The Next New Thing

The crisis called financial engineering into question, but that didn’t stop innovation. The industry continues to develop new securities and technological tools to gain a competitive edge.

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Future of Finance

Future of Finance

BACK IN 1997, MYRON SCHOLES WON THE ULTIMATE lifetime achievement award: the Nobel Prize in economics. The honor recognized the Stanford University finance professor’s work on the Black-Scholes option pricing model. It was a landmark in financial engineering, a discipline that combines market theories with advances in information technology to produce the increasingly complex derivatives and portfolio strategies that defined a generation’s worth of investment ingenuity and creativity.

The prize, which Scholes shared with Robert Merton, now of the MIT Sloan School of Management, came at a time when the economy was booming, an Internet-fueled technology explosion was brewing, and corporate profits and stock values were surging. Banks, hedge funds and other sophisticated players poured their own growing resources into IT, fueling more innovation in the form of complex structured products and model-based investing.

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Over the ensuing decade, however, recurring crises called the value of all that rocket science into question and cast financial innovation into disrepute. Merton and Scholes paid a personal price, having co-founded Long-Term Capital Management, the hedge fund firm whose collapse amid the 1998 Russian bond market default prompted a Federal Reserve–orchestrated bailout. Quantitative finance took an even bigger hit in 2008–’09 when such creations of financial engineering as collateralized debt obligations and credit default swaps — “financial weapons of mass destruction,” in the words of Warren Buffett — attracted blame for contributing to the worst downturn since the Great Depression.

Yet financial innovation lives on. Quants are still very much in business at investment banks and hedge funds, humbled somewhat by their losses during the crisis but as prolific as ever in their ability to model, analyze and trade using faster and cheaper technology. They are only part of the picture, though. Financial industry executives are thinking and talking much more expansively about innovation. Their priorities have turned more pragmatic and bottom-line-oriented, ranging from agility in product development to economies in back-office operations.

“A culture of speed and innovation is imperative,” JPMorgan Chase & Co. chairman and CEO Jamie Dimon wrote in the company’s latest annual report.

Robert Gach, global head of consulting firm Accenture’s capital markets industry practice, whose clients are a who’s who of the biggest firms in the business, says budgeting for innovation has become a board-level agenda item. “They need to find ways to harness technology, including reducing costs, because without that you don’t have a business and the ability to sustain it,” he says. “Innovation is important in everything from customer acquisition to defining products and services to cost management. It is critically important all through the value chain.”

The effort to broaden the scope of innovation has financial firms taking cues from Silicon Valley and other sectors with R&D in their DNA.

Citigroup, for one, has a chief innovation officer. CEO Vikram Pandit created the job for Deborah Hopkins, a former head of corporate strategy, in 2008. She keeps tabs on how entrepreneurial developments may affect or assist Citi’s businesses and oversees Citi Ventures, the bank’s strategic investment fund. Its holdings include minority stakes in Obopay, a San Mateo, California–based specialist in mobile payments technology; Silver Tail Systems, a Menlo Park, California–based provider of predictive analytics for cybersecurity; and InvestLab, a Hong Kong–based developer of trading technology. Hopkins and her team vetted more than 600 budding enterprises last year. “When you see that many, you start connecting the dots and seeing patterns,” she says.

Citi, JPMorgan and ten other financial institutions participate in FinTech Innovation Lab, a competition sponsored by Accenture and the New York City Investment Fund that offers promising start-ups expert advice and venture capital connections. Cristóbal Conde, former CEO of financial technology conglomerate SunGard Data Systems and FinTech’s 2012 executive in residence, says “a tidal wave of innovation” is under way, unlike anything he has seen in his 30-plus years in the business.

The innovations range from incremental new wrinkles in core products and business lines, such as mobile banking apps or life insurance policies tweaked for the needs of a longer-lived population, to potentially game-changing breakthroughs. An example of the latter is a finalist of this year’s FinTech competition, McLean, Virginia–based Centrifuge Systems. The company’s “big data” number-crunching systems tackle antifraud, cybersecurity and other challenges that cannot be addressed with traditional data mining or analytics, according to CEO Renee Lorton. “What they do is normal for intelligence agencies,” Conde says. “I have never seen this kind of analysis in financial services.”

In August, Conde signed on with another FinTech finalist, True Office, as executive chairman. The New York–based start-up applies mobile and gaming technology to regulatory compliance training in a way that engages employees “like a good comic book,” says Conde.

