Capital

journal of financial transformation

Capital Capital markets Financial capital Intellectual capital

12/2001/#3

journal the

DD journal03.v.11

28-11-2001

19:15

Page 1

In memory of Michael Packer, Managing Director - CICG Direct Markets, Merrill Lynch and a member of the journal editorial board, who was sadly lost to the tragic events of September 11th.

DD journal03.v.11

28-11-2001

19:15

Page 2

Lead your way out of tough times.

3 FREE Chapters

Michael Useem, PhD The William and Jacalyn Egan Professor Professor of Management

http://wh-execed.wharton.upenn.edu/2868.cfm

How Do You Learn To Lead? Executive Development Program

His new book shares eight gripping stories of real men and women in business, government, and the military, and draws formidable lessons in working effectively with those above us. Readers will learn how to add more value to their organizations by challenging authority the right way, at the right time.

January 20–February 1, 2002 May 5–17, 2002

To find out how to get three chapters for FREE and more information about Wharton Executive Education, please visit:

Advanced Management Program

http://wh-execed.wharton.upenn.edu/2868.cfm or call 1.800.255.3932 ext. 2868 (US & Canada), 215.898.1776 ext. 2868 (worldwide). [email protected] (subject 2868) e-mail

Professor Michael Useem, author of Leading Up: How to Lead Your Boss So You Both Win (Crown Business, 2001) teaches in these and other Wharton executive programs.

February 3–March 8, 2002 June 2–July 5, 2002 September 22–October 25, 2002

Essentials of Management May 19–24, 2002 (week one of two) June 23–28, 2002 (week two of two)

The Leadership Journey July 14–17, 2002

Leading Up: How to Lead Your Boss So You Both Win is available wherever books are sold. An audio version is available at Audible.com

DD journal03.v.11

28-11-2001

19:15

Page 3

Editor Shahin Shojai, Director of Strategic Research, Capco

Advisory Editors Nick Hahn, Partner, Capco John Owen, Partner, Capco Roger Preece, Partner, Capco

Editorial Board Franklin Allen, Nippon Life Professor of Finance, The Wharton School, University of Pennsylvania Jacques Attali, Chairman, PlaNet Finance Joe Anastasio, Partner, Capco Rudi Bogni, Former Chief Executive Officer, UBS Private Banking Nicholas Economides, Professor of Economics, Leonard N. Stern School of Business, New York University Michael Enthoven, Partner, Chief Operating Officer, Capco George Feiger, Partner, Capco Stuart Feffer, Partner, Capco Jordan Graham, Managing Director, Financial Services Industry, Internet Business Solutions Group, Cisco systems, Inc. Alasdair Haynes, Chief Executive Officer, ITG Europe Thomas A. Kloet, Chief Executive Officer, Singapore Exchange Limited Herwig Langohr, Professor of Finance and Banking, INSEAD Mitchel Lenson, Global Head of Operations & Technology, Deutsche Bank Group Donald A. Marchand, Professor of Strategy and Information Management, IMD and Chairman and President of enterpriseIQ ® Robert J. McGrail, Chairman of the Board, Omgeo Michael Packer, Managing Director - CICG Direct Markets, Merrill Lynch Jos Schmitt, Partner, Capco Kate Sullivan, Chief Operating Officer, e-Citi John Taysom, Founder & Joint CEO, The Reuters Greenhouse Fund Graham Vickery, Head of Information Economy Unit, OECD Norbert Walter, Group Chief Economist, Deutsche Bank Group Paul Willman, Professor of Organizational Behavior, Said Business School, Oxford University

DD journal03.v.11

28-11-2001

19:15

Page 4

We’re taking the knots out of global trading.

We’re Omgeo, the new global joint venture created by DTCC and Thomson Financial. We’re here to untangle the knots that disrupt cross-border trading. We call our solution Omgeo Intelligent Trade Management . It will accelerate both crossborder and domestic trading, facilitate shortened settlement cycles and reduce costs, errors and exceptions. Soon the trades you see today will settle tomorrow. That’s our commitment. SM

A DTCC/Thomson Financial Company Copyright ©2001 Omgeo LLC

Contact us: +44 (0)20 7369 7349 www.omgeo.com

Intelligent Trade Management Solutions

SM

DD journal03.v.11

28-11-2001

19:15

Page 5

Table of contents IMPLICATIONS OF SEPTEMBER 11TH 8

Opinion: Lessons from the tragic events of September 11th Adam Bryan President and CEO, Omgeo

10 Opinion: Disaster recovery and contingency planning: The legacy of September 11th Joe Anastasio Partner, Capco 13 Opinion: Effect of September 11th on the world economy Norbert Walter Group Chief Economist, Deutsche Bank 15 The economic impact of September 11th on the securities industry George R. Monahan Vice President and Director, Industry Studies, Securities Industry Association Frank A. Fernandez Senior Vice-President, Chief Economist and Director of Research, Securities Industry Association CAPITAL MARKETS 28 Opinion: Will emerging B2B e-Markets fulfil their promise? Julian Wakeham Managing Principal, Capco 35 Basic trends in the market for markets for financial instruments Stefan Prigge Institute of Money and Capital Market, University of Hamburg 45 Completing the single market in securities trading: A surgical revision of the investment services directive Benn Steil André Meyer Senior Fellow, International Economic, Council on Foreign Relations 53 STP/T+1: The European challenge. What are the implications of the U.S. move to T+1 settlement for European institutions? Paul Walsh Principal Consultant, Capco 63 The capital markets’ perspective on B2B e-commerce initiatives and alliances Andrew H. Chen Distinguished Professor of Finance, Cox School of Business, Southern Methodist University Thomas F. Siems Senior Economist and Policy Advisor, Research Department, Federal Reserve Bank of Dallas FINANCIAL CAPITAL 74 Opinion: Wealth management in the 21st century: The imperative of an open product architecture George Feiger Partner, Capco Shahin Shojai Director of Strategic Research, Capco

77 It’s time for asset allocation Noël Amenc Professor, Edhec Graduate School of Business, and Director of Research, ACT Financial Systems Lionel Martellini Professor, Marshall School of Business, USC Los Angeles 89 The challenges of risk management in diversified financial companies Christine M. Cumming Executive Vice President and Director of Research, Federal Reserve Bank of New York Beverly J. Hirtle Vice President, Federal Reserve Bank of New York 97 Managed network services pave the way for the Internet's future in financial transactions Bob Miller CEO and Founder, Slam Dunk Networks Inc. David Bartoletti Partner, Capco Fabian Vandenreydt Managing Principal, Capco INTELLECTUAL CAPITAL 106 Opinion: Cross cultural branding for private banks Nick Hahn Partner, Capco Elena Siyanko Research Associate, Capco 109 Coping with cultural differences in international market research Lall B. Ramrattan Instructor, University of California, Berkeley Alan Zimmerman Assistant Professor of Business, College of Staten Island, City University of New York Michael Szenberg Distinguished Professor of Economics, Lubin School of Business, Pace University 117 Liberating human capital: The search for the new wave of liquidity Shahin Shojai Director of Strategic Research, Capco Peter Gray Principal, Futurestep, a Korn/Ferry company Charlie Keeling Partner, Capco Samuel Wang Managing Principal, Capco 127 Intangible asset and value-creation reporting… increasing transparency at Skandia Scott Hawkins Sustainable Synergist, Skandia

DD journal03.v.11

28-11-2001

19:15

Page 6

Letter from the Chairman

Dear Reader,

The ability of the world’s largest capital markets to reopen so quickly after the terrorist attacks demonstrates the resiliency of the financial services industry.

And as we recover from the tragedy, we are learning that the industry has a much bigger role than only to turn a profit. It has the role to provide a home and a future for its employees, and it has a role in supporting the community in which it lives. And it’s in times like these that leadership and commitment are so very important.

The financial services industry, as a whole, demonstrated this very leadership and commitment. Almost immediately, it decided that terrorism could not collapse the world’s greatest financial system. The largest banks, exchanges, investors, and securities dealers worked hand-in-hand with central banks to ensure liquidity and to provide relief to organizations that were severely effected.

The third issue of the Capco Institute journal of financial transformation is dedicated to the future of the financial services industry. From disaster recovery, to the economic impact of the September 11th events on the securities industry, we are proud to uncover some of the lessons from that traumatic day. We also explore the challenges of risk management, straight through processing, global connectivity and communications, the role of the Internet, branding, and the value of human capital in the post-terrorism society.

I believe the industry now has a clearer view of the future it has been constructing all along. As we actively engage in the process of healing our people, our hearts, and our minds, we have an opportunity to collectively build an even stronger financial system and market economy.

And we will do this together.

Rob Heyvaert Chairman and CEO, Capco

DD journal03.v.11

28-11-2001

19:15

Page 7

Letter from the editor

Dear reader,

Senior financial executives were already concerned about the future of the financial services industry even prior to the tragic events of September 11th. The events of September 11th have significantly added to those concerns and left many questioning just how bad the situation can get and whether the recent stimulus package is able to prevent a global economic meltdown. It is in response to these uncertainties that we have devoted a whole section of this issue to the analysis of the implications of September 11th.

World-renowned experts share their views on how the financial services industry responded to the recent events and provide prescriptive recommendations on how we can be better prepared in the future. There is unanimous agreement that one of the best ways to limit the financial implications of such tragedies in the future is to achieve some of our goals, such as improved processing and the T+1 initiative, which will reduce portfolio risk significantly.

The economic prognosis is not as negative as we had initially thought. Data provided by the SIA demonstrates that the U.S. securities institutions will, thanks to the prompt response from the U.S. government and the financial services industry, post their fifth best operational/financial performance of all time, despite the negative impact of current events. The recent success in the War Against Terrorism also suggests that the conflict will not be as intensive and as prolonged as initially anticipated. This supports Professor Walter’s view that market recovery is not too far away.

However, it is with great sadness that I have to inform you that we have all lost a good friend and a valuable colleague during the terrible events of September 11th. Michael Packer, Managing Director at Merrill Lynch and an active member of our editorial board, was declared missing at the World Trade Centre. Our thoughts are with his family, friends, and colleagues. By the way of a humble response to his loss of life, we dedicate a section of this issue to the importance of intellectual capital, the most valuable asset an organisation possesses and something for which Michael will be remembered.

In other sections of this edition of the Journal we focus on financial markets and institutions. The capital markets section examines how the move to T+1 and new European legislation are helping to reduce the risks currently inherent within the financial services industry. The financial capital section of this issue focuses on how individual financial institutions can improve their operational efficiency in order to deal with their customer needs more effectively.

We hope that you find reading this issue stimulating and the information within it of practical benefit.

Finally, we would like to take this opportunity to wish you, your families, and colleagues a happy, prosperous, and peaceful New Year.

Shahin Shojai Editor

DD journal03.v.11

28-11-2001

19:15

Page 8

Lessons from the tragic events of September 11th Adam Bryan President and CEO, Omgeo The horrific events that took place on September 11th have

There is also another counter-intuitive outcome of the

touched us all and changed all of our lives forever. The finan-

tragedy. The closure of the U.S. markets for four days actual-

cial community, especially in New York, but also throughout

ly highlighted the importance of Straight Through Processing,

the world, has been challenged as never before by the terrorist

at least as far as things like trade affirmation and pre-settle-

attacks on the World Trade Center. Firms and institutions

ment communications are concerned. When the normal 3-day

affected by this tragedy, while still grieving for colleagues,

settlement period was extended by two full days as a result

friends, and associates that were lost, are now surveying their

of the trading hiatus, firms that had affirmed their

operations and setting priorities to repair the damage in the

September 10th trades same day found themselves in a much

wake of the disaster.

better situation than firms that needed to reconstruct their market exposure in the wake of the disaster.

Longstanding industry priorities, such as the U.S. T+1 initiative, have understandably taken a back seat for the moment

With the disruption of computer and telecommunications net-

to more pressing concerns, such as disaster recovery back up,

works as well as some physical records in the immediate after-

re-establishing and testing network connections, and repair-

math of the terrorist attacks, it became extremely difficult for

ing or replacing strategic technology necessary to firms’ trad-

several clearing banks to get funds and securities into position

ing operations. Recognizing this new reality, the Securities

to make settlement in a timely fashion. These problems were

Industry Association recently decided to postpone the move

eventually resolved, in large part as a result of the 4-day U.S.

to a T+1 settlement cycle in the U.S. to 2005.

market closure and a major cash infusion from the Federal Reserve into the U.S. banking system. But the inability of

Yet, trading continues apace during this time of stress, and

major banks to move funds and securities for a period of

markets have recovered a major portion of their losses since

several days exposed potential vulnerabilities in the system.

trading resumed after the tragedy. And while the investment industry may have another year before it actually needs to be

Settling trade details vs. settling trades

able to settle trades next day, the events of September 11th

As a consequence, one of the most important lessons we

made vividly clear that acceleration of the rest of the post-

learned from September 11th is that it makes sense to distin-

trade communications process now can significantly reduce

guish within the post-trade process between preparing for

everyday risks and costs which have not gone away, notwith-

settlement and actually making physical settlement. We saw

standing the new priorities.

during the U.S. market shutdown that actually settling trades on T+1 is arguably less important than having all the trade and

A show of resiliency

settlement details agreed as soon as possible, preferably on

If the ‘Attack on America’ was intended to destroy the Ameri-

trade date. Once these details are agreed, any further market

can financial markets and economy, it has served instead to

risk to the trading counterparties is eliminated regardless of

demonstrate their resiliency. Despite suffering an unthinkable

when settlement physically takes place.

loss of human life as well as physical and technological infra-

8 - The

structure, the U.S. securities industry hung tough, re-opened

With some U.S.$3.5 billion in spending now required just to

all markets successfully, and has traded without a hitch ever

replace the infrastructure that was lost on September 11th,

since. Just as the September 11th events have demonstrated to

there will unquestionably be something of a ‘crowding out’

the entire world the indomitable spirit of New Yorkers, the

effect in the near-term on spending for other initiatives. In

remarkable performance of the securities industry in the

this environment, a strategy of migrating from existing STP

aftermath of the tragedy has shown its true character as well.

infrastructures to enhanced solutions in a manner that is mini-

Journal of financial transformation

DD journal03.v.11

28-11-2001

19:15

Page 9

mally disruptive and will not require major new expenditures will enable the industry to continue to move forward to reduce the operational risks and costs that T+1 was designed to eliminate. Having another year to prepare for T+1 will provide the investment industry with the time to re-assess priorities, allocate its IT spend for recovery, and make organisational changes to accommodate a new world in which we now conduct business. Regardless of the T+1 date, however, firms and institutions that prepare to reduce operational risk now rather than later will not only distinguish themselves as leaders, they also will have gone a long way to guard their operations, and their businesses, from any further unexpected events.

9

DD journal03.v.11

28-11-2001

19:15

Page 10

Disaster recovery and contingency planning: The legacy of September 11th Joe Anastasio Partner, Capco September 11th will be etched on our minds for years to come,

week of Sept 17th. Although not all institutions performed as

and for many reasons. Some of us have lost family members,

well as the NYSE and NASDAQ, we should compliment the

others have witnessed the death of their colleagues and

industry for ensuring that trades that needed to be settled

peers, and all of us have lost our innocence. We have come to

were settled, and that everyone was able to complete the

the sad realization that we are all vulnerable to these horrific

trades they had transacted for.

acts of terrorism and that we need to protect ourselves against them.

It really is a great achievement to have put the financial world back on its feet after such a tremendous physical, financial,

The U.S. government is doing all it can to protect our physical

and psychological shock. Can you imagine what would have

security by ensuring that such actions never take place on the

happened if two-thirds of the trades that were undertaken on

U.S. mainland again. Other countries are taking steps to do

Monday the 10th, and were waiting to be settled, had not been

the same. Unfortunately, however, we do not just need protec-

settled so fast? The fact that the industry was able to become

tion against physical threat. We also need to be protected

almost fully operational helped ensure that such a tremen-

financially. One of the most significant outcomes of this hor-

dous threat to the industry was well managed.

rific act was the recognition, for all of us, that the supporting infrastructures of the major financial centers are still suscep-

The industry was able to get back on its feet so promptly

tible to terrorist attacks. We need to take the necessary steps

thanks to the disaster recovery and contingency planning

to ensure that should such a thing happen again, we are fully

(DRCP) that was undertaken. What’s more, the equities mar-

protected.

kets were able to become operational so fast because the NYSE was not directly hit by the terrorists. We should all be

This short piece aims to provide some guidance on how finan-

very grateful for that.

cial institutions can ensure that they are protected from events similar to September 11th. It does not try to provide an

There were, however, many examples of financial institutions

exhaustive list of solutions, but just some of the options that

that were not able to perform their functions as effectively as

can be considered. My intention is to make sure that we take

they should have done. This is, unfortunately, more true for

the steps necessary to protect our people and find ways to

small- and medium-sized organizations; but it also applies to

help institutions of all sizes survive future crises.

some larger institutions. And the most significant oversight on the part of us all was that we did not take into account the

First, however, I would like to take a few moments to discuss

extent of our vulnerability to the loss of our most important

what was previously being done by the industry and how it

asset - human capital.

reacted to the recent events. We had all taken the necessary steps to ensure that client

How well did the industry perform?

documents and systems were protected, but we had not given

There is no doubt that the financial services industry had

sufficient attention to how to get our businesses back on their

already taken many of the steps necessary to prevent a com-

feet when so many of our staff were incapacitated. While

plete meltdown in case of a major attack, and I would like to

many of us were making sure that there was connectivity

take my hat off to our colleagues at the New York Stock

within our organizations and with our partners, we did not

Exchange and NASDAQ in particular for becoming fully oper-

anticipate a situation where people would not even be able to

ational within a few days of the event. Even more impressive

get to their offices to get the business going.

was the resilience of the system in coping with the tremendous trade volumes that went through the exchanges in the

10 - The


September 11th was a terrible wake up call for the industry.

DD journal03.v.11

28-11-2001

19:15

Page 11

Technological advancements can help mitigate loss of data,

of bringing operational risk into everyday thinking. Effective

but they cannot protect our most valuable asset, our people.

DRCP would help mitigate a company’s ongoing operating risk

And it is the protection of these highly valuable assets that

and allow companies to prepare, in the most risk-averse ways

will be one of the main areas of focus for this paper.

(based on fiscal, legal, regulatory, and reputational impact), to respond to any potential scenario, including the loss of per-

In addition to the human factor, September 11th also highlight-

sonnel, a facility, or key infrastructure.

ed the risks inherent within our current system. Every day that the markets were closed, the time value of portfolio risk

Successful DRCP would empower senior managers across

increased. In some cases, settlement for transactions in cer-

departments to plan for every potential scenario and to quick-

tain markets was postponed and people who were waiting for

ly understand the cumulative effect that certain scenarios,

their trades to settle and clear found themselves at greater

real costs, and opportunity costs would have on operations

financial risk. T+1 is now more important than ever. If the indus-

and profitability. We must identify, for example, where undue

try had been at T+1 when the September 11th disaster occurred,

emphasis has been placed upon either an individual — one

there would have been significantly less risk in the system.

person knows all about the business but no one else does — or a location - all clearing and settlement is performed in one

T+1 is critical to the industry if the industry is to achieve the

location and the subject experts are located in one building.

levels of efficiency that are sought by all market participants. A piecemeal approach that allows industry practitioners to

The issue of multiple locations had been discussed for many

implement at their own pace will never come close to realizing

years before September 11th. Many institutions had already

either the credit and settlement risk reductions that are being

established support centers at different locations. New tech-

sought or the cost efficiencies necessary in the current cli-

nologies simplify such structures by making it much easier for

mate. I congratulate those institutions that have recognized

multiple sites to work with each other. The question that

this fact and consider their T+1 implementation strategies to

needs to be asked, however, is how far away from each other

be part of their DRCP.

should these locations be?

How we can be better prepared

I do not concur with the notion that all the major financial

of September 11th

have directly impacted many U.S.

institutions should move to Nebraska. What we should never

firms and forced them to redirect budget dollars. As a result,

forget is that this is a relationship business and that we need

the Securities Industry Association has moved the final imple-

to be located within reach of our clients. I believe that the

mentation date for T+1 to June 2005. Assuming that our

island of Manhattan is more than big enough to provide suffi-

industry does meet its target of 2005 for T+1 - and there

cient diversity to protect us from such events in future. Finan-

should be no reason why we can not — the most important

cial institutions can easily establish part of their businesses in

issues that we need to concern ourselves with are: How many

downtown Manhattan and part in midtown, and feel com-

locations should our businesses be distributed among, and

pletely protected. Financial institutions should, however, con-

how can we institute the necessary frameworks to protect

sider segregating different businesses across these two loca-

those courageous staff members physically impacted by

tions rather than having all the front office staff in one 50-

events similar to September 11th.

storey building and the support staff located in another.

While we would certainly hope that a tragedy like September

Companies should learn how to distribute their staff across

11th never happens again, firms must realize that DRCP – as

locations and how tasks can be distributed among different

part of a long-term operating strategy - is an important means

offices. Several floors in multiple locations will also help if a

The events

11

DD journal03.v.11

28-11-2001

19:15

Page 12

company needs to close them down and move. We all know of

■ Distribute staff across several geographical locations. The

the complexities involved in doing this for all of a 50-storey

New York Stock Exchange has recently announced plans

building.

to build a back-up trading floor, perhaps in another Manhattan location. Having only a single, physical trading floor makes the NYSE vulnerable.

Smaller companies will find it hard to come up with the money necessary for an industrial-proof DRCP. They have two basic

■ Cross-train staff so that other employees could replace

choices. They can either outsource their operations to bigger

those that are unavailable. This can be combined with an

counterparts or third-party providers (making sure that their

operational policy of regularly rotating resources so that

outsourcers have instituted the necessary DRCP to protect

staff gain real experience of operating within different

them in the event of a major crisis). Or they can create co-

departments. Outfitting systems with online user manuals

operatives with their peers.

or context-sensitive help files also ensures that employees can learn on the spot if necessary.

Such co-operatives would be similar to outsourcing agree-

■ Consolidate knowledge management so that necessary

ments, except that participants would create the support

information is maintained in a central database that can

function with their peers. They would share the costs of estab-

be easily and quickly passed on to those who replace inca-

lishing DRCP and would be confident of support in times of cri-

pacitated staff. Of course, it will be necessary to put in

sis. The main difference between these co-operatives and out-

place contingency plans against the potential loss of this

sourcing agreements is that in the former, participants can

information.

also rely on their partners to provide them with support staff to replace those that have been incapacitated. A co-operative whose members have been cross-trained to take each other’s places in case of a crisis would be a particularly good form.

■

Contract with solutions providers to have their experts fill in the vacant positions at short notice until new replacements can be hired and trained.

■ Provide hands-on training to students at universities to be able to provide a short-term replacement for those staff

Once financial institutions feel comfortable that their opera-

that have been incapacitated, creating in effect a business

tional infrastructure is adequately protected through an

school reserve core for the financial services industry.

effective DRCP, they need to find ways to ensure that their most valuable assets – people - can also be replaced in times

While no DRCP can completely protect an organization

of crisis. One thing that we all learned during the recent crisis

against such tragedies, it can help alleviate the problem and

is that while data and technology can be protected and in cer-

restore operations to normal more swiftly.

tain cases replaced, human capital cannot, at least in the short-term. The tragic case of Cantor Fitzgerald brings home

Conclusion

the true extent of such a tragedy to a major global power-

In conclusion, I would like to salute my colleagues in the finan-

house.

cial services industry for drawing together, helping each other come to terms with this tragic event, and for getting the

I believe that co-operatives are one way to alleviate the prob-

world’s most important financial center back to work. Their

lems associated with staff that become incapacitated, at least

determination to work through these events proves the

in the short-run and until full-time replacements can be found.

resilience of these great people and should make us all proud

They are, however, a more likely solution for smaller firms.

to call ourselves their colleagues. In this piece I have high-

Larger institutions could:

lighted some of the means by which organizations can be better prepared for such events and thus help ensure that these tremendous efforts do not go to waste.

12 - The


DD journal03.v.11

28-11-2001

19:15

Page 13

Effect of September 11th on the World Economy Norbert Walter Group Chief Economist, Deutsche Bank To identify a period in our economic history when we faced as

economy has been in deflation and recession. Neither zero

uncertain a future as we do today, one has to go back a very

interest rates nor successive pump priming fiscal programs

long way. The terrorist attacks on September 11th unleashed a

have done anything except leave the state enfeebled and

terrible uncertainty on a world economy that was already in a

indebted and unable to carry out vitally necessary reforms.

precarious state. The contrast with the final years of the 20th century, when anything seemed possible, is stark. During the

The fragility of the world economic outlook even before

final years of the last century people were speaking of the

September 11th is clear, if we consider the crisis across a range

Goldilocks economy. Economic growth was surging ahead

of emerging markets. From the ‘Tiger’ workshops of the New

while inflation remained subdued, thanks to ever increasing

economy in Asia (whose growth dropped from rates approach-

productivity - a product of huge developments in information

ing 10% to deep recession) to Turkey and Argentina - paying

technology and the Internet. A ‘New Economy’ was born.

risk premia that would destroy the healthiest economy - concerns were increasing throughout 2001.

Unfortunately confidence over-stretched itself and people lost sight of the fundamentals of any economy, new or old. As

The implications of the September 11th terror attacks spread

growth accelerated to unsustainable levels, interest rates had

far beyond the primary and secondary effects on airlines,

to rise to prevent inflation. The benchmark of the new econo-

travel, and tourism. It is far more than a natural catastrophe.

my, the Nasdaq, sputtered in early 2000 and since then has

The numbers who died and the material damage caused, ter-

been on a downward course. As earlier over-investment

rible and awful as they are, represent just one aspect of the

worked its way through the system, high interest rates affect-

attack against the open system we had come to take for grant-

ed all sectors of the economy. By summer 2001, only the con-

ed. The attack was against this system of co-operation and

fidence of the US consumer was keeping the economy afloat.

deliberately struck at the symbols of its financial and military power. By doing so, and exposing the fragility of the system, it

At first it seemed that Europe could avoid this slowdown. The

massively affected the confidence of both consumers and

bottlenecks in the reform process were beginning to be

investors. The already apparent weaknesses in the world

cleared. Fiscal stimulation would come from tax cuts, which

economy were clearly exposed and the way was set for a

would simultaneously have positive supply-side effects. That

sharp and potentially deep downturn.

this did not come to pass was in part a result of the collapse of the new Economy on this side of the Atlantic (indeed the

Because of the uncertainty that exists, it is even harder than

picture presented by the Neuer Markt is even more dramatic

ever to make economic projections. The war on terrorism will

than that of the Nasdaq). The unfortunate effects of a series

almost certainly be long and difficult. Indeed war may not

of food scares - exacerbated by the even more unfortunate

even be the right word for it. The experience of the UK against

reaction of consumers - on inflation, which limited ECB’s abil-

the IRA, of Spain and ETA, and the Bader-Meinhof gang in Ger-

ity to manoeuvre, also stifled economic growth in Europe.

many show how complex and multifaceted the task of fighting terrorism can be. Nevertheless, there are basic scenarios from

Moreover, the OPEC cartel began to work again. Oil prices rose

which we can work.

and then stayed high in spite of the slowdown. Memories of U.S.$12 a barrel faded as the prices stayed nearer U.S.$30

The best, but unfortunately unlikely (at most 15% probability),

even as the world economy slowed down.

scenario is a geographic containment of the current conflict and the disabling of the leadership and funding of the terrorist net-

Another weakness, to which far too little attention has been

work. Combined with effective economic policies now this would

paid, is the permanent crisis in Japan. Since the investment

allow a recovery in the summer of 2002. We could expect to see

boom of the late 1980’s ended, the world’s second largest

the first signs of this in the new year with rising share prices.

DD journal03.v.11

28-11-2001

19:15

Page 14

A broadening of the conflict to include more countries, with

already due to come into effect. And the monetary authorities

further destabilisation of the world political situation and

have pursued an aggressive policy of interest rate cuts. These

economy is also possible. If this were combined with continu-

should mitigate against the worst of the recession and enable

ing terrorist attacks on the U.S. a longer recession would have

recovery to set in as soon as possible, whatever the security

to be reckoned with, possibly even a deflationary situation if

developments.

the security situation deteriorates massively. Europe, on the other hand, has been much slower in its reacOn the other hand, a return to stagflation is also possible if

tion. The deft handling of previous difficulties by the ECB was

the conflict spreads to the oil producing countries of the Mid-

not repeated, and instead the focus seems to be on maintain-

dle East and supply routes are disrupted. The consequent tur-

ing credibility by being seen to resist political demands,

bulence in financial markets and heightened uncertainty would

regardless of their validity. However, I believe that the need

exacerbate difficulties. In this regard it is important to remem-

for action has now been recognised and that we can expect

ber that the overthrow of the House of Saud and the ‘liberation’

rates to be reduced to 2.75% by the year-end or early in 2002.

of the Holy Sites is the proclaimed aim of Osama Bin Laden. The governments have been similarly slow to act. Naturally, Some combination of these two scenarios, not necessarily in

budget deficits, unlike the U.S. surplus, complicate matters.

their worst form, is my best guess for the most probable out-

The stability pact has acted as a self-imposed straight jacket.

come. However, a massive intensification of the conflict can-

While its aims are correct, the seriousness of the current cir-

not be ruled out either. In such a situation we would truly be

cumstances has to be realised. The mistakes of the 1930’s

entering into a war economy, with all the consequences which

should not be repeated. This is not to argue for foolish spend-

that entails. This would be catastrophic for the world econo-

ing. Instead, already agreed tax cuts should be brought for-

my. The probability of such a development is, in my opinion,

ward. This is sensible both from the supply-side and demand-

quite low.

side perspectives. Likewise, already planned infrastructure improvements should be carried out sooner rather than later.

One of the greatest risks before us now is that we retreat from

This would minimise the time lags involved and also free up

the global economy, NATOisation instead of globalisation,

bottlenecks in the economy. In order to counteract future

effectively abandoning the poor of the world to their fate.

deficits and to continue to put state finances in order a simul-

Likewise, the increase in uncertainty and risk aversion could

taneous pre-commitment should be made to reforming social

cut off desperately needed investment to emerging

welfare systems, something which also makes sense in its own

economies.

right.

To avoid such a situation it is essential that we support multi-

Even if these measures are carried out, we cannot expect to

lateral institutions such as the WTO. Rich countries, now more

escape recession. However, we will manage to avoid the worst

than ever, have to open their markets to the poor. And where

effects of it. While a rapid return to the heady days of the late

criticism is warranted it should be taken on board (but not dis-

1990s is effectively ruled out, it is also just as unlikely that we

guised protectionism from western special interests). Not only

will be permanently incapacitated. The most successful social

would this improve the economic wellbeing of the world, it

and economic system the world has seen — democracy and

would also eliminate much discontent and frustration which

the free market — will find its strength again and the inven-

provides succour to fundamentalist organisations.

tiveness and creativity brought about by this system will once more create an environment that allows people to live better

However, action is needed on a domestic level too. Here the

lives. How long this takes is a question of our ability to

‘can do’ reaction of the Americans has been admirable. A mas-

respond to the challenges before us.

sive fiscal injection was quickly agreed on top of the tax cuts

DD journal03.v.11

28-11-2001

19:15

Page 15

The economic impact of September 11th on the securities industry

George R. Monahan Vice President and Director, Industry Studies Securities Industry Association

Frank A. Fernandez Senior Vice-President, Chief Economist and Director of Research, Securities Industry Association1

Abstract This paper looks at the implications of September 11th on the financial services industry. Our research finds that despite these horrific events, the securities industry will be able to post its fifth best performance of all time. This has been made possible by a combination of falling interest rates and effective operational controls.

1

This is a modified version of the original paper that appeared in SIA’s Research Reports Vol II, No. 8.

15

DD journal03.v.11

28-11-2001

19:15

Page 16


Introduction

include only a part — and perhaps a relatively small part — of

The securities industry sustained a severe blow as a result of

the real effect of those tragic events.’ For this reason, and to

the September 11th attacks. However, the fact that recovery

maintain consistent treatment for all firms across all indus-

began immediately helped mitigate, more than originally

tries (each firm, and each auditor, would otherwise have been

thought possible, the secondary effects of the terrorist

left with the very difficult task of separating direct effects

attacks. The attack itself resulted in a tremendous loss of life

from indirect in a consistent way), the EITF concluded that

and property. To this direct impact must be added the sec-

showing part of the effect as an ‘extraordinary item’ would

ondary interruption of business activity of many entities, busi-

hinder, rather than help, effective communication to readers

ness losses and the overall disruption of the U.S. economy.

of financial reports.

Much of the direct impact was to the securities industry and was disproportionately borne by firms located in New York’s

In addition, calendar third quarter industry aggregate finan-

financial district. The most severe damage was the loss of tal-

cial statements of NYSE member broker-dealers will not be

ent. Securities industry employees at all levels, representing a

available until at least Thanksgiving and probably not until

large number of firms, are missing and presumed dead. These

early December. Further, there are only a handful of publicly

losses are incalculable and their ongoing impact enduring.

held brokerage firms which make available quarterly financial

This paper looks at the implications of these tragic events on

statements, particularly income statements, to the public. Of

the financial services industry and the economy at large.

these, several of the largest firms, including some of those most physically affected by the events of September 11th, are

The financial impact of september

11th

August fiscal third quarter reporting firms and thus these

Disaggregating the actual impact of September 11th from the

impacts will not even appear until their fiscal fourth quarter

overall downturn in revenues and profits of securities firms

statements (ending November 2001) are made available just

during the third and fourth quarters, or what would normally

prior to Christmas. So far, only a handful of brokerages, includ-

be considered a ‘below-the-line’ extraordinary disaster loss,

ing only one major broker-dealer, Merrill Lynch, and a few

would be very difficult. This problem is further exacerbated by

Financial Holding Company (FHC) firms with brokerage sub-

the Financial Accounting Standards Board (FASB) Emerging

sidiaries, have released public third quarter financial reports

Issues Task Force (EITF) decision against using extraordinary

for the quarter ended in September 2001. All of the reported

item treatment for losses incurred in connection with the

effects were minimal (either footnoted, shown pro-forma or

recent terrorist attacks.

discussed in the accompanying press release) and mainly revolved around additional occupancy costs or lost revenue

Although accounting principles provide for treatment of gains

from commissions and trading from market closings from

and losses that meet certain technical criteria as extraordi-

September 11th through 14th.

nary as one separate line item on the income statement net of

16 - The

tax effects, the EITF determined that in this one particular

What can never be disaggregated are the secondary and con-

case, all direct and indirect effects must be netted with all reg-

tinuous impacts of September 11th. These include areas such

ular ‘above the line,’ ordinary revenues, costs or losses for

as a firm’s concentration of its proprietary holdings in, or

each respective impacted business line in the income state-

being a specialist or market maker in, securities of impacted

ment. The EITF stated ‘that, while the events of September 11

industries such as airline stocks and bonds. It also includes

were certainly extraordinary, the…economic effects of the

firms’ investment banking activities in affected industries, i.e.

events were so extensive and pervasive that it would be

specializing in originating aircraft lease asset-backed bonds.

impossible to capture them in any one financial statement line

Moreover, September 11 impacts the overall market declines as

item. Any approach to extraordinary item accounting would

the economy, and thus the equity markets, underperform


DD journal03.v.11

28-11-2001

19:15

Page 17


what they would have done in the absence of this event. There

In response to the slowing economy and market correction,

is no way to segregate increased revenue from the secondary

firms had already developed plans to reduce expenses signifi-

effects, such as higher municipal bond underwriting fees for

cantly, many of which were implemented in the second and

managing unforeseen additional municipal GO or revenue

third quarters. This resulted in a third quarter domestic pre-

bonds that will now be needed to cover rebuilding costs and

tax profit of U.S.$1.85 billion, a U.S.$1 billion, or 34% decline

budget revenue shortfalls, as states, cities, municipalities, and

from the second quarter’s already anemic level. This is the

agencies face heightened financing needs. It also includes

poorest domestic result since the U.S.$179 million loss

bond trading gains from further Fed easing that may not have

incurred in the third quarter of 1998. We now project full-year

otherwise been needed and the continuing question of net

2001 profits of U.S.$11.2 billion.

insurance effects of the event. Again, it appears that the direct ‘aggregate monetary affects’ for the securities industry

The securities industry was faced in 2001 with both an econo-

will be minimal and will be entirely concentrated in just the

my that was in a downturn, and the impact of September 11th,

New York operations of a handful of major international

which closed the U.S. equity markets for four days and dislo-

investment banks, which dominate the industry’s aggregate

cated many of the industry’s largest firms, and exacerbated

results. This in no way minimizes the enormous negative

the industry downturn from record levels experienced in the

impact this event has wrought on smaller firms located in the

first quarter of 2000.

WTC or surrounding areas, both on a financial and human level.

