The Capital Markets Industry the Times They Are A-Changin’

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 contingent on intermediating a critical mass of client flow. Market participants’ ability to seize the emerging opportunities in the industry will Leading custodians will take an ever more vary, depending on jurisdiction and factors global role, acting as gateways for transactions such as investment budget and balance sheet, and collateral, leveraging improved data and perceived neutrality, and regulated status. reporting capabilities. They will also play an Historically, success has been heavily driven essential role as tri-party agents facilitating by client network, connectivity, capital and funding and collateral transformation. pricing power, as evidenced by the relative Custodians’ success will rest on their ability size of bank and broker-dealer revenues. to deliver a wide spectrum of client services, However, in a more transparent market, this combining post-trade capabilities with core is increasingly shifting towards cost efficiency custody, though this will also bring them and operational excellence, often as a result of into intense competition with (I)CSDs, as savvy use of technology. already seen.

Copyright © 2014 Oliver Wyman 3 The agility and expertise of specialist Conclusions technology providers will make them essential given the residual uncertainty in the market Capital markets business models are changing and scarcity of investment budgets. Their role substantially. New opportunities are being will be threefold: supporting outsourcing push created for a broad range of actors spanning for back office functions, helping mine and the sell-side, the buy-side and market process under-utilized data, and development infrastructure providers. Some of these of software. opportunities are already advanced whereas others are less clear and only just emerging. In Adaptation of existing business models and a few areas, the industry will consolidate and collaboration with other market participants leave service delivery and risk management will be required. The diversity of requirements to a few experts, but in most areas, we expect needed in the new capital markets ecosystem, industry fragmentation will persist, though the size of investments required and the with a markedly new profile. inherent uncertainty of outcomes in the medium to long-term raise the value of In light of the change of the past five years and collaboration. For example, banks have the additional shifts expected over the next historically developed swathes of software five years, medium-term planning and strategy in house, much of it replicated and often not are becoming ever more important. All players across the sell-side, buy-side and market providing competitive differentiation. Success infrastructure providers need to identify the in the new paradigm is likely to focus on best opportunities, and then decide which role greater use of 3rd party developers to avoid to take in the 2020 capital markets and how to unnecessary duplication and focusing internal adapt to succeed. resources in those areas that can deliver differentiated results. Collaboration can We expect that regulators will intervene with take multiple forms, whether joint-venture, proposed solutions in those areas where partnership, white-labelling, client-vendor risk is shifting significantly, with a view of relationships, or even acquisition. driving mechanisms to stabilize the market. In those areas where capabilities are scarce or Overall, the role of market infrastructure investment requirements are unachievable, providers, custodians and technology collaborative models should be explored. providers will grow significantly, playing an increasingly vital role in the effective Firms will need to align their planning cycles operation of capital markets. However, the and approaches to the inherent uncertainty in sell-side will also benefit, optimizing their the market in terms of regulation, competitor business around financial resources and action and macro environment/volatility. sustaining returns at lower risk. Flexible management of innovation and advanced risk management practices will be essential to succeed.

Copyright © 2014 Oliver Wyman 4 Section 1 Where will opportunities be created and lost? Over the past 5 years, capital markets have This section examines these changes in detail, undergone a period of unprecedented change. starting with an overview of the current capital The primary drivers have been the wide- markets ecosystem. ranging post-crisis regulatory regime and a challenging macro-economic environment. However, the confluence of these factors, Current state of the capital plus additional market forces such as conduct markets ecosystem scrutiny, evolving end-client demand, and technological progress, mean yet more The capital markets value chain follows the significant change is still to come. Both the way lifecycle of a trade, from the inception of in which users interact with capital markets a trading idea, to execution, to post-trade and how providers enable access to them will securities services. be affected, ultimately causing changes in the way value is generated. These changes in value Enabling a trade to take place requires will take one of three forms: a series of supporting activities carried out by a multitude of different market •• New sources of revenues emerging as participants, together forming the capital users’ needs change and regulations markets “ecosystem”. mandate new activities •• Shifts of revenue from one provider Buy-side investors, who generate their own type to another, at a high-level revenue through investment, also provide the between buy-side, sell-side and market wider revenue that sustains the capital markets infrastructure providers, but also ecosystem. As buy-side investors trade, between e.g. (I)CSDs and custodians they generate revenue, either as fees paid or •• Outsourcing of cost from one provider spreads captured, for providers offering access type creating revenue opportunities to capital markets and associated services. The for others. sell-side is the primary and most immediate

Exhibit 1: Overview of capital markets value chain

VALUE CHAIN DESCRIPTION PRIMARY ACTORS EXAMPLE FIRMS

Primary Issuance of securities, debt and equity, e.g. IPO •• Goldman Sachs •• Citi Client relationship management and trade generation, Client Coverage Sell-side •• JP Morgan e.g. research •• UBS Fees paid for brokerage, exchange access, secondary Commissions IDBs commissions etc. •• Tullett Prebon Spreads and fees paid for trade execution and associated risk- •• ICE Execution Risk premiums Exchanges taking •• Deutsche Börse •• CME Loan-based transactions for trading clients e.g. repo, Financing •• BATS Chi-X margin financing

Clearing Reconciliation of orders, reporting and central margining •• Eurex Clearing CCPs •• LCH.Clearnet Settlement Transfer of deeds once a trade has been cleared

Safeguarding of deeds including actions on assets •• DTCC Securities Custody services e.g. dividends (I)CSDs •• Euroclear •• Clearstream Collateral Access, movement and deployment of collateral on behalf Custodians •• State Street management of clients •• BNY Mellon Post trade data Data access & analytics, software and platform support Data & technology & •• Thompson Reuters and analytics for post-trade other 3rd parties •• Sungard

Source: Oliver Wyman analysis

240

156

44 34 Revenue 24 23 15 17 3 2 Cost Sell-side Execution (I)CSDs Custodians Technology venues providers Average cost to income ratio ~65% ~60% ~70% ~80% ~75%

Note: Perimeter of activities as shown in Exhibit 3 Source: Company annual reports, Oliver Wyman analysis

beneficiary due to its client-centric role. As of today, the sell-side faces little They also make money from the issuance of competition for primary trading revenue from securities, i.e. primary trading, which includes other providers; other providers take only equity/debt capital markets and mergers 2% of total primary trade revenue. Execution & acquisitions which together generate an venues, as well as custodians and data and estimated $57 BN. However, the largest technology providers do, however, compete tranche of revenue for the sell-side comes with the sell-side for execution revenues from secondary trading which contributes from secondary trading. This is reflective of ~$180 BN in revenue and within that execution a broader trend that further along the value in particular. chain into execution and beyond, sell-side providers face increasing competition from Execution revenues can be separated into alternative providers for revenue. three main categories and associated activities for sell-side actors: The cost and balance sheet profile of participants varies significantly. For the sell- •• Commissions – Execution of the trade with side, balance sheet consumption and human no associated principal risk resource costs are both high, a function of its •• Risk premiums – Fee associated with the risk-taking revenue model. In recent years bank undertaking risk on behalf of their both have gone through structural change clients i.e. to guarantee a given outcome as charges for financial resources have been for the client cascaded through the business and bonuses •• Financing revenues/Net Interest have been reviewed. In contrast, market Income – Loan-based transactions that infrastructure providers operate with low allow clients to undertake trading, such variable costs and limited balance sheet. This as repurchase agreements (repo) or model has been subject to less change over the margin financing. past five years and consequently their cost/ income ratios have remained relatively stable.