Analytics, security and mobility are recurring themes among the latest technology innovations celebrated by FinTech and a similar competition sponsored by Swift, the international banking communications network. FinTech finalists included BillGuard, which analyzes online transaction and billing patterns to detect potentially fraudulent account activity, and Visible Market, whose StockTouch application delivers data visualizations, or heat maps, of market activity to Apple’s iPad. One of the 15 finalists at the Swift Innotribe Startup Challenge finals in Osaka, Japan, in October will be OpenGamma, a London-based provider of risk management systems, reflecting mounting interest in back-office and posttrade innovations (see sidebar, page 74).

Mobile apps are already commonplace for basic customer access — Massachusetts Mutual Life Insurance Co. introduced wireless retirement account enrollment in 2005 — and they are rapidly moving into the institutional space. Witness, for example, Broadridge Financial Solutions’ introduction last year of shareholder proxy voting via mobile devices, or Imagine Marketplace, an app store that New York–based trading and risk management systems vendor Imagine Software recently launched for its buy- and sell-side clients.

Joseph (Jay) Hooley, chairman, president and CEO of Boston-based State Street Corp., believes the industry is entering a period of “radical transformation” because of postcrisis regulatory reforms and changing customer demands and market structures. For instance, new rules for over-the-counter derivatives clearing will require significant investments in transaction-processing infrastructure. The overriding objective is “bringing transparency to what had been opaque,” says Hooley. The strategic intention is to “pivot from transactional services to where the value proposition will be: in information-based services” revolving around insights and analytics, investor and regulatory reporting, and compliance and risk management, he explains. Such initiatives require planning and investing with a three- to five-year view of market evolution. This suggests that the recent upsurge of activity is no flash in the pan.

FINANCIAL ENGINEERING MAY HAVE BEEN TARRED by the toxic connotations of CDOs and other instruments that contributed to the recent crisis, but the industry continues to generate plenty of new products. “Those who berate it,” Conde says of engineering, “also use exchange-traded funds and other things that financial engineering gave them.”

Vanguard Group founder John Bogle has proclaimed the ETF “the greatest trading innovation of the 21st century,” even though he has been dubious about its impact on the buy-and-hold investment approach he favors. The first ETF, State Street Global Advisors’ SPDR S&P 500, which tracks the Standard & Poor’s 500 Index, was launched in 1993, but the revolution is a 21st-century phenomenon. The ETFs universe has grown from 102 funds with $83 billion in assets in 2001 to 1,220 funds with $1.17 trillion as of June 30, according to the Investment Company Institute. By comparison, the U.S.’s 7,695 mutual funds had $12.17 trillion in assets on that date.

The pace of innovation has not flagged in exchange-traded products because “there are problems that need to be solved or improvements that need to be made that investors aren’t even thinking about today,” says Christopher Yeagley, who heads the $1.2 billion Etracs exchange-traded notes business at UBS. The bank introduced its first commodity-based ETNs, a variation on the ETF theme that trades more like bonds, in 2008. “If this is a nine-inning game, we are only in the second or third inning,” Yeagley says.

UBS currently offers 46 Etracs products and has six more in the pipeline, to be introduced by the end of this year. Recent launches include two products linked to blue-chip dividend indexes: the Dow Jones Select Dividend Index ETN (which has attracted $11 million in assets and delivered a total return of 10 percent since its May introduction) and the S&P Dividend ETN (with $11 million in assets and a return of 9 percent since May). Another instrument, which began trading in July, is the Etracs Alerian MLP Index ETN, representing a composite of 50 publicly traded energy master limited partnerships.

The impetus for new financial engineering persists even if some past products of the process have burned investors. In Scholes’ view, the basic functions of finance — facilitating transactions, financing large-scale projects and allocating risks — are static, while institutions and markets are constantly adapting and adjusting. Innovations naturally collide with the constraints of regulation and outmoded infrastructure. “One of the reasons we have financial innovation is to get around rules and regulations,” Scholes said in March at the Stanford Institute for Economic Policy Research. The Eurodollar market developed in the 1960s in part to sidestep domestic U.S. interest rate ceilings, for instance.

From Scholes’ point of view, the Dodd-Frank Wall Street

Reform and Consumer Protection Act may well spawn similar attempts at innovation. Bankers are likely to test the meaning of the so-called Volcker rule’s limitations on proprietary trading and seek to exploit holes in the Dodd-Frank stipulation that most OTC derivatives trades must go through central clearinghouses. Ideally, such tension will be creative, stifling neither innovation nor market workings. But Scholes allows: “Financial innovation is very uncertain. Many things don’t succeed.”

