From geofinance to eurofinance and cyberfinance
Discussion Paper
v. 2
Charles Goldfinger*
Information Technology is now a core constituent of financial services. Its impact has been both deep and pervasive. IT provides the critical set of services and infrastructure that every financial institution need to carry out its business. It also enables some institutions to develop a competitive advantage. The relationship between tactical and strategic use is dynamic: strategic can become tactical, once a technology is widely adopted. This was the case of ATM networks. On the other hand, tactical can become strategic: thus, a ubiquitous bank card can be transformed into a differentiation vector for loyalty services.
The impact of technology goes beyond competitive positioning. It has dematerialised the nature of financial markets and financial transactions. The dematerialization had two major consequences:
- an explosive growth of financial transactions, requiring greater processing power, and
- a proliferation and greater complexity of new instruments, requiring sophisticated analytical and management tools.
The main purpose of financial markets is no longer the trading of physical goods but the information exchange and risk management.
Last but not the least, the convergence of IT and financial services profoundly influences public policy toward financial markets and financial institutions. Their changing nature triggered new risks. As the traditional risks, such as credit risks, have not disappeared, the overall risk level of financial system has increased. At the same time, the ability to manage risks was significantly enhanced. This created a somewhat paradoxical situation: a greater fragility, as evidenced by a succession of crashes and crises (debt crisis in the 1980s, October 97 equities crash, Japanese banks crisis, Summer 98 global debt crisis, etc.), and a greater resilience: so far, the global financial system continues not just to function but to grow and prosper. By blurring distinctions between various categories of money and financial accounts, financial technology made more difficult the conduct of monetary policy and the supervision of financial institutions. When money becomes electronic, the very notion of financial institutions turns out to be more ambiguous and difficult to define. In the new landscape, the roles of financial institutions, technology providers and regulatory authorities need to be redefined.
In the past twenty-five years, financial services have undergone deep and extensive changes in all aspects of their business: products, delivery channels, market structure and regulatory oversight.
·
Products: Financial products have become
more varied and more complex. The product cycle has been accelerated: products
are conceived, deployed and made obsolete much more quickly than before. They have become more liquid and tradable,
as financial institutions seek to externalise and share their risks.
·
Delivery channels: Delivery channels
have proliferated in order to enable customers remote and permanent access:
ATMs, telephone banking, on-line banking, Internet banking, etc. Contrary to
early expectations, new channels have reinforced rather than cannibalised the
existing ones and have not fundamentally changed the market shares allocation
as all major financial institutions were quick to adopt a multi-channel
strategy.
· Market structure: Boundaries between different categories of financial services become blurred. Banking, insurance and capital markets firms are invading each other’s turf and competing aggressively. Market structure is becoming more fluid and unstable. Established hierarchies can no longer be taken for granted. Deregulation has attracted many newcomers: retailers, industrial companies, telecom operators. New entrants achieved significant inroads in a number of segments, particularly in the US. Yet, banks have demonstrated a remarkable resilience. In continental Europe, they successfully invaded life insurance and securities brokerage.
· Regulatory oversight: Boundaries between various financial services activities are no longer rigid. Geographical restrictions to entry have been considerably reduced. The increased risk level has led regulators to monitor international banking activities on a consolidated basis. Specific steps have been taken to better track positions in derivatives instruments.
There were nevertheless significant differences in the rate and scope of change between various segments of financial services:
- Wholesale banking has changed more than retail banking
- Markets have changed more than banking.
Globalisation has been particularly pronounced in wholesale banking and over-the counter financial markets such as foreign exchange. Corporate lending and investment banking are dominated by few global players, active in all markets, established or emergent. On the other hand, globalisation appears to have affected relatively less the retail banking, which remains largely fragmented and localised. This pattern of transformation of financial services, created by interactions between globalisation, information technology and deregulation, can be called “geofinance”.
The pace and reach of change are actually likely to accelerate in the near future. In particular, European banking and financial markets are on the verge of a large-scale upheaval under a combined impact of euro and Internet, the emergence of eurofinance and cyberfinance.
· Eurofinance: the creation of a common currency has set up a foundation for a very large integrated financial services market for 300 million people. Such market is already being built as evidenced by the explosion of activities in euro-denominated capital market instruments. Cross-border equity trading has also grown significantly.
