The International Securities Services Association (ISSA) white paper on the future of the industry is well worth a read. Some of the conclusions may be debateable but this is not surprising in a forward-looking analysis in an uncertain world. Critics may find the survey is biased towards the larger players, and this is realistic for they alone may have the financial firepower to generate needed investments. It is probable that the report overlooks the importance of shared infrastructure, cloud computing and outsourcing by smaller players as a survival strategy. And may I suggest smaller players may well be the larger ones outside the top five custodian banks and the top two or three infrastructures. Beyond them, the minnows in our industry may serve as local concentration points but they are not viable for a full-service proposition.
The report mentions COVID-19 and its implications as well as other systemic risks. It notes the pressure on margins and fees but no real attempt is made, or perhaps can be made, to quantify the increased event risk profile of the industry. The paper stresses the need for collaboration especially in the area of cyber security. But it is quite silent on detail for post SARS and COVID risks of repeated pandemics and those risks emphasise the imperative of automation of process and a total rewrite and rescoping of contingency planning. In addition, we are faced with other unpalatable event risks, such as political risks (ranging from state led income distribution control to directed strategies for firms benefitting from State revenues). ESG is a great movement but the economic risks of extreme ESG should not be ignored. Protectionism may retreat to some extent in the USA post the elections, but it continues to be rife in the EU and countries such as China. And overhanging all this is the risk of fragmentation, as back-to-front and other broad outsource options appear to be starting to generate concerns around concentration risks among regulators.
The report is sound at looking at varied operational challenges for the industry but there are a series of issues that I would add to their lists. Cyber security is highlighted but, in an age of burgeoning computer power with the advent of quantum computing, it is probable that we are at the start of a new challenge in this field. I suspect due diligence demands will kill off much of the fund of funds market as regulators accept that line of sight of the administrator must go beyond units in a fund to the structure and performance of the underlying funds themselves. Valuations, if ISSA is right and we move more into the esoteric end of the investment market, will become more judgemental and the risks of mispricing funds will increase. Transfer agency will become a more critical tool in anti-money laundering and, as payment systems tighten their process ahead of the post trade industry, there is a risk that criminal participation in the industry will grow. And, finally, we need to reduce risks also with the digitalisation of flows between companies and investors; rejected in the past for no reason other than companies and their lawyers preferring to retain the comfort blanket of ambiguity in legal wording for new issues and other communications.
As can be expected we see a hockey stick approach to financial performance in the report with two years of downturn being succeeded by an upturn. One of the saving graces of the industry is cited to be digital assets. I have in then past noted my view that the future totemic role identified by many for this new segment is unrealistic. ETFs are an incredible success story and have been a great benefit to the industry but their aggregated value of around a trillion dollars has to be set against the global market capitalisation of some $90 trillion.
The report is clear on the need for automation and this will drive down headcount albeit increase the average cost per capita as staff become more skilled across the board. M&A rears its head again but M&A as a vehicle for unit cost reduction is hard to manage, especially in today’s markets, while M&A to fill product gaps requires sound management knowledge of those gaps which, after all, constitute the predators’ areas of weakness. My suspicion is also that the changing structures and specialisations in the industry has led to headcount growth that may be too generous. Slim flat management structures are surely needed rather than the heavy and over specialised hierarchies we can see in many instances.
There are other areas where we need to question some of the views; I am sure the ISSA symposium, where the white paper will be further examined, will be a great forum for this. Are emerging markets going to really provide the scale and accessibility to be revenue substitutes for declining OECD demand as index linked in its different guises replaces alpha? Although competition is covered, what are the risks of partial replacement of the more profitable areas of the business or the price impact of the de-risking of those areas; and in the new more automated world is ad valorem going to survive? Is the white paper accurate when it opines that there is room for material growth in aggregate outsourcing by custodians, especially if cloud applications and similar technical substitutes prevail in many parts of the industry?
But, in total, a paper that leads one to pose these questions and promotes thinking around the issues is a vital contribution to our future strategies. For one thing is clear from the paper, the status quo will not prevail. And as Socrates said in 400 BC “The secret of change is to focus all of your energy not on fighting the old, but on building the new.”