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The Capital Market Industry

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The Capital Market Industry THE CAPITAL MARKETS INDUSTRY THE TIMES THEY ARE A-CHANGIN’ EXECUTIVE SUMMARY The past five years have seen unprecedented The success of market participants will depend change in global capital markets. Buy-side on how well they position themselves to and sell-side participants, custodians, market respond to these challenges. They will need infrastructure and financial technology to retain the flexibility to deal with ongoing providers have all had to reassess their uncertainty but also identify their role in strategies, business models and risk the medium-term. In this paper, we pose frameworks. Today we find ourselves at a three questions. critical juncture. A new structure for the capital markets industry is emerging, however a great Addressing these questions will be critical for deal of uncertainty remains. all capital markets participants. 1. Where will opportunities be created Regulation continues to drive much of and lost? the change. The move towards greater transparency, less leverage and improved 2. What risks are emerging? governance is broadly welcomed across the 3. Who is positioned to meet the industry’s industry. However, while some regulations wide-ranging needs in 2020 and beyond? have been chewed and digested, in many places policy and regulatory requirements are still moving targets. Where will opportunities be created and lost? On top of regulation, shifting investor demands, rapid evolution in and increased Market and regulatory forces are reshaping dependence on technology, emergence of new the industry. Economic pressure, constrained risks and ever more interconnectedness are financial resources, greater scrutiny of all substantially affecting the capital markets conduct and conflicts, evolving client needs, value chain. The result is movement in revenue and technological innovation are evident in pools, where risk resides, and which actors are virtually all parts of the market. While these best placed to succeed. forces are individually familiar to market participants, their confluence is leading to All participants are being forced to adapt their rapid changes in where revenue is generated business models as a result. Some traditional across the capital markets value chain. service models will be usurped by alternatives in parts of the new capital markets ecosystem. Changes are occurring via three mechanisms: New and existing providers will compete demand for new products and services in battlegrounds for new services such as generating new revenue; shifts of existing collateral management. The economics revenue-generating activities between of established businesses may change participants; and cost reduction efforts drastically in some areas of the value chain, creating revenue for providers of insourced and there will be a disproportionate impact on solutions. These are playing out at all stages of certain players. the value chain. Copyright © 2014 Oliver Wyman 1 The effect on execution is bifurcated between the form of customized client reporting, liquid and illiquid instruments. For the former, provision of standardized back office there is a heavy focus on price transparency services, asset optimization and potential in and conduct. Scrutiny on commissions is emerging markets. leading to unbundling of brokerage costs from other services such as research. Additionally, Underpinning all of these trends will be wider concerns on conflicts in the determination of and more sophisticated re-use of data covering indices and price benchmarks have already both instruments and transactions. Mining resulted in sales of some of these businesses. of this data can increasingly be monetized For illiquid instruments, burdensome capital through data enrichment, lead generation and funding requirements are the greatest and optimization of other processes such as challenge as returns deteriorate for both collateral management. dealers and investors. This is leading to a “futurization” through substitution into listed instruments or movement of sufficiently What risks are emerging? standardized instruments onto organized As the value chain and the role of market execution venues. There is debate on the participants within it changes, so will risk ownership and operation of such venues and levels across the capital markets ecosystem. their implications for reference prices. We also Some financial risk will migrate from the anticipate growth in agency models as market- execution layer and the sell-side to post-trade makers withdraw capacity. market infrastructure, particularly CCPs, Centrally cleared volumes will grow global custodians and ICSDs. Across the significantly as a result of regulatory mandates industry, operational risk will grow as a result and punitive initial margin requirements of increased flow and interconnectedness, on un-cleared OTC derivatives. Clients will with near-term peaks as participants undergo increasingly interact more directly with CCPs, a period of operational, regulatory and especially where their interests are divergent technological adjustments. with their clearing brokers’ interests. On one hand, this offers the sell-side the We expect initial margin requirements to have opportunity to reduce and optimize their risk, grown by >$1 TN by 2018, making collateral leveraging infrastructure solutions (e.g. OTC management increasingly important. To meet CCPs and tri- and quad-party solutions for OTC this growing demand for collateral, solutions and securities financing), mitigating in part the will be required to unlock dormant eligible Basel III impact. instruments held by institutional investors. Additionally, demand for tri-party repo will On the other hand, market infrastructure increase as withdrawal of bilateral repo providers are now facing a new set of risks. capacity due to the leverage ratio and NSFR Some, mainly operational, are unfamiliar threatens participants’ ability to access cash and driven by interconnectedness and for margin. Perhaps the greatest challenge will technological advancement. Others, typically be ensuring operational robustness as volumes financial, are familiar but now of previously of circulating collateral increase, prompting a unknown magnitude and origin (e.g. in OTC greater focus on standards. clearing and lending). These changes should drive large investments in risk management Core custody and settlement services and compliance (e.g. risk appetite statements, are moving ever closer to a utility model, control frameworks, monitoring systems, lines driven by a combination of price pressure of defense, risk culture and governance) to and regulatory standards. However, new reflect increased breadth of focus and greater revenue opportunities will emerge in scrutiny of non-operational risks. Copyright © 2014 Oliver Wyman 2 The concentration of risk in the industry is We expect that traditional sell-side revenues changing too, and arguably growing. A number will be eroded as execution is commoditized, of institutions are becoming systemically though this will be offset with benefits arising important as “nodes” processing a significant from greater use of market infrastructure proportion of flow across multiple venues, providers. Proactive use of execution venues, for example collateral hubs. Simultaneously, CCPs, and other, e.g. non-cleared exposure interconnectedness is increasing, for example and collateral management solutions will through (planned) open access to CCPs, which reduce risk and leverage. Focusing on smart has implications for the risk of contagion use of 3rd party software and technology will should one of these systemic nodes fail. significantly reduce costs, as will outsourcing of standardized back office functions. Overall, Regulatory changes are already underway this should offer the sell-side the opportunity to respond to these new and growing risks. to trim operating, funding and capital costs, Capital levels are being increased and ultimately protecting returns. leverage reduced, but this can never be the whole answer. No metric can fully replace The role of market infrastructure providers sound judgment in risk management. Banks will grow throughout the value chain; are in the midst of creating recovery & those that can best serve the risk and cost resolution planning covenants (e.g. living wills) mitigation needs of the industry will prevail. although these are proving to be a thorny In the execution layer, operation of effective implementation issue. matching venues and building solutions for new asset classes (e.g. credit) will increasingly Market infrastructure and custodian risk fall to market infrastructure providers. frameworks and recovery & resolution Exchanges will become open access networks frameworks are less well developed, yet and support execution venue selection, more important than ever to cementing including taking a role in hosting of 3rd party the new capital markets industry structure. platforms. Collateral management will be International consistency in the treatment driven by a combination of CCPs and of these globally important institutions (I)CSDs, operating on a pan-regional scale, (lacking in many areas) will also be critical. the former optimizing margin amounts and supporting bilaterally margined trades, while the latter focusing on efficient identification Who is positioned to meet the and allocation of collateral. This will be driven by a collective push for open access to CCPs industry’s wide-ranging needs and improved collateral standards, with in 2020 and beyond? success of individual (I)CSDs
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