During the first half of 2001, some firms held off on their expense reduction plans, hoping that there would be an

Summary of revised projections

upturn. When it failed to materialize, they took the steps nec-

Just prior to the tragic events of September 11th, SIA Research

essary to keep their firms’ operating profitably and serve their

had updated projections of securities industry performance

clients. The Federal Reserve Board assisted firms with its

for the third quarter of 2001. At that time, industry perform-

series of interest rate cuts, which significantly reduced the

ance had been expected to continue a pattern of sequential

firms’ interest expenses. Total compensation, the firms’ sec-

quarterly declines, but to remain in the black. Pre-tax domes-

ond largest expense, was reduced 10% in the second quarter,

tic profits had peaked in the first quarter of 2000 at U.S.$8.2

and an additional 10% in the third, largely from reduced pay-

billion. This figure had slid to U.S.$4.14 billion by the first quar-

outs to producers, brokers, traders, and investment bankers

ter of this year, before dropping further to U.S.$2.82 billion in

resulting from reduced transaction volume, and reduced

the second quarter. Activity in the third quarter of 2001, prior

bonus accruals.

to September 11th, was slightly weaker-than-expected and net operating profits were projected to decline to under

Mitigating circumstances

U.S.$2 billion. Initially, the terrorist attack, particularly as it

A number of factors have significantly mitigated the impact of

immeditely followed the week of market closings and the

September 11th and reduced potential losses in the aftermath

subsequent week of steep market declines, appeared to

of the attack, and contributed to downward revisions in cost

reduce industry prospects dramatically in the near term. The

estimates in recent days. Specifically:

prospect of a third quarter loss and/or a break-even second half for the industry appeared quite real, even likely. However,

■ Contingency planning paid off — Redundant sites and

although the securities industry sustained a severe blow,

procedures for backing up data saved incalculable time

recovery began immediately. This, along with other factors

and effort, and very little data was lost. This helped main-

discussed below, mitigated, more than originally thought pos-

tain the public’s trust and confidence in markets. These

sible, the financial damage.

contingency plans were also critical in enabling fixed

17

DD journal03.v.11

28-11-2001

19:15

Page 18


income trading activity to resume on September 14th and

forced selling by domestic institutional investors, such as

equity markets to reopen on September 17th.

insurance companies who needed liquidity to meet loom-

■ The rapid reopening of markets — which was due in no

ing claims and money market funds facing redemptions.

small part to herculean efforts by security industry employees, as well as some telecommunications

Effects on New York’s securities industry

providers. That markets functioned as smoothly as they

The securities industry is heavily concentrated in New York

did in the face of record trading volume during the week

City. One quarter of all jobs in the industry are located in Man-

of September 17th, after a rupturing of system connectivi-

hattan. There were 31 main offices and an additional 30

ty, is a testament to the efforts of operations personnel at

branch offices of broker-dealers located in the World Trade

markets, utilities, and member firms who were responsible

Center (WTC) itself, not counting the predominantly securities

for the restoration efforts. Market participants moved

industry owned/leased presence in the entire World Financial

quickly to reestablish connections lost with the destruc-

Center (WFC) complex on Hudson River landfill just west of

tion of telecommunications facilities at 140 West Street

the WTC. Although over 350 additional broker-dealers had

and elsewhere. Member firms established connections to

offices affected in areas south of 14th Street in Manhattan on

temporary locations or routed systems around impacted

September 11th, the impact was heavily concentrated in the

telecommunications connections. Problems that have

destroyed WTC complex and the damaged, immediately adja-

occurred in clearing and settlement systems, by and large,

cent buildings and operations.

have been and should continue to be resolved without significant further disruption.

The broader financial services industry (which includes the

■ Quick, effective action by government officials at local,

banking, insurance, and securities sectors) accounted for over

state and federal levels — The promise of federal support

half of total employment around the WTC and accounted for

for affected areas and of substantial fiscal stimulus helped

over 82% of wages in this vicinity. The securities industry

boost investor sentiment. The Federal Reserve’s actions,

alone accounted for over one-third of total employment and

which include record infusions of liquidity and cuts in

over three-fifths of total wages in the WTC vicinity last year.

short-term interest rates to 40 year lows mitigated credit

And this vicinity is defined as only that portion of lower Man-

and liquidity risk concerns, and helped widen significantly

hattan south of Chambers Street and West of Broadway,

net interest margins for the industry at a critical point. The

which, for the securities industry, is basically just the ‘new’

SEC (and to a lesser extent, Treasury) promptly granted

section of Wall Street built since the WTC, not the traditional

emergency regulatory relief to the industry, acting swiftly

section east of Broadway encompassing the New York Stock

and adroitly to address regulatory concerns and ease

Exchange and those firms and utilities spiraling out from the

impediments to a rapid recovery. Little more can be said of

nexus of Broad and Wall Streets.

the heroic efforts of local and state government employ-

18 - The

ees that has not been said already. Without their tireless,

■ Physical destruction of property

selfless efforts none of these other mitigation efforts

The entire World Trade Center complex covering 16 acres and

could have succeeded.

comprising 300 acres (13.4 million square feet) of office space

■ Investors, by and large, remained calm — Our thanks must

and its contents were destroyed. Excavation and clearing the

also be extended to our customers. Despite steep, initial

site is estimated to take 9 to 12 months and rebuilding in

drops in equity prices when markets reopened, indications

excess of 5 years. At least three other buildings (3 WFC, 140

are that individual investors took a wait-and-see attitude

West St., and 130 Liberty St.) sustained some structural dam-

and were net buyers of equity securities. This offset some

age. Repairs here are expected to take 12 to 15 months. Over

strong net selling by foreign portfolio investors and some

400 other buildings were examined and found to have no


DD journal03.v.11

28-11-2001

19:15

Page 19


structural damage but sustained some significant damage,

lion, with U.S.$1.7 billion estimated to replace destroyed hard-

principally to facades, windows, and exterior plant and equip-

ware and another U.S.$1.5 billion for services and software to

ment, with the damage largely varying with their proximity to

restore connectivity to new systems. However, these are

‘ground zero’. Repairs to most of these has already begun and

replacement costs and do not reflect the depreciated value of

is expected to take 2 to 3 months in most cases and, with the

the actual equipment lost or damaged. Estimates of other

exception of a few still within the ‘red zone,’ at least partial

property losses are more difficult to come by despite being

occupancy has occurred. No reliable estimate of the value of

concentrated in a relatively small number of firms.

the physical property destroyed is yet available. There are only partial estimates that vary in terms of reliability and ver-

■ Other losses and costs

ifiability. For example, the two towers were insured for a value

This would include required lease payments on unusable facil-

of U.S.$3.2 billion, but no estimates of damage to some build-

ities and equipment, which can be immediately recognized.

ings have been made because access to the buildings is only

However, a substantial number of other costs will be recog-

now being gained. Estimates from insurers of claims against

nized only as incurred. These would include:

them: initially ranged from U.S.$8.0 billion to U.S.$9.7 billion, are seen as predictably low; include a wide variety of claims

■ Costs of clean up and removal of damages — This cost at

other than property, and; are expected to rise as claims are

ground zero is expected to rise as the pace picks up. These

filed. Media reports as high as U.S.$35-U.S.$40 billion do not

costs are borne by the official sector, while private sector

provide information of what they include or how they were

cost will begin to accrue in earnest when access to nearby

derived and are considered unreliable.

areas such as the World Financial Center is restored and clean up can begin there.

Most of the ultimate burden of the claims for these losses lies

■ Costs associated with relocation from an unusable

with reinsurers, rather than insurance firms, and with pur-

facility — It is estimated that as many as 45,000 securi-

chasers of these claims in the reinsurance market. The distri-

ties industry employees have been displaced from

bution of these losses is broadly shared and is heaviest (in

destroyed facilities or facilities that will take longer than 3

excess of U.S.$1 billion each) on those most able to bear it, the

months to reoccupy. Roughly 25,000 relocated to sites

largest and most heavily capitalized firms, such as the two

within New York City, with the remainder dispersed large-

largest reinsurers, Munich Re and Zurich Re, along with firms

ly to New Jersey and Connecticut.

such as Lloyds, GE, and Berkshire Hathaway. In addition, insur-

■ Salaries and benefits paid to idled employees due to

ers are expected to recoup these losses on higher future pre-

ceased operations at unusable facilities — While the cost

miums and a sustained increase in demand for insurance

to the securities industry nationwide may exceed

products.

U.S.$800 million due to the cessation of market activity for four days, this didn’t raise the otherwise anticipated

Securities firms, while the principal occupants of affected

compensation expense for the week; in fact it lowered it in

sites, were overwhelmingly tenants, not owners, of the build-

the case of no payouts from no production. In New York

ings they occupied, and were insured against most forms of

City, more than 100,000 securities industry employees

loss. Property losses incurred by securities firms were mainly

were idled for an average of one week, with many

in the form of communications and information infrastruc-

employees (particularly those not critical to operations of

ture, furniture and fixtures, and some physical plant and

firms located in close proximity to ground zero) still idle.

equipment. Estimates of part of these costs are emerging

Again, this didn’t raise compensation expense from what

from varied sources. For example, Tower Group estimated the cost of replacing lost technology infrastructure at U.S.$3.2 bil-

it otherwise would have been. ■ business interruption and key man recoveries.

19

DD journal03.v.11

28-11-2001

19:15

Page 20


The cost to recreate lost data would also fall into this catego-

enues were down from 12% to 20% in the third quarter of

ry, although little data was actually lost, a testament to the

2001 compared to the second quarter for these firms. Com-

value of contingency planning. Redundant sites and proce-

missions, principal transactions, interest, and dividend rev-

dures for backing up data saved substantial time, effort, and

enue all were down. All five firms also had declines in their

money. However, restoring connectivity to this data at recov-

total expenses, as well as in both of the two major compo-

ery sites did involve significant investments of all three, and

nents of total expenses, interest costs and compensation.

normal operations are still being restored.

Total expenses for these firms fell, on average, 14%, reflecting a drop of 18% in interest expense and a 12% drop in compen-

The direct financial ramifications of the disaster (physical

sation.

plant/equipment, occupancy, and employee costs) are mainly concentrated in those firms that were located in the WTC,

The decline in compensation expense came despite slight

WFC complexes, and immediately adjacent buildings. Indirect

increases in overall employment across the board for these

effects, e.g. the shuttering of U.S. markets and the steep price

firms, and mainly reflected reduced production payouts and

declines upon their reopening, were of course felt throughout

much lower bonus accruals during the last quarter. Thus,

the industry and in global markets but were, relative to the

there was a reduction in pre-tax profits in fiscal third quarter

immense tragedy in human costs, surprisingly minimal to

for August reporting firms ranging from 12.4% to 30.4% from

overall operating results, even before business insurance

fiscal second quarter levels and the aggregate drop was 22%.

reimbursements.

Commissions, principal transactions, interest, and dividend revenue all were down across the board. (For the breakdown

Moreover, due to the concentration of the U.S. securities

of the impact on revenues and costs, please refer to the

industry, where the 10 largest firms comprise half of revenues

Appendix).

and capital of the entire domestic industry, the aggregate ed in a handful of the industry’s largest firms, which not only

Revised third quarter domestic brokerdealer operations

have multiple Manhattan physical locations but massive glob-

In late October, the publicly held securities firms reporting on

al operations. The human toll, by contrast, appears to have

a calendar quarter basis began releasing their third quarter

been borne most heavily by relatively few, smaller specialist

results. Combining these results with the adjusted results of

firms. For these firms, as for all firms, the indirect effects of

the August reporting firms (to reflect approximate calendar

the disaster will also be reflected in their third quarter finan-

quarter results) showed falloffs in both gross and net revenue

cial statements, or fiscal quarters encompassing September.

of from 2% to 20% from second quarter levels. The declines

Again, these indirect impacts were minimal compared to the

in profits ranged widely with a few small firms reporting small

overall aggregate results of the entire industry and we esti-

losses (one online discounter reporting a substantial loss) but

mate these to be relatively minor, particularly compared to

for all major firms and regionals, the quarter was disappoint-

the immense human tragedy that was incurred. This is prima-

ing but nonetheless profitable.

direct effects on the industry are almost entirely concentrat-

rily due to the fact that these effects were limited to the few closing weeks of an already weak quarter.

Applying these firms’ historical relationship to the total operations of all New York Stock Exchange member firms doing a

20 - The

Profits were down 22% before September

public business, our proxy for overall domestic operations of

Towards September’s close, five major firms with fiscal quar-

broker-dealers, we estimate that the industry posted a

ters ending August 2001 reported sharply lower results. All

U.S.$1.85 billion pre-tax profit for the third quarter, a 34%

showed declines in both gross and net revenue. Gross rev-

drop from the second quarter’s already anemic level of


DD journal03.v.11

28-11-2001

19:15

Page 21


U.S.$2.8 billion. Combining this with a forecast for improve-

Appendix

ment in the fourth quarter to U.S.$2.4 billion in profits, projects an annual pre-tax profit for the domestic securities indus-

■ Commission revenue

try of U.S.$11.2 billion, a 47% decline from last year’s full-year

Commission revenue for NYSE broker-dealers had peaked at

record of U.S.$21.0 billion, but the fifth highest total ever just

U.S.$10.6 billion in the first quarter of last year. This had

behind 1996’s U.S.$11.3 billion of pre-tax profits. Consensus

steadily fallen each quarter ever since and was down a cumu-

estimates by analysts call for a 14% improvement in the

lative 37% by the second quarter of this year to U.S.$6.7 bil-

aggregate profits for publicly held brokerages next year, which

lion. Third quarter dollar volume of trading on the NYSE and

would translate into a domestic profit of U.S.$12.8 billion

Nasdaq fell 16%, as compared to the second quarter. Commis-

which, if achieved, would be the third highest ever after last

sion totals will be down a similar 15% in the third quarter just

year’s record U.S.$21.0 billion and 1999’s U.S.$16.3 billion.

ended to U.S.$5.65 billion, mainly from the anemic trading activity in July and August. This was tempered somewhat by

Estimates of results at the U.S. securities industry’s global

increased volume in September, both prior to the 11th and par-

holding company level, again using the historical relationship

ticularly since markets reopened the following week, with

between the domestic broker-dealer profits to total holding

record trading activity on the day and the week of September

company profits, projects a 35% decline in pre-tax profits

17th. To contrast the before/after volumes – August’s average

from the second quarter’s U.S.$7.8 billion to U.S.$5.1 billion in

daily trading on the NYSE was 1 billion shares per day, the low-

the third quarter. Projections for full-year 2001 are U.S.$31.0

est since last August; September’s shortened trading month

billion in profits, the third highest ever after last year’s record

hit an all time record of U.S.$1.7 billion shares per day, exceed-

U.S.$58.0 billion and 1999’s U.S.$41.6 billion. Applying histori-

ing the previous record of U.S.$1.3 billion set this January.

cal trends calls for a global profit of U.S.$35.3 billion for 2002, which would still trail 1999 and 2000 profits.

Still, during the month of September the industry processed 6% fewer trades than in August, extending a declining trend

Conclusion

from the record monthly total in January of this year. Howev-

Despite the tragic events of September 11th, the securities

er, this was accomplished with only 15 full trading days com-

industry will manage to post its fifth best year ever. This has

pared to 23 in August, and hence on an average daily basis,

been made possible by major cost reductions in the two

September set a record for trade processing volume. Unfortu-

expense lines, which together account for three-fourths of

nately, the lost commissions and fees for the missing trading

total costs. One major cost reduction came from exogenous

days were not fully offset by the increased volume when mar-

circumstances as the Federal Reserve's 10 interest rate reduc-

kets were open, although some firms will receive business

tions in as many months has reduced interest expense by over

reinsurance for lost commissions for four days during the

40%. The firms' own reductions in headcount and bonuses

fourth quarter. The decline brings quarterly commission rev-

will also help bring compensation costs down by up to 20%.

enue back to late 1997 and early 1998 levels.

Consensus estimates call for a 14% improvement in aggregate profits for the securities industry in 2002 or U.S.$35.3 billion,

■ Principal transactions

pre-tax, globally, and U.S.$12.8 billion domestically, which

Principal transactions, which are largely composed of trading

would only trail 2000's annual record and 1999's second high-

gains (mainly from fixed income and OTC equity market mak-

est yearly total.

ing) and firms’ own investment accounts, had already been slashed in half from the record U.S.$14.1 billion recorded in the first quarter of last year to U.S.$7.1 billion in the first quarter of this year. Although this bounced back to U.S.$9.0 billion in

21

DD journal03.v.11

28-11-2001

19:15

Page 22


the second quarter, the improvement was entirely due to

year’s third quarter at U.S.$4.1 billion. However, falling equity

strong fixed-income gains as the Fed aggressively lowered

prices, an asset mix shift toward fixed income and away from

interest rates. However, in the third quarter, fixed income

equities, and already slowing growth of these businesses as

gains receded and OTC market making revenues plunged still

they matured resulted in quarterly declines in these revenue

further from reduced volumes, drastically falling prices and

sources of 44% and 18%, respectively. We estimate that these

almost no spreads. Spreads, which had been narrowing for

two revenue sources have declined further in the third quarter.

some years, were virtually eliminated by the implementation

This summer, net flows into equity mutual funds, equity index

of decimal pricing.

funds and balanced funds turned negative. Continued, albeit more subdued, growth of bond and money market funds have

Principal transaction revenue will fall U.S.$2.9 billion to

failed to offset the declining revenues from other asset classes.

U.S.$6.1 billion in the third quarter, which is 32% below second quarter levels, but only 14% below first quarter levels. Of the

Further depressing revenues from asset management opera-

total, U.S.$5.8 billion is from trading and U.S.$238 million is

tions has been the decline in the market value of assets held

from firms’ own investments (both realized and unrealized).

in fund portfolios, reducing the base on which asset management fees are calculated, a decline which accelerated after

■ Investment banking

the September 11th tragedy. Overall, mutual fund sales rev-

Overall, total corporate underwriting volume fell 14.6%, or

enue is thus estimated to have fallen 1.4% from U.S.$1.60 bil-

U.S.$94 billion, in the third quarter from U.S.$646 billion in

lion in the second quarter to U.S.$1.58 billion in the third quar-

the second quarter to U.S.$552 billion. Fixed income, the bulk

ter, its lowest level since the fourth quarter of 1998. Asset

of the total volume (but a smaller share of the fees), fell a less-

management fees have also fallen 1.4% from U.S.$3.35 billion

er 13%, or U.S.$77 billion, from U.S.$597 billion in the second

to U.S.$3.30 billion, its lowest level in two years. This is also an

quarter to U.S.$520 billion in the calendar quarter just ended.

unprecedented fourth straight quarterly decline in asset management fees.

Total equity underwriting (including preferred but excluding converts which we cover in fixed income), fell a much broader

■ Interest revenue and expenses

34%, or U.S.$17 billion to U.S.$32.3 billion in the third quarter.

The Federal Reserve’s six 50-basis point cuts and two 25-basis

IPOs, which were very scarce throughout the quarter, became

point cuts in the Federal Funds rate in this year’s first nine

non-existent in September. For the third quarter as a whole,

months had a positive impact on firms’ cost structure this

IPOs fell U.S.$13 billion or 81% to a mere U.S.$3 billion, the

year and a mixed effect on revenues. Interest rate cuts helped

lowest quarterly total in 10 years (first quarter of 1991). Thus,

fixed income trading gains but cut into margin interest rev-

we estimate that total underwriting revenue fell approximate-

enue and other interest revenue from reverse repos and stock

ly 16% from U.S.$4.3 billion in the second quarter to U.S.$3.6

loan activities.

billion in the third quarter. On the plus side, interest expense had already fallen U.S.$4.4

22 - The

■ Mutual funds and asset management fees

billion or 15% in the first quarter and an additional U.S.$3.9

Revenue from mutual fund sales and asset management fees

billion or 15% in this year’s second quarter. We estimate that

had shown steady growth every year for the past two decades

interest expense declined U.S.$4.0 billion or a further 18% in

until last year, reflecting demographics, reduced costs and the

the third quarter to just U.S.$17.8 billion, reflecting both lower

dissemination of the equity culture. Mutual fund sales revenue

rates and firms reducing their outstanding indebtedness. A

reached a quarterly peak of U.S.$2.3 billion in the first quarter

part of this came from the dramatic reduction of effective

of last year, while asset management fees topped out in last

federal funds borrowing rates financial firms encountered


DD journal03.v.11

28-11-2001

19:15

Page 23


after September 11th, lowering borrowing costs to unprece-

■ Compensation

dented levels. Cumulatively, a U.S.$12.3 billion or 41% reduc-

Total compensation costs fell U.S.$1.7 billion, or 10% in 2001’s

tion in gross interest expense has occurred in just nine

second quarter, all of which was accounted for by a reduction

months. However, this was largely, but not completely, offset

in payouts to producers, brokers, traders, investment bankers

by lower lending levels, lower dividend income, sharply

and others largely due to reduced transaction volume as well

reduced margin interest and reduced reverse repo and other

as reductions in bonus accruals. This drop was partially offset

securities lending interest revenue.

by a rise in other compensation costs, clerical salaries and benefit costs such as payroll taxes, medical insurance, retire-

After a slight upturn in the second quarter, margin debit bal-

ment plan costs, severance packages, etc., which are quite

ances resumed their continued decline this summer from

sticky because of the lag time it takes to bring these costs

their March 2000 peak of U.S.$278.5 billion at the end of the

down.

bull market. In the 18 months since that peak, margin debit balances have been slashed in half to just U.S.$144.8 billion

We estimate an additional 10% drop in compensation for the

this September, their lowest levels since late 1998/early 1999.

third quarter, which represents a decline of U.S.$1.5 billion.

Meanwhile, rates charged on these balances also have fallen

Again, this is from reduced payouts and bonus accruals, with

dramatically, by about 350 basis points. Margin interest rev-

year end 2001 bonuses (whether paid in 2001 or 2002)

enue fell 14% from U.S.$3.5 billion in the second quarter of

expected to be as much as 60% below record levels granted

2001 to U.S.$3.0 billion in the third quarter. This is just half of

for calendar year 2000 business.

the record U.S.$5.9 billion quarterly showings during mid-2000. Further strengthening this estimate is that despite a slight All other interest revenue is approximated from the FOCUS

uptick in employment among a few large reporting firms for

revenue line, ‘other revenue related to the securities busi-

the third quarter, the latest revised figures from the U.S.

ness.’ This line item fell U.S.$3.9 billion, or 14%, from U.S.$27.2

Department of Labor show domestic securities industry

billion in the fourth quarter of 2000, to U.S.$23.3 billion in the

employment peaking at 776,400 in February of this year

first quarter and another U.S.$2.7 billion, or 12%, to U.S.$20.6

which then fell by 18,500 net jobs, or 2.4%, through Septem-

billion in the second quarter, as the Fed cut interest rates

ber (11,300 in the third quarter alone), with anticipated further

aggressively. We estimate that this declined another 14%, or

revisions downward after preliminary estimates are revised.

U.S.$2.9 billion, in the third quarter to U.S.$17.7 billion. That’s

This trend will continue through at least year-end based on

a cumulative U.S.$9.5 billion, or a 35% drop in other interest

the already growing list of announced future layoffs since

revenue in just nine months.

September 11th.

Total gross interest revenue (combining margins with all other

■ Other expenses

interest receipts) has fallen from U.S.$32.8 billion in the fourth

The U.S.$14.0 billion in compensation expense and U.S.$17.8

quarter of 2000 to U.S.$20.7 billion in the third quarter of

billion in gross interest expense makes up 76% of the third

2001, a U.S.$12.1 billion, or 37%, decline in nine months. Com-

quarter’s estimated U.S.$41.8 billion in total expenses.

paring that against the previously discussed 41% drop in inter-

Declines in these two principal expense items reduced total

est costs over the same time frame, shows that net interest

expenses by 13%, from the U.S.$48.0 billion registered in the

revenue and margins have actually improved as much as 86%

second quarter. The remaining U.S.$10.0 billion of operating

since the Fed began its interest rate cuts. This has actually

expenses during the third quarter fell 6.5% from the

been one of the saving features for the industry’s financial

U.S.$10.7 billion booked in the second quarter.

performance this year.

23

DD journal03.v.11

28-11-2001

19:15

Page 24


Occupancy and equipment costs, including leases and building and equipment depreciation, held about even with the second quarter’s level of U.S.$1.8 billion with a slight rise by firms experiencing relocation costs offset by overall moderation in this cost line. Even with anticipated increases in the fourth quarter for dislocated firms, the overall industry effect is minimal since this entire cost line is just 4% of total industry expenses. In addition, the majority of the 184,000 securities industry jobs in New York City were not located at affected sites and total NYC industry employment is just one-quarter of nationwide industry employment.

24 - The


DD journal03.v.11

28-11-2001

19:15

Page 25

25

DD journal03.v.11

28-11-2001

19:15

Page 26

DD journal03.v.11

28-11-2001

19:15

Page 27

Capital markets

ABSTRACT

Will emerging B2B e-Markets fulfil their promise? Basic trends in the market for markets for financial instruments Completing the single market in securities trading: A surgical revision of the investment services directive STP/T+1: The European challenge. What are the implications of the U.S. move to T+1 settlement for European institutions? The capital markets’ perspective on B2B e-commerce initiatives and alliances 27

DD journal03.v.11

28-11-2001

19:15

Page 28

Will emerging B2B e-Markets fulfil their promise? Julian Wakeham Managing Principal, Capco The stunning collapse of a large number of dot.com compa-

The B2B e-Market landscape

nies has caused many true believers to lose confidence in the

It is important to recognize that very few emerging B2B mar-

promise of B2B e-Marketplaces as platforms for transacting

ketplaces, whether tender (BizBuyer.com, Freemarkets.com),

business. The reversal of fortunes was especially disappoint-

catalog hubs (PlasticNet.com), auction (ebay, Cattlesale.com),

ing to those who viewed B2B as an effective antidote to the

or exchanges (Foodtrade.com, e-steel.com), operate as gen-

high costs and flagging revenues of traditional brick and mor-

uine exchanges as understood by the financial markets. The

tar businesses. The demise of several ‘heavy weight’ B2B

key differences are highlighted by the traded asset character-

exchanges (Chemdex, Petrocosm and Metalspectrum) and the

istics: traded financial products are defined by price and quan-

disappointing performance turned in by most other e-Markets

tity with fixed settlement cycles, providing a low risk multi-lat-

has only reinforced this skepticism.

eral environment. Most if not all B2B assets have additional trading dimensions of quality and settlement cycle, which has

However, while the ardor and expectations for B2B e-com-

resulted in significant bilateral structures remaining in place

merce has cooled, the business imperative that sparked the

through and after the trade.

initial enthusiasm remains intact. Indeed, in our view, significant opportunities reside in the B2B space. We believe that

The markets for traded instruments and assets can be cate-

the ongoing need for corporate customers to release value

gorized along a trading continuum (see Figure 1) with two par-

locked in the trade cycle and to enhance top line revenue

tially offsetting dimensions: market complexity and market

growth will continue to fuel the growth of the e-Marketplaces.

liquidity. Complexity takes into account such factors as the difficulty of configuring the product, the number of possible vari-

The nascent B2B e-Marketplace is a vast one, encompassing

ations to the core product, and the extent to which the prod-

everything from e-procurement to trading channels for finan-

uct can be standardized. Liquidity reflects such attributes as

cial products. Despite the notable progress of B2B e-com-

the ease of finding buyers and sellers for a product or service,

merce thus far, there is tremendous uncertainty about the

the availability of market information, and the degree of price

ultimate shape of the B2B marketplace. Indeed, critical land-

transparency. Less complex products include many basic

scape defining questions remain unanswered; among them,

commodities, such as milk, power, and bandwidth, for which

the degree and the speed of consolidation within the B2B

liquid markets exist. More complex products would include

space, the nature of the dominant emerging e-Market config-

certain illiquid commodities, such as uncut diamonds, wines,

uration (e-procurement, auction, or exchange), and the types

commercial paper, and OTC derivatives. Markets for these

of support services that will be required. Additionally, it is still

products tend to be less liquid because of the lack of stan-

not clear what the user liquidity ‘break point’ will be; that is,

dardization and fungibility.

the point at which B2B extends its appeal beyond early adopters and engages an early majority, and the global mar-

In general, the more complex a product or service is, the more

ketplace approaches critical mass.

complex the contract negotiations between buyers and sellers will be. Complex products typically involve the trading of illiq-

In this paper, we address the market opportunities for emerg-

uid instruments or assets, entail physical as well as electronic

ing commodity exchanges, recognizing that they are only a

delivery of the goods, and require one-to-one credit and set-

small part of the total B2B market. We hope that our outline

tlement solutions, rather than standardized solutions. For

of the requirements for these very specific structures will

complex instruments, quality and settlement cycle character-

demonstrate why a much larger array of B2B exchanges are

istics act as additional dimensions to price and quantity.

failing.

28 - The


DD journal03.v.11

28-11-2001

19:15

Page 29

e-procurement

B2B e-Market

opportunity

opportunity

Slow

Existing financial markets

Transaction cycle

Fast

Complexity Significant Capex

projects

Non-traded products

Un-cut diamonds Commercial Non-commodity paper (non-Inv) products Insurance

MRO products FM debt

Traded products (chemicals, bulk drugs, paper, bonds, metal, softs)

Commodities (power bandwidth)

Asset derivates

OTC derivates

Commercial paper Commodity derivates (Inv grade)

Blue Chip shares

Credit derivates FX Exotics

MM

Liquidity Figure 1: B2B continuum

At this stage in the development of e-Markets, emerging

toward gradual adoption of the approach employed by more

exchanges have developed effective price exploration and bid-

mature financial markets, using integrated models once these

offer mechanisms. However, they have not yet replicated

issues are addressed. To get a flavor of that opportunity con-

structures put in place by existing financial markets that act

sider the following:

as mechanisms of price efficiency and, more importantly, help mitigate trading risks. These risks, which are endemic to the

■ Currently, enormous value in the form of cash flow costs

trading process, can be grouped into the following four areas:

remains trapped in the trade cycle. In the U.S. food and agriculture (F&A) sector alone, on any given day, cash flow

■ Credit risk — Is the party on the other side of the trade reliable? ■ Price risk — Is the mechanism efficient; that is, will partic-

(mainly working capital) of some U.S.$84 billion remains tied up in the trade cycle because of the typically extended 30- to 90-day, or longer, payment terms.

ipants get the best price available? ■ Market risk — Will participants be exposed to price movement between execution and settlement? ■ Settlement risk — Will the transfer of value take place according to prescribed standards?

■ Savings in procurement costs both in terms of price points (Sun Microsystems claim 20 – 24% reduction in component costs through the use of a private exchange1) and process costs, which include a variety of administrative costs accrued throughout the trade cycle, of between 3%

The failure of most e-Marketplaces to develop structures that

to 10% are achievable for corporations using e-Markets in

effectively address these risks have meant that an integrated

their present form. Typically, however, the benefits are

credit and settlement solution still does not exist in most B2B

only available for the large ‘sponsoring corporates’ of

markets. Lack of an integrated offer of cash and derivatives

private exchanges.

products on B2B exchanges has also hampered liquidity. In addition, on most B2B markets, the unbundling of long-term

Failure to address these multiple points of risk, or ‘pain points’

trading relationships and spot and future price setting has not

in the trade cycle, which are magnified in the cross border

yet occurred and most remain fragmented, which means that

environment, will continue to inhibit the growth of the B2B

volumes continue to be small, and transaction margins remain

e-Marketplace in the short and medium term. In some cases,

extremely thin.

they are, however, being addressed with considerable success for both the market and its members. Such a situation has

We believe that that there is a significant opportunity for

recently been heralded by the Aalsmeer Flower Auction

e-Markets to migrate along the trading efficiency continuum,

(VBA), which has addressed both the quality and settlement

1

‘Sun Smiles on Auctions’, Inside track, Financial Times, Monday October 15th

29

Information transfer

Counter-party þ ÞŽ idebtification

B2B exchange Þþ Treasury Payments ¾ł Ð & collections Ý××þŽŠÝš

Ł A/R matching Šš

Þ Tłršan rviŠceþs łsacŽtŠÝ iošn sþeÞ

Value transfer

−FŠšinł ašncþesþeÞ rviceþs ðS þe ŽŽt× rviŠceþs tþlemþešnŽt sþeÞ

Goods transfer

Market þŽ makers þÞ

-L Ýo gŠisŽtŠicła× rviceþs l sþeÞ

Exchange component Finance component Settlement component Liquidity component

Liquidity drivers

DD journal03.v.11

28-11-2001

19:15

Page 31

settlement, and transaction service is likely to account for

processes. This leaves a significant opportunity for partici-

some 70% (table 1) of all B2B marketplace revenues.

pants who can address the inefficiencies within the fulfillment, credit, and settlement steps of the trade process. In fact, the

The remaining revenue potential will flow from the provision

lack of real time credit instruments may be the greatest

of settlement, and market making services. However, the pro-

obstacle to developing liquid markets. In their August 20002

vision of settlement services will not be straightforward. A

report, investment bank Robertson Stephens highlighted the

handful of large players are likely to dominate the emerging

importance of the problem by stating: ‘No supplier will build,

e-Marketplaces that will need to support everything from

much less ship, a multi-thousand-million dollar order to an

physical to abstract instruments.

unknown counterparty with unknown payment characteristics.’

B2B Services

Revenue (% total available)

Pre-trading Market data, news, trust/member services

5-12%

Trading services Price discovery, market making, trade execution and clearing

14-25%

Post-trading services Settlement, credit, payments

71-80%

The emerging exchanges are recognizing that value adding settlement and credit solutions will increase user liquidity and contribute to higher margins. Banks, insurance companies, and infrastructure providers are rapidly aligning themselves with the emerging structures. However, with the rate of B2B participation uncertain, the break-even points for the market providers and supporting services is unknown.

Internal Capco Research: assessment based on average service fees from multiple financial services / commodddities markets and applied to 7 different industry verticals (summer 2001). Variations in % revenue available reflects industry characteristics (e.g. member numbers, transaction volume, traded value)

Defining a solution: creating a future industry model for B2B e-commerce In our view, addressing the on-going inefficiencies within the

Table 1: B2B service revenue opportunity

trade cycle through the integration of transfer mechanisms

As the existing financial markets have become more efficient,

for information, value, and goods is likely to be the next major

tremendous value has been released, liquidity has increased,

development in the B2B environment. Toward that end, there

and trading volume has exploded. The migration from T+3 set-

are a number of elements in the current trading environment

tlement to a T+1 environment will only enhance these benefits.

that must be addressed: 1) the absence of structures to miti-

In emerging e-Markets, however, settlement cycles typically

gate risk; 2) the trapping of substantial cash flows in the trade

range from T+30 to T+ 90 and can be even longer. The eco-

process as a result of the lengthy payment terms; 3) the dis-

nomic opportunity associated with releasing the billions of

parate, rather than integrated flows of goods, money, and

dollars locked into the extended payments cycles, and the

information; and 4) the still substantial process costs associ-

value associated with integrating that cash flow release with

ated with e-Markets as many basic, non-core functions,

highly efficient infrastructures, is staggering.

integrated in the financial operating systems of the market participants, have not been outsourced.

Thus far, existing e-Marketplaces have focused largely on what we define as the first three steps in the trade process: explo-

What will the liquid, fully functioning e-Markets of coming

ration, negotiation, and ordering. Indeed, price identification

years look like? In our view, they will have the following essen-

and clearing have increasingly become commoditized func-

tial characteristics:

tions. But e-Markets need to go beyond simply reducing price and market risk, and remove some of the processing overhead.

■ Complex e-Marketplaces will offer services across spot contracts and derivatives, allowing the un-bundling of

At present, fulfillment, credit, and settlement are discrete

trading relationships and forward price setting.

2 B2B: Building technology bridges outside the four walls of the enterprise.

31

DD journal03.v.11

28-11-2001

19:15

Page 32

■ e-Markets will offer solutions that address; counterparty, market, and settlement risk.

At the same time, providers will need to be selective in deciding which verticals and which ‘exchanges’ they wish to work with.

■ e-Markets will provide settlement solutions that span

The considerations are complex because of the generally low

physical delivery and complex abstract financial products.

levels of liquidity and the ongoing consolidation among

■ e-Markets will offer utility services that allow customers to

players. Because no one can predict with any accuracy the set

outsource their financial operating systems.

of winners, providers must create solutions and services for

■ Market makers will use enhanced end-to-end knowledge

supporting the emerging exchanges that are sufficiently

to facilitate liquidity and offer value-added advisory

generic to work across the universe of potentially emerging

services.

winners. Solutions must be flexible (in terms of product functionality), low cost, and easy and quick to implement.

No one can say with certainty which sectors of the B2B marketplace will be the first to evolve in accordance with the new

This interim e-Marketplace creates important opportunities

model. The migration to full clearing and settlement solutions

for providers at the operational design level, but it also raises

and the range of products required will vary by industry. How-

some critical questions. These include; is the solution flexible

ever, we expect markets for commodity or near commodity

enough to handle a diversity of products at a manageable

products, such as energy, petrochemicals, chemicals, minerals

cost-base, given that the investment may have to be written-

and metals, food, agriculture, and telecommunications to be

off for some markets as they fail, and can the provider inter-

among the first to introduce the new model. These markets

face and integrate with the other components of the solution

demonstrate near financial market characteristics already;

in a rapid and non-invasive way?

strong liquidity, spot or near spot pricing of products, a significant proportion of cross border trades, and a large number of

It is in response to these questions that large incumbents are

small to medium sized market participants. In addition, the

beginning to enter partnerships to create solutions. Existing

market participants have a need and desire for e-Marketplace

financial service infrastructure providers, banks, large corpo-

services and are willing either to adopt existing industry stan-

rates, and new entrants are coming together to develop solu-

dards (units of quantity, quality, and pricing) or alternatively,

tions. To support this trend and to integrate the critical serv-

to develop and impose an industry standard.

ices or components outlined in this article a number of ‘middle-ware’ solutions are coming to the market. It is perhaps

Prescription for the interim e-Marketplace

these solutions that hold the key to the future of B2B, with

In light of the limited liquidity that is currently available on many

providers.

B2B exchanges, we doubt that any single market will generate sufficient revenues within any one component (exchange,

Conclusion

financial services or credit, clearing and settlement, and mar-

Despite the gloom that has engulfed the B2B sector and

ket making) to justify substantial investment in an idiosyn-

plummeting expectations for its growth, the B2B marketplace

cratic financial or infrastructure solution. As a result, it does

is alive and well and likely to flourish in coming years. Still,

not make sense for service providing institutions to develop

participation in B2B e-Markets has been slower than many

technologies that are designed to serve a particular market or

early enthusiasts and advocates had expected. The existing

market segment. In our view, the horizontal penetration of

conditions that continue to impede the growth of the

multiple B2B verticals will prove to be a more profitable strat-

e-Marketplace include the following:

egy, which means that more broadly applicable solutions stand a better chance of making money for the provider.

32 - The

their ability to bolt together, at very low costs, the critical


DD journal03.v.11

28-11-2001

19:15

Page 33

■ Integrated credit and settlement solutions still do not exist within the majority of the B2B markets. Participants continue to rely on cumbersome, case-by-case credit solutions. ■ B2B markets are fragmented and volumes continue to be small. This results in multiple, very small pools of liquidity, which generally are incapable of supporting dynamic pricing. As a result, transaction margins are thin. ■ The integrated availability of cash and derivatives products on existing B2B exchanges is limited. This reduces liquidity and prevents the de-coupling of long-term trading relationships from spot and future price setting. In our view, these issues will be resolved through the development of integrated markets containing an exchange, financial services, settlement services, and market-making. These functions are unlikely to be provided by individual institutions, but instead are likely to result from partnerships and the integration of existing exchanges, financial institutions, clearing and settlement providers and large corporations. Over the next five years, we expect the B2B e-Marketplace to develop rapidly, spurred by increased segment liquidity from globalization, opportunities for massive value release in trade and payment cycles, and an accelerated search for operational efficiency, as corporates look to outsource their financial operating systems. The interest of branded names in commodities markets with a transparent base price against which to differentiate and enhance the value of the brand, coupled with the growing need for demonstrated risk management and the forward protection of costs and revenues, will also further the development of the e-Marketplace.