·
Cyberfinance: Both Internet banking and
brokerage are developing rapidly and Internet technologies are penetrating all
aspects of business operations. Cyberfinance associates closely traditional
banking financial institutions and technology providers. The latter are in
position to either marginalize or disintermediate financial institutions.
Furthermore, numerous efforts are being carried out to design and implement
Internet-based payment systems. Some of those systems, according to their
proponents, have a revolutionary potential and can trigger the emergence of
alternative monetary systems, which would be outside the reach of the existing
banking structure and its regulators.
Thus, while eurofinance appears a vector of continuity with the existing financial trends, cyberfinance contains a significant discontinuity potential.
Europe is
significantly overbanked and the need for consolidation in the retail banking
sector has been widely acknowledged. However, until late 1990s, the pace of
mergers and acquisitions in European banking has been rather lethargic. Since
1998 and even more since the official euro launch, the speed of consolidation
has accelerated and is likely to further step up. The value of merger and
acquisitions in financial sector has increased from 41 billion euros in 1997 to
174,5 billion in 1999.
In retail
financial services, the consolidation remains primarily national, most banks
and national authorities following the model of a “national champion” and
giving priorities to the strengthening of their home base. Cross-borders
mergers remain scarce and they primarily affect neighbouring countries (Benelux
or Scandinavia): the “national champion” model is evolving toward the regional
leader. It remains to be seen whether the takeover of Credit Commercial de
France by HBSC constitutes a first sign of major wave of global alliances or an
isolated case.
While the consolidation spotlight is on financial institutions, the success of euro-based financial services depends crucially on closer integration of the underlying infrastructure of payment systems and services. This infrastructure, while highly sophisticated, has been designed for national markets and treats crossborder transactions as marginal. Its structure is complex and hierarchical, with various systems for various payment categories (check/card, retail/wholesale). Those systems are interconnected by common membership and interoperability agreements but the degree of interconnection varies considerably.
This double fragmentation, national
and functional, results in higher transaction costs and lower efficiency of
crossborder retail payments and securities settlements. It also entails a proliferation
of incompatible standards. To take just one example, while there are at present
close to 100 million smart cards issued by financial institutions, they are
splintered into over 20 incompatible schemes, both from the technical and the
business viewpoints. Attempts to achieve interoperability have been laborious
and, so far, met with limited success.
Thus the consolidation of financial
institutions need to be accompanied by a consolidation of underlying financial
transactions and processing systems. While some progress, albeit slow, has been
made in the domain of securities processing with a merger of Deutsche Börse
Clearing and Cedel (ClearStream) and of Sicovam and Euroclear, European retail
payment systems remain highly disjointed and dominated by national interests.
Internet is considerably more than a networking protocol and set of communications standards. It is a broad environment, which encompasses both technical and business architectures. It leads to an ultimate blurring of boundaries between processing and communications Not only, as Sun affirms, “Network is the computer” but the converse is true is well: “Computer becomes the network.” Today, use of Internet is synonymous with logging on the personal computer, but as all-encompassing communication set of protocols, Internet will also be embedded in voice communications and in video transmission. Internet makes multimedia a reality.
From the economic perspective, Internet creates a whole series of new business models. Allowing a wide variety of pricing and valuation approaches, it provides highly sophisticated tools for transaction and behaviour monitoring. However, the tool availability does not imply that each click or eyeball can be priced by the service supplier and paid by the end-user. In the virtual world, value transfers are no longer tied to the actual exchange of goods and services. Internet generates tremendous value-added to its users and suppliers, but this value can no longer be captured by traditional methods such as marginal cost pricing or transaction fees. In the Internet universe, third party and indirect pricing are likely to be the rule rather than the exception.
There is no Internet hype: forecasts on the speed and the
extent of adoption of Internet-related technologies (Java) and applications
(electronic commerce), as wildly optimistic they might have seemed at the time
of their publication, are lagging behind the actual market development. Internet will have a broader, deeper and
more destabilising impact on both Information Technology and business sector
than the personal computer (of which Internet is a logical extension). In a
nutshell, Internet means:
·
Warp speed of development and, above all, diffusion of applications, products
and services
· Low costs: even if Internet development and operational costs are not as low as asserted by its enthusiastic proponents, they are considerably lower than that of traditional networks and application distribution. Similarly, Internet lowers significantly business transaction costs
·
New approaches to collaborative
work and transaction management.
