Fintech in Capital MarketsA Land of Opportunity

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About Expand ResearchFounded in 2001, Expand Research is transforming the way the world’s financial markets make business and technology decisions by providing timely decision support and research services on business and technology strategies to leading financial institutions globally. In July 2011, Expand became an independent subsidiary of The Boston Consulting Group. It has offices in London, New York, and Singapore.

November 2016

Philippe Morel, Charles Teschner, Valeria Bertali, Boris Lavrov, Kimon Mikroulis, Pierre Paoli, Will Rhode, Shubh Saumya, and Franck Vialaron

Fintech in Capital MarketsA Land of Opportunity

2 Fintech in Capital Markets

AT A GLANCE

Enormous opportunity arises when established capital markets (CM) players such as investment banks collaborate with young financial technology (fintech) compa-nies—but the potential is far from being realized. According to our analysis using Expand Research’s Fintech Control Tower, the entire CM ecosystem, including banks, must take action now to gain considerable benefits.

Capital Markets Fintechs Are Relatively Underfunded Of the roughly $96 billion in venture capital funding that has been raised since the turn of this century, only about $4 billion (or approximately 4%) has gone specifical-ly to CM fintechs. This is partly due to the highly specialized nature of the sector, which makes it harder to penetrate—even for brilliant startups—than either the retail or the commercial banking sectors.

The Promise of FintechsFintechs can help build capabilities that enhance client relationships, reduce costs, and facilitate regulatory compliance. But to really take off, they must also overcome barriers. These include the complexity of many banks’ and asset managers’ IT landscapes, the lack of management bandwidth to both innovate and comply with myriad new regulations, and the need for standards to build effective solutions.

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Despite rapid growth, CM fintechs have been attracting less than their fair share of VC funding.

The financial technology (fintech) phenomenon first started to evolve in the capital markets (CM) industry more than 40 years ago. Today, accelerated

both by the electronification of trading in the 1990s and the subsequent thrust of the entire financial services industry toward digitization, fintechs—which we define as firms that use innovative technology at scale to either enable or compete with other financial institutions—have experienced exponential growth in the CM domain.

The most prominent CM fintechs have been strongly supported and engaged by the CM ecosystem, which includes players such as investment banks, custodians, ex-changes, clearing-houses, and CM-focused information service providers. Such play-ers have been, and will remain, best positioned to pick the most promising fintechs for potential collaboration.

Yet despite rapid growth, CM fintechs have been attracting less than their fair share of venture capital (VC) funding. This shortfall is partly due to the highly specialized and regulated nature of capital markets, which may hinder outside investors. In-deed, when fintechs are backed by incumbent banks, they attract greater funding and mature more quickly than when they are backed solely by VC firms. Incum-bents that invest actively can shape business models and help fintechs evolve into collaborative suppliers rather than disruptors. Moreover, the funding that CM fin-techs have received to date has been heavily focused on front-office initiatives with-in execution and pre-trade. Funding for post-trade activities has been much more modest, with investment concentrated in a select number of fintechs, resulting in the highest average ratio of funding per company.

Simply put, fintechs focus on creating new value propositions or improving existing ones. They help build capabilities that can enhance client relationships, reduce costs through automation and simplification, and facilitate regulatory compliance. They also enable disaggregation of the value chain as they become more embedded in the supply chain.

Nonetheless, in order for the fintech boom to realize its full potential, a number of barriers must be overcome in the way that fintechs relate to investment banks and the CM ecosystem as a whole. These hurdles exist in the areas of simplifying IT ar-chitecture, developing industry standards, improving collaboration among players, and mitigating the risks of working with vendors, among others. Moreover, inertia on the part of incumbents can have a dire consequence: the inability to compete with new entrants that use cutting-edge technologies to reverse banks’ traditional

4 Fintech in Capital Markets

competitive advantage. Market structure changes brought on by technology, regula-tion, and shifting client needs make it critical for incumbent banks to take action now.

In addition, as banks begin to think of themselves more as data and technology companies, they need to start managing their IT stacks, and the data and analytics within them, as assets that can be commercialized. Banks can leverage the experi-ence gained in such areas as execution algorithms, direct-market-access connectivi-ty, and securities services, and explore opportunities for unconventional partner-ships. In order to move forward efficiently and effectively, however, banks must fully grasp the history and scope of the fintech domain. In this report’s analysis of the rapidly evolving CM fintech landscape, we used the Fintech Control Tower pro-prietary database of Expand Research, a BCG subsidiary. The database covers more than 8,000 fintechs.

