When it comes to improving financial markets, you don’t need to move mountains

What’s the best way to improve financial markets? New trading rules? Safer, faster technology? Or perhaps drilling holes through mountains?

Well for Paul Milgrom, the Shirley and Leonard Ely Professor of Humanities and Sciences at Stanford University, large construction projects that require cutting through a mountain or building a microwave tower are not only a bad way to improve financial markets, they are also bad economics. 

“From an economists’ point of view, those projects are a waste of economic resources in the economy; they don’t add to the efficiency of economic systems,” the Nobel Laureate told the audience of the 2021 Credit Suisse Asian Investment Conference (AIC).

Milgrom is of course referring to efforts by exchanges and investors to reduce - by milliseconds - the time it takes to transmit orders by laying fiber optic cables in the most direct route possible (even if that is through a mountain) or using microwave radio frequencies to transfer data more quickly. These efforts were most famously recounted in Michael Lewis’ book about high frequency trading, Flashboys: A Wall Street Revolt.

Rather than speed, “for economists, the important decisions influenced by financial markets take place on a much longer time scale. We’re trying to get appropriate pricing, firms are trying to get capital for companies and investors want sufficient liquidity so they can get in and out of investments.” 

Innovations Milgrom believes offer better prospects for market reform include reducing the leg risk created when conducting transactions with multiple parts. Securities markets are primarily organized around the buying and selling of one security at a time, “but as many investors are interested in a portfolio rather than an individual security, why are they not allowed to express a bid that has to do with a whole portfolio rebalance, rather than break it in little pieces?” 

Does blockchain have a future?

While it’s the preserve of economists to take the long-term view, the acceleration of digital disruption brought about by the pandemic is changing the financial services industry and fast. 

But if digitalization trends are accelerating, what does this mean for distributed ledger or blockchain technology, once heralded as a game changing innovation? As Blythe Masters, CEO of Motive Capital Corp, noted in her AIC discussion, while the technology holds a lot of promise for the financial services industry, it still faces significant barriers to adoption. These include the complexity of existing financial services infrastructure, the cost of change and also the aversion to change. 

“That aversion is partly psychological. There are participants and ecosystems that are threatened by that change and whose roles may have to evolve and may evolve out of existence. But the aversion also relates to the sheer cost and extent of the lift that’s needed when you’re introducing entirely new infrastructure,” according to the financial services and technology expert.   

Given the volume of announcements that have come out in recent years from banks, FinTechs and market infrastructure firms about their blockchain initiatives, investors could be forgiven for thinking that far from showing resistance, the industry has embraced the technology. Yet for Masters, the problem with many of these projects is they tend to only provide a solution to a small part of the overall problem, thereby creating more obstacles, not fewer.

“Even if it’s an elegant solution, it’s still an add-on to the status quo. You do not get to stop doing things the old way just by adopting this new solution.”

“The challenge in perpetuating the technology is the need for a pre-existing network of like-minded institutions that have the right motivation to essentially adapt and adopt the new technology,” she explained. 

The fragmentation in the industry is perhaps why one of the most prominent blockchain projects is the Australian Securities Exchange’s replacement of its entire post-trade settlement and clearing infrastructure for equities.  

“It’s no coincidence that this project has occurred in an ecosystem where there is a single centralized technology provider as the clearing and settlement agency,” noted Masters. 

Failure is not an option

So if accelerated digital disruption is the future of financial services, what is the outlook for the industry over the near term? Well get ready for a wild ride. Masters expects the next five years to see more “technological evolution and ruthless competition than probably in any other five-year segment in history.” 

And traditional banks face some of the biggest hurdles including an unlevel regulatory environment that provides less oversight to non-banks delivering financial services, the entrance of newcomers that can cherry-pick their business model and the technology they employ, and open banking laws that mandate competition in previously closed areas of markets. 

Not that FinTechs have it all their own way. Banks benefit from balance sheet capacity, their willingness to lend and take credit risk, as well as a high degree of trust. Moreover, as Masters pointed out many of the newer financial services firms face a fundamental problem – delivering profitability. 

“A successful business model has to evolve to the point where it is profitable. Many of the non-bank and neo-bank challengers that have enjoyed stratospheric growth rates, and are the darlings of the capital market as a result, have not been able to covert that growth into profit and therein lies the challenge,” she said at the AIC. 

And just in case the message is still not clear, Masters had a warning: “Those that fail to invest and that fail to truly appreciate the scale of the challenge will suffer and suffer dearly.”