Many of the most radical and far-reaching changes in the financial services industry over the next decade are likely to arise in the investment services sector. While they will not affect the daily lives of people in the same way retail finance does, they will still play a major part in determining how capital is formed and allocated in the global, regional and national economies. They will then, ultimately, affect everybody.
This article outlines five potential influences that could threaten the world’s capital markets and investment services over the coming decade:
- A Middle-East settlement and the establishment of a stable sharia economic zone
- The arrival of the BRIC (Brazilian, Russian, Indian and Chinese) economies and their impact on established global capital markets
- The creation of a single European market in investment services
- A piecemeal solution to the pensions crisis
- Investment in environmental defence programmes.
The Sharia economic zone
While most Sharia financial products and investment vehicles are produced for the domestic Middle-Eastern market, the new financial centres of Dubai, Qatar and Labuan, as well as the established areas of Bahrain and Singapore, are beginning to look farther afield. This is likely to create a large new multi-regional capital market, distinct from its international secular counterpart.
If it follows the pattern of other large regional marketplaces, it could result in the creation of a significant number of new or revitalised exchanges, competing for business, with some becoming pre-eminent. These are likely to draw capital and trading activity out of the EU and US exchanges, representing both an opportunity and a threat for them and their business and technology infrastructure providers.
The US and EU have a long history of providing sophisticated technology and financial services to many of the countries in the Muslim world. However, this will not necessarily carry over into the future.
The Middle-East states already obtain low-cost manpower from their neighbours in the Indian sub-continent and the Far-East, and these sources are gaining the technical and financial sophistication needed to supply them. The Indian business group Tata’s contract to provide clearing and settlement systems for the Dubai International Financial Exchange, displacing a powerful EU-based consortium, is one example of this trend.
The G7 investment services firms are going to be hard-pressed to win a significant proportion of new Sharia-orientated business except in close alliances or in joint ventures with local interests and low-cost producers.
BRICs and the knowledge economy
As the Brazilian, Russian, Indian and Chinese economies develop and integrate, their service and financial sectors can be expected to become significant players in global capital markets.
BRIC-based firms are already penetrating high-technology product and service markets in significant volumes, including some in financial services. G7-based financial institutions and infrastructure providers are heavy users of offshore services from the BRIC group, but how will this play out as these economies mature?
The BRIC domestic market, with its highly educated, and now experienced, workforce could well become too cheap, too smart and too well-connected for G7-based providers to penetrate. They will need to consider closer and more equal partnerships with their offshore service suppliers. It is possible that this competition from the BRIC economies will force the pace in the development of the knowledge-based economy.
In the investment services sector, one of the key knowledge-based products is research. We are now beginning to see its progressive monetisation, encouraged by regulation, but also driven by economic factors. The need routinely to generate and sell knowledge, as opposed to incorporating it into products and services, could be the stimulus for a much more systematic approach to its production, protection, management and distribution.
EU single market
By 2016, both the EU’s MiFID (Markets in Financial Instruments) initiative and the outstanding Lamfalussy barriers to cross-border clearing and settlement should have been resolved, and its impact felt throughout the marketplace.
Whether the EU markets will evolve in a similar way to those of the US is open to debate, since in the US they started with the integration of clearing and settlement, rather than with the markets.
However, it seems likely that a significant degree of exchange, clearing and settlement consolidation will have taken place by 2016. In a single marketplace, where network concentration is such an important factor in generating both economies of scale and reducing market impact, there is little room for large numbers of competitors offering similar services. Competition will be generated by a range of different trading protocols, from private institutional networks, pan-EU systematic internalisers, to public order book or quote-driven markets, with few major players for each type.
Given the increasing interest in cross-asset class trading, we should also expect the consolidation of the instrument types traded, with venues trading multiple asset classes and offering a range of options.
All this will take place in a market with many large players, complex legacy systems and processes, and established regulation and legal practices. Because of the standardisation needed in company, collateral and taxation law, and listing and settlement rules, market integration will only occur where there is an economic motive for speedy action.
MiFID will require complex, multilateral programmes of technical and organisational change to come to fruition. The pace will be relatively slow, and will not provide a platform for world-beating innovation by its participants. For that they will need to look to new instruments.
The pensions crisis
There has been a lack of political will to tackle the pensions crisis. For the young to invest in pensions, they must trust financial institutions and politicians to deliver on their promises, have an unshakable belief that they will survive to collect, and be able to balance the relative advantages of a better life today with a less bad life tomorrow.
The challenge for financial institutions is scarcely any less difficult: raise premiums/contributions to increase reserves today, or stay competitive and survive until tomorrow. Although radical change might be called for, it is likely that in the majority of countries change will be incremental. This might be no bad thing, since quick-fix solutions have a habit of missing the target. The problem is just too big to be resolved quickly within the resources of any but the most asset-rich states.
We are likely to see a number of relatively minor changes. These will continue to shift responsibility back to individuals, while giving them more flexibility in how they deal with it, for example: compulsory but progressive contributions to a second pillar scheme; low-cost superfunds and flexible retirement ages. For the capital markets, this is not bad news. The scope for investment services will expand, even if some will be fee-capped at very low rates. Volume must be made to deliver scale economies.
Environmental investments
Major investments are beginning to be made to avoid global climate change, and this seems set to continue as the development of the BRIC economies makes it increasingly urgent.
New solutions will have to be created to profit from the capital needed to pay for environmental protection. These are likely to include the development of the existing permissions markets, as well as direct government funding.
As the scale of the investments required is huge, there is likely to be major growth in the creation and trading of environmental contracts, such as natural resource permissions and emission allowances. These will be on a number of scales, ranging from local to global, and may eventually extend to less obviously commercial objectives such as diversity bonds and conservation credits.
As the range and number of environmental contracts grows, the scope for pooling, swapping and arbitrage between them will increase. And as with existing financial derivatives contracts, this will require an increasingly sophisticated means of data gathering, benchmarking and modelling – both to settle and to trade.
Because of the technical and knowledge challenges, and the fact that new products with no existing legacy are involved, this seems like an area of development in which G7 investment firms are uniquely well qualified to contribute.
Plus ça change…
In developed markets, regulation, automation, standardisation, cost-reduction and consolidation continue to be the major themes.
The main challenge to the industry is the sheer complexity of responding to the demands of the market in an environment where decades of development has encumbered every institution with legacy processes, systems and behaviours, and where the changes needed to improve matters are themselves complex.
The new economies of BRIC and the Middle East present a challenge to G7 financial institutions and service providers. Their low costs and increasingly well-trained and experienced staff will make it hard to win business with established products and services.
To penetrate these markets, G7 firms will need to:
- Develop, value and exploit knowledge – the much talked about 'knowledge economy'
- Form integrated sourcing arrangements, alliances and joint ventures with domestic firms to gain and sustain rights of access to their home market
- Take a long-term view on investment, which will be a test of boardroom resolve.
Environmental investment will be particularly characterised by rapid market product development and is probably one of the main areas in which G7 firms have a major advantage. In this area there will be a great need for the sophisticated technical intelligence gathering and modelling capabilities that have been developed in the G7 countries.
The only problem is that a significant part of this work may need to be aid-funded to achieve non- G7 co-operation.
What is certain is that the coming years look set to continue to challenge the long standing markets of the world’s developed economies, bringing ever increasing opportunities for the winners in the global capital markets.
