Introduction to Financial Technology

What is Financial Technology

Financial Technology (FinTech) is about building systems that model, value, and process
financial products such as bonds, stocks, contracts, and also money. At the very basic, these
financial products are represented by their respective dimensions price, time and credit. 

Financial systems incorporate trading systems and trading technology to enable the buying
and selling of products at different times and in different market spaces.

Financial technology depends on standard secure communication protocols for initiating and
synchronizing communication, for authenticating market participants, and for ensuring that
the market participants can communicate efficiently in a common language. This enables the
fast delivery of information, orders, and news on public or private, physical or non-physical
communication networks.

Financial technology integrates mathematical, statistical, computing, and economic models

with news and analytical systems; these are further integrated with message, transaction,
order processing, and payment systems.

Financial systems perform their activities in compliance with rules, procedures, guidelines,
and regulations.

Financial Systems and Trading Technology

Financial systems share many attributes with commercial systems; both systems incorporate
trading technology. Actions associated with trading include auctioning, negotiating, buying,
selling, borrowing, leasing, brokering, dealing, clearing, settling, and delivering. The
activities of trading require at least two actors; e.g., a borrower and a lender; a buyer and a
seller. Places where these actors meet are commonly called markets, trade fairs, exchanges,
or auction houses.

The difference between financial systems and commercial systems is in the products that are
modeled, valued and processed. Products that are bought and sold in the commercial systems
include things that we eat, drink, plant, wear, burn and consume. While the products that are
bought and sold in financial systems are intangibles that vary over time, such as credit,
ownership, contracts, obligations, and shares.

The First Exchange-Traded Companies: VOC and WIC

The Dutch East India Company [in Dutch, the Verenigde Oostindische Compagnie (VOC)
literally the United East-Indies Company] was established on 20 March 1602. They were
organised by several wealthy Dutch merchants who raised about 64 tons of gold, which are
enough to build several ships. The Dutch government granted the VOC a monopoly on trade
with Asia.

By 1604, ships were sent to India where they shipped back cloves, nutmeg, pepper, mace, and
other spices to Amsterdam. At their initial public offering (IPO) in 1604, an investor could
buy one share of VOC for either 500 pounds or 3,000 guilders. For the first few years, VOC
increased working capital in more ships, ports and employees. Their first dividend that was
declared and distributed in 1612 amounted to 287.50 pounds per share, corresponding to a
dividend yield of 57.5% of the original share price. 

By 1669, VOC had 150 merchant ships and 40 warships (for protection from pirates) and
employed over 20,000 people. VOC ships brought silver from Europe to purchase raw silk in
China. The silk was traded in Japan for gold and copper. These were traded for textiles in
India, which were further exchanged for spices in Indonesia. The spices were shipped back to
Amsterdam.

Over the years share prices fluctuated. In 1622, a VOC share costs 1500 pounds; in 1720, the
price was 6000 pounds (12 times the IPO price), but in 1781 the price fell to 125 pounds. The
average dividend yield was 18% per year, which was payable in cloves, VOC corporate
bonds, or other proxies for money. On the New Year Eve of 1799, VOC was dissolved after a
corporate lifetime of 198 years.

The Dutch West India Company [in Dutch, the West-Indische Compagnie (WIC)] was
organised on 3 June 1621 in the same way as the VOC. The capitalisation of WIC was 130
tons of gold. The Dutch government granted the WIC a monopoly on trade with Africa nd the
Americas.

Initially, shares of WIC and VOC were traded at the same value. Because of wars and
increased competition with Portugal and England, WIC was not as good investment as VOC.
In early 1670s, a WIC share was worth 3.5% of a VOC share. WIC went into bankruptcy
reorganisation in 1674.

The First Transaction Protocols

The transaction technology used at the Amsterdam Stock Exchange, based on a "handshake
protocol", that is similar in spirit to the technology used today. A protocol is a rule,
represented by a sequence of actions for two actors, which specifies how a particular activity
should be performed.

The "handshake protocol" for trading was discussed in the 1668 essay by trader Joseph de la
Vega.