The Fintech LandscapeSince the establishment of Instinet as the first electronic communication network in 1969, and the creation of Nasdaq as the first electronic exchange in 1971, there have been three major fintech waves. (See Exhibit 1.) The first occurred mostly in the 1980s and 1990s and featured roughly 100 CM fintechs, predominantly en-

0

60

45

30

15

19

5 5 5 57 7 6

10

18

29

3538

46

40

4750

31

23

3 3 3

13 13

21

15 14 1517

2 24

1974–1984

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

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2010

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2012

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2014

2015

WAVE 1: TRADITIONAL FINTECHS~19%

WAVE 2: FINTECH MILLENNIALS~25%

WAVE 3: FINTECH BOOMERS~56%

SETL DevelopmentOrchestrade

Number of companies founded

IHS Markit

CalypsoOpenLink

Murex

Bloomberg

Broadridge Financial Solutions

Mysis

SunGard

Ion

CurrenexIntercontinental ExchangeSmartStream Symphony

CommunicationServices

1985

Sources: CB Insights; DealRoom; Tech in Asia; Expand Research; BCG analysis.Note: The 551 companies included were active as of the first half of 2016. The total includes neither the 16 fintechs that did not disclose founding dates or were founded before 1974 nor the two that were founded in 2016.

Exhibit 1 | Three Major Fintech Waves

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ablers, that focused on market data, news distribution, risk management, and core processing. Most of these players are now embedded in sell-side and buy-side firms. Market electronification accelerated with the introduction of the Financial Informa-tion eXchange protocol in 1992, and by the late 1990s, electronic venues, such as Electronic Broking Services, had become the primary trading vehicles for interdeal-er foreign-exchange transactions.

The second wave took place from 2000 to 2007 and comprised just under 140 fin-techs that focused more on e-trading. These players included business disrupters, such as high-frequency trading, and execution platforms, such as Currenex.

Starting in 2008, the post-crisis wave of about 310 fintechs evolved to mostly com-prise enablers designed to fix the post-crisis challenges of falling revenues, high costs, complex legacy infrastructures, and fragmented liquidity and data. One such player was the buy-side-to-buy-side venue Luminex. Today, many of these firms are emerging startups with regulation built into their DNA. They use cutting-edge tech-nologies, such as machine learning, which are often delivered as a service.

It is worth noting that the latest wave of digitization is being fueled by incumbent banks’ rapid digital transformations and is characterized by paradigm shifts in tech-nology instigated by the proliferation of cloud hosting, artificial intelligence, peer-to-peer computing, and distributed ledger technologies. Regulation has been a key driver of the latest fintech explosion, as CM players have moved toward low-capital- intensive business models that require enhanced technologies.

Capital Markets Fintechs Have Received Less Than Their Fair Share of Funding. Of the roughly 8,000 fintech startups that we track globally across all business lines, only 569 are active in the CM space. And of the roughly $96 billion in VC funding that has been raised since the turn of the century, only about $4 billion (or approxi-mately 4%) has gone specifically to CM fintechs. (See Exhibit 2.) Thus, it is clear that the potential gains are much larger than those currently being realized. Indeed, the 2015 CM revenues of $330 billion (excluding those related to asset management) represent 9% of the total financial services revenue pool of $3.67 trillion. Therefore, the CM equity funding ratio, relative to the revenue pool share, is skewed at 1:2, with CM fintechs attracting less than half their fair share. If we use the broader definition of the CM ecosystem, which includes asset management, the ratio is even more pronounced, at 1:3.

The vast majority of fintech disruption in the banking industry is happening on the retail and corporate fronts, where technology provides a way for companies to serve large, diverse client bases while still reducing the cost of customer acquisition across a number of distribution channels. The prospect of mass adoption makes equity financing readily available, with numerous VC firms on the lookout for the “Uber moment” of finance. As a result, there is a large imbalance in the amount of VC investment going to retail and corporate banking versus the amount going to CM firms. The handful of CM-focused startups that do exist have not only generat-ed fewer VC funding rounds than their retail- and corporate-focused peers, but they have also attracted significantly less funding per round: roughly $11 million in CM in 2016, compared with about $14 million in retail and corporate banking.

The potential gains are much larger than those currently being realized.

6 Fintech in Capital Markets

Such differences are partly attributable to the perception of a higher risk of failure in the CM industry, which is highly specialized, heavily regulated, and dominated by a few incumbent players. This reality discourages VC investors who are not in-dustry specialists. In light of this, many CM players have taken up the dual role of investing strategically in new tech ventures as well as representing their traditional client bases.

An Attractive Investment Opportunity. Indeed, despite perceptions to the contrary, the overall CM ecosystem has thrived in recent years, generating a sizable revenue pool that is expected to markedly increase over the next five years. (See Global Capital Markets 2016: The Value Migration, BCG report, May 2016.) Given the size and growth of the industry, as well as the less crowded landscape, the CM fintech space is an attractive market for both investors and entrepreneurs.

