“Trust is the most important asset in capital markets and in our financial system”.
To preserve trust was paramount for the financial industry in the year 2020. The Covid-19 crisis was an unparalleled health and economic shock for all market participants. The pandemic led initially to a high degree of uncertainty and, temporarily, to significant dislocation in capital markets, associated with a spike in volatility. Elevated trading volumes and some liquidity issues in certain market segments (e.g. credit) put market infrastructure under strain.
From the point of view of an asset manager, a remarkable feature of the crisis was the fear of potential adverse feedback loops between financial markets and the real economy leading to a breakdown of the usual correlations between asset classes. Only the combination of timely, decisive, and coordinated actions by central banks with fiscal, regulatory, supervisory, and health authorities was able to repair market stability. As a result, confidence in the financial system was restored, markets recovered quickly and investors‘ risk appetite returned.
As exceptional as it was, 2020 turned into a very successful test of market infrastructure. Unlike the financial crisis in 2008/9, the pandemic had no (long-term) negative impact on confidence in financial markets. Market infrastructure (both in cash and derivatives markets) also proved resilient under highly challenging circumstances. In the fixed-income space, the transformation to new market structure features like all-to-all platforms and buyside-to-buyside trading was accelerated by the crisis.
Market access is key
For an active asset manager, it is of crucial importance during a market shock to be able to draw on skilled trading expertise with an adequate number of human resources, as well as reliable and sophisticated trading technologies. Furthermore, market access to a broad variety of liquidity pools is a key advantage.
Market dislocations do not only pose numerous challenges but also great opportunities for long-term investors. This is reflected in a significant degree of outperformance of our funds in the year 2020. For us, this proves that even under extreme market conditions, an active approach in asset management is able to deliver excess returns.
One of the lessons of Covid-19 is that rebuilding trust in markets also generates rising demand for equity products from retail investors. This trend has been intensified in the wake of a reinforced zero-interest-rate policy and negative real yields in Europe and the U.S. Covid-19 has had a big impact on different market drivers, like fiscal and monetary policy and sovereign debt levels. The pandemic has therefore not undermined trust in the financial system. It has, however, changed the investment environment and created new threats as well as opportunities in markets. An active approach in the investment process alongside a balanced view on risks and returns is needed.
Now and then – challenges, shortcomings, perspectives
“The interlink between the real economy and financial system is key: it is hazardous to regulate one part and not consider the impact on the other.”
The last 10 years have shown that liquidity is crucial for securing the functioning of capital markets – especially in times of crisis. Covid-19 has demonstrated that regulation needs to focus more on this issue. The opposite of good is well-meant: many measures in the past did not foster market liquidity (and sometimes even worsened it, e.g. by increasing the cost of risk capital and balance sheet in brokerage).
While regulation is often still focused on discretionary investors, systematic accounts and hedge funds or family offices have become much more important than before. These types of investors could make use of leveraged strategies that could raise the question of counterparty risk. As of today, the increased importance of these investor types and their potential market impact needs to be considered in regulation, especially given the fact that their behaviour could negatively affect the investment decisions of long-term-oriented investors.
New opportunities around the block
Beyond that, we see a lot of new opportunities in the area of market infrastructure. With distributed ledger technology (DLT), we might see disruptive consequences for existing parts of the current value chain in the financial industry.
Settlement of securities is still complex and time-consuming, even in the 21st century. From an investor's perspective, the broad adoption of blockchain in the settlement process can result in significantly faster processing and efficiency gains in the issuance of securities. We expect the use of blockchain in combination with tokenisation of securities to become a game-changer for the industry.
A future DLT-based tokenised settlement process offers huge advantages over today’s traditional book-entry system. For example, all formal rights and obligations associated with the security transaction are fulfilled and validated simultaneously in a so-called “atomic” blockchain-based settlement.
Additionally, we should all be prepared to “ride the crypto tiger”. The future importance of crypto assets as a new asset class is far from certain, but investors are looking to new sources of diversification in their portfolios via Bitcoin, Ether and other cryptocurrencies. There is a chance that these types of assets are here to stay. Currently, the perception of crypto assets as a viable investment alternative is one of the most hotly discussed topics in 2021.
Regulation – bold and limited
What’s more, it is not all about the pandemic. Climate change and thus the necessary transformation of the economy will shape financial markets for the future as well. Market infrastructure needs to be resilient, stable, and reliable. Market infrastructure is the prerequisite of economic prosperity. Smooth functioning and frictionless trading are essential in order to mitigate investment risks.
To take all that into account, we need to make sure that the costs for the implementation of regulatory requirements will not rise into immeasurable infinity. Markets need sufficient room to manoeuvre, and regulation needs to be both bold and limited.
The views, thoughts and opinions contained in this Focus article belong solely to the author and do not necessarily reflect the WFE’s policy position on the issue, or the WFE’s views or opinions.