Origin, a new central market place for issuers of debt private placements to post funding terms to intermediary banks, will go live in November, marking a rare foray for a fintech firm into the heart of the primary capital markets.
When Euromoney catches up with Raja Palaniappan, co-founder and chief executive of Origin – and a former corporate bond and derivatives trader at Lehman Brothers, Nomura and Credit Suisse who has been building his new business since 2015 – he is discussing final terms with the last of five banks who will debut on the platform at its now imminent public launch.
These banks will take the target funding terms in standard tenors and structures published by 21 regular issuers of private placements off medium-term note documentation (split evenly between supranational and financial institution borrowers of various sizes), seek to match those terms with the banks’ own investing customers’ requirements and so originate new deals typically of a size anywhere between $25 million and $150 million.
Although individual deals are smaller than in the benchmark public bond market, in any year private placements in aggregate can account for up to 30% of all funding raised in the debt capital markets.
For debt issuers, Origin offers one place to display standard terms to many dealers, instead of firing off separate spreadsheets to all of them by email or other messaging routes. They can update those terms quickly, simplifying communication requirements, while controlling which dealers on the platform see their terms. Ultimately Origin will allow issuers to benchmark borrowing rates against peers in a big funding market for which no central source of such primary market data yet stands.
For dealers it offers a central point of access to all documentation and information on a large class of important issuers, as well as real-time alerts of changing funding terms and associated swap movements.
It is an efficiency play, a way for dealers in particular to reduce the number of hours devoted to fairly mundane aspects of issuer coverage and processing of smaller transactions that are increasingly standardized.
Palaniappan cannot yet disclose the names of the first issuers, which include some of the biggest and most frequent borrowers in the global debt markets, or the dealers, a mix of mainly large European and US investment banks.
But his excitement is obvious. Having conceived the idea for Origin in 2015, bootstrapped it, refined its business model, raised additional funding and been through the Barclays accelerator, he has just seen it generate customer revenue for the first time from its pilot users.
Three aspects of the Origin story, in the context of what fintech means for the capital markets, appear quite striking. First, without wishing to rain on Origin’s parade, it does not appear to be a revolutionary business concept imminently set to overturn the entire structure of the debt capital markets.
In retail financial services, fintech newcomers have tended to take on the incumbents and seize customer business from banks with poor legacy technology, bloated cost bases, reduced leverage and higher weighted average cost of capital.
But this is not happening in capital markets.
Origin may smooth out the workflows and bring some transparency, but it does not seek to overturn market structure or disintermediate any of the core players.
Second, no one else seems to be trying to do that either, even though the technology has clearly existed for many years to connect the world’s biggest issuers of standard, plain vanilla debt securities directly to the biggest investors. Investment banks have been fretting about disintermediation since the late 1990s. But, unless they blew themselves up in the financial crisis, they are still with us. The newcomers have been boutique advisory firms, often monetizing the relationships and insights of a select handful of industry specialist investment bankers. Rarely are these tech-driven.
Various trading platforms have been set up to match portfolio managers seeking to move inventory directly between each other in the secondary credit markets, where traditional bank dealers are no longer willing to take positions. But this has not yet impacted capital raising.
By creating a platform that makes it easier for banks to deliver their investor demand to disparate issuers, we can help them to reclaim some of the profitability inherent in their core franchises.
- Raja Palaniappan, Origin
Few have even got as far as Origin. Toronto-based Overbond raised C$7.5 million ($5.6 million) in seed funding earlier this year to build a cloud-based, digital platform for corporate issuers, dealers and investors in the primary bond market in Canada to exchange deal messages previously sent manually and to improve price discovery. But it has not made much impact beyond Canada. Few of the DCM bankers Euromoney speaks to in New York and Europe have dealt with it.
Thirdly, at a time when venture capital investment is still pouring into fintech firms operating in peer-to-peer lending, remittances, payments, equity crowdfunding and even robo-advisory, investments in fintech firms focused on capital markets appear small.