In addition, as we have seen, evidence shows that fintechs supported by banks or other strategic players, such as exchanges, tend to reach maturity faster and be-come more successful than those that are not backed by such players. (See Exhibit 3.) They also attract much greater funding, because VCs tend to follow strategic players in their investment allocations. The presence of such investors in fintechs signals that they are high-quality companies with credible business models and good prospects. On average, industry-backed fintechs reach the exit stage in six

INVESTMENT IN CM FINTECHS COMPARED WITHINVESTMENT IN OTHER FINANCIAL SERVICES SEGMENTS

TRENDS IN CM FINTECH EQUITYFUNDING BY CLUSTER, 2000–2016 (H1)

0

25

50

75

100

Financial services revenue

pool 2015

CMecosystem

Share (%)1 Cumulative funding ($millions)

Numberof fintechs,2016 (H1)

Cumulativeequity funding,2000–2016 (H1)

97

7

7

35

42

45

40 43

47

441

63

0

2,000

1,000

3,000

4,000

5,000

2000

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2015

2016

(H1)

Retail banking

Corporate banking

Asset management

CM

Wealth management

Primary

Pre-trade

Execution

Post-trade

Support

$96 million40

$1.1 billion240

$2.2 billion184

$591 million50

$115 million55

Total funding: $4 billion Total number of fintechs: 569

Sources: CB Insights; DealRoom; Tech in Asia; Expand Research; BCG analysis.Note: The CM ecosystem revenues include asset management of $263 billion and investment banks, custodians, exchanges, venues, clearing-houses, and CM-focused information service providers of $330 billion. This results in a total of $593 billion.1Because of rounding, not all percentages add up to 100.

Exhibit 2 | CM Fintech Is a Small but Growing Portion of the Overall Market

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years, compared with seven years for firms backed only by VCs. Also, the average funding for industry-backed fintechs in the first half of 2016 was $24 million, com-pared with less than $11 million for those backed only by VCs.

Investment banks, however, have been facing revenue headwinds that are far more powerful than those faced by other players in the CM ecosystem. Indeed, informa-tion service providers are growing strongly and commanding price-to-earnings (P/E) multiples as high as 30 (compared with an average of 10 for investment banks). Banks have also been constrained in redistributing cash to shareholders because of recapitalization and deleveraging. Equity investments, therefore, provide avenues to reinvest retained earnings in projects with high returns on investment, helping to deliver long-term value to shareholders. Fintechs can help investment banks across the value chain by monetizing existing assets, such as data and algorithms, as well as by mutualizing industry costs. So-called know your customer (KYC) tasks, market data, client-reference data, and trade surveillance currently amount to $4.4 billion in annual IT and operations costs. And the opportunity will be even larger where efficiency is a primary goal, such as in the automation of trade processing. (See the sidebar “Blockchain-Based Solutions.”)

Execution and Pre-Trade Take Center Stage. Investors have been choosing fintechs that focus on enabling execution and pre-trade activities (with funding of about

FINTECHS BACKED BY THE CM INDUSTRY ATTRACTHIGHER FUNDING… … AND MOVE FASTER TO MATURITY

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8 97

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1310 11

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2010

Average size of funding round ($millions)

2011 2012 2013 2014 2015 2016(H1)

Backed by VCs onlyBacked by the CM industry

0

3

6

9

Backed by VCs only

Average number of years to event

Backed by the CM industry

Seed Round A Round BRound C Round D M&A

1.8 1.72.9

1.5

3.1 3.44.5

5.3 5.7 5.6

7.1 6.7

~7 years

~6 years

Exhibit 3 | Industry Support Is Key to CM Fintech Success

Sources: CB Insights; DealRoom; Tech in Asia; Expand Research; BCG analysis.

8 Fintech in Capital Markets

$2.2 billion and $1.1 billion, respectively), at a combined ratio of about 6:1 relative to post-trade activities. (See Exhibit 4.) Moreover, post-trade and support remain the least mature segments of the value chain, with early rounds up to series B represent-ing 82% and 64%, respectively, of the total funding they have received since 2000.

For investment banks, this dynamic partly reflects an effort to revive the age of rev-enue growth, notably by increasing the share of client wallet. Although there are areas in which banks could create new products and increase trading volumes, the pursuit of market share in a stagnant environment is a zero-sum game for the in-dustry as a whole, because competitors can improve their relative positions only by capitalizing on market share dislocations.

Also in play are reactive strategies to maintain positioning in a market with increas-ing electronification. With front-office compensation representing roughly 40% of to-tal costs, banks recognize the benefits of moving toward more cost-efficient service models with lower front-office headcounts. Most important, banks may be finding it easier to apply front-office technology, which can be deployed one bank at a time, rather than back-office initiatives, which could require significant industry collabora-tion to fully realize any benefits. Moreover, although explicit post-trade costs repre-

The main promise of blockchain technology in capital markets lies in the full automation of trade process-ing across asset classes. The greatest expected impact is on products such as syndicated loans, foreign exchange for currencies not covered by continu-ous linked settlement, and over-the-counter derivatives, whose back-office processes remain largely manual.

