Balancing the effect of automation on workforce

Balancing the effect of automation on workforce

In the spirit of the recent Brexit discussions, I would like to shed some light on another matter of broader economic and social significance that will have repercussions for the financial services and capital markets in the long run as well. The ever-increasing emphasis on automation and use of artificial intelligence will help companies streamline their operations and economize on scarce resources. But there is a flip side to the coin that is possibly getting sidelined in the rush to 'robotize' the workplace. I am referring to the need to retrain and absorb the  workforce that is getting replaced due to automation. 
There has been some mention in the media recently of the lack of relevant skills in the Spanish workforce at a time when the rate of unemployment is above 20%. Companies are struggling to find workers with the right training. Similarly, in emerging markets such as India and Indonesia, the high rate of population growth and the high proportion of younger people means that there is an urgent requirement for jobs, and before that for the right training to make the youth employable. Spain's example shows that emerging markets cannot take employment creation for granted. The rate at which the population of India is growing means that it needs to create employment at a rate only China has been able to match in human history. China grew on the back of a manufacturing boom over three decades. India is mainly a service economy that is now dealing with the after-effects of the global financial crisis and growing automation. Its struggle to encorage the manufacturing sector and provide employment opportunities has been evident in the last year. Other emerging markets such as Nigeria, Indonesia and Pakistan are in a similar quandry. 
From a financial market point of view, automation obviously has benefits, and Celent has always been a strong advocate of the same. But in the long run, there is a need to provide alternatives to the workforce both in mature and developing economies, without which there would be a dampening effect on economic growth and market performance. Jobless growth can only take us so far.

Moving towards a more stable and healthier OTC derivatives market

Moving towards a more stable and healthier OTC derivatives market

The Bank for International Settlements (BIS) recently reported that there was a decline in the cost of replacing outstanding OTC derivatives, the first since the financial crisis. There was a similar decline in the gross notional amount outstanding as well. While this indicates the tough regulatory regimes worldwide in the aftermath of the crisis, it also a sign of a healthier and more resilient OTC derivatives market. Due to the rising regulation-related costs of trading, market participants are looking to make their OTC derivatives trading more efficient. Tools such as trade compression and collateral optimization are being used for this purpose. So the decline in outstanding is also an indication of more efficient trading due to compression. Another sign of the efforts to reduce systemic risk is the rise in volumes of OTC derivatives that are being centrally cleared. The greater use of clearing houses is something that regulators have been espousing for some time, and an approach that most market participants and observers agree with. Besides the internal factors, external economic ones such as interest rates and exchange rates also explain some of the decline in value of OTC derviatives trading. Again, these are a sign of market fluctuations and do not necessarily represent any market decline. In our view, the BIS numbers are indicative of both the changes that regulators have put in place over the last 7-8 years and of a global economy that is still recovering from the financial crisis and the following economic challenges.

Equity market upheaval in China

Equity market upheaval in China
The recent restrictions being placed by the Chinese government on trading in the Chinese market are creating an artificial barrier to the normal and efficient functioning of the market. The equity market is mainly a reflection of the structural economic underpinnings of the economy. If the economy and the firms in it are doing well, then the stock market would also perform well. If not, then it would be normal to expect a downswing in the market. By focusing on the equity market and not on the economy itself, the Chinese government might be ignoring some of the structural weaknesses in its economy that are creating the downward pressures in the markets. Creating an artificial bubble is normally not in anyone’s interest, although an argument might be made that it has become more de riguer after the spate of quantitive easings and similar regulatory interventions in the aftermath of the financial crisis. Another issue that has been pointed out by some observers is that the weighting and role of Chinese stocks in leading global indices also becomes unrepresentative due to such interventions, and the index managers have to then weigh the balance of having such stocks against the imbalance created by having them in the index. Furthermore there is less incentive for the market participants to pick stocks on the basis of firm and industry performance, since the intervention seems to be keeping up the prices of stocks that would otherwise have been expected to not perform as well. Hence, there are several issues that can arise from such an action and it might be in the interest of Chinese regulators and the markets as a whole to reduce the level of intervention.

