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Millennium think piece
World markets seem to be riding a firmly established trend towards ever increasing values and volumes. Most participants, and most of the infrastructure that supports them, are highly profitable; and these firms are operating in a climate of strong expected profit growth. Yet the same forces giving rise to price appreciation and volume growth are creating considerable uncertainty for the intermediaries and infrastructure providers which service both issuers and investors. The rapid pace of technical progress alters competitive conditions, and creates winners and losers, in the securities inter-mediation business just as much as it does in industrial and commercial companies which make up the stock market indices!
The main threat for those of us who live at the heart of the securities market is, of course, dis-intermediation. Exchanges fear the rise of ECNs. Settlement systems such as CREST are anxious about dis-intermediation by investment banks and retail-facing brokers. Sub-custodians and global custodians fear competition from national and international settlement systems. Even the mighty investment banks fear dis-intermediation by technology which delivers investment, and perhaps even issuing, opportunities directly to the end users of capital markets.
The main factor facilitating these changes is, of course, the ability of modern computing technology, and modern secure electronic communications, to automate and demystify processes which were formerly labour-intensive dark mysteries.
On top of that, there is a wave of harmonisation and rationalisation sweeping through world markets , the successful introduction of a common currency for much of Europe is just one symptom of this radical change. To put it bluntly, much of the inter-mediation process connecting issuers and investors in securities markets is, or is rapidly becoming, commoditised.
Viewed from the perspective of other mature industries, the only surprise is that this process is greeted with surprise by so many of the participants in the industries. Participants in other long-established industries (think of coal mining, or textile production) have grown used to the fact that they must either operate on a very substantial scale, using factors of production which offer the best value for money on a world scale; or become niche players occupying specialised sectors of the market, which protect them from international competition by local regulation and/or local preferences, or which are not big enough to be worth the attention of a world-scale producer. That analysis might well lead one to conclude that the future will be dominated by a very small number of players, which operate at world scale in what is an increasingly a single market for securities. Ultimately, the world might contain no more than one trading mechanism for all securities; one clearing and settlement mechanism for all securities; and a very small handful of securities intermediaries, providing universal banking services.On top of that, would be a small handful of local businesses, exploiting particular legal/regulatory niches in local markets, where the returns from specialisation are insufficient to induce the huge global players to compete.
I am glad to say I do not think that this is the world that faces us. This is because technology not only levels playing fields globally, in a way which promotes economies of scale through a competition, but also broadens the competitive context, by allowing new businesses to become cheap and effective entrants.
Consider, for example, electronic trading. This is an industry where the costs of entry are low - an electronic trading system can be built or bought for a few million dollars. Thanks to the internet, the proprietor of such a system no longer has to spend tens of million of dollars on proprietary communications to his trading engine. Moreover, the same technology allows those who wish to trade to try out new engines very cheaply - they too do not need to invest in specialised technology. Also, of course, the nature of trading is such that a customer can switch, on a trade-by-trade basis if he wishes, from one provider to another. Finally, trading systems can become ever more 'clever' in specialising in facilitating a trading style, and in particular in the degree of contingency that they offer in order of execution, so as to adapt themselves to different constituencies of trader in the markets, ranging from the big investment bank to the individual. In this particular case, I believe that technology will lead to increased competition, not reduce competition. (That increase in competition would of course be facilitated by less competition between national markets in providing the rules of engagement, achieved through regulatory harmonisation - this is an area where competition between regulators will doubtless reduce!)
Much the same will apply to the intermediaries themselves, I believe. Rapidly changing technology in the way that securities are originated and distributed will lend itself to competition from the nimble new entrant - some of whom may well be large firms with technology and/or distribution advantages, but some of whom will at least be genuine start-ups. Doubtless the big investment banks will continue to be important, but they will not be the only game in town by a long way.
Even someone so irresponsible as to volunteer as author of a Millennium think-piece must legitimately be expected to pronounce on his own industry, I suppose. As some readers may know, CREST is itself a new entrant into the industry, which has recently settled its 100 millionth real time transaction, about three years after coming into being. So CREST is rather clearly a high volume player in a highly technological world. What is our future?
I have to respond that I simply do not know. I believe that our settlement technology is superior to that of most, perhaps all, of the established players in the industry. Yet highly effective technologies can be rendered obsolete by technical changes elsewhere in the world, and we must be alert to that.
Our industry has a degree of protection from global consolidation, stemming from the very complex legal issues that surround the prime service which we deliver - security: security of exchange of stock for cash, and security of holdings. Participants in world markets should become still more concerned about these issues, as volumes and the size of arbitrage positions rise in world markets.
Systems like ours also provide a different kind of security - the security that customers can exert control over their own affairs, in a real-time way, in a world where deadlines are rapidly becoming shorter.
And, a further reason for our mild confidence, systems like ours provide huge security against rising volumes - no one wants to see the world enmeshed in another settlement nightmare (like that of 1987) simply because the infrastructure cannot cope with the consequences of ever rising trade volumes.
Nevertheless, the same forces press on clearing and settlement systems as on other established participants in our markets. We too have to decide whether to seek to be one of the surviving giants as traditional businesses consolidate, or whether to seek out new directions in the exciting new businesses made possible by the technology which is forcing the consolidation.
The specific implementation of this in my world might well be that national settlement systems either have to find a role as one of a relatively small number of global commodity transaction-processing hubs, or become a niche player in their own domestic market, dealing with the local savings/investment market, probably primarily at the retail level. This will be a difficult choice for all of us.
Fortunately for me, I do not think that choice needs to be made yet for CREST. We are in the fortunate position of having a very dynamic retail investor market, which generates large numbers of transactions. This transaction revenue enables us to keep the cost of our service low both for retail, and for the many world-leading broker dealers and custodians who use CREST for the important institutional business. (CREST does not charge for custody of its domestic securities!) I firmly believe that we can continue to provide a service for both, bringing retail volumes to keep costs low for the institutional business, and ensuring that the institutional business is there to provide an excellent basis for execution for the retail business, for a number of years to come.
This is not a little England strategy. (How could it be, when Ireland is part of our system?) We are working closely with partners in Switzerland and elsewhere to create a single virtual settlement system, which allows a customer who has invested in one of our systems the ability to transact securities round the world with participants round the world, with no new investment.
This possibility is brought to us by the same technological forces that I ment- ioned at the outset of this article - real-time electronic processing, and secure real-time electronic communication.
All of us have grown used to the idea that telephone companies compete, but do so in an environment that nevertheless guarantees a single virtual world telecommunications system. Simply, we take it for granted that we can phone somebody in a foreign country without fussing about whether we are using a land line at home or in the office, or a mobile; and without having any idea what technology or what business relationship our foreign interlocutor is using.
This is the world we have already entered for settlement and custody, with the introduction of the real-time link between CREST and Switzerland last autumn.
Establishing these links, is cheap, quick and effective, just as in telecommunications. They are a vital part of sweeping away the costs and impediments to competition in our increasingly globalised world markets, and I am proud that CREST is at the forefront of this process. .
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