Recent events have forced the entire world to slow down, giving businesses the opportunity to reflect on their journey to date and plans going forward. In recent years, banks have been radically reshaped by technology, as well as economic and regulatory pressures, but the relentless nature of digital disruption promises to further accelerate the pace of change.
The challenge posed by legacy systems
The trade-off between casting your gaze back and looking to the future has been a difficult balancing act for banks to strike for many years now. Every financial institution that predates the digital era has had to build its technology platforms iteratively while continuing to provide core banking services for its customers. Now many will be struggling to some extent with legacy technology systems. The operational challenge of maintaining underlying infrastructure acts as a persistent burden on banks’ IT budgets.
Those areas of banking that were earliest to adopt electronification and then digitalization are those now beset by the longest tail of legacy issues. This is certainly true of investment banking. The electronification of secondary trading began as early as the 1970s with the emergence of the Instinet network, followed by the move away from open-outcry exchanges. Investment banks’ front offices have been at the cutting edge of digitalization ever since. Today, stocks, derivatives, and even over-the-counter assets such as bonds and foreign exchange are primarily traded electronically.
However, electronification has not kept pace in investment banks’ back offices. Instead of emulating the automation of the front office, they remain heavily reliant on manual processes and ad hoc communications to resolve issues. These legacy back-office systems require a higher headcount and are a major contributor to the expense, opacity, and inefficiency of post-trade processing, an issue which has become systemic to the industry.
Opening the door to the digital disruptors
The challenge that legacy systems pose to banks is compounded by the way in which digital disruption is leveling the playing field. An established banking franchise was once an almost insurmountable barrier to entry for a start-up. But nowadays financial services are being unbundled, commoditized, and distributed via digital channels. While banks painstakingly modernize each of their existing products and overhaul the infrastructure they rely on, FinTech companies can cherry-pick a single service and build a digital-native solution from scratch. For the banks, it is a prospective death by a thousand cuts.
Banks face a stark choice: either invest in state-of the-art systems to support cutting-edge products or be rendered irrelevant by the FinTech companies who will.
We see this especially prominently within investment banking. In 2016, XTX Markets, a quantitative-driven electronic market-maker, became the first non-bank institution to break into the top 10 of Euromoney’s annual rankings of the largest foreign exchange liquidity providers. The company has since been joined in the top 10 by another non-bank liquidity provider, HC Tech. The threat posed by FinTech start-ups has spurred a technological arms race on the part of the bulge-brackets who occupy the remaining spots, to defend market share.
In emerging areas of electronic trading where banks enjoy no incumbency advantage, the chips may be stacked in favor of the legacy-free FinTechs. Take Algo Wheels, the little-understood software tool for buy-side traders designed to automate, report on, and optimize trade execution. As yet, no provider has established a leading position in this market niche. It is the more agile, innovative FinTech start-ups – unencumbered by the higher costs incurred by swollen, inefficient back offices – who are perhaps best placed to meet the significant market demand.
Balancing the old and the new
So how should banks approach the handicap of legacy technology systems, to defend their market share and nullify nimble FinTech start-ups’ intrinsic advantage? How best to balance the old and the new? Inevitably you will encounter strong opposition to simply mothballing the old systems. In most cases, the necessary work of patching up legacy systems – or paying down your ‘technical debt’, as industry insiders refer to the problem – will have been going on in the background for years, if not decades, and may have absorbed millions in budget.
But this is the classic thought process that underpins the ‘sunk cost’ fallacy. Rather than continuing to throw good money after bad to prop up legacy systems, banks must take the difficult decision to write off their technical debt and start afresh. Otherwise we are rapidly approaching a tipping point at which the price of maintaining legacy systems will be unsustainable – above all, in terms of the opportunity cost, as new market entrants press home their advantage.
Banks must instead focus on creating modern, flexible, agile systems that support rapid business growth and change, through a combination of buying and building. As they look to the future, they face a stark choice: either invest in state-of the-art systems to support cutting-edge products or be rendered irrelevant by the FinTech companies who will.