ACTORS DATA & EXECUTION TECHNOLOGY VENUES PROVIDERS & (EXCHANGES, OTHER VALUE CHAIN SELL-SIDE IDBs, CCPs) (I)CSDs CUSTODIANS 3RD PARTIES TOTAL

Primary $57 BN $1 BN $55-60 BN ECM: $20 BN DCM: $22 BN M&A: $5 BN Client Coverage

Commissions

Execution Risk premiums $13 BN $4 BN $3 BN $190-210 BN

Financing $180 BN Cash: $53 BN Clearing Listed: $ 22 BN $4 BN <$1 BN $5-10 BN OTC: $108 BN

Settlement

Securities Custody $1 BN $3 BN $39 BN $40-45 BN services Collateral management Post trade data $4 BN $20 BN $20-25 BN and analytics

Revenue ~$240 BN ~$24 BN ~$3 BN ~$44 BN ~$23 BN ~$330 BN

Source: Company annual reports, Oliver Wyman analysis

Exhibit 4: Growth in revenues by market participant 2008-2013, index 2008=100

160

140 Sell-side

120 Data & technology providers & other 3rd parties

Execution venues 100

Custodians

80 (I)CSDs 2008 2009 2010 2011 2012 2013

Source: Company annual reports, Oliver Wyman analysis

Copyright © 2014 Oliver Wyman 8 Forces affecting the capital taking for banks − making it more challenging markets ecosystem to deliver above-hurdle returns. This has prompted a more rigorous approach to This current state is undergoing a period where and how scarce financial resources are of considerable change, precipitated by deployed in optimizing business mix, as well as six key market forces. These touch all day-to-day front-line risk taking. dimensions of the value chain and an array of market participants: 3. GREATER TRANSPARENCY Regulation (MiFID II, Dodd-Frank, EMIR, 1. PRESSURE ON PROFITABILITY AIFMD, PRIPS etc.) is enforcing minimum While revenues across capital markets have standards for pre- and post- trade price been put under severe strain during and post- transparency. The price discovery and trade crisis, efforts to reduce the cost base have execution process is changing, creating had mixed success, and we still see structural opportunities for more agency-driven imbalance across market participants: models in OTC derivatives and cash fixed- income products. Data availability is as a •• Sell-side: over-capacity in the sell-side result improving both in terms of availability combined with a structurally higher and quality. cost base (e.g. due to increased cost of compliance as well as changes in the remuneration systems towards higher 4. CONDUCT SCRUTINY fixed and lower variable components) has There is heightened scrutiny around potential resulted in an imbalance between revenue conflicts of interest that negatively affect and cost. end-clients/the buy-side. For example, this •• Market infrastructure providers: has resulted in a drive for separation of duties significant impact of regulatory between the operation of price-dependent implementation cost on investment cycles market functions (e.g. index calculations, and business mix. As clients request new LIBOR and FX fixes) and risk-taking. Moreover, services, partially insourced, market there is an increased focus on operational infrastructure providers are starting to “hygiene”, e.g. transparent process, enhanced review economics and sustainability of reporting. However, this is exacerbating the established business models. economic challenge for providers due to •• Custodians: scale economics only additional cost. available to the largest players globally, with starkly contrasting prospects for rest 5. EVOLVING CLIENT DEMAND of industry, e.g. in local custody. Declining margins and increasing cost base have Clients are adapting to the changing been the main drivers, but even the largest landscape, generating demand for additional players have experienced deteriorating service needs, but they are also exploring cost/income ratios. opportunities to extend their own role within markets. Clients’ objectives remain centered around maximizing returns whilst minimizing 2. CAPITAL, BALANCE-SHEET, LIQUIDITY AND COLLATERAL CONSTRAINTS risk and cost, but what this means in practical terms is changing in different ways for different Regulation (Basel III, leverage ratio, liquidity participants. For large institutionals, issues rules, collateral rules) has targeted a reduction such as security and segregation are coming of financial leverage in the system – limiting to the fore, while for hedge funds yield remains the capacity and increasing the cost of risk the primary concern. Corporate exemptions

Copyright © 2014 Oliver Wyman 9 may dampen their urgency to adapt. The other emergent technologies may stimulate overall trend is one of investors re-evaluating new waves of change, e.g. cyber currencies and how they interact with the market, both in cloud computing. These new uses will in part be terms of the services they use and which driven by the effects of other market forces. providers they source them from (including in-house options). Changing opportunities in 6. GREATER ROLE OF TECHNOLOGY capital markets ecosystem Technology has and continues to drive These market forces are not new to the evolution in capital markets. Rapid advances industry, but in combination they are now and the lower cost of technology remain a resulting in major structural changes. catalyst for change, especially since high- Execution is becoming commoditized, leading frequency trading has come under scrutiny. to a shift in services across providers. Core Potential opportunities and their impact span settlement and custody are moving closer to the post trade lifecycle; some are familiar to the a utility model, while in parallel value-added market, e.g. electronification of markets and post-trade and adjacent services are growing, increased straight-through processing, while for example collateral management.

Exhibit 5: Impact of market forces on capital markets value chain

MARKET FORCES CAPITAL & BALANCE DRIVE FOR EVOLVING GREATER ECONOMIC SHEET GREATER PRICE CONDUCT CLIENT ROLE OF VALUE CHAIN PRESSURE CONSTRAINTS TRANSPARENCY SCRUTINY DEMAND TECHNOLOGY

Client Coverage

Commissions

Execution Risk premiums

Financing

Clearing

Settlement

Securities Custody services Collateral management

Post trade data and analytics

Affected by market force

Across the value chain, execution is the Capital constraints are resulting in a largest pool of revenue in the capital markets widespread push for clearing, including more ecosystem at $200 BN, of which the sell-side contracts within established securities, plus takes the greatest portion. However, this currently non-cleared OTC derivatives, and has been declining post crisis driven by a repo/securities lending. This trend is being combination of regulation and a challenging further accelerated in anticipation of collateral macro-economic environment. The former has requirements rising due to introduction of led to withdrawals in capacity due to scarcity initial amounts on un-cleared derivatives. The of requisite financial resources and reduced established interaction of CCPs to clearing risk appetite, while the latter has dampened broker to end-client is also changing driven end-client demand. We anticipate further by new segregation models and the economic significant change as other forces come into impact of regulation. This is being captured in effect, for example leverage ratio rules. pricing as for example, clearing brokers inflate the cost of full segregation accounts for clients. On the supply side, market-makers are re- pricing to reflect a structurally higher cost base or withdrawing/scaling back, which Securities services will continue to occur as, for example, gross balance sheet and availability of collateral Securities services make up the second become constraints. On the demand side, largest share of revenues in the capital clients are assessing whether to accept these markets ecosystem, which has been growing higher costs or find cheaper alternatives moderately but steadily. (e.g. standardized listed derivatives instead of OTC). The trend towards passive investment This growth is despite significant strategies will also reduce executed volumes, commoditization in custody and settlement as will any potential clampdowns on high- due to price pressure at buy side clients (who frequency trading. predominantly utilize these services from custodians) and the standardizing influence of Commissions are under scrutiny by both regulation. Within Europe, TARGET2-Securities clients and regulators, with pressure to (T2S) is introducing a cross-border settlement unbundle pricing, prompting re-evaluation of platform that links custodians and (I)CSDs. rolled-up services, e.g. research. Custodians will seek to utilize this platform either directly or indirectly, significantly further In a similar vein, the location of pricing commoditizing settlement across Europe. calculations (e.g. indices, fixes) is being Furthermore T2S will lead to new competitive challenged from the perspective of potential structures, particularly in cross-border conflicts of interest. Finally, greater focus on markets, and hence lead to further margin fairness of execution in terms of access and pressure on the supply side. As a result, 10-15% benign liquidity (i.e. observable and tradable) reductions in revenue are to be expected for is leading to re-evaluation of dark pools and some players. internalization engines and the respective role of brokers and exchanges.