33

DD journal03.v.11

28-11-2001

19:15

Page 34

DD journal03.v.11

28-11-2001

19:15

Page 35

Capital markets

Basic trends in the market for markets for financial instruments

Stefan Prigge Institute of Money and Capital Markets University of Hamburg

Abstract In recent years, a large number of IPOs of public exchanges have been announced. These were mainly in response to growing pressure from the institutional investor community and intense competition from Alternative Trading Systems, such as ECNs. When these announcements were initially made, most anticipated a move to a more customer-centric business model, with profit-maximization the ultimate objective. Unfortunately the reality is very different. The sell-side has maintained its control, through large ownership of shares, in these new publicly traded exchanges and has made it difficult for them to pursue their goal of profit maximization. This paper describes how the market for markets has evolved in recent years and what steps are necessary in order to make them more focused on meeting the needs of their customers.

35

DD journal03.v.11

28-11-2001

19:15

Page 36


Introduction

Tradepoint, a regulated market, is called an ECN. In this article,

Five years ago, Pagano and Steil (1996) wrote: ‘As the market

the following system will be used: a regulated market is an

for trading services becomes increasingly contestable, Euro-

exchange. The established exchanges are called traditional

pean exchanges will be forced to react by widening access,

exchanges, and their rivals are ECNs (‘E’ seems permissible

reducing fees, hiving off ancillary services, expanding their

since they all appear to offer electronic trading facilities).

product range, and instituting new and cheaper modes of transacting. In order to do this, they may first have to undergo painful organizational restructuring, generally involving the

■ Tradepoint as a challenger to traditional spot

stock exchanges

dilution of member-firm control and increasing the direct influ-

Although it has since merged with the Swiss Exchange to

ence of issuers and investors.’ This was a very good prognosis.

become virt-x, the relationship between Tradepoint and the traditional European stock exchanges is still insightful. Trade-

The goal of this article is to carve out some basic trends in the

point was a London-based electronic stock exchange that

recent developments on a more abstract level. To make the

was recognized as an investment exchange and had been

connection clear between the more abstract considerations in

designated as a regulated market throughout Europe under

the article’s analysis section and what actually happened in

the ISD (Investment Services Directive). Moreover, the SEC

the real world, the evidence section of this article describes

allowed, with some restrictions, U.S. firms direct membership

some recent events. This article’s objective is not to provide an

in Tradepoint.

encompassing diary of developments. Instead, from a primarily European perspective, it will describe selected major incidents

Trading in listed U.K equities started in 1995. Tradepoint Finan-

that make good cases in point for the following analysis.

cial Networks plc. was itself a listed company, the shares of

The article must be confined to trading, leaving aside other

which were traded on the AIM segment of its domestic rival,

major business fields, in particular listing; netting, clearing,

the London Stock Exchange. Prior to 1999, shares were held

1

and settlement; and information and other services .

by the venture capital company Apax and dispersed owners. But Tradepoint never attracted a significant trading volume,

Evidence

never generated profits and, therefore, seemed to be on its way out of business.

■ Definitions In most discussions on the implications of new emerging rivals

The status of Tradepoint in the market for trading facilities

to traditional exchanges, such as Tradepoint or BrokerTec, the

dramatically changed in the summer of 1999, when a consor-

term Electronic Communications Network (ECN) is often used.

tium led by the Reuters’ subsidiary Instinet injected £14 million

Unfortunately, however, there is no universally accepted defi-

into Tradepoint and bought a 54% stake. In September 2000,

nition of an ECN [see Baum (2001) on the regulatory use of the

Tradepoint’s ownership structure was as follows: Tradepoint

term ECN]. For example, Domowitz and Steil (1999) state that

Consortium 54% (almost evenly held by Instinet, Morgan

‘an exchange or trading system is analogous to a communica-

Stanley, Archipelago, American Century, Warburg Dillon Read,

tions network, with a set of rules defining what messages can

Credit Suisse First Boston, Merrill Lynch, Dresdner Kleinwort

be sent over the network, who can send them, and how they

Benson, Deutsche Bank, ABN Amro, JP Morgan), Apax 14%,

translate into trades.’ Seen this way, every electronic trading

and other shareholders 32%.

facility seems to be an ECN, whether it is an exchange that has a legal entity or not. In the current discussion, the term ECN

Tradepoint’s backing by powerful investment banks in connec-

seems to be used mainly for the group of electronic trading

tion with its regulatory status garnered a great deal of public

systems challenging the traditional exchanges. Consequently,

attention. In July 2000, Tradepoint started its trading facility

1

36

For a fuller picture with more references, see Prigge (2000). European Central Bank (2001) provides a quite useful analysis of netting, clearing, and settlement in Europe. Also the issue of (self-) regulation cannot be dealt with in this article; for recent treatments, see Karmel (2000), Baum (2001), and IOSCO (2001).

DD journal03.v.11

28-11-2001

19:15

Page 37


for about 230 continental European equities that constitute

need for membership at several local exchanges, a central

the major European indices.

counterparty, and netting. So far, trading volume on Jiway is so disappointingly low that Morgan Stanley Dean Witter

■

The ever-changing alliances between traditional European spot stock exchanges

recently decided to quit this venture.

There is a close connection between the activities at Trade-

In March 2000, the project of Euronext was publicly

point (and others) and the actions undertaken by traditional

announced. Euronext is the merger of Paris Bourse, Amsterdam

European spot stock exchanges2. In May 1999, only a few days

Exchanges, and Brussels Exchanges. The holding company

before the consortium entered into Tradepoint, eight Euro-

Euronext N.V. is a Dutch stock corporation. After full imple-

pean exchanges agreed to form an alliance with the principal

mentation, which has not been finished yet, trading of equities

purpose of building a unified European stock market. After

will take place on a single integrated trading platform.

months of discussions, with apparently no real breakthrough,

Euronext went public this July.

in September 1999 a few investment banks were rumored to have come together to build their own platform for trading

At the beginning of May 2000, the iX Intermezzo began. After

European blue chip stocks. In a meeting only a few days later,

the announcement of Euronext, the general public eagerly

the eight allied exchanges could not agree on a single trading

anticipated the reaction of the London Stock Exchange and

platform and instead decided to connect the existing domes-

Deutsche Börse. They disclosed their intention to join as

tic trading systems via interfaces to a virtual European

equals in iX. At a later stage, Nasdaq planned to join iX. The

exchange that would commence in November 2000.

merger project was criticized from the very beginning. It remains highly doubtful whether the general meetings of the

The traditional exchanges’ activities clearly were reactions to

LSE and Deutsche Börse would have seen 75% majorities for

the danger of losing business to ECNs, as the following state-

the merger. However, a few days before, OM Gruppen

ment of Deutsche Börse’s CEO, Werner Seifert, indicated:

launched a bid for the LSE, which the LSE declared hostile.

‘We’re there with our seven partners trying to do everything

The general meetings were cancelled, and the LSE turned

so that no one thinks about bringing Tradepoint to life’ [Wall

down the whole iX project in September. A few weeks later, OM

Street Journal Europe (1999)]. But the alliance did not work

Gruppen’s bid failed. Deutsche Börse and LSE have since gone

satisfactorily. The traditional exchanges felt that major moves

public, but they did not join partners.

were necessary, but they lacked the power to act jointly. As a consequence, Deutsche Börse AG started its Euroboard initia-

In July 2000, virt-x was announced. Virt-x is a market for pan-

tive in December 1999. Among other things, it included a spot

European blue-chip trading created by the Swiss Exchange

market for European blue chips and an IPO. But the plan was

and Tradepoint. The Swiss Exchange and the Tradepoint

abandoned in favor of iX (International Exchanges).

Consortium each hold 38% in virt-x, making virt-x the first merger of a traditional exchange and an ECN. Because Trade-

■ The acceleration in the race for a pan-European

point was renamed virt-x, virt-x plc is quoted in the London

spot trading facility for blue chips in 2000

AIM, and virt-x enjoys the U.K. and U.S. exchange status of

In February 2000, Jiway surprisingly entered the market.

Tradepoint. Trading started this June. Virt-x aims mainly at

London-based Jiway Ltd. was originally owned by the Swedish

institutional investors and other wholesale traders.

OM Gruppen (60%) and Morgan Stanley Dean Witter (40%). Jiway was aimed at the individual investor. The Financial Services Authority recognized Jiway as an investment exchange. Jiway promised cost savings by eliminating the

2 For a comprehensive list of global mergers and alliances of automated exchanges see Domowitz and Steil (1999) and Cybo-Ottone et al. (2000).

■ Bond trading: the BrokerTec attack and the

failure of BondClick In the bond market, there were also numerous initiatives

37

DD journal03.v.11

28-11-2001

19:15

Page 38


announced [Rutter (2000)]. A short glance at BrokerTec and BondClick delivers useful insights. BrokerTec Global LLC was launched in June 1999 by a group of seven major banks and securities houses: Goldman Sachs, Morgan Stanley Dean Witter, Merrill Lynch, Credit Suisse, Lehman Brothers, Salomon Smith Barney (Citigroup), and Deutsche Bank. Since then, seven additional banks have joined the group. Its goal is to create a global bond trading and clearing platform for both spot and forward trading. A good case in point is the way BrokerTec launched the derivative wing of its initiative. In July 1999, it sent a letter to leading derivatives exchanges and clearing houses to ask for their participation in the construction of a unified global trading and clearing platform. In an ultimatum-like style, the addressees were given only about 14 days to reply and five weeks to send in their proposals. BrokerTec is still advancing its plan: it bought the trading platform from OM Gruppen and expects to launch the operations of BrokerTec Clearing Company before year-end. The failure of BondClick is quite instructive. Run by ABN Amro, Barclays Capital, BNP Paribas, Caboto, Deutsche Bank, Dresdner Kleinwort Wasserstein, and JP Morgan, success seemed quite probable. But according to the report by Evans (2001), the principals did not join forces, suffering instead from mutual distrust because most of them were participating in other competing bond-trading facilities. As a consequence, despite a good starting position, BondClick could not survive and merged with BondVision, an MTS division, this February. ■ The emergence of Electronic Communications

Networks (ECNs) With respect to spot trading in equities, ECNs are essentially a U.S. phenomenon, which is usually attributed to the more advanced automation of traditional exchanges in Europe. The interesting point here is the following: an essential feature for understanding the current upheaval in the market for markets is the

Credit Suisse First Boston Tradeweb Dealer-investor on-line bond trading system BrokerTec Inter-dealer bond and futures broking system EuroMTS European government bond trading system Tradepoint Electronic stock exchange, based in London, 4.87% stake Goldman Sachs Hull Group Options trading, full stock acquisition Wit Capital Retail on-line investment bank, 20% stake Archipelago ECN, 25% ownership Optimark Alternative trading system, minority stake (undisclosed) Brut ECN, 10% stake Primex Trading Alternative trading system, joint venture with Merrill Lynch and Madoff Securities Strike ECN, 5% stake through Hull Group BrokerTec Inter-dealer bond and futures broking system; one of seven founder members EuroMTS One of 24 banks in the inter-dealer bond broker for the European market Tradeweb Dealer-investor on-line bond trading system. Goldman is one of four banks in initial consortium Easdaq European stock exchange, minority interest J.P. Morgan Archipelago Tradepoint

ECN, minority stake Electronic stock exchange, based in London, 2.26% stake

Lehman Brothers Strike ECN, minority stake BrokerTec Inter-dealer bond and futures broking system; one of seven founder members EuroMTS One of 24 banks in the inter-dealer bond broker for the European market Merrill Lynch Direct Markets Merrill’s e-commerce division BrokerTec Inter-dealer bond and futures broking system; one of seven founder members Primex Trading Alternative trading system, joint venture with Goldman Sachs and Madoff Securities Tradepoint Electronic stock exchange, based in London, 4.87% stake Morgan Stanley Dean Witter Tradepoint Electronic stock exchange, based in London, 4.87% stake Easdaq European stock exchange, 2.5% interest Brut ECN, minority interest Eclipse ECN pushing after-hours trading, minority interest Salomon Smith Barney/Citigroup Strike ECN, minority stake BrokerTec Inter-dealer bond and futures broking system; one of seven founder members Tradeweb Dealer-investor on-line bond trading system

ECNs’ ownership structure. It highlights in particular the significant impact of major investment banks. The following table, 3

published in September 1999, provides instructive examples .

38

3 See also Benhamou and Serval (1999), Meridien Research (1999), Nickson (2000), and Risk (2000)

Table 1: Investment banks’ stakes in electronic trading facilities Source: Currie (1999); data most probably as of summer 1999, stakes in Tradepoint as of September 2000

DD journal03.v.11

28-11-2001

19:15

Page 39


■ The trend toward electronic trading

example, announced such intentions. Additionally, going pub-

All major new competitors have entered the market for markets

lic changes the governance environment of an entity signifi-

with an electronic trading facility. Moreover, prominent former

cantly. For example, listed stock exchanges such as the LSE

supporters of floor trading among the traditional exchanges

may become the subject of a hostile takeover bid. Governance

are also trying to develop electronic platforms. Domowitz and

structures and market models are closely connected. For

Steil’s (1999) list of exchanges moving to automated auction

example, for almost two years now, the CBOT has been think-

trading enumerates such prominent names as CBOT, CME,

ing about demutualizing, but it has yet to find a governance

Liffe, LSE, and MATIF. Often these initiatives were forced by

structure that is acceptable for the majority of its members,

prior heavy losses in market share against electronic com-

who are still primarily engaged in floor trading and fear being

petitors. In many instances, these changes in the market

superseded by electronic trading in a new profit-oriented

model were accompanied by severe conflicts among the

CBOT [see Cybo-Ottone et al. (2000) for further references].

incumbent members who had the decision power.

Analysis The CBOT’s replacement by Eurex as the world’s largest

Two parallels come to mind when looking at the developments

derivatives exchange is a good example. The history of their

in the securities markets. First, the advances in information

cooperation is quite erratic. One major feature of the cooper-

technology that have already revolutionized other business

ation was to move CBOT away from an open outcry market

sectors that were more appropriate for e-commerce — the

toward electronic trading. Attempts to cooperate in late 1998

book retail business, for example — are now beginning to

and early 1999 failed to gain the members’ votes and led to

impact the securities markets. However, the main distinction

the dismissal of the pro-cooperation chairman. Only five

here is that unlike the securities markets, those other indus-

months later, after further losses in market shares, a second

tries were already highly competitive even prior to the advent

poll brought a clear majority for a cooperation. A joint venture

of new technologies. This leads to the second parallel:

called A/C/E (Alliance/CBOT/Eurex) was set up. In August

the impressive speed and force with which the power of com-

2000, the electronic trading platform A/C/E, built on Eurex

petition impacts market structures and incumbent market

technology, went live. This platform serves, inter alia, as an

participants when barriers to competition are brought down

electronic trading device within the CBOT. Its share in total

through deregulation. An appropriate example is the lively

CBOT volume has increased steadily since then and amount-

market for long-distance calls in Germany that emerged soon

ed to 23.1% in September 2001.

after deregulation in 1998. Power shifts from producers to consumers, and the consumers’ preferences become the decisive

■ Changes in the governance structures of

traditional exchanges

feature. A well-differentiated supply emerges. In addition, a dramatically improved price-service ratio is to be expected.

The measures taken by traditional exchanges support the

Traditional exchanges were not hit by such a deregulatory

conclusion that their former governance structures were not

strike on a specific date; instead, competitive pressures began

appropriate for their current needs. One major trend is the

gradually and continued to increase in strength over time.

demutualization of exchanges, which allows the detachment

However, it met with structures that had developed over

of ownership from membership. It took only a couple of years

centuries in an environment with, at best, moderate

for demutualized exchanges to move from being exceptions to

competition.

becoming the norm4. Demutualization often is accompanied by an announcement of a change in the exchange’s goal: it

■ Demand side aspects

turns from being a service provider for the members to a profit

What are the consumers’ preferences? Don’t they all want the

maximizer for the owners. The LSE, Nasdaq, and CME, for

same thing, to trade securities at the lowest possible cost?

4 See Domowitz and Steil (1999), Cybo-Ottone et al. (2000), Licht (2000), and IOSCO (2001) for chronologies and further details. Although only a handful of traditional exchanges are currently listed, their numbers are expected to grow dramatically. Deutsche Börse, Euronext, and LSE went public this year; Australian Stock Exchange,

Stockholm Stock Exchange (as a part of OM Gruppen), Hong Kong Exchanges and Clearing, and Singapore Exchange had made this step before [IOSCO (2001)]. The Swiss Exchange is listed indirectly via virt-x.

39

DD journal03.v.11

28-11-2001

19:15

Page 40


This is too simplistic a view. As long-distance telephone calls

they are exposed to increasing pressure. If customer pref-

have turned into a differentiated good, the same can be

erences remain unsatisfied or transaction services are

expected with respect to securities trading. According to the

overpriced, due to significantly lowered entry barriers,

two goods hypothesis put forward by Schmidt and Prigge

competitors will not hesitate to make use of this opportunity.

(1995), the transaction of an asset consists of two components: the asset, which is homogeneous, and the transaction

At the moment, securities houses and others seem to be in

service. The latter may be, for example, immediacy, market

the comfortable position of passing most of the pressure from

depth, transparency, anonymity, or investor protection.

their customers on to the other parties connected to the trad-

Customers will have differing preferences for the second. To

ing platform because they occupy the eminent position of

keep the following discussion brief, only three customer

switchmen for a large share of the order flow [Rudolph and

groups will be distinguished.

Röhrl (1997)]. If the other parties connected to traditional exchanges, such as dealers or market makers, are not willing

■ Private investors — Numerous studies prognosticate a

to follow the switchmen’s lead, the latter are in a good posi-

strong increase in the trading volume of private investors

tion to set up competing trading platforms. They can do this

for Europe and the U.S. But private investors are already a

either in collaboration with other switchmen, such as Trade-

strong force as can be witnessed by the strategy of Jiway.

point or alone with an internal trading system, such as

Hence, their preferences are relevant.

Deutsche Bank’s Autobahn, a trading system, for European

■ Asset managers/institutional investors — Asset man-

government bonds. It is important to note the dual character

agers are significant customers of trading services. Asset

of securities houses, as both users and competitors of trading

managers must demonstrate performance to attract cus-

facilities. As Breuer (2000), CEO of Deutsche Bank and chair-

tomers. The focus in asset management is shifting to cost

man of Deutsche Börse’s supervisory board, put it: ‘In the

containment; trading costs are a major cost component.

future, there will not only be competition among exchanges,

This powerful group passes the competitive pressure it is

but also increasingly between exchanges and banks’ [author’s

exposed to on to the other parties involved in transaction

translation; see also Lee (1998)].

execution. However, the switchmen’s power might be transitory because Both individual and institutional investors are, of course, inter-

of the danger of being circumvented by private and institu-

ested in buying attractive price-service combinations. Howev-

tional investors transacting directly with each other. Automa-

er, it is quite probable that both groups will demand different

tion and IT already allow, or might allow in the near future,

trading services and that there is intra-group heterogeneity as

institutional and private investors remote access to trading

well. Thus, the diversity of trading facilities that are emerging

facilities, thus opening the alternative, or threat, of a (more)

testifies to the empowerment of customers [Accenture (2001)].

open, or less intermediated, trading facility. For institutional investors, so-called crossing networks, which are a sub-

40 - The

■ Securities houses, investment banks, and others —

group of ECNs that match buy and sell offers without price

Securities houses and others are different from individual

discovery, already exist (i.e. ITG Europe’s Posit or E-Crossnet).

and institutional investors in that they are both on the

As to private investors, Potthoff, member of Deutsche Börse’s

supply and on the demand side. They are customers of

management board, declared in October 2000 that because

trading services when they trade for their own account

the exchanges’ customers (banks) are active in entities which

and when they offer asset management services. On the

are competitors of the exchange, the exchange was thinking

demand side, they will prefer prices as low as possible for

about granting private investors direct access to the

given transactions, too. As suppliers of transaction services,

exchange, i.e. to bypass the banks as access intermediaries.


DD journal03.v.11

28-11-2001

19:15

Page 41


■ Supply side: general aspects

The opposite could be called a member- and customer-con-

Domowitz and Steil’s (1999) view fits nicely with the evidence

trolled entity (MCCE). The key to the following argument is to

presented above. They claim that contestability in the market

recognize that a trading platform is not a monolith. A trans-

for markets increased markedly during recent years and that

action can be interpreted as a chain of services. To name just

this is mainly due to automation. Without advanced IT, floor

a few, perhaps an access intermediary is necessary because

exchanges used to enjoy network externalities in that they

the investor is not allowed to enter the market directly. Or per-

occupied the position of liquidity pools. Other features con-

haps the market model requires the participation of a special

tributing to high market entry barriers were higher develop-

intermediary, such as a market maker, in each transaction.

ment costs for trading venues, regulation, and a smaller size

The providers of these services are the parties connected to

of the market for exchange services. These barriers protected

the MCCE. They may also have an interest in its market value.

the incumbents from severe competition.

But also of enormous importance are the returns the parties generate from their status as, for example, market maker or

The situation has changed dramatically during recent years.

securities house with heavy trading activity on this platform.

Now the market turnover is much bigger and thus more

It cannot be taken for granted that the parties connected to

attractive for suppliers. Costs for developing and operating an

an MCCE have homogenous interests. Competitive pressure

automated trading platform have decreased significantly and

can be expected to affect the components of the service chain

are now lower than for a floor-based platform. Moreover,

unevenly, and the structure and even existence of the chain as

access costs have diminished due to remote access and

such might become questionable. Moreover, the chain elements’

remote membership, which became admissible because of

options to respond to the pressure differ. The usual means of

changes in regulation such as the ISD in the EU. Information

coping with the resulting conflicts in a listed stock corporation,

on prices and quotes for one asset in different markets is eas-

Hirschman’s (1970) exit and voice, cannot fully be applied in an

ily available. This weakens the anti-competition effect of the

MCCE. Therefore, the superior power of some connected parties

network externality and fosters the development of a land-

may finally direct an MCCE’s decisions. Another option is to com-

scape of numerous trading platforms for a particular asset,

promise at the expense of parties not involved in the decision.

which specialize in satisfying the preferences of different clienteles. Demand for devices that improve the comprehen-

Prior to competition, most traditional exchanges occupied the

sive overview of the market situation will increase with the

status of a quasi-monopoly. Consequently, in case of conflicts,

number of marketplaces for a particular asset. So it should be

the last option offered an easy way out. In a non-competitive

expected that private suppliers will provide this service soon

environment, many privileges for connected parties can

[Schmidt et al. (2001)], thus strengthening the coherency of

emerge. Privileges are understood as those features of a

the marketplace as a whole, i.e. the entirety of all trading venues.

trading facility that differ from the benchmark of an open trading facility. Therefore, no distinguished parties exist,

■ Supply side: governance aspects

everybody who wants to trade places his order directly in the

Following the model of Hart and Moore (1996), one can label a

market, and no trading intermediaries are involved [Schmidt

certain governance structure outside ownership: ‘Under out-

(2001)]. Such privileges include, for example, the necessity of

side ownership, the people who have control over the firm,

having the price determined by a specialist or the mandatory

and take decisions on the firm’s behalf, are typically not the

use of an access intermediary. This is not to say that privileges

same people who buy and use the firm’s product.’ The goal

were formerly, or are now, necessarily attached to inefficien-

of an outside owned and controlled entity (OOCE) is most

cies or monopoly rents in favor of the privileged parties, even

probably maximization of its market value; the owners are

though Pirrong (1999) finds some empirical support for the

homogeneous in this respect.

conjecture that exchange members earn monopoly rents.

41

DD journal03.v.11

28-11-2001

19:15

Page 42


Now, in a more competitive environment, the pressure toward

first impression, we are still far away from their alternative

more efficient trading facilities affects the privileges. For

model, outside ownership.

example, granting remote access may impair the position of incumbent members; or the introduction of a new market

Consequently, we should focus at least just as much on deter-

model may deteriorate a member group’s position or even

mining whether an exchange is an MCCE or an OOCE as we do

rationalize it away. Put more generally, in a competitive pricing

in evaluating its ownership structure, cooperative versus

environment, conflicts and heterogeneity among the parties

public [Sharing the view of Pagano and Steil (1996) and

connected to an MCCE rise [Di Noia (2000)]. Privileges, as a

Rudolph and Röhrl (1997)]. Seen this way, the changes in

rent-generating device, will be less available as a conflict

governance structures in the global market for markets we

resolution tool. Consequently, exit has become a serious

have observed so far are not as far-reaching as they might

option for some MCCE parties.

first appear. The bid for the London Stock Exchange provides a good illustration. The LSE transformed into a stock corpora-

The new entrants into this market, such as Tradepoint or

tion, and its equities were then traded OTC. Nevertheless,

BrokerTec, may be corporations, but most importantly they

when the shareholders discussed the pros and cons of iX and

are still MCCEs. However, their principals are much more

OM Gruppen’s bid, the effect on the LSE’s market value

homogeneous than in traditional exchanges5. The principals

played, at best, a minor role. The debate focused on the deals’

are banks and securities houses, i.e. parties ‘who buy and use

consequences for the LSE’s members’ business activities. The

the firm’s product’. Currently, they are probably the most

overwhelming majority of the LSE’s shareholders were still

powerful group among the parties connected to an MCCE, but

members and acted as such. If the LSE really had moved sig-

their power might be transitory.

nificantly from an MCCE toward an OOCE, the share price would have had much more weight. But these occasions

The large number of new trading venues serves several pur-

proved that the LSE then, despite having its shares traded

poses. Most major securities houses have a stake in numerous

OTC, was still an MCCE.

ECNs as a hedge to be on the winning side should one of these systems emerge as the dominant platform. Establishment of a

What are the ingredients of a marked step toward an OOCE

trading platform is also a threatening gesture. In these cases,

structure? The incorporation of a trading facility operator and

exit and voice are clear complements. Those parties connected

the selection of shareholder value maximization as the ulti-

to MCCEs who now have a comparative advantage to exit gain

mate goal of the organization would be a more far-reaching

power (voice) within the traditional MCCEs. This is the gener-

event if it were accompanied by an IPO. First, simply because

al pattern of action and reaction in the market for markets

it would provide an opportunity for real outsiders — i.e. persons

between the competitors and within the traditional exchanges

only interested in the market value of the shares — to buy

as described above. In the latter case, within the traditional

shares. Second, the greater the size of the stake initially

exchanges, part of the reaction includes a redistribution of

offered to the public, the higher the incentive for the pre-IPO

privileges that takes place in favor of the more powerful groups.

shareholders to signal credibly that the listed corporation will

At the same time, increasing competition should diminish the

follow a market value maximizing policy. Otherwise, the pre-

magnitude of privileges and rents derived thereof.

IPO shareholders would suffer from a grave reduction in the proceeds of the issue. This disadvantage increases, of course,

42

This interpretation of the evidence corroborates those of Hart

with the size of the stake offered as does the significance

and Moore (1996), who find that a cooperative structure

of other post-IPO market-related governance mechanisms. A

becomes less appropriate with increasing competitiveness

listed trading facility operator with a large free float could be

and heterogeneity among its members. But contrary to the

truly emancipated from the MCCE parties. Taking this view,

5 Although the BondClick case revealed that even then the degree of homogeneity is not necessarily sufficient. Such tensions may have induced many banks and securities houses to foster the development of in-house trading facilities.

DD journal03.v.11

28-11-2001

19:15

Page 43


the Australian Stock Exchange with a free float of about 60%

ty than in-between solutions. Those trading venues jointly run

may come closest to an OOCE structure at the moment,

by several, but not all, major securities houses seem to be less

whereas other exchanges, even the listed ones, may still be

stable because the securities houses remain competitors. This

MCCEs rather than OOCEs.

may cause destabilizing distrust, both among the principals of a trading facility on the one hand, and among those securities

Conclusion and outlook

houses standing outside the trading venue and those

Exchanges have been almost totally shielded from competition

securities houses managing the venue on the other. The same

for decades. Now they find themselves in an increasingly com-

considerations may be applied to future developments in

petitive environment. The interplay between supply and

netting, clearing, and settlement, which were beyond the

demand side factors has made the market for markets attrac-

scope of this paper.

tive to new suppliers. The consumers are empowered at the expense of the suppliers. On the supply side, this causes fights

References

on several fronts: competition between old and new suppliers

•

and conflicts within the old supplier entities, especially

•

because one group connected to the old suppliers is also a major contributor to the new suppliers. The group of order flow routers is currently in a powerful position, but their

•

(borrowed) power might fade with the emergence of more

•

open trading venues, to which institutional and individual investors have direct, non-intermediated, access. The changing

• •

environment also affects the governance structures of trading venue operators. However, even new or listed operators are

•

still close to the traditional MCCE (member- and customercontrolled entity) structure.

•

According to general economics, in an ideal market with full

•

competition, suppliers offer a deeply differentiated range of products and services in response to the great diversity of preferences among the customers. We see such a development currently in the markets for markets. Because of gigantic advances in IT, the coherency of the pricing of the homoge-

• • • •

neous good, the pure trading object, need not suffer from fragmentation. Coherency could be ensured by providers of order routing counseling services and arbitrageurs, offsetting

• •

most of the liquidity pool externality that formerly had been a major force in trade centralization.

• •

Looking at the internal power structures of trading venues, a plausible expectation seems to be that neutral trading facilities, possibly with an OOCE structure, and internal systems run by each securities house promise greater stabili-

• • •

Accenture, 2001, ‘Leaving Safe Havens’, The Accelerating Evolution of the European Exchange Landscape. Study. Baum, H., 2001, ‘Technological Innovation as a Challenge to Exchange Regulation: First Electronic Trading, Then Alternative Trading Systems and Now ‘Virtual’ (Internet) Exchanges?’ Working Paper, Max Planck Institute for Foreign Private and Private International Law, Hamburg. Benhamou, E. and T. Serval, 1999, ‘On the Competition between ECNs, Stock Markets and Market Makers’, SSRN Working Paper Number 223872. Breuer, R.E., 2000, ‘In einer virtuellen Welt ist der Kunde König‘, Börsen-Zeitung, 23.9.00, B1. Currie, A., 1999, ‘The New Battleground’, Euromoney, September, 53-66. Cybo-Ottone, A., C. Di Noia, and M. Murgia, 2000, ‘Recent Development in the Structure of Securities Markets’, Brookings-Wharton Papers on Financial Services, 223-273, 281f. Di Noia, C., 2000, ‘Customer-Controlled Firms: The Case of Financial Exchanges’, SSRN Working Paper Number 250468. Di Noia, C., 2001, ‘Competition and Integration among Stock Exchanges in Europe: Network Effects, Implicit Mergers, and Remote Access’, European Financial Management, 7, 39-72. Domowitz, I. and B. Steil, 1999, ‘Automation, Trading Costs, and the Structure of the Securities Trading Industry’, Brookings-Wharton Papers on Financial Services, 3481, 89-92. European Central Bank, 2001, ‘Consolidation in Central Counter Party Clearing in the Euro Area’, ECB Monthly Bulletin, August, 69-77. Evans, J., 2001, ‘Click, Click, You’re Dead’, Euromoney, August, 76-79. Hart, O. and J. Moore, 1996, ‘The Governance of Exchanges: Members’ Cooperatives versus Outside Ownership’, Oxford Review of Economic Policy 12/4, 53-69. Hirshman, A.O., 1970, ‘Exit, Voice and Loyalty’, Harvard University Press, Cambridge, Mass. IOSCO, 2001, ‘Issues Paper on Stock Exchange Demutualization’. Karmel, R.S., 2000, ‘Turning Seats into Shares: Implications of Demutualization for the Regulation of Stock and Futures Exchanges’, SSRN Working Paper Number 256867. Licht, A.N., 2000, ‘Stock Exchange Mobility, Unilateral Recognition, and the Privatization of Securities Regulation’, SSRN Working Paper Number 246789. Lee, R., 1998, ‘What Is an Exchange? The Automation, Management, and Regulation of Financial Markets’, Oxford University Press, Oxford. Meridien Research, 1999, ‘ECNs—Who Will the Winners Be?’ Nickson, C., 2000, ‘Back to the Buttonwood Tree’, Euromoney, June, 41-47. Pagano, M. and B. Steil, 1996, ‘Equity Trading I: The Evolution of European Trading Systems’, in Steil, B., ed., The European Equity Markets. The State of the Union and an Agenda for the Millennium, ECMI, London et al., 1-58.

43

DD journal03.v.11

28-11-2001

19:15

Page 44


• • • •

• •

•

•

•

44 - The

Pirrong, C., 1999, ‘The Organization of Financial Exchange Markets: Theory and Evidence’, Journal of Financial Markets, 2, 329-357. Prigge, S., 2000, ‘Recent Developments in the Market for Markets for Financial Instruments’, SSRN Working Paper Number 258593. Risk, 2000, ‘Bank Initiatives in Electronic Trading’, Risk 13/3 (Electronic Trading Special Report), 22-24. Rudolph, B. and H. Röhrl, 1997, ‘Grundfragen der Börsenorganisation aus ökonomischer Sicht’, in Hopt, K.J., B. Rudolph, and H. Baum, eds., Börsenreform. Eine ökonomische, rechtsvergleichende und rechtspolitische Untersuchung, SchäfferPoeschel, Stuttgart, 143-285. Rutter, J., 2000, ‘New Adventures in Credit Trading’, Credit, 1, 24-32. Schmidt, H., 2001, ‘Regionalbörsen und spezielle Handelsplattformen für Europa’, in Hummel, D. and R.-E. Breuer, eds., Handbuch Europäischer Kapitalmarkt, Gabler, Wiesbaden, 397-409. Schmidt, H. and S. Prigge, 1995, ‘Börsenkursbildung‘, in Gerke, W. and M. Steiner, eds., Handwörterbuch für das Bank- und Finanzwesen, 2nd edn., Schäffer-Poeschel, Stuttgart, 311-321. Schmidt, H., M. Schleef, and A. Küster Simic, 2001, ‘Warentests für Handelsplattformen—Zur Anlegerfreiheit am Aktienmarkt’, Zeitschrift für Bankrecht und Bankwirtschaft 13, 69-79. Wall Street Journal Europe, 1999, ‘Deutsche Boerse Has Bold Plans’, Wall Street Journal Europe, 21.12.99, 15, 25.


DD journal03.v.11

28-11-2001

19:15

Page 45

Capital markets

Completing the single market in securities trading: A surgical revision of the investment services directive

Benn Steil André Meyer Senior Fellow, International Economics Council on Foreign Relations

Abstract Over the past decade, European exchanges have undertaken enormous reforms in their trading platforms and internal governance. Automation of trading combined with the internationalization of the major trading institutions has significantly intensified pressures for the consolidation of exchanges and systems. For this process to operate efficiently it is important that unnecessary legal barriers to cross-border competition and consolidation be removed. This requires reform of the Investment Services Directive, to which the European Commission is already committed. This article explains the logic behind the changes which would be required, and recommends a highly targeted revision of the Directive that is likely both to avoid damaging delay in the Council of Ministers and to be effective when implemented.

45

DD journal03.v.11

28-11-2001

19:15

Page 46


Introduction

operations on far fewer platforms. This has led to a wave of

The development of the European securities exchanges over

dramatic merger and alliance proposals (see table 1), which

the past decade has been a considerable success story. Owing

augur a fundamental restructuring of the competitive land-

directly to the force of cross-border competition, European

scape in trading operations and the re-allocation of market

exchanges have implemented major reforms in trading systems

regulation authority across EU national securities commis-

and internal governance which have significantly improved

sions. These issues were brought to the fore in 2000 with the

their efficiency and reduced investor trading costs [Domowitz

ill-fated proposal of the London Stock Exchange and Deutsche

and Steil (1999)]. Yet the exchanges are now facing enormous

Börse to create a single merged exchange (iX), with regulatory

pressure from the major international trading houses to cut

responsibilities to be divided by market segment between the

costs much further by consolidating trading and settlement

UK and Germany.

Merger or alliance

Status

Exchange mergers AEX: Amsterdam Stock Exchange and European Options Exchange HEX: Helsinki Stock Exchange and SOM BEX: Brussels Stock Exchange and BELFOX OM Stockholm Exchange: Stockholm Stock Exchange and OM Wiener Börse and ÖTOB Paris Bourse and Monep Paris Bourse and MATIF Borsa Italiana and MIF Eurex: DTB and SOFFEX NYBOT: Coffee, Sugar & Cocoa Exchange and NY Cotton Exchange Singapore Exchange: Stock Exchange of Singapore and SIMEX Euronext: Paris, Amsterdam, and Brussels exchanges virt-x: Tradepoint and Swiss Exchange (blue chip equities) Archipelago ECN and PCX equities HEX and Tallinn Stock Exchange Hong Kong Stock Exchange and Hong Kong Futures Exchange Bovespa (Brazil) and BVRJ International Petroleum Exchange and Intercontinental Exchange Chicago Board of Trade and Chicago Board Options Exchange MATIF and MEFF Alberta Stock Exchange and Vancouver Stock Exchange BVLP (Lisbon) and Oporto Derivatives Exchange Euronext and BVLP (Lisbon) Eurex Bonds and EuroMTS

I* I I I I I I I I I I I I I A A A A N N N N N

Common trading system Oslo Stock Exchange and OM (derivatives) I FUTOP (Denmark) and OM (derivatives) I Norex: OM Stockholm Exchange and Copenhagen Stock Exchange I Deutsche Börse, Wiener Börse, and The Irish Exchange I Eurex and HEX I Chicago Board of Trade and Eurex I NEWEX (central and eastern European equities): Deutsche Börse and Wiener Börse I Norex and Oslo, Reykjavik, Riga, and Vilnius exchanges A International Petroleum Exchange and Nord Pool A Table 1: Automated exchange mergers and alliances, 1997-2001 * I = implemented; A = agreed; N = being negotiated.

