As we prepare for the next decade, the time is right to consider what might drive innovation in capital and asset markets. But to look ahead, it is often instructive, if not critical, to look backward.
During my career in banking, I often found that reviewing prior experience from across the industry helped inform a view of what the future might hold. When looking at innovations in U.S. banking and capital markets during the past several decades, I believe three underlying themes emerge that can help us understand the future.
1. Regulation and policy can inform new ideas.
Without question, staying close to your customer is a critical ingredient in new product innovation. But interestingly, sometimes unexpected forces like regulation drive new products.
For example, consider the growth of money market funds in the 1970s: Regulation Q had capped the interest rates that banks could pay on certain deposits. Depositors sought higher yields from outside the banking system, so money market funds became an attractive option. According to the Federal Reserve Bank of St. Louis, between 1977 and 1982 alone, money fund assets grew from less than $5 billion to nearly $250 billion, thus accelerating growth in a competitive investment product.
From my perspective, some parallels can be observed today. Since 2016, for instance, rules governing certain derivatives trades require collateral to be exchanged between counterparties. The resulting increase in demand for collateral drives new products in the custody and collateral management space.
To help past and current policies inform your innovative efforts, ask yourself the following questions:
• Which regulatory and policy changes create opportunities today? Keeping innovative team members close to regulatory trends can give them a preview of future demand.
• Similar to money markets in the 1970s, which asset classes have seen a surge in growth, and do these asset classes have the processes, controls and data available to enable orderly growth? Understanding which asset classes are growing quickly highlights not only growth opportunities but also the infrastructure that might need improvements in order to handle the increased demand.
2. Back-office limitations can become front-office problems.
Just as regulation and policy are unlikely sources of demand, so too is the back office. When times are good, back-office problems can go unnoticed or unsolved. But during a crisis, back-office shortcomings can lead to bigger problems and drive change. One example stands out from the 1980s repo market.
Drysdale Government Securities was a bond trading firm. It borrowed bonds from other dealers and agreed to return the bonds plus the interest received. However, there was no industry standard for treating accrued interest. Drysdale was unable to return bonds borrowed, so it defaulted. Since accrued interest had not been tracked, lenders lost out on accrued interest as well. What followed were innovations enabling interest to be tracked, accrued and collateralized to enhance repo market soundness and transparency.
Again, there are some important questions leaders should be asking themselves in light of this lesson from Drysdale Securities, including:
• Do you understand how your back office operates? Speaking with operations employees at all levels of the hierarchy can bolster your understanding of back-office problems that could become tomorrow’s front-office issues.
• Do lenders who accept collateral know exactly where it is held, and are ownership records and account titles clear? It is critical to know how to access collateral, ensure clear records of ownership and understand where and how your collateral is held.
• If you operate a financial technology company, how can you create peace-of-mind by enabling lenders to take possession of their collateral in times of crisis? A lender’s ability to take possession of the collateral if and when they need to can reduce uncertainty in times of crisis.
3. Evolving is critical.
One final theme is that large institutions, both public and private, reassess their mandates over time. This provides opportunities for collaboration with financial technology firms.
A salient example is central banking. No longer are central banks focused solely on price stability as a policy objective, but economic growth and, in some cases, financial inclusion are now a common part of their mandate. For example, the Central Bank of Kenya and Bank of England promoted innovation in their own markets; the former did this through mobile banking and the latter did this by facilitating the entry of innovative banks into the regulated space in the U.K.
Institutional asset managers keen to have a social impact have also evolved their remits. When selecting investments, asset managers used to focus on “negative screening,” or filtering out investments misaligned with their standards. In the 1990s, negative screening gave way to “positive screening,” which is a more active approach of selecting investments.
I believe more evolution is likely as institutions add environmental and governance factors as investment criteria, forming an ESG-focused whole. It’s also worth noting that in 2019, Business Roundtable emphasized that maximizing shareholder profits can no longer be the primary goal of corporations. Clearly, the remits of large institutions are poised to evolve beyond their original intent.
As asset managers, corporations and central banks broaden their remit, ask yourself:
• Do you have the necessary technology and data to empower these changes? Understanding how institutional decision-makers view their remits can help identify the seeds of future demand.
• How can technology help asset managers and corporations apply their own ESG principles to a broader range of assets — beyond securities? Asset managers who invest in commodities, and corporations that buy commodities as manufacturing inputs, can benefit from increased transparency.
As the new decade commences, let’s not forget the less obvious, less glamorous drivers of innovation. Each provides a refreshed context for financial technology companies and larger institutions to make markets more transparent and better prepared for a future crisis. And for the next big ideas, look to the older, more established institutions — not just the new, disruptor upstarts.