Copyright © 2014 Oliver Wyman 11 In the longer-term, technological capabilities optimization. This is also enabling providers to and client demand may lead to growing meet users’ increasing demands for “big data” pressure to reduce settlement times, moving and sophisticated ways to analyze it. Neutrality closer to T+1/0 from T+2 (previously T+3). is becoming a point of concern with respect to Enablers could include cyber currencies, data, as end-clients rationalize who sees their overcoming the historical constraints around flow, how this information is processed and FX mismatch. how they might be advantaged by it. Beyond this, we expect certain data layers to be offered In the course of further commoditization of for free in the near term, causing value and vanilla settlement and custody and increasing business model shifts. regulatory requirements, buy and sell side institutions will seek to centralize and outsource back office functions due to cost Asset class perspectives and regulatory pressures. This will create opportunities for securities services providers. In addition to the broad trends we observe Furthermore, clients will also require enhanced (commoditization of execution, utility-like reporting capabilities such as bespoke structures for standard settlement/custody, reporting services or online access capabilities. growth in enhanced post-trade and adjacent The development of such reporting tools services) there are more specific trends within and new services, increased regulatory each asset class. How these trends are playing requirements and upgrades to infrastructure out varies significantly depending on: to address inefficiency issues, are all exerting •• Contract type – e.g. OTC contracts are significant cost pressure on custodians. subject to significant new collateral requirements that may push revenue Collateral requirements are expected to to some degree towards standardized, increase by >$1 TN of initial margin by 2018 listed contracts due to clearing obligations and introduction of initial amounts for un-cleared OTC – collateral •• Principal vs. agency driven – as capital and management in turn will become increasingly balance sheet constraints tighten, value in important to users. Capital and balance sheet those asset classes that require principal constraints are pushing minimizing margin risk e.g. repo, may shift to new agency requirements and optimizing collateral models e.g. tri-party allocation to the top of the agenda for both •• Severity of regulatory impact and conduct end-clients and clearing brokers. In turn scrutiny – FX trading is under significant asset owners are looking towards custodians conduct scrutiny, especially focusing on for support in optimizing use of their assets FX fixes, which may result in value shifts to not only for investment purposes but also alternative providers. collateral management. Broadly, those assets which are most liquid, such as cash equities, FX and bonds will Data & analytics be subject to considerable client pressure to standardize and develop transparency, Technological progress is extending the scope while illiquid assets will continue to be for data and analytics across various activities, most affected by funding constraints and for example custody plus asset servicing, regulatory pressure. risk positions and collateral location &

Drive for greater transparency and Cash equities conduct scrutiny forcing standardization while greater role of Govies technology is forcing further FX electroniﬁcation

N Index

I O CDS T A IR swaps Listed

R D I Z derivatives N D A

A Single name T Evolving client demands and economic S CDS Corporate pressure forcing electroniﬁcation while CDS client demands and capital and balance sheet constraints are forcing Non-ﬂow OTC standardization

ELECTRONIFICATION

Source: Oliver Wyman analysis

Cash equities integrity of the market structure will shift favor back to more transparent, 3rd party markets. For cash equities large parts of the value chain Pressure on sell-side models (high fixed cost- from execution to post-trade are already base, overlapping infrastructure, deteriorating heavily commoditized. Value creation in the margins) is limiting the number of dealer execution layer has recently centered on platforms that can succeed. We expect greater sell-side internalization and the operation of co-operation and co-mingling of liquidity with dealer-owned dark pools and helping clients 3rd party infrastructure will occur more and navigate fragmented liquidity. Conduct scrutiny more going forward. and a renewed focus on best-execution will drive volumes and value back to third party regulated markets. While interoperability and Bonds margin compression have quasi-eliminated cash equities clearing revenues, in Europe, Many initiatives have recently attempted to TARGET2-Securities will lead to a shift in value shift corporate bond execution to a platform from settlement to custody and asset servicing. structure but have failed to gain traction in the market. There are a number of structural factors that make such a shift challenging; the FX lack of issuance standardization, large number of instruments, low trading velocity and volatile As with cash equities, value creation in FX liquidity. Regulation and technology should trading has been driven by the internalization drive innovative solutions to overcome these of flows captured through proprietary single challenges. Data-driven solutions on inventory dealer platforms. Recent regulatory and and quote tracking, proxy matching and conduct scrutiny around reference prices liquidity aggregation initiatives will help reduce and broader questions raised on the overall the dependency on principal risk-taking.

Copyright © 2014 Oliver Wyman 13 The structural challenges for government execution venues (SEFs) and organized bonds are less steep (e.g. fewer sovereigns trading facilities (OTFs) will move closer to than corporates); as a result electronic listed venues, with tighter pricing and a higher trading has begun to take hold – particularly degree of electronification. The scale of this for small ticket sizes. We expect further shift will be determined by the resulting commoditization of the execution layer, platform structure; incremental change if particularly if central-limit-order book the current request-for-quote (RFQ) model platforms gain a critical mass of liquidity. is preserved but in an electronic format (e-RFQ) or more radical shifts if a central-limit- order-book (CLOB) is supported. In recent Listed derivatives years, index-CDS has experienced such a transformation (electronic share of trade The increase in funding and capital cost of volume 75%+, margins <0.5bps). OTC derivatives (for both cleared and non- cleared contracts) is driving “futurization”; the migration of OTC volumes to listed Non-flow OTC derivatives. The scale of migration will be (structured rates, credit, equity swaps) determined by investors’ willingness to accept basis risk in favor of lower direct transaction Increased collateral requirements associated costs. However, as with cash equities, with bi-lateral margining will require a margin pressure will commoditize execution fundamental re-pricing of non-flow OTC to where possible, even more than has been cover capital and liquidity costs. Despite the case in listed derivatives in the past. It this, dealers will likely remain central to will become harder for the sell-side to make non-flow OTC and shift towards providing money as clearing fees will move to CCPs and adjacent services to improve efficiencies, such margin becomes segregated due to EMIR as margin requirements. Some market infrastructure providers will attempt to win through listed derivatives by launching OTC-like products Repo & securitized lending with listed derivatives benefits, e.g. lower margining requirements, but there is some Leverage constraints will likely make uncertainty on the willingness of market securitized financing value-destroying for the participants to embrace such new products sell-side under the current model, therefore and provide liquidity. prompting re-pricing, withdrawal of dealer capacity and/or increased use of CCPs for clearing repo and securities lending. Flow OTC (swaps, CDS) Access to repo and securities lending markets remains crucial to enabling the efficient The flow OTC execution layer will become sourcing and transformation of collateral, as commoditized through price transparency and well as broader funding purposes for broker- also become more dependent on exposure dealers and end-clients. We expect value to and collateral management (margining). shift to a tri-party and cleared repo/securities As standardization of flow OTC continues, lending model, where custodians, (I)CSDs and a template for the overall direction of travel CCPs drive an infrastructure-led solution to exists in listed futures and options. Swap source and connect buy-side liquidity.

