General | Uncategorised
Written by Alisa Walker
Apr 28, 2023
We have all experienced the turmoil landscape of capital markets. Following the pandemic, the past year has continued to bring unexpected change en masse. Conflicts between Russia and Ukraine, and Taiwan and China, as well as in other regions show movements of regional deglobalization. Western countries have seen their highest inflation rates since the second world war and supply chains remain uncertain. Additionally, we have all been shaken by the sharp and intense turnarounds in monetary policy. It could be said that no matter how big or small, new developments will no longer come as a surprise – the turmoil landscape has become somewhat normal.
Capital markets are subject to these pivotal changes, known as megatrends. This is because megatrends dominate the market developments, its individual players, and their receptive business models.
Megatrends are large structural changes that have irreversible global consequences, usually within the coming decade. They can start as an isolated incident, but their impact ripples widely across the globe. As to be expected, megatrends are often centered around economic power, natural resources, technology, and society – none of which are mutually exclusive. While megatrends provide security based on long-standing data, their unpredictable developments and implications always leave a degree of uncertainty.
The development of megatrends can also be observed in the realm of capital markets leading to a more dynamic environment which in turn influences decision-making on both a macro and micro economic scale. In this essay, we identify five megatrends and their impact on capital markets: The rise of ETF investing and digital investing services, distributed ledger technology and cryptocurrencies, sustainable investing and ESG, digitalization and automation, and artificial intelligence and machine learning.
Megatrends and their impact on capital market
The rise of ETF investing and digital investing services
A trend that remains consistent for equity capital markets is the rise of exchange traded funds (ETFs). Despite an 11% fall in assets under management (AUM) for Europe in 2022 due to geo-political conditions, 12% yearly average growth is predicted over the next five years. The European ETF market is the global sustainability leader, with a high 19% of ESG ETFs in the entire market.
ETFs are managed by investors on digital investing platforms. This comes as wealth transfers from Boomers and Gen X to Millennials and Gen Z. Millennials and Gen Z are generations who grew up with digital technology and consequently expect digital services. It is also worth noting that they are typically highly conscious of topics such as global warming and sustainability. Considering this, institutions need to meet the needs of their target audience by providing suitable investing solutions so they do not lose a significant client base in the medium and long term. There is still great potential for incumbent players to develop in this area of service offering.
Importantly, this consumer-focused trend is mirrored on the corporate client side, where digital advisory processes are gaining ground. After all, operational efficiency gained from investment advice expedited by digitalization can be a significant factor for corporate clients in such services.
As a capital markets technology leader, we at LPA have always had our finger on the pulse of the latest trends and developments in capital markets. While we have chosen not to specifically occupy the ETF investment space focused on B2C, we are at the forefront of the move toward digital investing services in the B2B space. With both software solutions and consulting services, we have guided our clients from manual investment advice and execution processes to fully automated, digital environments where clients have instant access to financial institutions’ service offering and can navigate through a seamless workflow process from start to finish.
Distributed ledger technology and cryptocurrencies
Distributed ledger technology (DLT) provides secure and decentralized methods of data sharing – an approach that is transforming the administrative infrastructure of capital markets. Banks are increasingly developing pilot solutions with conventional and new asset classes, showing clear traction towards tech in the industry. On this, March 2023 marked the start of the DLT Pilot Regime, part of the Digital Finance Package introduced by the European Commission in 2020. The pilot tests the central bank digital currency (CBDC) and enables eligible companies to utilize a DLT-based trading facility and/or financial instrument settlement systems within a flexible regulatory environment. Additionally, any amendments to EU regulations that will be necessary due to DLT, such as the Markets in Crypto Assets (MiCA) regulation, can be closely observed.
The rise of DLT and therefore crypto investing is impacting the financial industry. Increasingly more financial institutions are expanding their service offering to enable their clients to trade crypto with their respective bank. The offering of such products requires more than a regular new product process (NPP) to be initiated. Instead, it necessitates that the respective institutions have a thorough understanding of the technology and provide both an adequate technical infrastructure and processes from order acceptance and routing or execution, to settlement and custody.
Implementing crypto products or using decentralized finance (DeFi) has initially been observed with reservation, due to risk and compliance matters for the issuer. However, as long-standing innovative finance experts, for our clients, state-of-the-art technology has already enabled compliant democratized financial system transformation.
Sustainable Investing and ESG
Around 270 asset managers with USD 60 trillion AUM have now signed the Net Zero Asset Managers initiative of net zero portfolio emissions by 2050. Especially within the EU, the arising ESG (Environmental, social and governance) framework is increasingly used not only for more environmentally conscious investment decisions but also for the broader impact of corporate social responsibility. The core issue remaining, however, is the true definition and significance of ESG and how it is best measured. Compared to the established credit rating industry, the ESG rating industry is far from a point of consolidation. According to The Sustainability Institute by ERM, of 600 individual ESG ratings and rankings (in 2018) the overall correlation is often weak with the core sources of divergence being both what factors measured and how these factors are measured. Hence, investment managers can influence the shade of green of their portfolio by simply selecting the rating most favorable to them – potentially with resulting allegations of greenwashing.