When Euromoney spoke to Palaniappan in March this year about the creation of Origin, it had then raised less than £1 million ($1.2 million) in start-up capital. Buoyed by recent receipt of customer revenue, he is taking in some more funding now, but suggests this is more the building of a prudent cushion that is not taking up too much management time. It is certainly not a life-or-death effort to complete a big funding round crucial to building the company.
A recent white paper from the Boston Consulting Group, ‘Fintech in the capital markets, a land of opportunity’, suggests that of roughly $96 billion in venture capital investment in fintech since the start of the millennium, only $4 billion, roughly 4%, has found its way to fintech firms focused on capital markets. Although figures for venture capital investment may be supplemented by money devoted by banks themselves to capital markets fintech, this still looks like a sideshow to the main event.
Of the roughly 8,000 fintech startups that BCG tracks globally, only about 570, just over 7%, are active in capital markets.
It is not hard to see why venture capitalists, yearning to hit the Uber moment in finance, have gone after retail financial services first. Retail is by far the bigger market. Boston Consulting Group calculates that the total global revenue pool for financial services last year was $3.67 trillion. Of that, capital markets revenues, excluding those earned from asset management, accounted for just $330 billion, or 9% of the total.
Yet by that calculation, capital markets firms are still attracting less than half the venture capital investment into fintech that they ought to be. That may be because venture capitalist investors are put off by a segment of financial services that is quite specialized, very heavily regulated and already dominated by a small number of large players.
They may be missing a big opportunity. That dominance of the big players is receding. Before the crisis, every large commercial and investment bank aspired to be full service and global, offering every capital markets product and service to as many customer groups as it could in as many locations.
Capital markets businesses in their current form will only survive through radical restructuring, focused on cost reduction and greater use of shared utility infrastructure, in which fintech will play a central role, even if it stops short of outright disintermediation.
Palaniappan and his co-founder and former Nomura colleague Robert Taylor, now chief technology officer at Origin, first conceived of the company as a disrupter of the established order in debt capital markets. As derivatives traders, they had seen technology bring transparency, efficiency and price competition to the secondary markets, and figured the same was long overdue in the new-issue business where it seemed a simple concept to connect frequent issuers to the biggest asset managers and to cut out the middleman.
Now, as he prepares for the next phase of Origin’s development, scaling up to attract a greater critical mass of debt issuers and dealers, Euromoney invites Palaniappan to reflect on what he has learnt so far.
“We are witnessing the decline of the universal bank model,” says Palaniappan. “It used to be that a sophisticated, frequent issuer of MTNs looking to diversify funding sources that might want to tap into demand not just from BlackRock and Pimco but from Canadian pension funds, Taiwanese insurance companies, Middle Eastern sovereign wealth funds and European high net-worth could go to a small handful of giant banks that would each be able to tap into all of those pools.
“But now the mind-set at the senior most levels of the banks is to get out of any business where the bank is not in the top three so as to improve return on equity. That does three things. It means even the top dealers are laying people off and covering less of the investor and issuer universe. That in turn means that issuers are now looking for more dealers.
"It also means some of the tier-two or tier-three dealers that may have very strong links just with certain groups of investors, but don’t have connections to issuers across the world, now have a chance to showcase that distribution. By creating a platform that makes it easier for banks to deliver their investor demand to disparate issuers, we can help them to reclaim some of the profitability inherent in their core franchises.”
He uses an example: “We spoke to one dealer who has such a pool of demand in a particular region and had been thinking of an expensive rebuild of DCM capability to establish coverage of issuers that might see value in that distribution. By coming onto our platform, it can already see issuers that it has no coverage of and that it now realizes are very busy users of private placements. Building connections to them and serving them in this particular market can now be achieved at a much lower cost without building a very expensive coverage infrastructure.”
So while a new entrant like Origin might appear unambitious for not wanting to disintermediate established players, it might still be an agent of profound change in its target marketplace at the core of the new issue business.
And private placements are just a starting point. The overwhelming majority of such deals have some kind of currency or interest-rate swap attached. Processing these derivatives contracts brings its own operating burden, which now typically includes calculating credit valuation adjustments between the bank and the issuer that have to be included in pricing the swap and, even for big and generally highly rated SSA issuers, two-way collateral management agreements.