Copyright © 2014 Oliver Wyman 14 Section 2 What risks are emerging? The changes we anticipate in the capital Where such changes occur, actors will be markets ecosystem will also affect the exposed to an unfamiliar scale and profile of quantum and preponderance of risk across the risk, and consequently the development of value chain and market participants. The main appropriate processes to mitigate and control mechanisms will be actors entering new parts these new risks will become critical. As a result of the value chain, greater volumes and/or increased scrutiny will be placed on some complexity, and concentration of risk among a actors’ risk management frameworks as well smaller set of institutions. as recovery & resolution plans.

Exhibit 7: Overview of risk types and drivers

EMERGING SOURCE EXAMPLE CAUSES COMPLEXITY DRIVERS Operational risk Failure of internal •• Process failures •• System outages processes, people •• Systems failures/IT risk •• Interconnectedness and systems •• Damage to physical assets •• New technologies •• Compliance/legal risk •• High frequency trading Credit risk Default by borrower, •• Credit default risk •• Agency models leading to loss •• Country risk •• Bilateral margining of principal and/ •• Shift to central clearing or interest

Market risk Adverse change in •• Equity risk •• Buy-side market-making market prices •• Currency risk •• Internalization •• Interest rate risk •• Commodity risk Liquidity risk Lack of funds to •• Funding liquidity risk •• Withdrawal of repo capacity support operations •• Market liquidity risk •• Execution venues for new or inability to exit asset classes market position

Source: Oliver Wyman analysis

We anticipate three main trends in risk profile given the already intense focus in this area in as a result of the changes in the capital recent years. markets ecosystem: 2. SYSTEM WIDE INCREASE IN 1. DE-RISKING FROM THE SELL SIDE IN OPERATIONAL RISK DUE TO INCREASING RESPONSE TO REGULATION FLOW, USE OF TECHNOLOGY, INTERDEPENDENCY AND COMPLEXITY The sell-side will have an opportunity to Operational risk is likely to increase across the de-risk, reaching far beyond the reduction of market, both due to higher volumes and new prop activities which has already occurred. complexities. Flow is expected to increase in Primarily this will occur by reducing the existing post-trade operations as a result of the volume of risk they are exposed to through shift to listed instruments and the introduction central clearing, collateral management, of new products. increasing use of agency models, disposal of business lines and outsourcing. Further New risks will arise from increasing reductions from in-house risk management interconnectedness resulting from optimization will be comparatively small commoditization of services and outsourcing

Copyright © 2014 Oliver Wyman 16 of operations from the sell-side. This will likely 3. INCREASED LIQUIDITY AND CREDIT be exacerbated due to increased velocity RISK RESIDING WITHIN CCPS AND of flow e.g. electronification and high- (I)CSDS AS A RESULT OF GROWING frequency trading. VOLUMES AND SERVICES CCPs and (I)CSDs are expanding into Additionally, operational complexity is new parts of the value chain causing their increasing due to number of stakeholders liquidity and credit risk to increase. In involved and players entering new areas of the addition, CCPs are taking on increasing value chain which are still in flux. levels of risk – counterparty credit risks Finally, new risks are emerging from increasing (primarily gap risks due to collateralization), legal and regulatory requirements as result of liquidity risks around collateral and greater scrutiny of faults, e.g. sanctions and operational risks as a result of sell-side conflicts of law, and increased implications for and buy-side efforts to de-risk. failure, e.g. substantial fines. As the roles of market participants change, it These new operational risks come in two is important they evaluate the implications on forms; transitional and inherent. As a result of their risk profile and make active judgments new entrants into areas of the value chain and about the resiliency of their risk management increased customization of products short frameworks and processes. Through this term transitional risk will be high, whereas assessment, participants can carry out inherent risk will increase system wide and optimization of their risk profile and ensure then stay at the same level. This combination correct resources are in place to mitigate creates a short term spike in operational risk. and control the new risks they face.

Exhibit 8: Evolving profile of risk for market participants

OPERATIONAL CREDIT LIQUIDITY MARKET RISK RISK RISK RISK Buy-side changing the composition of credit and liquidity risk Buy side while increasing market risk

Sell side Sell side de-risking across all risk types

Exchanges & IDBs

CCPs Increasing operational Growth in liquidity and credit risk at (I)CSDs risk at market CCPs, (I)CSDs and Custodians infrastructures Custodians

Data & technology providers & 3rd parties Market-wide Operational Shifting credit and liquidity risk (aggregate impact) risk increasing

Source: Oliver Wyman analysis

Copyright © 2014 Oliver Wyman 17 Sell-side Exchanges will experience increased flow, and therefore increased risk, due to a move The overall trend for the sell-side is one of to standard execution and introduction of de-risking: actively e.g. via clearing; and initial margin for un-cleared OTC derivatives. passively, as certain activities move to Additionally as they expand their business, e.g. alternate providers. exchanges purchase of index companies and dark pools relocation to neutral venues, they The introduction of central clearing and margin will experience new operational risks. Spikes in requirements for bilateral OTC derivatives outages will remain the largest operational risk will result in a decrease of both credit and while the effects of these outages will rise with liquidity risk. The sell-side can further reduce greater interconnectivity. risk profiles as well as associated capital and funding costs, through clearing and CCPs will experience increased volumes margining of products beyond requirements as demand for cleared products increases, (e.g. securities lending and repo, derivative which will in turn increase the quantum of risk exposures with exempt counterparties) and residing in the CCPs (though margin held and optimizing netting across counterparties own resources committed should increase in and venues. proportion). Additionally, as new contracts are offered for clearing and phased into use, Additionally, outsourcing of standard back risk will increase though with some mitigation office functions will help reduce operational through netting benefits. Expansion of risk for the sell-side, though potential services into OTC and bilateral margining will expansion into new areas of the value chain also introduce new forms of risk, although this may also create new operational risks. Vendor is likely to be operational rather than financial relationships, including outsourcing, will unless regulators accept multi-lateral netting become a more important dimension of risk solutions for bilaterally margined trades. management for the sell-side, as integral Further expansion into collateral management services move out of their direct control. more broadly, e.g. data & analysis and safe Appropriate risk assessments of vendors and keeping, will add new operational risk. resolution protocols to mitigate e.g. reverse migration risk will be essential. One concern for CCP risk relates to a potential “collateral crunch”. This could lead to pressure on CCPs to widen collateral eligibility, in turn Market Infrastructure increasing risk if newly accepted instruments have a higher margin period of risk or greater Market infrastructure providers will take on likelihood of default. Another outcome of more risk, and in turn come under increased such a “collateral crunch” could be greater scrutiny from regulators around the globe. homogeneity of collateral eligibility and The expansion of individual actors’ business haircuts to allow easier movement of collateral activities is adding more complexity as they between CCPs, which would lead to increased combine several business lines “under one market and liquidity risk as well as increased roof”, some with bank-type footprint, other risk of systemic failure. focused around processing.

