Viewpoint – Encouraging innovation in derivatives markets

A few weeks ago, Deutsche Börse —the parent company of Europe's largest derivatives exchange Eurex — joined a $19.4 million funding round for a fintech company called Wematch. This funding round was the latest example of an important trend in the derivatives industry: the infusion of innovation from fintech startups.

The derivatives industry has always embraced innovation, but it's no longer a young industry. Large banking organizations and exchange groups provide most of the trading and clearing services, and their numbers have been thinned out by several waves of consolidation. That creates an opportunity for young companies to shake things up by introducing new technologies and business models.

FIA estimates that more than $500 million has been invested in the startups who participated in FIA’s Innovators Pavilion. 

In some areas of finance, venture capital is flowing into startups that want to disrupt existing ways of doing business. That is rarely the case in the derivatives world. Instead, most of the startups we see are more like Wematch, which is working with banks and exchanges to improve the way derivatives are brokered.

Here at FIA, we take special interest in Wematch because it was one of the companies that participated in our Innovators Pavilion last year. The Pavilion is our annual showcase for fintech startups, and Wematch was one of three companies that won awards at last year's show for outstanding innovations.

Since we launched this program in 2015, more than 100 startups have come to the FIA Expo in Chicago and demonstrated their innovations in the derivatives industry to a wide range of stakeholders. Not all have been as successful as Wematch. In fact, a fair number have failed—it takes a rare combination of great ideas, determined leadership, excellent marketing and supportive investors to take on the incumbents in this industry. But the majority are still in business, and many have become key players in the derivatives ecosystem.

One measure of success is the amount of capital invested in these startups. FIA estimates that more than $500 million has been invested in the startups who participated in FIA's Innovators Pavilion. To be sure, the Pavilion is not intended to be a platform for capital raising. Its main purpose is to introduce these young companies to potential customers and business partners. But participating in trade shows can be a key element in a go-to-market strategy for a startup, and no other event has such a precise focus on the needs of the derivatives industry.

Over time we have learned several key lessons from observing the growth trajectory of the startups that have participated in the Innovators Pavilion. The first relates the kinds of innovation, which fall into three main categories – cutting edge technology, innovative business models, or repurposed innovation from another industry segment.

For example, we have seen many startups developing new use cases for machine learning, natural language processing and other forms of artificial intelligence. We have seen many startups that are using cloud technology to deliver services in new and different ways. And we have seen many startups that have replicated technological solutions developed internally by the largest and most sophisticated firms and made them available to small and medium sized firms, and sometimes even individual traders.

We also have learned that external funding for these startups comes from two main sources: independent venture capital firms that focus on fintech, and the strategic investment arms of banks, exchanges and trading firms. The Wematch funding round is a good example. The investors included not only a major exchange but also J.P. Morgan, one of the largest banks in the industry, and two venture capital firms, Illuminate Financial and Augmentum Fintech.

Third, we have seen two big clusters of innovation that are particularly relevant to this industry—regtech and crypto. Regtech refers to the technological solutions developed to make the compliance process more efficient. Since the financial crisis of 2008, the regulatory requirements on derivatives trading and clearing have increased dramatically, and a host of startups have stepped up with well-designed solutions to ease the workload.

In the case of crypto, we have seen several waves of innovation. The first was in the areas of trading platforms, then came several companies in the compliance area. More recently we have seen a flurry of startups that are delivering institutional-grade solutions, and this year for the first time we are seeing the "defi" model applied to derivatives.

Both clusters of innovation are highly relevant to this industry because they reflect the balancing act that we make between innovation and regulation. Banks and exchanges are highly regulated, and they have far too many stakeholders to "move fast and break things" as they say in Silicon Valley. On the other hand, any industry that cannot innovate is doomed to wither away as customers find their way to other, better solutions.

We know that many of the startups in the Innovators Pavilion will not succeed. But we also know that some will flourish and become part of the next generation of service providers for the derivatives industry. And we firmly believe that the ideas and energy that these entrepreneurs bring to our industry will keep the spirit of innovation alive for years to come.