Fear and Loathing in Fintech Vendor Land

Editor's note: This post originally appeared, in slightly different form, on the author's blog and LinkedIn page.

FIS last week announced a deal to acquire SunGard. The press releases and news articles point out, correctly, that both companies provide services and products to the financial services industry in a complementary manner. So far so good – especially, I assume, for the private equity funds that owned SunGard.

Let's peel off the onion a few layers deeper, shall we?

First, the astute reader will have noticed that banks are under assault and are furiously trying to reinvent themselves as "digital" banks. The astute reader will also have noticed that to become a digital bank means much more than reinventing distribution channels – a necessary exercise but not a sufficient one. Indeed, to become a digital bank, one has to reorganize how such a bank works and this includes revamping one's processes, workflows and how data flows vertically and horizontally, in and out of the organization. Quite the endeavor!

Oh, and I forget, one has to, eventually, replace its core systems. And this, astute readers, is a Herculean task.

Most experts will tell you that banks' core systems are antiquated, date back to the 1980s at best, may be older in some cases and are woefully inadequate for today's challenges. Most experts will also tell you the price tags to replace said core systems are astronomical. Several leading consultancy firms have therefore crafted very sophisticated strategic road maps advising incremental change. I call this strategy "passing the buck," even though I recognize the intractable nature of the problem.

So far, FIS and SunGard, along with all other vendors in the space, have not been able to come to market with innovative core systems or software platforms that adequately address the new "digital" paradigm banks are faced with, either on the retail or wholesale side. (This does not mean they will never succeed or that they are not trying as I write this post.) In any case, the incumbent vendor side of the industry has fallen short of adequate responses, technology-wise, and the banks have had to scramble by patching together disparate products and service in suboptimal ways.

Let's peel the onion one more layer, shall we? SunGard powers many of the custodial accounting systems of the current securities settlement architecture. These systems are the very things that distributed ledger platforms will eventually replace. I must admit to a certain level of cockiness on this call. (I have skin in the game – my firm is an investor in Ripple Labs, the developer of a distributed ledger protocol.) Still I am sticking to my prediction. It is also telling that most if not all top-tier banks and capital markets participants are dabbling with distributed ledger and blockchain technologies. I know this first- and secondhand.

FIS and SunGard face a double dilemma: they must a) innovate internally to deliver a more modern array of products to its financial services clients while mitigating cannibalization of current revenue streams across the company, and b) stay relevant in the face of emerging technologies in specific areas.

Astute readers will remind me that on the one hand FIS is a $6.5 billion revenue company, that SunGard is a $3 billion company and that both have strong cash flow and a roster of marquee clients; and on the other hand, the distributed ledger ecosystem is at best 18 months old and is in the early stage of pipe dreams and pilot projects. All true, but these arguments miss a few key strategic aspects.

First, large financial services incumbents have no other choice than to change the way they do business. Consumer behavioral changes, regulatory pressure and market structure changes are ensuring change cannot be avoided. Second, financial services incumbents are aggressively engaging in strategic cost-cutting to deliver higher returns on equity to their shareholders – top-tier bank CEOs have mandated significant cost cutting over the next five years to counter the drop in ROE since the great recession. The twin consequences of these key drivers are re-engineering and experimentation, and this does not bode well for large finserv infrastructure service providers. They also will have to adapt and feel the pain of changing operating environments.

I assume the seven PE firms that purchased SunGard in 2005 – prior to the great recession – are well aware of the long-term changes the financial services industry is facing. This looks to me like a timely and shrewd sale.

Pascal Bouvier is a general partner at Route 66 Ventures, an investor in early- and growth-stage financial services and financial technology companies.