Financial services industry: Evolution or disruption?

Dushyant Shahrawat is formerly a Principal Executive Advisor at CEB. We caught up with him to hear his views about the impact innovation is having on the financial services industry.

Journal:There is a lot of buzz around disruptive innovation in the financial services industry. What is the likelihood that it will spread from leading sectors like retail banking to the rest of the industry, for instance the investment management industry?

Dushyant Shahrawat: Disruption has become the new buzzword of 2016. Everyone is talking about it. But actually, the definition of disruption implies that your firm or industry is going to be turned upside down because a new product or service is introduced to new users in a way that tips the balance in the market. Innovation, on the other hand, is when an existing product or service is improved for existing users. In my view, we need to tamper our expectations for massive disruption in the institutional buy-side due to high barriers to entry, tough regulatory requirements, and entrenched business practices.

Having said that, we should expect changes in the institutional buy-side sector. Asset managers may manage the same assets, but they shouldn’t expect the same fees, the same terms, and the same loyalty as they have been accustomed to. Even if institutional money managers maintain the same amount of assets, they may be forced to manage lower fee-paying assets, or the client mix may change.

Even if institutional money managers maintain the same amount of assets, they may be forced to manage lower fee-paying assets, or the client mix may change.

Let’s take an example from the retail lending market to see how this may play out. There is an alternative student lending company called SoFi, which targets low credit risk students with loans and offers lower interest rates than University credit unions. I applied to refinance my student loan and was approved within 30 minutes. It was super convenient, they reduced my rate by 1%, and there was no human interaction necessary.

Is this disruptive? Yes, it is. By stealing the best clients away from University credit unions, SoFi is negatively impacting the credit union’s lending portfolio and driving up its risk. We may see the same type of change sweeping the investment management industry.

Journal: I guess this is an example of what we’re seeing in the retail banking industry at the moment.

Dushyant Shahrawat: Yes, exactly. A lot of small firms are taking away profitable elements of the industry. A recent report by Goldman Sachs noted that, “$11 billion (out of $150 billion) in profits is at risk of leaving the banking system in the next 5+ years from online marketplace lenders.” And that’s just one element of retail banking. 

These new companies have made the first move, and we can expect more of these changes in other parts of the financial industry. I believe that while core financial activities provided to consumers (i.e. lending, investing, and payments), won’t change any time soon; product design, distribution, and pricing will surely change in the coming years. 

Journal: Can you give us a broader perspective on innovation across different industries? Why are capital markets, and especially the investment management industry, lagging behind this innovation and disruption that we see in the retail banking sector?

Dushyant Shahrawat: Let us start at the top. My research shows that financial services and healthcare are the slowest industries to adapt to all these changes sweeping business for the last few years. As human beings, we are least resistant to change when it comes to our money and our health. It’s human inertia to not try anything new for these types of services. This is a big factor why finance and healthcare haven’t witnessed the changes we are seeing in other sectors.

Now, within the financial industry, we are seeing innovation in the retail banking sector driven more due to the fact that it services individuals, and retail customers are demanding it. Customers have been exposed to the power of new technology and innovation delivered to them in several industries, such as retail, media and entertainment, and social media. They are now demanding similar improvements from their financial services providers, and retail banks are the first to experience these demands.

The stakes are much higher on the institutional buy-side. The vast amounts of money that asset managers have fiduciary responsibility for, and the long-term loyalty and relationships between asset owners and institutional managers, means this industry has remained very conservative and resistant to innovation compared to retail banking.

The vast amounts of money that asset managers have fiduciary responsibility for, and the long-term loyalty and relationships between asset owners and institutional managers, means this industry has remained very conservative and resistant to innovation compared to retail banking.

Journal: Are high entry barriers to the asset management industry holding innovation back?

