Technology could remake...or destroy... emerging financial markets (I)

Previously in this series we explored the impending changes in the global financial industry with particular focus on how these developments threaten to reshape investment management. Here, we revisit a strand of that discussion, focusing on the threats these changes pose to the industry in less developed emerging and frontier markets.

As with any system, industries evolve under a set of incentives and constraints which, depending on general they are, often dictate their inherent robustness or fragility in the face of unforeseen environmental changes. While adaptability is the key to long-term survival, strong, narrow-focused incentives and/or constraints tend to compromise this feature leading to rigid, fragile systems. 

 In the foregoing parts of this series we outlined how environmental drivers and constraints have shaped both markets and industry architecture in developed financial markets. In particular, we highlighted how conflicts between the diversity of client needs and the costs it imposed on the industry's operating model was resolved by, among other innovations, the popularisation of collective investment schemes.

On the one hand, the limited scalability of the prevalent investment management model; the industry's drift towards collective schemes and the network effects this engendered, helped shape it into a natural oligopoly favouring the emergence of a handful of dominant players. On the other hand, the persistent necessity of addressing a diversity in client needs also encouraged proliferation and specialisation, allowing the emergence of many smaller players catering to different niches and approaches.

Thus, under a system which encourages innovation and differentiation, these two countervailing trends have led the industry to evolve organically into a rich and diverse tapestry of service providers who work fairly collaboratively in a range of mutually dependent spheres. Whether they be the various categories of exchanges, securities brokers, large and small institutional or retail funds and managers of various varieties on both the sell and buy sides; all inhabit a robust, self-reinforcing ecosystem that provide a very wide range of tools to end-clients and their fiduciaries.

Different strokes  

For less developed markets, such evolution has rarely been so seamless or organic. For one, these markets are generally plagued by a uniform set of problems fueled by a combination of structural, environmental and fiscal factors. In particular, the generally low level of disposable income in these economies means that the threshold for cost effective service delivery required by the industry is situated quite high-up in the wealth pyramid, excluding the generality of the population, limiting the effective size of the industry and hampering scalability, even under collective schemes.

Correspondingly, the fee structures required to sustain the relatively small (both in size and number), mostly active-type mutual-funds available in these markets is typically not viable for clients at the lower rungs of the pyramid. Much limited in the scope of themes covered, highly-correlated across different providers and largely exposed to the same primary risks factors, these funds are scarcely able enhance their clients' ability to accumulate wealth over time. Besides, the addressable segment of the population in these jurisdictions typically comprises those with the best access to financial services from more developed markets, which weakens the position of domestic fund managers.

Furthermore, infrastructural and institutional deficits often heighten the costs of service delivery, e.g. by making the identity verification and management required to run a financial system effectively unduly burdensome. In addition, given their lower levels of financial literacy, more hand-holding is generally required to acquire and manage clients in these markets, making this one of costlier elements of the investment management process and creating additional barriers for players in this space.

Own goal

As serious as environmental and fiscal problems are, they are often considerably worsened by choices made by the industry and their regulators. In particular, as outlined in this companion article, policy making and regulatory intervention in these jurisdictions is often reactive, myopic and riddled with bad incentives, helping to create and perpetuate sub-optimal industry structures.

One area where the effect of this has been particularly pronounced is in financial market innovation and the near-complete absence of industry-wide initiatives to tackle some of the more obvious problems. For instance, regulators in these markets rarely pay any serious attention to the costs of delivering financial services and often compound it. Nigerian financial markets, for example, continue to maintain a bloated roll of sundry intermediaries to administer securities holdings despite changes in technology long rendering them obsolete; and transaction and listing fees continue to proliferate in many asset classes.

This lack of imagination and templated approach to policy-making has in no small measure contributed to very limited tool-box of investment and risk management products available in these markets, leaving investors, their managers and the broader economy hard-pressed finding means to disperse risk and manage investment outcomes. Conversely an inherent bias against investing off-shore which often arises from a misguided notion of 'developing local markets' means that managers have had little opportunity to learn to utilise the tools available elsewhere.

The devil in the detail

Beyond this, the investment industry in many such markets have generally adopted the traditional discretionary model of fundamental investing as their primary operating framework driven, for the most part, by uncritical mimicry of the larger players in developed markets. However, in the context of the foregoing discussions about the peculiar structural problems in emerging markets, it is far from clear that this approach is optimal.

For one, this model is costly to implement and difficult to scale (vertically or horizontally), making it is particularly susceptible to the inherent inefficiencies and constraints of less developed markets. For example, constrained by the size of the business and its ability to support the requisite manpower, scaling research coverage effectively beyond a handful of securities/markets outside their own shores is often a prohibitive venture under this operating model.

Also, hampered by knowledge gaps, as well as regulatory and other structural obstacles, it is often difficult for these managers to leverage the more favourable architectures available in more developed markets. This compromises their ability to cost-effectively deliver functional financial services to domestic clients under this model; short of completely outsourcing their mandates to foreign managers. Even in home markets, one often finds that product development, if at all guided by any coherent strategy, is typically opportunistic.

For instance, a recent rush by managers in Nigeria to develop money-market funds was a much belated and herd-driven effort to take advantage of long-standing gaps created by low interest rates on banking deposits in a market where the central bank persistently props up short term interest rates to bolster the currency. However, after an expensive listing process, many would have found themselves confounded by sudden recent changes in central bank policy restricting outside access to money markets and uncharacteristically lowering short-term interest rates, possibly in a bid to protect banks from this onslaught.

The nature of the threat

Needless to say these problems have the impact of building significant rigidities into the financial systems of these less developed markets, rendering them, not only incapable of adequately securing financial welfare of their clients, but also woefully unprepared for impending changes in the global financial landscape. In particular the technological changes we elaborated upon in previous essays pose a potent strategic threat to managers in these markets as they promise to break down access barriers which have hitherto served to protect less developed markets, potentially leading to a massive erosion in their client base.

The emergence of globally acceptable crypto-currencies represents a major vulnerability in this regard, especially given that currency depreciation typically represents the single most important source of value destruction for savers in these economies; a problem which regulators not only seldom seek to address but often exacerbate. Also, the anticipated advent of mass personalisation in the investment industry opens the door to effective financial services that clients in these markets frequently lack; a threat particularly pronounced among the wealthier clientele who usually serve as the mainstay for managers in these regimes.

This, in essence, is the dilemma confronting less developed financial markets. On the one hand, the environmental shortcomings and poor architectural choices considered earlier create gaping vulnerabilities in their operational fabric, with the previously discussed technological changes constituting the primary avenue for the realisation of the threats they pose. On the other hand, however, these very same developments also offer a pathway, not just for survival, but towards flourishing. We examine these issues more closely in a follow up article.