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UK Remains at the Forefront of the Fintech Revolution

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Despite fierce competition, the UK remains at the forefront of the fintech revolution according to the ‘Finance for Fintech’ report, launched recently by London Stock Exchange Group and TheCityUK.

The independent survey, carried out by YouGov, interviewed over 400 fintech companies across eight countries, all of which have had at least Series A funding rounds or above, and provided interesting insights into the global fintech scene.

Bullish UK fintech scene

UK fintechs are bullish about their growth prospects.

The research highlighted that fintech companies operating in the UK expect to grow by 88 per cent over the next three years, 8% higher than the overall average.

Vital to this growth is raising finance and this process is reportedly more straightforward for UK fintechs in public markets than those operating in other countries, making it an attractive location for fast-growth companies. Chancellor Philip Hammond recently supported this view, pointing out that investment in UK fintech more than doubled last year, outpacing the funding of EU rivals such as Germany.

Interestingly, fintechs surveyed placed the UK as the third best  location for businesses seeking to grow their international footprint, only behind the US and China.

Fintech Revolution in Europe?

That said, competition is heating up.

Europe increasingly seeks to strengthen its position as a regional fintech hub. On 8 March, the European Commission announced an action plan on how it will do just that; new rules that will help crowdfunding platforms to grow across the EU’s single market.

The impact of this will be interesting as one of the primary barriers to fintech growth is competition according to 43% of those surveyed.

Regulation

Fintechs require a supportive global regulatory environment to flourish.

You have to applaud the FCA’s exploration of a potential global regulatory sandbox following the success of its UK version. The UK version, launched in 2016, helped fintechs to test innovations with real customers in the live market but under controlled conditions.

The global sandbox could allow firms to conduct tests from London into different jurisdictions at the same time, enabling regulators to collaborate to solve cross-border problems.

This has the potential to strengthen London’s position as a destination for global fintech companies as they can come from all around the world to test their products and find out how they can expand internationally.

Fintech is by definition without borders.

The research shows that fintechs across the world are becoming increasingly cross-border in their growth aspirations with 72% of the 400 companies surveyed planning to expand into new countries. 73% believe they will need to move into new or develop existing market sectors in order to achieve this growth and almost three-quarters believe long-term growth will be driven, at least in part, by new technologies.

It is worth noting that those who have reached Series D rounds or above have the biggest appetite for expansions and anticipate achieving a monumental growth of 320%.

While fintechs seek global expansion, it is important they don’t lose sight of the importance of being located close to the core financial hubs as crossover will, by and large, determine their success.

It is clear that in order for fintechs to thrive and continue to transform the global financial services sector, they need access to finance, a supportive global regulatory environment and proximity to the global financial services sector. The UK currently offers all three.

The report demonstrates that while the UK remains at the forefront of the fintech revolution, it must continue to innovate and work collaboratively in order to maintain its leading position, especially with Europe hot on its heels.

 

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Mark Carney on realising the potential of fintech

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Regulatory support for the growth of fintech in London has certainly been evident in recent years.

Democratisation of financial services, greater consumer choice, lower costs and greater resilience of financial infrastructure are just some of the reasons why the Bank of England (BoE) is encouraging financial technology (fintech) development in the UK.

That’s according to Governor Mark Carney, who addressed an audience of fintech entrepreneurs, regulators, politicians and banks at the UK Treasury’s inaugural International Fintech Conference in London.

Regulatory support for the growth of fintech in London has certainly been evident in recent years. The Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) have changed their authorisation processes to support new business models, and the BoE also established a fintech accelerator last year.

To date, it has worked with a number of firms on proofs of concepts relating to cyber security, using artificial intelligence (AI) for regulatory data, and distributed ledger technology.

But what is interesting in this speech is the BoE’s focus on ensuring “the right hard and soft infrastructure are in place” – a central plank of the Governor’s vision of maintaining London’s role as the centre of fintech excellence.

“Over the centuries, we have learned that markets and innovation thrive with the right hard and soft infrastructure”, he said. “Hard infrastructure ranging from transport links to broadband and payments architecture; and soft infrastructure from the rule of law to market practices, codes of conduct, and regulatory frameworks.”

So how does this relate to fintech, one may wonder? Governor Carney continued: “With respect to soft infrastructure, the Bank is assessing how fintech could change risks and opportunities along the financial services value chain. We are then using our existing frameworks to respond where necessary.”

On developing the right “hard infrastructure”, Carney pointed to how the BoE is working to develop the financial system’s hard infrastructure to allow innovation to thrive while keeping the system safe. In particular, he highlighted how it is widening access to some of its systems to include Payment Service Providers (PSPs) in order to boost both competition and system resilience.