Meanwhile, the political sphere is working toward a consolidation of ESG requirements: PRI responsible investment regulation database reports that there are now 500 sustainable investment regulations, compared to less than 50 in 2015. Given the fragmented ESG rating landscape and the still existing vast gaps in their respective assessments, the regulatory environment is expected to expand in order to successfully consolidate requirements and methodologies – and possibly the industry as a whole.
For individual players within the financial industry, such consolidation may be either a curse or a blessing. But for the industry as a whole, we believe the pros heavily outweigh the cons. After all, a level playing field is the basis for competition – also in the context of ESG and greenwashing issues. The topic of ESG will and has to develop further if its goals are to be achieved, and this development will inadvertently lead to continuous change within the financial industry and its constituents.
To support financial institutions to stem the challenges accompanying the developments, our consulting practice has laid a deep focus in ESG. Born out of our intrinsic motivation to foster and develop ESG for both the financial industry and for the economy as a whole, we have developed a broad and deep body of ESG-specific expertise and software for our clients. From front-office product development to middle-office risk management processes and systems, all the way to back-office compliance and (regulatory) reporting, we support our clients across the entire ESG spectrum.
Digitalization and automation
The era of digitalization that was accelerated during the pandemic does not show any signs of regression. Worldwide spending on digital transformation technologies is forecast to almost double from USD 1.31 trillion in 2020 to USD 2.51 trillion in 2024. As a result, capital markets which are significantly affected by the need to transition from manual to digitalized operations to maintain operational competitiveness, have been forced to either adapt their business strategies accordingly or simply be left behind.
However, digitalization and automation are not new to capital markets. In fact, this trend has long been a topic that has led to company restructuring and downsizing.
But there has been reservation and precautions around implementation because the transition from manual to automated processes often includes great efforts and operational risk, and of course, high costs. Nevertheless, the increasing opportunities that arise from shifts to digitalized and automated internal operations for banks, asset managers, and insurance companies lead to increased relative improvements to existing processes.
We at LPA have focused on this development for the last two decades, actively supporting our clients with both consulting services and software solutions to automate procedures.
One of the most prominent and well-known solutions may have been our automated generation of key information documents for packaged retail and insurance-based investment products (KIDs for PRIIPs) for a large body of financial institutions within the German banking landscape. At the same time, our renowned software suite offers digitalization and automation across the entire capital markets, corporate banking, and asset and wealth management spheres. Specifically, we support our clients with software solutions for structured products, OTC products, legal documents and contracts, and asset management-focused regulatory reporting.
Artificial intelligence and machine learning
Generative artificial intelligence (AI) has gained significant attention in recent years, with interest at an all-time high as of January 2023. This peak can be attributed to the development of ChatGPT4, a user-friendly conversational AI interface by OpenAI. However, AI and predictive analytics have been of relevance for some time. They have already been implemented for banking data models and despite initial reservations concerning security and associated risk, a more open approach to using cloud platforms has led to more AI opportunities. Additionally, thanks to “transfer learning,” the democratization of AI has brought an increased AI adoption among smaller enterprises.
However, big promises and slow advancements in technology have resulted in slow AI adoption that is limited to initial proof of concepts and prototypes. Yet, 2023 has already brought significant change to this standstill. This is largely due to technology such as Large Language Models (LLMs), with the likes of ChatGPT4 and greater access to this technology through application programming interfaces (APIs). Furthermore, no code solutions have also lifted the barriers to AI adoption, making it available to business minds and not only technology specialists.
At LPA, we support financial institutions to seamlessly adopt new technologies. We have implemented solutions and use cases in the market for ESG, portfolio optimization, and data driven parametrization for trade surveillance. We also realize natural language processing (NLP) powered contract navigation and case management for syndicated loans, big data analytics in anti-money laundering (AML), and more. As we brace for the coming innovation cycle, we see opportunities in enterprise search, corporate banking relationship management and intelligent automation across the full chain of banking operations.
Capital markets are driven by several megatrends, some of which we have discussed in this essay. The fast advances in technology and generational transfer of business require nontraditional solutions to meet client needs while remaining compliant. Both of which are possible when implemented with care and expertise. Scalability is essential for all players, whether it be for documentation generation, adaptations to (syndicated) lending processes, or the ever-expanding regulatory landscape. Despite an arguably reserved implementation of digitalization, automation and AI in capital markets and asset management, ongoing application shows that the benefits reaped by industry players are worth the initial challenges encountered.
Having initially disrupted capital markets with digitalization in 1999, we are thrilled to observe that despite hurdles, the discussed megatrends are gradually normalizing innovation in the industry. In this regard, we are glad to be a dedicated partner of capital market players. With two decades of on-the-ground experience, we do not only guarantee compliance, but business competitiveness in a dynamic and often unpredictable landscape.
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