A member of the Exchange opens his hand, and another takes it, and thus sells a number of
shares at a fixed price, which is confirmed by a second handshake.

After the confirmation handshake signifying that the trade was executed, the protocol
commits the seller to deliver VOC shares to the buyer on the 20th of the month (the closing
date) and the protocol commits the buyer to pay the seller on the 25th of the month (the
settlement date).

Some trades required an actual transfer of shares. The protocol was that on the 20th of the
month, the seller 

Financial Systems and Information Technology

Information technology (IT) can add great value to the financial services sector by addressing
the need of key stakeholders: the institution's customers, business functions, operations
functions, risk management functions, IT functions, and regulatory bodies. However, creating
business solutions that fulfil the needs of diverse groups are complex processes that involve
balancing conflicting business requirements, managing technology limitations, and
navigating through organizational and external politics.

Nevertheless, IT solutions provide many benefits to financial institutions, supporting their

growth and enabling new lines of business. New customer-focused solutions can make
financial institutions more competitive and enable them to dominate market segments.
Customers could also benefit from improved convenience and access to diverse financial
products.

On the other hand, ineffective use of technology and the inability to deliver IT solutions can
lead to customer dissatisfaction, employee frustration, and business stagnation.

BUSINESS DRIVERS

Increased Competition

The greatest change affecting the financial services industry has been the shift from being a
protected market to a more competitive market. The transformation has occurred at different
rates in different geographies and was initially spawned by regulatory changes. Competition
has caused a domino effect, with more competitive financial institutions taking the lead,
setting higher standards, and attaining a position of strength for subsequent industry
consolidation.

Increasing competition had reduced profit margins for many traditional products and services
that became commoditized over time. It has also presented opportunities for creating new
products and services that commanded higher premiums.
Recently, competition has also come from start-up financial technology (Fintech) companies
that aim to disrupt incumbent financial institutions. Fintech companies seek to leverage
technology more effectively and provide innovative financial products and services that are
more attractive to customers than those products and services being provided by traditional
financial institutions.

Increased Scale

Increased competition has led to consolidation across the industry, enabling banks to take
advantage of economies of scale. The largest banks engaged in universal banking, providing
a comprehensive set of products and services including deposit taking and lending,
derivatives trading, securities trading and underwriting, fund management, and insurance. 

Increased scale has helped to reduce unit costs, lower risk by increasing diversification and
improving return on investment for large IT infrastructure expenditures. International
expansion provided the opportunity to extend existing products to new markets.

Yet, introducing existing products to new markets is complicated; regulatory requirements,

customer preferences, and business practices vary across different countries and have to be
addressed.

Increased scale, especially where it came from the consolidation of multiple entities, had a
major impact on the IT and operations of financial institutions. Larger business operations,
along with the increased competition, often necessitated the integration of the previously
siloed business functions. It also eliminated duplicated functions and systems to achieve
greater efficiency. The integration also identify synergies across business lines that could
create greater business value and provide new opportunities.

The integration of systems and services across business units has enabled the financial
institutions to bundle together multiple products and services, such as deposits, credit cards,
and payment facilities to form consolidated offerings. Integrating business capabilities also
supported cross-selling; i.e., expanding the usage of existing products across different
customer segments.

Changing Revenue Sources

Financial institutions have traditionally obtain their major income from the net interest
margin; i.e., the difference between the interest income that they receive and their pay-outs.
The stiff competition, demographic changes of their customers and increase of scale had
caused extended period of low interest rates and shrinking net interest margins.  Over time,
the financial institutions have expanded their focus on fee-based revenue and relied less on
income derived from the net interest margin.

As compared with revenue derived from net interest, fees provide an income source that is
less sensitive to interest to interest rates and business cycles. Shifts in interest rates and
customers' credit quality usually do not directly impact fees.  Growth in fee-based income
does not require financial institutions to increase the size of their balance sheets, unlike the
income from lending. Balance sheet growth is generally undesirable as it often requires the
financial institutions to raise additional capital. Thus, promoting fee-based products and
services has been the common goal for the financial institutions for the past decade.
New Delivery Channels

New customer delivery channels have supported the growth and profitability of the financial
institutions. For example, new delivery channels like the phone and Internet banking had
enabled an increase in volume and reduction in transaction costs of the institutions.

