In this final chapter we aim to provide an outlook for the capital markets industry. We live in times of unprecedented change and uncertainty; hence, instead of applying the crystal ball approach, we

• Review the state of the financial system, noting that banks have become safer but that some risks may have shifted into capital markets (section 1).
• Review the impact of potentially unintended consequences of regulation (section 2).
• Conclude with a view that the industry needs to reinvent itself and provide perspectives on how Blockchain could be part of that journey (section 3).

SECTION 1: SAFER BANKS, BUT IS THE FINANCIAL SYSTEM SAFER?

As a result of a wave of regulation after the crisis and significant management action, banks have now become safer. Leverage ratios are down, capitalization levels are up, funding is more stable, and banks hold a higher share of highly liquid assets. Regulators, via stress tests such as CCAR in the United States, also have a much better understanding of the risks banks take and have built a much more strategic regulatory dialogue.

Yet there are some offsetting effects of shifts of risk to the capital markets. Factors like a higher share of electronic trading and more centralized clearing have increased overall operational risks and asset owners have absorbed a much higher share of liquidity and credit risk, as shown in Figure 33.1.

Recent regulatory initiatives have impacted broker‐dealers' ability to act as risk taker—both from a principal investments and a market‐making perspective. Hence we may have started to observe what one day may be called the demise of the risk taker. A risk taker is a party that purchases a good with the hope that it will become more valuable at a future date (for example, a ticket broker). In the context of the capital markets, risk‐taking involves the practice of engaging in financial transactions in an attempt to profit from fluctuations in the market value of a financial instrument. While risk‐taking maintains a negative connotation (i.e., a scalper of sports tickets, or a trader irresponsibly assuming excessive risk), risk‐taking serves a vital purpose in the markets. Particularly in times of market stress, clients still primarily look to broker‐dealers to act on a principal basis (i.e., risk taker) in order to source liquidity.

The paradox of transparency has also contributed to a more challenging environment for broker‐dealers. What do we mean by the paradox of transparency in the context of the capital markets? Simply put, transparency involves giving market participants access to financial information, including price levels, market depth, and financial reports. Although it's hard to argue against transparency, a prerequisite of free and efficient markets that creates a level playing field, there is a subtle but negative aspect to it where the risk–reward equation is asymmetrical and traders may be discouraged from committing capital (i.e., taking risk) if the profit upside is restricted. The debate is best reflected in the discussion of Finra's TRACE reporting requirement, which undoubtedly makes the market more transparent, but (as many broker‐dealers have argued) makes it more difficult for them to recycle risk back into the market within the reporting time windows. There is likely to be an optimal point for market liquidity between the spectrum of complete transparency (and hence limited risk‐taking) and a full principal risk‐taking model (and hence a world with more information arbitrage opportunities).

These changes have had an impact on liquidity in secondary fixed‐income markets. While liquidity levels prior to the global financial crisis may have been inflated, most market participants find the current market a more difficult one to source liquidity in, particularly in a stressed environment.

In light of new (FinTech) providers looking to provide solutions to this liquidity challenge, a spirited debate rages on the role of all‐to‐all platforms in the future of the fixed‐income marketplace. The role of the broker‐dealer and hence the principal‐based trading model was always driven by the lack of immediate coincidence of wants between potential buyers and sellers of a bond. Various large corporates have thousands of bonds outstanding, which compares to typically one or a few types of stock (equity). Hence equities markets lend themselves toward a trading model of a centralized limited order book, whereas this is not the case in fixed income, driven by the diversity of the market.

At the more liquid end we have seen successful marketplace solutions gaining traction. We also observe FinTech solutions looking to tackle the underlying information problem (“Who owns the bonds that I look to buy?”). In combination these solutions are likely to have a positive impact on secondary market liquidity. However, this does not yet mean we will end up in an all‐to‐all world. The buy‐side has traditionally played a price‐taker role, and it requires significant change and investments (and in some markets change in regulations) to become a price‐maker. A full shift to an all‐to‐all model would also have significant implications on the middle and back office, as, for example, pension funds and asset managers currently don't have the ISDA (International Swaps and Derivatives Association) agreements and risk/compliance management capabilities in place to directly trade with each other without intermediation by a broker‐dealer.