If Origin does attract a critical mass of issuers and dealers – and it will certainly price its service at the outset to make this more likely – it remains to be seen what further links it might build in collaboration with processing utilities in associated markets.
This is how the fintech story looks most likely to play out in capital markets; not quite as headline grabbing as disintermediating the incumbents – collaboration does not sound nearly so exciting as disruption – yet still plugged into forces of profound change now sweeping through investment banks.
In September, EY and UK fintech trade body Innovate Finance published ‘Capital Markets: innovation and the fintech landscape, how collaboration with fintech can transform investment banking.’
Its conclusion invites readers to write on a white sheet of paper a business model for the investment bank of the future and carries an echo of the old joke of the tourist in a provincial city asking for directions back to his hotel and the helpful local assuring him that the most important thing is not to set off from here.
While disintermediation in retail financial services and the rapid gains in market share by fintechs are well documented, barriers to entry in capital markets are much higher.
- David Williams, EY
The authors suggest that instead of copying the investment bank of today, the investment bank of the future will do far fewer things itself. It will outsource much of its processing and settlement infrastructure to shared utilities, for example, and insource from third parties many of the key requirements for customer coverage. It might employ collaboration to bring together and integrate a best-of-breed trading platform with a largely externalized blockchain-enabled back office, procured smartly on an as-a-service basis. To service clients, the investment bank of the future will still put its best brains in the front office, but supported by all the artificial intelligence and analytics they need sourced flexibly from specialist providers.
Rather than duplicating the sales forces of all its competitors covering the same issuers and investors, it may jointly distribute certain pre-trade information on a shared platform. It may seek to share the growing and heavy cost of market data, mutualizing the cost of sourcing it from monopoly suppliers. Where its new infrastructure is best in class, it might consider white-labelling it to competitors.
David Williams, partner at EY, tells Euromoney: “While disintermediation in retail financial services and the rapid gains in market share by fintechs are well documented, barriers to entry in capital markets are much higher. Yet investment banks are also beset by declining returns on equity, structurally high costs because of hugely complex legacy infrastructure, and compliance requirements that are unlikely to ease any time soon.
David Williams, EY
“Many experienced managers have left the industry, and of those that remain, many are legitimately focused on the immediate challenges. They therefore welcome game-changing, external innovation that has been funded by others.
"There are now many fintech firms founded by bright technologists working together with seasoned finance industry veterans, tapping into a number of key technology trends – the cloud, robotic process automization, process and service externalization, advanced analytics, artificial intelligence, blockchain – to address these structural issues for capital markets firms. We believe that for the most part this will happen in collaboration with the incumbents rather than in competition.”
It may be an unkind over-generalization, but investment-banking profitability has collapsed in recent years partly because in the good times investment banks poured all their energy into product innovation and rather neglected the back office.
John Cryan, chief executive of Deutsche Bank, is probably the one bank leader who has come clean about how the German bank, a winner in the old model of investment banking, that was quite brilliant at creating and dealing in the most complex, esoteric derivatives and nimble at parcelling up and transferring the unwanted residual risks to customers, somehow still employed large numbers of contractors to come into the office and input processing details manually into the general ledger.
“If you look at the returns on equity of the top global investment banks, they have been running an average just over 8% for the past five years and managed just over 6% in 2015,” points out Lawrence Wintermeyer, chief executive of Innovate Finance. “Part of the explanation has been macro issues like negative real rates. But banks also have to look at cost-to-income ratios of 70% and 80% and re-examine their own value chains. Those cost-to-income ratios simply aren’t sustainable.”
For that reason, bankers say privately that while they are keen to experiment with potentially game-changing technologies like blockchain, a more urgent priority is to quickly contain processing costs, especially those relating to managing regulators’ data requirements and compliance functions. One source tells Euromoney that investment banks have seen these expenses increase at a 15% compound annual growth rate through several years of flat revenues.
