Innovation Imperatives for Financial Services

In today’s heavily regulated era, the innovation agenda for financial services firms should be to enhance transparency, focus on competencies and ensure compliance. Improving data and risk management will be critical, as well as revitalizing post-trade infrastructures to boost efficiency and reduce costs.

Executive Summary have a market in which change appears to be the From time immemorial, capital markets have only constant. evolved to address ever-changing investor requirements, tastes and risk appetites (see Figure 1, next However, there is a downside to fast and furi- page). The ensuing innovations can be classified ous instrument innovation. For starters, some in three broad categories: financial instruments, investment instrument innovations that emerged trading infrastructure and execution. in the last decade have been tied to the ongoing global financial crisis. Asset-backed securities, The emergence in the early 20th century of for example, were at the core of the sub-prime specialized markets for listed securities begat mortgage crisis of 2007-2008; derivative instru- what is today’s continuous innovation in financial ments like these are believed to have set off the instruments. Numerous equity and debt instru- full-blown global economic crisis that ensued.1 ments have emerged over the years to address Given their ubiquity, and the interconnectedness evolving market needs, as well as to help financial of the financial services industry with the broader and non-financial firms better manage risk. economy, financial instruments are typically associated with economic crises. The rise in electronic trading in the 1980s marked a key turning point in the innovation continuum. In the post-subprime financial market landscape, Today’s algorithm-driven software for high-fre- a key imperative for regulators, industry groups quency trades represents yet another significant and organizations is to create mechanisms that disruptive shift. Over the horizon is the promise of enhance market safety while permitting innova- self-learning trading algorithms competing with tion to flower and take hold. This can be achieved each other, requiring minimal degrees of human by preventing the adverse consequences of over- intervention. Moreover, as alternative trading regulation, while ensuring continued rules harmo- venues have emerged to enable large institutions nization by regulatory bodies worldwide to suit to trade anonymously at a reduced cost, we now the increasingly globalized nature of the business.

cognizant reports | september 2012 Capital market firms must improve their data Meanwhile, instruments emerged to provide risk and risk management capabilities. Risk manage- management benefits. They include: ment should be viewed as a critical compliance and business imperative. It is the key to ensuring • Commodity and interest rate futures, which compliance, enhanced transparency, healthier allow businesses to hedge their exposure business practices and, perhaps most importantly, to adverse commodity price/interest rate to rebuild the trust that was lost following last movements. decade’s financial industry crisis. Back-office func- • Inflation indexed bonds, which allow tions, a hitherto ignored area, deserves a neces- better management of the risks incurred by sary upgrade to revitalize the post-trade function the adverse impact of a rise in inflation. by enhancing efficiency and reducing costs. • Catastrophe bonds, which insure against the impact of natural calamities. Financial Instrument Innovations • Credit default swap (CDS) or credit derivatives, Financial instruments have come a long way since which allow institutions to hedge the credit the advent of listed stocks that allowed trading on risks of loans they originate. exchanges, aiding in the development of formal marketplaces and liquidity. Some of the innova- Another significant area of innovation is securi- tions that sought to address the requirement of tization to allow firms to convert streams of loan capturing market needs include: receivables into tradable securities that are sold to investors with a high tolerance for risk; these • Mutual funds, which extended professionally instruments enable institutions to extend more managed, diversified asset portfolio benefits credit and meet liquidity demands. to a wider investor population, while helping households acquire financial assets. Uniqueness of Instrument Innovations • Hedge funds to address the needs of investors Innovations in financial instruments differ vastly with high net worth and a far higher appetite from innovations in other industries, whose for risk. benefits and potential downsides are clear. Unlike • Exchange traded funds (ETF) to provide attrac- a drug whose ill effects may be limited to only tive investment opportunities at far lower those who consumed it, the adverse impact of costs by focusing on passive investing that financial instruments affects the entire economy, mimics select indices. not just the parties involved in specific transac-

History of Financial Innovations

Year Innovation Year (cont'd.) Innovation (cont'd.)