Mortgage-backed CDOs were largely responsible for financial innovation’s “bad rap,” Tanya Styblo Beder, chairman of advisory firm SBCC Group, said at the same Stanford event. Beder — whose 2011 book, Financial Engineering: The Evolution of a Profession, covers the field’s high and low points — predicted that “innovation will be alive and well.” One outlet for it, she said, will be assistance to governments in managing the troubled assets taken onto their balance sheets during the crisis. She noted that the market for asset-backed securities other than mortgages has remained vibrant thanks to improved guarantees and transparency. “There is a message in there about the next stage of securitization,” Beder said. “Not as a new innovation but as a retooled innovation.” For instance, in a bid to revive the issuance of mortgage-backed securities, the Association for Financial Markets in Europe and the European Financial Services Round Table recently launched a program to label high-quality instruments as prime collateralized securities.

TECHNOLOGY IS A KEY SOURCE OF INNOVATION, OF course, and few industries devote as much money to tech as the financial services business does.

The financial sector spends nearly $400 billion a year globally on information technology, according to Celent, a Boston-based research affiliate of consulting firm Oliver Wyman Group. The firm estimates that 25 to 30 percent of that IT spending makes its way into new-system development rather than maintenance of existing functions. Top-tier institutions like HSBC Holdings and JPMorgan each spend $4 billion to $6 billion, and some have been increasing their budgets at a faster pace than the 3 percent annual industry average. Even a trickle of these sums can pay for advanced trading algorithms or customer databases that could confer a competitive edge, be it fleeting or lasting.

State Street spends more than $1 billion a year on IT — a steady 20 to 25 percent of operating expenses. Those resources cover what chief information officer Christopher Perretta calls “business as usual.” For longer-term strategic initiatives, the company, which has $22.4 trillion in assets under custody and administration, runs a separate “transformation program” budget, subject to board approval. That budget funded a $450 million commitment two years ago to build a private cloud computing infrastructure, with cost efficiencies and product innovation agility among its objectives. “It was a very public display of intentions at a tough time,” says CEO Hooley. “Better and more timely information, real-time and in the cloud, is the future.” The project is two-thirds finished, and State Street says it will deliver $94 million in pretax expense savings this year.

Accenture’s Gach says financial companies are increasingly adopting State Street’s method and budgeting in terms of “run versus change” — that is, resources devoted to running the company versus those promoting change and innovation. “Investments are mandatory in some things, like regulatory compliance,” Gach says, “but there is now this focus on funds for innovation.”

The progressive march of technology in the form of Moore’s law — the ability to get more computing power, transaction speed and storage capacity out of fewer machines at lower costs — gives large-scale operators more to work with. At JPMorgan, CIO Guy Chiarello has said, these economies have allowed the company to reallocate $1.5 billion over the past three years from “running the bank” to “investing in new products, new markets and new value for our customers.” Those initiatives include a systems integration effort called One Chase that provides a consolidated view of retail customers’ activity across the firm, to improve customer service and marketing, and mobile applications such as QuickDeposit — which enables consumers to deposit checks by taking a picture of them with their smartphones — and Jot, which gives small-business owners an automatic feed of credit card transactions that can be tagged for accounting and budgeting purposes.

But for all the scale and market power that a JPMorgan can bring to bear, genuine innovation is an uphill struggle for a megabank, says Thomas Sanzone, a former Citigroup and Credit Suisse chief information officer. Now head of consulting firm Booz Allen Hamilton’s commercial financial services practice, Sanzone says “innovation that is game-changing, not an incremental improvement,” is rare because firms have to be principally concerned with core operations. What’s more, he says, “market leaders tend not to want to change the game. Someone else will be more disruptive.”

If a financial firm can put millions of dollars into “change programs,” all the better, but innovation can be outsourced — and often is — to organizations with that core competency. Apple and Google spend billions on R&D and produce iPads and Google Maps. At banks, “money spent on the ‘R’ of R&D, the cutting edge, is very small,” says ex–SunGard CEO Conde.

There have been exceptions. Consider the old Citibank. In the 1970s, under John Reed, then head of retail banking and later chairman and CEO, Citi owned an off-site “skunkworks” and often designed its own equipment, including automated teller machines. During the Internet boom J.P. Morgan & Co. formed LabMorgan to incubate new-business ideas. Those that flew included fixed-income trading platform MarketAxess Holdings, which went public in 2004 and has a market valuation of $1.2 billion, and foreign exchange trading network FX Alliance, which went public in February and was acquired in August by Thomson Reuters for $625 million.