There are also factors such as streamlining of the trading process (typically called robo‐bidding or automated principal models), and enhancing liquidity discovery through artificial intelligence. While the use of technology will not solve all trading and liquidity issues, it is clear that such innovation will be pivotal in driving efficiency, reducing risk, and enhancing returns.

However, in the short term, as a result of these changes in liquidity and reflecting the shifting risks in the industry, regulators are now increasingly shifting their focus to the buy‐side. The U.S. SEC alone has launched a broad range of initiatives including topics such as liquidity risk management, derivatives, data reporting, and transition planning. Also the FSB recently launched a consultation process in its publication, “Structural Vulnerabilities of Asset Management.” These initiatives all look to address the growing regulatory concern with regard to these shifting risks. It will be critical to address these concerns while at the same time ensuring that regulation that was invented for banks deploying their own balance sheets is sufficiently customized to the asset management industry, which typically acts on an agency/fiduciary basis.

SECTION 2: ARE THERE ANY UNINTENDED IMPLICATIONS OF RECENT REGULATION?

Much has been written about the consequences of post‐crisis regulation. As argued earlier in this chapter, banks have become safer and their ability to act as risk taker has been reduced. The impact on reduced secondary market liquidity has frequently been cited as an unintended implication of regulation, although we would argue that regulators were very well aware of this likely implication.

Regulations have also largely erased products with inherent opacity and, on the back of that, simple solutions have flourished. What these solutions have in common is their simplicity and responsiveness to customer needs, whether attempting to extract the FX volatility from depository receipts or enabling a retail investor to take efficient physical delivery of gold. There is also an opportunity for new financial instruments to manage certain risks such as one that might solve for the risk of rising medical care. For example, a market for the medical component of the CPI might make sense. Another example would be a market instrument linked to house prices that would allow for insurance against declines in house prices or allow people who are not yet able to afford to buy their own property to get exposure to the market and hence hedge against rising house prices.¹

Regulation has also forced previously more opaque markets such as the interest rate swap and options markets, which were historically transacting through bilateral agreements, to migrate to central clearing solutions such as swap execution facilities. Prices are now more transparent, and both credit exposure (counterparty risk) and contagion risk have been mitigated. The accessibility, transparency, and reforms initiated after the LIBOR and ISDA Fix scandals have bolstered confidence in the swaps markets and made them an integral and growing segment of the capital markets.

Yet there may be a few examples where regulation, in many cases in combination with macroeconomic developments, have had unintended consequences. We would highlight two in particular: the challenge of cash management and an emerging financing challenge for the real economy.

Managing cash for both investors and corporates used to be among the simplest activities. Banks were typically keen to get clients' deposits and money market funds and offered a capital markets alternative. Today there is a convergence of events occurring in the cash space that may result in hundreds of billions of dollars moving from certain short‐term investment products to others.

The liquidity coverage ratio (LCR), the net stable funding ratio (NSFR), and the supplementary leverage ratio (SLR) are impacting how banks manage their balance sheets. The LCR is a stress test that requires large banks to hold a certain amount of high‐quality liquid assets (HQLAs) to offset outflows that could occur in a stressed environment over a 30‐day period. HQLAs are typically low‐yielding. As a result, banks are closely monitoring the amount of HQLAs they need to hold. Overnight deposits (as well as deposits with tenors of 30 days and less) are included as outflows subject to certain factors under the LCR. Consequently, banks will not value overnight and short‐term deposits as highly as they historically would have, resulting in comparatively lower rates being paid for these deposits. In addition, the SLR is a new capital ratio that requires compliance in 2018, but has begun to be reported by the large banks in 2015. It will likely result in large banks decreasing or at least closely monitoring their asset base, and consequently their deposit levels. As a result, banks may be pushing certain depositors to invest in off‐balance‐sheet vehicles such as money market funds.

