Updated: Nov 25, 2021
The true purpose behind penning down these thoughts is to challenge the status quo, and re-wire some of the beliefs surrounding value creation in the post trade space.
Inorganic Growth cannot be the silver bullet.
"Life is what happens to us, while we are busy making other plans."
While this expression can be traced back to a 1957 Reader's Digest article by Allen Saunders, it has subsequently been used at many places including a John Lennon song that practically immortalized the line. And it wouldn't be far from truth, if we used this as a metaphor today, to explain what's happening in the post trading space, specifically in the securities services business related to custody operations and fund services where margins have progressively declined in the face of growing cost of processing. At reduced margin, volume becomes the only savior and therefore this is leading to consolidations which are happening at a rapid pace on both sides of the Atlantic. This article deals with a line of thought that negates economies of scale derived from acquisitions or consolidations as the only key strategy for survival in the long run.
Consolidation is definitely important, as Bloomberg mentions that an entity needs to be at least at a critical level of ten billion euros in assets under management to be profitable as a custodian in today's market condition. Most market participants are below that limit and ultimately, organizations who don’t reach this critical size will not sustain in the long term. However, there is no silver lining for entities which are only growing inorganically big without a road-map of how they will adopt to the changing landscape of post trading space which is evolving exponentially faster than what may be visible normally.
If we were to consider the complete business chain that securities services support, the hard fact is that, much of value creation lies with the asset managers, while other intermediaries (custodians being one) are only living on the crumbs. The irony is, in today's market custodians don't make money (any more) out of providing custodial services, and the margin from other services are thinning rapidly. However, scale can only create value for shareholders in the medium run, who become the beneficiaries of reduced fixed cost that can be spread over a larger asset base. It doesn't warrant survival in the long run unless there is a vision to create growth assets from innovation that will redefine the way how custodians shall operate in the future. In hindsight, let us consider some key changes from the past which have redefined custody operations during the last few decades.
Dematerialization - The age of physical segment (when negotiable instruments were still papers) gave place to their dematerialized form in the late nineties. This was a revolution of its own kind and people who have experienced this transition can associate the change to key benefits it ushered into the primary and secondary markets - lowering of post trade cost, ease in benefit distribution and reduction of settlement cycles being some of the key changes that benefited end shareholders. However, with this evolution, much of revenue that came for custodians from safe keeping got eroded because now there were no physical securities to safe-keep. As far back as memories can take, custody margins took the first beating around this time. And since then, there hasn’t been a year when I have not seen this as a concern in the annual reports, as how custodians must evolve to keep their market share from eroding and be at a margin that can make sense to the shareholders. Using the same lens if we were to look forward a few years from now. The future of dematerialized securities, (maybe) rests in "STOs". If this happens, the current landscape of post trading business will go through a radical change and technology will render most of the current custodial systems redundant. A handful of them who will survive this onslaught are the few early adopters (amongst far many), who are investing in disrupting the market now in defining the new protocol. They for sure will lead the change from front. We will discuss more on this in later sections.
Market Harmonization - During the last one decade, custodians have not only witnessed consolidations at an entity level but have as well seen process consolidations targeted towards market harmonization. For a long time, much to the woes of shareholders, who traded cross border, custodians continued to add value in the being the intermediaries through their network of global, sub and local networks to help settle the trades. And such inter-mediation garnered the much-needed revenue from operations for the custodians. However, as technology improved and the need for common market standards in processing settlements was realized across the European Union, concepts like T2S started taking shape and as a result, dependency on complex custodial networks as a sole means to facilitate settlements gave place to custodians just being a part of such harmonized market protocols became a reality. The consequences for custodians being - reduced post trade service fees and increase in fixed overhead to adopt to common market standards to continue to survive in the market.
Increased Market Supervision – Post 2008 financial crisis, regulators have been systemically stringent on all financial intermediaries. Southward pressure of margins has also been because of increased cost of compliance to such changing regulations.
While seeking for growth, look for a strategy that will not only delver the most ‘Growth’, but the one that will come with the most ‘Value’.
When we talk of growth, we consider different ways in which an entity can grow, and we often tend to make the mistake of treating them all as equivalent. But data has emerged over time, that looks at which growth approaches are most likely to create value and which ones may fall short. Studies on corporate valuation models, and previous researches which have looked at companies adopting different growth strategies over time, have ranked the value strategies from best to worst.
By far the best strategy empirically found across companies is the strategy of innovating new products, redefining the existing product lines that would generate new sources of revenues. New products that breakthrough into new markets earlier than competition and thereby grow organically. So why doesn't entities try this model? Well they do, but only a few succeed. And for those that succeed, realize that there is no better strategy than this one. The reasons why this strategy fails many a time is not for the strategy itself but our approach to measure the outcomes of innovation which we shall deal in another write-up.