Copyright © 2014 Oliver Wyman 18 (I)CSDs will expand their service offering •• Clarifying risk governance and the three into areas that expose them to new intraday lines of defense across the organization credit and liquidity risk, in direct competition •• Upgrading and further institutionalizing with custodians. (I)CSDs are also looking to risk management functions expand across securities servicing and data •• Launching other initiatives in areas like risk & analytics which will lead to an increase in culture, reporting and infrastructure. their operational risk. Furthermore, growing complexity in collateral management will However, overall more work is required to also lead to new operational risk. A prime ensure risk frameworks are fit for purpose example of this is intermediating solutions for in order to accept more risk. Should these collateral allocation which are becoming more improvements fail to occur, there will likely be sophisticated and with wider scope in terms of limitations to potential growth as the sell-side participants and regional coverage. and end-clients rationalize their exposure to certain institutions; for example, diversifying Custodians’ attempt to build clearing services relationships across multiple providers, or will expose them to new financial risks and operating through a capitalized intermediary also require new commitments of capital as with clearing brokers. against this. Additionally their expansion into collateral management and exchange venues will add new operational risk. These Data and technology providers new opportunities will only be accessible to and other third parties the largest firms who will also experience increased flow as the industry consolidates. Third party services are becoming increasingly The largest custodians are also entering important within the capital markets ecosystem the (I)CSD space in Europe, which reflects resulting in increasing demand and risk. Third this trend of consolidation, and will also parties are looking to expand into new areas of increase risk through interconnectedness. the value chain, e.g. execution venues, which will both expose them to new operational risks These actors need to put the right processes and increase their systemic importance. in place to properly understand, mitigate and control new risks. The most sophisticated Third parties are currently unregulated and players have started upgrading their risk and therefore risk management practices are compliance functions across the board: typically less robust than those of regulated entities such as banks and CCPs. As their •• Defining and formalizing risk strategy and systemic importance increases, e.g. as data appetite linked to business strategies providers for KYC authentication and as •• Developing more advanced frameworks execution venues, further scrutiny will be to measure, monitor and track all relevant placed on them. Third party providers need to key risks ensure that they and the industry have robust •• Institutionalizing risk management processes in place to prove that they are able processes with stress-testing and war- to effectively self-regulate. gaming becoming a key management tool

Copyright © 2014 Oliver Wyman 19 Buy-side frameworks. Securities lenders in this case will need to evaluate their counterparty Similar to the sell-side, the buy-side has an risk and mitigants such as haircut levels. opportunity to mitigate risks by increasing Heterogeneity of risk management amongst the use of CCPs and collateral management. the buy-side will also become an increasing This will also come with some increased concern as providers devolve risk to them. Risk operational complexities and risks, for example management platforms are typically white- liquidity implications in the event of CCP labelled solutions and therefore susceptible failure. Such issues are prompting the buy- to similar risks across participants, which will side to explore solutions such as segregated need to change. accounts. However, a more proactive stance on understanding credit exposure to both In summary, historically significant attention clearing brokers and CCPs will be required, and resources have been deployed to manage and the implications of an operational failure traditional risks of the sell-side (market, credit); by one of those parties. risk management now needs to rapidly evolve and adapt (revised controls, monitoring The buy-side is also becoming more exposed systems, frameworks etc.) to fit the new risk to each other as agency models take hold. profiles across the industry. The sell-side needs For example, off-balance sheet tri-party to focus more on operational risk whereas repo makes collateral lenders and borrowers part of sell-side credit and liquidity risk shifts counterparties to each other rather than the to market infrastructure providers (CCPs, (I) agent bank, which is likely better capitalized CSDs) nuancing their traditional risk profile and with more robust risk management (focused around operational risk).

Global systemically important banks have been developing Market infrastructure providers can learn from the experience and submitting recovery & resolution plans to global that banks have had recently in the development of their regulators for some time now. The amount of resources being respective recovery & resolution plans. Notably, separability invested in these stress environment planning exercises are and sustainability of critical operations and alignment with staggering. In spite of vast investments, banks still have more existing stress testing processes are likely to be flashpoints. work ahead. Moreover, regulators have increasingly placed greater emphasis on quantitative support underlying bank’s plans, In contrast, market infrastructure providers, in the absence particularly around the quantification of the impact of stress of clearly articulated regulatory guidance and deadlines events, recovery actions, and resolution strategies. It is in many cases, have taken a slower and more deliberate reasonable to expect that these expectations will find their approach to recovery & resolution planning, with many way to the non-bank financial sector in short order. large institutions still working toward their first recovery plan submission. Given the systemic importance of many A best practice recovery plan for market infrastructure market infrastructure providers, particularly when there is no providers is similar in structure to the frequently discussed direct substitute for services provided, market participants recovery plans of G-SIFIs, though their contents will need to can and should expect additional regulatory scrutiny in this be tailored to the specific infrastructure risk profiles. Six core area over the coming years, particularly as regulators shift elements to be included in a market infrastructure provider’s their attention from the banking to non-banking financial plan are as follows: sector. While market infrastructure providers performed admirably through the recent financial crisis, high-profile 1. Critical services: Identification of services whose failure events have raised public awareness around the operational would have a material negative impact on third parties and risks that market infrastructure providers face both from their jeopardize financial stability. exposure to participants and from the complexity of their 2. Stress scenarios: Identification of idiosyncratic and own infrastructure. systemic stress scenarios that would prevent the infrastructure company from providing critical services. In A common view held is that resolution is not a viable option addition to covering the company’s risk profile, this should for many large, systemically important market infrastructure include the risk of third party failure to perform critical providers. However, regulators have repeatedly stressed functions. As outlined above, the stress scenarios should the fact that they will not allow “too big to fail” institutions be linked to the company’s stress testing procedures. to continue in their current form and that both bank and non-bank financial institutions will require credible plans for 3. Triggers: Definition of qualitative and quantitative their recovery and, if needed, orderly wind-down, that do not measures and thresholds, whose breach triggers recovery. contemplate extraordinary government support. Unlike their Outline of escalation process once triggers are breached bank counterparts that must lead development of both their and description of the governance structure for ongoing recovery & resolution plans, market infrastructure providers, plan maintenance. in most cases, are expected to lead recovery planning with 4. Recovery tools: Identification of appropriate recovery regulators driving resolution. tools, differentiated by scenario type. Articulation of As market infrastructure providers continue to expand necessary steps and time needed to implement them. across the value chain (e.g. by pursuing exchange/CCP/CSD 5. Tool to address structural weaknesses: Tools to vertical integration and new businesses such as collateral address underlying cause of stress and strategic analysis management), the recovery & resolution planning process will identifying structural weaknesses and determining value not only become more complex, but also more important. and marketability of businesses for disposal.