Yet at the same time, money market reform in the United States is causing many clients to reexamine their investments into prime and tax‐exempt funds. Institutional prime and tax‐exempt money market funds will become floating‐NAV vehicles in October 2016 and will require the ability to impose redemption fees and/or bring down gates preventing any withdrawal activity should the funds' seven‐day liquidity levels fall below 30%. Many money market fund investors utilize the vehicles for cash that they may need immediately in an emergency situation. As a result, the possibility of a gate coming down, limiting their ability to access that cash, or a fee being imposed, causing them a loss upon redemption, may make prime and tax‐exempt money market funds less attractive to these investors and cause them to reduce or eliminate their positions in these funds. In addition, the concept of a floating NAV, resulting in a potential principal loss in a money market fund, may also give some investors pause, resulting in withdrawal activity from institutional prime/tax‐exempt money market funds. Due to these changes, and their expected impact on the attractiveness of these funds to certain investors, there is currently an expectation that a large amount of balances will be withdrawn from them between now and end of 2016. No one knows exactly what that amount will be, or where the balances will go (though much of it is expected to be moved to U.S. Treasury/government money market funds, as floating NAVs will not be a requirement imposed on these funds, and fees/gates are optional), but it is estimated that hundreds of billions of dollars will be in flight as a result of these changes.

All of this is happening at a time when short‐term rates are expected to increase in USD, and we expect to see dormant clients reexamining their liquidity options as product yields begin to differentiate more. In summary, this may lead to hundreds of billions of dollars moving quickly across the system, which may have systemic implications that have not yet been fully analyzed and understood.

The second potentially unintended implication of regulation may be a negative impact on the real economy. As secondary market liquidity in fixed‐income instruments is increasingly concentrated in a few sectors, large issuers, and on‐the‐run securities, it may become much more difficult for midmarket corporates to access capital markets, particularly as broker‐dealers are also forced to reduce their research capacity given the lower level of client flows they experience and their reduced capacity to take risks, which both negatively impact their revenue outlook. This is likely to be of particular concern in Europe, where the Capital Markets Union (CMU) was intended to accelerate the development of the capital markets and bring it closer to the depth and breadth observed in the U.S. markets.

In that context it is worth noting that while securitized products, in particular U.S. subprime mortgages with poor structures and low‐quality assets, were at the heart of the financial crisis, they play a significant role in ultimately providing financing to the real economy as they improve banks' balance sheet turnover and create investment opportunities. These products have advantages such as being generally flexible; they can be tailored to meet investor preferences for ratings, credit risk, prepayment risk, and liquidity, as well as preferences for fixed‐ or floating‐rate bonds, short‐, medium‐, or long‐term maturities, fixed payments or adjustable payments, and amortizing principal payments or bullet principal payments. While the market came to a virtual stop during the financial crisis, in subsequent years, most securitized markets in the United States have recovered with the exception of some formerly prominent markets such as non‐agency MBSs and CDOs. The Fundamental Review of the Trading Book (FRTB) will now further negatively impact broker‐dealers' economics in structured products, but we believe that revitalizing these markets further, particularly in Europe, will be critical to ensure sustained financing for the real economy.

SECTION 3: A NEED FOR REINVENTION

The pace of change in the capital markets industry will likely remain unprecedented for a while. As we have shown in this chapter, various fundamental forces are in play and they haven't found a new equilibrium yet.

Many of the trends we have outlined put the broader role of broker‐dealers into question. They have historically run an integrated model, providing the “3Cs” to their clients: content, connectivity to markets, and capital provision. The relative competitive advantage differs across the various product categories as shown in Figure 33.2.

Many of the traditional sources of competitive advantage are now under threat, creating the potential for disruption of parts of the value chain. Pressure will be particularly high in the more liquid space and the need to differentiate with content in the structured and illiquid space is likely to become ever more important.

Broker‐dealers also remain under significant financial pressure as they are starting from already depressed economics. More capacity is likely to be withdrawn (strategic pruning) in the short‐to‐midterm, which may further negatively impact market liquidity. But that alone is not sufficient. The entire operating model will have to be overhauled, legacy systems decommissioned, and complexity reduced (Figure 33.3).

Blockchain (distributed ledgers) may play a critical role along that journey.² The concept of Blockchain has taken the financial services sector by storm, with venture capital and investment pouring into technology startups. Debate over Blockchain's promise, as well as its limitations, is ongoing. For every believer who says Blockchain is the most revolutionary technology platform to emerge since the Internet, there are skeptics who claim it is merely the latest tulip mania.