Post-trade and the clouds over Europe

Post-trade and the clouds over Europe
Europe has been dealing lately with all the issues around the Greek debt and the possibility of a “Grexit”. While the final decision on the matter would have its significant repercussions, the uncertainty that has come with the problem in the last few months is also expected to have its own associated costs. It could also impact the long-term competitiveness of the region vis-à-vis its competitors in the US and Asia-Pacific. When we focus specifically on the capital market issues. there are several significant regulatory changes happening in the European capital markets at this point in time. EMIR, Mifid II, Basel III, T2S and CSDR are all regulations at various stages of implementation. From a post-trade point of view, several of these regulations are expected to have significant impact, especially when we talk about T2S and CSDR. However, the continuing concern over regulatory implementation in Europe is that the delay and uncertainty over when the regulations come into effect could prove costly for the region overall. An example is the delay by European Securities and Markets Authority (ESMA) in providing the draft technical standards. Similarly, the recent decision by Monte Titoli to delay joining the T2S, at least for a few months has proven to be a setback for the project, considering it was easily the largest CSD to participate in the first phase and would have been instrumental in measuring the effectiveness and success of the implementation. There is a lot of ground that the regulators and industry are trying to cover in an economy that is still suffering from the after-shocks of the financial crisis. While trying to do everything in a hurry isn’t the answer, it is important to ensure that the deadlines are kept as much as possible, otherwise on-going delays will directly impact European market’s competitiveness.

Looking beyond ‘Bondification’

Looking beyond ‘Bondification’
There has been an interesting article in the Financial Times by John Authers on the ‘bondification” of the equity markets, namely the tendency for fund managers to invest in good dividends, low debt and high return on equity. Some of the causes of this phenomenon include the low interest rate regime in many of the mature markets such as the US and the tendency for high risk aversion after the financial crisis. Authers also quotes a move away from traditional finance theory as comparing returns with the risk-free rate does not always work given the issues in defining what a risk-free rate is in the current fixed income market landscape. He also mentions issues fund managers have with risk diversification since it did not seem to work in the financial crisis for commodities or emerging market equities. The author concludes by saying that the bondification of risk might not necessarily be desirable in the long run. I agree broadly with the conclusions of the author but would also like to point out some relevant issues in this context. The first is that the low interest rate environment will not stay forever, hence the market is going to move away from the tendency for bondification and this would benefit both fixed income and equity markets. The fixed income markets would see more activity and the equity markets would be able to get out of the constraints that bondification places on it, including investment into mainly blue chip stocks which would be popular anyway and away from less established or riskier stocks of smaller firms. The second issue is regarding the falling relevance of the investment models, namely the use of the risk-free rate and falling tendency for risk diversification. Just because there was a financial crisis does not mean that financial theory or models become less relevant. The issue was less with the models and more with the practice and issues in the economic, business and political environment. The use of a risk-free rate might still be of relevance, it might just have to be calculated more carefully and using a set of return indicators instead of certain benchmark bonds. Similarly, risk diversification is still as relevant as it was before the crisis. With the lessons from the crisis, our approach can become more sophisticated and complex, but we cannot stop using diversification just because it might have failed in the financial crisis, which was (hopefully) a once in a lifetime phenomenon. It should work as long as there is no crisis of similar proportions.

Operations challenges for APAC asset managers

Operations challenges for APAC asset managers
The global capital markets have been going through a turbulent recovery phase in the last few years. Asia-Pacific is no exception to this rule and the region’s asset managers will come up against a set of operational issues and constraints to be addressed in a difficult market environment. Addressing regulatory pressures, be they from within their own jurisdiction, or from without, will be paramount in the mind of asset managers. It is important for managers to consider the various KYC and AML requirements internationally and how they affect their respective jurisdictions. This is not an isolated enterprise, and must be undertaken along with the task of upgrading the operational capabilities, and if required, acquiring the necessary platforms or systems to address these concerns. As much as possible, asset managers must try and use a comprehensive solution, underlining a desirable holistic approach to the issue. Most asset managers will meet their various operational requirements by using a mix of in-house and third party services. Outsourcing is nothing new to the industry, but can still be challenging. It has its own set of risks which need to be considered and mitigated for successful operations. Firms have to ensure a strong integration of the outsourced services with the in-house operations. Another challenge is the complexity of products being utilized by asset managers to meet their clients’ needs. With more choices available and structured products becoming popular again in leading Asian jurisdictions, firms have to ensure that their risk management systems are capable of handling greater product complexity. These are only some of the issues asset managers need to keep in mind, and overall they would be well served with taking a more holistic approach to operations management, and ensuring they make sufficient investment in their systems to help them handle the various challenges.

