Security and Integrity of the Data is Imperative for Growing Threat to Cyber Security

By Frances Hudson, Investment Director, Global Thematic Strategist, Standard Life Investments

Frances Hudson, Investment Director, Global Thematic Strategist, Standard Life Investments

Are the Capital Markets Young Enough to Embrace Disruptive Technology?

The capital markets have evolved and adapted over centuries, so it is unlikely that disruptive technology will defeat them, even if adoption and progress is patchy. Some disruption is welcome; however, at times technology has resulted in increased volatility, more noise and, therefore, reduced information. More connectivity also entails greater vulnerability to cyber-attacks.

"Technology and regulation are key sources of change in financial markets. Technological innovation and mastery of data are increasingly differentiators for capital market participants"

Innovation in financial technology (FinTech) represents both opportunities and challenges to traditional business models as the ways in which customers (individual and institutional) interact with capital markets change. Some of the new and enabling technologies offer a step up in transparency that fits well with the regulatory agenda.

However, it is unlikely to be smooth sailing. Concerns around security, regulation and taxation may, in time, raise some of the low barriers to entry.

Another change from technology has been the increasing presence of systemic or algorithmic traders in the markets. These have accounted for up to 70 percent of US trading volumes at times. A subset, High Frequency Traders, aim to execute trades based on algorithms with speed of execution as the differentiating factor. They can be disruptive to capital markets. In cases where algorithms, simplified in order to reduce latency and predicated on price alone, encounter positive feedback multiple algorithms will simultaneously trade a stock in the same direction, culminating in rapid larger movements and thus increasing market volatility.

The algorithms also rely on a quantitative interpretation of market conditions within a defined set of parameters. If those parameters are breached, they immediately drop out of the market precipitating a rapid reduction in liquidity and, at times, flash crashes.

Blockchain: Is there a Real Business Case for the Capital Markets?

Blockchain or other similar distributed ledger systems could cut settlement and clearing costs and improve transparency in capital markets in the medium term.

However, universal adoption of such a system and the associated changes to reporting may not be welcomed by all. For example, notification of large trades is sometimes delayed to avoid disrupting the markets, which would be more difficult with this kind of system, as every aspect of each transaction is recorded and logged and the resultant log cannot be edited.

From the number of distributed ledger and Blockchain initiatives underway in financial institutions, there seems to be broad acceptance of the business rationale. Initial investment is substantial and new and old systems would have to be run in parallel for a while to satisfy regulators and achieve a smooth transition. Any such project will require trust, collaboration and knowledge sharing between market participants across technologies, conventions and geographies, but capital markets have achieved this before.

The opportunity is there for banks and established financial players to automate and reduce infrastructure costs, or regulators to track transactions. Some proponents have claimed Blockchain technology could go beyond markets to underpin a universal cashless system. However, a crypto currency application of Blockchain is more contentious. A universal digital currency would cause problems for national central banks with respect to monetary policy.

Change in Investment Banking and Capital Markets

Technology and regulation are key sources of change in financial markets. Technological innovation and mastery of data are increasingly differentiators for capital market participants. Analytical techniques utilizing artificial intelligence and machine learning to extract valuable information and screen out noise from large and growing data sets is important and requires different skill sets, such as data science and programming, rather than conventional analysis.

At the same time, security and integrity of the data held by capital market institutions matters. The present and growing threat to cyber security and trading systems is a major risk. There have been numerous examples of the reputational damage caused by security breaches at financial institutions and the regulators will be keen to see the developments in the cyber security employed in capital markets.

In a post-GFC world, banks have come under severe regulatory pressure from direct regulation to stress tests. They have reassessed risk and de-levered, shrinking balance sheets and paring back certain activities and operations. Higher capital requirements and changing funding models have led to a more cautious attitude to lending. Reliance on sovereign backing heralded a retreat from cross-border activities particularly for European banks.

For the capital markets, the banks’ retreat from areas such as proprietary trading, commodities, real estate lending and infrastructure, has opened the markets to new and different participants. This has accompanied the development of new instruments and increased activity in both public and private markets. There is now onlyone global investment bank amongst the global top ten infrastructure managers by AUM; the others are either specialist infrastructure outfits or asset managers representing long-term ‘real money’ investors.

The new political administration in the US may see the regulatory pendulum swing back in favour of the financial markets to some extent, as aspects of regulation are eased or reversed. Elements of Dodd Frank, Basle IV measures and leadership at the regulators are in scope. However, more flexible interpretation of the Volcker Rule on proprietary trading will not necessarily lead to investment banks picking up as before. Meanwhile, European regulation is still building with MiFID II due in 2018.