The second in rank is to find new markets. Geographically, or within the same market by adopting diverse methods which can increase their market share without the need to continuously innovate and improve their product lines. Fighting for market share in a growing market is not a bad strategy. Because even if the market share has remained constant or grown only marginally, however if the market is growing, profitability is guaranteed. But what if the market is not growing? Given this the situation targeting for growth and visualizing new markets to gain, will only turn out to be like following a mirage that would soon be realized as non-existent. Bad Strategy!
And then we get to the last two strategies which historically have been proven time and again, more as losers than winners. Out of which one is decreasing prices to win over competition. If one fights for market share in a stable market, then many a times, the only way to target for bigger market share is planned to be carved out by cutting prices, which surely is not value enhancing. It might deliver more growth, or keep the entity afloat for some time, but the lower margins that this growth comes with, will lower value in the long run and as well strangulate resource from with. It’s often like fighting the last battle of survival.
And the worst strategy that ranks as last, is the one that comes through acquisition. It argues that if growth comes only by acquisitions, especially if they are large publicly traded companies, then the only way one can win is by paying a hefty premium over the market price that ups the anti. If acquisitions are for a strategic reason and synergies play out well, they turn out to be success stories. However if its only to optimize on cost, then scale can only create value for shareholders in the medium run, who become the beneficiaries of reduced fixed cost that can be spread over a larger asset base. It doesn't warrant survival in the long run unless there is also a vision to create growth assets from innovation that will redefine the way how entities shall operate in the long run.
So taking clues from the past and building on top of some of the technological advancements, the roots of which have already been laid in the post trading services space, in the following section we shall discuss as how the future of custody services may evolve for large players in the securities services sector.
Just when the caterpillar thought that the world was over, it became a butterfly:
Whether the realization comes now or later, the truth is that the post-trade market is currently being shaken by fundamental changes with the emergence of new technologies. And this article rests on the premise that some of these changes, may radically alter the landscape. Intermediaries who shall lead the transformation will be the ones who will survive the change. Finding an answer to the question, as how will the world post-trade market look like in a decade from now is a complex challenge, however action needs to be taken at the right time and here are a few strategies that may be key to creating value.
From Digital Securities to Tokens - Just as instruments transformed from physical to digital forms during late 1990s and early 2000, sooner than later digital securities will get replaced by tokens. The future of safekeeping will no longer be equivalent to providing custody of assets but rather the storage of cryptographic keys that control those assets. Quoting ESMA - “having control of private keys on behalf of clients could be the equivalent to custody/safekeeping services, and the existing [regulatory] requirements should apply to the providers of those services.” The digital evolution of tokens and smart contracts are being scripted much faster than it can be contemplated and the smarter entities in this space are already in the game playing it right. For example, custodians, which are today a tad ahead than the others have already mapped out their strategies of the token-based future and they are coming up with custodial services offerings to institutional investors and hedge fund managers who are keen to invest in tokens or cryptos. The ones that take the lead and define the future of tokens in the post trade world will lead the change and ones which are not evolving as fast, will be left to live or perish on the crumbs left for the late majority.
Harnessing the power of APIs through collaboration and standardization – Benefits of exchanging information through APIs between Service Providers and Client is well documented and realized across the industry now. Over and above, markets protocols such as PSD2 in EU and Open Banking in UK, are making mandatory for Post Trade intermediaries to open their data for consumption. The next level challenge therefore, for intermediaries in post trade space is in driving product or technology innovation not only from within the confines of single business units but creating a mutualized framework allowing these technologies to obtain mass market adoption. If emerging or disruptive technologies are to achieve scale, they will need to be standardized for harnessing their power across multiple entities which make the ecosystem. In fact, SWIFT is already involved in API standardization, having recently published a blueprint for common API standards which can be adopted across European financial entities in their effort to meet PSD2 and other open banking recommendations. The smarter post trade players are already partnering with SWIFT to homogenize their API strategies and meet ISO20022 standards as initial steps that will help them drive API standardization.