The three trends are mutually reinforcing. Their impact can be summarised around two major themes: ubiquity and mobility.
Ubiquity has three dimensions:
· Ubiquitous computing. The range of intelligent access and processing devices will continue to expand well beyond personal computers towards various forms of information appliances.
· Ubiquitous networking. Internet is likely to accelerate the trend to lower communication costs and, more importantly, force network operators to pass cost savings to consumers.
· Ubiquitous programming. Object technology and Internet carry the promise of democratisation of software application development process.
Computing
and networking are increasingly mobile
and this trend is likely to continue. It will be further stimulated by two
technologies: wireless communications and smart cards. Both those technologies
experience explosive growth, which is comparable to that of Internet. It should
be noted that Europe is fairly advanced in the deployment of those two technologies.
There is a widespread perception
that the European Union is lagging behind the US in the deployment of
cyberfinance. This perception should be qualified. European banks do not lag behind
the US banks in the deployment of Internet banking, quite to the
contrary. Banks such as Merita Nordbanken, Deutsche Bank or Barclays have more
clients and offer a greater range of services than their US counterparts.
Europe also leads in the development of pure Internet banks such as Egg in the
UK, which boast 940 000 clients at the end of 1999 or e-bank or unofirst, the
world's first global Internet banking group, valued in early 2000 at 2.4
billion euros.
The situation is quite different in Internet securities trading. In the US, Internet-based trades represent 20% of the total and their share is increasing. Industry structure has undergone a dramatic change: Internet brokers such as Charles Schwab and E-trade became a major market force. In Europe, Internet securities trading remains a largely marginal phenomenon. Very few Internet brokers have attracted more than 100 000 clients and in countries such as UK or France, market leaders have less than 50 000 clients. No Internet-based alternative trading system has been created. Many senior technologists within the exchanges and large financial institutions look at Internet with a mix of doubt and loathing and are not ready to endorse it as a foundation of new architecture.
This lag is worrisome. While Internet banking is progressing rapidly, Internet securities trading shows a truly explosive growth. The former is still a relatively marginal phenomenon, affecting less than 5% of banking transactions, the latter already has a major impact on the overall equity business.
Cyberfinance
amplifies the trend toward dematerialisation and virtualisation. The range of virtual channels will continue
to expand: in addition to PC-based banking, mobile banking is likely to be
deployed on a large-scale in Europe. More importantly, Internet will become the
architectural core of all distribution channels, whether physical or virtual.
Banks will need to move from a multi-channel to cross-channel distribution
strategy.
Cyberfinance will also affect the transaction and payment infrastructure. Internet model dissociates the network from physical infrastructure. By providing common standards, it allows interconnection between heterogeneous networks. Furthermore, with encryption technology, digital certificates and smart cards, it is now possible to use security in a modular and flexible fashion. A highly secure environment can be created on the public networks. To what extent these developments change the prevailing approaches to payment and transaction processing networks, based on dedicated infrastructure and proprietary protocols ? What are the implications for their architecture ? For their access and control policies ?
Does cyberfinance portends a banalisation of financial services ? Does it reduce barriers to entry to a point where any network can become a market, any computer a clearing system and anybody can issue electronic money ? In the new environment, what is the meaning of: financial transaction, financial intermediary (bank, broker, broker/dealer) and money ?
Cyberfinance
is a perpetual co-opetition
game. Traditional financial institutions must decide what attitude to adopt toward IT suppliers,
who control key
technologies and have deep deployment know-how, yet at the same time
have gained direct access to customers. Such attitude is a constantly changing mix of trust and distrust,
co-operation and competition. On the one hand, banks and IT suppliers
co-operate in order to create common infrastructures and interoperable systems
and to decrease development and operational costs. On the other hand, they
compete aggressively to differentiate their products.
The combined impact of eurofinance
and cyberfinance present European financial institutions with three major
technology challenges :
· From payment infrastructure to trust
infrastructure
· From national to European
infrastructure
· From centralised to distributed to
ubiquitous computing/networking architecture.
* Managing Director, Global Electronic Finance and Chairman, Financial Internet Working Group (FIWG). Opinions expressed in this paper do not constitute an official position of the European Commission or FIWG members.