“Banks need to deal in a much smarter way with regulatory requirements in the short term, not years from now” says Williams at EY. “There is huge potential for advanced analytics and robotic process automation [RPA] to transform how banks are protected and controlled. Human talent should be deployed on value-added tasks where judgement is required. Software robots should be performing repetitive tasks, such as moving data from here to there.”
Many operational processes change frequently and sometimes at short notice; in the past this has hampered their automation through traditional IT integration. But RPA differs from traditional process automation in that software robots typically address the user interface of existing platforms, as opposed to automating processes within the software code and database layers of the applications themselves.
The software robots can be trained by business users with a deep understanding of the processes and changes to them.
“RPA won’t, by itself, transform processes and systems that aren’t great in the first place, but they can take costs out very quickly by working 24/7 and slashing process times from hours to minutes,” Williams says. “So you could see a big role for RPA in managing data intensive tasks such as know-your-customer [KYC] processes. Many of the investment banks are also looking at using RPA across operations and finance functions. Whilst it’s relatively early days, it won’t be long before RPA is widely deployed for processes such as reconciliations, collateral management, valuations, tax operations and financial reporting”.
Sources at some of the investment banks tell Euromoney that they are also looking at using robotic software in real-time position valuation and daily P&L calculations, although none has yet industrialized this.
Banks also have to look at cost-to-income ratios of 70% and 80% and re-examine their own value chains. Those cost-to-income ratios simply aren’t sustainable.
- Lawrence Wintermeyer, Innovate Finance
Venture capital money is flowing most freely towards fintech firms focused on regulatory compliance at corporate and investment banks, so-called regtech, because there is an obvious and immediate need for banks to get on top of this right now.
Wintermeyer says: “Banks are in a strong position in that they can now outsource the costs of developing answers to their most important cost problems to third-party fintech developers, backed by venture capital money, that want to sell to them rather than replace them. Banks can test out and refine these fintech offerings and select winners through their own accelerators, rather than each investing heavily in solutions that may fail or may not be inter-operable with systems to which they must connect at regulators or at counterparties.”
Yet, at the start of the year, when EY published its annual banking barometer, based on interviews with 250 senior bankers at financial institutions across Europe including retail and specialist banks, as well as universal corporate and investment banks and wealth managers, it found that just 23% were ready to start collaborating with fintechs. It is a surprisingly low proportion. Perhaps banks still see fintech firms as essentially a threat rather than providers of a solution.
“There may be some cultural reasons for this,” one senior banking source tells Euromoney. “There are obvious vested interests inside banks whose continued employment depends on maintaining legacy infrastructure. There is also some reluctance to invest within annual budgets on operational improvements that might be uncertain to succeed and only deliver benefits next year or the year after. And, ridiculous though it sounds, there is still some of the old mentality that a managing director with 500 staff reporting to him is more important than one with 150 staff reporting to him, even if the bigger department could take out 350 of those people and move the business forward much more efficiently.”
Those attitudes cannot prevail much longer.
The EY and Innovative Finance report on collaboration with fintech picks up a quote from David Rutter, chief executive of R3 CEV, which is co-coordinating banks’ joint investigations into possible applications for blockchain, or distributed-ledger technology, potentially the most revolutionary technology to have emerged in financial services, from the unappetizing foundation of the cryptocurrency bitcoin.
“With the technology available, we can change the way transactions are done, reducing costs from dollars to pennies,” says Rutter. And such cost reductions could mean that epitaphs for certain investment banking business may have been delivered too early. “Through collaboration, we have the opportunity not only to revive businesses that have died,” claims Rutter, “but also to create new ones that haven’t even been thought of.”
Through collaboration we have the opportunity not only to revive businesses that have died, but also to create new ones that haven’t even been thought of.
- David Rutter, R3 CEV
Some big things are going to happen on blockchain in the years ahead – and lots of little things as well that in aggregate might have a big effect on how the capital markets operate and how issuers raise funding.