Stock Exchange Interest Rate Futures

1600s Publicly Listed Stocks Fannie Mae

Central Bank Exchange Traded Funds 1900s Japanese Rice Futures Market Credit Default Swaps

Call Options Electronic Trading 1700s Mutual Funds Catastrophe Bonds

Inflation-linked Bonds Algorithmic Trading

Futures Exchange, Chicago High Frequency Trading

Hedge Funds 2000s Continuous Linked Settlement 1900s Securitization Alternative Trading Systems, Multilateral Trading Facilities Black-Scholes Option Pricing Model Target2-Securities

Figure 1 Source: The Economist, World Economic Forum, Oliver Wyman

cognizant reports 2 tions. This is a result of the interconnectedness the floor of the stock exchange, yelling to desk- of financial systems with the general economy, based traders, backed by powerful computers. which transmits the benefits and negative impacts of innovations somewhat equally. Then came high-speed algorithmic trading, which replaced human traders with software that In fact, securities firms are both creators and generates trading orders based on underlying followers of innovation. They both experiment algorithms. High frequency trading (HFT) has with and adopt new instruments from competi- already captured around half of the trading tors to create investment standards that build volumes today and is set to rise further (see markets and house revenue streams.2 Robert Figure 2). Merton calls this phenomenon “the innovation spiral,”3 in which institutions devise new In the previous era, traders’ physical proximity instruments to meet their emerging needs that to the stock exchange floor mattered; however, they then standardize and promulgate into the what matters now is the co-location of servers to markets, spreading their breadth and depth. achieve trade execution speed advantage, since the difference of a few milliseconds of latency can These instruments continuously mutate, extend- result in losses or gains of millions of dollars. While ing the cycle of standardization and adoption. algorithm-driven HFT is criticized for causing Interestingly, the never-ending hunt for invest- incredible market volatility,4 high-frequency trad- ment returns and competition motivates players ing has upped the ante for institutions to improve to evolve key instruments. ETF, an innovation their execution speeds. The next wave of innova- that sought to provide diversification benefits tions on this front will likely come from trading a la market indices to small investors at far software driven by self-learning algorithms.5 lower costs, is one example. Today’s ETFs invest in a wide array of assets, from commodities Trading venues have also shifted, driven primar- through equities. ily by the desire to consider multiple sources of liquidity in search of better execution. They Trading, Execution and Infrastructure include alternative trading systems (ATS) in Innovations the U.S. and Canada and multilateral trading Technological advancements have transformed facilities (MTFs) in Europe, which have given rise securities trading over the past few decades. The to dark liquidity pools. In the U.S., ATSs are gradu- big game changer is electronic trading. Trading ally gaining market share from the traditional has evolved from the days when brokers thronged exchanges (see Figure 3, next page).

Rise of the Machines Algorithmic trading, as a percent of total trading

70 70 Equities 60 60 forecast 50 50 Futures U.S. 40 40 Options 30 30 Foreign Exchange 20 20 Europe Asia Fixed Income 10 10

0 0 2004 ‘06 ‘08 ‘10 ‘12 ‘14 2004‘06 ‘08 ‘10

Source: “Playing with Fire,” The Economist, Feb. 25, 2012 Figure 2

cognizant reports 3 The dark pools are driven by the desire for ano- thus forcing them to compensate by leveraging nymity to minimize the market impact cost, as better access to their clients.7 With the arrival of well as the cost of transactions. Another motive central counterparties (CCPs), post-trade events is to prevent competitors’ trading algorithms in OTC derivatives will increase, requiring mar- from sniffing their orders in transparent markets. ket participants to implement systems that allow Regulatory frameworks provide pre-trade trans- straight through processing of these trades.8 parency waivers to dark liquidity pools, subject to certain conditions.6 Meanwhile, regulatory moves toward CCP-enabled clearing, as well as margin requirements for OTC Despite the strides made in increasing the effi- trades that are not cleared through a CCP, have ciency of trading venues and securities trading sparked fears that a bulk of these trades could firms’ front offices, inefficiencies still persist in move to smaller markets in Asia. While such fears the post-trade infrastructure. The middle and appear exaggerated, margin requirements could back offices that handle trade confirmations and result in an end to exotic OTC trades.9 settlement remain plagued by excessive manual intervention; the lack of automation here is lead- The Target2-Securities (T2S) platform is another ing to time delays and revenue losses. In the wake infrastructure innovation that is taking place to of the recent crisis, firms rushed to automate reduce the cost and risk of cross-border trans- back-office functions to save money, improve actions in Europe. In the Eurozone, cross-border operational efficiency and ensure regulatory transactions are considered to be more expensive compliance, overlooking the key functional areas than in the U.S. T2S is expected to overcome this where continued innovation could help drive pro- challenge, along with several of the “Giovannini ductivity gains and competitive advantage. barriers” identified by the Giovannini Group in its 2001 and 2003 reports. The need for back-end support systems will increase, as the need for participants to com- Given the complicated nature of the cross-border ply with the Dodd-Frank Act and the European trading cycle in the Eurozone, this is a welcome Market Infrastructure Regulation initiative drives move that could help reduce settlement and oper- over the counter (OTC) derivatives to be routed ational risks and enable a move toward shorter through exchanges and swap execution facilities settlement cycles of T+2. But continued delays (SEFs). Trades routed through exchanges or SEFs have meant that the project has experienced could give rise to the use of algorithms applied repeated delays and is expected only in 2015. to derivatives trading. Greater automation will (For additional insight, see “Target2-Securities restrict dealers’ abilities to differentiate on price, Platform: Implications for the Post-Trade Arena.”)