Blockchain-based solutions are currently being developed through two approaches: industry collabora-tions that involve multiple players, such as the Hyperledger Project, and efforts led by individual players (SETL, NASDAQ OMX Group with Chain, UBS with Clearmatics Technologies, and the Depository Trust & Clearing Corporation). However, although prototypes exist, there is still minimal traction within the industry because of the relative immaturity of the technology and the fact that solutions

based on private blockchain imple-mentations are the only acceptable alternatives to bitcoin-like public chains for financial institutions.

Of all the tech clusters, blockchain- based fintechs have experienced by far the highest compound annual growth rate over the past three years. Yet disclosed funding for such projects is still significantly behind other areas of innovation, such as data and analytics (a ratio of 1:4). Cross-industry settlement of billions of daily trades among globally dispersed counterparties, although theoretically feasible by using block- chains, represents one of the toughest use cases for a technology still in its infancy. Automation of more simple processes, such as recording client data on decentralized ledgers for KYC and for anti-money-laundering purposes, is likely to emerge first.

BLOCKCHAIN-BASED SOLUTIONS

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sent 15% to 20% of the total cost base, the implicit costs arising from cash flow ineffi-ciencies, such as excess collateral for clearing, can weigh down capital resources.

Ultimately, data and analytics underlie the entire value chain, and investment banks have started to recognize data as a strategic asset that offers differentiation opportunities. (See the sidebar “The Focus Is on Data and Research.”)

The Fintech Value PropositionBanks are constantly in search of measures that can help them restore ROE. In ad-dition to monetizing existing assets and mutualizing costs, fintechs can come to their aid by building capabilities to improve existing client relationships and experi-ences, streamlining front-to-back costs, and optimizing regulatory compliance.

Improving Client Relationships. Fintechs can help prioritize profitable clients and optimize pricing and sales strategies. For example, transaction cost analysis can help establish a complete internal view of client profitability through rigorous analytics, allowing banks to raise their game on pricing, increase hit ratios, and capture client flow. Such initiatives can shield banks from increased competition, as client flow is expected to become more price-sensitive with the advent of the second Markets in Financial Instruments Directive (MiFid II) and its best-execution requirements covering nonequity asset classes. In addition, banks can provide more coverage and high-touch resources to clients that have a more profitable flow.

Funding CAGR, 2013–2016 (H1) (%)

Number of fintechs

100

50

150

200

0 20 40 60 80 100 120 140

Primary SupportPost-trade

Trading-market data,analytics, and research

MatureVenues/platforms

Shared services

Pricing &OMS/EMS3

Clearing,reconciliation,

and settlement

Risk,collateral

management,and trade

surveillance

Client data analytics& KYC1

Primary marketintelligence

Alternativefunding

platforms

BlockchainHigh growth

Algorithms,smart order routing,and pre-trade risk Collaboration, communication,

and connectivity

Core trading technology,infrastructure, and user experience

Electronic brokerageand HFT2

Pre-trade Execution

Exhibit 4 | CM Fintech Investment Has Focused on Execution and Pre-Trade Activities

Sources: CB Insights; DealRoom; Tech in Asia; Expand Research; BCG analysis.Note: Bubble size represents cumulative equity funding since 2000; the execution bubble includes brokerages.1KYC = know your customer.2HFT = high-frequency trading.3OMS = order management systems; EMS = execution management systems.

10 Fintech in Capital Markets

The data and analytics niche is one of the largest for CM fintechs: approxi-mately 150 companies are active within the space, and they have received $670 million in funding. Another 950 companies, with $11 billion in funding, offer solutions to CM players as well as to the wider financial services market. Such proliferation of fintech firms is not surprising, considering that the efficient processing and exchange of information underpins the CM industry. Moreover, the explosion of available data means that the opportunity for harnessing it is both urgent and critical.

Historically, broker-dealers were the principal accumulators and gatekeep-ers of data, deriving power from their market-making role in the order flow. But poor data governance and too many silos have led to significant underutilization and undervaluation of this asset.

Today, the financial services industry treats data management as a primary function. And while the role of the chief data officer has become relative-ly established, the position will continue to evolve as data begins to be monetized. This increase in importance has been enabled partly by the regulatory push for transparen-cy and standardization in the mar-kets, as well as by recent technologi-cal advancements in aggregating and analyzing both structured and unstructured data.

Despite this progress, however, issues with data management are far from resolved. Big data solutions are

sometimes deployed on top of existing data silos to meet short-term goals, with few improvements in the underlying core data architecture. To avoid amassing an ever greater technological burden within the organization, therefore, deployment must be accompanied by efforts to improve data governance standards.