46 - The


Globex Alliance: Chicago Mercantile Exchange, MATIF, MEFF RV, Singapore, Montreal, and BM&F (Brazil) ParisBourse and Australian Derivatives Exchanges Euronext and Bourse de Luxembourg

A A A

Common access system MATIF and MEFF RV I Chicago Mercantile Exchange and LIFFE I Euro-Globex Alliance: MATIF, MEFF RV, and MIF A SWIFT-FIX access protocol: Amsterdam, Brussels, Frankfurt, London, Madrid, Milan, Paris, and Zurich A Strategic alliance / joint venture Benelux exchanges Globex: Chicago Mercantile Exchange and MATIF Cantor Financial Futures Exchange: Cantor Fitzgerald and New York Board of Trade MITS: London Metal Exchange and MG OM Gruppen and NGX Nasdaq Japan: Nasdaq and Osaka Securities Exchange Nasdaq and Hong Kong Stock Exchange Chicago Board Brokerage: Chicago Board of Trade and Prebon Yamane Nasdaq and Australian Stock Exchange NYMEX-SIMEX ParisBourse, Swiss Exchange, Borsa Italiana, and Lisbon Stock Exchange London Stock Exchange and Buenos Aires Stock Exchange Nord Pool and Leipzig Power Exchange Australian Stock Exchange and Singapore Exchange Chicago Mercantile Exchange and Cantor Fitzgerald International Petroleum Exchange and NYMEX Eurex and NYMEX GEM: Amsterdam, Australia, Bovespa (Brazil), Brussels, Hong Kong, Mexico, New York, Paris, Tokyo, and Toronto exchanges Chicago Board Options Exchange and Osaka Securities Exchange LIFFE and Boston Stock Exchange (options trading)

I I I I I I

I A A A A A A N N N

N N N

DD journal03.v.11

28-11-2001

19:15

Page 47


The European Commission is considering a significant revision

A second major principle enshrined in the White Paper is har-

of the 1993 Investment Services Directive (ISD) as part of its

monization of minimum standards, which acts to limit the

‘Financial Services Action Plan’. In this article, we identify the

scope for competition among rules by mandating member

specific areas of the text that are likely to act as barriers to

state conformity with some base-level EU-wide requirements.

effective cross-border exchange competition and consolida-

The principle is intended to ensure that ‘basic public interests’

tion, and go on to recommend surgical revisions to the text

are safeguarded in a single market with different national

that are likely both to be politically palatable within the Coun-

rules and standards. Whether this principle facilitates or

cil of Ministers and effective in operation.

inhibits the free movement of goods, capital and labour depends wholly upon the manner in which it is applied. It can,

Principles of EU financial regulation

on the one hand, facilitate free competition by stopping

The EU legislative framework for financial markets is grounded

member states from erecting ‘standards barriers’ against one

in a concept widely referred to as ‘competition among rules’,

another's products and services, while on the other it can

which takes the continuing reality of separate and distinct

inhibit free competition by barring certain products or

national legal and regulatory systems as given. The principle

practices from the market altogether.

outlined in the European Commission's 1985 White Paper supporting competition among rules is that of mutual recog-

Prior to the formal launch of the Single Market initiative in

nition, according to which all member states agree to recognize

1985, the harmonization approach was predominant in the

the validity of one another's laws, regulations and standards,

drive for political and economic integration. Mutual recogni-

and thereby facilitate free trade in goods and services without

tion, as the Commission’s White Paper made clear, was con-

the need for prior harmonization. Directly derived from this

sidered an inferior integration mechanism, made necessary

principle is the Second Banking Co-ordination Directive provi-

only by Council obstructionism in the Commission’s pursuit of

sion for a single licence, colloquially referred to as a ‘single

common rules2. Given that mutual recognition was therefore

passport’, under which credit institutions incorporated in any

chosen as the basis for Single Market legislation primarily on

EU1 member state are permitted to carry out a full range of

pragmatic grounds, it is perhaps not surprising that neither

‘passported services’, detailed in the Directive's annex,

the Commission nor the Council has ever enunciated a con-

throughout the EU1. Similar guidelines are laid down for the

ceptual framework for determining where one approach was

provision of cross-border investment services in the Invest-

likely to result in more efficient market outcomes than the

ment Services Directive (ISD). Reinforcing the market-opening

other3. However, the political dynamics of the Council have

effect of mutual recognition is the assignment of home coun-

since illustrated that harmonization of rules and standards

try control, which attributes the primary task of supervising a

generally operates to curtail liberalization, whereas the com-

given financial institution to its home country authorities.

bination of mutual recognition and home country control

Home country control should, in theory, provide some assur-

has proven reasonably effective in muting the influence of

ance that foreign EU firms will not be put at a competitive

protectionist lobbies. The evolution of the ISD from its initial

disadvantage by host country authorities seeking to protect

1988 Commission draft to its 1992 approval by ‘qualified

domestic firms. However, a major exception to the home

majority’ in the Council4 provides an excellent case study

country control provision exists for ‘rules of conduct’, which

in the interplay between the harmonization and mutual recog-

remain the province of the host country.

nition approaches5.

1

and more effective if the Council were to agree not to allow the unanimity requirement to obstruct progress where it could otherwise be made. . . . In principle, . . . mutual recognition could be an effective strategy for bringing about a common market in a trading sense.’ (Commission of the European Communities, 1985:18) 3 ‘I have to confess’, wrote a former director-general of DGXV, ‘that I find myself cheerfully unrepentant in face of the criticism that the Commission has not made any serious attempt to develop a theory of harmonization’ (Fitchew 1991:1). 4 Italy and Spain voted against the final compromise text. 5 See Steil (1998) for a detailed account of the Directive’s creation.

The institution must be authorized to carry out an activity in its home state before it can invoke its passport rights to do so in other member states. 2 ‘The harmonisation approach has been the cornerstone of Community action in the first 25 years and has produced unprecedented progress in the creation of common rules on a Community-wide basis. However, over the years, a number of shortcomings have been identified and it is clear that a genuine common market cannot be realised by 1992 if the Community relies exclusively on Article 100 of the EEC Treaty. There will certainly be a continuing need for action under Article 100; but its role will be reduced as new approaches, resulting in quicker and less troublesome progress, are agreed. . . . Clearly, action under this Article would be quicker

47

DD journal03.v.11

28-11-2001

19:15

Page 48


‘Regulated markets’ in the ISD

Aspiring foreign competitors such as Instinet, eSpeed and

Article 15.4 of the ISD provides for a ‘single passport’ for EU

Brokertec Global must, therefore, operate at a significant

trading systems, allowing a system authorized by the compe-

competitive disadvantage.

tent authority in one national jurisdiction to provide remote services in all the others. This single passport is a manifesta-

Given the clear indications that existing exchanges will in

tion of the concepts of mutual recognition and home country

short order be expanding their cross-border services, and that

control, utilized in a number of Single Market Programme

new electronic competitors will be entering the fray, it is now

directives to facilitate market integration without the need for

more important than ever to ensure that the ISD does not act

prior harmonization of laws and regulations across the Union.

as a barrier to the long sought integration of the European capital markets. If flaws in the ISD are not addressed, we are

The ISD single passport, however, only applies to so-called

likely to witness the wholly undesirable transformation of EU

‘regulated markets’. Harmonizing a definition of such markets

national securities commissions from market regulators into

was a source of enormous controversy within the Council of

trade negotiators, operating on behalf of local incumbent

Ministers during the original ISD negotiations, which began in

exchanges threatened by more efficient foreign competition.

1988. If an exchange or trading system was not legally

This trend is already clear in the US, where the Securities and

a ‘regulated market’, then it was obliged to seek explicit

Exchange Commission has steadfastly refused direct

authorization to operate in each and every national jurisdic-

electronic access for non-US exchanges, while at the same

tion in which it wished to provide services, even if only by

time turning a blind eye to US brokers providing their own

remote cross-border electronic link. Local protectionism was,

electronic links direct from US investor desks to foreign

therefore, a real threat to any trading system operator that

trading systems.

could not satisfy the ‘regulated market’ criteria. This article will focus on four clauses in the ISD which relate The London Stock Exchange’s SEAQ International trading

to the legal concept of the ‘regulated market’:

platform was the primary target for protectionist manipulation of the ‘regulated market’ definition in the ISD negotiations.

■ the listing requirement in article 1.13

A significant competitor to the continental exchanges in the

■ the ‘new markets’ provision in article 15.5

late 1980s, it had nonetheless been overtaken by the time of

■ the ‘concentration principle’ in article 14.3

the ISD implementation deadline in 1996. Cross-border expan-

■ the ‘transparency’ rules in article 21.

sion of electronic trading systems proceeded rapidly in the late 1990s, but as the exchanges generally refrained from

We explain the source of their protectionist potential, and

competing in each other’s products there were few opportu-

recommend surgical revisions of the text to mitigate it while

nities for testing the protectionist potential of the ‘regulated

minimizing the likelihood of provoking political gridlock.

market’ definition. This is now set to change dramatically.

De-linking listing and trading A significant recent example has emerged in electronic bond

Exchanges typically perform functions wholly unrelated to the

trading. The Italian Treasury has given an effective monopoly

actual trading of securities, and indeed are frequently

in electronic trading of Italian government securities to the

required by national law to perform such functions. The most

MTS ‘telematico’ system by restricting central clearing coun-

significant one is listing the company shares to be traded on

terparty services to official ‘regulated markets’, as designated

the exchange.

by the Treasury in accordance with the ISD. MTS is the sole operator so recognized for Italian government securities.

48 - The


DD journal03.v.11

28-11-2001

19:15

Page 49


Listing is fundamentally a quality control function, designed

down listing costs and to discover the optimal listing

to ensure that companies admitted to a given segment of the

standards for companies with different characteristics.

market (e.g. large cap or small cap) meet disclosure requirements appropriate to their size and age. Its role in the equity

The ISD unnecessarily conflates the regulation of corporate

markets is comparable to that of ratings in the bond market,

disclosure with the regulation of trading systems. Listing of

even if the mechanisms of being listed and rated are very dif-

securities in conformance with basic standards is held to be a

ferent. But just as bond rating agencies have a strong incen-

hallmark of a regulated market, and acquisition of a single

tive to rate bonds more accurately than their competitors, list-

passport is therefore made contingent on it. As SEAQ Inter-

ing agencies should have strong incentives to set listing

national did not list the continental stocks which it traded in

requirements for publicly traded companies neither too low

the late 1980s and early 1990s, a formal listing requirement

nor too high. If disclosure requirements are excessive for the

was clearly a threat to its cross-border operations at the time.

size and age of the companies wishing to be publicly traded,

A North-South split emerged in the Council of Ministers

then the agency will unnecessarily sacrifice listing revenues. If

during the ISD negotiations over the appropriateness of a listing

they are set too low, however, investors are more likely to be

requirement, leading to a compromise around deliberately

harmed by unexpected events, like profit warnings. Investors

ambiguous text. Article 1.13, therefore, specifies that a ‘regulat-

will therefore shun such stocks, and the agency’s reputation

ed market’ must satisfy the requirements of the Listing

and pricing power in the listings market will suffer.

Particulars Directive (79/279/EEC) ‘where [the Directive] is applicable’. Failure to identify who ultimately determines

It is an unfortunate historical legacy, however, that in much of

applicability leaves considerable room for protectionism by

the world governments have treated listing as a self-regulatory

host state authorities on behalf of their own domestic

function to be performed by the monopoly national exchange.

exchange operators.

As a matter of logic and history, however, listing should never have been considered an obligation that needed to be

Newer European trading platforms (e.g. virt-x and Jiway)

imposed on exchanges. The board of the New York Stock

intend to transact securities listed elsewhere, which they

Exchange (NYSE) began imposing formal listing standards in

themselves do not list, and there would be no benefit to the

1856, and did so wholly of its own accord and in consideration

market in requiring them to duplicate this function. In order to

of its own interests. The main reasons for the development of

pre-empt protectionist barriers to the expansion of these and

such standards would appear to have been the protection of

other markets, and to encourage the development of a com-

members trading on their own account and the incentive to

petitive market for listing services in Europe, the ISD should

listing provided to companies from the public signal of finan-

be revised to make clear:

cial soundness and stability (Banner 1998). This incentive is reflected in the fact that exchanges typically extract a signifi-

■ that whereas ‘regulated markets’ may be obliged by home

cant proportion of their annual revenues from listing activities

state authorities to deal only in formally ‘listed’ stocks, the

(36 percent on the NYSE in 1999).

actual listing function may be performed by any exchange or other body (such as an accounting firm, rating agency

Whereas listing is clearly a valuable market function, it is

or government institution) duly authorized to provide

important to recognize that there is no logical reason why

listing services in any EU national market.

trading system operators should necessarily be the ones to carry it out. It could just as easily be performed by accounting

■ that it is the home state authority which is authorized

firms or rating agencies, and done on a competitive basis.

to decide whether the Listing Particulars Directive is appli-

Competition for listing standards should help both to drive

cable in any given case. This would ensure that a trading

49

DD journal03.v.11

28-11-2001

19:15

Page 50


system operator designated as a ‘regulated market’ in one

then be creating a ‘new market’. This would further restrict

jurisdiction is not denied single passport rights in another

the scope of the single passport and severely limit the

jurisdiction on the basis that that particular operator does

prospects for cross-border trading system competition.

not itself ‘list’ the securities which it trades. Having been incorporated into law in a number of Member

‘New Markets’

States, the concentration principle will be exceedingly difficult

Article 15.5 states that article 15 ‘shall not affect the Member

to remove, or even significantly amend. Therefore reducing

States’ right to authorize or prohibit the creation of new markets

the legal scope for host state authorities to negate the ‘regu-

within their territories’. This clause is redundant if its actual

lated market’ status of foreign trading systems is likely to be

intent was merely to reinforce home state discretion in desig-

the only politically viable means of addressing its protection-

nating ‘regulated markets’. But the intent appears to have

ist potential.

been to furnish host states with an escape clause from the single passport provision for screen-based trading systems.

‘Transparency’

By declaring a foreign trading system to be a ‘new market’, a

Transparency in the ISD refers to rapid publication of post-

host state could deny it single passport rights.

trade transaction data. In a competitive market, governmentmandated transparency rules are either unnecessary or

Indeed, an early sign of the potential for abuse of the new

damaging. They are unnecessary for the electronic auction

markets clause came in 1995, when the Dutch Ministry of

systems being operated by the EU exchanges, since all of

Finance opined that a foreign screen-based system wishing to

them have the incentive to sell real-time transaction data to

provide for remote access in the Netherlands might be

private vendors, such as Reuters and Bloomberg. They are

considered as intending to create a ‘new market’ in the

damaging for block transactions facilitated by dealers,

Netherlands [Steil (1995)]. The Dutch position provoked con-

because dealers will not quote prices on blocks if they are

siderable criticism from abroad, and was never applied. If its

forced to reveal the transactions to their competitors before

validity were to be upheld, however, the single passport would

they have rebalanced their portfolios. And if block transac-

be entirely negated. With the recent establishment of new

tions are eliminated by transparency rules, the market is not

trading platforms for equities and bonds the potential for

actually made more transparent. Whether the investor breaks

abuse is now considerable. In order to eliminate this possibility,

up a large sell order for execution in an auction market, or

article 15.5 should simply be extirpated from the Directive.

sells the entire block to a dealer who then does the same, the transactions will always get published the same way, through

‘Concentration’

the auction market.

Through the removal of the new markets clause, the protec-

50 - The

tionist potential of another provision, the so-called ‘concen-

The ISD transparency rules (article 21) are in their present

tration principle’, article 14.3, will be considerably lessened.

form inconsequential, so there is no pressing need either to

Another source of North-South tension in the drafting of the

amend or remove them. A further compromise in the ISD

Directive, the concentration principle gives Member States

negotiations led to an ambiguous requirement for ‘regulated

the right to mandate that transactions in domestically listed

markets’ to publish ‘at least’ weighted average prices at regu-

securities be carried out only on a ‘regulated market’. The new

lar intervals6, with unspecified delays permitted for ‘very

markets clause gives Member States the possibility of claim-

large’ transactions. Deutsche Börse demonstrated that the

ing that a trading system designated a ‘regulated market’ by

requirements could be avoided entirely by declaring all trades

its home authority is not actually a ‘regulated market’ outside

that they did not wish to publish, those done by telephone, to

its home state if tries to expand its product base – as it would

be ‘off-market’. Since, logically, only their electronic trading


6 I am aware of no market which publishes weighted average prices in place of individual transaction prices.

DD journal03.v.11

28-11-2001

19:15

Page 51


system (IBIS, now Xetra) required a single passport to accom-

of the Listing Particulars Directive. A trading system

modate remote access, this system itself became the ‘regulat-

operator should not be required to enter the listing busi-

7

ed market’, and trades off the system remained outside the

ness as a condition for acquiring a single passport. Home

scope of the ISD transparency rules.

state regulators should be permitted, but not obliged, to require trading systems which they designate to be ISD

The Forum of European Securities Commissions (1999) has

regulated markets to trade only formally listed securities,

called for the real-time disclosure of ‘all completed transac-

but any institution authorized to provide listing services in

tions’, but acknowledges the application of delays or suspen-

any EU jurisdiction should be considered competent to carry out such a listing requirement.

sions in accordance with article 21. However, they have also called for real-time disclosure of bid-ask prices and volumes,

■ Article 15.5 should be eliminated, so as to preclude an EU

known as ‘pre-trade transparency’, without derogation. Such

authority from denying single passport rights to a foreign

limit order revelation, however, is not clearly desirable in all

‘regulated market’ on the grounds that it is seeking to cre-

market architectures. New electronic call market structures,

ate a ‘new market’ in its territory.

where trading occurs at specific pre-designated points in time, process complex contingent orders which are frequently not

These changes will further serve to mitigate the protectionist

amenable to pre-trade revelation8. Furthermore, disclosure of

potential of the ‘concentration principle’ enshrined in article

pre-trade indication prices may actually encourage undesir-

14.3. With regard to the transparency provisions in article 21,

able gaming of such systems, through manipulative order

it is best not to open a contentious new political debate in the

placement and retraction strategies. Therefore, FESCO’s

Council over this text. The provisions are unnecessary, but

statement that the organization ‘does not regard it as the role

fundamentally harmless in their current form. It is important

of the regulator to prescribe market design’ is incompatible

only that FESCO do not seek to expand their application to

with regulations requiring order revelation. The latter is inti-

‘off-market’ transactions facilitated through dealer capital, or

mately related to market design, and should therefore not be

to pre-trade price and volume information in the case of peri-

mandated.

odic call auction trading systems.

Summary and conclusions

References

The rapid spread of automated trading systems in Europe over

•

the past decade has significantly intensified competitive pres-

•

sures for consolidation of exchanges and platforms. It is therefore important that unnecessary legal barriers to cross-border access and competition be dismantled. This entails revisiting a

• •

number of problematic clauses in the Investment Services Directive. •

Although there are considerable problems with exchange reg-

•

ulation in the current ISD text as a result of the difficult political compromises that led to it, the actual revisions necessary

•

Banner, S., 1998, Anglo-American Securities Regulation: Cultural and Political Roots, 1690-1860, Cambridge: Cambridge University Press Commission of the European Communities, 1985, ‘Completing the Internal Market: White Paper from the European Commisson to the European Council’, June Domowitz, I., and B. Steil, 1999, ‘Automation, Trading Costs, and the Structure of the Securities Trading Industry’, Brookings-Wharton Papers on Financial Services Fitchew, G., 1991, ‘Political Choices’, in R. Buxbaum et al. (eds), European Business Law: Legal and Economic Analysis on Integration and Harmonization, Berlin, Walter de Gruyter Forum of European Securities Commissions, 1999, ‘Standards for Regulated Markets Under the ISD’, December Steil, B., 1995, ‘Illusions of Liberalization: Securities Regulation in Japan and the EC, Special Paper Series, the Royal Institute of International Affairs Steil, B., 1998, ‘Regional Financial Market Integration: Learning from the European Experience’, Special Paper Series, the Royal Institute of International Affairs

to address the most fundamental ones are rather small. Two amendments to the Directive would suffice: ■ Article 1.13 should be rewritten so as to make clear that a ‘regulated market’ need not itself meet the requirements

7 Trades on the floor with Kursmakler (specialist) intermediation are also published immediately. 8 For example, OptiMark and BondConnect.

51

DD journal03.v.11

28-11-2001

19:15

Page 52

DD journal03.v.11

28-11-2001

19:15

Page 53

Capital markets

STP/T+1: The European challenge What are the implications of the U.S. move to T+1 settlement for European institutions?

Paul Walsh Principal Consultant Capco1

Abstract In this paper, we have highlighted the potential implications of a move in the U.S. to T+1 on European financial institutions. We explain that while many European institutions feel that they are sheltered from this move, those that undertake trading activities in the U.S. will find that they need to make the necessary investments to meet this objective if they are to continue servicing their clients effectively. Those that fail to prepare for T+1 do so at their own peril. In addition to addressing how European institutions will be impacted, this paper also provides some prescriptive recommendations on what steps might be necessary to meet this important challenge.

1

I would like to thank the following for their help with this paper: Colin Hewett of Nomura, and Lisa Berk, Simon Freeman, Marilyn Hignett, and Jan Mostyn of Capco. Any remaining errors are the sole responsibility of the author. The views expressed herein are those of the author and do not necessarily represent the views of Capco or its management.

53

DD journal03.v.11

28-11-2001

19:15

Page 54

STP/T+1: The European challenge

Introduction

cross-border trade can touch as many as 25 different people,

STP or Straight Through Processing - the seamless, electron-

processes and systems before it is finalized.

ic process that encompasses the entire life-cycle of a trade, end to end, from order through execution to settlement, across

To cope with the introduction of a T+1 settlement, a complete

the whole financial markets value chain - has been an ongoing

redesign of the institutional post-trade model has been pro-

challenge for the Capital Markets industry for many years.

posed. This will allow the industry to streamline today’s operating model, increase capacity, decrease the number of excep-

The proposed move by the U.S. securities markets to next day

tion items, and significantly reduce costs by eliminating many

settlement, T+1, provides the industry, and the complete STP

redundant and manual steps.

process, with its greatest challenge to date. The potential benefits to the whole industry value chain is unparalleled, with

A risk that some European institutions are taking is that they

reduced settlement risk and huge increases in processing effi-

are assuming that the move to T+1 in the U.S. is simply a

ciencies, leading to much lower unit costs. According to The

domestic matter and that they will not be impacted. Those

Securities Industry Association (SIA)2, if the U.S. securities

who take this position do so at their own peril. The move to

industry wishes to reach the T+1 panacea, it will need to invest

T+1 is a significant issue for anyone who trades North

approximately U.S.$8 billion. In return, however, the industry

American securities, especially those that are operating in a

will save U.S.$2.7 billion a year, with an average payback of

different time zone3. The objective of this paper is to highlight

3 years.

the importance of the move to T+1 on the major European institutions and explain how they can prepare themselves for

The move to T+1, initially scheduled for June 2004 and now

this inevitability.

moved back to June 2005 in response to the tragic events of September 11th, continues the U.S. lead in shortening settle-

Background

ment cycles within major markets. Many countries outside

The proposed new industry model for a T+1 environment -

Europe, such as Canada, Japan, Australia, and Singapore have

defined in the SIA ‘Institutional Transaction Processing Com-

also announced their intention to move to T+1. Within Europe,

mittee’ (ITPC) white paper (2001) - is a radical change from

settlement predominantly occurs on trade date plus three

the current process. It is based around the provision of Virtu-

(T+3). This trade cycle is one that France and the U.K. have

al Matching Utilities (VMUs), which allow for the seamless, real

only recently met, Germany currently operates a T+2 settle-

time matching of trade data throughout the trade lifecycle.

ment cycle. However, France has already announced its inten-

Figure 1 depicts the flows and interactions between the vari-

tion to move to a T+1 settlement cycle, and will announce their

ous institutional players and the VMU, as proposed by the

target date by year-end.

ITPC white paper.

Previous moves to shorten the settlement cycles to T+3 have

The VMUs operate in the post-trade, pre-settlement arena and

all introduced major changes. However, the move to a T+1 set-

match the Notice of Execution (NOE) and Allocations, includ-

tlement cycle will require radical change, particularly when

ing net proceeds, between the investment manager and the

you take into account the problems associated with settling

broker/dealer. Once the trades have been matched, the neces-

and clearing cross-border trades. Cross-border affirmation

sary settlement instructions are delivered to the required

and settlement rates in Europe are currently significantly

depository.

behind their U.S. domestic equivalents, which only adds to the

54 - The

problem for European players. As an example of the complex-

Currently, two major organizations have positioned them-

ity of the process, recent studies have indicated that a single

selves for the VMU role, Omgeo, a joint venture between the


2 T+1 Business Case: Final Report, July 2001 3 The SIA’s research department indicates that the gross activity of U.S. securities traded by European investors during the 3rd quarter of 2000 was U.S.$1,905,043 million. This breaks down into approximately U.S.$700,000 million for equities and U.S.$1,200,000 million for fixed income products.

DD journal03.v.11

28-11-2001

19:15

Page 55


Investment Manager Allocates shares among client accounts

Broker dealer

attached to an alternate solution and vice versa. The Securi-

Sends NOEs

ties and Exchange Commission (SEC) is working closely with

Send final cumulative NOE

the regulated VMUs to put in place an ‘interoperability’ code

Order NOE (1) Allocations (2) Match status (4)

NOE (1) Final NOE (1) Allocations (2) Match status (4)

■ Match NOE's with

allocations (3) ■ Produce match Ł

status report (4)

operate, such that participants can interact with little or no

Matching utilities

Allocations (2) Client account settlement instructions (6)

SSI Database

■ Append settlement

instructions (6)

Settlement authorization Pending settlement instructions (7)

Passive settlement approval (8)

concern as to which VMU their counterparts have chosen. In

Client account settlement instructions (6)

instructions (5) ■ Distribute settlement

Custodian

practice this is a complicated problem to solve. The SIA inter-

Broker/dealer clearer

operability committee has some key decisions to make, one of

Settlement authorization

cussions indicate this will be undertaken by the investment

Settlement notification

Depository

of practice. The idea being that VMUs should seamlessly inter-

Passive settlement approval (8)

Settlement Figure 1: Proposed institutional transaction processing model - SIA T + 1

which is where the matching will be carried out. Current dismanager’s VMU. Additionally, it is not clear how the cost/pricing models will function, how the ‘Single Standing Settlement Instruction (SSI) database’ concept will operate in practice, or how the VMUs will differentiate themselves to gain market share. ■ How will the change to T+1 happen

Depository Trust and Clearing Corporation (DTCC) and Thom-

T+1 settlement has been a topic of discussion for a number of

son Financial, and the Global Straight Through Processing

years. However, since the publication of the SIA T+1 Business

Association (GSTPA), a global initiative comprising many key

Case document in July of last year, focus has reached critical

industry participants. In addition, there are also a few other ven-

mass and an industry-wide program has been initiated.

dors who are considering offering this service in the U.S. market. The SIA has formed 24 subcommittees5, and many more assoIt is anticipated that membership of a VMU will be a mandato-

ciated working groups, to guide, plan, and manage the move

ry requirement in the T+1 arena and that participants in the

to T+1. One key subcommittee from a European perspective is

U.S. markets will have a number of alternatives open to them

the Foreign Exchange Committee. This subcommittee has

to satisfy this requirement. They could either join one of the

been tasked with reviewing the issues associated with settle-

planned VMUs or interface with one of these utilities via a

ment of U.S. securities that are accompanied by a foreign

‘concentrator’4. A concentrator would take on the membership

exchange transaction. The output from this committee will be

costs and obligations of the VMU, then support the delivery of

particularly relevant for non-U.S. investors and will enable

trade information into the VMU from other organizations. This

them to gain a better understanding of the specific changes

facility will be of benefit to organizations that have either

they will have to accommodate. Also, although a working

effectively outsourced their back-office activities or cannot

group of the Institutional Transaction Processing Committee

justify the expense of Information Technology (IT) investment,

(ITPC) has a mandate to focus on cross border issues, discus-

process re-engineering or indeed VMU membership.

sions are also underway to introduce a European presence into this committee.

Although a single VMU solution would appear optimal, the U.S. has pursued a multiple VMU solution in order to ensure

Currently, the cross-over to T+1 is scheduled for June 2005

that competition among providers would result in better serv-

and the full cross industry testing will take place in June

ice and pricing. Given this scenario, the question of interoper-

2004. There are a number of key milestones to be met in

ability arises. For example, how does an investment manager

order to achieve these goals. Some of the most important are

attached to one VMU effectively deal with a broker/dealer

mentioned below.

4 Currently the concentrator concept applies only to the GSTPA offering. 5 Examples of some of the subcommittees include: the Institutional Transaction Processing, Interoperability, Standards/Codes of Practice, Corporate Actions, Securities Lending, and Testing.

55

DD journal03.v.11

28-11-2001

19:15

Page 56


■ The draft model for interoperability between VMUs will be

in mid-2003, implementation of early netting and also

made available to the industry at the end of the 3rd quar-

elimination of their end-of-day batch reporting suite with

ter, 2001. This will be the first time the industry sees how

the introduction of multi-batch intra-day reporting. In

the VMUs will interact. It is obviously a key milestone for

addition, a Real Time Trade Matching (RTTM) utility for

many institutions and may well influence their plans in

streetside only fixed income trades is being planned for

terms of their approach to the VMUs.

implementation by mid-2003.

■ By the end of 2001, two milestones will be achieved that have significant relevance to the European market. First,

As a measure of the scale of the expected change, Tower

the Foreign Exchange and ITPC committees will submit

Group estimates that there will be U.S.$19.2 bn spent on STP

draft rule changes to the Legal and Regulatory committee,

projects from 2001 to 2004. 30% of this will be European

and second, the position paper for best practice use of the

spend, that equates to U.S.$5.8 bn. 90% of this spend, on a

institutional transaction processing model for cross-bor-

per institution basis, is expected to be ‘within 4 walls’, i.e. insti-

der matching will be produced. This paper is expected to

tution specific internal spending.

contain all the appropriate timing proposals and deadlines The magnitude of this program will demand a major exercise

for cross-border flows. ■ GSTPA and Omgeo’s cross-border systems are both due to

in planning, coordination, and change management, and will control the lives of many people over the next few years.

be in production at the end of 2001. ■ Omgeo intends to begin the transition period to their planned T+1 operating environment mid-2002. It has

■ Timing – the generic issue

recently indicated that institutions can migrate from the

Timing is a central issue of concern for European players. The

current Thomson/DTCC solutions at their own pace, hence

facts are simple, the life-cycle of a trade between execution

affording them greater flexibility in migration planning.

and settlement will be compressed into two days. Although

■ The return of physical certificates prior to sale will be

Europe will always have 5 extra hours in which to react to any

mandated from mid-2002. This is likely to mean significant

problems, many important issues as to how each institution

business process change for many institutions.

will operate in the new environment remain unresolved.

■ The DTCC has significant changes planned as part of their

An example of the major activities and how they map from the

overall T+1 initiative. Included in these changes are: re-

T+3 to the T+1 timescales is shown in figure 2 for a U.S. equi-

writing the Continuous Net Settlement system (CNS) due

ty transaction.

T+3 Trading Activities

T+1 Trading Activities

Trade Date

T+1

T+2

T+3

Order entry Execution

Trade agreement Confirmation Trade guarantee Allocation

Netting Settlement instructions

Balancing of securities & cash Cash movement at DTCC Security movement at DTCC

Locked in trades Cash movement at DTCC Trade matching Submission of allocations Security movement at DTCC Real time netting Trade guarantee Balancing of securities & cash FX cover of trade

Figure 2

56 - The


DD journal03.v.11

28-11-2001

19:15

Page 57


The SIA Standards and Codes of Practice sub-committee has

indicate the level of commitment behind it and give institu-

been tasked with drawing up guidelines for the timings of

tions sufficient time to make systems and process changes

each stage of the trade processing life-cycle. To date, the

necessary prior to adoption.

following deadlines have been agreed: The SIA has also deemed membership of an institutional trade matching utility to be a critical item of regulation. The current T – 16:00p.m. (EST) Investment manager determines when it is ready for the broker/dealer to issue the final cumulative NOE. If not notified, it is assumed at 16:00p.m.

Investment manager

T – 16:30p.m.

All final cumulative NOEs must be received by the VMU

Broker/Dealer

Allocations (including net amounts) for all executed trades must be received by the VMU. Trades entered after this time will be considered next day trades and will settle two days hence.

Investment Manager

T – 17:00p.m.

T+1 – 12:00 midday Trades can be disaffirmed

process, in particular the process and timing of trade allocations, must be streamlined. Ideally investment managers should be required to participate in a trade-match system in much the same way as broker/dealers currently participate in such a system through exchange membership. In this manner, the trade can be matched within minutes of the Notice of Execution (NOE) being submitted. In the case of fixed income trading, there are further complexities due to the decentralized nature of this market. The SIA is looking to the SEC, and SROs in general, to mandate membership of real-time trade comparison functions for

Any

inter-dealer trades. The Real-Time Trade Matching (RTTM) proposal has been agreed as the solution to this problem.

It has also been agreed that all allocations must always be

Other key regulatory changes include a revision to the

submitted within 30 minutes of receipt of the NOE.

prospectus delivery requirement, such that hard copy prospectuses do not need to be mailed out to participants

From the above timelines, it can be concluded that the Codes

within 24 hours of pricing the offer, and revisions to SEC Rule

of Practice subcommittee will recommend that all allocations

15c6-1(c) regarding the settlement cycle for the commence-

are matched on trade date. The assumption at the moment is

ment of secondary trading of an initial public offering, to put

that there is likely to be a small period of time on the morning

a T+2 or T+ 3 cycle in place.

of T+1, where minor problems can be overcome and settlement still achieved. In all likelihood, regulations will be

The implications for European players

introduced that ensure trades that are not matched will not be

A great deal has been written on the move to T+1, and while

settled.

many of the issues facing each industry participant are the same whether they are based in New York or Europe, there

■ The key regulatory changes

are some key specific issues that need to be addressed by

A number of regulatory items have been raised as being

non-U.S.-based players. These, as well as the more generic

critical to the successful implementation of T+1. The key item

issues around the industry initiative, will be discussed below.

is SEC Rule 15c6-1, which establishes three business days as the standard settlement cycle in the U.S. securities markets. The SIA T+1 committee is looking to the SEC to amend this

■ Will 10 p.m. be the norm as opposed to the

exception?

rule by the end of 2001, so the changes can be accomplished

The introduction of the new environment will require radical

by June 2005. Amending the rule early in the program will

change to each participant operating model. One of the key

1

McWilliams and Siegel (1997) outline procedures for using the event-study framework.

57

DD journal03.v.11

28-11-2001

19:15

Page 58


issues for European players will be the changes in trading and

VMU matching capabilities will replace confirmation-

support hours, in particular the timeliness of reaction to fail-

process in its entirety, and make it redundant overtime.

ures during any stage of the transaction cycle. The issue is

Regulatory changes are being discussed to support this.

more complex for European players than for U.S. nationals

■ Changing relationships along the value chain - The VMU

due to the number of parties involved in the process. For

will replace traditional channels of communication, both

instance, an investor in Europe will, in all likelihood, settle

automatic and verbal, between the trading community,

through a Global Custodian, who will in turn make use of the services of a Sub Custodian, to eventually settle the transac-

the custodians, and the CSDs. ■ Trading Hours - One issue on the minds of many European players, is the potential effect on trading hours and

tion at the DTCC.

required operational support. Currently fund managers The 5 hours head start on the U.S. settlement cycle, will not

often pass over trades to broker/dealers to work within

be a significant benefit to the European players. It will be

limits/conditions over the day. The following day, the fund

imperative that each institution completes as much of the

manager will review the trade, ensure best execution,

trade cycle as possible on trade date. There will, therefore, be

adherence to original conditions etc. If an order is not fully

many key activities that can only be progressed at the end,

executed the fund manager will have to review the alloca-

and not the beginning, of the day.

tions and perhaps allocate all to a single client or fill only some client orders. In a T+1 environment, all this control of

It is essential that each institution conducts a review of the

the trade will have to occur on trade date. If European

whole trade process flow prior to T+1 in order to identify their

players extend their operating hours to 10 p.m. (or even

key concerns. Some potential issues and specific areas of

1 a.m. for the Pacific Exchanges to cover the full U.S. mar-

focus are:

ket operating hours) then the resource cost could increase by as much as 20-30%. Indeed, in its business case, the

■ Direct flow of executed orders into internal trading

SIA has raised the specter that institutions may need

systems – The need for direct flow of executed orders into

resources to resolve issues overnight. This would imply

the internal trading systems, or as a minimum direct

that even 10 p.m. might not be sufficient coverage for the

trader input, will be a basic requirement for all investment

European players.

managers and broker dealers. This covers all trade details and includes allocations being input on trade date. Given

Due to the high cost of systems re-engineering, and the added

the current paper based processes at many institutions in

requirement for extended front office and operational sup-

Europe this is a key challenge and one that will require

port, many institutions will consider alternative approaches,

detailed planning. There are significant cultural changes

such as outsourcing or passing responsibility for the original

required in dealing practices to ensure the new process

order, or the post-trade processing cycle, to an associated

works.

office in the U.S.

■ Exception-based processing will be a necessity - STP levels of greater than 90%6 will need to be common place

As a result of the anticipated requirement for outsourcing, a

with operations moving to an exception-based process,

number of new organizations have recently been created to

which is proactive rather than reactive. In a recent survey

offer outsourcing solutions to asset managers. Included in

of major global custodians, no candidate received an STP

these are JP Morgan’s Asset Manager Solutions Group and

7

score greater than 56% . This highlights the scale of the

Encompys, joint venture between the Bank of New York,

challenge.

Accenture, Microsoft Corporation, and Compaq Computer

■ The confirmation process becomes redundant – The

58 - The


Corporation.

