Bestselling FinTech author, Global Industry Strategist, Experienced Quant and Risk Manager, International Keynote Speaker, FinTech Entrepreneur and Thought Leader: Paolo Sironi is a true FinTech superstar! He recently published his latest book, “FinTech Innovation: From Robo-Advisors to Goal Based Investing and Gamification”, and Jochen Heussner got a chance to talk to him about the book, why regulation is the real driver behind innovation, and whether StartUp success is getting more difficult.
Paolo and I had first arranged to talk about his new book a couple of weeks ago but then his hectic schedule made it difficult to find a convenient time as he was jetting around the globe talking about his book and, I suppose, also do a bit of work in his main role as the IBM Investment and Risk Analytics Spokesperson. He sometimes jokes about Lufthansa being his living room and you can see why. He describes himself as a Thought Leader, which seems to be one of those overused buzzwords, but once we got talking you understand why can’t help but agree with this description in his case.
His first book “Modern Portfolio Management: From Markowitz to Probabilistic Scenario Optimisation” was a well received modern risk management perspective for practitioners. Paolo also contributed to “The FinTech Book”, the very successful collection of crowdsourced content from the global FinTech community. Now, in “FinTech Innovation”, a survival guide for the FinTech era of banking, he looks at financial technology and its growing impact on the global banking industry, based on the example of digital advisors or, more catchy, robo-advisors, which put the traditional wealth management model further under pressure (see our post on the subject here). For the purposes of this articles it should be sufficient to explain that robo-advisors employ automated portfolio management based on algorithms. It’s an online service and thus eliminates the need for a human financial advisor from the equation. Robo-advisors employ the same or similar software as their human counterparts, but because of automation they can offer their services at a fraction of the costs and therefor making it accessible to the more average investor. This results on one hand in lower costs as well as fees, and on the other hand lower investment thresholds since traditional wealth management is often reserved for already very wealthy people.
In “FinTech Innovation”, Paolo takes the reader on a journey below the disrupted surface of the wealth management industry, providing insights into what happens in its underlying layers and also hints at how the industry may have to change. The book is divided into three parts, Personalize Personal Finance (Part One), Automated Long-Term Investing Means Robo-Technology (Part Two), and (Goal Based Investing is the Spirit of the Industry (Part Three). Throughout the book he doesn’t limit himself to describe how existing models are being disrupted; he also points out the importance of a sustainable model beyond the cost factor. When I asked him whether the use of robo-advisors would lead to a democratisation of wealth management, he explained that the value of this trend goes beyond driving down costs. In particular, he stressed the benefits of gamification, especially for regulators, but also highlighted that for robo-advisors to succeed in the long run, they would need to embrace the advantages some aspects like gamification bring.
To better understand this, we might have to take a step back and explain a few things and also focus on why he believes that regulation is the real engine of innovation in the wealth management space.
Firstly, for the sake of completeness and better understanding, I think we should briefly explain two key concepts of the book, Goal Based Investing and Gamification.
Goal Based Investing is basically a change of perspective from the traditional model of analysis of market variables (e.g., expected return, variance, Sharpe ratios) towards client-centric representations of investment goals (e.g., probability of achieving targets). It puts the individual at the centre of the investment decision-making process since the true risk that individuals face is not market volatility but the probability of falling short of personal goals.
Therefore, the approach is a true game changer because it requires greater interaction between the advisors, human or digital, and final investors to elicit more consistently their risk tolerances as well as their ambitions and preferences over time.
Gamification on the other hand refers to the use of engaging gaming mechanisms to modify the behaviour of individuals. It should be mentioned that the book when discussing Gamification focuses on new innovative ideas which relate not solely to the need of engaging clients through their digital life and guide them to visit the virtual premises of a digital bank, but mainly to the possibility of educating final investors about the perils and biases related to financial investments. The real impact of Gamification lies for that reason in its potential to help investors rewire their brains and mitigate some well-known biases identified by behavioural finance and prospect theory to avoid making inconsistent decisions.
Why FINTECH is a unique opportunity for better regulation
So, now to the question of regulation and innovation: according to Paolo, regulation is the real engine of innovation in the wealth management space because it is modifying the way institutions are selling to their clients. Or to take an example from the wealth management industry, due to the raise of transparency through regulation, financial institutions don’t receive the commissions they used to, so this changes the distribution channels. Wealth managers therefore have to package advice instead of products and for that they have to come up with a new narrative. Due to new regulation like PRIIPs firms can’t discuss expected returns and that’s why they have to get around this and start from a different angle, and that is Goal Based Investing.