From harmonization of settlements like T2S to T+0 settlements on DLT - Markets have evolved from a physical system where settlements cycles were T+14 to T+3 to now T+2. However, inefficiencies in the systems still remain because of which near STP is still an utopian though resulting in higher cost of post trade operations. Distributed Ledger Technology (DLT) is likely to have a huge impact on settlement cycle. Primary premise for a DLT based system is direct clearing and settlement between participants in a trade, thus removing the need for intermediaries after a trade has taken place. While DLT’s ability to remove some of the intermediaries from the financial markets continue to be debated, it is clear that the risk in markets would be significantly condensed if a DLT-based settlement system allowed assets to move on the transaction date itself. Such an innovation would reduce or even eliminate the need to post collateral, while increasing market efficiency, liquidity and harmonization. The challenge today is to visualize as what would be the role of Custodians or Transfer Agents in this new business model. Not necessary that they will also be the ones to get eliminated. One of the models prescribe Custodians and TAs to be on the nodes that make the DLT while institutions continue to take custodial services of tokens which the custodians will hold. While another prescribes custodians to transform from providing custody of assets (which they do today) to rather become the safekeeper of cryptographic keys that control those assets. This leads to the same thought that Custodians which evolve faster to take the lead in this space will be the clear winners.
Distributed KYC to optimize on cost - The post trade Industry has long struggled to bring efficiency in the process of executing and maintaining KYCs. Plus, regulations have become complex and stronger surrounding this function that has further added to cost of maintaining these data. Mutualization of KYC data between participating entities within the same value chain has often been thought as a possible solution to do away with this repetitive activity, however before the advent of DLT this was not thought as technically viable. If DLTs becomes a reality, then one of the main beneficiaries of this technology will be in the way how KYC functions may evolve on permissioned networks, that will significantly reduce cost of client on-boarding.
Corporate Actions on DLT for true STP - Currently one of the important steps in Corporate Actions processing by custodians is in the successful generation of a Golden Copy of the announcements, as it has significant impact on the complete downstream processing of the event. A lot of resources are spent towards scrubbing and cleansing of the event information received from diverse set of sources and in most cases, market intermediaries are spending humongous resources in scrubbing the same piece of data many times over in not so much of an STP environment. In the future when securities are issued as tokens, Corporate Actions on those securities will be coded as self-executing smart contracts on the DLT which will get invoked when specific set of underlying conditions (considerations) are met. This will meaningfully reduce the need to scrub diverse set of information coming from multiple sources to create a golden copy and then further bring more efficiency in executing multiple steps till a Corporate Action could be processed. Often, it's argued that it may be impossible to issue derivatives as tokens and likewise process corporate actions on structured products on a DLT. The answer is simple - There is no limit to complexity in logic that can be put on lines of codes unless it's an infinite loop that can't be executed via smart contracts, in which case it's the logic that needs to be fixed and not the capability of smart contracts that should be questioned. Given that one of primary asset services functions in post trade is corporate actions processing, custodians and other intermediaries must embrace this transformation and be the front-runners in pioneering this change.
While the above 5 may be just the few ways how post trade can evolve, there is no denying the fact that custodians have to look beyond consolidations to bring real value to post trade services. There are often questions raised on the applicability of technological disruptions (DLT being just one) in Capital Markets in the absence of well laid out regulatory norms. However, it’s not entirely true that all of them continue to be wholly unregulated. Numerous state agencies in different countries, are trying to fast regulate applications for these technologies in some fashion. But the diverse approaches taken by different countries remain a challenge and this will need to converge at some point. Having said that, I am myself strongly convinced that while cryptocurrencies will find it difficult to gain acceptability under any form of regulation as possible replacements to fiat currencies (and rightfully so - https://www.thebtn.tv/exclusive-content/article/liberate-libra-currency-war-and-let-it-find-its-meaningful-place-sto), however application of DLT is here to stay, and regulations will fast evolve surrounding their adaptation. Therefore, taking shelter on this reason alone, and not innovate will only catch incumbents on their wrong foot in times to come.
Yesterday is gone, tomorrow is yet to come, and so let's begin today.
The post-trade market is becoming smaller, not by volume but by players, as the existing old structure continues to fragment as a consequence of fast evolving technological innovations, permitting new approaches to securities processing and information dissemination, allowing newer entities to enter the market. The days of plenty are numbered as the size of the industry declines and innovation is now in the hands of FinTecs that operate at the technological front-line. The key strategy for the incumbents to succeed in this scenario is to work in consortiums, remove some of the barriers to entry and partner with FinTechs who have more viable ecosystems to innovate, than their own floors. The real synergy is in multiplying on a foundation that gets build on technical competencies of FinTechs and domain expertise of incumbents. And we see this marriage already happening amongst the smarter post-trade players and FinTechs. Having been at the convergence of technology and business in the post trading world for last 2 decades, I am fairly convinced that markets will self-evolve and entities will come together to partner and play this game well.
Have never been a fan of dead diagrams (myself), without a discussion to support what's being laid out, and therefore not clogging this space with a set of complex flows to ponder on, as how may the future of post trade look like in paper. However if this triggers enough curiosity to explore more, do feel free to connect for a discussion or debate.