Percent of U.S. Equity Market Volume Growing market share of alternative trading systems

80 77 73 65 62 60 Exchanges*

38 40 35 27 Alternative 23 Trading Systems 20

0 2008 2009 2010 2011E

* Exchanges include BATS, NASDAQ, NYSE Area and regional exchanges Source: “U.S. Securities and Exchange Commission Organizational Study and Reform,” The Boston Consulting Group, March 2011.

Figure 3

cognizant reports 4 Innovation’s Role in Financial Market — the environment, innovation itself and the area Crises of application.14 Amid the ongoing financial crisis, financial instrument innovation of the early 21st century Environmental forces that shape markets and is being closely examined for the severe adverse drive innovation typically change over time and economic consequences that ensued. Given their influence outcomes. Innovations attempted in ubiquity, financial instruments are typically found an unhealthy environment that provides the at the center of economic crises. Innovations per wrong incentives are likely to produce negative se are neither evil nor good. They can evolve and outcomes. On the contrary, a healthy environ- be applied to meet specific objectives. The objec- ment that fosters a long-term view that encour- tives are influenced by a host of external and ages firms to appropriately assess attendant risks internal factors. As The Economist recently put it, can lead to positive outcomes.15 In the run-up to “When bubbles froth, innovations are used inap- the recent crisis, the environment was beset by propriately — to take on exposures that should a host of adverse factors, including the following: not have been, to manufacture risk rather than transfer it, to add complexity.10” This is also sum- • Prolonged deregulation paved the way marized11 by Steve Kohlhagen, an advisory board for shadow banking (see Figure 5, next page) member at the Stanford Institute for Economic to flourish. Policy Research (SIEPR), who said that blaming • Institutions took part in opaque OTC financial innovation for crises is like blaming the derivatives, coupled with high leverage (see Wright brothers for 9/11. Figure 6, page 7). • Central banks remained solely focused The systemic significance of innovations arises on inflation targeting, even as asset prices when the markets for these instruments grow bubbled. wider and deeper and pose unintended conse- • Environmental factors such as overt tax quences.12 ETF’s rapid growth is a case in point incentives for debt, a prolonged rise in prop- (see Figure 4). A Kauffman Foundation report13 erty values and easy availability of mortgages warns of potential systemic risks that can arise even for subprime borrowers, incented individ- due to the growing influence of ETF investments, uals to expose their household balance sheets which are increasing correlations among index to excessive debt. constituents. • At the institutional level, back offices that process trades remained largely anti- The benign or malignant consequences of finan- quated,16 even as the front offices made head- cial innovations are determined by three sources way to meet increasing market demand.