For example Credit Suisse, Ipreo, Symbiont and R3 announced in late September the successful initial completion of a project to use smart contracts on blockchain to improve the syndicated loan market. Bank participants in the proof of concept, which will continue through the end of this year, include BBVA, Danske Bank, Royal Bank of Scotland, Scotiabank, Société Générale, State Street, US Bank and Wells Fargo. Buy-side firms AllianceBernstein, Eaton Vance Management, KKR and Oak Hill Advisors also joined the project.
By connecting a network of agent banks through blockchain, the project proves the potential for faster and more certain settlements in the heavily paper-based loan market, as well as efficiency gains across the whole life cycle from issuing to servicing loans.
The core technology for the venture is provided by Symbiont, a developer of smart contracts, and Ipreo in a collaboration called Synaps. Through Synaps, loan investors have direct access to an authoritative system of record for syndicated loan data. This yields immediate savings by reducing manual reviews, data re-entry and systems reconciliation. In the future, loan-data processing can be done exclusively on the distributed ledger, eliminating the cost for each market participant to maintain its own separate lending system.
“This project demonstrates the potential for blockchain technology to fundamentally reshape the syndicated loan market and the capital markets more broadly,” says Emmanuel Aidoo, head of the distributed ledger and blockchain effort at Credit Suisse.
Mark Smith, CEO and co-founder of Symbiont, claims: “Smart contracts can revolutionize the entire life cycle of a loan, from creation to settlement in secondary market trading. The payoff isn’t just cost savings, but the potential to create entirely new business opportunities for financial institutions.”
Perhaps the most notable aspect of this venture is the scale of collaboration between existing players in the syndicated loan market to mutualize the cost of devising a technology upgrade for a core business notoriously still running on emailed PDFs and even paper faxes.
The extent of the collaboration underscores the banks’ realization that modernizing decades-old back-office technology is a vast undertaking that should be addressed collectively to avoid a vast waste of effort and money.
The fintech crowd, meanwhile, is learning lessons about the sheer complexity of the capital markets ecosystem.
Adi Ben-Ari, a veteran of enterprise IT in telecoms and at Lloyds Bank, is the co-founder and chief executive of Applied Blockchain, a small group looking for new practical applications of distributed ledger technology. One of these involves issuing and receiving invoices. Ben-Ari believes the platform his firm has been working on could translate into the ability to issue short-term bonds backed by invoices.
Ben-Ari tells Euromoney: “The cynical side of me thinks that financial markets have lots of inefficiencies which persist because they protect the position and boost the earnings of certain incumbents.
"And even participants that don’t benefit directly themselves from those inefficiencies may be in no rush to take them out if that removes a rival incumbent that is party to the same distributed ledger collaboration initiative. A technology entrepreneur may find that a bank that competes with another participant in the particular area you are focusing on may not welcome technology that takes that rival out because in other areas his own bank depends on that incumbent or derives revenue from it.”
After the extraordinary hype around blockchain in the second half of 2015, doubts have increased over the security of the technology especially since the hack this summer of Ethereum, the second most-prominent cryptocurrency network after bitcoin, by members of a decentralized autonomous organization that drew off $64 million of its ether currency.
That led to a so-called hard fork, or effective re-set of the entire system, in an effort to invalidate the hacked tokens: apparently a form of heresy to extremist believers in crypto.
Applied Blockchain was an early adopter of Ethereum. Does the hack and subsequent hard fork not at least raise questions over the whole application of distributed ledger technology to capital markets?
Ben-Ari says: “Honestly, I see it as a positive. The people at the core of Ethereum may be technologists, developers, cryptocurrency enthusiasts, but they really are as open as it is possible to be, whereas some other blockchain technologies operate in closed laboratory-like environments. Something like this was always likely to happen. But being constantly open to attack means that Ethereum is now absolutely battle-tested. And what’s more it is evolving in good ways. It has brought out a new version that is a hundred times faster, as a private chain, than the original, so its scalability and performance is less in question.”
He says: “I know that some people inside the banks say that blockchain isn’t scalable. But, then, presumably there were people at Blockbuster Video who used to say that Netflix was too slow.
“The tipping point still came. And at the end, it came quite fast.”