Bankers Trust Alex Brown. In March the firm announced it was buying a 19% stake in US on-line stock trader National Discount Brokers.
But are these the type of transformational deals the banks need? Probably not. Each simply adds an extension to traditional business models, extensions which are themselves also suffering from margin pressures.
DLJ has gone somewhat further, and before e-commerce became fashionable. At the start of 1998 the firm decided to break into the US high-grade bond business, largely a league table business. By developing an information system called the FED [financial engineering desktop], which this year was renamed Global Edge, DLJ was able to give corporates the tools to analyze the minutiae of their own business and funding options, leaving the bankers free to concentrate on strategy. By concentrating on providing content rather than execution capabilities electronically, the bank has managed to offer clients something completely different, and that has earned it a lot of respect, and profitable business.
Barclays Capital has entered into an interesting agreement with Schwab, the discount broker and on-line trading king. It provides the foreign exchange services to allow Schwab customers with accounts in more than one currency to move funds more around more easily. It's still foreign exchange, but looked at from a completely new angle.
Merrill Lynch and CSFB invested in a more interesting model than the bank consortia recently, both putting money into a company called CapitalKey, an investment bank which focuses on smaller businesses, say those with revenues of less than $100 million a year. The bulge bracket firms cannot compete here - the need for the large deals to pay the fees is huge - so it appears that a these two have decided to outsource to an organization which specializes in the sector. "Small businesses and small transactions are its mantra," says Deutsche Bank Alex Brown analyst Gary Craft of CapitalKey. "This is the sweet spot to the economy's growth and one where Wall Street's incremental focus on bigger deals is increasingly undeserved."
One sector to watch for new business development is that of the inter-dealer broker. Being more focused on pure trading markets, they are the players being disintermediated first. Cantor Fitzgerald has created e-speed, an electronic trading platform previously used just by Cantor traders. It is now its own company, spun out in an IPO last December. Its president, Fred Varacchi, describes the company not as an inter-dealer broker, but as a "business-to-business vertical electronic marketplace." In April the company announced a partnership with both Williams and Dynergy to create an on-line market place to trade energy, commodities and telecommunications. E-speed will run the site and clear the trades.
Around the corner, at the foot of Wall Street, is GFINet, the on-line subsidiary of another inter-dealer broker, GFI, and one which has been doing similar things to e-speed, only earlier, having linked up with partners to trade telecoms, electricity and environmental products last year. "Our strength has been in bringing buyers and sellers together quickly and efficiently," says Doug Yorke, executive vice president at GFINet. "So a couple of telecoms company guys might start off trading together, and then add a few more, but it's not a market. That's where we come in, setting up the infrastructure and documentation to allow everyone to trade."
Changing the old business model
Much, of course, depends on how comfortable regulators will be with traditionally non-financial companies getting involved in the business. But any such player must also be a smart player. If there is one lesson from the last 12 months about the role of e-commerce in financial markets it is that getting amazoned is not nearly as easy as it has proved in the world of consumer business. Amazon.com was able to steal a march on the traditional book selling model and embarrass the incumbent bookstore, Barnes and Noble, seriously enough for the latter to rush out an on-line version which was substandard. Amazon.com is now the on-line bookshop.
A similar uprising has occurred in retail share trading, with full-service brokers, such as Merrill Lynch, Salomon Smith Barney and PaineWebber being put on the back foot by Schwab, E*Trade, TD Waterhouse and others.
But in wholesale markets that has not happened. "I think the idea of 'if you build it, they will come' has been proved wrong," say Yorke. "You need more than just clever technology. The real rocket science is in getting people to use it."
Already there are examples of this. The most recent is ereorg, an on-line market place for trading bank debt and distressed debt. Judging by the number of resumés received from traders at traditional institutions this is no bad idea. But from the outset its creator and CEO Ronald DeKoven had been insisting on maintaining complete neutrality; he did not want to appear to be favouring any market participants, nor to appear to be controlled by them, by offering them equity stakes or seats on the board.
That all changed last month. After weeks of rumours that incumbent players were not happy with his approach, DeKoven stepped down as CEO, becoming chairman, and handing the reins - and the title - over to his president and COO Philip Andryc, a former senior executive at Morgan Stanley Dean Witter who came on board in January after a few months' sabbatical. Ereorg is now speaking to market participants about becoming equity partners and board members.
On the other hand, bank consortia run by the banks are not ideal either. They create the impression of being defensive and in favour of retaining the status quo - which basically means dictating to their clients. Lori Mirek, who is CEO of Currenex, an independent foreign exchange trading platform, regards her firm's third-party neutrality as key to gaining clients' trust and therefore their business.
Yorke at GFINet takes a similar view. "Each day we seem to be debating our strategy as yet another announcement comes out which appears to show that neutrality doesn't matter. It can shake your beliefs, but we remain convinced that within 18 months we'll be proved right on neutrality being key." GFINet talked to a couple of consortia about acting as the neutral partner earlier in the year. One of them had so many banks participating, says Yorke, that "it took weeks to get them all into one place for a board meeting". Another foundered on the very simple equation which would be needed to be regarded as neutral: GFINet would have to have a 51% equity stake. That, unsurprisingly, is not something the members of these consortia are yet prepared to do.
The only revelation is that so many competitors are prepared to consider working together. The majority of them aim to be exchanges in all but name, and no such venue will be able to exist long-term without at least a nod to neutrality.
Conclusion
Investment banks like to take comfort from the fact that even with the demise of trading as a revenue stream, they still have risk management, advisory services, and transaction processing. But they ought to be careful not to get too cocky. Trading, and the access to information which goes with it, has been the life-blood of these firms. Adapting to this change is hard enough. To assume that these other three businesses will not be affected verges on negligence. Tools such as CFOWeb.com or DLJ's Global Edge can help bypass traditional risk management services.
Transaction processing is the easiest of the three to disintermediate the banks on. The career change of Philippe Buhannic can stand as testimony to that. Buhannic designed, built and ran CSFB's electronic trading system, PrimeTrade, for six years, making it the most comprehensive platform out there from trading to back-office settlement. "It's relatively easy to get the front office up and running," he says. "But all the work is in the middle and back office. It takes months, if not longer, and very few are anywhere near CSFB." But he left in May to become CEO of a start-up, Trading Screen, which aims to build an integrated trading and settlement platform for all securities, able to speak to all order management systems. That's a move you make if you feel the banks are unable to do it themselves.
But it is over advisory that the biggest question mark remains. With so much information now available to all players, there is an even greater need for someone to interpret it all. But it is a brave person who claims that the internet won't substantially change even this business. That's what people said about on-line trading.
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