Here to Stay Exchange-traded funds, assets in trillions 1.4

1.2

1.0

0.8

0.6

0.4

0.2

0 2000 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07‘08 ‘09 ‘10 ‘11

Equity Fixed Income Commodity Source: “Playing with Fire,” The Economist, Feb. 25, 2012 Figure 4

cognizant reports 5 Beyond environment factors, innovation per se Another cause of the innovation-influenced can sow the seeds of destruction via inappropri- downturn was disregard for the financial literacy ate disclosure and a lack of transparency about needed to understand the complexity of instru- attendant risks. The move to create structured ments such as derivatives. Typically, innovations investment vehicles, for instance, was rooted in take shape within the confines of an institution the industry’s desire to move debt from bank bal- and are gradually adopted by the wider mar- ance sheets into new structures, thus circumvent- ket. The knowledge of risks associated with the ing capital provisioning mandates,17 in addition to product evaporates as it moves further from the allowing banks to extend credit beyond healthier original innovators. Even sophisticated buyers of limits. Another example is synthetic ETF, whose instruments are known to lack understanding of underlying swaps — in addition to exposing inves- their implications.20 tors to counterparty risk — can result in collat- eral that does not resemble the assets the ETF is The application of innovation is known to be meant to track.18 influenced by broader industry motivation. Moral hazard arising from the prospect of government Perhaps the larger blame goes to how these inno- bailouts in the event of failure is a well-known vations were applied. The problem with mortgage motivation. Firms were known to dilute their backed securities (MBS) and collateralized debt underwriting policies, since the securitization of obligations (CDOs) — which many pundits believe MBSs and CDOs allowed them to shift the credit set off the global financial crisis — was not due risk to third-party syndicates. to the instruments themselves but to the fact that sub-prime loans were packaged with so- Cleaning Up from Innovation’s called “better ratings.” Reduced documentation Aftermath requirements for mortgage qualification (a variant The impact of the economic crisis and the devised originally for the rich self-employed and measures undertaken will be felt for a long time small business owners), was offered to low-income to come. The foremost challenge ahead of the borrowers, which undermined the underwriting financial market regulators, industry groups and process. The deciding factor was the worthiness of institutions is to evolve mechanisms to make the sale of these loan instruments to MBS inves- financial innovations safer. At the organizational tors rather than whether borrowers were capable level, institutions need to focus on developing of repaying the principal, plus interest.19 Similarly, robust data and risk management capabilities for availability of CDS (credit default swaps) encour- meeting the twin challenge of compliance and aged firms to undermine credit risk assessment. competencies.

Shadow Bank vs. Traditional Bank Liabilities

$25

$20

$15

$10 ($ trillions )

$0 1 7 3 2 5 6 4 8 11 10 07 02 03 001 199 005 006 009 004 008 000 199 199 199 199 199 199 2 1999 199 1990 20 20 20 2 20 20 2 2 2 2 2

Shadow Liabilities Net Shadow Liabilities Bank Liabilities

Source: “Shadow Banking,” Federal Reserve Bank of New York, July 2010, Revised February 2012. Figure 5

cognizant reports 6 Making Innovation Safer Striking the Right Regulatory Balance Innovations are necessary for the evolution of Innovations are known to cause market financial markets. The ability to innovate has disruption, which has to be managed by proper never been a challenge for most financial firms. controls, regulation and availability of warning As is evident from the recent crisis, the biggest signals informed by the capture and analysis of challenge for regulators, industry groups and the appropriate data (i.e., investment ratings). financial services firms is to develop ways and The reason why last decade’s instrument innova- means to minimize the ill effects of instrument tion delivered unintended negative consequences innovation (as referenced above). was the lack of financial controls, poor data availability and regulations that could not keep pace The crisis presents an opportunity to reinvent with rapid change. the system. As Andrew Lo of the Massachusetts Institute of Technology suggests,21 the financial Regulators are appropriately positioned to shape industry needs to establish an independent body a healthy environment that influences positive modeled on the lines of the National Transporta- outcomes from financial innovations. The key is tion Safety Board (NTSB), which has the impec- to strike the right balance, since excessive regula- cable track record of continuously increasing the tion can choke innovations crucial to the natural safety of commercial aviation. Robert Shiller, an evolution of markets. Much of the financial regu- economist and Professor of Economics at Yale, lation underway on both sides of the Atlantic is advocates the idea that the government has to aimed at addressing these issues. Regulators are assume sponsorship of innovation, just as is it also attempting to bring more market players into does with scientific innovation.22 the scope of regulatory enhancements; they are also seeking to curb leverage and raise capital Industry groups also have a useful role to play. requirements. They can work toward evolving best practices around innovation processes and ensure their OTC derivatives reforms intend to bring these dissemination among participating institutions. trades to the exchanges or swap execution facili- These groups can also join hands with regula- ties and clear them through central clearing- tors in applying innovations to monitor unfolding houses. Swap data repositories are expected negative outcomes.23 to aid regulators in monitoring likely systemic threats from concentrations of counterparty exposures. The idea that central banks should pay

