Innovation and change in the financial industry

Regulatory change driven by the credit crunch is perceived to add cost and be an added burden to businesses. However, Samuel Ely, managing director at GammaDS, argues that it will actually spark innovation, create opportunity, lower costs and increase revenue for a range of firms within the financial industry.

Cayman should position itself to capture a share of the new market and revenue streams before they are monopolized by other global financial centers, he writes. 

Ever since the “credit crunch” and subsequent commitments from the G20 meeting in Pittsburgh, Pennsylvania, in 2009, the financial industry has been in flux.  

I have experienced it personally, having gone from working in a bank and dealing mainly with internal businesses as well as some industry working groups to being thrown into a new world of representing the bank and industry in roundtables with politicians, regulators and central banks.  

The global regulatory change propelled by politicians through regulators in an endeavor to mitigate systemic risks in the global banking system has been a shock to the system. 

When, back in 2008 at the height of the credit crunch, I attended a roundtable hosted by Vince Cable (Britain’s Secretary of State for Business, Innovation and Skills), my position representing the banks and derivatives at a table containing politicians, SMEs, lawyers and corporates could not have been worse.  

At that time, derivatives were commonly termed “weapons of mass destruction” and anti-banking slogans could be heard from the street corners to Westminster. 

In the meetings, I advocated education and understanding of the products and their uses. A car can be used as a weapon to run someone over or a mode of transport in the daily commute. 

Equally, derivatives can be used to speculate, as we have seen spectacularly with Enron, Amaranth, LTCM, to name but a few. However, thousands of organizations also hedge their exposures and manage their risks through the use of derivatives. In the Cayman Islands, for example, Cayman Airways or CUC could hedge their fuel costs to protect against a spike in oil prices, thus enabling efficient management of the businesses long term without the fluctuating costs.  

My feeling is still the same – education and understanding are needed both within and outside of the financial services industry. The Chartered Institute of Securities and Investment in London, where I am a chartered fellow, and the Securities Industry Financial Markets Association in New York City both do a fantastic job at education, but much more needs to be done. 

The motto of the City of London, “dictum meum pactum,” or “my word is my bond,” may well have been forgotten by many in the public, but it has been a core requirement and pillar on which the city was built. In my opinion, this equally should apply to all financial services globally, including Cayman. We should all outwardly promote ethical behavior, which would instill more confidence in the industry. 

 

Opportunity for innovation 

The regulatory change and lack of understanding of the uses of derivatives has created opportunity through innovations in the marketplace.  

This is because while there is consensus on goals and targets, specific solutions are needed. The lack of insight and understanding of how and what should be created gives those with insight a first mover advantage and the opportunity to fill this void.  

Cayman and the organizations that operate here have a unique chance to take a bigger role in the overall global financial industry through expansion of existing, and more importantly, new areas of business. 

Because of the characteristics of Cayman, the greatest differentiators to attract and grow are also the biggest hindrance in the global financial landscape. As for both the financial services in general and derivatives in particular, Cayman needs to educate on its positioning, differentiators and offerings, and get the message to participants in the traditional banking centers, just as the likes of Hong Kong does on a regular basis. It would help the understanding, comfort and acceptance of the benefits offered. 

With the shifting markets, the time and the opportunity is now, before the market commoditizes and status quo is set for the decades to come. It has often been debated as to where global infrastructure could operate from when some of the traditional safe havens have been compromised. 

Having met with organizations throughout the world and worked with a G20 country on solutions that will fit and deliver for the needs of both the regulators and central banks, as well as the participants, it is a big challenge but more than achievable through innovative solutions that can benefit all by reducing costs, decreasing risk and implementing solutions, and ultimately increasing business and profitability for all. 

Individual organizations can also do a great deal. What I have discovered having worked through a cross-section of the industry with tier 1, tier 2 and regional banks, as well as buy-side and service providers, is that there is a big requirement to innovate and change, and new opportunity for all types of participants, as well as new participants who were never in the markets. 

 

Opportunities 

There are opportunities throughout the life cycle of trading from execution through clearing, settlement and risk management, including collateral management, documentation, cash flows and valuations. These affect people, processes and systems. 

One example would concern buy-side firms such as hedge funds, institutional funds, pension funds, private wealth managers, funds of funds, private equity, alternatives or single family in the over-the-counter (non-exchange traded) derivatives markets.  

Historically, buy-side firms would need to go through banks via phone or instant messaging to gather quotes and ultimately hit the bid or lift the offer. In the process they would take on the counterparty risk of the bank, not to mention all the documentation and legal costs for each individual trade.  

Now, there is the opportunity to eliminate the counterparty risk, the majority of the costs, gain access to products on screen, electronically, in liquid two way markets and be able to submit own bids or offers. This changes the market and who the liquidity providers can be.  

There is also the distinct opportunity for new entrants who were precluded from the OTC markets, whether due to their size, position or adverse rules. It meant they were missing the enormous benefits of derivatives including hedging, arbitrage, lower cost efficiencies and leverage.  

The absence of counterparty risk, daily published pricing and mark-to-market without complex valuation exercises open up the markets and give access to more participants to benefit. 

With all this change, there is the obvious need for the right skill sets to innovate and develop the businesses in addition to good training and development of existing resources to support the new processes. 

The change in execution being described above is facilitated by the electronic mandated derivatives trading on SEFs or swap execution facilities (known as MTF, multi-lateral trading facility, in Europe).  

Fundamentally, the answer is an electronic execution venue for derivatives products. An SEF is a technology with its assets being the infrastructure and people behind it. SEFs are competitive-neutral intermediaries broadcasting prices.

They do not clear contracts, they make contracts available for trading. Electronic trading today is essentially done on venues that are SEF designated. Desired attributes for an SEF are established liquidity and flexibility with multiple execution methods and connectivity to market infrastructure.

All asset classes will be covered including credit, equity, rates, FX and commodities. It allows for various forms of trade execution which can be performed in many different ways including request for quote (RFQ), central limit order book (CLOB), SQ streaming quote and request for market (RFM). 

We focused on the execution, but all the participants in the process are impacted, from the banks to the exchanges and clearing houses to the buy-side and the administrators who support them, as well as all the internal departments in the chain to the software providers and support services. 

These are just a few examples but dependent on the business there are many areas that should be examined.  

 

For further information and more in-depth analysis visit www.GammaDS.biz or email contact@GammaDS.biz or the author Samuel Ely at SJE@GammaDS.biz

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