While in the United States the Depository Trust and Clearing Corp. is fielding proposals for a complete replacement of its credit default swap (CDS) settlement and reporting infrastructure, the Australian Stock Exchange is attempting to address changing regulatory requirements with a Blockchain‐based pilot. Regulators such as the Bank of England and the European Securities and Markets Authority (ESMA) have published thoughtful commentary on the feasibility of digital cash and distributed ledger technology. Collectively, the tone of conversations has shifted from “Is this worth exploring?” to “How do we best engage?” Financial commitments to Blockchain are also growing. Investments in Blockchain startups to date have reached $300 million, a figure that is growing swiftly. Investments totaled $125 million in 2015, and this has already been surpassed in the first half of this year.³ Although predominantly venture capital backed, a handful of companies have attracted significant bank investment. Furthermore, we see growing internal spending by banks, which we estimate totaled $80 million in 2015.⁴

Blockchain applications in wholesale banking and capital markets are seeking to keep the decentralized nature of the network and immutability of the underlying ledger while reinstating accountability and governance models that allow legal recourse and support existing regulatory frameworks. We see the most promise for distributed ledgers existing within a permissioned environment of known participants who can transact privately among one another while selectively granting visibility of their own data to regulators and third parties, such as analytics providers.

The ultimate impact of Blockchain is still debated. Some believe the impact will be limited to the back office and other behind‐the‐scenes processes. Early efficiency benefits indeed accrue most obviously to the middle‐ and back‐office through data standardization, reduced trade breakage, and simplified infrastructure. However, when real‐world assets—represented digitally through tokens or smart contracts—are able to settle between owners at the speed of execution if desired, an innovation tipping point will occur. Settlement flexibility will enable new pricing models and service offerings. However, beyond better data management, the ability to verify assets held on‐ledger as truly unique is an innovation not offered by traditional databases. For example, escrow of these digital assets could reduce risk in collateral management; real‐time calculation of underlying asset risk could enable more accurate pricing of asset‐backed securities.

However, the need for reinvention is not only limited to the sell‐side; it equally applies to the buy‐side. For them, the main challenge is to adjust to the new liquidity environment by upgrading in‐house trading and risk management capabilities, reducing dependency on the sell‐side, and engaging with new sources of liquidity. In combination with an accelerated shift toward passive products and continued fee pressure in the current low‐yield environment, we also expect growing pressure on an industry that enjoyed stellar growth on the back of QE‐driven asset inflation post the global financial crisis (Figure 33.4).

Blockchain technology also has the potential to help asset managers tackle some of these challenges.⁶ FinTechs and market infrastructure providers are expected to initially offer Blockchain solutions to asset managers but we believe that in time asset managers will also develop their own Blockchain applications. We see four successive waves of deployment for Blockchain technology as shown in Figure 33.5. Initially, we expect the first two waves to be focused on sharing and using data, before expanding to critical infrastructure once confidence in distributed ledger technology grows. The final wave, in which a truly decentralized financial ecosystem arises, is perhaps the most ambitious and the most uncertain.

In summary, both the sell‐side and the buy‐side are under significant pressure to reinvent themselves, particularly as new competitors look to break up the traditionally integrated value chains. This is a trend we are likely to observe in banking more broadly. We call it modular financial services, as shown in Figure 33.6.⁷

Modularization has already impacted various other industries and we are living in a modular world already in parts of the financial services industry. U.S. mortgages, payments, or the Property and Casualty (P&C) insurance industry are the best examples.

Applying the modular concept to the broker‐dealer world, one could imagine a world of broker‐dealers focusing primarily on content provision with parts of connectivity being provided by alternative trading platforms and parts of the required capital sourced from institutions facing fewer balance sheet constraints than the broker‐dealers themselves.

In summary, the industry and the roles the various participants play remain in flux, potentially resulting in significant shifts in economic value in the years to come. But it is incumbent upon regulators and market participants to collectively strike the appropriate balance of risk management, transparency, financial innovation, and creativity to optimize market liquidity and access to funding while mitigating systemic risks. A healthy capital market is ultimately the bedrock of a strong real economy.