“The UK has led the world in innovation in the wider payments ecosystem. And we are committed to keeping pace with customer demands for payments that are seamless, reliable, cheap, and ubiquitous. Our challenge is how to satisfy these expectations while maintaining a resilient payment systems infrastructure.

“That’s important because the Bank operates the UK’s high-value payment system ‘RTGS’ (Real-Time Gross Settlement) which each day processes £1/2 trillion of payments on behalf of everyone from homeowners to global banks. Understandably, we have an extremely low tolerance for any threat to the integrity of the system’s “plumbing”.

“Currently, only 52 institutions have settlement accounts in RTGS. Indirect users of the system typically access settlement via one of four agent banks. These indirect users include 1,000 non-bank PSPs at the front-end of the financial services value chain. As they grow, some PSPs want to reduce their reliance on the systems, service levels, risk appetite and frankly goodwill of the very banks with whom they are competing.”

Interestingly, the BoE has decided to widen access to RTGS to include non-bank PSPs in order to help them compete on a level playing field with banks, and is working with the FCA and HM Treasury to make this a reality.

This ties in with Carney’s final example of the “soft and hard infrastructure” – coordinating advances in hard and soft infrastructure ensure the Bank can help the industry realise the true promise of fintech.

“New technologies could transform wholesale payments, clearing and settlement. In particular, distributed ledger technology could yield significant gains in the accuracy, efficiency and security of such processes, saving tens of billions of pounds of bank capital and significantly improving the resilience of the system.”

A full copy of Mark Carney’s speech is available here.

Regtech is booming, but is the UK missing out?

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Regtech (n). Short form for the regulatory technology being created to meet regulatory monitoring, reporting and compliance.

Regtech is booming, with USD 2.99 billion invested globally across over 400 private investment deals in the last five years.

Yet despite its predominant position in almost all other areas of financial technology, the UK is still lagging behind the US when it comes to regtech investment.

Just 9% of the almost three billion invested since 2012 went to UK based companies, according to the CB Insights figures. This put it a distant second behind the US, which scooped up 78% of the total investment.

Banks are looking to reduce costs to cope with a tougher investment market and find ways to handle the flood of new rules which the January MiFID II deadline will unleash. In this environment, it is little wonder investors see the potential for technologies which promise to make compliance easier, more efficient or more reliable for the financial sector.

UK regulators appear to have spotted the opportunity as well, and the Financial Conduct Authority (FCA) is looking to do what it can to help the UK’s regtech sector catch up with its transatlantic counterpart.

The regtech industry spans a wide variety of technologies and the industry which promises to make compliance easier, more efficient or more reliable. Some companies are using artificial intelligence to help banks comply with regulation, while the R3 group of over 40 banks is looking at how distributed ledger technology (DLT) can make reporting to regulators simpler.

Some regtech firms believe that Brexit could be a big boost to the UK’s regtech industry.  With the UK’s financial sector’s relationship with the EU now in flux, both in terms of regulatory equivalence and cross boarder trade, ““Brexit is a brilliant opportunity”, sais Diana Paredes, CEO of regtech start-up Suade.

The UK regulator, the Financial Conduct Authority (FCA) has also been working to encourage the UK regtech sector. The FCA’s executive director of strategy and competition, Chris Woolard, is keen to stress the role regtech companies can play. Talking to Financial News, he said, “It’s something quite positive where firms are taking quite seriously how they apply technology to their own compliance question.”

The FCA has also been leading the way when it comes to nurturing innovation. “There are other regulators around the world that have more funds and resources, and other regulators with more powers. But it was really only the UK financial regulator that has built into its governance a mandate to promote innovation and competition, as well as the traditional mandates of financial stability and consumer protection,” Imran Gulamhuseinwala, EY’s global leader for fintech, told the Financial Times.

Most notably, in 2015, the FCA launched its ‘sandbox’ to help companies developing new technologies. The sandbox allows banks firms which require regulatory approval before being able to operate their technology to test in a live environment. This allows firms which would otherwise need to develop their full technology and achieve FCA approval before fully testing their product, to develop their technology in a way which is responsive to both the FCA’s requirements and the demands of live operation.

So far, the sandbox service has proved popular with 69 companies applying for the first cohort in 2015 and a further 77 applying for the second cohort, according to a recent statement from the FCA. Following the success of the first cohort, the FCA has begun helping regulators across the globe to develop their own sandbox programmes, including in Japan, Canada and China.

It is heartening to see the UK regulator supporting this process and creating an environment where the next generation of firms who using technology to enhance the regulatory environment and reporting/confirmation/validation processes.

Financial markets have been buffeted by scandal and repetitional damage of late. It is time to programme some trust into the source code.