The value migration happening today has been aided by a reduction of information asymmetry, as exchanges, information service providers, and the larger buy-side players hold informa-tion that is comparable to that of broker-dealers. Moreover, the regula-tory drive for unbundling is causing providers to price research on a standalone basis and to find new ways of monetization. The intellectual property within research can be used to launch indices and systematic strategies, in line with the move of investors toward low-cost index funds and smart beta investing.

When it comes to distribution, some fintechs, such as the research aggrega-tor Visible Alpha, can enable the delivery of research in new ways. This includes access to the underlying ana- lytical models, semantic search, and sentiment scoring capabilities, so that research consumers can mine the large daily output in unique ways. Also, licensing agreements can provide revenue sharing opportunities from the rise of alternative data. The Chicago Board Options Exchange, for example, has partnered with Social Market Analytics to launch dynamic indices that track stocks with high sentiment scores and facilitate options trading based on social media.

THE FOCUS IS ON DATA AND RESEARCH

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A second category of front-office fintechs is focusing on enabling banks to increase retention by improving the client experience and helping banks embed themselves into their clients’ workflow. Indeed, until recently, most front-office applications were built in-house, available only on specific platforms, and siloed under a thin layer of integration at the level of the user experience. Today, driven by the adop-tion of a suite of HTML5 technologies, this situation is changing as the industry moves toward a more flexible user experience model. Fintechs can now enable banks to create a smooth and unified client experience that tracks behavior across different platforms. Moreover, new fintech offerings such as multi-issuer structured product platforms allow banks to match products with investors’ risk preferences, thus shifting product governance to more client-driven, self-service solutions that avoid inappropriate selling.

The reality is that many investment banks lag behind organizations in other indus-tries when it comes to tracking customer satisfaction, at a time when customer ex-pectations have increased substantially. Banks thus have an immense opportunity to leverage predictive-modeling solutions that blend financial-market and client transaction data to understand and anticipate client needs. Use cases vary from es-tablishing client profiles and predicting demand for certain products to forecasting the propensity to issue equity or debt or to perform block trades.

Partnerships with fintechs can also reduce the time to market for proprietary prod-ucts and services and increase revenue. For example, Goldman Sachs collaborated with Motif Capital to issue structured products that express the unique thematic views of clients.

Streamlining Costs. Most fintech enablers in the CM ecosystem have a lower-cost component in their value proposition and can thus provide investment banks with an alternative route to additional efficiency gains. Consider the modern trading desk, for example, which is evolving to adopt a unified communication approach that merges channels, such as voice and electronic (including digitizing voice trading through speech recognition). Services that enable trading from any location, while leveraging cloud-computing services, could become ubiquitous in the future. Such software could eliminate large portions of legacy systems and costly private- communication lines, as well as improve overall asset productivity. By moving to internet-based cloud-computing services, investment banks can rent computing power and hardware in a way that efficiently meets fluctuating demand.

In addition, mutualizing costs in post-trade and support is a particularly attractive opportunity, the benefits of which have yet to be fully realized. Current utility play-ers are still nascent, and adoption is slow because the market remains fragmented.

Meanwhile, process automation is expected to maintain momentum across both front- and back-office activities as machines continue to replace human workers. Some of the most promising areas are intelligent processing, which can be found in functions as varied as robotics and machine learning systems, and the application of distributed ledger technology for settlement, confirmation, and reconciliations. Other potential areas to realize cost efficiencies include connectivity and order management systems in fixed-income and trader communications.

Partnerships with fintechs can reduce the time to market for proprietary products and services and increase revenue.

12 Fintech in Capital Markets

In many of the above cases, the potential for cost reduction on the respective func-tions can be significant (greater than 50%). However, the transformation should start from the ground up, with the infrastructure layer, to avoid leaving fundamen-tal IT architecture problems unresolved.

Furthermore, to become credible as a viable substitute, fintechs must offer high standards of service and reliability. To be sure, a major challenge in adopting inno-vative solutions today is building trust. The potential for regulatory accreditation can quickly raise fintech credibility.

Overall, up to 75% of sell-side IT costs are nondifferentiating, according to Expand Research. A large proportion could be externalized to fintechs over the next 15 years, leaving the remaining 25% to be built and managed internally as a competi-tive asset—such as by developing systems that provide pricing sophistication, client analytics, and execution.

Optimizing Regulatory Compliance. Regulations have been a huge burden for investment banks since the 2007–2008 financial crisis. In investment-banking technology functions alone, around $3 billion is spent annually on regulatory and compliance IT, which includes only officially reported regulatory projects. So-called regtech firms, which have received about $200 million in funding, have stepped up to help banks navigate the evolving regulatory maze. Currently, there are more than 400 sources of regulatory information, with many regulatory tasks (such as KYC and trade surveillance) requiring extensive manual efforts. Regtech companies, deploy-ing technologies such as natural-language processing and machine learning, prom-ise to automate these processes while reducing duplications caused by regulatory requirements that overlap across jurisdictions. In addition, behavioral technologies, such as Behavox, can analyze employee actions and provide risk warnings for possible noncompliance, helping banks proactively deal with any conduct issues that could cause incidents.

