Capital Markets

Overview

One Minute Read

Capital Markets is a key sector of the global financial services market, where institutions, businesses and consumers can access capital, commodities and investments. Technological innovation, regulatory reforms and the increasing digitalisation of people’s daily lives are reshaping the financial services landscape. Indeed, digitisation has long transformed Capital Markets from physical to electronic trading. Despite this, true end to end digitisation of the value chain has not happened, leaving considerable friction, cost and a lack of transparency. The COVID-19 pandemic has accelerated this with a cross-generational shift to digital. Rising interest rates, volatile markets and economic downturn create opportunties and risks as well as underline the need to accelerate transformation. Capital Markets is also a critical enabler for tackling climate change and sustainability. In response, the sector is transforming towards to a digital financial ecosystem, driven by five challenges and the widespread adoption of digital technology.

Sector Description

Capital Markets is a $3 trillion sector of the $25.6 trillion global financial services industry [1].

Capital Markets (sometimes called Wholesale Banking) involves a number of intermediaries that enable capital to be raised (primary markets) and liquidity to be transferred (secondary markets). The global capital markets drive equities and fixed incomes markets of over $250 trillion [2].

The process of a traditional capital markets transaction consists of three phases. First, a trading venue, such as a stock exchange, brings two people together, with one person wanting to SELL a finanical instrument and the other wanting to BUY one. Once the (1) trade is agreed, the (2) clearing of the securities transaction begins. The so-called (3) settlement represents the final phase of a securities transaction. At this point, the securities are finally delivered. In each of these three phases, the intermediary companies invest a lot of time and effort. This generates costs.

There are three main segments: organisations:

- Asset Management - is a firm that invests a pooled fund of capital on behalf of its clients, whether consumers or businesses. They are also known as Investment Management businesses. This is the BUY side of Capital Markets.

- Investment Banking - has two roles. Firstly they assists corporations with one-time transactions such as an initial public offering (IPO) into primary markets or supporting merger or acquisition deals. Secondly they provide trading services to clients including Asset Managers, Hedge Funds, Banks and Brokerages, Pension Funds, Corporations, and Governments to access market insight, risk management and trade execution in order to invest and manage risk across financial asset classes. This is the SELL side of Capital Markets.

- Market Infrastrucure - These include the Trading Venues (system and service) in which multiple parties can buy and sell securities, derivatives and other financial instruments and Settlement or Clearing Houses that are used for the clearing, settlement and recording of payments, securities, derivatives or other financial transactions.

Regulation and technological innovation are fundamentally changing the capital markets industry, which had led to new market entry, new services and industry consolidation as players tap new sources of revenue.

Segments

Asset Management

Invesment Banking

Market Infrastructure

Drivers

Shaped by the global megatrends, the pandemic and the declining economy, the sector is being transformed by five major drivers:

Commoditisation – The move of many products to liquidity exchange trading have squeezed margins, especially as complex, high margin products fell out of favour and proprietary trading diminished. Players are seeking differentiation to attract customers and find attractive opportunities. A number of digital investment management companies have entered the market to take advantage of this demand.

Trust & Compliance – The 2008 financial crisis challenged the trust previously placed in banks, ensuing new regulations focused on capital adequacy and market transparency. As a consequence, aggregate costs for major investment banks were 25% higher in 2014 than they were in 2005 [1]. Regulation is intensifying, especially around cybersecurity, operational resilience, customer data & privacy, anti-money laundering (AML), transparency, ESG and digital assets. High profile failures in investments like crytocurrencies may also have an impact.

Innovation – Capital Markets have been early adopters of technology such as low-latency and algorithmic trading. New technology will be key to differentiation. Front-to-back digitisation has not occured and is paramount to achieve greater efficiency, provide new digital services and deliver a superior customer experience. Sustainable Finance or ESG (environmental, social & governance) and digital asset investments are also a critical innovation. The challenge is how do the capital market players harness these technologies and how does regulation keep up.

Efficiency – Capital markets are complex with many steps in the value chain leading to increased costs. Many legacy processes and technologies exist, disruptors will seek to reduce friction whilst maintaining trust and compliance. Resilience of capital markets is critical especially during moments of crisis like COVID-19.

Profitability - Global markets hit an inflection point in 2022. The reset button has been hit for nearly every major asset class. The sectors’s clients—institutional, corporate and consumer alike—are under pressure as they cope with the declining economic situation and anemic asset class return forecasts, which will impact future revenue growth and margins. Pre the 2008 financial crisis Investment Banks were achieving 20%+ ROE, but this is nearer 10% today due to capital requirements, regulatory costs, commoditisation and new players [2]. Market Infrastructure players are seeking scale and revenue diversification to drive growth. However both niche Investment Banks (1.7x) and Financial Exchanges (4.5x) trade at a premium to traditional banks [3]. Consolidation is likely to continue.

Transformation

The industry is transforming towards to a digital financial ecosystem where the primary channel is digital & mobile; money, assets and paper products are transformed to digital on digital platforms, artificial intelligence is used to complement human interactions and manage risk, and where finance is embedded seamlessly into everyday life.

Despite electronic trading, true end to end digitisation of the Capital Markets value chain has not happened, leaving considerable friction, cost and a lack of transparency. Capital Markets is therefore shifting to a ‘digital finance ecosystem’ where assets and securities are fully digitised, and big data, analytics, AI and automation are used to drive new differentiation, straight through processing, coupled with transparent data-driven compliance and reporting.

Capital Markets understand that the new normal is digital:

- The COVID-19 pandemic has had a less direct impact on Capital Markets but the shift to digital interactions, digital products and remote working will continue to accelerate digitisation of markets.

- Digitising the end-to-end capital markets customer journey is key to improve customer experience, increase efficiency and reduce costs. - Even in higher value services, such as asset management, digitising the end-to-end customer journey is key to improve customer experience, increase efficiency and reduce cost. Investment management platforms, such Robinhood or Nutmeg, have created new competition for the traditional Investment Management companies.

- Almost three quarters (72%) of UK banks are embracing digital technology to make their business operations greener [3]. This holds true for Capitial Markets with its extremely high usage of datacentres.

- The crisis has also driven a rapid increase in cyber-attacks and fraud, a 20% increase in actual attacks and a 500% increase in attempted attacks [4 ]. Protecting Capitial Markets is key.

- According to the seventh annual global banking survey conducted by The Economist Intelligence Unit in March, 45% of respondents said their strategic response to the COVID crisis was to build a “true digital ecosystem [5].” This presents an opportunity for the true digitisation of Capital Markets.

Transformation will require a shift to the design & development of:

Digital Platfoms & Assets

Quantamental Analytics

Intelligent Automation

Data-driven Compliance.

Digital Technology

Fundamentally Capital Markets participants will need to adopt three key technology approaches:

Digital-first for the new normal digital experiences and straight-through processing.

Cloud-first for operational efficiency and time-to-market gains. Workloads
in the cloud increased from 8% to 15% in just one year 2021-22 [2].

API-first for effective ecosystem collaboration. They may also leverage technologies such as Distributed Leger Technology (DLT).

This will be supported by significant investment in Data, Analytics, AI & Automation to to deal with a deluge of information caused by the growth of regulation and information, and to deliver better customer experiences, quantamental analytics and straight through processing.

Capital Markets rely on speed, and so networking is critical to deliver a fast and reliable experience globally.

Security, Compliance & Data Privacy is also critical as customers will expect the Capital Markets to operate at a very high level of security and privacy to protect customer confidential information and money.