Smaller buy side firms and regulation

Smaller buy side firms and regulation
Increased regulation has become a way of life in the financial markets. Buy side firms are also devoting a lot of time and energy to meeting regulatory requirements. The share of expenditure for regulation and compliance has also risen accordingly. Firms are often building their IT strategies around the various requirements arising from Dodd-Frank, MiFID II, FATCA, Basel III, EMIR and so on. In this environment, smaller buy side firms are possibly in a tougher position than some of their larger asset management and hedge fund counterparts. The reason is that they do not have the same financial and technological capability and hence have to often adopt a more piecemeal approach to regulation and compliance. Their IT systems and platforms are also not geared fully to meet these needs, and streamlining the same is often beyond the capacity of many such small firms. An interesting development that has resulted from the spate of regulations post-financial crisis is the reduced participation or even effective withdrawal of the banks from different types of risk-taking activities. This has been accompanied by the effort by buy side firms to fill some of these needs. While this is an important area of opportunity for buy side firms, it is also something they should be cautious about. The reason is that the increase in buy side activity has to some extent moved the sell side risk to the buy side. This is accompanied by some liquidity problems due to the declining sell side activity. While smaller buy side firms are probably affected less by this issue than some of the largest asset managers, nevertheless they need to ensure their risk management systems are capable of bearing any new and additional stresses that the larger systemic role of the buy side might bring. Celent is currently conducting a lot of research looking at the various requirements of buy side firms, and I am about to publish a report that discusses the specific needs of smaller buy side firms when it comes to regulation. This research would also look at some of the ways in which these firms can cope with their pressing demands, and discusses how it is important for them to stand back and take a more holistic approach to regulation.

Utility Model in Capital Markets

Utility Model in Capital Markets
In the aftermath of the financial crisis, the regulatory environment has undergone rapid changes and is still evolving, creating additional obligations for financial institutions, particularly in the areas of risk management, reporting and regulatory compliance. Since many of financial institutions have to make same, or similar, changes to their processes and systems due to new regulations, many of them are looking to “mutualize” the costs – an arrangement where an independent third party provides the technology and services that banks can in turn use on pay per usage basis. This is giving rise to a new utility type of offering that is a step in the outsourcing value chain. As a consequence of these changes we have observed in last 6-12 months the emergence of shared service-utility mode of offering which is a highly standardized type of offering built by a third party provider and offered to financial institutions on a pay-per use basis. Often these solutions were conceived in direct response to the user communities’ expressed needs for them. Not surprisingly therefore some of the ones being launched in the market are by bank owned or bank backed institutions and have had active involvement of many banks in their design and development processes. One area that has seen a number of solutions emerge under the utility-shared service model is the know-your-customer (KYC), client on-boarding space. The current practices in managing KYC, on boarding operations are complex and redundant requiring every customer to exchange information with every financial institution they deal with. The utility model on the other hand envisages gathering all customer information at a single space that can in turn be shared with financial institutions. A recent Celent report discusses the drivers behind the emergence of the utility model and studies four solutions in the KYC, on-boarding space that have been or will soon be launched under the shared service-utility model, including SWIFT KYC Registry, Thomson Reuters Accelus Org ID, Clarient Entity Hub (by DTCC and 6 co-founding banks), and Markit | Genpact KYC Services.

