Industry braces for a seismic shift

The emergence of robo-advisors is one of the most obvious examples of tech-driven change over the past couple of years. Yet, these relatively small upstarts are expected to have an outsized impact on the investment industry’s future.

In fact, Randy Cass, founder and CEO of one of Canada’s first robo-advisors, Toronto-based Nest Wealth Asset Management Inc., argued in a panel discussion at OSC Dialogue 2016 that the future of advice is inevitably digital – including from the traditional full-service firms: “This is not a fintech/millennial story; this a seismic shift, disruption story.”

The initial attraction of robo-advisors for investors is the prospect of a lower cost of doing business. In fact, according to Nest Wealth’s research, investment fees are one of the largest expenses that Canadians will pay in their lifetime, second only to their home and outpacing other major expenses, such as cars, education and health care, Cass says. Robo-advisors provide a way to pare down that expense and potentially boost long-term savings.

This demand for lower-cost investment alternatives is only going to grow, Cass argues, once the second phase of the client relationship model (CRM2) reforms are fully implemented and investors begin to receive the annual cost reports that are mandated under those rules early in 2017.

“In a year or two, thanks to CRM2, everyone is going to [see the] dollar amount that they are paying in investment fees [on their client account statements],” he says, “and investors will be able to turn to a robo-advisor for a fraction of that price.”

This, in turn, is going to put more pressure on traditional financial services firms to seek greater efficiency. “That goose that lays golden eggs [that is, the fees] has only another year or two left in it before [financial services firms] have to do something with their margins,” Cass adds.

Yet, the Big Six bank-owned firms are not about to fold up their tents and go home. Mark Wiedman, global head of iShares at New York-based asset-management giant BlackRock Inc. acknowledges that digital advice is the future of the retail investment business. Furthermore, he says, the winners at this game are likely to be the existing big players, not the startups that currently are driving innovation.

“Robo-advisor technology is going to change the world, but the winners are going to be the big, branded incumbents that clients already have relationships with,” Wiedman says, pointing to the powerful advantages that those firms enjoy, including scale, brand, capital, experience with being regulated and technological agility.

The big tech players (such as Apple Inc. and Alphabet Inc.) can’t compete in the investment business directly because of the regulatory challenges, Wiedman says. Meanwhile, the upstarts don’t have the scale, the brands or the capital to compete with the existing large financial services firms.

Robo-advisors aren’t likely to be able to build significant scale because the incumbent players are aware of the trend toward digital and are prepared to do something about it, Wiedman suggests. He anticipates that in the end the existing big players, such as the bank-owned dealers, will win and many of the smaller robo-advisors will be acquired by the incumbents.

Still, regardless of who wins this game, the advice business will be transformed fundamentally over the next several years, Cass adds: “Right now, we are in the first inning, with one out, of a long baseball game in terms of what digital is going to allow us to do.”

Robo-advisors in these very early stages generally provide their clients with simple portfolios of ETFs that meet clients’ basic needs, and these online suppliers are a low-cost, straightforward alternative to traditional investment dealers.

However, cass foresees technology enabling all firms to do a much better job of fulfilling the more emotional, handholding needs that human financial advisors provide. And so, he says, tech-savvy firms will be able to mine their client data and use that to drive interactions.

For example, firms can identify which clients are likely to get more nervous when market volatility spikes, and then be able to target communications to those investors designed to ease those fears. Beyond that, Cass foresees routine client communication becoming largely automated.

“Within two years,” Cass says, “clients will be managed by a traditional advisor at a large firm that will handle all of their interactions through a digital, rule-based platform.”

Indeed, he foresees a not too distant future in which clients receive entirely automated messages from their advisor, reminding those clients to contribute to their account, alerting them when their portfolios deviate from their plans or suggesting a meeting with the advisor.

“These will come in a very personal, touching email from your advisor, he says, “but clients will not know that they sent it until they pick an action to respond to it. This is where automated advice is going.”

The prospect of a future in which advisors will “catfish” their own clients – that is, appear to be communicating by email, but actually using a digital engine to determine investment needs – may be somewhat chilling. However, Cass argues, the practice may well lead to more responsible saving and investing behaviour among clients: “The fact that you can do all of this without anyone focusing on it, but through rules-based technology, will result in people saving more [money], not less.”

At the same time, the back-office side is facing the prospect of its own fundamental transformation. The systems for clearing and settling transactions, along with other record-keeping functions, are facing a shakeup. Distributed ledger technology (DLT), also known as “blockchain” technology, is expected to revolutionize the back office as the digitization of advice transforms front-line advisory services.

Blythe Masters, CEO of New York-based Digital Asset Holdings LLC, points to the extensive work underway on blockchain technology in a variety of projects – funded by both venture capitalists and strategic investors – that count on the technology’s ability to improve the plumbing of the financial system immensely.

Much of that existing infrastructure is coming to the end of its useful life anyway and will have to be replaced one way or another over the next five to 10 years, Masters says. He argues that the financial market infrastructure could be upgraded with blockchain technology that has the potential to fundamentally transform these functions rather than investing in a newer version of the current systems.

For example, blockchain theoretically can power automated, straight-through processing, thereby reducing costs, producing better audit trails and enhancing regulatory reporting.

The big question: “Is the investment industry prepared to take the leap to this novel approach to record-keeping?” The answer could come shortly. Digital Asset has developed a prototype for the Australian Securities Exchange (ASX), which plans to replace its post-trade clearing system. The ASX is scheduled to make an announcement by the end of 2017 regarding whether to build its new system based on a blockchain model or go with a more conventional option.

In the meantime, Canada’s Big Six banks, and most of the global financial services firms, are participating in efforts to develop blockchain technology in the hope that it can one day replace major chunks of the financial services infrastructure.

TECHNOLOGY IS REDEFINING ADVICE

Technology isn’t just disrupting the investment business; it’s also posing an ever-greater challenge to regulators as they grapple with ways to fit dealers’ evolving capabilities into the traditional regulatory framework.

This task is highlighted in a proposed guidance paper from the Investment Industry Regulatory Organization of Canada (IIROC) for “order execution only” (OEO) firms issued in early November. That proposal aims to address changes that have taken place in the investment industry since IIROC first published guidance for OEO firms in 2001.

Back then, the firms that provided order execution services took orders from clients mostly over the phone or online. Dealers weren’t obliged to ensure suitability as long as they were simply receiving orders and not providing advice.

Now, however, IIROC is reconsidering what constitutes “advice” in a tech-driven world. So, IIROC’s new guidance sets out the regulator’s views on whether various capabilities that these online brokers provide, such as stock-screening tools and social media, amount to providing advice.

For example, the guidance paper concludes that “retweets” and “likes” on social media both could be considered recommendations. The paper also indicates that when deciding whether a communication from a dealer to a client constitutes a recommendation, the source communication – whether an actual person or generated automatically by an algorithm – is irrelevant. Thus, investment advice now can come from a machine and doesn’t have to originate from a person.

In addition, information that a dealer “pushes” to a client rather than being “pulled” by the client is more likely to constitute advice, the IIROC paper states. Regulators are making this distinction, in part, because information that’s pushed to clients often is based on data mining. Thus, regulators believe that that information is more likely to be treated by clients as being relevant to them. The IIROC paper concludes that dealers should not push tools to clients based on either data mining of their trading history or other investor-specific information.

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