Gamification, however, is also an opportunity for regulators: In order to start an investment decision customers are asked to fill out questionnaires, determining what said investor would do if a specific scenario happens. This happens with the objective, at least in theory, to get to know the investor to advise them accordingly, though it is clear that this practice has flaws. Paolo suggests instead to gamify the process and put people in a position where they are actually tested and see how they respond to achieve a more accurate profile and testing an investor’s risk tolerance under stress. This approach could also be applied at a later stage of the investment process or even repeatedly to better reflect the real intentions of an investor by giving them the chance to, for instance, simulate and “play” certain investment scenarios with their portfolios. Machines can also determine on this basis patterns in investor behaviour and advice correspondingly to improve how investors respond to market movements and help facing uncertainty. Especially since, as Paolo put it, often your behaviour impacts your final investment performance more than the evolution of the financial markets.
More so, it’s also a unique opportunity for regulators to invite banks to help investors learn about the risk and returns of their portfolios and not to overwhelm them with term sheets that no one is going to read.
When we turned to an outlook for the industry to discuss whether we would simply see a race to the bottom before an eventual consolidation, Paolo pointed out that final investors are often seduced by an investment experience which seems to be more personalized when compared with traditional e-trading solutions. Personalisation and a holistic approach will be key when the race to zero prices becomes added value service. After all, all institutions will have to find a sustainable business model, which cannot simply be driving down costs and commoditising advice.
Regulatory Response and The future of FINTECH
Talking about the conflict between incubents and newcomers of the financial services industry, I also asked him about one argument that is often cited in this context and in favour of established banks: the experience of traditional financial institutions in dealing with regulators and regulations while StartUps might be inclined to focus their limited resources on product building and finances, however Paolo did not think it necessarily needs to be the case for FinTechs. As he explains if a FinTech manages to simplify its business model, it could well result in a lower regulatory burden, but he also acknowledges the importance of sandbox environments created by regulators to get a good idea off the ground. He, in general, also seemed to be favourable in respect to the attempts of regulators facing FinTech and innovation. He emphasises in his book the growing concerns of international supervisory bodies about the soundness and sustainability of the players in shadow banking and acknowledged some critical episodes the industry is experiencing like events in marketplace lending. However, when we discussed whether we could see a crack down on FinTechs by regulators who are more cautious in light of the Global Financial Crisis and the criticism they got for being too soft and lenient, he thought that lawmakers are mindful of the need for a careful approach. He thinks that regulators understand that while banking services need to be simplified, costs are rising and revenues are shrinking, which already puts a lot of pressure on firms. Therefore, authorities know that they have to enable banks to work in a transparent environment and that this needs to happen through facilitating a technological transition. He appreciates it is a very difficult challenge: look at innovation, make sure its not damaging, but let it flourish, because banks need this innovation, too, as they will otherwise simply be forced to downsize further without giving customers any additional value. Thus, the role of Compliance regulation is to make sure that you create common playing field where you pay for what you get, which is something that got lost before and during the financial crisis. Regulation ought to rein this in, so that the money links again to the value, though he appreciates that this isn’t easy.
Besides, as he states in the book, when it comes to established financial institutions and FinTechs, he does not necessarily want to indulge in a discussion about which of them (firm or business model) is better suited to emerge as a winner, nor which FinTech will survive the first five or ten years of innovation. He does though invite financial institutions to get ready to act, because, in his words, the time for change is now!
One of the reasons Paolo can speak with such authority is that he has personally gone through the process of developing a good idea into a successful company: He founded a FinTech joint-venture to integrate investment management and Goal Based Investing principles, which following the acquisition of funding partner Algorithmics became a part of IBM. When I asked him though whether he thinks if it is easier today than back in 2008 to start a FinTech considering all the attention the industry gets, he wasn’t sure though. From his experience and what he sees, he said, especially in the US it is a lot more competitive, more so than in Europe and Asia, since the transformation has already started and it is a little bit more mature. Another and maybe more important aspect though are false expectations and impatience of investors: Often very little time is given to FinTechs nowadays to break through, while it may well take many years to develop a good idea, create a pipeline and so on.
FinTech Innovation in Italy?
Given my own personal interest, I couldn’t help to finish the interview by asking him about his views on the Italian FinTech scene, especially since the regulatory and bureaucratic hurdles often frustrate me in what is possibly my favourite country. In any case and what may surprise many, though it shouldn’t if you examine it closely, Italy is actually a perfect example, at least historically, for startup growth: the economy is built on a large number of small enterprises, which could be a unique advantage. However, given the huge credit squeeze there’s not much money for innovation and younger entrepreneurs. Paolo also added that while the quality and knowledge of people is there as well as a general favourable regulatory framework, in his opinion, it is more the backside of the rules or its lack of enforceability considering, for example, the time it takes Italian courts to provide legal clarity. This combined with the shortage of entrepreneurial spirit and the understanding that such activities are a risky business can make it difficult to create a sustainable and lasting company. Having said that, he stresses that as in his case, however, eventually it comes down to finding the right partners and opportunity for a solution, which could happen as well in Italy, but the country’s peculiarities certainly don’t increase that probability.
Paolo Sironi’s new book “FinTech Innovation: From Robo-Advisors to Goal Based Investing and Gamification“ is published by Wiley and you can find it together with additional information here.