I recently was asked by one of the leading EU custodian banks to take a look at the big strategic challenges the industry was facing in the long-term. Other than a feeling of relief at being able to avoid some of the near term critical political risks facing markets, I was struck by the scale of the challenge facing the industry. Change has been dramatic since Lehman but that change has been driven mainly by regulators and governments; the challenges of the future will be industry specific and even more hazardous to navigate.
The biggest challenge is around data. Data demands of the future are not going to be satisfied by creating data lakes at an entity-by-entity level. First, there will be a standards challenge with entities needing to clean up their data quagmires. They also need to join up with third-parties and infrastructure to create data utilities, not only in the field of static data but also in respect of dynamic data such as securities pricing.
They need to force the industry, and especially the lawyers, into the digital age so that they add standardised machine-readable summaries to all primary market documentation. And they need to rid the market of the aberration, especially in the field of securities numbering, of the incompatibility of data used in different segments of the securities market. The external world will need firms to operate as one rather than as silos. The internal world will require firms to undertake a major re-engineering of their business models and IT platforms, including the enhanced use of robotics and artificial intelligence to eliminate manual process and the adoption of new technologies including but not limited to the current industry love child of block chain.
The end result needs to be the dissemination and real-time 24/7 availability of data. The current data approach of too many firms equates to data dumping where intelligent data and analytics are needed. And it is only with these changes that we will be able to move from where we are today with a blend of STP plus repair or restructuring at each destination to full STP across the entire securities life cycle.
The second biggest challenge will be around people. Accurate fail free transaction processing will become a norm for the survivors with automation also leading to a further shortening of the settlement cycle, although time zones and the continued global nature of investment means that T+1 will be a formidable and perhaps undesirable barrier to cross. This means the industry will move its value added from processing ability to two core attributes, namely risk mitigation and information. As a result, its development, client support and relationship teams will need to move up the learning curve quite sharply if they are to retain their value to clients.
The regulatory objective is clearly to redistribute risk across the value chain and the main risk takers are the deep pocket sell-side firms. The state across the globe will never again pick up the pieces post a Lehman scale event and will ensure that market players can carry the can. We have moved from caveat emptor or buyer beware to caveat venditor or seller beware. This factor is evident from the trend of liability allocation in the asset safety provisions of the AIFMD and UCIT regulations. This trend is unlikely to be a globally aligned one and will lead to increased regulatory arbitrage with the EU potentially a major loser to the US and Asia. And as the geographical footprint of the industry changes, the mobility of key executives will need to accompany it.
Infrastructure also needs to evolve. It needs to up its game in delivering new technologies, and like the companies it serves, it needs to revisit its IT architecture to consider more outsourcing, more use of cloud-based applications and facilities, and faster time-to-market. Its current core competence of basic custody and settlement will move to information quality. But it will have to continue as a risk distributor rather than a risk taker as it is illogical to place the capital backing needed for the latter in such limited purpose vehicles. And that inevitably means, especially in the likely event that regulators decide to apply capital allocations to the asset safety and intraday exposure risks of the industry that the investor CSD model, which has not been marked by huge successes, is unlikely to survive.
With a growing trend to securitise financial transactions and an increased demand for collateralised settlement exposures, CCPs especially will see major increased volume albeit reduced terms for their settlement as distinct from their futures related exposures. But this will be met with demand for high quality liquid assets over and above supply, and thus an inevitable move to allow less liquid assets into the collateral pools. This will encourage more lending and active collateral management but will also add to the risk capital demanded from market participants. And exchanges will garner a greater share of secondary market activity through their matching engines with brokerage houses focusing more on position risk from primary markets rather than secondary ones. Technological advances are also likely to eradicate the anomaly of high frequency traders.
In this environment, overcapacity on the sell-side will continue to drive down fee income even with new products, and I doubt the return on custody assets or those under administration will see anything other than a decline even with new opportunities to monetise data or increase collateral optimisation activity. Brokerage spreads will come under similar pressure for the same reason, and overcapacity driven price weakness will be exacerbated by the downward trend in investment management fees as funds move more into the tracker and basic benchmarking area. Greater transparency for all forms of pricing will weigh heavily on explicit fee income and its more nebulous spread-based or timing-related equivalents across capital markets.
On the custody front, the successful players will need scale and skill to navigate the challenges ahead. But most of all, they will need to focus on their client relationships with cash and cash management, treasury and capital markets, risk mitigation and absorption or access to distribution networks being as important a component of custody or fund administration decisions as the core business itself. Quite simply in today’s complex markets a supplier needs to be more than niche in an ever more commoditised activity if they are to be candidates for big ticket business. In reality, traditional securities services as a standalone product is long past its sell by date and is being supplanted by well-structured digital financial market services.