Implicit in the efficient use of any regtech tool is maintaining a certain level of data standards. Regulatory harmonization and convergence require international coordi-nation between the private sector and the official sector. The regulatory goal of de-veloping a more robust financial system must involve developing and adopting data standards, such as the Financial Industry Business Ontology common language, and finding ways to nurture the regtech ecosystem.

Four Factors Are Critical to Getting the Most Out of FintechsThe value that can be delivered by CM fintechs is often diluted by certain industry barriers that need to be understood and overcome. These barriers exist in areas such as simplifying IT architecture, developing industry standards, improving collaboration among industry players, and mitigating the risks of working with vendors.

Simplifying IT Architecture. Over a period of years, many banks have been adding IT infrastructure without consolidation, resulting in excessive complexity. That complexity, in turn, has required banks to deploy middleware to provide interfaces among their fragmented applications. In addition, dealing with a large number of

Fintechs must offer high standards of

service and reliability.

The Boston Consulting Group 13

vendors places significant strain on internal resources. Ultimately, investment banks need to avoid creating additional application layers and work to become more agile in order to integrate fintechs and transform the IT architecture uninhibited by legacy issues. The agile method delivers iterative, minimum viable states that continue to communicate with the existing infrastructure and allows for gradual migration to the new platform. Agile involves rapid prototyping to identify use cases and develop solutions that help a company adapt its IT operating model more quickly.

Developing Industry Standards. Although CM players can play a significant role in developing common assets, regulators can act as a catalyst for technological innova-tion by promoting standardized solutions. For instance, the European Securities and Markets Authority decided to use International Securities Identification Numbers as identifiers for derivatives under MiFID II in order to expedite implementation. The industry is still grappling, however, with a common standardized approach for describing all facets of the CM universe, such as reference data for distributed ledger technology, given the complexity of the financial instruments, entities, and processes involved.

Improving Collaboration Among Industry Players. Governance frameworks within industry-owned fintechs can foster better collaboration among industry players, increase adoption rates, and promote goodwill on the part of incumbents because they have a stake in ensuring their fintech partners’ success. In addition, initiatives such as Project Neptune, launched by a group of banks and investors to facilitate the exchange of fixed-income inventory information among participants, demon-strate the benefits that accrue to both the sell side and the buy side as a result of unifying their efforts.

Indeed, the current lack of interoperability and open innovation among fintech and CM players hinders new business and sourcing models. The adoption of open inno-vation principles can drive cocreation across firms by combining enterprise assets in new ways. Some of these assets could be monetized by individual firms. Applica-tion programming interfaces (APIs), for example, have become a prominent feature of the digital economy and constitute a core capability of technology leaders such as Uber, Twitter, Google, and Facebook. Moreover, third parties can develop appli-cations that leverage enterprise assets though APIs, thus connecting firms, develop-ers, and end users. CME Group, for instance, has partnered with Dwolla to make real-time margin payments on behalf of CME’s customers.

Mitigating the Risks of Working with Vendors. The advent of multiple startup firms supplying solutions to the market has led to the perception of an increase in risks when working with vendors. Reducing these risks will be critical for the industry to drive innovation. At the same time, in light of regulatory capital constraints, the appetite for operational risk has diminished.

For fintechs, many of which have yet to attain the necessary maturity to displace es-tablished practices, knowing how to build solutions that both minimize integration costs and enable the firms to work alongside other industry vendors in a seamless manner is crucial. Fintech clients will need to analyze and mitigate both contractu-al risks and operational risks, such as reliability and security. To help in these areas,

Reducing the risk of working with vendors will be critical to drive innovation.

14 Fintech in Capital Markets

some fintech offerings have emerged to provide so-called know-your-third-party ser-vices that simplify vendor due diligence.

Taking an Engagement ApproachIncumbent banks need to find the optimal engagement mix for interaction with the fintech community and actively select individual companies to acquire, invest in, or partner with. A recent BCG report described five potential innovation models. (See Global Capital Markets 2015: Adapting to Digital Advances, BCG report, May 2015.) The models are as follows:

• Business incubation and acceleration can provide support for, and coopera-tion with, startup companies in the early stages of development.

• Venturing allows banks to make equity investments in order to assess and take advantage of new growth opportunities.

• Strategic partnerships allow banks to explore joint ventures that drive incre-mental revenue and extend market potential.

• Mergers and acquisitions can act as fast-to-market solutions when investment banks acquire developed companies.

• Internal R&D has a significantly longer lead time and a considerably higher total cost of ownership, but it allows banks to maintain full control.

Our analysis of fintech engagement shows that incumbents’ preferences for the mix they choose varies according to the nature of their strategic growth plans (organic versus inorganic), their degree of innovation momentum, and their digital maturity. (See Exhibit 5.)