Besides benefiting the financial institutions, the new delivery channels have also increased
customer convenience, enabling transactions to be initiated from anywhere, such as at home,
at work and also while shopping. Being able to reach out to customers through their mobile
phone has made it easier for the institutions to continuously communicate with their
customers.

Yet, the new delivery channels have more tightly intertwined IT with the business processes
of the financial institutions. The institutions' business staff need to be IT literate in order to
understand how technology can be leveraged to support business goals, and also to
understand its risks and limitations. On the other hand, the institutions' IT staff need to learn
more about the customers and the institutions' business requirements so that they could
develop an effective IT solutions.

Nevertheless, the introduction of new channels and channel-related processes has also
brought on new business risks. Identifying and mitigating these risks are only possible by
having the business users and IT solution implementers understand each other's domains and
work closely together.

Regulatory Changes

In Malaysia, the new and much more comprehensive Financial Services Act 2013 (FSA) has
replaced the Banking and Financial Institutions Act 1989 on June 30, 2013. The aim of the
new law is to promote financial stability, to protect the rights and interests of the consumers
and also to prevent future financial crisis with new international standards.

The FSA has extended the scope of law whereby it focuses not only on corporate governance,
but also to include matters of intervention and remedial actions, shareholding, capital
requirements and consumer protection.

Before FSA, the Malaysian financial systems were regulated by four main legislations; i.e.,
the Banking and Financial Institutions Act 1989, the Payment System Act 2003, the
Insurance Act 1996 and the Exchange Control Act 1953.  With the enforcement of the FSA,
all these laws have been repealed.

Demographic Changes

The rise of the millennial generation has become a driving factor for the financial institutions'
businesses. The term millennials refers to the generation of people born between 1980 and
1994. Compared with other generational groups, millennials are more open to using
alternatives to banking services, such as non-traditional payment services and peer-to-peer
lending. They prefer communications through digital channels, such as email, text messages,
Internet banking and mobile applications.
Catering for the needs and preferences of the millennials is important for the financial
institutions because these younger consumers represent greater long-term revenue generation
potentials for the institutions. 

TECHNOLOGY DRIVERS

Today, the financial services industry is highly dependent on technology, and information
technology (IT) is an integral part of most business processes and solutions. Coming along
with the benefits of the new technology, the ongoing technological change also introduces
complications and challenges. Amongst the greatest challenges is that the financial
institutions have to deal with outdated legacy systems.

The technology drivers and their implications of their changes on the financial institutions are
as follows:

- Technology Infrastructure

Technology had influenced financial institutions' products and services and has become the
foundation of financial solutions. For many years, the primary challenge was to find ways to
circumvent technological limitations such as memory available and CPU speeds. In the 1980s
and 1990s, financial services systems had to be designed to work around the limitations of
low-bandwidth voice-only phone lines.

Today, high-bandwidth Internet and fourth generation (and fifth-generation) mobile data
connections can easily reach a large number of end customers. The capabilities of IT
infrastructure in terms of hardware, software and networks have greatly improved over the
past decades. The hardware processing speed and memory of mobile (and smart phones)
today had exceeded what was available to run core banking systems two decades ago. User
interfaces are much more flexible, powerful and intuitive.

Having more implementation options had created the challenge of choosing the best platform
for the given solution purpose. Cost, performance, stability, and skills availability must all be
considered. Furthermore, as the rate at which new technology offerings are introduced
increases, so does the rate at which technology becomes obsolete. Thus, refreshing and
consolidating technology platforms have become major concerns for financial institutions.

- Distributed Processing

Increases in computer-processing power combined with reduction in the cost of hardware and
network bandwidth have led to the wide-scale use of IT within the financial institutions. The
migration from centrally located mainframe computers to servers and desktop workstations
had further enabled financial institutions to easily relocate computing resources.