Fidelity Investments relies on an in-house research arm, the Center for Applied Technology, to project strategically important developments 12 to 18 months in the future, according to Stephen Scullen III, president of corporate operations.

Robert Goldstein, head of BlackRock’s institutional client business and the firm’s BlackRock Solutions technology business, says there are three dimensions to R&D: systems programming and modeling; risk and data analytics; and “spending time with clients, listening to them, watching how they are using our tools.” The last branch is “often forgotten but among the most critical components of R&D,” Goldstein notes.

As a rule, says Accenture’s Gach, financial firms will not produce “pure innovation as a scientist would see it.” Where the industry excels, he explains, is in applied innovation: “doing things better, faster and cheaper, and creating new value for customers.”

As a result, firms will more readily apply technologies coming out of entrepreneurial ecosystems like the FinTech Innovation Lab, the portfolios of private equity funds, and IT companies in, or selling into, the financial industry. Conde, who advises private equity firms Providence Equity Partners and TPG Capital, sees considerable ferment among start-ups, but technology company R&D budgets are where the real money is.

SunGard, for example, had $4.5 billion in revenue last year, including $2.8 billion from financial systems, and reported capital expenditures of $284 million, a sum that dwarfs the few millions in a typical Series A venture capital round. Brokerage outsourcer Broadridge devotes $150 million, or 10 percent of annual fee revenue, to R&D out of a total technology outlay of about $400 million, according to CIO Mark Schlesinger.

Chicago Mercantile Exchange parent CME Group, which posted $3.3 billion in 2011 revenue, reported spending nearly $100 million on communications and technology support. “We have exceptional technologists who are empowered to do R&D on their own,” says CIO Kevin Kometer. As a reward, their names go on the patents they develop. For example, one of the latest of the more than 80 CME patents, a margin calculation system for exchanges and clearinghouses, is credited to business architect Suneel Iyer and four others.

Two of the most aggressive and deep-pocketed financial industry innovators, Bloomberg and Fidelity, are very different enterprises, but they have a few things in common. They are privately held, so they do not disclose their financials. They acknowledge spending prodigiously on technology and R&D. And they regard technology as a means to improve service, not an end in itself.

“We like to think of ourselves as innovative,” says Fidelity’s Scullen, who has lately been focused on the disruptive technologies of mobile devices and the production of apps for his millions of customers. But Scullen says he is afraid that the “i” word can be overused and ring hollow. He prefers to concentrate on the mandate that anything Fidelity does must “add value for the customer.” Its technology and culture revolve around that. Eight CIOs report to Scullen and to business-line presidents, all of whom are fully engaged in technology decisions. “Here you really have to know the details of technologies, projects, expenses,” says Scullen. “It is not a delegated responsibility.”

Thomas Secunda, Bloomberg co-founder and global head of financial products and services, takes a similar approach. “My 3,000 programmers [out of 15,000 total employees] aren’t there to support the existing system,” he says. “They are there to dynamically and aggressively add new functions to our system. Our goal is to serve our customers, and technology is a major part of that.”

The latest manifestation of that effort is NEXT, a major upgrade of the Bloomberg Professional terminal that the firm completed this year. The new system allows users to personalize their screens and jump among applications more readily, and it incorporates a more intuitive, easy-to-use interface, which resembles that of an iPad.

Bloomberg is also prepared to think outside the box. In May the company made a rare acquisition in buying PolarLake, a provider of enterprise data management systems. The move sheds light on where Bloomberg is heading as a service provider — and how the industry may follow its lead.

“The days of all these firms building their own technology are ending, and they are going to outsource a lot of that,” Secunda says. “Our customers will be worrying more about costs and less about being proprietary. The same way Bloomberg automated a lot of activities in the front office, we think we can do that in the enterprise.”

Secunda is bold in his vision of an industry reexamining its economics. That is how the game can change. Bloomberg is seeking to define disruption on its terms and may be in a position to influence the course of an entire industry.

Then again, in a different economic or profit cycle, any powerful incumbent could be vulnerable to an unforeseen competitive threat, as happened to Digital Equipment Corp. and United States Steel Corp. But whether driven by an army of in-house technologists or a lone engineer scraping for seed financing, innovation is a force of nature in finance. It long predated the computer age and has yet to be snuffed out by political backlash or regulatory tightening. • •

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