CM fintechs are mostly engaged through M&A and VC funding rather than through incubators or accelerators. This may be owing to the sophistication and high value of their intellectual property (IP), making them attractive acquisition targets. Challeng-ing market conditions, including regulatory and cost constraints, have also meant that many CM players have preferred inorganic growth, taking advantage of consolidation opportunities and external innovation channels rather than internal development.

Information service providers have the most aggressive inorganic strategy, using mostly M&A to acquire fintech assets. Such providers also use strategic partnerships to extend their offerings. Exchanges and venue operators are the second most ac-tive in M&A, as they diversify into multiasset trading and nontransaction business-es. These players have been expanding into software segments that command lofti-er P/E multiples owing to higher expected growth. Favorable revenue prospects have also spurred these players to become active in internal R&D with new product launches and services.

Some banks have shown a balanced approach that includes the use of incubator and accelerator programs. These programs can afford such banks the first pick of

CM fintechs are mostly engaged

through M&A and VC funding rather than

through incubators or accelerators.

The Boston Consulting Group 15

promising businesses, the opportunity to cost-effectively outsource experimental R&D, and the ability to discover budding tech talent. Internal innovation labs, meanwhile, can help attract IT expertise. Moreover, investment banks have been registering patents to protect and monetize the IP they have been developing inter-nally. For example, Goldman Sachs has filed patents both for a virtual settlement currency called SETLcoin and for swap futures contracts to secure recurring reve-nues from third parties. Regulators and central banks have launched their own ac-celerators with the potential to help fintech companies achieve authorization.

An Urgent Need for ActionThough the overall CM ecosystem has been thriving in recent years, the industry is facing a perfect storm of multiyear revenue declines on the sell side, an exodus of technical talent (partly toward fintechs) that requires banks to look outside their own organizations for resources, an expanding supply of fintechs brought on by the growing need to replace legacy IT architecture across the industry, and a wealth of maturing technologies (such as cloud, machine learning, and big data) that are ready to be applied to the CM industry. Banks must take action now both to protect their own interests and to boost the CM fintech ecosystem as a whole. These actions include:

• Focusing on standardization

FINTECHS FOCUSED ON CM ARE MOSTLYENGAGED VIA M&A AND VC

INCUBATORS AND ACCELERATORS ARE PREFERREDFOR ENGAGING WITH FINTECHS

R&D

M&A

Strategicpartnerships

Venturing

Incubatorsand

accelerators

0 65 130 195

Clearing-houses Custodians Exchanges

Banks Information service providers Venues

R&D

M&A

Strategicpartnerships

Venturing

Incubatorsand

accelerators

0 6 12 18 24 30 36 5442 48CM-focused fintech engagements by type (%)Total number of fintech engagements by type, 2010–2016 (H1)

44 161 20

71312410

2

1

13

311574

33 615197

291264

5

0

1

2

19

15

53

17

Exhibit 5 | CM Players Have Varying Preferences for Their Fintech Engagement Mix

Sources: CB Insights; DealRoom; S&P Capital IQ; Tech in Asia; Expand Research; BCG analysis.Note: Based on an analysis of the fintech engagements and internal R&D initiatives of 40 CM players: 14 banks, 11 information service providers, 8 exchanges, 3 custodians, 2 clearing-houses, and 2 venue operators.

16 Fintech in Capital Markets

• Opening the banking framework to reduce integration costs

• Improving strategic principal-investment capabilities to overcome the lack of VC funding

Banks also need to manage their technology stacks as investors do and quantify the value of their portfolios. For example, investment banks can identify potential ven-tures by leveraging their current IT assets, much the way Goldman Sachs has done by forming a joint venture with Synchronoss to begin monetizing its IP in mobile communication technologies.

Overall, the shifting competitive landscape has heightened the urgency for CM play-ers to proactively explore fintech adoption. Nonbank players have already broken into traditional fortresses of investment banking, such as market provisioning. Ca-pability gaps between nonbanks and banks have been decreasing, while investors have been growing impatient in the face of chronic underperformance. A wait-and-see approach is no longer viable. Banks that defer their options will lose significant value by not participating in the innovation process. They face the risk of disinter-mediation by competitors.

Ultimately, fintechs are introducing new paradigms that CM players can exploit to their advantage. (See the Appendix.) Proliferation in innovation means that the landscape is complex and difficult to navigate. By establishing labs to focus on early- stage, novel technologies that are core to their principal activities, and by systemati-cally pursuing adjacencies that have synergies with their existing portfolios, invest-ment banks can position their businesses for a bright digital future.

The Boston Consulting Group 17

AppendixThe table below provides a value-chain-oriented overview of the various fintech categories, along with brief definitions of different types of players.