Leverage at the LCFIs High leverage levels marked the pre-crisis period Ratio 50

0 1999 ‘00 ‘01 ‘02‘03 ‘04 ‘05‘06 ‘07‘08 ‘09 ‘10

U.S. securities houses U.S. commercial banks European LCFIs Major UK banks

Source: “The Future of Finance and the Theory that Underpins It,” The Future of Finance Conference 2011, London School of Economics. Figure 6

cognizant reports 7 serious attention to asset price bubbles is gaining improved reporting for compliance purposes. ground, while the appropriate ways and means Moreover, the use of advanced analytical tools of doing so are still being debated.24 Neverthe- on the “big data” accumulated through new less, the potential dangers of over-regulation and instruments, as well as the return to greater trad- the lack of regulatory harmonization worldwide ing volumes of all securities, can reveal hidden threaten to undercut ongoing reforms in markets insights that can guide financial firms toward that today are far more interconnected globally greater efficiencies, better product and service than ever before. Finding the right level of regula- innovation and a forecast of emerging trad- tion and harmonization is necessary for ensuring ing scenarios and opportunities by combining a healthier and better marketplace. historic data with expected events.

Improve Data and Risk Management Improved data management is also crucial for Institutions must improve data and risk manage- another top priority: better risk management, ment to survive market uncertainties. Financial which is a top agenda item for regulators seek- services organizations, banks and capital markets ing to safeguard systemic stability. Consequently, firms, in particular, should focus their efforts on the risk management function, hitherto a domain building a culture that devotes greater attention of a few experts equipped with quantitative to reputation and refrains from pursuing innova- tools, has now moved to the top of the corpo- tions that may undermine it. Organizational inno- rate agenda. The view that risk management was vation processes need to be reinvented and inte- predominantly a compliance issue is giving grated into an enterprise-wide risk management way to a more proactive and holistic approach. framework.25 As a result, firms need to take an enterprise- wide stance that allows them to move beyond a Risk management should be viewed as a key fragmented understanding of their risk exposure. business and compliance imperative. As the crisis abates, financial firms need to continually focus Looking Ahead on compliance, risk management, cost efficien- To say these are trying times for financial ser- cies and rebuilding client trust. Their technology vices firms would be a vast understatement. infrastructure has not kept pace with the wave Among the many challenges these firms face is of instrument innovation that swept across the a severe crisis of confidence that undermines industry over the past decade. their strategic thinking and move-forward plan- ning activities. Regaining investor “trust,” which Financial firms need to give high priority to is the real capital for financial firms, remains a making technological enhancements to their work in progress. No matter how difficult this is banking systems, as this is crucial for achieving to resolve, firms must view trust building as an several key objectives, from improving processes, opportunity to reinvent and reorient their innova- to creating transparency and enhancing compli- tive capabilities to better serve not only investors ance. To achieve this, they need to overhaul their but also their own interests. legacy banking systems, a key part of which is creating consistent data structures across the The key to this resides in laying the right cultural organization. No wonder enterprise data man- foundation. As Robert Shiller suggests in his book agement has emerged as an important area of Finance and the Good Society,26 “The financial focus for financial services firms as they look to crisis reminds us that innovation has to be accom- prepare for a highly regulated future. plished in a way that supports the stewardship of society’s assets. And the best way to do this is to Integrated data structures will enable hitherto build good moral behavior into the culture of Wall siloed data to be standardized, removing incon- Street through the creation and observance of sistencies and errors, thus enabling a single best practices in its various professions — CEOs, version of the truth for all concerned functional traders, accountants, investment bankers, law- departments. This will have several benefits, the yers and philanthropists.” most important being reduced complexity and

cognizant reports 8 Footnotes 1 “Playing with Fire,” The Economist, Feb. 25, 2012, http://www.economist.com/node/21547999.

2 Ibid

3 Robert C. Merton and Zvi Bodie, “A Conceptual Framework For Analyzing The Financial System,” WP#95-062, July 18, 1994, http://www.nek.lu.se/NEKeno/Finance%20B/A%20Framework%20 for%20Analyzing%20the%20Financial%20System.pdf.