6 Source: Capco internal research and analysis 7 Source: Global Investor, May 2001

DD journal03.v.11

28-11-2001

19:15

Page 59


■ In an ideal world a single virtual matching

utility would seem optimal

With regard to T+1, there is the issue of how each VMU currently plans to operate in terms of SSIs. The SIA transaction

Many global organizations suffer from the problem of region-

processing model proposes that the VMU has access to an SSI

alization when it comes to dealing with the VMU-based project

database and enriches the transactions with the necessary

initiatives. Although both the current VMUs have positioned

settlement accounts as they are received. The current GSTPA

themselves globally, the perception is that the GSTPA initia-

model relies on the contributing parties adopting a ‘just in

tive is more focused on Europe and Omgeo on the U.S. Hence

time’ enrichment procedure and to add the settlement

organizations find themselves with two different groups of

accounts themselves. In order to operate in the U.S. T+1 arena

people in different geographic locations, each responsible for

this model will have to change.

separate solutions. Project teams are in fact tracking these initiatives, developing solutions, and indeed beginning to

Omgeo have indicated that they will base their solution on the

participate in testing. All this leads to added expense. Most

current Thomson/DTCC infrastructure already utilized by

participants wish that in the end only one of these solutions

many of the market players. The Thomson’s ALERT database

will eventually be required.

and the DTCC SID database will be combined to create a single central SSI database that Omgeo will use to determine set-

Omgeo have the potential to steal the march in this battle,

tlement accounts.

they currently have a global client base of 6000. A key aspect of their offering will be how they plan to migrate these clients

It should be noted that one of the key SIA principles is that

from their current systems to their new T+1 solution. If they

each institution should only have to maintain one single exter-

can do this efficiently and in a trouble free manner, then the

nal database. This implies that there needs to be a significant

choice is going to be much easier for many players.

amount of cooperation between the multiple VMUs. We have yet to see how this might really play out, given its criticality to

Additional complexity is likely to be added to this picture in

the success of T+1.

the near future from a global perspective. Canada and Singapore are currently planning their own T+1 campaigns. Both are

Given the above, there should be significant benefits for the

considering new and separate initiatives for VMUs. Interoper-

participants in the new process. They will effectively be out-

ability will be the life-line for market participants.

sourcing the data management for their counterpart SSIs to the VMU. There may not be head count savings in the short-

One thing is clear, market participants will continue to hedge

term but as these changes become more global in scope sav-

their bets as to which VMU(s) to join, until there is a clearer

ings may well become apparent.

view as to how this will all eventually settle down. ■ Connectivity to the VMU is the only obvious ■ Standard Settlement Instructions,

the different models

change There are many aspects to consider when planning a move to

Standard Settlement Instructions (SSIs) and static data in

T+1, not least of them is the technology solution. Considera-

general, are much maligned functions in most institutions.

tions will include: messaging and connectivity, static data,

Even without the pressures of T+1, there is a critical need to

straight through processing (STP) capability, reducing batch

clean up in-house data, which is generally held in a multitude

processing cycles and real-time data availability for various

of databases, in different forms, for different clients, with

key aspects of the processing.

little symmetry.

59

DD journal03.v.11

28-11-2001

19:15

Page 60


Many organizations already have a program underway to

ly settlement. This implies the implementation of the follow-

move to ISO 15022 SWIFT messaging standards. This is the

ing: Connectivity, real-time delivery and real-time non-batch

standard that has also been adopted by the VMUs, so it will be

based processing. Each of these is a challenge in its own right.

a good foundation to build upon.

Together, they become quite formidable.

As we have discussed, one of the key changes in the IT infra-

It is quite likely that European players will have to increase the

structure will be the provision of connectivity to the chosen

number of hours that operational support staff will be avail-

VMU. There are two points that need to be considered here.

able in order to operate during the U.S. market hours. This will

Firstly, do organizations want to implement a single connec-

lead to increased online system requirements. Currently sys-

tivity solution operating on behalf of multiple sites, or perhaps

tems within many institutions operate end of day batch cycles.

multiple connections for the different sites. It may be that the

These cycles can start as early as 8 p.m. Within a T+1 environ-

VMUs force the choice. Otherwise each participant will have to

ment, systems are likely to be required for online processing

come up with its own internal strategy. Each option has impli-

until 10 p.m. or later. Institutions may, as a result, have to look

cations and the solution will be driven by the situation within

at significant systems re-engineering to reduce the batch

each particular organization.

cycle in order to accommodate the new hours of operation. This, in effect, will continue the drive towards near 24 x 7 sys-

The second issue stems from the breadth of information cov-

tems availability.

ered in the messages to the VMUs. Inclusion of net proceeds and settlement accounts (dependent on the chosen solution)

Merrill Lynch has predicted that the cross-border trading vol-

will imply that some messages may need to be driven from the

ume will double every three years from the current volume of

back-office. Not all back-office systems, however, hold the NOE

200,000 trades per day, to 600,000 in 20038. The degree of

or block trade information. Internal re-engineering may

automation in the cross-border securities trades process is

therefore be necessary. Alternatively, interfaces to the VMU

estimated to be as low as 5% - 10%. To be able to cater to the

gateway may be required from multiple systems. For some

anticipated increased volume, there will be a need for a three-

global players, the overall connectivity issue will be a complex

fold increase in the number of people employed to handle

problem to solve.

settlement. Alternatively, the whole process needs to be fully automated. Coupled with the T+1 drive, this places the institu-

With the advent of shortened settlement cycles, the data flow

tions’ processing and systems environments under tremen-

between key business units within an organization must occur

dous pressure for change.

on a much more real-time basis. The basic premise being that the trades, including allocations, must be matched within the

The changes mentioned are significant for even the best pre-

VMU on trade date. Recent research conducted by Omgeo

pared institutions. For institutions that are less well prepared,

indicates that only 11% of U.S. equity trades are affirmed on

the requirements may well be too much. Institutions will look

trade date. In order to achieve the required improvement in

for help in achieving this change, which will increasingly come

this flow, organizations will need to manage the executions

in the form of other initiatives, such as outsourcing.

coming from their order flows on a real-time basis. The trade figuration and settlement account generation must also be achieved in real-time. Once the trade data has been collated

60 - The

■ Liquidity may be the real issue for

foreign exchange transactions

and reported to the VMU, it will need to be delivered in real-

Several key issues arise in the foreign exchange area, which

time to cash management systems, to enable funding, and to

are not always obvious. There will undoubtedly be infrastruc-

stock lending systems, to facilitate stock availability for time-

tural changes. One could argue that there will have to be a


8 Source: The Banker, Supplement May 2001

DD journal03.v.11

28-11-2001

19:15

Page 61


complete review of the foreign exchange and money market

date and will be required to issue a recall of the stock. The

processes within each institution to ensure all relevant staff

stock will have to be in position for settlement the following

are aware of new deadlines and funding requirements.

day. All this activity will have to happen in real time. The current infrastructure is considered inadequate to support the

There is also the significant potential impact of CLS (Continu-

required process. The SIA T+1 Securities Lending Committee is

ous Linked Settlement) due for implementation in the second

considering how this process can be improved. An automated

quarter of next year, which will itself bring some critical infra-

recall utility has been suggested and is under review. The pro-

structure changes. Institutions will certainly need to control or

posed recall utility would support connections from order

plan their FX usage more closely. There may even be instances

management systems and stock lending systems. It would

where pre-funding may be required. This will almost certainly

automate and standardize the recall process, making it much

be an issue for Far Eastern players.

more likely that stock could be returned in a timely manner for settlement.

T+1 may also drive various institutions to review their relevant depot and nostro agents. Holding cash and securities at the

This is yet another example of STP improvements that will

same institution may become a necessity. It may be that insti-

lead to cost benefits for the participants in the longer term,

tutions simply cannot easily manage their FX in certain sce-

but will require further investment in the short term.

narios. Consequently, opportunities may arise for custodians and others to begin offering value-added services to cater for

■ Reducing risk can in itself be a risky process

a client’s funding shortfalls.

There is no doubt the new VMU driven operating model will have a dramatic effect on risk, in particular calculation of

However, one area that requires significant further investiga-

operating and credit risk plus monitoring and approval.

tion and market discussion is the effect on pricing and liquidity in the foreign exchange markets. At present, trades can be

Operating risk has become the new industry buzzword follow-

covered at spot (T+2), on the day following trade date. Once

ing the recent Basle declarations. Many players are already

T+1 is introduced, FX will need to be covered on a

facing enough hurdles in trying to work out what its implica-

today/tomorrow basis. This is not a new concept and many

tions are within their current operating model without the

institutions can and do trade on this basis, but at what price

changes being driven by T+1. There is no doubt that the goals

and with what choice? Liquidity may become a key issue in the

of T+1, and STP in general, will lead to a reduction in operating

whole T+1 arena, and will certainly be a key consideration for

risk (and hence capital allocations), as processes and commu-

the SIA foreign exchange sub-committee.

nication lines are automated. However, it should be recognized that in the short term there will certainly be some

■ Stock lending and timely recall

increased risks as trading practices, both systems and proce-

Both asset managers and broker/dealers participate in stock

dures, are altered.

lending activities. In a T+3 environment there is sufficient time in the post trade execution to recall any lent stock required

Credit risk will also be subject to major change. There should

and so enables settlement. The current process involves sig-

be a significant reduction in relevant counterparty settlement

nificant manual intervention and is based largely on fax,

exposures. However, given the difficulties many institutions

phone, and e-mail communications. In a T+1 environment this

have in this area, the two key areas of focus will continue to

is going to be much more of a challenge.

be the ongoing monitoring and the approval process. These will need to be prompt, efficient, and most importantly

Custodians will be notified of the impending trade on trade

accurate.

61

DD journal03.v.11

28-11-2001

19:15

Page 62


Conclusion This document has highlighted the challenges that European financial institutions will face as a result of the move by the U.S. securities industry towards implementing a T+1 settlement cycle. We explain that contrary to the beliefs of many, European institutions will also need to prepare themselves for the move to T+1 if they wish to continue servicing their clients effectively. While the costs, both in terms of manpower and financial, can be quite high, there are distinct benefits to be derived from preparing for this change. The move to T+1 will certainly happen. Those institutions that undertake the necessary changes to prepare for it will reap the benefit.

62 - The


DD journal03.v.11

28-11-2001

19:15

Page 63

Capital markets

The capital markets’ perspective on B2B e-commerce initiatives and alliances Andrew H. Chen Distinguished Professor of Finance Cox School of Business, Southern Methodist University

Thomas F. Siems Senior Economist and Policy Advisor Research Department, Federal Reserve Bank of Dallas

Abstract In the business-to-business (B2B) sector, new electronic commerce (e-commerce) initiatives like Internet-enabled supply chains and electronic marketplaces (e-marketplaces) offer firms significantly lower procurement costs, increased operating efficiencies, and expanded market opportunities. Using an event-study methodology, we find that the capital markets respond favorably to firms announcing new B2B e-commerce initiatives and alliances. For B2B e-marketplaces, we find slightly higher, though statistically insignificant, average abnormal returns associated with vertical markets than with horizontal markets. When examining the data by the type of partner the e-commerce provider aligns with, we find that the capital markets reward firms the greatest when they form alliances with a competitor or a computer industry giant. The abnormal returns associated with these announcements are on average more than three times greater than returns from announcing a B2B e-commerce initiative alone or with Old Economy industry leaders.

63

DD journal03.v.11

28-11-2001

19:15

Page 64

The capital markets’ perspective on B2B E-commerce initiatives and alliances

Introducton

my paradigm using the event-study methodology. This

Since businesses first started using the Internet as a transac-

methodology allows us to identify abnormal stock returns to

tion vehicle in 1995, the growth has been impressive. Forrester

firms from a specific event, thereby allowing us to understand

Research estimates that worldwide electronic commerce (e-

the capital markets’ perspective at the event date. In efficient

commerce) revenues were about U.S.$200 billion in 1999 and

capital markets, prices should immediately adjust to reflect

project that it will grow to U.S.$6.8 trillion by 2004. The great-

any and all new information. This implies that stock prices

est impact is expected to be in the business-to-business (B2B)

reflect all available information about individual companies

sector, where the Commerce Department reports that B2B e-

and about the economy as a whole. Thus, announcements

commerce accounts for about 80 percent to 90 percent of

about new B2B e-commerce initiatives or alliances should

total e-commerce.

immediately raise stock prices if investors believe the firm’s value will be increased by higher net future cash flows result-

New Internet-enabled supply-chains and electronic market-

ing from higher productivity, lower costs, and/or higher

places (e-marketplaces) will enable companies to significantly

revenues.

lower procurement costs and increase operating efficiencies. These new B2B e-commerce initiatives streamline the supply

We empirically investigate several types of B2B e-commerce

chain by making better use of large volumes of information.

announcements from the capital markets’ perspective. Over-

Siems (2001) shows that the time it takes to match buyers and

all, do new online B2B exchanges create shareholder wealth?

sellers can be radically reduced, precautionary inventory lev-

Do the capital markets view B2B e-commerce initiatives that

els can be lowered, and the range of potential suppliers and

form vertical (intra-industry) exchanges differently from

distribution outlets can be expanded as geographic bound-

those that form horizontal (cross-industry) exchanges? Are

aries disappear.

the returns higher or lower for those firms that announce plans to complete new B2B e-commerce initiatives by them-

Through these improvements, B2B e-commerce will signifi-

selves versus forming an alliance with another B2B e-com-

cantly impact U.S. economic growth. Brookes and Wahhaj

merce company or Old Economy leader? And how do the cap-

(2000) argue that B2B e-commerce will have an economic

ital markets view acquisitions of other B2B e-commerce tech-

impact over and above that of the normal process of innova-

nology providers?

tion and productivity growth. They suggest that as a result of

64 - The

B2B e-commerce, annual GDP growth in the large industrial-

Why B2B e-commerce creates value

ized countries should rise by an annual average of 0.25 per-

In exchange markets, transparency along the supply chain

cent for the next ten years — with the level of GDP being even-

regarding price, availability, competing suppliers, and

tually 5 percent higher than it would otherwise have been.

alternative products can radically change the dynamics of the

These authors conclude that the dominant long-run effect of

buyer-seller relationship. Both parties can benefit as shared

B2B e-commerce will be on output and equity markets, rather

information increases competition and reduces costs for

than on inflation and bond markets.

searching, bargaining, decisionmaking, policing, and enforcement.

As long as investors believe that these new B2B e-commerce

Internet exchanges introduce unprecedented market and

initiatives and alliances will ultimately result in higher profits

process transparency. B2B e-marketplaces can provide nearly

and increased productivity without fueling inflation (the New

perfect information at all points along the supply chain,

Economy view), then investors should respond favorably to

increasing efficiency and lowering costs for participants. Such

such announcements. We examine the potential impact of

exchanges also enable companies to develop, manage, and

B2B e-commerce initiatives and alliances on the New Econo-

monitor internal and external processes - including work-in-


DD journal03.v.11

28-11-2001

19:15

Page 65


process and finished-goods inventories - far more efficiently

tiative with a large and well-recognized computer industry

and effectively. The improved coordination gets the right

leader, such as IBM Corp., Microsoft Corp., or EDS Corp.

goods and services to the right places at the right times with

■ Alliance: competitor — The e-commerce technology provider announced plans for a new B2B e-commerce initia-

lower costs.

tive with a competitor. We divide new B2B e-commerce initiatives that create online

■ Alliance: old economy — The e-commerce technology

exchanges into two types: vertical and horizontal. Vertical

provider announced plans for a new B2B e-commerce

markets are industry-specific; they focus on an individual

initiative with an Old Economy industry leader, such as

industry, such as steel, plastics, electronic components, or

General Motors or Ford in the automotive industry, or

chemicals. Electronic exchanges in vertical markets serve par-

Shell or Chevron in the energy industry.

ticipants primarily by bringing buyers and sellers together to

■ Acquisition — The e-commerce technology provider

transact business up and down the entire industry supply

announced plans to acquire another technology firm to

chain. They also provide industry-specific news and informa-

aid in future B2B e-commerce initiatives.

tion and other value-added services, such as employment opportunities, discussion forums, and event calendars that

Using these classifications, we test various hypotheses to

create community within the industry. These benefits can sub-

determine the value that the capital markets place on differ-

stantially reduce operating costs.

ent alliances that announce new B2B e-commerce initiatives.

In contrast, horizontal markets cross industries. They focus on

Methodology and data

creating an exchange for goods and services at a specific link

We use the event-study methodology, a useful tool for exam-

in the supply chain that is common to multiple industries, such

ining the consensus estimates of future benefits attributable

as MRO (maintenance, repair, and operations) supplies, logis-

to organizational initiatives, to identify and understand the

tics, and benefits administration. Typically, goods and services

capital markets’ perspective on new B2B e-commerce initia-

exchanged over horizontal e-markets are standardized and

tives and alliances1. Generally speaking, the event-study

can be outsourced to third-party providers that have well-

methodology analyzes stock returns relative to a portfolio of

defined, fixed-price products. As a result, the value added by

stocks representing the market. Differences in returns are

horizontal e-marketplaces is in automating workflow and

analyzed on days leading up to and following an event date -

reducing process costs to the participants of the exchange.

in this case, the B2B e-commerce initiative or alliance

This enables businesses in various industries to operate more

announcement date - to determine whether shareholder

efficiently and effectively.

returns differ significantly from the general market return for stocks. The strength of this methodology is that it captures a

We further divide announcements about new B2B e-com-

large number of investors’ overall assessment of a firm’s

merce initiatives by the type of partner, if any, the e-com-

discounted present value.

merce technology provider said it would form an alliance with. The following five categories of alliances are used:

Using the event-study methodology, differences in returns to companies engaged in vertical and horizontal B2B e-market-

■ Alone — The e-commerce technology provider announced

places can be assessed. The returns to firms that ally them-

plans for a new B2B e-commerce initiative without form-

selves with other technology providers and those that team

ing any alliances.

with Old Economy leaders can also be compared.

■ Alliance: computer — The e-commerce technology provider announced plans for a new B2B e-commerce ini-

1

McWilliams and Siegel (1997) outline procedures for using the event-study framework.

65

DD journal03.v.11

28-11-2001

19:15

Page 66


The event-study methodology is a forward-looking approach

mation technology to better manage industry supply chains.

that focuses on identifying abnormal returns to firms from a

Consequently, we expect that the capital markets will react

specific event. If the capital markets respond favorably to an

favorably to announcements of new B2B e-commerce initia-

announcement, positive abnormal stock returns around the

tives, resulting in positive abnormal stock returns (that is, risk-

announcement date would be expected. Consequently, abnor-

adjusted returns in excess of average stock market returns)

mal returns provide a means of assessing an initiative’s

around the date of the announcement. Alternatively, negative

2

impact on a firm’s future profitability. The methodology is

abnormal returns might indicate that the capital markets view

based on the hypothesis that as new information becomes

new B2B e-commerce initiatives as unprofitable strategies,

available, it is fully taken into consideration by investors

perhaps because they suspect factors other than shareholder

assessing its current and future impact. The new assessment

maximization motivated the initiative. Such factors might

results in stock price changes that reflect the discounted

include management’s level of compensation, job security,

value of current and future firm performance. Significant pos-

and span of control.

itive or negative stock price changes can then be attributed to individual events3.

Among the many benefits touted in announcements of new B2B e-commerce initiatives are the ability to:

In this paper, the event is the release of a firm’s B2B e-commerce announcement through the media4. Our events are

■ Expose sellers in one marketplace to all potential buyers.

derived from a list of defining events in B2B by Phillips and

■ Create a hub for development projects, market feedback,

Meeker (2000) for Morgan Stanley Dean Witter. The events in

and customer collaboration.

this report include announcements of B2B e-commerce IPOs,

■ Reduce time to market.

e-marketplaces, acquisitions, joint ventures, and alliances. We

■ Provide expansive catalogs of products and services.

include only announcements that involved an established,

■ Provide end customers with fast response, high cost

publicly traded e-commerce technology provider, removing those announcing IPOs. The resulting thirty six announcements include thirty-nine individual stock price events and cover the period from July 1999 through March 2000.

efficiency, and superior service. ■ Increase operating efficiency through an integrated Internet supply chain. ■ Streamline purchasing operations. ■ Reduce supply-chain costs, increase manufacturing

The capital markets’ perspective We test two hypotheses to examine the capital markets’ response to announcements about B2B e-commerce initia-

efficiency, and reduce inventories. ■ Reduce cycle times, improve transaction flows, and manage parts inventories.

tives and two hypotheses to examine the response concerning the type of partner, if any, the e-commerce technology

Table 1 shows the average abnormal returns for all the firms in

provider announced it would form an alliance with.

our sample that announced a new B2B e-commerce initiative5. Average abnormal returns for five event periods are reported:

■ Hypothesis 1: we expect positive returns for

announcements of new B2B e-commerce initiatives.

66

the day before the announcement (t=-1), the day of the announcement (t=0), the day following the announcement (t=+1), cumulative returns from the day before the announce-

As Subramani and Walden (2001) discuss, e-commerce initia-

ment to the day of the announcement (t=-1 to t=0), and cumu-

tives should position firms to exploit the growing importance

lative returns from the day before the announcement to the

of and expected growth in e-commerce, leading to benefits in

day following the announcement (t=-1 to t=+1). Also reported

the future. Such initiatives signal that a firm plans to use infor-

are the t statistics and significance levels that test whether

2 Please refer to Appendix I for a description of the methodology 3 See Chen and Siems (2001) for additional details on the firms used in this study and for the statistical tests of significance. 4 Because information about B2B e-commerce announcements may have leaked prior to the issuance of press releases, a search of major news and business publications using the Dow Jones Interactive News Service was conducted to see if any information was anticipated. In one case there were several news reports five days prior to the press release, so the event window used for this announcement was

moved five days forward. 5 All the abnormal returns this article reports are based on using the S&P 500 stock market index in the market-model regressions. These results are, however, qualitatively robust when using either the Wilshire 5000 stock-market index or the Nasdaq composite stock index. These other indexes were used to test whether the technology-sector stock correction of early 2000 and potential investor sentiment swings affected relative returns.

DD journal03.v.11

28-11-2001

19:15

Page 67


Event period

Overall

Day before announcement (t=-1)

1.25% (1.893)

Day of announcement (t=0)

4.05% *** (4.401)

Day after announcement (t=+1)

2.08% (2.151)

Two-day event window (t=-1 to t=0)

5.30% *** (4.450)

Three-day event window (t=-1 to t=+1)

7.38% *** (4.875)

Number of firms

39

the former to have higher abnormal returns than the latter. If horizontal e-Marketplaces have abnormal returns higher than vertical e-Marketplaces, this might indicate that investors consider productivity improvements gained through providing goods and services at a specific link in the supply chain across industries of greater value than efficiency gains along the supply chain. As shown in Table 2, when the initiatives are segregated by the type of B2B e-marketplace, we find both horizontal and vertical e-marketplace announcements result in significantly positive CARs. Horizontal B2B e-marketplace announcements result in a two-day CAR of 4.88 percent and a three-day CAR

Table 1: Test of hypothesis 1: positive average abnormal returns expected for announcements of new B2B e-commerce initiatives. Note: t statistics in parentheses. *** Significantly different from zero at the 0.01 level.

the returns differ significantly from zero. All of the announcements taken together produced positive

of 6.06 percent. Ten of the fifteen firms making a horizontal B2B e-marketplace announcement received a positive return for both windows.

Event Period

Vertical e-Marketplaces

Horizontal e-Marketplaces


1.19% (1.442)

1.33% (1.228)


4.36% *** (3.896)

3.55% ** (2.168)


2.64% (2.060)

ARs to shareholders. Most noteworthy are the two- and threeday CARs. The two-day CAR is 5.30 percent, and the three-day CAR is 7.38 percent, with twenty-six of the thirty-nine firms receiving positive abnormal returns during both event win-

1.18% (0.862)

dows. Abnormal returns to shareholders are significantly different from zero for both windows at the 1% level. This result


5.56% *** (3.774)

4.88% ** (2.401)


8.20% ** (4.271)

6.06% ** (2.459)

strongly supports Hypothesis 1 that the capital markets respond favorably to firms announcing new B2B e-commerce initiatives. Number of firms

■ Hypothesis 2: we expect higher returns

for vertical e-marketplaces than horizontal e-marketplaces. Announcements for both vertical and horizontal B2B e-Mar-

24

15

Table 2: Test of hypothesis 2: higher average abnormal returns are expected for announcements of vertical e-Marketplaces than horizontal e-Marketplaces. Note: t statistics in parentheses. *** Significantly different from zero at the 0.01 level. ** Significantly different from zero at the 0.05 level.

ketplaces should produce abnormally positive returns, as both

For vertical B2B e-marketplace announcements, the two-day

types of initiatives should result in significant efficiency gains

CAR is 5.56 percent and the three-day CAR is 8.20 percent.

and lower costs for participants. But because vertical e-Mar-

Sixteen of the twenty-four firms making a vertical B2B

ketplaces focus on the needs of an entire industry (up and

e-marketplace announcement received a positive return for

down the supply chain) whereas horizontal e-Marketplaces

both windows. While the returns are higher for firms making

focus on specific business processes that span multiple verti-

vertical e-marketplace announcements, they do not statisti-

cal markets (individual links in the supply chain), we expect

cally differ from the returns for firms making horizontal

67

DD journal03.v.11

28-11-2001

19:15

Page 68


e-marketplace announcements. These results, therefore, do

As shown in Table 3, for the nine firms announcing plans for a

not support Hypothesis 2, that capital markets prefer vertical

new B2B e-commerce initiative on their own, the two- and

e-Marketplaces to horizontal e-Marketplaces. The capital mar-

three-day CARs are 3.95 percent and 4.84 percent, respec-

kets seem to view both types of B2B e-commerce initiatives

tively. Neither CAR is significantly different from zero. Howev-

favorably and anticipate increased efficiencies and reduced

er, it is interesting that the first five announcements (those

costs that will produce future benefits.

prior to February 2000) resulted in significantly positive CARs, whereas the last four announcements (those after Jan-

■ Hypothesis 3: we expect higher returns to

uary 2000) resulted in significantly negative CARs. The two-

firms forming alliances when announcing new e-commerce initiatives.

and three-day CARs for the first five announcements are 9.38 percent and 15.91 percent, respectively. For the last four

When announcing alliances with other companies to initiate

announcements, the two- and three-day event-window

new B2B e-commerce strategies - whether the alliance is with

returns are –2.83 percent and –9.00 percent, respectively.

computer industry giants, competitors, or Old Economy lead-

These results suggest the possibility of a first-mover advan-

ers - we expect higher abnormal returns than when announc-

tage to firms that position themselves as B2B e-commerce

6

ing a new B2B e-commerce initiative alone . If the capital mar-

leaders.

kets foresee potential synergies and competitive advantages from allying with firms that have similar goals and objectives,

For firms announcing alliances for new B2B e-commerce ini-

then alliances should create more support and depth for the

tiatives, the returns are positive and mostly significant, as

initiative. If e-commerce technology firms that announce

Hypothesis 3 suggests. The two- and three-day CARs for the

plans for B2B e-commerce initiatives by themselves generate

five firms announcing an alliance with a large and established

higher abnormal returns than firms that plan to align with oth-

computer industry business are 12.22 percent and 18.46 per-

ers, this might indicate that the capital markets foresee poten-

cent, respectively. For the four firms announcing an alliance

tial problems with the proposed alliance.

with another e-commerce technology provider, the two- and three-day event-window returns are 11.55 percent and 14.43

Event Period

Alone

Alliance Computer

Alliance Competitor

Alliance Old Economy


0.70% (0.723)

4.82% ** (1.774)


3.25% (1.831)

7.40% *** (2.551)

11.09% *** (4.331)

6.25% (2.158)

2.88% (0.773)

0.84% (0.464)

-0.47% (-0.062)

1.40% (1.027)


0.89% (0.925)


3.95% (1.806)

12.22% *** (3.058)

11.55% *** (3.019)

3.79% (2.245)


4.84% (2.008)

18.46% ** (3.743)

14.43% ** (2.911)

4.64% (2.101)

Number of firms

9

5

4

Table 3: Test of hypothesis 3: higher average abnormal returns are expected to firms forming alliances when announcing new e-commerce initiatives Note: t statistics in parentheses. *** Significantly different from zero at the 0.01 level. ** Significantly different from zero at the 0.05 level.

68

2.39% (2.148)

6 While we have no information about whether alliances with competitors, computer industry giants, or Old Economy leaders will result in higher abnormal returns, we can test for significant statistical differences between groups of stocks.

15

DD journal03.v.11

28-11-2001

19:15

Page 69


percent, respectively. Taken together, alliances with competi-

abnormal returns, this might indicate that the capital markets

tors and large computer companies result in two- and three-

expect these firms to generate synergies via economies of

day CARs of 11.92 percent and 16.67 percent, respectively, both

scale or scope by reducing costs and eliminating redundan-

of which are significant at the 1% level7.

cies. This outcome could also indicate that the capital markets see potential gains from providing a larger selection of prod-

The firms announcing plans for new B2B e-commerce initia-

ucts and services or see the possibility of enhancing market

tives with Old Economy leaders also received positive average

power by reducing price competition.

abnormal returns, but they are not significantly different from zero. The two- and three-day CARs for the fifteen firms

Table 4 shows the abnormal returns for firms announcing the

announcing alliances with Old Economy industry leaders are

acquisition of another e-commerce technology provider. For

3.79 percent and 4.64 percent, respectively. Nine of the fif-

the six firms that announced they were acquiring another e-

teen firms received positive returns during the two event win-

commerce company, the two- and three-day CARs are 1.15 per-

dows. It appears that the capital markets view alliances with

cent and 4.10 percent respectively, neither of which is signifi-

industry leaders favorably. However, the returns are fairly low

cantly different from zero. Interestingly, the AR for the day

(and not significantly different from zero), especially when

before the announcement is –3.24 percent, with five of the six

compared with the returns for alliances with competitors and

firms experiencing negative abnormal returns. This negative

computer industry leaders.

average abnormal return is quickly erased, however, as five of the six firms received positive ARs on the day of the

In fact, average returns for alliances with competitors and

announcement, for an average event-day return of 4.39 per-

computer industry leaders are significantly higher than those

cent. In conformance with Hypothesis 4, these results suggest

made through partnerships with Old Economy leaders. Capital

that the capital markets view acquisitions of other technology

markets may respond more favorably to competitor and com-

providers as neither a positive nor a negative.

puter industry partnerships than to alliances with these Old Economy leaders because of the perceived synergies, name recognition, and increased operating efficiencies created by

Event Period

Acquisition


-3.24% * (-1.025)

resources to compete for additional B2B e-commerce business.


4.39% * (1.488)

■ Hypothesis 4: we expect insignificant returns


2.96% (1.016)

such alliances. Also, partnerships of competitors and computer companies mean neither party has to expend additional

to firms announcing the acquisition of an e-commerce technology provider.


1.15% (0.328)


4.10% (0.854)

Generally, alliances and mergers are designed to create competitive advantages and should therefore enhance market valuations. However, we expect that announcements of ecommerce technology firms’ plans to acquire another e-commerce technology provider will not result in significantly positive or negative abnormal returns. This is because acquiring firms typically must pay a substantial premium for target

Number of firms

6

Table 4: Test of hypothesis 4: insignificant returns are expected to firms announcing the acquisition of an e-commerce technology provider. Note: t statistics in parentheses. * Significantly different from zero at the 0.10 level.

firms, which is often viewed unfavorably by capital markets (Roll 1988). If acquiring firms produce significant positive

7 Because of the low number of observations, these results must be viewed with caution. Nevertheless, taken together, alliances with computer industry giants and competitors in B2B e-commerce initiatives do generate statistically significant positive abnormal returns. Further, the statistical significance for these results are not driven by any particularly large return for just one firm.

69

DD journal03.v.11

28-11-2001

19:15

Page 70


Hypothesis

Findings

1. For e-commerce firms announcing B2B e-commerce initiatives, the abnormal returns should be positive.

Strong statistical support. (Abnormal returns are positive and significantly different from zero.)

2. Abnormal returns to firms announcing vertical e-Marketplaces should be greater than those to firms announcing horizontal e-Marketplaces.

Weak support. (The two groups do not statistically differ, although both groups have positive abnormal returns significantly different from zero.)

3. Firms announcing alliances for new B2B e-commerce initiatives should receive higher abnormal returns than for those firms pursuing such initiatives on their own.

Strong statistical support. (Abnormal returns are highest for alliances with competitors and computer industry giants. These returns are significantly different from the abnormal returns for alliances with Old Economy industry leaders and going it alone.)

4. Firms announcing plans for the acquisition of e-commerce technology providers should experience neither positive nor negative abnormal returns.

Support. (Abnormal returns are positive but not significantly different from zero.)

Table 5: Summary of hypotheses and findings

Conclusion Table 5 summarizes our hypotheses and findings. Our results

markets value alliances between e-commerce technology

indicate that the capital markets view B2B e-commerce initia-

providers more than solo B2B e-commerce initiatives or those

tives favorably. These initiatives promise increased efficiencies

undertaken with Old Economy industry leaders. One explana-

and reduced costs by streamlining operations up, down, and

tion for this is that when e-commerce technology firms com-

across industry supply chains. Firms making such announce-

bine resources, there is less room for outside competitors.

ments received significantly positive average abnormal

When e-commerce technology providers plan new B2B e-com-

returns around the date of the announcement, suggesting that

merce strategies on their own or with an Old Economy indus-

B2B e-commerce strategies create significant future benefits.

try leader, competition is not lessened and the capital markets view the news less favorably.

We also find significant positive average abnormal returns associated with both vertical and horizontal e-marketplace

References

announcements. The returns to firms making vertical e-mar-

•

ketplace announcements are slightly higher than those to

•

firms making horizontal announcements, but they do not differ significantly from each other. It appears that the capital mar-

•

kets foresee gains from both types of e-Marketplaces, whether they create efficiencies up and down the supply chain or at a

•

single point across supply chains of different industries. •

When examining the data by the type of partner the e-commerce provider aligns with, we find that the capital markets

•

reward firms the greatest when they form an alliance with a

•

competitor or a computer industry giant. Average abnormal returns from these announcements are more than three times

•

higher than those from announcements of plans for new B2B e-commerce initiatives planned alone or with an Old Economy industry leader. This is noteworthy, as it suggests that capital

70 - The


•

Armitage, Seth (1995), ‘Event Study Methods and Evidence on their Performance,’ Journal of Economic Surveys 9 (March): 25-52. Brookes, Martin, and Zaki Wahhaj (2000), ‘The ‘New’ Global Economy_Part II: B2B and the Internet,’ Goldman Sachs Global Economics Weekly (February 9): 3-13. Chen, Andrew H., and Thomas F. Siems (2001), ‘B2B eMarketplace Announcements and Shareholder Wealth,’ Economic and Financial Review, Federal Reserve Bank of Dallas (First Quarter): 12-22. Dyckman, Thomas, Donna Philbrick, and Jens Stephan (1984), ‘A Comparison of Event Study Methodologies Using Daily Stock Returns: A Simulation Approach,’ Journal of Accounting Research 22 (Supplement): 1-30. McWilliams, Abagail, and Donald Siegel (1997), ‘Event Studies in Management Research: Theoretical and Empirical Issues,’ Academy of Management Journal 40 (June): 626-57. Phillips, Charles, and Mary Meeker (2000), ‘The B2B Internet Report: Collaborative Commerce,’ Morgan Stanley Dean Witter Equity Research (April). Roll, Richard (1988), ‘Empirical Evidence on Takeover Activity and Shareholder Wealth,’ in Knights, Raiders, and Targets, ed. John C. Coffee, Jr., Louis Lowenstein, and Susan Rose-Ackerman (New York: Oxford University Press), 241-52. Siems, Thomas F. (2001), ‘B2B E-Commerce: Why the New Economy Lives,’ Southwest Economy, Federal Reserve Bank of Dallas (July/August): 1-5. Subramani, Mani R., and Eric Walden (2001), ‘The Impact of E-Commerce Announcements on the Market Value of Firms,’ Information Systems Research (June): 135-54.

DD journal03.v.11

28-11-2001

19:15

Page 71


Appendix I

periods from t=-1 to t=0 and from t=-1 to t=+1. Dyckman,

To determine what a firm’s stock price would have been in the

Philbrick, and Stephan (1984) find that two- and three-day

absence of the event (in this case the B2B e-commerce

event windows are preferable to choosing one-day windows

announcement), the price is regressed against a market index

because of rumors of the announcement and insider informa-

to control for overall market effects. To calculate abnormal

tion. These calculations indicate whether the returns to the

returns, the estimated coefficients from the market-model

shareholders of the e-commerce technology providers are

regression are used to compute the predicted value of the

abnormal compared with those expected from general market

firm’s stock. For each security j, the following regression

movements.

model is used to calculate abnormal returns at time t: The market model in Equation 2 breaks down the total return ARjt = Rjt (aj + j Rmtt )

(1)

on stock j into two components: one that reflects general market movements and one that reflects price variations caused

where ARjt is the abnormal return for stock j at time t; Rjt is the

by firm-specific events. Deducting (aj + βjRmt) from Rjt (as

actual return for stock j at time t ; aj is the ordinary least

shown in Equation 1) neutralizes the effect of general market

squares (OLS) estimate of the intercept of the market-model

movements but does not neutralize firm-specific price varia-

regression; Rmt is the return to the market at time t, as approx-

tions caused by events other than the announcement. To neu-

imated by Standard & Poor’s 500 stock market index; and βj is

tralize these firm-specific price variations, the cross-sectional

the OLS estimate of the slope of the coefficient in the

average of the abnormal returns for the total sample of stocks

market-model regression .

for each period is computed.

The parameters aj and βj are estimated from the market

For a sample of n stocks, the mean abnormal return for each

model as follows:

day t is:

8

R jt = aj +

jR t

εjt

(2)

where εjt is the residual. Daily returns for individual-firm stock

AR

ARjt ,

where t=-1,0,+1. The cross-sectional average neutralizes firm-

prices and the market index are from the Center for Research

specific price variations unrelated to the B2B e-commerce

in Securities Prices database. The date of the event (announcement) is t=0, the market model is estimated over

announcements because the announcements were not simultaneous. Hence, the expected value of AR is zero in the absence

the period from t=-165 to t=-15 days relative to the event date,

of abnormal returns due to B2B e-commerce announcements.

and the event window is from t=-1 to t=+1. The final calculation of abnormal returns is to compute cumuOnce the market model is estimated, the resulting estimated

lative average abnormal returns from day t=-1 to t=0 and from

values for aj and βj are used in Equation 1 with data for Rjt and

t=-1 to t=+1, using the formula

Rmt to calculate the abnormal returns (ARs) over the event window for each e-commerce technology firm. Because the

AR(-- 1,t1

∑ AR t ,

=-1

event date is known, a short window is used (Armitage 1995). In addition to the abnormal returns computed for the day

where t1 = (0,+1) and CARJ (-1, t1) is the cumulative average

before the announcement (t=-1), the day of the announcement

abnormal return for the sample of n stocks over the event

(t=0), and the day following the announcement (t=+1), we also

period interval from t=-1 to t=t1. The expected value of CAR is

compute cumulative average abnormal returns (CARs) for the

zero in the absence of abnormal performance.