Illuminating Markets – a vision for cash and collateral management

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Roberto Verrillo, Head of Strategy and Markets at Elixium, outlines his view on the key issues in the repo and collateral market.

Changes to the regulatory environment that have already taken place, and those that will occur over the next few years, have put us on a path that will change the industry forever. The impact on how the industry executes its business has been fundamentally changed.

The result of these changes has been an almost uniform decline in profitability for investment banks. Many operations have already begun efforts to re-structure large areas of their business to maintain return on equity (ROE) levels that are acceptable to their shareholders. This process will continue for several years yet.

I suggest reading ICMA’s excellent report written by Andy Hill “Perspectives from the eye of the storm” for more information about the current and future evolution of the repo market.

Basel III significantly increases the cost of doing business, taxing risk and market-making via increased capital requirements and increasing the cost to certain activities by requiring higher quality and amounts of capital. (See leverage ratio and liquidity coverage/net stable funding ratio -Basel III[1]). The more balance sheet intensive a particular business area is, the higher the “hurdle rate” for returns should be. In this regard market making (via capital costs for holding positions) and repo stand out.

Many firms have not yet implemented an exhaustive study of what these hurdle rates ought to be. These are not standard across the industry but are firm specific and are calculated using varying inputs particular to each individual institution and their relevant regulatory requirements. Ultimately these metrics will decide what each institution’s balance sheet will be and the required ROE.

We believe that as this process of re-pricing and charging business areas for the regulatory cost of partaking in certain businesses (and transactions) progresses, the market will find many more institutions cutting back and re-structuring their current business models, or simply pulling out of certain markets or product lines altogether.

NSFR (Net Stable Funding Requirement) rules under Basel III are calibrated such that longer-term liabilities are assumed to be more stable than short term liabilities. This will lead to greater demand for longer dated deposits, particularly corporate deposits which are treated favourably for banks under the rules.

NSFR provides for different, Available Stable Funding (ASF) and Required Stable Funding (RSF), weightings depending on the type of counterparty and the residual maturity of the transaction. This will make many financing transactions that are still viable under current regulatory capital treatment extremely onerous. Fifty percent RSF weightings will be applied to all loans (including reverse-repos) to non-banks, regardless of the residual maturity of the transaction, and independent of the underlying asset. In other words, this would mean that all reverse-repos with non-banks under one-year maturity would require the provision of stable funding against 50% of the value of the reverse-repo. For example, a bank transacting a $100 million overnight reverse in AAA government bonds with an insurance company or hedge fund would carry a requirement for $50 million of (long term) stable funding, even if this reverse was match-funded by repo.

The FRTB (Fundamental Review of the Trading Book) due to be implemented in local regulation by 2019, is a supervisory framework for the next generation of market risk regulatory capital rules for international banks. It will add further granularity to this process by identifying how profitable each business is within an institution at a “desk Level”.

It will also overhaul the standardised approach to market risk, forcing big banks to calculate and report it for the first time, radically altering the way that modelling approval is granted and policed, Value-at-risk (VAR) will be replaced with expected shortfall (ES) as the standard risk measure, redefining the boundary between banking and trading books. Approval by the regulator will be required, at a desk level, for banks to operate using their own internal models.

An ISDA study of 21 sample Banks concluded that, as a result of FRTB implementation, the overall increase in market risk capital, would be between 1.5x and 2.4x compared to current levels.

Current implication for repo

The cost of providing balance sheet to customers that may simply require a home for their cash has become increasingly prohibitive, leaving some banks having to turn away short term deposits/repo’s and/or charge what might look like unreasonable costs for either accepting said deposits or only offering the facility to clients from whom they generate revenue on other products as part of a wider relationship.

Because of this lack of willingness to, or difficulty in, pricing collateral transactions, many of these transactions have become economically unviable. Backward-dated pricing and resulting dysfunctional collateral markets are in evidence not only during reporting periods such as month, quarter, half and year end, but increasingly over a “normal” date run – volumes and liquidity are both showing signs of drying up.

“Previously, business lines might have been kept as part of the core business strategy, even if they did not meet the hurdle rate for returns. But in time banks will become more ruthless and cost aware about whether these activities can be a valid part of a long-term business model.

“Repo, as a standalone product, is no longer profitable. Repo desks have gone from being profit centres to cost centres. This has already happened; whether yet realised or not” – Andy Hill -ICMA.

“The provision of repo pricing and liquidity by banks has become more of a value-added service for clients, largely subsidised by other, more profitable businesses. “ ICMA quarterly report Q4 2015 – pages 25-28.”

Improving efficiency

There has been an exodus of banks from non-core businesses, but even in areas where they remain active, banks can make significant cost savings by accessing liquidity pool providers (such as Elixium) for distribution.

