New technology: consider risks as well as reward
Investment firms are being bombarded with warnings about how technology may disrupt their business models. That disruption is coming looks an odds-on bet. Its shape and form, however, and its eventual impact, remain to be seen.
The simplistic message of ‘adapt or die’ needs to be tempered by some clear thinking about the possible consequences – not least because technology may be only one factor in the development of the new business model.
Investment firms can be panicked into making rash choices, but they should resist the urge to instantly rebrand as a technology-investment complex, and bear in mind the risks involved in the adoption of technology.
The first question fund managers should ask themselves is whether or not to implement a new technology. If this sounds obvious, Hugo Larguinho Brás, a director at PwC, believes the question is not adequately considered by many firms.
“The first step is to understand the technology itself - the potential, its functionalities and limitations,” Larguinho Brás told participants at a Euroclear roundtable event in Luxembourg.
Sometimes a technology is still in an assessment phase. It helps to get information about its take-up and success in other sectors and other countries before committing to a contract with a vendor.
Not only does a technology need to be suited to a particular investment firm, but also to clients and suppliers of the firm, who may have to adapt or change their systems too. They may be reluctant to do so.
“Take blockchain,” says Mohamed M’Rabti, Deputy Head of FundsPlace and Head of ETFs. “It is a dream at the moment. But you will need agreement over using blockchain with other participants. This is critical because once you’ve made the change, it’s very hard to go back.”
“With technology developing at warp speed, rather than incrementally as in the past, more investment firms are leveraging vendor platforms. This reduces cost and allows faster adoption of new technologies,” notes Elisabeth Meyers, Director for FundsPlace Product and Sales Solutions, Euroclear.
But every time a human action is replaced by technology, a sphere of expertise migrates from the firm to the vendor. Although efficiency is increased, this migration can cleave the firm from key value-adding processes.
If the vendor’s infrastructure is compromised by hackers or a major climactic or geopolitical event, the firm may not have sufficient expertise to deal with the fallout. This highlights the need for a disaster recovery plan which goes beyond having a back-up system in a secondary location.
Meyers: “Regulation is not necessarily addressed during discussions between investment firms and vendors. A technology which has been approved in one region or country may not be welcome in others.”
Take blockchain, to which there is considerable antipathy in some jurisdictions, but which has attracted a cautious welcome in others.
While many regulators are sceptical about blockchain, history shows that the regulatory environment tends to adapt to technologies that can be shown to have beneficial effects and future potential.
Technology developments often outpace regulators’ ability to process them, so a direct discussion with the local regulatory body is useful for the avoidance of doubt. This approach can bear fruit particularly in the case of technology that is not explicitly compliant.
“It’s a bit chicken and egg,” said Larguinho Brás. “You can’t build product if the regulator doesn’t allow it. But, equally, the regulator can’t give its view until a product is developed and working.”
Some regulators are happy to thrust themselves into the middle of an issue, while it is possible to cajole others into engaging with individual investment firms about individual technologies.
Making the assumption that new technologies reduce costs can be a mistake.
Investment firms are not all familiar with on-boarding new technology and don’t always see the need to build a business case for new technology that incorporates cost savings.
“This can lead to bad surprises,” said Larguinho Brás, “and can affect the return on investment. It’s best not to let enthusiasm get the better of you.” Sometimes a technology can reduce cost, but increase other risks – and this needs to be included in the business case too.
The risks of non-adoption
Then there is the risk attached to not adopting new technology or adopting it way after competitors.
It is natural that some firms are fast starters and others take time to follow because they don’t want to make mistakes, says Larguinho Brás. “The minimum every company must do is to take in interest in new technology, try to understand it and define a plan for it. Even if that plan is to wait, you must know why you have decided this.”
Much technology that is uniformly used in the investment industry today was taken up relatively slowly in its formative years.
Examples include basic computing, exchanges of information by email and trade confirmations by instant messaging systems. “An email was not viewed as an official channel of communication until relatively recently,” noted M’Rabti.
Some firms are reluctant to use technology that will make jobs redundant. This is a false concern, argues M’Rabti. “Better software allows people to focus on other things where they can add more value.”
Evidence for this is available in the Luxembourg funds industry. Not long ago, all transaction confirmations were performed by fax, whereas SWIFT is now the universal technology for messaging.
“You might have thought this would have posed a risk to jobs,” said Larguinho Brás. But, in fact, since the introduction of automated messaging, AUM has doubled in Luxembourg while employees working in the Luxembourg financial industry have risen slightly too.
“There is no need to be afraid,” Larguinho Brás added.
In summary, big changes are taking place in the investment industry, with technology one of the key drivers. But it is vital firms have a clear idea of what new technology can and cannot do for them and the many other factors that will be critical to the development of any new industry business model.
What it should not do is make the industry more opaque. More transparency and greater control are paramount to helping the industry function better and its ability to attract greater inflows in the future.
Operational controls and supervision
When implementing a new technology, it is crucial to look at the operational controls and supervision of the processes in scope, and to involve from scratch your Risk Management department.
Some controls of human actions – for instance four-eyes checks of data input – might no longer make sense once these actions will be automated by a new technology. Similarly, the focus of operational supervision will often be less on human actions and more on technology reliability.
The transition of operational controls and supervision from the previous model (“human”) to the new model (“technology”) can be progressive, especially if there is a risk of financial or client impact.
Explain to your Risk Management how the new technology works and how you plan to use it. It is the right way to preserve your company’s risk profile and supervision approach.
- Be wary of making a panicked, knee-jerk reaction to the message ‘adapt or die’. Any disruptive business model in the investment industry is likely to result from the convergence of many elements, technology being only one of them.
- Firms should improve their understanding of the functions and limitations of new technologies they are considering. They should also be wary of outsourcing risk - every time a human action is replaced by technology, expertise migrates from firm to vendor.
- A technology which has been approved in one region or country may not be elsewhere. Technology developments often outpace regulators’ ability to process them, so direct discussions with regulators can be helpful.
- Investment firms don’t always build a business case for new technology that incorporates cost savings. Where they do, the assumed cost savings may not materialise.