Finance isn’t just a technology problem. Photo: Shutterstock/dgcampillo
A lesson that any technology company getting into finance quickly learns is that finance isn’t necessarily a technology problem at all.
On the one hand, it’s a cooperation and network effects problem—when it comes to developing widely accepted protocols and standards—although tech companies are already familiar with this.
On the other, however, it’s a regulatory problem. For Silicon Valley tech companies used to asking for forgiveness rather than asking for permission, this can come as a jarring wake up call.
This need for compliance goes a long way toward shaping the rules of the game.
So what factors will shape those rules in 2016?
J. Christopher Giancarlo is the commissioner of the Commodity Futures Trading Commission (CFTC). Last month, he gave a guest lecture at Harvard Law School outlining the six major developments he sees transforming global finance.
1. Cyber Threats
According to Giancarlo, “cyber risk is the number one threat to 21st century financial markets.”
Market regulators should have no illusions about the fact that cyber belligerents—both foreign and domestic—view the world’s financial markets as 21st century battlefields. Cyber enemies could use a range of new battlefield tactics to try to cripple financial markets, from destroying the course of banking and trade settlement transactions to using poison pill algorithms to flood markets with bad data and fake trades in order to drive trading volatility and market collapse. And attacks would not just be directed to Western financial markets: all markets around the globe are vulnerable to attack, whether as a primary target or an attack response.
2. Disruptive Technology
From automated electronic trading (think High Frequency Trading) to financial cartography (network transparency and risk management) to… bum bum bum… the blockchain—we’re entering “a new phase in human history,” explains Giancarlo, “when exponential digital technologies are rapidly changing the very nature of human identity, work, leisure and society.”
The Bank of England has called the blockchain the “first attempt at an ‘internet of finance’” with the potential to de-centralize legal recordkeeping the same way the Internet decentralized data and information. This transformation will not come without consequences, however, including a greatly disruptive impact on the human capital that supports the recordkeeping of contemporary financial markets. On the other hand, the blockchain will help reduce some of the enormous cost of the increased financial system infrastructure required by new laws and regulations, including Dodd-Frank.
3. Government Intervention
As Giancarlo notes, we’re in the middle of “an extraordinary period of governmental and central bank intervention in the U.S. economy that is widely distorting the nature and functioning of global capital markets.” (The Fed raised rates for first time since forever last month.)
The Fed is not the only central bank engaging in such extraordinary market intervention. The phenomenon extends to the People’s Bank of China (PBOC), the Bank of Japan and the European Central Bank (ECB), the priorities of which seem to be market stability over vitality and price settin over integrity of asset values.
4. Market Illiquidity
U.S. banks on the sidelines. Chart: WSJ
As we’ve written about in the past, liquidity is the lifeblood of the economy. Moreover, we also pointed out that regulations are putting a crimp on market liquidity—traditionally provided by major banks—that will give to the rise of non-bank market makers. Giancarlo agrees.
Traditionally, large global money center banks served to reduce such market volatility by buying and selling reserves of securities and other financial instruments to take advantage of short-term anomalies in market prices. Their balance sheets served as market “shock absorbers” in times of market turbulence. Now, market “shock absorbers” seem to be a thing of the past. Throughout these recent sharp volatility episodes, banks appear to have been unable to step in aggressively to provide additional trading liquidity. According to one senior banker, “Wall Street’s role as an intermediary and risk taker has shrunk.” This evolution appears to have been underway for some time.
5. Market Concentration
There’s been a “wave of consolidation is taking place across the financial landscape, concentrating the provision of essential market services within fewer and fewer institutions,” explains Giancarlo. That’s a problem.
A modern, dynamic economy can only prosper if it is supported by efficient banking sectors and capital markets featuring a large and diverse range of service providers meeting changing customer needs. Just as eco-systems in the natural world benefit from broad bio-diversity, so do vibrant and durable financial markets thrive best with a broad array of service providers and trading counterparties. Unfortunately, global financial markets are now undergoing a pronounced reduction in the bio-diversity of market service providers, with deleterious effects on market safety and soundness. Market regulators must find a way to reverse this trend, which threatens the systemic safety that Dodd-Frank was meant to preserve.
Giancarlo believes that the financial crisis of 2008 has caused globalization to reverse. The result is market fragmentation and increasing systemic risk.
Just as healthy financial markets require “bio-diversity” of service providers and trading participants, so do they benefit from broad continuity of trading systems. The current fragmentation of global financial markets may be likened to habitat fragmentation in the natural world, in which large, continuous biological habitats are divided into a greater number of smaller eco-systems, isolated from each other by a matrix of dissimilar habitats, leading inexorably to broad ecosystem decay. In a similar way, trading market fragmentation caused by ill-designed rules and burdensome regulations – and the application of those rules abroad – is harming market liquidity and market safety and soundness, increasing the systemic risk that the Dodd-Frank Act was predicated on reducing. Amidst the current tide of de-globalization and slowing world economic growth, market regulators cannot continue to ignore the growing systemic risk caused by market fragmentation.