Harmonisation of settlement

Basel rules are implemented as the Capital Requirements Directive in Europe and the specific capital requirements for EU firms are based on their MiFID permissions.

There is increasing interest secured financing transactions, with the market moving from unsecured to secured financing and impending enactment of regulation surrounding the margining of OTC products. There is a stream of regulation that will have a significant impact on collateralised markets which involves harmonisation of settlement discipline regimes across Europe. The industry will have to identify an efficient operating model to manage these changes.

“4.6 Market access and interoperability

Activity description

The activity covers market practices or legislation that obligate or restrict the settlement of (stock exchange and/or central counterparty-cleared) transactions in a specific issuer CSD. The consequence for foreign investors, custodians and/or investor CSDs in such (issuer) markets is that access to settlement flows is restricted owing to the unfair competitive advantages established in those issuer markets. The restriction implies that entities wishing to offer settlement services on these securities need to become participants in the issuer CSD or central counterparty.”

Page 46 ECB Harmonisation Progress Report 13/04/15

http://www.ecb.europa.eu/paym/t2s/progress/pdf/ag/fifth_harmonisation_progress_report_2015_04.pdf?986629e468a824c5d0069151574ead5c

In an environment of litigation and lawsuits is it reasonable to suggest to pension funds, hedge funds, sovereign wealth funds asset managers, CCPs, corporate treasurers, local authorities and other government entities such as public utilities should be precluded from access to a transparent trading facility for the re-investment of their short end cash and or securities or for sourcing collateral/margin?

http://www.reuters.com/article/2015/11/26/interestrateswaps-lawsuit-idUSL1N13K2IE20151126

In Europe, EMIR sets out a legislative framework for Central Counterparties (CCPs), trade repositories and OTC derivatives. This framework includes new requirements covering capital requirements, risk managements and organisation.

MiFID2 will be introduced with a view to de-restricting market access on a non-discriminatory basis. There is a requirement for Multilateral Trading Facilities to implement non-discriminatory rules regarding access to its facility.

MiFID2 introduces additional pre and post-trade transparency requirements for a number of financial instruments, these proposals aim to create a level playing field for the regulation of all organised trading. The trading obligation in Europe will be introduced in the Markets in Financial Instruments Regulation (MiFIR).

Mandatory Swaps Margining and the effect of Mandatory Swaps clearing on collateral markets;

Initial Margin (IM) and Variation Margin (VM) for uncleared OTC derivatives will be phased in from September 2016 through to June 2021. The US will start IM from September 2016 for the largest of counterparties but the EU has delayed the start of IM until June next year.

Clearing banks that traditionally put up money to support default funds within CCP’s are increasingly reluctant to do so as they have to hold a significant amount of capital on their balance sheet to support this business.

Variation margin to CCPs must be in the form of cash – there is a need for collateral to cash transformation and the size of the potential problem cannot be underestimated as banks step away from providing balance sheet to support short dated, low margin repo activity.

CCPs are working to engage buyside counterparties via differing initiatives be they sponsored or direct CCP membership.

It is envisaged that mandatory swaps clearing in Europe could create unprecedented demand for high quality liquid assets (HQLA) and its transformation, for use in initial and variation margining of swaps.

Eventually CCPs may offer cross-netting capabilities across a range of products.

Elixium – re-engineering collateral markets.

Elixium is an all to all collateral trading platform that addresses the current fragmentary nature of the market.

Standardised processes and protocols facilitate a transparent, efficient marketplace that simplifies the process of ‎rapid counterparty diversification amongst all institutions seeking to raise cash or collateral.

Connecting traditional players with new entrants and addressing the growing demand and supply of cash and collateral presents an exciting opportunity for Elixium.

The repo and collateral market is a critical source of funding for many institutions but remains balance sheet intensive. As institutions come under pressure as a result of regulatory changes such as the Liquidity Coverage Ratio and Net Stable Funding Ratio, a reduction in balance sheets has impacted the depth and cost of liquidity available.

It is broadly accepted that the market will see more buy-side entrants, and all-to-all trading. The Elixium all-to-all marketplace has been developed specifically to facilitate access to a much wider counterparty base, which previously, have been restricted from direct participation by overly complicated legal and restrictive trading structures.

Legacy trading models are no longer as relevant in today’s market as they once were. As regulation creates new challenges and reshapes the traditional repo market-making model, stakeholders are trying to adapt and innovate both to meet those challenges and to exploit potential new opportunities.

Roberto Verrillo is head of strategy and markets at Elixium.

[1] Basel III is the global framework of principals that are agreed internationally which local regulators are consequently expected to implement into local law. It is worth noting that the US and EU are not 100% aligned on leverage ratio. (See CRD IV for the EU rules)