It does not matter much any longer if you are a global mega-player or a local niche supplier. To some extent it does not matter if you are systemically important or not. Generally speaking you are subject to the same challenges. We have a regulatory environment where complexity and reach has exceeded the wildest nightmares of the pre-Lehman market. We have a technological revolution that requires major re-engineering and material extension of one’s technology platforms. And we have a need for a broad skillset that is leading to organisational structural tensions.
Paradoxically, it may be that change is rebalancing the scales more in favour, or perhaps less to the disadvantage, of smaller players at the expense of the traditional industry giants. Beyond questions of the scale of contingency arrangements and the allocation of capital, all players operate on a uniform playing field. This has required large investment and that has disadvantaged the smaller players; we need to question though whether the balance is changing.
We assume we are at the last gasp of the regulatory storm that has engulfed our industry. There is a small retreat from the extreme requirements of Dodd-Frank in the US. Asia Pacific acted more rationally to the post-Lehman events, partly because they were less impacted. European regulation grows in complexity and, as detail is added to the rule books and new controls, such as the CSDR settlement discipline regime are added to the equation, there is a tension between free market forces and rigorous central control. This will be epitomised in the evolution of the UK market post-Brexit, although it is too early to say how that will evolve. Logically, as most pan European funds have migrated their depositories to EU locations, we could see a two-tier structure of Euro eligible and global non-EU UK regulated businesses with some organisations straddling both options and others governed by the UK only one.
On the technology front, there is light at the end of the tunnel for the smaller players. Change plays to the simpler IT and operational architecture of their business proposition. Although some segments, including small hedge funds, will find it hard to create added value links to the major outsource entities, there is ample choice for the rest of the market. Operational outsourcing is moving into the middle-office of fund managers, allowing them to focus most on performance and distribution. Pure third-party technology options are increasing, especially in the cloud, from data and information management and dissemination through to core processing requirements. Smaller players have more scope to operate with single providers; larger ones must take heed of the stricter contingency requirements of the regulators not only through multiple suppliers but also through the avoidance of potential single points of failure. There will be major expenditure by the large players and third-party providers on new technologies. And cyber security will be a critical cost, not only for the outsourcing industry but also for individual firms as they are forced to enhance the security of their points of access to third party applications.
There is a lot of hype but, in reality, less fundamental change. To date the change has been incremental and peripheral. Artificial intelligence in any of its guises can be applied to eliminate cost, but more importantly enhance performance, in core processing. I am yet to find a corporate event, the allegedly most complex component of our custodial world, that could not be managed through logic and thus RPA. Similarly, I believe that in the high ninety percent of all pricing for funds could be automated. Much of the standard queries can, as was noted in the last Global Custodian magazine, be handled through chat bots.
But the horizon is littered with more options. Blockchain will, I believe, enter a period of disappointment for its most ardent protagonists. But that overlooks the fundamental problem of the market that blockchain can tackle. Multiple stock records, standing settlement instructions, industry identifiers and similar commonly used data sets are a huge cost, throughout the intermediary chain; and a single credible record has great value. The idea of a golden record precedes even my original entry into this business. But blockchain creates a technical environment that can enable this although it also requires a cultural shift in the industry to ensure that all regard accurate data and compatible standards as a business imperative. And blockchain, by having the potential to eliminate unnecessary functions, albeit I doubt that many intermediaries, will change the core of many current processing systems. Both the investment book of records, the custody record and the fund administration record should operate off a common source. And a wider static data universe could easily be populated in a timely, consistent and accurate fashion with access to accredited users.
On the skill side, smaller players may have a structural advantage although they have also a problem of reach. People in smaller organisations tend to have multiple roles and closer proximity to colleagues. They can therefore visualise more effectively the entire value chain in real life. In larger entities there is greater specialisation and less opportunity for broad vision. Training is useful but no substitute for hands on experience and proximity working. Almost 50 years ago, the industry undertook a major rationalisation as it moved from paper to dematerialisation or immobilisation. That had two impacts: first it deskilled half the back office, and secondly management found a permafrost of antipathy to change. Today we are hitting a similar quantum of change with two advantages. We have a labour force that is relaxed about change and one that expects change. But we should not underestimate the shock for someone to find they have no longer the technical skill set that marked them out. And we need to gauge how we undertake the rationalisation of structures that will be needed without creating despair. For we need to accept, in an industry where sixty to seventy percent of cost relates directly or indirectly to headcount, that lower headcount is the only way to achieve a cost structure that can be tolerated by a funds’ industry where tracker rates rather than alpha rates are going to drive revenues.
I would forecast that, over the next decade or so, the average investment manager of the future will focus on creating value and growing distribution rather than operating a big processing business. Brokerage houses will be primary rather than secondary market focused with an ever-growing share of secondary trading being matched over a relatively small number of low-cost trading platforms. Prime services will reduce as shorter settlement cycles reduce the need for credit, leverage appetite will reduce as market volatility increases in the face of ever-growing political risk, while asset finance will become less profitable in the face of greater capital hits on financial risk exposures in banking markets. Most securities services businesses will employ half their current headcount and outsource, through the cloud, their technology to a turnkey provider of third-party applications.
The super tankers have a huge challenge. They are too big for some of the solutions. The smaller players have a challenge for their structural change will be fundamental. But this is going to be the age of the change masters.