4 Leo King, “Official: Trading Software Did Not Cause Financial Crash,”Computerworld UK, Jan. 27, 2011, http://www.computerworlduk.com/news/it-business/3258231/official-trading-software-did-not-cause- financial-crash/.

5 Dave Cliff, Dan Brown, Philip Treleaven, “Technology Trends in the Financial Markets: A 2020 Vision,” Government Office for Science, Foresight, 2010, http://www.bis.gov.uk/assets/foresight/docs/com- puter-trading/11-1222-dr3-technology-trends-in-financial-markets.

6 Ibid

7 “OTC Derivatives Market: Update on Current Regulatory Initiatives,” Deutsche Bank Research, Nov. 14, 2011, http://www.dbresearch.de/PROD/DBR_INTERNET_EN-PROD/PROD0000000000280806/OTC+ derivatives+market%3A+Update+on+current+regulatory+initiatives.PDF.

8 “OTC Trading: Impact of The CCP Model,” Cognizant Technology Solutions, 2011.

9 Clare Dickinson, “U.S. and European OTC Trades Set to Dominate After Move to Exchange Clearing,” Hedge Funds Review, April 18, 2012, http://www.hedgefundsreview.com/hedge-funds- review/news/2168333/audio-european-otc-trades-set-dominate-exchange-clearing.

10 “Playing with Fire, The Economist.

11 Comment by Steve Kohlhagen, SIEPR Advisory Board, while moderating the discussion on “Financial Innovation and the Economic Crisis” SIEPR Economic Summit 2012, http://www.youtube. com/watch?v=tk93jQcUc-s.

12 “Playing with Fire,” The Economist.

13 Chris Flood, “Kauffman Foundation Attacks ETF Industry,” Financial Times, Nov. 9, 2010, http://www.ft.com/intl/cms/s/0/367cfd78-ec04-11df-b50f-00144feab49a.html#axzz1xC5DJayA.

14 “Rethinking Financial Innovation: Reducing Negative Outcomes While Retaining the Benefits,” World Economic Forum and Oliver Wyman, 2012, http://www.oliverwyman.com/world-economic-forum-and- oliver-wyman-report-rethinking-financial-innovation.htm.

15 Ibid

16 “The Case for More Functional, Utility-Like Trade Management Systems,” Cognizant Technology Solu- tions, March 2011, http://www.cognizant.com/insightswhitepapers/Trade-Management-Systems.pdf.

17 “Rethinking Financial Innovation,” World Economic Forum and Oliver Wyman.

18 “Playing with Fire,” The Economist.

19 “Rethinking Financial Innovation,” World Economic Forum and Oliver Wyman.

20 “Playing with Fire,” The Economist.

cognizant reports 9 21 Andrew W. Lo, “The Financial Industry Needs Its Own Crash Safety Board,” Financial Times, March 2, 2010, http://www.ft.com/intl/cms/s/0/011cbf2e-2599-11df-9bd3-00144feab49a.html#axzz26MIhrCOz.

22 “Surveying the Economic Horizon: A Conversation with Robert Shiller,” McKinsey Quarterly, April 2009, https://www.mckinseyquarterly.com/Surveying_the_economic_horizon_A_conversation_with_ Robert_Shiller_2345.

23 “Rethinking Financial Innovation,” World Economic Forum and Oliver Wyman.

24 “Should, or Can, Central Banks Target Asset Prices?” The International Economy, Fall 2009, http://www.international-economy.com/TIE_F09_AssetPriceSymp.pdf.

25 “Rethinking Financial Innovation,” World Economic Forum and Oliver Wyman.

26 Robert J Shiller, Finance and the Good Society, Princeton University Press, 2012, http://press.princeton.edu/titles/9652.html.

Credits Author Rajeshwer Chigullapalli, Head of the Thought Leadership Practice, Cognizant Research Center

Analyst Akhil Tandulwadikar, Senior Research Analyst, Cognizant Research Center

Subject Matter Expert Sudhir Gupta, Assistant Vice-President, Cognizant Banking and Financial Services Practice

Design Harleen Bhatia, Creative Director Suresh Sambandhan, Designer

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