8 Most published event studies use the S&P 500 index to estimate the parameters for calculating abnormal returns.

71

DD journal03.v.11

28-11-2001

19:15

Page 72

DD journal03.v.11

28-11-2001

19:15

Page 73

Financial capital

ABSTRACT

Wealth management in the 21st century: The imperative of an open architecture It’s time for asset allocation The challenges of risk management in diversified financial companies Managed network services pave the way for the Internet’s future in financial transactions

73

DD journal03.v.11

28-11-2001

19:15

Page 74

Wealth management in the 21st century: The imperative of an open product architecture George Feiger, Partner, Capco Shahin Shojai, Director of Strategic Research, Capco by clients demanding not only more fee transparency but also

Vertically integrated private client business

benchmarks with which to assess the bank’s performance.

The world of private banking is undergoing rapid change.

This dramatic change has been accompanied by growing pres-

Competition is intensifying and new secrecy laws are nibbling

sure from regulators to break the secrecy laws.

at its foundations. The large institutional asset managers that used to view private banking as a market lacking in both imag-

The intensification of competition, coupled with the greater

ination and innovation are beginning to see it as a possible

dissemination of information in the wealth management mar-

source of additional revenues, especially in light of the fee

ket, has permanently changed the perceptions of customers

pressures on their traditional businesses. It will take a long

about what’s in it for them. They have learned three things:

time for many of these newcomers to recognize the differences between this industry and theirs. Meanwhile, their

■ Most of the value for customers themselves comes not

appearance in the market is exacerbating the fee pressures

from the product building blocks of a strategy, but from

that were already being felt by private banks.

the strategy itself; that is, from the way things are put together.

In addition to fee pressures, the newcomers have also brought

■ Some products and services are objectively better than

the present structure of private banking into question. Most

others with the same nominal goals or objectives, and the

private banks have adopted the traditional, vertically integrat-

best suppliers of these products and services will vary

ed model of a financial institution, advising clients to use

over time. Mutual funds are now ranked. Indeed, in the

products that are manufactured internally and managed

U.S., mutual fund sales are entirely driven by rankings, and

through an in-house infrastructure1. This vertically integrated

this will soon be the case in Europe too. As in the U.S., Euro-

model reflected the historical drivers of growth in European

pean fund managers are finding themselves all over the

private banking (especially in Switzerland). The main source of

performance map, and this is visible to their clients as well.

differentiation for these traditional providers was their per-

■ There are objective standards for the cost and quality of

ceived security. Investors were more concerned with investing

standard transaction services and products. The online

their money in a safe haven than in having their assets man-

brokerage industry, and the price war it created, has been

aged by sophisticated advisers (although the two are far from

the instigator of objective standards of execution quality

being necessarily mutually exclusive).

and transparent levels of price for standard services. Cost transparency has colored the dialog between adviser and

Within this comfortable world, competition arose only from

client in private banks, and has led in many cases to com-

those institutions that were better at portraying themselves

moditized pricing.

as paradigms of secrecy and security. Now, private bankers can no longer afford to manage all Unsurprisingly, the technological revolution, with its emphasis

assets in house. They must accept that in certain asset class-

on customer empowerment and choice, and which has shaken

es they might need to outsource manufacturing to third party

up the world of investment management, is now impacting the

asset managers and as a result, in certain circumstances, to

secretive world of private banking. A new generation of more

consider separating the client advisory service from asset

financially savvy clients has begun to question the level of

manufacturing.

fees and to demand greater transparency about how their assets are invested. Financial advisors, careful not to discuss the price of advice with clients and inclined to wrap their own costs into the very high transaction fees, are being approached

1

74

Brokerage firms tended to be exceptions, but in general they have dealt with less affluent clients, or with wealthy clients speculating with small amounts of ‘play money’.

DD journal03.v.11

28-11-2001

19:15

Page 75

Two areas where this separation has been most visible are:

In vertically integrated organizations, there can be substantial internal difficulties in moving to an open architecture model.

■ Alternative asset products (hedge funds, private equity,

The asset management arm must stand on its own feet in sell-

structured products), which originated in organizations

ing to third parties, but typically will have inadequate experi-

with established reputations in these products. Virtually

ence in true arm’s length marketing and sales. The advisory

no private bank had established a presence in these fields,

arm, typically, will also have a lot to learn about evaluating

although a number are now active with funds-of-funds.

competing product offerings, and about contract negotiation

■ Investment banking strategies such as single stock hedg-

with arm’s length suppliers. Most fundamentally, unless the

ing, pre-and post-IPO advice and tax structuring. Dynamic

internal MIS has always allocated revenues as if there were

trading strategies for the adjustment of very large portfo-

two implicit freestanding businesses, there can be large cross-

lios had to come from capital market players. Even those

subsidies in current performance measurements and com-

private banks with investment banking arms have found it

pensation systems. Undoing these can be very problematic

virtually impossible to coordinate their in-house invest-

indeed.

ment banking and private-banking units, so the private banking customers have been served from elsewhere.

Emerging architecture of private client advice

As a result of these factors, we anticipate that there will be a

The separation of advisory from portfolio manufacturing will

slow polarization of ‘private banks’ into two models.

not solve all the problems that private banks might face in the future. They will increasingly find themselves investing large

■ The ‘open architecture’ bank which charges for its advice,

sums of money in technology infrastructures to cope with the

and offers in-house products only where there is a strong

demands of today’s highly demanding clients. It is very hard to

case for special expertise. For example, the private bank-

grow revenues fast enough to keep up with these costs. Pri-

ing division of an investment bank strong in trading will

vate banks will have to find other solutions to their techno-

always be able to offer credible arguments in favor of its

logical requirements. One viable solution would be to out-

own hedge funds. The open architecture model has both

source the management of many non-client-facing opera-

branding and economic advantages. It helps to reinforce a

tions, such as custody, settlements, aggregation, etc. Private

relationship of deep trust and personalization, as there is

bankers might be apprehensive about undertaking such dras-

no obvious conflict of interest between the needs of the

tic steps, but recent experience, for example with custody, has

customer and of the bank. In terms of product cost (and

proven that so long as the client-facing operations are kept in-

indeed of infrastructure cost to the extent that this can be

house, outsourcing supporting operations will not damage the

outsourced), the open architecture bank can obtain

quality of service.

economies of scale well beyond the size of its own customer base because it benefits from the scale economies

We are already observing these types of arrangements. Co-

enjoyed by its suppliers across their entire customer base.

operatives are being created among private banks to out-

■ The captive distribution arm of a large and comprehensive

source the management of their back offices. Under these

asset management organization that has achieved suffi-

agreements, members of the co-operative share the costs of

cient brand leadership to survive benchmarking compar-

the necessarily huge investments in technology. These types

isons. Fidelity is the organization that most easily comes

of arrangements become essential as customers become

to mind in this category. Smaller players with weaker

more demanding and start to require more real-time access to

brands will have trouble explaining why they offer some

their accounts. Yesterday’s batch accounting solutions are

outside products but not all.

simply not up to the job.

75

DD journal03.v.11

28-11-2001

19:15

Page 76

These new technologies will not only allow private banks to meet their clients’ needs. They will also allow them to identify those operations that make a true contribution to the bottomline. There are still a large number of private banks that are unable to get customer information easily and have to rely on manual tools just to aggregate a group of clients’ accounts. Those unwilling to share these costs with their peers have to recognize that although there are cheap ways to solve the problem in the short-run; the real solution is much more expensive and can take many years. But all this is demanding and stressful. In light of these difficulties, the temptation, especially in successful companies, will be to delay a move to open architecture. Reluctance to change usually carries few immediate financial consequences. The stickiness of long-standing relationships means that client franchises erode only slowly. Nonetheless, this caution is a mistake. ■ A franchise erodes invisibly before it erodes visibly. For example, the Swiss private banks have not so much lost clients as they have share of client assets. They are slowly becoming a ‘safe deposit box’, while monies earmarked to earn returns are increasingly managed elsewhere, increasingly by American banks, which are considered to have more financial acumen. Reversing this image will require years of work. ■ The talent in the business erodes as advisers who recognize the advantage of the open architecture model move to other organizations. Those left behind are, thanks to natural selection, more reluctant to change the way they operate, and they end up driving out more talent. ■ Ability to innovate is handicapped, since innovation requires not only an understanding of the benefits to the client brought by new products but also the ability to convince and enable the in-house product managers to make their own versions. In light of budget constraints, this limits the breadth of the client offering.

76

DD journal03.v.11

28-11-2001

19:15

Page 77

Financial capital

It’s time for asset allocation

Noël Amenc Professor, Edhec Graduate School of Business, Director of Research, ACT Financial Systems

Lionel Martellini Professor, Marshall School of Business, USC Los Angeles

Abstract Despite repeated evidence that asset allocation accounts for a very large fraction of a portfolio return, the industry has never stopped favouring stock picking as the preferred form of active investment strategy. In this paper, we attempt to rehabilitate the importance of active asset allocation in the investment process. We review the benefits of traditional and alternative style management and provide evidence that optimal strategic and tactical asset allocation strategies are likely to significantly enhance the risk-adjusted performance of a multi-style multi-class portfolio. We finally argue that the future of hedge fund investing may very well lie in the opportunities such alternative investment vehicles offer in terms of improving the asset allocation process.

77

DD journal03.v.11

28-11-2001

19:15

Page 78


Introduction

Stock picking itself, in this approach, comes under strict

In recent years, the asset management industry has largely

supervision. For the ‘benchmarked’ management ‘fundamen-

concentrated its research and investment efforts on the

talists’ the only operations authorised are the over- or under-

sophistication of asset selection tools and concepts. Portfolio

weighting of the quantities of the securities contained in the

management has been dominated by benchmarks. In that

benchmark. One therefore prefers to speak of ‘stock timing’. It

context, the only source of outperformance over the long-

does not involve introducing, in searching for alphas, an unac-

term was the manager's skill in selecting or overweighting the

ceptable beta, i.e. a security that would not be exposed to the

right assets (alphas) while respecting the portfolio's exposure

same risk factors as those of the benchmark. The dogma of

to the benchmark risk factors (betas).

‘doing nothing outside the indices’ has given rise to constantly biased readings of academic or empirical evidence on the

This situation may appear paradoxical in a discipline that

importance of asset allocation. A revealing example of these

emerged from the portfolio diversification research promoted

readings relates to comments made on the renowned Brinson,

by Markowitz from 1952. All the more so since the Nobel prize

Singer, and Beebower survey (1991) by major investment firms

winner's successors strengthened the arguments in favour of

who wished to promote passive allocation strategies and

asset allocation, notably by showing, at the beginning of the

products. Even though this survey is only stating the obvious,

1990s, that the main source of portfolio performance (97%)

namely that more than 90% of the evolution of portfolio

was the style (or styles) that characterised the portfolio

return measured quarterly is the result of the evolution of the

[Sharpe (1992)].

asset classes in which it is invested (in other words, when the water rises, the boat rises!), three-quarters of the commenta-

However, in spite of this conceptual confirmation of the pre-

tors concluded that the choice of asset allocation policy, and

dominance of asset allocation, whether in styles or classes,

thus the choice of benchmark, explains 91% of the perform-

the industry never stopped favouring stock picking. In fact,

ance of the portfolio.

asset allocation has been the victim of real theoretical confusion. Considering that one of the practical consequences of

It is therefore pointless to practice active allocation manage-

the financial asset equilibrium models and their founding

ment, notably by using ‘market timing’ or ‘style timing’; let's

hypothesis, efficiency, was that it was difficult to beat the mar-

leave the reference index or indices to look after the core per-

ket portfolio over a long period, investment firms concluded

formance of the portfolio.

that the best allocation was passive. This passivity led to the domination of indices in asset management.

Even though, in a recent article, Ibbotson and Kaplan (2000) acknowledged that the conclusions and interpretations of the

The fact that the choice of index was itself a decision, and

Brinson, Singer, and Beebower survey were not relevant and

therefore a bet on the portfolio's exposure to the particular

showed that the difference in return between funds was prin-

index risks (betas), was of little importance. Everybody

cipally due to market or style timing, benchmarks and stock

behaved as if Roll's 1997 article had never been written, as if

picking are resilient! An analysis of European investment

the chosen index represented the famous market portfolio

firms' sales arguments for their institutional clients Edhec

that the author had described as being unobtainable. From

(2001) shows that the 1991 survey is explicitly mentioned by a

then on, considering that the index represented ‘equilibrium’

majority of firms to justify their ‘benchmarked’ management

allocation, the only value added possible, for those who

services, the acceptable active value added being stock picking.

wished to engage in active management without deviating from the equilibrium allocation, was from stock picking, which allowed managers to take advantage of very temporary inefficiencies in the securities market.

78 - The


DD journal03.v.11

28-11-2001

19:15

Page 79


Misquotation of Brinson, Singer and Beebower survey (1991) Percentage of writers who misinterpret the Brinson survey as an answer to the relationship between asset allocation and the level of returns. For example : ‘One study suggests that more than 91% of a portfolio’s return is attributable to its mix of asset classes. In this study, individual stock selection and market timing together accounted for less than 7% of a diversified portfolio’s return’. Vanguard Group

75%

Percentage of writers who misinterpret the Brinson survey as an answer to the impact of choosing one asset allocation policy over another. For example : ‘A widely quoted study of pension plan managers shows that 91.5% of the difference between one portfolio’s performance and another’s is explained by asset allocation.’ Fidelity Investments

10%

Other misquotations

13%

Percentage of writers who accurately quoted Brinson (only one correct interpretation).

2%

Table 1: Results of Nutall and Nutall's survey (1998)

Style management sacrificed

to increase the statistical robustness of factor models, an

Since the work of Fama and French (1992), who completed

important feature in a non-stationary environment. For

Sharpe's analysis, the majority of institutional investors and

once, financial analysts, happy to find interpretable fac-

the major investment firms have brought style management

tors about which they had something to say, and the

to the fore in answer to the difficulties posed by the irrele-

quant, happy to find robust variables to explain risk and

vance and instability of the CAPM's beta. As early as 1977,

return, were in agreement.

Richard Roll stressed its extreme fragility, due to the

■ Finally, style management provided some academic evi-

impossibility of finding an index that is representative of

dence to a fledgling industry: multi-management. The

market equilibrium and, as such, used as a reference for risk

question was how to sell value added based on selection

measurement of securities.

of the best managers with researchers who, year after year, wishing to defend an almost ‘fundamentalist’ view of

The style approach presented three advantages compared to

market efficiency, relentlessly tried to show that ‘winners

other management methods:

do not repeat’!

■ The decorrelation between the styles, much more stable than between sectors or financial market places, allowed

11.0%

3.5% 40.0%

strongly diversified portfolios to be built and thus significantly improved their efficient frontier.

45.5%

■ Style analysis is based on a small number of objective microeconomic attributes - such as size, profit growth, dividend distribution rate, etc - that facilitate the implementation of both stock selection and risk management tools. From a stock selection standpoint, making bets on styles

Strategic asset allocation

Stock picking

leaves financial analysts within their comfort zone, as it is

Tactical asset allocation

Fees

their core competency to be making recommendations based on companies' attributes. From a risk management standpoint, using a small number of micro attributes tends

Figure 1: Percentage of variation between funds Source: Ibbotson, Kaplan (2000) and Edhec (2001)

79

DD journal03.v.11

28-11-2001

19:15

Page 80


It therefore seemed possible to get practitioners and

Golin/Harris Ludgate, 64% of European institutional investors

researchers to agree to the idea that the worst managers are

have already invested in hedge funds (36%) or are prepared

the least specialised and those who tend to change style fre-

to do so (28%) in 2001, compared to 56% in 2000.

quently [Chan, Chen, Lakonishok (1999)]. It did not signify that the style guaranteed performance persistence, but simply

This strong interest in hedge funds does not, however, explain

that the worst were more likely to repeat. It was not a major

certain factors:

statement, but it was probably too much already! ■ The decline in investment opportunities in traditional From the multi-manager/multi-style approach, the asset management industry only adds value through 'fund picking'. The

asset classes This loss in attractiveness is not only due to traditional man-

paradigm that associated outperformance with asset selec-

agers' inability to take advantage of market inefficiencies, as

tion alone persisted by adapting itself. While active managers

they are too constrained by regulations and their adherence

seek to out-perform their benchmark through their ability at

to the reference benchmark, but also to the low degree of

detecting stocks with positive abnormal return, or alpha,

diversification provided by purely geographical allotment of

multi-managers base their performance on their ability to

assets. Geographical diversification disappears when the man-

detect managers with positive alpha in the hope that the

ager needs it the most, i.e. when the markets fall sharply [Lon-

alpha of diversified managed portfolios exhibit more persist-

gin and Solnik (1995)].

ence than that of individual stocks. Portfolios: ranked by S&P 500 (1990-2000)

Arguing that it was impossible to forecast styles, multi-

8

managers promoted the concept of stylistic neutrality as an

6

asset allocation rule. In a way, having demonstrated the superiority of allocation by style, its promoters hurried to abandon it

4

in favour of an approach that went back to favouring interna2

tional diversification which, unfortunately, the herd-like behaviour of the stock markets had been doing its best to remove.

0

And the alternative class arrived…

-2

In the last few years, alternative investments, and in particu-

-4

lar hedge funds, have been growing very strongly. It is esti-

-6

mated that more than U.S.$500 billion were invested in hedge funds at the end of 2000. Although hedge funds were initial-

MSCI EAFE

MSCI North America

MSCI Europe

MSCI Pacific

MSCI Far East

S&P 500

ly held, for the most part, by private individuals, either directly or through funds-of-funds, it should be noted that today

Figure 2: Correlation between indices representing geographical zones (1990-2000) Source: Schneeweis (2001)

institutional investors contribute a significant share of their assets to this new asset class. ■ Hedge funds present very attractive risk-adjusted This craving for hedge funds is not only American - it is also

80 - The

European. Recent surveys conducted by Watson/Wyatt and

returns The hedge funds' freedom to intervene in the markets, togeth-

Golin/Harris Ludgate1 bear witness to this considerable evo-

er with their manager's specialisation in a particular style, is a

lution in institutional allocation. According to the consultancy

source of alphas. Not only can hedge funds easily carry out


1

Indocam/Watson/Wyatt (2001) and Golin/Harris Ludgate (2001).

DD journal03.v.11

28-11-2001

19:15

Page 81


arbitrage operations and take advantage of temporary market

■ Portfolio diversification based on alternative

inefficiencies, they can also easily implement dynamic trading

investment decorrelation with traditional asset

strategies. This production of outperformance can also be

returns is without doubt the main reason for investing

increased by the leverage effect obtained from using derivatives, securities lending and borrowing operations and short

in the alternative universe Among the reasons cited by European institutional investors

selling.

[Invesco (2001)] for increasing their allocations to alternative assets, the desire to implement an effective diversification

Moreover, returns on alternative investments generally present

policy seems to be the most important (40% of respondents).

a relatively low level of correlation with traditional asset

The investors' reasons are consistent with numerous academic

returns and therefore resist in times of unfavourable market

studies which underline the effectiveness of the diversifica-

conditions [Schneeweis (2001), Bernard and Schneeweis

tion that is obtained from their decorrelation compared to

(2001)].

traditional assets [Amin and Khat (2001)]. Since hedge fund styles are exposed to different risk factors, their insertion in a

Return

Stdev

Sharpe Ratio

EACM100

14.8%

4.3%

2.11

Relative value

10.2%

3.4%

1.37

Event driven

13.3%

5.2%

1.48

Equity hedge

19.7%

10.5%

1.34

Global macro

17.9%

10.5%

1.17

Multi-style multi-class active allocation decisions

S&P 500

15.4%

13.9%

0.71

The academic and empirical evidence on the qualities of

Lehman Bros. Bond

8.0%

4.2%

0.58

hedge fund diversification should enable the financial indus-

diversified portfolio allows a better efficient frontier to be obtained.

try to reconsider the portfolio management process using the

Table 1: Performance of EACM and traditional indices (1/1990-12/2000)

multi-style/multi-class allocation concept. The multi-managers' value added, for example, should come not only from their selection and/or purchasing unit capacity. They should also be

Portfolio annualized standard deviation 16

able to use the independence that comes from their ‘gate

100% S&P 500

keeping’ role to offer value added based on asset allocation,

100% EACM 100

14

whether involving diversification or style timing (or both).

12 50% S&P 500 and 50 %Ł Lehman brothers bond

10

We present below the results of tests of implementation

8 100% Lehman brothers bond

6

of Strategic Style Allocation and Tactical Style Allocation

4

decisions that show the appropriateness of an active portfolio

2

allocation process.

0 0

2

4

6

8

10

12

Figure 3: Risk and return: bonds, equities, and hedge funds (1/1990-12/2000) Source: Schneeweis, 2001

14

■ Strategic multi-style multi-class allocation A classic way to analyze and formalize the benefits of multistyle multi-class allocation decisions is to note the improvement in the risk-return trade-off hedge funds allow when included in a traditional long-only stock and bond portfolio. Since seminal work by Markowitz (1952), it is well-known that this trade-off can be expressed in terms of mean-variance analysis under suitable assumptions on investor preferences

81

DD journal03.v.11

28-11-2001

19:15

Page 82


(quadratic preferences) or asset return distribution (normal

tional investment styles, respectively2.

returns). Our methodology for testing minimum variance portfolios is In the academic and practitioner literature on the benefits of

similar to the one used in Chan et al. (1999) and Jagannathan

alternative investment strategies, examples of enhancement

and Ma (2000). We use the previous 48 months of observa-

of long-only efficient frontiers through optimal investments in

tions to estimate the covariance matrix of the returns of the

hedge fund portfolios abound [see for example Schneeweis

style indexes. For each universe (AI only and AI/TI), we form a

and Spurgin (1999) or Karavas (2000)].

global minimum variance portfolios. These portfolios are held for 6 months, their monthly returns are recorded, and the

One problem is that these studies only focus on in-sample

same process is repeated again. The means and variances of

diversification results and standard sample estimates of

these portfolios are used to compare minimum variance port-

hedge fund return covariance matrix. In a recent paper

folios to value-weighted and equally-weighted benchmarks.

[Amenc and Martellini (2001)], we extend existing research by estimator of the covariance structure of hedge fund index

■ Results In the AI only investment universe, we find that the ex-post

returns, focusing on its use for optimal portfolio selection.

volatility of the minimum variance portfolio generated using

evaluating the out-of-sample performance of an improved

implicit factor based estimation techniques is almost 3 times ■ Methodology We choose to focus on the issue of estimating the covariances

lower than that of a naively diversified equally-weighted

of hedge fund returns, rather than expected returns, as there

weighted Global Tremont Index, such differences being both

is a general consensus that expected returns are difficult to

economically and statistically significant. This indicates that

obtain with a reasonable estimation error. What makes the

optimal variance minimization can achieve lower portfolio

problem worse is that optimization techniques are very sensi-

volatility.

portfolio, and almost 7 times lower than that of the value-

tive to differences in expected returns, so that portfolio optimizers typically allocate the largest fraction of capital to the

Differences in mean returns, on the other hand, are not sta-

asset class for which estimation error in the expected returns

tistically significant (t-stat = .11 and .16, respectively), suggest-

is the largest [Michaud (1998)].

ing that the improvement in terms of risk control does not necessarily come at the cost of lower expected returns.

Therefore, we focus on the one portfolio on the efficient frontier for which no information on expected returns is required,

Mean Return

the minimum variance portfolio. More specifically, we consid-

Std Deviation

er the following two investment universes: a portfolio invest-

Minimum Variance Portfolio

12.16%

1.57%

ed only in hedge funds (AI only) and an equity-oriented port-

Equally Weighted Portfolio

9.13%

4.79%

12.50%

9.95%

folio invested in traditional equity indices and equity-related

Global Tremont Index

alternative indices (AI/TI). The return on Credit Suisse First Boston/Tremont indices (Convertible arbitrage, Dedicated short bias, Emerging markets, Event driven, Fixed-income

Table 2: Multi-Style Multi-Class Strategic Allocation : AI Only Universe Source: Ex-post annual performance (1999-2000)

arbitrage, Global macro, Long/short equity, Market neutral, and Managed futures) and S&P indices (S&P 500 growth, S&P 500 value, S&P 400 mid-cap, and S&P 600 small cap) are used as proxies for the performance of alternative and tradi-

82 - The


2 The equity-oriented portfolio is invested in S&P 500 growth, S&P 500 value, S&P 400 mid-cap, and S&P 600 small cap for the traditional part, and in Tremont dedicated short bias, Tremont market neutral, and Tremont long/short for the alternative part.

DD journal03.v.11

28-11-2001

19:15

Page 83


130

Similar results are obtained in the AI/TI equity oriented uni-

125

verse. The ex-post volatility of the minimum variance portfolio

120

generated using implicit factor based estimation techniques is

115

almost 5 times lower than that of a naively diversified equal-

110

ly-weighted portfolio, and almost 9 times lower than that of

105

the S&P 500.

100 95

A confirmation of these results can be found in figure 5, that displays the evolution of U.S.$100 invested in January 1998 in

Dec 00

Nov 00

Jul '00

Sep 00

May '00

Mar '00

Jan '00

Sep '99

Nov '99

Jul '99

May '99

Mar '99

Jan '99

90

the S&P 500, an equally-weighted portfolio of traditional and alternative equity-oriented indices, and the minimum variance

Minumum variance portfolio Global tremont index

portfolio.

Equally-weighted

Figure 4: Multi-Style Multi-Class Strategic Allocation : AI Only Universe

Mean Return

There is now a consensus in empirical finance that expected

Minimum variance portfolio

12.46%

2.02%

Equally weighted portfolio

12.66%

9.62%

13.16%

17.67%

S&P 500

asset returns, and also variances and covariances, are, to

Std Deviation

some extent, predictable. Pioneering work on the predictability of asset class returns in the U.S. market was carried out by Keim and Stambaugh (1986), Campbell (1987), Campbell and Shiller (1988), Fama and French (1989), and Ferson and Har-

Table 3: Multi-Style Multi-Class Strategic Allocation : AI/TI Universe Source: Ex-post annual performance (1999-2000)

vey (1991). More recently, some authors started to investigate this phenomenon on an international basis by studying the

As an illustration, figure 4 displays the evolution of U.S.$100

predictability of asset class returns in various national markets

invested in January 1999 in the Global Tremont Index, an

[see, for example, Bekaert and Hodrick (1992), Ferson and Harvey

equally-weighted portfolio of Tremont indices and the mini-

(1993, 1995), Harvey (1995), and Harasty and Roulet (2000)].

mum variance portfolio. As can be seen from the figure, the minimum variance portfolio has a much smoother path than

The use of predetermined variables to predict asset returns

its equally-weighted and value-weighted counterparts.

has produced new insights into asset pricing models, and the

170 160 150 140 130 120

Sep '98

110

May '99

Minumum variance portfolio S&P 500 Equally-weighted portfolio

100

Dec '00

Nov '00

Sep '00

Jul '00

May '00

Mar '00

Jan '00

Nov '98

Sep '98

Jul '98

Mar '98

Jan '98

Nov '98

Jul '98

May '98

Mar '98

Jan '98

90

Figure 5: Multi-Style Multi-Class Strategic Allocation : AI/TI Equity Universe Tactical Multi-Style Multi-Class Allocation

83

DD journal03.v.11

28-11-2001

19:15

Page 84


literature on optimal portfolio selection has recognized that

■ Volatility indicators

these insights can be exploited to improve on existing policies

■ Liquidity indicators

based upon unconditional estimates. For example, Kandel and

■ Business cycle indicators

Stambaugh (1996) argue that even a low level of statistical

■ Credit risk indicators

predictability can generate economic significance and abnor-

■ Inflation and monetary policy indicators

mal returns may be attained even if the market is successful-

■ Equity and fixed-income market indicators

ly timed only 1 out of 100 times. While Samuelson (1969) and Merton (1969, 1971, 1973) have paved the way by showing that

For each index, we selected a very limited number of variables

optimal portfolio strategies are significantly affected by the

(less than 5) that allow for a good trade-off between quality of

presence of a stochastic opportunity set, optimal portfolio

fit and robustness. We systematically test for evidence of het-

decision rules have subsequently been extended to account

eroscedasticity and multi-colinearity and correct for these

for the presence of predictable returns [see in particular Bar-

when needed. We also test for the robustness of the model by

beris (2000), Campbell and Viceira (1998), Campbell et al.

dividing the calibration period into two sub-samples of equal

(2000), Brennan, Schwartz, and Lagnado (1997), Lynch and

duration, and using a Chow test to test for stability of regres-

Balduzzi (1999), and Lynch (2000), for a parametric approach

sion coefficients between two periods.3 Models with relatively

in a simple setting or Brandt (1999) and Ait-Sahalia and

high in-sample R-squared that clearly fail the Chow test are

Brandt (2001) for a non-parametric approach in a more gen-

discarded in favor of models with lower R-squared but higher

eral setting]. Practitioners have also recognized the potential

stability.

significance of return predictability and started to engage in tactical asset allocation strategies as early as the 1970’s.

In table 4, we provide information on the in-sample and outof-sample performance of the predictive models for the

In a recent paper, Amenc, El Bied, and Martellini (2001) pro-

Tremont hedge fund indices, as well as traditional equity

vide evidence of predictability in hedge fund index returns,

indices. The second column contains the in-sample R-squared

and discuss the implications in terms of tactical style alloca-

of the regression. The third column contains the hit ratios of

tion decisions.

the model, i.e. the percentage of time the predicted direction is valid, i.e. the index goes up (resp. down) when the model

■ Evidence of predictability in style index returns Given that we are searching for evidence of predictability in hedge fund returns with the goal of implementing a style allocation strategy, we have attempted to find the best possible trade-off between quality of fit and robustness. With a focus

predicts it will go up (resp. down).

Hedge Fund Indices (CSFB/Tremont)

R-squared but low out-of-sample R-squared (robustness prob-

Convertible Arbitrage Emerging Markets Equity Market Neutral Event Driven Fixed-Income Arbitrage Global Macro

lem), we have opted to select a short list of meaningful vari-

Traditional Indices

ables. These variables were selected on the basis that they

S&P 500 Growth S&P 500 Value S&P 400 Mid-Cap

on attempting to avoid the pitfalls of data snooping, rather than trying to screen hundreds of variables through stepwise regression techniques, which usually leads to high in-sample

had proven predictive powers, natural influence on asset returns, and fall within the following categories:

In-Sample R2

Out of Sample Hit Ratios

1994-1998

1999-2000

51.8 % 25.1 % 14.8 % 15.7 % 53.4 % 22.0 %

87.5 % 50.0 % 95.8 % 79.2 % 62.5 % 54.2 %

17.7% 9.7% 7.8%

58.3% 54.2% 58.3%

Table 4: In- and Out-of-Sample performance of predictive models for alternative and traditional style indices (1994-1998) Source : Amenc, El Bied, Martellini (2001)

84

3 A Chow test consists of dividing the sample into two groups, estimating the model separately for each of the two sample groups and computing the error sum of squared residuals for each sample group. Then assume that the regression coefficients are the same over the entire period by estimating the model again but with

the pooled sample. A Chow statistic is then obtained based on the restricted error sum of squares to test the null hypothesis that there is no structural change using the F-distribution tables [Chow (1960)].

DD journal03.v.11

28-11-2001

19:15

Page 85


We find very high hit ratios, all above 50% and one at 95.8%,

■ Tactical Style Allocation in the AI/TI Equity Universe

signalling the presence of statistically significant predictabili-

We consider the following two tactical style allocation

ty in hedge fund returns.

portfolios: P1: benchmark is a given strategic allocation (25% S&P

■ Performance of tactical style allocation portfolios We also examined whether there is any economic significance

Growth, 25% S&P Value, 20% S&P Mid-cap, 15% Equity

in the predictability of hedge fund returns by investigating the

mization of the information ratio

implications in terms of a tactical asset allocation model.

P2: benchmark is the S&P 500; objective is maximization

market neutral, and 15% Event driven); objective is maxi-

of excess return with a 2% tracking error constraint4. ■ Tactical style allocation in the AI only universe The benchmark used is an equally-weighted portfolio in the 6 Tremont indices under consideration. The objective is to maximize the information ratio, i.e. the excess return

145

135

per unit of tracking error. The performance of the portfolio is measured in terms of the ex-post information ratio, and in terms of a portfolio hit ratio (denoted as hit ratio 2),

125

115

which is the percentage of time that the return on the tacthe benchmark .

105

wealth

tical style allocation portfolio is greater than the return on

95

date

Dec 98

Apr 99

Aug 99

TSA port.

Dec 99

Apr 00

Aug 00

Dec 00

SSA bench

Figure 7: Wealth process (P1)

125

■ P1: Ex-post hit ratio 2 = 62.5% ■ P1: Ex-post information ratio = 1.66 (7%/4.2%) 115

105 wealth

135

95

date Dec 98

Jun 99 TSA port.

Dec 99 SSA bench

Jun 00

Dec 00

115

Hit ratio 2 = 83.3% Benchmark : ■ Annual mean return = 11.78% ■ Annual volatility = 4.32% TSA portfolio : ■ Annual mean return = 13.2% ■ Annual volatility =4.24% Ex-post information ratio : 2.44 (1.4%/0.58%) ■ Annual excess return = 1.4% ■ Annual tracking error = 0.58%

wealth

Figure 6: Wealth process

95

date

Dec 98

Jun 99 TSA port.

Dec 99

JunŁ 00

Dec 00

S&P500

Figure 8: Wealth process (P2) ■ P2: Ex-post hit ratio 2 = 62.5% ■ P2: Ex-post information ratio = 1.3 (4.9%/3.8%)

4 The presence of a tracking error constraint is consistent with current practice in the industry. The performance of the unconstrained portfolio is even more spectacular (1.7 ex-post information ratio with 15.6% excess return and 9.3% tracking error).

85

DD journal03.v.11

28-11-2001

19:15

Page 86


Conclusion

Appendix 1

In addition to the results presented in this paper, further evidence in support of the proposition that strategic and tactical asset allocation can generate superior risk-adjusted perform-

Definition of hedge fund investment styles according to Category Strategy Convertible Arbitrage

Invest in the convertible securities of a company. A typical investment is to be long in convertible bonds and short in stock of the same company.

expected to extend to Europe.

Dedicated Short-Bias

Maintain consistent net short (or pure short) exposures to the underlying market.

Because the returns on alternative investment strategies

Emerging Markets

Equity or fixed income investing in emerging markets around the world.

Market Neutral

Exploit equity market inefficiencies by being simultaneously long and short matched equity portfolios of the same size within a country.

Event-Driven

Equity-oriented investing designed to capture price movement generated by an anticipated corporate event (merger, acquisition, dis tressed securities, etc.).

ance can be found in the fact that the amount of investment engaged in global asset allocation funds has been growing very rapidly since the mid-1990’s in the United States, a trend

exhibit in general low correlation with those of standard asset classes, it is expected that hedge funds will take on a more significant role in active allocation strategies. While in its infancy, the world of alternative investment strategies consisted of a disparate set of managers following very specific strategies. Significant attempts at structuring the markets have occurred over the last decade, which now allow active asset allocation models to be applied to hedge funds, as well as to traditional investment vehicles. In particular, investible portfolios replicating broad-based hedge funds indices are today available

Fixed-Income Arbitrage Profit from price anomalies between related interest rate securities. Global Macro

Leverage views on overall market direction as influenced by major economic trends and/or events.

Long/Short Equity

Equity-oriented investing on both the long and short sides of the market, with an objective different from being market neutral.

Managed Futures

Systematic or discretionary trading in listed financial and commodity futures markets and currency markets around the world.

with relatively high liquidity. We actually believe that the future of hedge fund investing lies as much in the betas of alternative investment vehicles (systematic exposure to rewarded risk factors including market risk, but also volatility, credit, and liquidity risks) as in their alphas (abnormal performance emanating from managers’ specific skills). Source: CSFB/Tremont

86 - The


DD journal03.v.11

28-11-2001

19:15

Page 87


CSFB/Tremont

•

Expected returns in this program are to be understood as con-

•

ditional estimates of the expected returns, based on the infor-

•

mation contained in the predictive variable used to forecast index style returns.

