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Technology-enabled risk-taking in specialised financial-services businesses

Within our value creation framework, the three foundational or transformative technologies of open-source systems, artificial intelligence and blockchain/DLT enable the build-up of efficient risk-taking platforms. The specialisation of the risk-taking activities though is the prerequisite for the effective deployment of these underlying technology components. It defines the different deployment models with its use cases in trading, investing and lending.


This article elaborates on the benefits of applying such a technology-enabled specialty finance approach. It covers three deployment models that gained substantial advantages through the application of foundational technologies. Multi-manger platforms, specialty finance and challenger banks implement these principles and provide operational efficiency and augment decision-making. The three categories of foundational technologies themselves are covered in more details in the book “Transforming Financial Institutions”.


Service integration, cross collaboration, and specialised capabilities

The principles of open architecture with its standardised integration and interoperability of services and systems allow specialisation in a cross-collaborative framework. Specialised risk-taking and distribution capabilities for an asset class and/or a client segment are instrumental in operating successfully in today’s complex operating environments. On the other hand, scale and efficiency in a highly regulated business can only be achieved through a large-scale organisational reach. Technology brings those two worlds together and allows specialisation and scale through cross-collaboration. These principles are often supported by the legal and regulatory frameworks of open and embedded finance. In the following paragraphs, we are breaking them down into three specific deployment models in trading, investing, and lending.


Multi-manager platforms

Multi-manager platforms such as the ones of Citadel, Millennium and Balyasny Asset Management allocate capital across teams of specialist traders. These specialised teams operate on efficient and agile cross-collaboration platforms. Technology is the glue that holds these platforms together. Each manager builds specialised capabilities by leveraging the technology platform that sits at the core of the wider trading operations. Customised tools allow traders to gain a competitive advantage in their specialised field. Specific data, trading access and execution capabilities are key requirements and competitive differentiators. Risk, profit, and loss functionalities remain important for each team but also the management of the consolidated risk exposure on the wider platform.


The capabilities are integrated in the platform’s core workflows through the user interface and customised for each team’s user experience. The integration leads to a scalable cross-collaboration platform which is key for the global, large-scale reach of the business. The complexity through the different functionalities remains an operational challenge and requires consolidation across the technology stack. Those functionalities often sit in applications with customised workflows which further requires an interoperability layer for the interface but also the use of different trading devices. Citadel X and One are prominent (public) examples of this approach and have contributed to the firm’s impressive financial success.


Specialty-finance and alternative-investing platforms

Specialty finance has historically been defined as any financing activity that takes place outside the traditional financial system. We are using the term broadly for specialised risk-transfer businesses that target commercial and customer segments with dedicated and tailored propositions. Most specialty finance platforms have been established as alternative lending and investing platforms, targeting segments that find it difficult to obtain financing through traditional channels. Their model is focused on the performance of the underlying asset, and funding often provided through innovative facilities and structures. These platforms are in the process of disintermediating the global banking landscape. Certain customer segments have increasingly been underserved by incumbent financial institutions. Regulatory and capital requirements under Basel IV have accelerated the retreat of traditional players leaving a funding gap of over several billion in specific market segments. This trend will continue and lead to a deep ecosystem of specialised providers across the capital structure.


Specialty finance players focus on assessing risk in a more tailored and effective manner, looking at a broader range of available data as opposed to the more ratio-driven and formulaic approach that traditional financial institutions have been using. The thorough level of underwriting allows them to provide debt and equity financing in special situations, often declined by traditional lenders, while obtaining a premium price to cover the risk and assessment work. Specialised investing and lending capabilities are key for the success of this commercial model. It is not only the process enhancement and automation of workflows but the key aspect of the data availability and integration in the investment and risk-management process. Artificial intelligence with its big data and machine-learning tools is key across the lifecycle from originating an investment and lending opportunity to execute and monitoring it. Specialised Software as a Service (SaaS) solutions are getting deployed. Data is the key entry point and operational requirement, followed by the contextualisation of the data and the build-up of specific decision-making capabilities.


Challenger banking

Challenger banks are smaller, and often more recently created banking platforms. They range from digital banks such as Starling, Tandem, Revolut, and Monzo to focused segment players such as OSB Group, Aldermore, and Virgin Money. To compete successfully with the incumbent players, they focus on a specialised proposition in a niche segment and/or are operationally enabled by technology with a differentiating customer experience. Challenger banks are either newly built through foundational technologies and open-architecture design or spun-out of large-scale operations at larger incumbent banks. For the latter, the technology platform usually gets replaced by modern systems and design principles.


The commercial differentiation requires a specialised approach while its successful scalability requires the service integration in the wider incumbent ecosystem. Several successful challenger banks have built a niche offering in specific part of the mortgage market or successfully built lending platforms for moto finance and other consumer products. Neo-banks with a digital offering follow open design principles across collaboration and integration. Many of those digital banks though have focused on basic service provisions such as deposits, savings, payments and third-party investing, and have shun away from lending and more risky endeavour. Their profitability has been at a lower end, and many even struggled to get their banking license. The focus needs to shift to specialised risk-taking activities in lending and/or provides its customers with access to trading and investing products that are truly differentiating. This shift must be supported by the wider regulatory agenda of open banking and finance.


Notes:

1) See chapter four of "Transforming Financial Institutions: Value Creation through Technology Innovation and Operational Change" for further details on foundational/transformative technologies

2) See "Meet Citadel X" in INSIDER, May 2, 2023


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