While final regulatory guidance and requirements will likely 6. Market Infrastructure links: Identification of financial vary by jurisdiction, it is broadly expected that the required exposures between infrastructure providers to coordinate core elements of a market infrastructure recovery plan will relevant aspects of recovery plans. follow those articulated in the CPSS-IOSCO consultative report issued in August 2013 on the Recovery of Financial Market Infrastructure.

Copyright © 2014 Oliver Wyman 21 Section 3 Who is positioned to meet the industry’s wide-ranging needs in 2020 and beyond? In response to the changes occurring in client interface are most in demand. Market the value chain, providers are already infrastructure providers have focused exploring new opportunities and building on sectors demanding bespoke market new capabilities, products and services to structures, operational scale and efficiency. seize them. These are in varying stages of development, driven by how visible and certain However, the overall trend in the industry the corresponding opportunities are. is one of actors attempting to extend their participation in the value chain, building out Traditionally, each actor in the market has from their traditional areas of focus. (I)CSDs, focused on a core business which is well suited for instance, are moving into asset servicing, to their characteristics. Banks, for example, whilst custodians encroach on the territory have concentrated on areas where principal of the (I)CSDs and exchanges. This will result risk, regulatory status, and a combined in established actors coming under pressure

Exhibit 9: Impact of market forces on capital markets value chain

ACTORS DATA & TECHNOLOGY PROVIDERS EXCHANGES & OTHER VALUE CHAIN SELL-SIDE & IDBS CCPs (I)CSDs CUSTODIANS 3RD PARTIES BUY-SIDE

Client Coverage

Commissions 5 8

Execution Risk premiums 9 Financing

Clearing 6

Settlement

Securities 1 Custody services Collateral management 4 7 Post trade data and analytics 2 3

Core model Emerging model

1 Building out front to back capabilities in push for 5 Custodians with some electronic execution and clearing – vertical integration 6 looking to build out for front-to-back capability

2 Market infrastructure providers expanding into data, 7 Custodians layering collateral management over 3 analytics and technology existing model, e.g. tri-party repo sourcing

4 (I)CSDs expanding into asset servicing and building out 8 Development of execution venues by data and collateral management solutions technology providers 9 Buy-side taking greater role in own clearing Source: Oliver Wyman analysis

Copyright © 2014 Oliver Wyman 23 from new entrants. However, the competitive Historically, success has been delivered by landscape varies greatly between different client network, pricing power, connectivity layers of the value chain, and the success and specialization, as evidenced by the relative of these growth initiatives will depend on size of the sell-side compared to market whether they possess the attributes required infrastructure providers. However, success in each layer to bring products and services under the new paradigm will require a different to market. set of capabilities, including cost efficiency, use of technology, consolidation of flow, and The characteristics needed to successfully ecosystem relationships. deliver propositions to market are changing: The over-riding theme for these capabilities •• Balance-sheet, and the ability to take and is operational excellence. A winning model manage market and credit risk is becoming will operate from a low variable cost base, critical in a narrower spectrum of areas, likely driven by a strong technological toolkit, particularly in the OTC clearing and and connect seamlessly into the market settlement and custody spaces across regions and participants. In a number •• It is becoming more important to be able to of areas, the ability of providers to offer attract sufficient liquidity, and to efficiently users a consolidated view across otherwise price and match the corresponding flow fragmented markets and business lines will •• The ability to develop innovative be invaluable. For example, agency matching technology solutions (and commit becomes more efficient as the share of market resources to doing so) and the increases; collateral optimization improves as ability to effectively deploy them are diversification benefits increase and collateral becoming more important as the role of can move more easily. technology grows •• Demand for neutrality of providers (e.g. While technology has long been considered separation of risk-taking from market a driver of success, the way in which it is operation) is growing as scrutiny around developed and deployed is shifting. In the case conduct, transparency and conflicts of of software, the banks’ arms race has been interest have increased duplicative and costly. In the future, success •• Firms need to be agile, able to rapidly will likely be driven by banks operating as respond to changes in market structure excellent users of 3rd party software. This •• There is a need to be open to new raises a broader success factor of managing collaborations and partnership models vendor relationships, ensuring appropriate across traditional boundaries. performance management and quality control, as well as mitigating risk (e.g. migration/ With buy-side investors driving flow and reverse migration). therefore revenues, success is dependent on who best delivers the markets to these users. The areas into which providers are building However, we see several changes of emphasis their businesses are not consistently aligned on which characteristics are most important to with the areas in which they are most achieve this, with alternate factors becoming advantaged. In some cases, providers will need the fundamental differentiators between to adapt in order to succeed. Moreover, they winners and losers. will find themselves in competition with other providers who are better suited to successfully delivering solutions in that space.

ACTORS DATA & MARKET INFRASTRUCTURE TECHNOLOGY PROVIDERS EXCHANGES & OTHER VALUE CHAIN SELL-SIDE & IDBS CCPs (I)CSDs CUSTODIANS 3RD PARTIES BUY-SIDE

Client Coverage

Commissions

Execution Risk premiums

Financing

Clearing

Settlement

Securities Custody services Collateral management Post trade data and analytics

Core model Emerging model Able to enter with minimal adjustments to business Adjustments to business needed to enter Major adjustments to business needed to enter Source: Oliver Wyman analysis

Of the sectors which are open and accessible •• Areas where infrastructures and third to new entrants, some stand out as offering parties can offer enhanced transparency advantages over incumbent providers: and so negate information advantage. •• Areas where market infrastructure providers Traditional players will come under pressure will be able to act more efficiently and from new entrants moving across the value independently of other business interests in chain. ICSDs, and some large CSDs for instance, the medium-term are expanding into asset servicing, altering •• Areas where buy-in from regulators is likely their relationships with CCPs and custodians. due to systemic risk and/or importance and However, whilst (I)CSDs are well equipped for neutrality considerations this move, investment banks would require •• Areas where market infrastructure adjustments in order to move into collateral providers and their clients can easily form management services. Across the system the new ventures without near term conflicts opportunities for repositioning are determined of interests by the characteristics of each actor:

Copyright © 2014 Oliver Wyman 25 Sell-side development and focus on successful implementation of systems. This presents Two key characteristics make the sell-side a host of new challenges, including how to secure in their core markets. The first and control and integrate these systems, as well foremost is their role as principal risk takers, as how to assess their performance. Beyond whether market-based or credit-based. This is technology, the sell-side will outsource a inherent in roles such as market-maker, lender range of middle and back-office functions that or clearing broker. The second key strength provide little differentiation; KYC for example. is their centricity to clients’ interaction with capital markets, whether from the perspective With proposals to unbundle research from of idea generation, accessing markets, or commissions pricing, research groups will providing financing. When clients have increasingly have to justify their own value complex needs, they will often turn to the proposition. We therefore see the potential for sell-side in the first instance due to their ability consolidation in equity research as boutique to offer bespoke solutions based around risk- dealers lack the resources to support top taking and/or financing. The advantage of research groups. being the incumbent relationship should not be under-estimated. For data & analytics, the sell-side will continue to play a fundamental role, but with a focus On the other hand, the sell-side is constrained on individual, sophisticated insights for in other parts of the value chain. While users’ clients rather than market data. This will demands for data & analytics are growing, likely center on their execution expertise, banks’ traditional role as providers of this e.g. pricing, forecasts, and risk assessment. information is diminishing due to their partial As execution becomes transparent and view of the market. This is exacerbated by the commoditized, dealers will have to become reluctance of more sophisticated clients to more innovative and leverage data assets to offer full visibility of their positions and activity create a competitive edge in pricing. We also to a potentially conflicted party. expect retardation in some of the instances of “reintegration”, e.g. closer ties or acquisition of Consequently, we expect banks will focus on post-trade entities. de-risking and preserving client relationships, and therefore protecting returns. For example, we see banks withdrawing significant financial Exchanges resource capacity (RWAs, balance sheet) from fixed income, and exploring business models Exchanges have a key role providing high that can increase the velocity and productivity quality reference prices for “lit” (as opposed of their balance sheet (e.g. agency models, to “dark”) markets in a neutral setting. Many automated trading) while maintaining the exchanges have the ability to gather and capabilities required to continue to serve their monetize data, though this is dependent on clients. Principal risk will continue to migrate the degree to which liquidity for their target out of the sell side, due to the punitive costs, instruments is fragmented. Attracting a large creating the potential for equipped buy side share of flow is vital for obtaining a full view groups to fill the void. of the target market. Whilst many exchanges deliver data sets to exchange members, The sell-side’s approach to technology will exploitation of this data more widely is limited change significantly in the coming years. currently. We expect new solutions to emerge Instead of developing increasingly complex in this space in the medium-term, with the systems themselves, banks will outsource virtual consolidation of data across exchanges.

Copyright © 2014 Oliver Wyman 26 Whilst exchanges will continue to play a key monetization of this data occurs today. CCPs role providing reference prices, they may also as owners of margin calculations and haircut further diversify to own dark pools within the levels could potentially play a vital role in the boundaries of regulatory guidance. They will delivery of collateral management solutions be at the forefront of launching new listing and which are dependent on these inputs. We execution venues cross segments leveraging already see CCPs start to prepare accordingly close connections with the surrounding by refining haircut methodologies in a ecosystem. They will also form partnerships first instance. with their clients and potentially third party data providers to create new execution Whilst we do not see the core business of CCPs optimization services cross venue. They will changing, the drive to clear a wider range be increasingly able to extract value from of products will make their role even more the large quantities of data gathered from important. As such, they will require far more trades and transactions on their platforms. robust risk-management systems, including Some exchanges will use their technology recovery & resolution planning to cover either capabilities to create cross-exchange their own default or that of a member firm. data repositories, potentially leveraging cloud solutions. CCPs will also have a key role to play in setting the risk management standards for bilateral margin derivatives and for the use CCPs of collateral across the industry. Banks will require their assistance to set up bilateral CCPs are the beneficiaries of regulatory margining infrastructure. mandates for central clearing. However, their ability to succeed can still be constrained by geographical location, especially given CSDs and ICSDs regulatory balkanization following EMIR, as well as client demand for “over-the-top” (I)CSDs benefit from a perceived products/services they provide with clearing, independence and their ability to form e.g. segregated accounts, collateral eligibility, strong networks. In certain areas this margin optimization. The quality of risk- independence gives them an advantage management practices also drives flow, as over global custodians – for example where clients seek out robust, well-financed CCPs national regulators mandate local custody and to reduce exposure to a potential default. collateral management. EU regulation also Furthermore, there likely exists a natural limit ensures that their core (domestic) settlement to the flow any one CCP can attract, due to business is not under threat. fears of possible concentration risk. In this context, we see a clear trade-off between However, these firms are disadvantaged standardization and customization. Following by a lack of technological agility, a lack of implementation of OTC reform, the industry specific new capabilities and skills and by and particularly regulators will need to review regulation which constrains their ability to the balance that has been struck and whether enter into partnerships. Although (I)CSDs this is consistent with the objectives and spirit only have a backwards view of collateral, they of the regulation. possess extensive data on CCPs, making them well placed for collateral management CCPs also benefit from extensive, live position services, including optimization, re-use data. The value of this again depends on the and transformation. fragmentation of the market, but limited

Copyright © 2014 Oliver Wyman 27 The standardization introduced under T2S may Custodians result in utilitization of (I)CSDs’ core custody and settlement business. However, these Thanks to their central position in the market, firms are likely to diversify to take a network custodians benefit from a strong network aggregator and collateral coordinator role. and an encompassing business model. This will bring the role of (I)CSDs into direct Global custodians have a proven record competition with that of global custodians. of operating complex cross-border, cross- service technology models: a real asset in the The new post-trade landscape will allow new increasingly globalized custody system. entrants to the European market, including the big US players. Larger firms will have an Like (I)CSDs, custodians utilize their opportunity to offer a full suite of securities independence (though sometimes hindered servicing, and data and technology products through nominal association with capital (asset servicing, for instance). markets arm) and holistic view of the market, particularly for collateral management. In the US, we will see further optimization However, they are disadvantaged by a lack of of the established post trade value chain, experience in the market infrastructure layer, as collateral services offer opportunities for as evidenced by their struggle to develop foreign entries and recovery & resolution plans execution venues. Although custodians have trigger a link between the 2–3 systemically strong connections to asset managers in relevant post trade providers. particular, they lack the individual relationships required to generate critical mass for their In Asia, we expect the emergence of an platforms. Those custodian banks with a ICSD-type model at least across smaller capital markets arm will be advantaged in markets, with a view of bringing down the this regard. cost of operation. A similar model could be envisaged in the Middle East, where different There is also a difference between the actors are already reviewing the creation of a capabilities of the global top tier custodians, cross-market master CSD and/or processing and those of the smaller, lower tier, firms. In platform. In some emerging markets, we the clearing sector, for example, large global will see a de-coupling of the CSD from the custodians can penetrate market segments exchange as members and regulators push to that smaller players cannot. These leading reduce systemic risk. firms are also able to offer a Custody+ model (i.e. custody combined with clearing and Both (I)CSDs and custodians may increase collateral management services), which their role as facilitators of corporate actions, increases their value-add. managing elections and market claims, issuing buyer protection instructions, and pre- This does, however, place additional demands financing payments. Which of the two actors on them: Custody+ requires significant will ultimately take this role is unclear and systems investment in order to enable partnerships are likely. timely analysis of clients’ asset positions and margin calls.