• •

References: • •

• • • • • • • • • • • • • • • • • • • • • •

Ait-Sahalia Y. and M. Brandt, 2001, ‘Variable selection for portfolio choice’, Journal of Finance, 56, 1297-1351. Amenc N. S. El Bied, and L. Martellini, 2001, ‘Evidence of predictability in hedge fund returns and multi-style multi-class tactical style allocation decisions’, working paper, ACT/EDHEC multi-style/multi-class research program. Amenc N. and L. Martellini, 2001a, ‘Portfolio optimization and hedge fund style allocation decisions’, working paper, ACT/EDHEC multi-style/multi-class research program. Amin G. and H. Khat, 2001, ‘Hedge fund performance 1990-2000 – Do the ‘money machines’ really add value?’, working paper, University of Reading. Barberis N., 2000, Investing for the long run when returns are predictable, Journal of Finance, 55, 225-264. Bekaert G. and R. Hodrick, 1992, ‘Characterizing predictable components in excess returns on equity and foreign exchange markets’, Journal of Finance, 47, 467-509. Bernard J. and T. R. Schneeweis, 2001, ‘Alternative investments: Past, present and future’, in The Capital Guide to Alternative Investment, ISI Publications. Brandt M., 1999, ‘Estimating portfolio and consumption choice: A conditional Euler equations approach’, Journal of Finance, 54, 1609-1645. Brennan M., E. Schwartz, and R. Lagnado, 1997, ‘Strategic asset allocation’, Journal of Economic Dynamics and Control, 21, 1377-1403. Brinson G. P., B. D. Singer, and G. L. Beebower, 1991, ‘Determinants of portfolio performance II: An update’, Financial Analysts Journal, May-June Campbell J., 1987, ‘Stock returns and the term structure’, Journal of Financial Economics, 18, 373-399. Campbell J., Y. Chan, and L. Viceira, 2000, ‘A multivariate model of strategic asset allocation’, working paper, Harvard University. Campbell J. and R. Shiller, 1988, ‘Stock prices, earnings, and expected dividends’, Journal of Finance, 43, 661-676. Campbell J. and L. Viceira, 1998, ‘Who should buy long-term bonds’, NBER, working paper 6801. Chan L., H. L. Chen, and J. Lakonishok, 1999, ‘On mutual fund investment styles’, working paper n°7215, National Bureau of Economic Research, Chan L., J. Karceski, and J. Lakonishok, 1999, ‘On portfolio optimization: forecasting covariances and choosing the risk model’, Review of Financial Studies, 12, 937-74. Chow G., 1960, ‘Tests of equality between sets of coefficients in two linear regressions’, Econometrica, 28, 591-605. Edhec, « Allocation d’actifs et attribution de la performance : Premiers résultats », Working Paper, décembre 2000. Elton, E., and M. Gruber, 1973, ‘Estimating the dependence structure of share prices - implications for portfolio selection’, Journal of Finance, 28, 1203-1232. Fama E. and K. French, 1989, ‘Business conditions and expected returns on stocks and bonds’, Journal of Financial Economics, 25, 23-49. Fama E., and K. French, 1992, ‘The cross section of expected returns’, Journal of Finance, 47, p. 427-465. Ferson W., and C. Harvey, 1991, ‘Sources of predictability in portfolio returns’, Financial Analysts Journal, May/June, 49-56. Ferson W., and C. Harvey, 1993, ‘The risk and predictability of international equity returns’, Review of Financial Studies, 6, 527- 566. Ferson W., and C. Harvey, 1995, ‘Predictability and time-varying risk in world equity markets’, Research in Finance, 13, 25-88.

• • • • • • • • • • • • • • • • • • • • • •

• •

Golin / Harris / Ludgate, February 2001, ‘The future role of hedge funds in European institutional asset management’, Survey. Harasty H. and J. Roulet., 2000, ‘Modeling stock market returns - An error correction model’, Journal of Portfolio Management, Winter, 33-46. Harvey C., 1995, ‘Predictable risk and returns in emerging markets’, Review of Financial Studies, 773-816. Ibbotson R. G., and P. D. Kaplan, 2001, ‘Does asset allocation policy explain 49,90 or 100 percent of performance?’, Financial Analysts Journal, January-February Indocam Watson Wyatt, March 2001, Alternative investment review relating to the Continental European market place, Survey. Invesco, June 2001, European institutional asset management, Survey. Jagannathan R., and T. Ma, 2000, ‘Covariance matrix estimation: Myth and reality’, working paper, Northwestern University. Jorion P., 1985, ‘International portfolio diversification with estimation risk’, Journal of Business, 58, 259-278. Jorion P., 1986, ‘Bayes-Stein estimation for portfolio analysis’, Journal of Financial and Quantitative Analysis, 21, 3, 279-292. Kandel S., and R. Stambaugh, 1996, ‘On the predictability of stock returns: an asset allocation perspective’, Journal of Finance, 51, 385-424. Karavas V., 2000, ‘Alternative investments in the institutional portfolio’, Journal of Alternative Investments, 3, 11-26. Keim D., and R. Stambaugh, 1986, ‘Predicting returns in the stock and bond markets’, Journal of Financial Economics, 17, 357-390. Ledoit O., 1999, ‘Improved estimation of the covariance matrix of stock returns with an application to portfolio selection’, working paper, UCLA. Longin F., and B. Solnik, 1995, ‘Is the correlation in international equity returns constant?’, Journal of International Money and Finance, 14, Lynch, A., 2000, ‘Portfolio choice and equity characteristics: characterizing the hedging demands induced by return predictability’, working paper, NYU. Lynch A., and P. Balduzzi, 1999, ‘Predictability and transaction costs: the impact on rebalancing rules and behavior, forthcoming, Journal of Finance. Marchenko V., and L. Pastur, 1967, ‘Eigenvalue distribution in some ensembles of random matrices’, Math. USSR Sbornik, 72, 536-567. Markowitz H., 1952, ‘Portfolio selection’, Journal of Finance, 7, 77-91. Merton R. C., 1969, ‘Lifetime portfolio selection under uncertainty: the continuoustime case’, Review of Economics and Statistics, 51, 247-257. Merton R. C., 1971, ‘Optimal consumption and portfolio rules in a continuous-time model’, Journal of Economic Theory, 3, 373-413. Merton R. C., 1973, ‘An intertemporal capital asset pricing model’, Econometrica, 41, 867-888. Michaud R., 1998, ‘Efficient asset management: a practical guide to stock portfolio optimization and asset allocation’, Harvard Business School Press. Nuttall J. A., Nuttall J., « Asset allocation claims – Truth or fiction ? », Unpublished, 1998. Roll R., 1997, ‘Style return differentials, illusions, risk premiums, or investment opportunities’, in The Handbook of Equity Style Management, 2nd edition, 93-120, Samuelson P., 1969, ‘Lifetime portfolio selection by dynamic stochastic programming’, Review of Economics and Statistics, 51, 239-246. Schneeweis T. R., June 2001, ‘Hedge funds: Risk and return alternatives for the modern investor’, working paper, CISDM, Schneeweis, T., Spurgin R., 1999, ‘Quantitative analysis of hedge funds and managed futures return and risk characteristics’, in R. Lake ed., Evaluating and Implementing Hedge Fund Strategies. Sharpe W. F., 1963, ‘A Simplified model for portfolio analysis’, Management Science, 277-293. Sharpe W. F., 1992, ‘Asset allocation: Management style and performance measurement’, Journal of Portfolio Management, 18, p. 7-19.

87

DD journal03.v.11

28-11-2001

19:15

Page 88

DD journal03.v.11

28-11-2001

19:15

Page 89

Financial capital

The challenges of risk management in diversified financial companies Christine M. Cumming Executive Vice President and Director of Research Federal Reserve Bank of New York

Beverly J. Hirtle Vice President Federal Reserve Bank of New York1

This article examines the economic rationale for managing risk on a firm-wide, consolidated basis. Both financial institu-

Abstract

tions and supervisors agree on the importance of this type of risk management. However, the ideal of consolidated risk man-

In recent years, financial institutions and their supervisors

agement, which may seem uncontroversial or even obvious,

have placed increased emphasis on the importance of consol-

involves significant conceptual and practical issues. As a

idated risk management. Consolidated risk management, also

result, few if any financial firms have fully developed systems

referred to as integrated or enterprise-wide risk management,

in place today. The absence thus far of fully implemented con-

can have many specific meanings, but in general it refers to a

solidated risk management systems suggests that there are

coordinated process for measuring and managing risk on a

significant costs or obstacles that have historically led firms to

firm-wide basis. Interest in consolidated risk management has

manage risk in a more segmented fashion. We argue that both

arisen for a variety of reasons. Advances in information tech-

information and regulatory costs play an important role here

nology and financial engineering have made it possible to

by affecting the trade-off between the value derived from

quantify risks more precisely. A wave of mergers, both in the

consolidated risk management and the expense of construct-

United States and overseas, has resulted in significant consol-

ing complex risk management systems. In addition, substantial

idation in the financial services industry as well as in larger

technical hurdles remain in developing risk management sys-

more complex financial institutions. The 1999 Gramm-Leach-

tems that span a wide range of businesses and types of risk.

Bliley Act seems likely to heighten interest in consolidated risk

All of these factors are evolving in ways that suggest that the

management, as the legislation opens the door to combina-

barriers to consolidated risk management are increasingly

tions of financial activities that had previously been prohibited.

likely to fall over the coming years.

1

The authors would like to thank Gerald Hanweck, Darryll Hendricks, Chris McCurdy, Brian Peters, Philip Strahan, Stefan Walter, Lawrence White, and two anonymous referees for many helpful comments. The views expressed are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York

or the Federal Reserve System. A longer version of this paper originally appeared as ‘The Challenges of Risk Management in Diversified Financial Companies. ‘Federal Reserve Bank of New York Economic Policy Review. Volume 7, Number 1. March 2001. This paper is available at http://www.newyorkfed.org/rmaghome/econ_pol/.

89

DD journal03.v.11

28-11-2001

19:15

Page 90

The challenges of risk management in diversified financial companies

Consolidated risk management: definitions and motivations

involving banking, securities, and insurance underwriting in

At a very basic level, consolidated risk management entails a

diverse financial activities present significant challenges to

coordinated process of measuring and managing risk on a

consolidated risk management systems, as greater diversity

firm-wide basis. This process has two distinct, although related,

often means that the system must encompass a wider range

dimensions: coordinated risk assessment and management

of risk types.

so-called financial holding companies. Such combinations of

across the different types of risk facing the firm (market risk, credit risk, liquidity risk, and operational risk), and integrated

Financial market practitioners cite the interdependent nature

risk evaluation across the firm’s various geographic locations,

of risks within an organization as a motivation to develop con-

legal entities, and business lines. In theory, both dimensions

solidated risk management systems. For instance, Lam (1999)

must be addressed to produce a consolidated firm-wide

argues that ‘managing risk by silos simply doesn’t work,

assessment of risk. In practice, few financial firms currently

because the risks are highly interdependent and cannot be

have in place a consolidated risk management system that

segmented and managed solely by independent units in the

fully incorporates both dimensions, although many large insti-

firm’. Similarly, a senior executive at a major U.S. bank asserts

tutions, both in the United States and overseas, appear to be

that ‘the careful identification and analysis of risk are, howev-

devoting significant resources to developing such systems

er, only useful insofar as they lead to a capital allocation sys-

(Joint Forum 1999)2.

tem that recognizes different degrees of risk and includes all elements of risk’ [Labrecque (1998)].

To understand consolidated risk management it is important to recognize the distinction between risk measurement and

The primary implication that Lam and others draw from this

management. Risk measurement entails the quantification of

finding concerns the role that consolidated risk management

risk exposures. This quantification may take a variety of forms

systems can play in helping firms to make better-informed

— value-at-risk, earnings-at-risk, stress scenario analyses, and

decisions about how to invest scarce capital and human

duration gaps — depending on the type of risk being measured

resources. For instance, Mudge (2000) stresses that a consis-

and the degree of sophistication of the estimates. Risk man-

tent framework for evaluating firm-wide risk and return

agement, in contrast, refers to the overall process that a finan-

across diverse financial activities is a key to evaluating the

cial institution follows to define a business strategy, to identi-

benefits of potential mergers among banking and insurance

fy the risks to which it is exposed, to quantify those risks, and

firms. Similarly, Lam (1999) argues that consolidated risk

to understand and control the nature of the risks it faces.

management systems can help firms understand the

Thus, consolidated risk management involves not only an

risk/return trade-offs among different business lines, cus-

attempt to quantify risk across a diversified firm, but also a

tomers, and potential acquisitions.

much broader process of business decision making and of support to management in order to make informed decisions

The supervisory community has advocated that financial

about the extent of risk taken both by individual business lines

institutions adopt consolidated risk management procedures

and by the firm as a whole.

in the guidance it published in the 1990s. The rationale offered by supervisors seems to be a concern that, in the absence of

90

Recent trends in the financial services industry have

a firm-wide assessment, significant risks could be overlooked

increased the challenges associated with this process. Finan-

or underestimated. A report of banking, securities, and insur-

cial institutions increasingly have the opportunity to become

ance regulators, for instance, argues that ‘the additive nature

involved in a diverse range of financial activities. In the United

of concentrations and the risk of transmission of material

States, the 1999 Gramm-Leach-Bliley Act enables affiliations

problems within a conglomerate point to the value of both

2 In large measure, these efforts are an extension of a longer-term trend toward enhanced risk management and measurement in the financial services industry. Many of these efforts have focused on developing risk measurement and management systems for individual risk types or businesses (for instance, market

risk in a securities firm or credit risk in a bank’s loan portfolio). In consolidated risk management, however, the focus is on an expansion of these single-riskmanagement systems to span diverse financial activities, customers, and markets.

DD journal03.v.11

28-11-2001

19:15

Page 91


conglomerate management and supervisors conducting a

ible and thus likely to have spillover effects on other busi-

group-wide assessment of potential concentrations’ (Joint

nesses through the cost of capital, the cost of funding, and

Forum 1999).

revenue effects through the loss of customer approval3.

Understanding the role of consolidated risk management

■ Consolidated risk management

What economic fundamentals underlie the belief of financial

The consolidated firm would appear to have incentives to

institutions and supervisors in the importance of consolidated

manage its risk on an aggregate basis whenever spillover

risk management? In this section, we try to understand why it

effects, and especially diversification benefits, are non-negli-

matters whether risk is managed on a consolidated basis or at

gible. At its heart, this is the logic that Lam and others in the

the level of individual businesses or risks within a firm.

financial services industry have applied in support of consoli-

and the theory of the firm

dated risk management: the idea that a diversified financial Standard portfolio theory suggests that the overall risk of a

firm should be viewed as a ‘portfolio’ comprising its different

firm will depend on the variation in profits in each of the firm’s

units and business lines.

operating units and the extent to which this variation is correlated across units. If the variation in one unit tends to

This view is closely related to the broader question of how

diversify the risk of others, then the overall risk of the firm will

firms decide which activities are coordinated within the firm

be less than the risk of its separate parts. In that case,

and which activities are coordinated through the markets. We

decentralized risk management would tend to present a

can draw on the insights of the ‘theory of the firm’ literature

conservative view of the risk of the overall firm.

to enhance our understanding of the role of consolidated risk management. Coase (1937) first noted that the efficiency of

An important offset to this diversification effect can come

markets might be expected to lead firms to rely on markets

from spillover effects in which the actions of one unit within

and contracts with third parties to conduct their activities, but

the firm affects the risk of the others. These spillover effects

that in fact many decisions are made, coordinated, and exe-

can be market-based, as when two units of a financial firm

cuted by internal mechanisms such as reporting hierarchies,

hold positions in the same market. Alternatively, they may be

production organization, and compensation plans. Coase’s

reputational- or contagion-related, as when problems in one

insight was that a firm carries out inside the firm those activ-

part of a diversified firm affect confidence in other parts of

ities that it can manage internally at a cost lower than the

the firm, for example, by causing acute near-term liquidity

information and transaction costs involved in purchasing cor-

problems across the firm, as discussed in the Joint Forum

responding services or goods outside the firm.

report (1999). These spillover effects can be enhanced during times of crisis or severe market disruption. A firm that man-

Since the mid-1970’s, economists have further developed and

ages risk on a unit-by-unit basis may have to spend valuable

extended the Coase analysis by elaborating more fully on the

time simply determining what its aggregate position is in the

roles of contracting for goods and services and the ownership

affected markets, rather than being able to react quickly to

of assets in determining what is coordinated within the firm

developing market conditions.

and what is coordinated by markets. Grossman and Hart (1986) noted that the combination of uncertainty and com-

Spillover effects can also have a longer run dimension. For

plexity makes contracting with inside or outside parties diffi-

example, innovative businesses or those involving massive

cult. In the presence of less than fully specified contracts,

technology investments can engender what some analysts

ownership and control of assets is synonymous with owner-

call ‘strategic risk’. Failure in such ventures may be highly vis-

ship of the rights not otherwise covered by contract. Thus, the

3 The large investments that many financial institutions are making in electronic trading and banking are examples of strategic risk related to establishing the competitive position of a firm in a fast-changing and greatly contested market.

91

DD journal03.v.11

28-11-2001

19:15

Page 92


ease or difficulty of contracting plays a major role in deter-

ple of coordination within the firm potentially being more effi-

mining what occurs inside the firm. Ownership demarcates

cient than external markets. Gertner, Scharfstein, and Stein

the boundary of the firm’s internal activities, which often

(1994) attribute the efficiency of internal capital markets to

involve the ‘non-contractible’ aspects of the firm’s activities.

the strong incentive to monitor capital use that owners have

In the Grossman and Hart analysis, bringing activities under

relative to debt holders, especially if many aspects of the

common ownership (integration) makes economic sense

firm’s capital use are not limited by the debt holders’ contract.

whenever efficiency gains, from improved information and

In addition, capital allocated to an unsuccessful project can be

coordination within the firm, exceed the efficiency losses

shifted to another use within the firm at less cost than would

resulting from the reduced entrepreneurial incentive of the

be involved in liquidating the assets of the project in the mar-

manager who is no longer an owner.

ket, if capital and resources in one use are close enough substitutes for those in other activities.

For a diversified financial firm, these insights can be applied to interactions between the various units within the firm. We can

Froot and Stein (1998) offer a model of capital allocation

think of activities conducted by a corporate parent on a firm-

and capital structure for financial firms that develops the

wide basis as coordination ‘inside’ the firm, while activities

relationship between risk management and capital allocation

conducted independently by separate units of the firm are

formally4. In their model, financial institutions fully hedge

analogous to the ‘market’ activities discussed in Coase and in

risks for which liquid markets are available. Financial institu-

Grossman and Hart. Following this logic, risk management and

tions have incentives to engage in risk management whenever

other corporate control activities will be conducted on a con-

they face risks that cannot be traded in liquid markets

solidated basis when it is too difficult or costly for the individ-

because they need to hold capital against the non-tradable

ual business units to contract among themselves.

positions according to the amount of risk in the portfolio5. The desirability of any given investment depends on the extent to

The type of spillover effects and interrelated risks discussed

which the investment’s non-tradable risk is correlated with the

above arguably create just such a situation. When the actions

non-tradable risks of the firm’s other portfolio positions.

of one business unit in a diversified firm potentially affect the risks faced by others, the contracting problem — in this case,

■ Debt holders and other creditors

what risk exposures may be undertaken by the various busi-

Financial institutions may have additional incentives to

ness units within the firm — becomes very complex to solve on

engage in consolidated risk management because of the

a bilateral basis. In such circumstances, the incentives to cre-

concerns of debt holders and other creditors. In agreeing to

ate a centrally run consolidated risk management system may

extend credit, these parties must take into account the moral

be strong.

hazard incentive that the firm has to increase its risk exposure — to the benefit of the firm’s shareholders and the detriment

■ Fungibility of financial resources

of its creditors — once the credit has been extended. Moral

Consolidated risk management allows the firm to allocate cap-

hazard is particularly a concern for financial firms, which can

ital efficiently. The fungibility of capital within the firm — what

change their risk profiles relatively rapidly.

some have called a firm’s internal capital market — means that the risks undertaken by one unit can affect the resources

Consolidated risk management systems provide a way for

available to another through the workings of the internal cap-

financial institutions to make a credible commitment against

ital market.

such behavior. In particular, these systems facilitate better disclosure by providing a consistent and comprehensive assess-

92

The financial institution’s internal capital market is an exam-

ment of the firm’s true risk exposure that can be used by cred-

4 In the Froot and Stein analysis, banks choose their capital structure, risk management policies, and investment policies jointly, rather than impose a short-run capital constraint. However, when capital is costly, banks economize on the amount of capital they hold and therefore take risk management concerns into account in their investment policies.

5 Note that the reliance on markets for hedging for liquid risks and internal capital allocation for non-tradable risks is another version of the contractible/noncontractible distinction discussed earlier.

DD journal03.v.11

28-11-2001

19:15

Page 93


itors to monitor the institution’s activities. The enhanced dis-

This balance of diversification benefits against information

closure made possible by consolidated risk management sys-

costs also influences the size of the business for a given level

tems may mitigate some of the spillover effects described

of capital. If the firm finds the cost of information high relative

above by providing meaningful information about the true

to the diversification benefit, the firm will manage each busi-

extent and nature of linkages between various businesses

ness separately, and in doing so it will assign relatively high

within the consolidated firm.

amounts of capital to each business line as if there was no diversification benefit. As a result, the scale of the firm’s over-

Obstacles to creating consolidated risk management systems

all business will be lower than it would have been if diversifi-

That firms have not immediately adopted consolidated risk

reduce fixed information costs, make it possible for firms to

management systems suggests that there are significant

take greater advantage of diversification benefits, and

costs or obstacles that have historically led firms to manage

increase the scale on which businesses can be conducted.

cation effects were realized. Improvements in technology

risk in a more segmented fashion. When a firm is involved in multiple business activities, these activities are frequently

■ Regulatory costs

segregated to some degree so that taking advantage of diver-

Regulatory barriers can take a variety of forms, including busi-

sification affects engenders costs. These costs include the

ness line capital and liquidity requirements set by regulators,

costs of integrating and analyzing information from the two

prohibitions or limits on capital and funds that can be trans-

business lines (information costs) and regulatory barriers,

ferred from one business line to another, or the necessity of

such as those that limiting the movement of capital and liq-

seeking prior approval or giving prior notice to move funds

uidity within a financial organization impose. Both tend to

between business lines. Most commonly, business lines segre-

inhibit the use of consolidated risk management.

gated from one another by such regulatory requirements are in different locations or different legal entities, subjecting the

■ Information costs

two business lines to different regulations. However, similar

Information costs involve both the resources involved in trans-

types of costs can be imposed by rating agencies, creditors, or

mitting, recording, and processing the information and the

even investors. The costs exist when the requirements or

amount of decay in the time value of the information, reflecting

expectations set externally differ across individual legal enti-

the lags in assembling and verifying information. At any given

ties within a firm.

moment, there may be competing information technologies with similar scale effects, but a different mix of costs in terms

As with information costs, we can consider the regulatory

of monetary outlays and time to assemble information (for

costs to reflect both monetary outlays to manage or circum-

instance, a highly automated process versus a manual one).

vent regulatory barriers and the waiting period or decay in profit opportunities in the time needed to comply with or

Information costs are shaped largely by technology. Informa-

overcome regulatory costs. While in some cases regulatory

tion systems tend to have substantial fixed costs that usually

requirements can make it virtually impossible to move capital

increase with the size of the information system, but low

or liquidity from one business line to another in the short-run,

marginal costs until the particular system approaches capacity.

in many cases regulatory requirements can be satisfied at

To make consolidated risk management worthwhile, for a

some cost. Where satisfying requirements is not possible, the

given volume of information, the value of recognizing the

firm can plan its organization and its capital and funding strat-

impact of diversification, which is a function of the amount of

egy to create flexibility in managing regulatory requirements,

diversification inherent in the firm’s activities, needs to

usually at the cost of holding excess capital and liquidity in

exceed the costs of investing in the information infrastructure.

some units.

93

DD journal03.v.11

28-11-2001

19:15

Page 94


Once again, the firm will invest in managing regulatory

firms and functional supervisors in the different business lines

requirements only if the diversification benefits are seen to

have tended to approach risk management and measurement

exceed the information and regulatory costs. The global trend

from quite different perspectives.

toward lower regulatory barriers to moving capital and liquidity within the firm, combined with financial engineering,

The state of development of modeling technology and the

appears to have reduced substantially the cost of managing

assumptions and techniques used to estimate potential losses

regulatory requirements.

vary across the various risks. Some major reasons are the nature of the risk, the availability of data, and the frequency

The decline of information costs and the erosion and repeal of

of measurable events. Market risk can be estimated using

regulatory barriers have been so great that many of the

available series of daily data, price and portfolio changes are

principal hurdles to consolidated risk management within a

continual, and the one-day horizon for measuring potential

financial conglomerate have fallen. Problems in measuring,

losses is standard. Credit risk tends to exhibit lower frequency

comparing, and aggregating risks across business lines now

variation as changes in credit status tend to evolve over

appear to be among the most important remaining barriers.

weeks or months rather than on a day-to-day basis and as fewer historical data are available to aid in model calibration.

Technical challenges and research questions

Operational risk — the risk stemming from the failure of com-

At a very general level, there appears to be an emerging con-

tures a mixture of events, some of which involve relatively

sensus about how various forms of risk should be quantified.

frequent small losses (settlement errors in a trading opera-

Most risk measurement methods used by major financial insti-

tion, for instance) and others which involve infrequent but

tutions are intended to capture potential losses over some

often large losses (widespread computer failure). Consistent

future horizon due to the risk in question. These methods can

data on these losses are difficult to obtain. Some risks — such

use a probability-weighted approach to estimating potential

as legal, reputational, and strategic risk — are rarely quanti-

losses (as in a value-at-risk or earnings-at-risk system, where

fied, as both the data and theoretical techniques for capturing

the distribution of future earnings is calculated) or can pro-

these risks have yet to be developed.

puter systems, control procedures, and human error — cap-

vide point estimates of potential losses under certain extreme circumstances (as in a stress test or scenario analysis

These differences present a challenge for calculating consoli-

approach or in an ‘expected tail loss’ estimation). The common

dated risk exposures that span several risk types. Should a sin-

thread is the focus on potential future losses, either to earn-

gle horizon be chosen for all risks and, if so, which one?

ings or economic value6.

Should the time dimension be explicitly factored into the risk assessment, with paths of risk over time? How should the cor-

Beyond this general consensus, however, the picture is con-

relations between various risk exposures be measured? Is it

siderably more complex. As noted above, an aggregate risk

possible to develop a ‘top-down’ approach that somehow

measure must incorporate different types of risk (market,

blends the risks facing the firm without measuring them sep-

credit, and operational) and must bring together risks across

arately, such as an analysis of income volatility? Is there some

different business lines (banking, insurance, and securities).

way of combining ‘top-down’ with ‘bottom-up’ approaches to

Although the broad risk concept applied within and across

consolidated risk measurement?

these two dimensions may be similar, the details differ con-

94

siderably, making simple ‘bottom-up’ aggregation approaches

This discussion assumes that to produce a consolidated meas-

difficult, if not impossible, to implement. In addition, aggre-

urement of risk exposure, it is necessary to develop risk meas-

gating across business lines presents challenges because

ures that are highly comparable across risk types. However,

6 Other potential definitions of risk could involve pure volatility measures, such as standard deviations of earnings or economic value, or sensitivity measures that capture the derivative of earnings or economic value with respect to particular risk factors, such as the ‘value of a basis point’.

DD journal03.v.11

28-11-2001

19:15

Page 95


perhaps a more fundamental question is whether a consolidated risk management system needs to have a fully consolidated risk measurement methodology at its core. Our sense is that the answer to this question is a resounding yes, largely because the ability to evaluate results against risks taken had already become a major feature of financial institution management back in the 1990s.

Conclusion As the above discussion suggests, there is considerable scope for further research to enhance our understanding of the benefits and shortcomings of consolidated risk management. Many of the key research questions involve technical issues in risk measurement and financial series modeling. In addition, further research into the main question of this article — the economic rationale for consolidated risk management — could produce findings that would be of clear use to supervisors and financial institutions. Our study presents some initial ideas, but clearly much more work needs to be done.

References • •

•

•

•

•

•

•

Coase, R., 1937. ‘The Nature of the Firm.’ Economica, 4, no. 4 (November): 386-405. Froot, K. A., and J. C. Stein, 1998. ‘Risk Management, Capital Budgeting, and Capital Structure Policy for Financial Institutions: An Integrated Approach.’ Journal of Financial Economics 47, no. 1 (January): 55-82. Gertner, R. H., D. S. Scharfstein, and J. C. Stein, 1994. ‘Internal versus External Capital Markets.’ Quarterly Journal of Economics, 109, no. 4 (November): 1211-30. Grossman, S. J., and O. D. Hart, 1986. ‘The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration.’ Journal of Political Economy, 94, no. 4: 691-719. Joint Forum (Basel Committee on Banking Supervision, International Organization of Securities Commissioners, International Association of Insurance Supervisors). 1999. ‘Risk Concentration Principles.’ December. Basel, Switzerland: Bank for International Settlements. Labrecque, T. G., 1998. ‘Risk Management: One Institution’s Experience.’ Federal Reserve Bank of New York Economic Policy Review, 4, no. 3 (October): 237-40. Lam, J., 1999. ‘Enterprise-Wide Risk Management: Staying Ahead of the Convergence Curve.’ Journal of Lending and Credit Risk Management, 81, no. 10 (June): 16-9. Mudge, D., 2000. ‘The Urge to Merge.’ Risk Magazine. February, p. 64.

95

DD journal03.v.11

28-11-2001

19:15

Page 96

DD journal03.v.11

28-11-2001

19:15

Page 97

Financial capital

Bob Miller

Managed network services pave the way for the Internet’s future in financial transactions

CEO and Founder, Slam Dunk Networks Inc.

David Bartoletti Partner, Capco

Fabian Vandenreydt Managing Principal, Capco

Abstract A discontinuity between corporate strategy and IT connectivity has denied many financial institutions the flexibility they need to respond to changing business conditions. The existing communications networks are simply unable to accommodate the needs of global financial institutions for growth and greater efficiency. But given the volatile business environment and the operating inefficiencies imposed by the current leased line infrastructure, the global markets will soon need a costeffective, yet functional connectivity solution. Fortunately, the latest security and reliability enhancements to the Internet make it a viable, better alternative.

97

DD journal03.v.11

28-11-2001

19:15

Page 98


Introduction

the existing communications infrastructure is unable to link

CEOs of financial institutions have rarely made connectivity a

global financial institutions with new business partners in a

top priority when crafting their corporate strategy. The dis-

cost-effective and timely fashion. This shortcoming has

continuity between corporate strategy and IT connectivity has

become painfully obvious to market professionals.

created a level of operating inefficiency that hinders financial institutions from achieving the degree of flexibility they need

Quite simply, financial firms need a new connectivity infra-

to respond to changing business conditions. It is also true that

structure that will better support the dynamic aspects of their

most financial institutions have been wholly dependent upon

business strategy. That the financial markets have reached

the major telecommunications carriers to provide the connec-

this impasse is understandable. While communication chan-

tivity to their most strategic business partners. This depend-

nels are the first points of contact between companies and

ency on leased lines has only added to the operating ineffi-

their customers and business partners, the connectivity strat-

ciencies imposed upon financial institutions.

egy has largely been relegated to the information technology department.

But this is about to change, in large part because the communication networks that for years have supported the global

Senior executives now understand that the most efficient

markets have essentially reached a breaking point. It is not

organizations have aligned their IT and connectivity strate-

that the leased line networks have failed, or even that they are

gies with their business strategies. This new way of thinking

about to, although they are vulnerable to disruptions in serv-

requires changes in the communications infrastructure.

ice. If anything, these networks are as reliable as they have

Rather than challenging the constraints imposed by the exist-

ever been for their current tasks. Indeed, if the financial mar-

ing infrastructure, too many companies have accepted them

kets were a static environment, with little need to change or

as a fact of life. As a result, the opportunities that a more

adapt to shifting business conditions and accommodate new

‘agile’ infrastructure could provide have not been brought suf-

business partners, the current infrastructure of leased lines

ficiently to the attention of senior management.

operated by the major telecom carriers would be sufficient. Financial institutions could continue to spend enormous sums

Internet connectivity is an important component of this agile

on their connectivity solutions if they could rely upon their

business model. The Internet provides a platform that sup-

operating margins to stay at or near the high levels they

ports the automation of business processes around the corner

enjoyed during the economic expansion of the 1990’s.

or around the world. Securities institutions need a secure, reliable, and cost-effective means of delivering financial transac-

However, the markets are dynamic, and the current period is

tions and electronic messages to their clients. This need can

one of the most volatile in recent memory. Moreover, the eco-

only be met with a scaleable and inexpensive connectivity

nomic expansion of the last decade has evaporated and this

infrastructure that is compatible with existing applications

has imposed a new discipline on operating costs. These fac-

and does not require financial institutions to re-engineer their

tors will ultimately force the financial markets to find new

business processes or replace applications they have relied

means of connectivity to replace the existing legacy infra-

upon for years.

structure. To their credit, financial institutions have not been standing

98

The problem presented by the connectivity solutions current-

still: far from it. They have been working hard on re-engineer-

ly deployed in financial services concerns the networks’ inabil-

ing their business processes throughout their enterprises.

ity to accommodate the needs of global enterprises for

But, they have yet to fully exploit the Internet’s ability to

growth and greater efficiency. As it is presently constructed,

seamlessly extend the reach of these new business processes

DD journal03.v.11

28-11-2001

19:15

Page 99


to external business partners. In addition, securities firms

The disparity in the connectivity methods used to reach dif-

have struggled for years to connect all their trading systems

ferent customer segments is further evidence of the short-

through straight through processing (STP). While they are still

comings of the existing communications architecture.

short of this goal, they have made significant process. The constraints of the current methods of connectivity are becom-

The key question is whether a substitute exists. The

ing even more apparent as the securities markets in the U.S. race

unadorned public Internet is not up to the task. But if the

toward a 2005 deadline imposed by regulators to implement T+1.

Internet is enhanced with software intelligence and a managed service that makes it both secure and redundant, it

An STP-enabling network must provide universal connectivity,

becomes not only a viable alternative but, given the dramatic

control, flexibility, and global reach at a reasonable price. Oth-

savings and improved functionality, the preferred method.

erwise, the vast majority of financial institutions will never adopt it. But as the financial markets progress toward STP

Low costs by themselves may not be enough to convince most

they will, out of necessity, develop networking and other tech-

financial firms that an alternative to leased lines exists. But if

nologies that help them increase revenue and the quality of

a managed service from an independent third party can offer

service they provide their business partners with, while low-

financial institutions improved functionality and connectivity

ering their overhead.

among business partners while lowering operating costs, then the business case for that service becomes compelling.

The high cost of leased lines The traditional method financial institutions have used to

Given the critical nature of most processes in the financial

establish links among each other has been a leased line, a pri-

markets, such a service must include a trust management

vate network, or a Virtual Private Network (VPN). The cost

infrastructure and a service level management infrastructure.

typically starts at U.S.$1,000 per month and can rise to 10

The trust management infrastructure provides mechanisms

times that amount for an international link. In addition, most

to create and enforce security and trust in the market, protect

telecom providers have an extensive order backlog that forces

the privacy of each party to a business process, minimize their

customers to wait 30 days to six months or longer before a

risk, and enforce industry standards. The service level man-

line is operational. Meanwhile, they often demand a two-year

agement infrastructure guarantees an acceptable end-to-end

commitment before a line is installed.

service level and flawless operations of the interoperability layers and trust infrastructure.

Given the costs and the delays, it’s obvious why most financial institutions use leased lines for only their top clients. They do

The shortcomings of the leased line infrastructure are further

business with the remainder via traditional phone lines, faxes,

compounded once the degree of integration the global mar-

e-mails, or whatever is handy, and they endure the obvious

kets will require in the near future is addressed.

shortcomings of these methods.

Needed: improved connectivity Part of this reality is due to the natural course of businesses.

The nature of the entire relationship between buy-side firms

It is a common practice for branch offices and back office

and their sell-side counterparts is rapidly becoming more col-

departments to operate ‘off-the-radar’ of senior IT manage-

laborative and will need to include concurrent business

ment. This leads them to develop or acquire their own appli-

processes such as running risk management models during

cations with minimal consideration for how they fit into the

the price discovery process. This will require major improve-

overall IT architecture and the strategy of the parent compa-

ments in connectivity among the buy-side, the sell-side, front

ny. Obviously, this creates an additional level of inefficiency.

offices, back offices, and third-party clearing and settling

99

DD journal03.v.11

28-11-2001

19:15

Page 100


agents. Some of these processes, such as settlement and

enhanced. They are now considered as reliable as traditional

clearing, are still lacking automation and are costly. Once

encryption standards deployed by the major telecom carriers

again, the cost of the existing leased-line infrastructure stands

and on legacy computing environments. Providers of these

in the way of financial institutions quickly moving toward

secure delivery services will assume greater responsibilities

assembling business processes in a collaborative fashion.

as the markets evolve and permit financial institutions to deploy their resources on initiatives where they can differen-

The business relationships among the various parties on Wall

tiate themselves from their competitors.

Street, The City, and other global markets are so complex and so crucial to the financial industry’s smooth operation, that it

Alignment as continuous process

is extremely important for a new connectivity infrastructure

A connectivity service that rides the Internet does much more

to be rapidly scaleable and allow quick deployment of new

than just help businesses lower their overheads. It also helps

links.

them better align the connectivity infrastructure that supports their business processes and their corporate strategy.

Aside from the telephone, the Internet is arguably the most scaleable business communications system in history. Its abil-

If financial institutions are to continue expanding in the glob-

ity to quickly link business partners is unequalled. Rather than

al markets, this alignment will become a necessity. Connectiv-

be limited to only a handful of business partners, financial

ity among business partners will have to become more than

institutions could, if the need arose, establish links to thou-

just part of an annual budget review and a daily priority

sands. Given the lower cost and quicker time to implement

throughout the year.

Internet based services, business processes that are executed through Internet connectivity could therefore offer a quicker

While a cost-effective connectivity infrastructure will become

return on investment relative to those that rely on traditional

the preferred method for reaching business partners, the

connectivity solutions.

actual connectivity will be a commodity function managed by an outsider. This will allow them to deploy internal staff on

Certainly, skeptics will question the Internet’s ability to per-

tasks that can help businesses differentiate themselves from

form these functions. In the past, people also did not believe

the competition.

that local area networks could replace dedicated video circuits for delivering real-time mission critical price information to

Financial institutions that are re-evaluating their communica-

traders’ desktops. Innovative technology firms proved them

tion expenditures will also have to consider that the 23.8%

wrong. The proven reality is that you can create mission-criti-

average annual return enjoyed by the S&P 500 index between

cal networks on the Internet.

1995 and 1999 is now viewed as an anomaly. Most market strategists and portfolio managers expect that for the fore-

The financial industry’s view that the Internet is neither as

seeable future returns on the major equity markets will be

reliable nor as secure as the existing telecommunications

much closer to the 4.93% averaged by the S&P 500 from

lines that form the backbone of today’s financial markets is

1955 through 1999. In fact, the poor returns in the equity mar-

accurate only when referring to the Internet alone, without its

kets are not plaguing only the U.S., but have clearly become a

potential enhancements. But widely available security tech-

global problem as the recession has spread to Europe, Asia,

nologies such as Public Key Cryptography (PKC) and Secure

and the emerging markets. This problem is putting a strain on

Socket Layer (SSL) can make the Net every bit as secure as

financial institutions everywhere.

leased lines. Since the mid-1990’s, PKC, SSL, and related technologies such as digital certificates have steadily been

100

The lower returns will force buy-side firms to achieve greater

DD journal03.v.11

28-11-2001

19:15

Page 101


operating efficiencies and lead them either to reduce the

account for counterparties who were not in their normal loca-

number of sell-side brokers they use or demand lower-cost

tions. Had these same financial institutions been prepared to

services. This will naturally force sell-side firms also to search

use the Internet for their transactions, they would not have

for greater operating efficiencies.

experienced this problem.

