Winds of change
The world of financial services is in flux, but between Brexit, regulatory change, and ever-changing consumer expectations, there could be opportunities for asset managers, says Henry Hilska of VirtusaPolaris
Asset Management is no exception to the dramatic changes currently facing the financial services industry. This transformation is happening on a global level, including the introduction of regulations that impact firms’ operating models in a variety of ways. Technological innovation is a driver of the changes affecting how firms interact with their clients, impacting asset managers and others within the financial services space.
Regulation forces transformation
Through mandates such as the Dodd-Frank Act, regulators have been instrumental in moving fixed-income trading onto exchanges and other established venues like swap execution facilities (SEF) and away from the bilateral or principal trading model. This effort is ongoing across various instruments, including fixed income derivatives. To date, the transition has not been smooth, with the fluctuating derivatives markets serving as just one example. A large volume of more standardised swaps is now centrally cleared through these newly established venues.
However, there is fragmentation and reduced liquidity as sell-side dealers are forced to limit balance sheet exposure due to stricter capital requirements brought on by Basel III. Bilateral swaps will continue to exist as they serve the specific requirements of corporate treasurers, but are not typically as liquid, and thus not good candidates for central clearing. The cost of these structures will increase as regulators have proposed additional margin rules for non-centrally cleared transactions.
Apart from the desire to move the market to a central counterparty model, along with increasing capital and margin requirements, regulators in the EU are also implementing the Markets in Financial Instruments Directive (MiFID) II. Though it is an EU directive, the rule is expected to affect more than half of US-based asset management firms as well. It is also expected to remain an important regulation even in the post-Brexit world for any asset manager wishing to do business in the EU. Among the requirements of this regulation is the need to provide and verify ‘best execution’. This rule, as it is being discussed, is expected to require the consideration of the following points:
• Liquidity is a major factor that can vary between trading instruments, as well as between asset classes;
• Best execution requires quantitative analysis of orders and transactions, as it is correlated to the profitability of a trade or strategy;
• Data is required to be provided by sell-side firms to their clients;
• Best execution goes beyond individual transactions and requires the most appropriate trading strategy; and
• It also incorporates the entire trade lifecycle, and requires consideration of efficient post-trade processing.
The chief obstacle for buy-side firms related to the implementation of these rules is access to the data needed to perform the necessary analysis. These obstacles are exacerbated by the reality of having different execution platforms. There is now a need for buy-side firms to review both their operating models and technology stacks to ensure that they are best positioned for these new requirements. Firms will need both data and systems that can process the information, as well as the quantitative skills to perform the necessary transaction cost analysis across various asset classes and strategies. Firms have been increasing this knowledge base by reaching out to the sell-side firms and even other industries for this talent.
Another paradigm shift affecting asset management is the aforementioned increasing role of an agency-trading model. As much as sell-side firms are now more reluctant to house derivative exposure, they are also being influenced to limit balance sheet usage for assets, such as fixed income bonds, by the very same capital issues. Thus, the migration from a principal trading model to an agency model is underway. Ultimately, this should aid in the ability for buy-side firms, which have the regulatory and fiduciary duty to provide best execution to obtain the necessary data, since the agency model should provide participants a benefit from economies of scale.
From a customer perspective, there are also major changes to engagement and distribution models that come from a combination of technology, customer expectations and increased competition. The digital transformation that is disrupting the nature of the business-to-consumer model is changing the expectations customers have for their business relationships in other industries as well. This evolution requires asset management organisations to create efficient channels to distribute information beyond the traditional paper statements delivered in the mail.
This change creates additional challenges for buy-side firms as the information distributed through digital channels can be delivered immediately and provides for two-way communication with the client. There is a need to ensure that the most appropriate business model is implemented so both the traditional and digital models work most effectively and accurately in tandem. Additionally, asset managers have historically been conservative and have not been leaders in this transformation. This may actually provide some benefit, as there are a number of lessons learned that can be brought to the table from the experiences of other industries.
The changes that are affecting asset management are far-reaching and present a number of challenges. However, these trials present opportunities to improve both the efficiency of trading operations and the overall customer experience. Ultimately, the firms that succeed in making the transition to a more automated, digital approach will stand to benefit the most.