Copyright © 2014 Oliver Wyman 28 As the market evolves, we expect global The sell side already outsources many front- custodians are likely to tap aggressively into office systems to third parties; while data post trade market infrastructure territory, providers are also equipped to expand and competing for this space with (I)CSDs. In provide products such as indices. Although the order to differentiate themselves, global organizational efficiency of these firms would tier 1 custodians will offer the wider range of suit a post trade role, we do not see business services included in the Custody + model, and synergies here. will also look to in-source asset servicing in order to reduce their dependence on the local We see the range of services offered by and regional custodians. We may see some technology outsourcing firms increasing movement up the value chain, with custodians greatly by 2020. Some of this expansion providing investment advice, market access will come from providing the middle and and execution capabilities, clearing and data back office systems which have become & analytics. commoditized and outsourced from the sell-side. However, there will also be some Technology-driven capabilities, for example diversification; data & analytics firms are digitalization and data analytics, have the already moving into indices and creating potential to further reshape the business model trading platforms and chat based tools. but are likely to take significant time to evolve. There will be a significant shift in the way Domestic custodians will likely focus on products are delivered. The move to SaaS and developing differentiated value propositions ASP options will continue, with the technology for specific buy-side client groups (e.g. no provider hosting the service and clients frills proposition for local pension funds with accessing it on demand. local service model) or more closely integrate with banks and sell-side stakeholders in order to leverage client relationships and Buy-side offer integrated front-to-back solutions on a local scale. In any case by 2020 we expect As well as being the driver for flow throughout many domestic custodians to have reviewed the system, the buy side is also a major their business model and focused on a source of dormant collateral. This can be model operated at sustainable economics, further released using the enhanced custody either stand-alone or as part of potential model. In addition, hedge funds are able to regional solutions. bridge risk-intermediation and liquidity gaps, taking risk premiums from the sell-side. HFT algorithms can be rented out to help execute Data & technology providers block trades, but this does require an API into and other 3rd parties an exchange to enable use of the system. We expect new membership models will evolve in Sell-side firms are often unable to devote the near term. sufficient resources over the long timescale that is required to develop innovative systems. Demand from the buy-side will be a factor Specialist technology providers, however, have driving change across the system. However, the expertise and the ability to market their there will also be increased opportunity for products to many clients, thereby achieving the buy-side to provide access to its dormant the scale to reduce costs. collateral. Hedge-funds may also take a role as market-makers and we will see buy-side actors continue to take on more principal risk.

Copyright © 2014 Oliver Wyman 29 Due to regulatory changes and the desire communication networks. Finally, we see of the sell-side to reduce risk, certain risk- exchange groups picking up the indices management requirements will be foisted businesses being disposed of by banks. onto the buy-side. Although this places a new burden on these firms, it presents an By 2020 the predicted shifts in value will have opportunity for those who are best able to taken hold, changing the market dynamics. deal with the change. Market infrastructure Going forward, navigation in this space will be providers businesses may also explore how complex for all providers, who can adopt one of they can assist with these demands. a number of medium to long term strategies:

With all these anticipated outcomes, there 1. INTEGRATED END-TO-END PROVISION is the inherent challenge of uncertainty. This is due to future stimuli, such as changing Where providers have a full range of regulation and market conditions, but also capabilities, services are being integrated from depends on how the competitive landscape execution through to settlement and custody, pans out. A key aspect of the latter is the extent providing a one-stop shop for buy-side clients to which firms can overcome the challenges such as investors and hedge funds. This laid out above and ultimately succeed in strategy offers potential revenue and cost areas where they perhaps lack all of the synergies and could be coupled with a scaling requisite capabilities. up strategy (e.g. based on M&A or open To operate in new business sectors where access approach). The client appetite for this adjustments are needed, firms can either approach is, however, as of yet untested. adapt or collaborate. Examples of adaptation may include non-traditional firms securing 2. DEVELOPMENT OF NOVEL SERVICES SEC licenses in order to conduct repo AND PRODUCTS clearing, and global custodians getting CSD Players with an appetite for innovation are licenses. However, there are some sectors developing novel services and products in where adaptation is not enough, and which response to revenue pressure. For instance, can only be exploited through collaboration platforms are being developed that combine between firms. analytics, trading and clearing, and portfolio and data management services for asset Collaboration can take place in any number of owners and managers. However, in certain ways, ranging from commercial relationships industries it may be prudent to be the fastest through to joint ventures and acquisitions. follower, as opposed to the first mover. Examples of this can be found in the technology space. For instance, partnerships 3. OPTIMIZE THE CORE with technology and data analytics firms could allow the sell-side to equip itself to enter the Smaller players are predominantly opting for a collateral management sector. defensive, wait and see approach, but continue to suffer from high cost/income ratios with There is also already evidence of market little opportunity for attracting new revenues. participants using partnerships and Players should focus on client profitability acquisitions to adapt. Recently we have management and core product strengthening seen collaborations between data and to avoid losing market share. Cost reduction technology providers, supported by initiatives, such as outsourcing, lean and banks, to deliver KYC data solutions. productivity management may also need to Additionally, buy-side participants have been be considered. purchasing infrastructure solutions such as

Copyright © 2014 Oliver Wyman 30 The relative merits of these strategies will In light of the change of the past 5 years and be idiosyncratic to providers. However, the the additional shifts expected over the next industry-wide net result of following them 5 years, medium-term planning and strategy will likely be the emergence of new industry are becoming ever more important. All players structures, driven by large processing factories across the sell-side, buy-side and market which are able to provide end-to-end solutions. infrastructure providers need to crystallize the The diversity of established niche providers best opportunities, and decide which role to will enrich this model, and we will see further take in 2020 capital markets and how to adapt evolution over time in service areas which are to succeed. still being “tested” by the market. We expect that regulators will intervene While strategies will vary by provider with proposed solutions in those areas segments, growth rates cannot be the sole where risk is shifting significantly, with a factor for judging winning models. Rather, view of driving mechanisms to stabilize the successful institutions will be those who market. In those areas where capabilities are able to focus on client segments and are scarce or investment requirements are products with the most attractive risk adjusted unachievable, collaborative models should economics, while investing in systems and be explored covering the whole spectrum of capabilities to achieve scale and develop possible models. competitive advantage. Firms will need to align their planning cycles and approaches to the inherent uncertainty in Planning for change the market in terms of regulation, competitor action and macro environment/volatility. In summary, capital markets business Flexible management of innovation and models are changing substantially, creating advanced risk management practices will be opportunities for a broad range of actors essential to succeed. spanning the sell-side, the buy-side and market infrastructure providers. Some of these opportunities are already advanced whereas others are less clear and only just emerging. In a few areas, the industry will consolidate and leave service delivery and risk management to few experts, but in most areas, we expect industry fragmentation will persist, though with a markedly new profile.

ABBREVIATION DEFINITION

API Application programming interface ASP Application service provider CAGR Compound annual growth rate CCP Central counterparty CDS Credit default swap CI Cost to income ratio CSD Central securities depository EMIR European Market Infrastructure Regulation FI Fixed income FX Foreign exchange HFT High-frequency trading HNWI High-net-worth investor ICSD International central securities depository IDB Inter-dealer broker KYC Know-your-customer LIBOR London Interbank Offered Rate MDP Multi-dealer platform MI Market infrastructure MiFID Markets in Financial Instruments Directive OTC Over-the-counter Repo Repurchase agreement SaaS Software as a service SDP Single-dealer platform SEC Securities & Exchange Commission T+1 Transaction date plus 1 day settlement T2S Target 2 Securities

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ABOUT THE AUTHORS Daniela Peterhoff is a Partner Hiten Patel is a Principal in the EMEA Corporate in the Market Infrastructure practice. and Institutional Banking Practice. +41 44 5533 510 +44 20 7852 7816 [email protected] [email protected]

Axel Miller is a Partner in the EMEA Corporate Benjamin Holroyd is an Associate in the EMEA Corporate and Institutional Banking Practice. and Institutional Banking Practice. +49 89 939 49 854 +44 20 7852 7868 [email protected] [email protected]

John Romeo leads the Market Infrastructure practice and is Global Head of Corporate Finance and Advisory. +44 20 7852 7416 [email protected]

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