VALUE CHAIN FINTECH CATEGORY DEFINITION

Primary

Pre-trade

Execution

Post-trade

Support

Primary market intelligence

Algorithms, smart orderrouting, and pre-trade risk

Alternative funding platforms;product development,syndication, and structuring

Private stock issuance, M&A, and crowdfunding marketplaces connecting institutionalinvestors and private companies

Tools for optimization of order execution, finding the best price, venue, timing,method, and queue of a trade

Traders' view of real-time market risk and profit and loss

Exchange-traded-funds providers, structured product distribution

Platforms providing data and analytics on primary markets, including M&A activity,IPOs, and private stock issuance

Applications and hardware for trade collaboration and communication, includingliquidity-sourcing platforms and trading turrets

Tools for aggregation, analysis, and visualization of trade and market data, includingtransaction cost analysis

Engines used to automatically calculate the market and fair value of securitiesand derivatives in real time; applications to manage and monitor different types oforders, such as stop orders and limit orders, and post them to the market

Intermediaries that help connect to a venue or platform (B2C)

Companies, such as exchanges, that allow users to execute trades

Companies that provide trade capture and booking systems, including trade positionmanagement and credit limit checking

Tools to manage credit and market risk, calculate risk exposures, and post collateralfor trades across multiple counterparties

Transversal support functions: finance, fraud management, security, HR, internalregulatory and compliance functions not related to the trade life cycle (for example,regulatory monitoring)

Companies that allow the tracking and analysis of client behavior and performance,such as through CRM

Client on-boarding, background checks, and due diligence on credit rating, suspiciousactivity, and anti-money-laundering

Monitor to ensure fair dealing and the best execution of trades; report and preventthe exploitation of inside information; prevent fraudulent trading activities, and so on

Generation of clearing instructions for clearing-house, clear trade, chasing, andlitigation management; reconciliation between the bank and market or other parties;settlement of trade positions

Companies that use distributed ledger technology for specific applications in capital markets (predominantly trade and post-trade services)

Key providers of market data and trade communications

Design and implementation of the user experience for the trade system

High-level research providers, including research management (generation,distribution, and content management)

Connectivity to market venues, including exchanges, multilateral trading facilities,interdealer brokers, external dark pools and crossing networks, broker connectivity,financial-information-exchange connectivity engines, and low-latency solution providers

Collaboration andcommunication; connectivity

Trading-market data analyticsand research

Pricing, order managementsystem, and executionmanagement system

Brokerage

Venues and platforms

Core trading technology,infrastructure, and userexperience

Risk and collateralmanagement; tradesurveillance

Clearing, reconciliation,and settlement

Blockchain

Shared services

Client data analytics andknow-your-customer

18 Fintech in Capital Markets

About the AuthorsPhilippe Morel is a senior partner and managing director in the London office of The Boston Con-sulting Group. He is the global leader of the capital markets segment within the firm’s Financial Institutions practice. You may contact him by e-mail at morel.philippe@bcg.com.

Charles Teschner is a senior partner and managing director in the firm’s New York office. He leads the North American capital markets segment within the Financial Institutions practice. You may contact him by e-mail at teschner.charles@bcg.com.

Valeria Bertali is a capital markets knowledge expert in BCG’s London office. You may contact her by e-mail at bertali.valeria@bcg.com.

Boris Lavrov is a project leader in the London office of Expand Research. You may contact him by e-mail at boris.lavrov@expandresearch.com.

Kimon Mikroulis is a capital markets senior knowledge analyst in BCG’s London office. You may contact him by e-mail at mikroulis.kimon@bcg.com.

Pierre Paoli is a partner and managing director in the firm’s London office. You may contact him by e-mail at paoli.pierre@bcg.com.

Will Rhode is a principal in BCG’s New York office. You may contact him by e-mail at rhode.will @bcg.com.

Shubh Saumya is a director in the firm’s New York office. You may contact him by e-mail at saumya.shubh@bcg.com.

Franck Vialaron is a partner in Expand Research’s London office. You may contact him by e-mail at franck.vialaron@expandresearch.com.

AcknowledgmentsThe authors would like to thank their BCG colleagues, as well as Emily Chapman and Esther Gross of Expand Research, for their valuable input and insights.

The authors would also like to thank Philip Crawford for his contributions in writing this report, and Katherine Andrews, Gary Callahan, Lilith Fondulas, Kim Friedman, Abby Garland, and Sara Strassenreiter for their assistance in its editing, design, and production.

About the BCG Fintech Control TowerThe BCG Fintech Control Tower is a research framework developed jointly by BCG and Expand Research both to identify initiatives, technologies, and companies that matter most in today’s fin-tech ecosystem, and to assess their impact. It currently tracks over 8,000 companies and initiatives worldwide.

To find the latest BCG content and register to receive e-alerts on this topic or others, please visit bcgperspectives.com.

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© The Boston Consulting Group, Inc. 2016. All rights reserved.11/16

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