Big Banks’ exodus from Commodities

Big Banks’ exodus from Commodities
Goldman Sachs, Morgan Stanley, Barclays and JP Morgan used to be the biggest traders of commodity among banks. However, this space has witnessed many of the big banks exiting the business line in recent times. JPMorgan recently decided to exit physical commodities trading business by selling its raw-materials trading unit to Mercuria Energy Group Ltd. Morgan Stanley decided to sell its physical oil business to Russia’s Rosneft. Barclays decided to exit some of its commodities business. Deutsche Bank said it would exit dedicated energy, agriculture, dry-bulk and industrial-metals trading. Bank of America Corp. said it would dispose of its European power and gas inventory. UBS decided to shrink its commodities business sharply. Goldman began a process to sell part of its physical trading operations. This retreat of the big banks from commodity business has been driven by tighter regulation, stricter capital requirements, increasing political pressure and lower profitability in recent times. Key regulations impacting banks in commodity trading include Basel III, Dodd-Frank, and the Volcker Rule. Rules brought in to address the financial crisis of 2008 (Basel III, Dodd Frank) require banks to hold more capital than in the past against trading operations, which has made holding commodities more expensive for the banks. New charge for credit valuation adjustment (CVA) – which requires higher charge for longer dated trades with lower rated counterparties – is likely to have significant impact on hedging practices of longer dated trades. Further, regulators are pushing for over the counter trades to the public exchanges, which is likely to significantly reduce profitability of such trades for the banks. Volcker rule, aimed at banning banks from trading with their own capital, is another catalyst in this regard. Anticipating this rule many banks have already scaled back or spun off their proprietary trading desks. Politicians have also exerted pressure on banks to cut back their commodities business. Regulators and some senators have expressed concerns about banks being in the business of natural resources. This has been largely prompted by events like Deepwater Horizon oil spill, complains from other industries and associated media coverage. Policy makers are now seeking comment and exploring ways to limit banks’ role in trading of commodities.The U.S. Federal Reserve is considering new limits on trading and warehousing of physical commodities. Policy makers suspect that there are conflicts of interest when the same entity is involved in the physical market and also in trading derivatives on the same underlying. Commodity Futures Trading Commissions (CFTC) is investigating the effect banks are having in the commodities markets, as it has been argued that banks played a major role in the rising commodity prices, including that of agro-prices, in the latter part of the last decade. Lacklustre market conditions are another driver behind many banks’ decision to shrink or wind up their commodity business. While regulatory burdens have added to cost side of the business, less volatility in commodity prices have hit top line. Combination of these factors has resulted in lower revenue from the business. Industry estimates suggest commodity-trading revenue for the ten biggest banks shrunk by over 67% in 2013 compared to peak levels attained in 2008. This trend of falling revenues holds good for not only the commodity business, but also to the FICC (Fixed income, currency and commodity) segment in general. Forced by this, some banks are shrinking or winding up their Fixed Income business as well. These developments are making commodity trading an inefficient use of capital at a time when other markets, such as equities, are showing signs of recovery.

Safe heavens and investment hells

Safe heavens and investment hells
Reported through the Wall Street Journal yesterday, the Germans have issued a bond (a German treasury note known as Schatz) with a zero coupon. This is unprecedented in some ways. What it says is that investors are so desperate that they are willing to forfeit any yield for the privilege of parking their funds for two years in what they see as safe assets, as the escalating debt crisis in the euro zone continue to play out in contagious and unpredictable ways. What’s driving demand? Between insurance companies and pension funds that offer products with ‘guaranteed returns’ or conservative fund portfolios that place an emphasis on value preservation; financial institutions hunting for sources of liquid, high quality collateral for regulatory purposes, repo and OTC derivative markets; and CCPs demanding more stringent margin requirements, one can expect this race to compete for a share of acceptable safe assets to grow. Investors that have been burned over the past few years are saying capital preservation remains a paramount objective for them. For me, financial markets are so dislocated at the moment that perceived “safe havens” are elevated to “safe heavens” by investors in their flight to safety, whilst distressed entities/sovereigns are condemned to investment hell (so to speak). However, such polarization between the two extremes of ‘elevated heavens’ and “investment hells” perhaps point to me that the market is running out of options for safe assets. It also begs the question of whether this is an illusion that is too good to be true. At the moment, not even favored safe haven assets such as gold, investment grade government and corporate debt, and covered bonds are necessarily immune to the shaking that is rippling through the markets. In this instance of German treasuries, zero yields in theory means that it is completely ‘risk free’, for which there is no such thing, not in terms of absolute safety anyway. Germany may be the strongest economy in the Eurozone but contagion effects are difficult to predict. There are a few points of caution here: First, the growing concentration of capital flows into these perceived safe assets is in itself a risk and (arguably) creates a bubble effect. Secondly, the polarization dynamic between the haves and have nots create large imbalances that will amplify structural volatility. Thirdly, current (and emerging) regulatory regimes like Basel 3, Solvency 2 and Dodd Frank/central clearing are almost, in tandem, sucking in and ‘consuming’ safe assets. It creates a backdrop for these effects to continue. Is this an unintended consequence that we do not want or need in the longer term?