Financial Markets

Europe’s capital markets stand at an inflection point against a backdrop of the confluence of two trends – one political, one technological. These present an opportunity to take a decisive step forward. By Dixit Joshi, managing director, group treasurer, Deutsche Bank 

Smarter technology enables us to build a capital market ecosystem which, if successfully implemented, would benefit all its participants and facilitate the convergence of European capital markets in the post-Brexit environment. This step, if taken, would also reverse a post-crisis paradigm in which systemic barriers have been deployed as bulkheads against risk contagion. Interconnectedness, which helped precipitate the last financial crisis, may help us guard against the next.

Ten years ago, the financial crisis triggered a fundamental re-evaluation of risk in the banking industry. Banks’ capital resources were found to be too low relative to leverage; the threat of liquidity constraints had been seriously underestimated; and the interconnectedness of our industry was found to present a contagion risk far greater than the system was prepared for.

This led, in turn, to the development of new risk mitigants. Capital bases were rebuilt, leverage cut and liquidity levels increased. Risk mitigation efforts frequently involved building deliberate internal firebreaks against the risks of systemic contagion. Simultaneously, national regulators have strengthened, and continue to strengthen, local capital requirements. For both systemically important banks and national jurisdictions, preventative ‘buffers’ have become part of the landscape. Now, two emerging trends challenge that paradigm.

Political drivers

The first is political: the need to develop and deepen EU capital markets through deeper Capital Markets Union. This notion has been under discussion for some time. The benefits are potentially enormous, both to investors and to businesses seeking financing, if Europe’s increasing economic and political integration is backed up by more unified capital markets. Nonetheless, capital market interconnectedness faces significant political and regulatory hurdles – the need to harmonise legal frameworks is just one. After the contagion risk exposed in the financial crisis, the banking industry, lawmakers and regulators face a fundamental question: how can more integrated capital markets benefit businesses and national economies, without compromising system integrity or effective supervision? Simply put: can the financial system be both more interconnected and safer?

Technological implications

The second is technological: with data the oil the of the 21st century, business models need fundamental reframing. The implications for banking are profound, and potentially existential. Some commentators talk of the ‘Amazonification’ of the banking industry: access to banking services is increasingly through digital channels. Customers, from private individuals to large institutions, may need banking, but not necessarily banks. Responding to this challenge is a major differentiator for banks today. It may also herald a paradigm shift in the way our financial system works.

Distributed ledger technology, notwithstanding the current hype, redefines our view of system interconnectedness. By creating a consensus of replicated, shared, and synchronised digital data, mutually accessible across multiple sites and national jurisdictions, we create a new order of transparency between all participants in the system. Potentially, all stakeholders stand to benefit. Matching capital supply and demand becomes more efficient, faster and cheaper than ever.

Real-economy businesses seeking to raise capital, and potential investors, stand to gain from common access to such an ecosystem. For banks, liquidity becomes far easier to manage, and bottlenecks can be avoided.

Their cost of managing risk is significantly lower in a system which is transparent to all its inhabitants. Underwriting, and corporate actions such as coupon payments and stock splits become almost self-executing. This becomes all the more valuable if national capital markets become more integrated.

Regulators also win

Regulators also stand to gain. With informational integrity and transparency, to which supervisory authorities have direct access, regulators gain unprecedented transparency over transaction flows, individual transactions and ultimate beneficial owners. Potential breaches become apparent in real time. The cost of compliance is far lower, and its effectiveness far higher, than in a fragmented information landscape in which basic information gathering forms a significant part of the supervisory effort. The traditional trade-off – the compromise between safety and ease of use – may no longer apply.

Of course, caveats exist. Significant further harmonisation of legal frameworks, capital market regulation, and specifics such as insolvency laws would be a must. Without this alignment, the shared transparency of the distributed environment is less beneficial. The technological backbone of shared ledgers must be proven to be reliable and secure against cybercrime and other forms of abuse. Common standards of access – for example, technological ‘passports’ – would be needed. All of this would require not only significant technological development, but also upfront investment and political will. Significantly, this will require a change in mindset: from a fragmented landscape of winners and losers to a community of shared gains.

Eyes on the prize

Despite these notes of caution, we must not lose sight of the prize. The prospect of creating a secure data and transaction ecosystem, with access for all relevant actors in a cross-border capital markets environment, may offer us the opportunity to improve the flow of capital within the single market, and turn one of the post-crisis paradigms on its head. Interconnectedness, which contributed to the near-collapse of the global financial system 10 years ago, may yet be harnessed as a force for good.

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