Dushyant Shahrawat: I think so. In the institutional buy-side sector there are high barriers of entry from a capital, regulatory, and brand perspective. Asset owners don’t like risk, so they will naturally go with one of the 400 largest firms in the industry that come with an established track record and brand. It’s not easy to get into this exclusive club. New startups with fancy names and good looking websites don’t cut it here. This is good news for those Top 400 firms, but they shouldn’t take it for granted.

Innovation will gradually creep in, as expectations from current and prospective clients change. The next generation are the ones testing out robo-advisors and using the new services that are disrupting retail banking. By the time they are the influencers of tomorrow, you’d better hope that you can satisfy their demands.

Journal: Some FinTech commentators seem to think that robo-advisors are the closest we come to ‘disruption’ in our industry? Do you agree?

Dushyant Shahrawat: Not if we stick to our use of the term ‘disruption’. The rise of robo-advisors is just a new distribution channel for investment firms. But what is interesting is that when a relationship moves away from a human to a platform, then loyalty is very likely to matter less over time. We are essentially training a generation to think differently about who manages their money. This is the fundamental change that robo-advisors are bringing about. 

Firms should also be looking at what companies like Facebook and Google are doing, what we can learn from them, and their ambitions in capital markets. Their reach is enormous and they are determined to grow that reach even more.

Currently, these high tech companies are very interested in industries where there are a lot of consumers and a lot of transactions. They have the ability to learn a lot from the data in ways that other players don’t. These hi-tech companies want to learn more about consumer shopping habits, so they see payments as a very important element that they want access to. That’s why we are seeing offerings like Apple Pay and Google Wallet. They don’t necessarily care about the payment itself, but they want all the transaction data. The more they know about personal spending habits the more they can target their offerings, such as ads.

For Facebook, their next developmental phase is to seamlessly integrate shopping onto their platform and create more integrated communities. This could be for example, a community focused on sharing investment ideas and best practice. Once these communities take off, what could be the natural next step for Facebook? Would they integrate investment options into their platform so that buying assets becomes as easy as buying a new pair of shoes, directly from Facebook’s platform? Maybe not, but Facebook can definitely start influencing how young customers make investment decisions.

Journal: Another innovation that has come out of the FinTech boom has been blockchain. How do you see it affecting institutional buy-side firms – what is a good use case for it in our industry?

Dushyant Shahrawat: Blockchain is certainly interesting, and a lot has been written about it recently. I think blockchain is a 5-7 year play and will require that investment management system providers adjust and adapt accordingly. One of the popular cases bandied about blockchain is in settling securities transactions.

Securities began being bilaterally cleared back in the 1970s, once a week. Then they figured that it could be done more efficiently by grouping settlements together so that there was less risk and fewer transactions. This of course gave rise to the clearing houses that still exist today. Now, 40 years on, blockchain technology essentially allows firms to go back to clearing settlements bilaterally without the need of a middleman, the modern day clearing firm. This promises major change, but don’t expect large settlement corporations such as DTCC to just stand aside, and let blockchain take their business away. 

Now, 40 years on, blockchain technology essentially allows firms to go back to clearing settlements bilaterally without the need of a middleman, the modern day clearing firm.

Journal: In closing, what do you recommend investment managers should focus on in the face of this IT-led innovation sweeping business today, and over the next 5 years?

Dushyant Shahrawat: First, keep an eye on the major hi-tech firms like Google, Facebook, Amazon and Twitter.  These firms have no plans to directly enter the financial services industry. But they will enter the payments business, they will greatly influence customer behavior including which financial providers customers pick, and act as a distribution channel for financial products and services.

Second, large financial institutions are gradually being pushed towards activities that are capital intensive, heavily regulated, and require heavy risk undertakings. They will remain major players, but they will be pushed to deal with the low-fee, non-sexy parts of the business, they will become factories that manufacture products, while newer participants begin capturing much of the value.

Third, for investment products, who manages our money remains important, but will become relatively less important over time. Most investment products have become commodities, and firms that manage distribution channels or influence customer behavior will matter more and more.