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Capital markets Prometheans: The case for being a first mover in blockchain

Is the risk of being left behind a risk worth taking?

Angry scientist with his failed experiment

As mad scientists on the payrolls of major bond houses carry out experiments in the futuristic field of distributed ledger technology (DLT), it is fair to ask how exactly the banks themselves will benefit.

After all, the main tangible effect of all this innovation so far has been to increase the amount of money spent by investment banks on technology.

Not that they’re complaining about it. If anything, the big banks seem to be competing to see who can spend most.

HSBC was the latest to join the arms race, announcing on February 22 that it was aiming to put at least 21% of its operating expenses towards tech by 2025. It already spends $6bn a year, or 19% of its total costs.

JP Morgan — notwithstanding the views of its CEO Jamie Dimon, who said cryptocurrencies have “no intrinsic value” — has been one of the most enthusiastic investment banks for blockchain technology. It created a blockchain unit in 2016 and launched its own digital coin, JPM Coin, in 2019. More recently, it has embraced the so-called metaverse by opening its doors in the online world Decentraland, whose payment system is based on Ethereum.

And everyone in the European capital markets is familiar with Société Générale’s in-house blockchain lab, Forge, which has helped the French firm to position itself at the centre as such developments as the European Investment Bank’s debut digital bond in April 2021.

But this all comes at a cost. After all, tech is one of the few industries where compensation rivals that of investment bankers. Not everyone is happy about the expenditure.

"Until we can go in with both feet into blockchain from a regulatory point of view, things will only happen or improve at the margin, i.e. help us make marginal gains to what we do already," complained a syndicate banker in London. "There's no doubt that blockchain is a game changer for primary capital markets but only when we are allowed to use it. At the moment it's £300,000 a year for our desk — that's the equivalent of around two associates — just to be there in case something happens."

All of which raises the question, are these ballooning investments in innovation departments worth it?

In some areas of banking, the answer is obviously ‘yes’. In retail, the benefits of having a best-in-class online and mobile user experience are plain to see. In M&A advisory, perhaps less so, although analysts would probably welcome any app that automated the process of compiling a 100-page pitch book.

What about in the application of blockchain to the capital markets? The potential efficiency gains, if the DLT evangelists are to be believed, are enormous, not to mention the prospect of self-adjusting coupons.

But it is precisely in capital markets that the case for being a ‘fast follower’ rather than a ‘first mover’ is especially strong.

Fast followers…

The whole point of capital markets is to allow organisations that need capital to tap into financial resources distributed around the world in pension funds, on insurance companies’ balance sheets, sitting in corporate treasuries, piling up in hedge funds, and everywhere else.

For this process to work efficiently, bonds need to be somewhat commoditised and — to use a word whose meaning many have only recently learned — fungible. Ideally, an investor would look at a bond and find that it is the same as any other bond, except for the risk of default.

Therefore, for any new bells and whistles to be successfully pinned on to bonds, those bells and whistles need to be widely adopted and accepted. That’s part of the reason why technological change here happens at such a glacial pace.

This being the case, why would any bank go out on a limb and experiment with a new technology like blockchain? Once the bank has cracked the code, they will need to share it with their competitors, otherwise their discovery will be useless.

Indeed, investment banks have come up with a way to share the risks associated with innovation that requires market-wide adoption: the consortium.

Since advances in the application of blockchain technology stand to benefit all market participants, it makes sense for banks to band together and pool their resources. One example of this is Fnality International, the company developing a blockchain-based payment system for wholesale markets, whose shareholders are a group of 15 banks from around the world.

Wouldn’t it be smarter, then, for a bank to take a back seat, at least in this particular field of innovation, and wait for its competitors to do all the hard work?

It’s a point that is not lost even on some fintech entrepreneurs.

“I think if that’s a positive decision, that’s completely legitimate,” said one of the many ex-bankers now trying to foist a technology platform on his former colleagues and rivals. “You’ve weighed up the pros and cons and decided you’re going to leave it for other people to do the pioneering, make the mistakes, define the future or whatever. If they’re ahead of you, how much have you actually lost?”

Another banker-turned-fintech entrepreneur went even further, suggesting that in some cases banks may be pursuing landmark technological breakthroughs mainly because the executives involved thought it would help further their careers.

“The individuals who are pioneering this are typically people who are either trying to ‘cement a legacy’ or purchase a ‘lottery ticket’ to becoming an expert in a lucrative field if the field takes off,” he said. “From the perspective of a bank, it would be much better to just sit back and wait for the chips to fall where they may.”

…or first movers

But there are some strong counterarguments. Firstly, the marketing and public relations benefits should not be written off entirely. Blue chip banking clients typically want to work with world class investment banks, and being at the forefront of technological innovation is another marker of this, a bit like leadership in sustainable finance. JP Morgan, at least, seems to understand this.

Technological prowess appeals to other stakeholders, too, such as employees, and not just those in the innovation team. GlobalCapital knows of at least one senior capital markets banker who quit his firm in part because his ideas for innovative blockchain based transactions were rebuffed.

And crucially, there is the question of how a financial institution can make a calculated decision on whether or not to invest in a groundbreaking technology unless they have some idea of where that technology might lead.

What if automated bonds on the blockchain eventually eliminate the need for a conventional bookrunner altogether? Would it not be better to have advance warning that such a change is in the air?

Ultimately, there are good arguments in favour of being both a first mover and a fast follower. A deliberate choice to be one or the other is valid.

What would be inexcusable, however, would be to think it doesn’t matter, leave it entirely up to everyone else, and assume that one’s own firm will be able to catch up later, come what may.

"That's different from making a decision to be a fast follower," said the first fintech entrepreneur. "It's like saying I'm not going to hedge my forward FX exposure — that's a conscious decision. There are clearly organisations who've said, 'We're going to wear the yellow jersey, be at the head of the peloton, define this future and run the risk of going down dark alleys'. But a number of people are in the position of 'We just can't make up our minds.'"

One thing is for sure: there will be no room in the future of capital markets for the complacent.

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