The cost of repetition

As the world’s financial intermediaries create more alliances and partnerships with technology companies and as FinTech becomes an imperative of any serious industry annual report, we need to ask if technology is a risk or an opportunity for the sector.

As the world’s financial intermediaries create more alliances and partnerships with technology companies and as FinTech becomes an imperative of any serious industry annual report, we need to ask if technology is a risk or an opportunity for the sector.

The securities ecosystem is in dire need of re-engineering. Technology companies will be partners and predators but neither they nor infrastructure nor the custodian banks can survive without each other. The future lies in unravelling the confusing web we have built around the business and replacing it with a logical structure.

Across the value chain, the cost of trading is too high, irrespective of whether it is the cost of primary issuance, secondary markets, derivative instruments or simple cash movement. Data has limitations as a value due to the absence of true standards across markets and the legacy systems that hold and duplicate much of the core information needed by banks and others. Connectivity is too bilateral and markets need it to be more multi-dimensional.

Parties to the securities ecosystem include regulators and central banks; trading venues and their matching, allocation, novation and netting arms; CCPs, CSDs, trade repositories and variants of these vehicles; custodian banks and their growing population of service providers from FinTech, the Cloud, communication networks or other banks. The costs of this vast population can be measured in percentage rather than basis points of assets held and that is self-destructive. The repetitive functionality of these entities with identical or similar processes occurring in multiple locations is inefficient, creates risk and is a non-differentiated, allegedly competitive, structure that is long past its sell-by date.

There are many streams of work needed across the securities market and we need a clear vision of where we are going. For it is no use progressing issues in the traditional silos; the solution needs to be much more integrated if we are to create real efficiencies and eliminate major risks.

Technology is a key stream. First, we need to examine the overall IT architecture of the market to grapple with three core problems: duplication, especially of data; confusion across standards; and cyber security.  Blockchain appears to be the lead candidate for elimination of duplication and creation of guaranteed data; it still has a mountain to climb to become proven but appears to have successfully tackled three core challenges; namely scale, some of the scope issues and, at least for the moment, security.

Secondly; we need to establish how we can improve connectivity? The biggest challenge facing interconnectivity is the multitude of messaging and instrument identifier standards used by the huge number of communication networks, both private, collective and public, that carry information between the different market participants. There needs to be adoption of at least compatible standards albeit the ultimate goal must be a single standard. There also needs to be a streamlining of networks. And, thirdly, the IT architecture has to tackle the challenge of cyber security. If the world of the future is to be more concentrated and more interconnected, the values at risk increase and thus the prizes for successful cybercrime increase exponentially.

Regulation is another stream. Regulators need to take on an influencing role in standards and IT developments. The capital adequacy menace, used so effectively in the foreign exchange markets prior to the launch of CLS, appears the appropriate tool for them to apply. But there is an equal challenge in that regulation has become an incomprehensible mountain of directives, rules and interpretations, mired in ambiguity and creating risk.

In addition, due to their preoccupation with detail, regulators seriously lag market developments. We need regulators to recognise that the world is changing. There is no ideal legalistic utopia. We need to move away from rules defining down to the minutiae to general and clear principles that all can understand. This requires regulators to have the right of interpretation. But it also requires them to agree the scope of their powers or we will have overlap, continued ambiguity and cross-jurisdictional dispute. The structure of regulation is broken and we need to change it. Those that say that granting powers of interpretation to regulators will lead to abuse should reflect on the fact that the current ambiguity in much regulation already gives them that power, but merely adds a legalistic overlay that costs money and rarely produces changed results

Infrastructure is the third stream for collectively it is no longer fit for purpose in its current build. Infrastructure needs to take a rain check on several core aspects of its design. The critical ones are the structure of primary markets, the timeframe of settlement, the liability it accepts and the scope of its membership. There are no rational reasons why primary markets should be as complex as they are. In today’s age of fast and effective communication, information and book building can be automated, simplified and democratised including taking out the bulk of the high cost of intermediation in this sector.

Secondary markets are basically order matching systems with the potential for position takers, albeit normally in scale only on leading counters, taking performance risk and adding liquidity to markets. Settlement is a simple mechanism that needs legal certainty and should be basically same day with a risk weighted cost of money component if it is deferred. CCPs should be redundant in the cash markets in this world although, if their stakeholders wish to take on the risk, they could be financiers for deferred settlements. CCPs will still have a role in term markets although more work is needed to ensure legal certainty cross jurisdictions around netting and novation and also models that enable interoperability of key components of the CCP world. And we need to review the role of data repositories for the bulk of the data they hold, if it is really technically accessible by the intended recipients, is gathered without a clear view on its application other than post-event analysis of past risk events.

That leaves the final stream relating to the commercial sector. These are the risk takers and process factories. Risk takers have to be banking or insurance regulated institutions or entities with a comparable capital buffer. We need capital allocation for the risks they assume and those risks to be quantified rather than bundled into general opaque and un-provisioned pools of operational risk. A key role of banks will continue in liquidity provision but also in guaranteeing asset safety and settlement integrity. They will have a role in asset financing, the custodial equivalent of bank lending. And they could well have a financial role in process factories through performance guarantees over and beyond the risk guarantees that they assume.

Much of the current process needs to be centralised and the role of individual banks for this is not automatically self-evident. We have to eliminate duplication in data, as already noted, but we also have to eliminate duplicative processes. Some relate to static data, others to commodity functions and yet others to communication networks. The cloud and infrastructure have an obvious role, but, as already indicated, concentration risk means that cyber security is of paramount importance. As processes are automated technology hubs become the logical platforms for much of the industry’s core processing.

How do we take this forward? The industry needs a body, like the old G30, to recodify the logical structure but it has to be overseen by trusted parties outside the vested interests of the old world. And, if that exercise creates logical steps to a more secure and less impaired environment, then we need to ensure that the major nations, perhaps through G20 this time, create that environment which mandates a change programme around which the industry can coalesce. It will not be easy and the future template for the market can hardly be expressed in these thousand words but the radical steps proposed here are perhaps some, definitely not prescriptive, that we need to consider if we are to flourish as an industry into the next decades.