The business case for abandoning the existing leased line

Guaranteed delivery on the Internet

infrastructure is also borne out by the sheer magnitude of its

The ability of a managed service provider to guarantee deliv-

costs. Global 1,000 corporations, particularly commercial and

ery of a financial transaction carried via the Internet is crucial

investment banks, spend literally billions of dollars each year

for the simple reason that financial institutions have grown to

to maintain the leased lines operated by the major telecom

trust leased lines despite the high cost. Unless there is an

service providers.

unusual disruption, leased lines do provide a reliable means of linking business partners. For this reason, any transaction

The Internet as a reliable connectivity solution

service that rides the Internet will have to demonstrate to

The terrorist attacks of September 11th that destroyed New York’s

right enhancements, it is possible for the Internet to be even

World Trade Center underscored the weaknesses inherent in

more reliable than leased lines.

prospective clients that it too is at least as reliable. With the

much of the existing telecom infrastructure, and showcased the robust nature of the Internet. The land lines for most busi-

With leased lines, brokers, investors, and business partners

nesses and residents in lower Manhattan were useless for

are usually assured that the moment they click the send but-

days – and in some cases weeks – after the attack, and regu-

ton on their browser or hit the return key on their keyboard,

lar phone service was disrupted throughout the greater New

their transaction will reach their counterparty. It does not

York area.

matter if the business partners are trading goods and services between LaSalle Street and South Wacker Drive in Chicago

The Internet, however, remained intact. Rather than be sur-

or if a Hong Kong based investor is sending a trade order to a

prised by this performance, people need to remember that

broker in London’s Canary Wharf. But if one of those parties

the Internet was created more than 30 years ago by the U.S.

uses the public Internet to trade with a business partner, the

Department of Defense and academia to ensure reliable com-

transaction will leave the protection of his firewall and be

munications in the event of a nuclear war. If anything, Sep-

apparently vulnerable until it reaches the recipient’s firewall.

tember 11th proved that the Net was not only durable, but also

Until it reaches its destination both partners will need assur-

reliable enough to handle business transactions under the

ances that, not only is the message still on its way, but that it

most difficult of conditions.

has not been tampered with in transit. For this reason, an Internet-based system that proposes to replace the current

On a global level, the Internet is a very stable platform with no

leased line environment needs to employ several features to

single point of failure and a fast, cost-effective message deliv-

guarantee each transaction’s delivery. While the raw Internet

ery mechanism that cannot be brought down by a natural or

doesn’t have the security and reliability that financial institu-

man-made disaster.

tions require, it can be hardened for the needs of the securities industry. A service that employs redundant components,

Ironically, several financial institutions that relocated to back-

redundant geographies, redundant backbone carriers, and

up sites found themselves trying to connect to business part-

redundant intelligent technologies can guarantee to financial

ners who had also moved. Unfortunately, the communications

institutions that their place on the network will be available

networks deployed as part of the disaster recovery did not

when needed and that their messages will reach their clients

101

DD journal03.v.11

28-11-2001

19:15

Page 102


and business partners.

at home and overseas. Businesses in all industries are well aware that their future growth hinges upon their ability to

Several enhancements to the public Internet would accom-

reach customers and suppliers in foreign markets.

plish this goal. One such feature would be a tracking and auditing system along the lines of FedEx’s tracking service. By

At the same time that the financial industry has reached a

using the shipment’s tracking number, the sender and intend-

crossroads with its communications networks, the global

ed recipient of any document can follow its transit from point-

economy has been melting down. This has put a premium on

to-point along the network. An Internet based service would

operational efficiencies. So the financial markets find them-

also require a disaster recovery mechanism to ensure that

selves being squeezed from one direction by a communica-

messages reach their destination and security features to pro-

tions infrastructure that is prohibitively expensive to operate

tect each message’s content.

and expand, and by a fall in revenues from the other. Meanwhile, the need to meet the deadline for T+1 is not going away.

A further advantage of an Internet-based managed service is

At the same time, the deteriorating economic environment is

that it will permit financial institutions to interact with all cur-

pushing it to seek less expensive alternatives to the existing

rent and prospective business partners. An application that is

infrastructure.

installed locally at a client’s site can be operational in a few days and shorten the connection time between business part-

Despite the high cost of the current infrastructure, no major

ners considerably relative to the weeks or months now

bank is about to replace its leased lines with an alternative

required for leased lines. Such an application should also be

communications method unless it can be guaranteed that the

designed so that it is compatible with a financial institution’s

new method is equipped with disaster recovery and adequate

existing systems.

security.

The speed of installation also enables businesses to capitalize

Learning from FIX

upon new markets and new opportunities and permit them to

To understand why the need for a new communications archi-

begin generating revenue from a new customer within a few

tecture is so acute in the global financial markets, it helps to

days. Given the long delays in installing leased lines, the capi-

look at the Financial Information eXchange (FIX) protocol,

tal requirements of purchasing the necessary equipment, and

which was pioneered by Fidelity Investments and Salomon

the cost of committing to a leased line for one or two years,

Brothers in the early 1990’s. In the past few years, FIX has

and the ease of relying upon an Internet-based system essen-

become a de facto standard for equities trading at the major

tially translates into a quick return on investment. But these

sell-side and buy-side firms.

efficiencies can only be gained if the financial markets are supported by a more flexible and agile communications con-

Some of the issues that drove Wall Street’s adoption of FIX are

nectivity strategy and architecture. To achieve agile connec-

also behind the financial industry’s efforts to implement STP

tivity the markets will also require a greater degree of appli-

and T+1 settlement. They illustrate how operational efficiency

cation and business process interoperability.

can be enhanced by a communications infrastructure that adds to connectivity rather than hinders it. Sell-side opera-

102 - The

The drive to achieve this interoperability is occurring amid a

tions in particular face a difficult task in communicating with

long-term trend toward increasing globalization, especially in

the largest possible number of customers and traders. They

the capital markets. Investors are no longer content only to

may have thousands of buy-side customers of all sizes,

purchase the securities of their home markets. They have

on every continent, with many different trade management

been looking far afield for new investment opportunities, both

applications. In order to continue growing their revenue base,


DD journal03.v.11

28-11-2001

19:15

Page 103

institutional and corporate desks must find an efficient way to

taking as long as they did complying with FIX.

communicate across geographies, customer sizes, and system capabilities.

The financial markets worked for most of a decade to comply with FIX. But the markets’ experience with the standard also

Typically, an organization’s top 50 customers provide the

forced financial institutions to rethink how they approach

majority of its trading revenue. These large institutional buy-

connectivity. Global companies will only migrate to a new con-

ers can afford leased lines connecting them directly to the

nectivity infrastructure so long as it is compatible with their

sellers, and have invested in FIX-compatible portfolio and

existing IT infrastructure and does not require a re-engineer-

trade order management systems. Also, because of their

ing of their existing systems or business processes beyond

sophistication, these customers are responsible for a smaller-

what they are already doing as they migrate to T+1 and STP.

than-normal share of reconciliation issues and problem con-

Even so, the interoperability of connectivity among financial

firmations. In contrast, account growth is more dependent on

institutions is, by itself, only a partial answer. Before the finan-

newer customers who are less sophisticated and less likely to

cial markets can achieve their optimal level of operating effi-

install dedicated connections to the selling organization.

ciency they will need to achieve application and business process interoperability. That is the objective of Slam Dunk, a

Institutional buyers exchange indications of interest (IOIs),

California based company that installs secure application soft-

price quotes, trade completions, and allocations via FIX-for-

ware at clients’ sites1. Financial institutions already move bil-

matted messages. These messages may flow over leased lines

lions of dollars every day via the messaging formats created

or order routing networks, but they fail to reach a large num-

by the Society for Worldwide Inter-bank Financial Telecom-

ber of potential buyers who are not yet connected to major

munications (SWIFT), and the Internet solutions that comple-

broker-dealers. Such buyers are using more traditional trad-

ment SWIFT’s standards are the ones that financial institu-

ing approaches such as phone, fax, e-mail, and snail mail. Exe-

tions will most readily adopt.

cuting trades and managing prices for this segment of the customer base is slow, expensive, labor-intensive, and error-

Conclusion

prone.

However financial institutions choose to react to their connectivity dilemma, the truth is that the financial services land-

Fax and e-mail confirmation suffer from well-known deficien-

scape is no longer a ‘private club’. Inexpensive, standardized

cies: delivery is uncertain, security is poor, and lost messages

systems and connectivity solutions are the ideal model for

cannot be tracked or audited. These uncertain delivery mech-

supporting its future growth. Companies will need to converge

anisms dissuade customers from managing multiple sell-side

to create a level playing field, but in order to diverge in their

relationships and contribute to problems in reconciling and

business strategies and customer relationships, they will need

confirming trades.

to farm out commodity tasks to third parties. The ‘not invented here’ syndrome has become a hindrance to success in the

The end result is that the sell-side’s clientele has been split

financial markets. The businesses that are the first to recog-

into two segments: a top-tier of FIX-compliant large institu-

nize this new landscape will have the agility to quickly and

tional investors connected to their brokers via leased lines,

cost-effectively establish links with existing trading partners

where trading is a largely efficient and cost-effective opera-

and sign up new ones. The operational efficiencies they gain

tion, and the rest. Keep in mind that it took Wall Street most

will allow them to exploit new business and revenue opportu-

of the 1990’s before its top buy-side clientele reached the cur-

nities and lower the cost of reaching new clients. The busi-

rent levels of efficiency. Yet, if the financial markets are going

nesses that are slow to react to the new business model will

to meet their deadline for T+1, they do not have the luxury of

cede the competitive advantage to their rivals.

1

The Slam Dunk application encrypts each message to guarantee its security, creates a duplicate, and then sends both the original and its copy via independent routes along the network. Once they’re on the network, the encrypted messages are stored in multiple databases before they reach the recipient. The network will not fail or a message fail to reach its recipient because of an isolated disruption.

When the message is received, the recipient’s software decrypts it and reads it. In addition, the network’s performance is continuously monitored. Any time there’s a disruption to the network, it is diagnosed, and messages are routed around the source of the break.

103

DD journal03.v.11

28-11-2001

19:15

Page 104

DD journal03.v.11

28-11-2001

19:15

Page 105

Intellectual capital

ABSTRACT

Cross cultural branding for private banks Coping with cultural differences in international market research Liberating human capital: The search for the new wave of liquidity Intangible asset and value-creation reporting… increasing transparency at Skandia

105

DD journal03.v.11

28-11-2001

19:15

Page 106

Cross cultural branding for private banks Nick Hahn, Partner, Capco Elena Siyanko, Research Associate, Capco Brands add economic value above and beyond the value of the

way of creating an international brand is to expand a single,

products and services that a private bank offers. How? Wealth

strong, existing brand. To do so, marketers must have a keen

management is about promises of future benefits: ‘follow this

ear for the ‘cultural pitch’ of different markets, and communi-

financial strategy and ....’. Clients believe the promises to the

cation execution that delivers those differences in a powerful,

extent that they have trust and confidence in the institution

memorable way.

and in their adviser. Brands create trust and loyalty; they bolster the quality of the products and services. This reputation

How brands work

of trust is the sustainable point of differentiation. Products

To understand this, we start with how brands work. A brand is

change and can be copied quickly. Therefore, private banks

a single-minded value proposition that is relevant, different,

must build relationships with, and pose arguments to clients

and better, to some target audience, within some competitive

as to why they ought to trust them to deliver that future

context (i.e., Merrill Lynch Private Banking provides HNW indi-

promise. And they must do so in a way that is differentiated

viduals with superior, balanced advice on how they can

from their competition. They should not simply rely on prod-

achieve their particular objectives). Further, a strong brand

uct performance.

has to have real product and service content, in addition to emotional/psychological components or benefits. For a brand

Interestingly, despite this critical role of branding in financial

to be effective, it requires both of these components to sup-

institutions, they are remarkably bad at it. Using a commonly

port each other. (i.e., Merrill Lynch offers advice that is highly

accepted method to measure brand value (Interbrand/Citibank

responsive and compelling, supported by award winning

methodology), the brand of Goldman Sachs is valued at

research and an extensive global advisor network).

U.S.$7.9bn, or about 20% of its total market capitalization. By

106

contrast, Bank of America, whose brand is less strong, has a

More evolved brands in mature categories tend to focus more

brand value of only U.S.$5.7bn, representing only 6% of its

on emotional benefits, usually values-based (i.e. achievement,

market capitalization. Further, financial institutions as a group

security, belonging, integrity, connectivity/togetherness, and

are the weakest of all brand categories in terms of value, with

well being), than physical ones, since their products and serv-

only 4 in the top 100 (2000 Interbrand/Citibank study), or

ices tend to become commoditized over time. This does not in

merely 7% of the total value. The weighted average value of

any way mean that the product or service is any less critical.

these top financial services brands, as a percent of total mar-

It simply means that the value proposition is more powerful

ket capitalization, is 14%, less than half the level of brands in

when expressed in emotional terms, and supported by high

the consumer goods or technology categories. In the lan-

quality and well aligned products or services. Good examples

guage of the marketing industry, this is simple to explain.

of these more evolved brands are Coca-Cola (friendship and

Though some financial service brands are quite well known

authenticity), Marlboro (rugged individualism), Nike (personal

(high awareness), most have relatively low differentiation (low

empowerment), Absolut (self-expression and individuality),

target relevance, uniqueness, superiority, and market share

and Gucci (sex and sensuality). In each case, the product or

leadership) -- they are mere identifiers as opposed to brands.

service is excellent relative to its competitors, and works to

So there is a lot of potential for generating value.

fully deliver on the promise made by the brand.

Banks have had difficulties in creating a brand proposition

In the financial services industry, Goldman Sachs is a good

that delivers strong value consistently over time in a single

example of an evolved brand. Goldman Sachs’ brand is about

market. They will now face greater difficulties as geographic

the confidence and trust of leadership; they have become the

boundaries come down and they pursue expansion beyond

true gold standard in this regard over time. Customers strongly

their local markets. By far the quickest and most cost effective

believe in this psychological proposition, despite Goldman’s

DD journal03.v.11

28-11-2001

19:15

Page 107

relatively short history, for three reasons: 1) financial acumen,

setting is identified with wealth and privilege. In this case, the

as evidenced by the money the partners have made for them-

brand message conveys both a short- and long-term attitude

selves, 2) credibility from the presence of deeply impressive,

– it depicts present happiness and warmth (contemporary)

highly credible public figures like Abby Joseph Cohen, and 3)

combined with the implied timeless notion that the watch is

unmatched access to the most sophisticated, high quality

an heirloom to be passed on through generations (traditional).

products given their leadership in Global equity underwriting

So the watch becomes an enduring, powerful emblem of both

and M&A advisory. The question now becomes: how to com-

the current and future family happiness and security. Now

municate these powerful brand notions in a way that cus-

what if one decides to try to express this same brand proposi-

tomers will easily understand, remember, and find compelling?

tion in the U.K., or in Japan, or in New Zealand? Would the same attitudes and expressions exist? Would the same adver-

Communicating a brand

tisement resonate with customers? Typically not.

Taking a brand idea and communicating it effectively to one’s target is the next challenge. How this works is that marketers

Cross-cultural branding

must find insights relevant to a given target – attitudes, behav-

The Holy Grail of cross-cultural branding, as referenced earli-

iors, emotions – to express the brand idea or values. Attitudes

er, is to maintain the core brand proposition, while ensuring

are things like how one thinks (i.e. linear or associative); one’s

the communication or expression of that brand is locally rele-

attitude toward change (i.e. bias toward the new or the tradi-

vant. This is possible because strong brands are founded on

tional); how one views one’s self vis-à-vis the society at large

values, and values are generally universal. It is the attitudes,

(i.e. individuality valued, doing things to forward a greater

behaviors, and expressions of those values that can vary by

communal good valued); and one’s mode of living (i.e. atti-

culture. So suppose private bank X, which already existed in

tudes toward and definitions of success, status, and well-

North America and the U.K., wanted to expand into Continen-

being).

tal Europe. Differences in value offering (which can be significant) aside, the company would have two fundamental choic-

So for example, the value of ‘achievement’ can be articulated

es. They can either introduce: 1) a whole new brand (via the

as a father caring for his family (importance of collective suc-

introduction of a new brand, or through a merger/acquisition)

cess), or an individual being successful in business (impor-

which, while more expensive than expanding the existing

tance of individual success), or attaining material wealth (atti-

brand, may be appropriate given unwanted associations with

tudes towards success). The ways these values are perceived

the parent brand, or highly differential pricing, etc.; or 2) the

and expressed should take into account the cultural environ-

existing U.S./U.K. brand into the new geography in a manner

ment of the given market. Marketers must then use this infor-

such that it has relevance to the new local market.

mation in all their communication mediums. All manners of communication, both within and without the company, must

The second path is generally preferable, as it is significantly

reflect these attitudes.

less costly (only need to support one brand versus multiple, able to leverage pre-existing awareness and equity, etc.),

The luxury good brand, Patek Philippe watches, provides a

quicker to implement, and builds momentum, or a ‘halo’,

good example. The brand is about enduring, timeless quality,

around a singular idea. The way one effectively does this is to

and the deep comfort/satisfaction/security that comes from

ensure the core brand’s values remain intact (remember the

that. Their U.S. print ad shows a young, well-dressed father

‘confidence’ of Goldman Sachs), and that one correctly identi-

teaching his son to ride a bicycle. The father has on a simple

fies local attitudinal insights and expressions. It is then a mat-

gold wedding band and no visible watch. The people’s expres-

ter of expressing the core brand’s values using local insights

sions convey a high level of intimacy and empathy, and the

and expressions in communication, which is the role of adver-

107

DD journal03.v.11

28-11-2001

19:15

Page 108

tising agencies, advisors, etc.

Conclusion Well constructed and maintained brands can help generate

An example of this is UBS Private Banking. The UBS brand is

significant value and competitive advantage. But they can

about delivering the values of achievement and well being,

quickly lose their power in a local setting if the way they are

supported by the long and hallowed tradition of trust, safety,

expressed is not relevant to the local market. If the expression

and personalised service among Swiss bankers. Across Spain,

is made relevant, however, the gains in cost savings, speed to

Japan, and Germany, these values and benefits have the same

market, and the ‘halo’ of a cross-geography brand can be sig-

relevance, but the way they need to be expressed is very dif-

nificant. On the other hand, if the core values of the existing

ferent. This is because each of these cultures has unique dif-

brand are not maintained, the brand will lose its core meaning

ferences – with distinct beliefs, attitudes, and behaviors. In

and become diluted. This will cause larger long-term prob-

some cases, there are similarities across the cultures, in other

lems, regardless of the resonance of the local brand commu-

cases differences. In almost all cases, the expression of a given

nication.

belief, attitude, or behavior is indeed different and distinct. In Spain, for example, UBS print ads feature Old Spanish art masters (Gris, Velasquez), which generally reflect the importance of tradition. One of the paintings used, ‘Maids of Honor’, depicts a Royal Infanta surrounded by her family. This depiction highlights the importance of belonging, family, and collectivism. Both elements of expression communicate the higher level notion of well being. In Japan, print ads feature traditional Japanese objects (Bonsai plant, tea ceremony utensils), shown together with more modern western images of wealth and achievement (ballet, yachts). This reflects the notion that tradition and modernity go side-by-side in Japan, while also reflecting the broader value of achievement. For Germany, visuals were not used at all, but rather the ads featured clever word play and focused on a consumer hotline. This depiction expresses the locally relevant notions of rationality, authority, and competence, which together convey the higher level message of achievement. So in each case the local communication is reflective of local attitudes and their expressions, while also delivering UBS’s core brand values of achievement and wellbeing. This is an excellent example of cross-cultural branding.

108

DD journal03.v.11

28-11-2001

19:15

Page 109


Lall B. Ramrattan

Coping with cultural differences in international market research

Instructor, University of California, Berkeley

Alan Zimmerman Assistant Professor of Business, College of Staten Island, City University of New York

Michael Szenberg Distinguished Professor of Economics, Lubin School of Business, Pace University

Abstract This paper analyzes how international marketing researchers deal with cultural differences in the modern global economy. A survey was designed to examine several hypotheses related to the evolving diversification of cultural factors in a worldwide setting, given international managers’ product responsibilities, research needs, choice of media for conducting research, and international marketing positions. We used indices to capture a country’s level of cultural individualism, collectivism, power distance, masculinity, femininity, and uncertainty avoidance. In addition, we have incorporated dynamic relationships among indices of cultural change and economic development. The results validate the proposition that cultural differences can be explained by those indices.

109

DD journal03.v.11

28-11-2001

19:15

Page 110

Coping with cultural differences in international market resarch

Introduction

lems. Our definition reads: ‘By cultural problems, we mean fac-

International market researchers (IMR) have long recognized

tors such as differences in beliefs about social interaction,

that the two-factor model (capital and labor) has less impact

materialism, religion, ways to communicate, and what to com-

on foreign trade patterns than do natural and human

municate.’ Respondents were asked to rate on a scale from 1

resources. Because human resources encompassing cultural

to 5 (1 representing no problems, and 5 representing signifi-

traits are difficult to measure, they are subsumed in the error

cant problems) the level of difficulty in different countries and

term of empirical models to explain elements of comparative

across various research media, including focus group studies,

advantages that were not explicitly taken into account [Har-

mail, telephone, and personal interviews.

rod and Hague (1964)]. The term culture is difficult to define and measure, as its influence in marketing research is felt

Specification

rather than directly observed, and its nature is diverse. Social

We have specified several statistical hypotheses based on the

scientists have standardized the use of culture in marketing

surveyed data (except for the HDI index in Corollary 1). To esti-

studies to the values it gives to personality, time pattern,

mate the indices for Hypothesis 1, we used nominal scores

action and reaction, and self-concepts [Usunier (1993)]. This

from the responses in the survey. We have used the average

type of categorization, attributed mainly to Kluckhohn and

of the scores, as we are more concerned with representation

Strodtbeck (1961), allows cultural studies in terms of the indi-

than with replicating Hofstede’s estimates. In addition,

vidual, power distance, masculinity, uncertainty avoidance,

because of data limitation, we have combined some of the

and Confucian Dynamics or collectivism [Hofstede (1980)].

indices, namely collectivism and individualism, and masculini-

Within this paradigm, researchers are now equipped with

ty and femininity. Hofstede, however, used the mean on scored

several approaches for tackling cultural phenomena.

responses on three questions for PD (Power Distance) and UA (Uncertainty Avoidance) (see appendix B). IND and MAS are

The purpose of this paper is to explore how IMR managers are

scored on 14 work related goals. They were based on the vari-

coping with cultural problems in a rapidly evolving global

ance explained by the first factor in a factor analysis program.

economy. The paper begins with a description of a survey

The FEM variable is related to MAS in a dominant sex role

instrument designed to capture the theory and practice of

pattern [Hofstede (1980)], and COL was worked in with IND

IMR managers across a variety of international corporations.

discussions. The hypotheses are listed as follows:

The marketing problems facing managers within the cultural domain range from simple data collection [Cavusgil (1987)], to

■ Hypothesis 1: (Culture: Hofstede and others)

the preference of local or foreign research companies [Dou-

The major premise of our investigation is that IMR man-

glas and Craig (1983)], to complex advertising consideration

agers’ concern about cultural phenomena is explained by

as to which technological method or media is most effective

indices of its internal cultural concentration or diversifica-

and cost efficient. The next section places the cultural prob-

tion or integration within the countries with which they do

lem in a theoretical context, highlighting the dynamic prob-

business.

lems confronting IMR managers. The rest of the paper is built on the results and the discussion of the data from the survey.

■ Hypothesis 2: (Product Responsibility)

(More information about survey design and model is available

If IMR is still in the embryo stage of development, initial

in Appendix A.)

manager responsibility will be concentrated on daily consumer products at the expense of all responsibility, given

In an attempt to evaluate the way in which IMR firms confront

their experience, place of business, and the country’s level

the myriad dimensions of culture, we asked the respondents

of human development.

to adopt a broad, yet pragmatic, definition of cultural prob-

110

DD journal03.v.11

28-11-2001

19:15

Page 111


■ Corollary to all the Hypotheses: (UNDP)

■ Hypothesis 3: (Research Needs) If the motto of research that needs to be followed is ‘Think

The higher the average level of human development, the

Globally; Act Locally,’ then IMR firms will provide personal

higher the level and complexity of the IMR functions will

supervision, suppliers’ selection, and quality surveillance;

be, given the diversity of the countries of research in

in short, primary preference will be given to research

terms of their culture, research media, research needs, etc.

considerations. The results of Table 2 are generated by iterative Three-Stage ■ Hypothesis 4: (Methods)

Least Squares. Even though this is a cross-sectional study,

Because most countries are now embarking on develop-

weighted single or system least-square techniques are less

ment, the implication is that their phone media has not yet

productive in terms of probability due to the diversity of coun-

matured. If research is to be effective, then the media mix

tries, techniques, media, and functions, and the random

will be biased towards achieving in-depth interviews via

nature in which firms choose them minimizes the het-

focus groups, desk, home, and street surveys.

eroscadistic distribution of their variances. Our optimal list of instrumental variables excludes the dependent ones. In

■ Hypothesis 5: (Manager’s International Position)

Appendix A, it spells out the cultural variables (IND, COL, PD,

Being in an international position requires sensitivity to

MAS, FEM, UA), and the firm’s description variables (CP, CS, IP,

foreign culture and requires the understanding of others’

IS). It includes all but the RN variable in the role set (DM, SS,

lifestyles and values. To the extent that a firm is located

SR, IR), all the age cohort variables, the New York dummy

within a cosmopolitan area such as New York-New Jersey,

variable, and the constant.

this need may already be assimilated into its marketing procedures and further effort in that direction may not

Table 2 indicates the regression results for the four dependent

enhance its position.

variables: index of culture, product responsibility, research needs, and the position in the firm. The overall results yield 19

Independent Index of Variables Culture Y COL* IND MAS-FEM UA AGE NY HDI CP CS IP IS DM SS SR IR Geoww Index Constant R2

t-Value

Product Responsibility: AP(5)

0.12

3.11 ***

--

-0.20 -0.26 -1.13 -0.31 1.62 -----------.37

-1.99 ** -2.61 *** -1.73 ** -2.54 *** 7.28 *** -------------

--3.40 0.62 3.99 -0.39 0.01 -0.08 0.13 -------3.51 0.34

Table 2: 3-Stages regression results Sample Size=26 Note: ***=Significant at the 99% level

**=Significant at the 95% level

t-Value

Role in Research Needs: RN (4)

---3.29 *** 2.39 *** 2.45 *** -1.88 ** 0.05 -0.44 0.48 -------2.49 *** --

---1.03 -0.30 0.39 -----0.01 0.17 0.31 0.13 ---.80

t-Value

---1.65 * -3.66 *** 2.61 *** -----0.07 1.62 * 3.19 *** 1.06 -----

Position in Firm: INTL (2) ----0.66 -0.29 1.20 --------0.10 -0.30 -.39

t-Value

----0.62 -1.84 ** 4.20 *** --------0.27 -2.27 ** ---

*=Significant at the 90% level.

111

DD journal03.v.11

28-11-2001

19:15

Page 112


out of 26 significant coefficients, with 13 significant at the 99

comprehension. On the other hand, the average level of HDI

percent level. Jointly, collectivism and individualism (COL*IND)

across the spectrum of countries is more than proportionate-

explained 0.12 of the variation in the index of culture. But vari-

ly positive when correlated with cultural concerns. This may

ation explained by concerns for human development (HDI)

be explained by the dynamic interplay between economic

was unsurpassed, measuring 1.62. Such a concern with HDI

development and cultural changes.

also explains the largest amount of positive variation in product responsibility, and in the respondent’s position in the firm,

For the product responsibility equation, which addresses

to the extent of 3.99 and 1.2, respectively. The HDI is subordi-

Hypothesis 2, the IMR’s function and effort in the consumer

nated only by the age variable in explaining variation in

product areas take away from their overall product responsi-

research needs, measuring only 0.39 vs. 1.03.

bility. This result subscribes to an evolutionary product research hypothesis. In such a scenario, the initial wave of

The results of the index of cultural equation are highly signif-

daily consumer products are followed by consumer services,

icant. It validates Hypothesis 1, positing a significant relation-

to be followed subsequently by high-tech products, then fol-

ship between the existence of cultural problems on one hand,

lowed by the introduction of financial service industries. It is

and indices of cultural, economic, demographic, and geo-

not surprising that the average age variable, which is less than

graphic variables on the other. All of the estimated coeffi-

5 years, is positive and statistically significant. Many countries

cients are significant, and given the binary nature of the index,

have only recently joined in the global economy, and cultural

the R2 is relatively high. The cultural index results reveal that

assimilation is taking place slowly. The significantly positive

cultural problems increase with individualism, collectivism,

HDI and New York influences attest to the recent strides made

and the average level of human development across the coun-

by developing countries (and the UNDP innovative new meas-

tries in which IMRs do business. Place of business has been

ure of it), and economies attributable to a cosmopolitan place

identified as important. If the IMR firm is based in the cosmo-

of business.

politan New York - New Jersey area, where a variety of cultural experiences prevail, interacting in business activities

The research need equation, which addresses Hypothesis 3, is

with other countries is facilitated substantially. In fact, the

sending a profound message: ‘Think Globally; Act Locally.’ The

marginal effects of being in those areas is inverse to concerns

role of personally supervising research and selecting suppliers

4

with cultural problems .

gains significance over design methodology. The supervision of research underscores the emphasis on quality surveillance

The cultural indices performed better in combination than

in determining research needs. Design methodology varies

separately. The vectors of collectivism crossed with individu-

from culture to culture, and is not standardized. The prefer-

alism, and masculinity adjusted for femininity performed best.

ence seems to be for in-depth or door-to-door interviews, fol-

Uncertainty avoidance stands alone. After including those

lowed by focus group methodologies, then by cellular phone,

major predictor variables, it was found that power distance did

and e-mail or web surveys. The fact that the New York-New

not contribute to the explanation of the model. However, its

Jersey place of business variable is significant, but negative,

influence is present through the instrumental variable set.

subscribes to the call for understanding local cultures and hands-on-supervision.

Table 2 shows that the combined influence of COL and IND is

112

dominated by the joint gains in MAS and FEM and UA. The net

The average age variable is not a significant predictor of a

effect shows comprehension by the IMRs rather than igno-

firm’s international position. One possible explanation for this

rance regarding cultural problems. The influence of an

result is that the global economy is still young and evolving.

increase in the average age of doing business also enhances

The New York-New Jersey variable performed consistently as

4 The marginal effect of NY-NJ subareas is defined to be --Pr[Y = 1 X, NYNJ=1] -- Pr[Y = 1 X, NYNJ=0] -where Y, and New York-New Jersey are defined in the text, X = the mean value of all independent variables, and Pr refers to the Probability (Green, 817).

DD journal03.v.11

28-11-2001

19:15

Page 113


in the other equation, but here it is significant only at the 95

tor 2. In an analogous way, the results also show that the

percent level. The evolving level of a country’s economic develop-

home and focus group surveys mostly characterize Factor 1 in

ment, as measured by the HDI index, enhances the managers’

the problem in method selection, scoring 0.87 and 0.77,

international position. While none of the cultural index vari-

respectively. The results for both the problem and usage sides

ables alone explained the managers’ position significantly,

underscore the personal over the impersonal approach in

their combined effect, which is dominated by the negative influ-

method selection. The absence of a telephone network is

ence of MAS-FEM and UA indices, is a significant influence.

probably a key factor in the weak performance of the phone medium, making it impossible for random digit dialing sur-

Method consideration

veys, for instance, although cell phones may have a counter-

It is generally believed that the ‘bang per buck’ for media dif-

acting influence.

fers depending on the level of development of the country. Therefore, we should expect to find differences in method

Conclusions

effectiveness. Our survey collected data from mail, telephone,

This paper validates social scientists’ hypothesis that cultural

focus group, desk, home, and street media for the respon-

phenomena in international marketing can be explained by

dents across the countries in which they do business. We first

traditional cultural indices such as individualism, collectivism,

reduced the data to a few manageable indicators using factor

masculinity, femininity, power distance, and uncertainty avoid-

analysis. The results are in Table 3 below, which shows that

ance. We found all cultural coefficients to be significant, with

the two extracted factors explained over 60 percent of the

four out of six significant at the 99 percent level. Among

variance in the two categories of methods, usage and prob-

other things, the model attests to an evolutionary approach

lem, encountered by the IMR firms. We used the correlation

regarding the types of product and research needed in the

among the variables to group their common characteristics,

global economy. The traditional product cycle chain (daily con-

and invoked the varimax rotation technique to improve the fit.

sumer product, consumer services, high-tech products), and the media preference order (in-depth interviews, focus

The factor results of Table 3 indicate that the first factor in the

groups, cellular phones, e-mail, the web) are significantly

usage category is heavily loaded on desk and street inter-

underscored.

views, scoring 0.88 and 0.85, respectively. On the other hand, focus group and home interviews are related most strongly to

We found that a high level of Human Development Index (HDI)

the second factor, scoring 0.87 and 0.83, respectively. If we

and a cosmopolitan location alleviate international research

were to name these two factors, the ‘personal’ approach to

problems. Cultural problems decrease as the average age of

method selection would be a more suitable label for Factor 1,

business experience increases.

and the ‘impersonal’ approach would be most suitable for Fac-

Usage of Method

Problems with Method

Media

Factor 1

Factor 2

Common

Factor 1

Factor 2

Common

Mail Phone Focus Desk Home Street % Var:

0.55 0.55 0.13 0.88 -0.15 0.85 0.36

0.09 -0.07 0.87 -0.22 0.83 0.10 0.25

0.31 0.31 0.78 0.82 0.70 0.73 0.61

0.36 0.74 0.77 -0.08 0.87 0.71 0.42

0.32 -0.09 0.40 0.92 -0.21 0.30 0.21

0.23 0.56 0.75 0.85 0.79 0.59 0.63

Table 3: Method factors usage vs. problems Source: Estimated by authors. Common = commonality. Usage = number of countries in which a medium is used. Problem = the average score across countries for the medium.

113

DD journal03.v.11

28-11-2001

19:15

Page 114


The overall results suggest that marketing research in the rel-

Appendix A: Survey design and model

atively young global economy is advancing in a nomological manner. IMR managers are proceeding step-by-step in their

■ Survey design

understanding of culture, products, needs, and international

An accurate sample size for international market research has

positioning. In that process, steps by the United Nations

been a challenge to determine1. The structure of the target

Development Program to formulate more accurate indices,

population, according to the American Marketing Association

such as the HDI, can contribute to the comprehension of cul-

(AMA), reveals that 15 of the top U.S. firms involved in mar-

tural barriers.

keting research account for 67 percent of revenues in 19972. The target population is further stratified as to user and

References • • •

• • • • • • • • • •

• • • • • •

provider. Our study is limited to the domain of the former group.

Clark, T., 1990, ‘International Marketing and National Character: A Review and Proposal for an Integrative Theory,’ Journal of Marketing, October, 66-79. Dunn, T., F., B. Hisiger, and T. McLaughlin, 1998 ARF\AMA Marketing Research Industry Survey, May, Available on the Internet. Durkheim, E., Le Suicide, cited in Robert J. Shiller, ‘Human Behavior and the Efficiency of the Financial System’, Handbook of Macroeconomics, ed. John B. Taylor and Michael Woodford. Forthcoming. Greene, W. H., 2000, Econometric Analysis, 4th edition, (Englewood Cliffs, NJ: Prentice-Hall). Green, P. E., and D. S. Tull, Research for Marketing Decisions, 4th edition, (Englewood Cliffs, NJ: Prentice-Hall, 1978). Hannerz, U., ‘Cosmopolitans and Locals in World Culture,’ Theory, Culture and Society, v. 7, 237-51. Cited in Shiller op. cit. Harrod, R., and D.C. Hague, International Trade Theory in a Developing World (London: Macmillan Co., 1964). Higgins, B., 1968, Economic Development (New York: W. W. Norton Company) Hofstede, S., 1980, Culture’s Consequences: International Differences in WorkRelated Values (Beverly Hills: Sage Publications). Kluckholm, F. R., and F. L. Strodtbeck, 1961, Variation in Value Orientations (Westport: Greenwood Press). Lazear, E. P., 1995, ‘Culture and Language’, NBER Working Paper Series, Working Paper 5249, (September). Meier, G. M., 1995, Leading Issues in Economic Development, Sixth edition, (New York: Oxford University Press,). Moorman, C., G. Zaltman, and R. Deshpande, 1992, ‘ Relationships Between Providers and Users of Market Research: The Dynamics of Trust Within and Between Organizations,’ Journal of Marketing Research, 19, August, 314-328. Myers, J. H. 1976, ‘Benefit Structure Analysis: A New Tool for Product Planning,’ Journal of Marketing, 40, 23-32. Nakata, C. and K. Shivakumar, 1996, ‘National Culture and New Product Development: An Integrative Review,’ Journal of Marketing, 60, 61-72. Roth, M. S., 1995, ‘The Effects of Culture and Socioeconomics on the Performance of Global Brand Image Strategies,’ Journal of Marketing Research, 22, 163-175. Steffle, V., 1971, New Products and New Enterprises: A Report on an Experiment in Applied Social Science (Irvine: School of Social Science, University of California) Usunier, J. C., 1993, International Marketing: A Culture Approach (Englewood Cliffs, NJ: Prentice-Hall). Williams, W. H., 1978, ‘How Bad Can ‘Good’ Data Really Be?’ The American Statistician, 32, No. 2.

Although we focus on cultural activities, the response rate in our survey is similar to that obtained by the ARF/AMA3. We obtained 13 completed responses in the New York-New Jersey area alone, and another 13 from the rest of the U.S. The sample also has an unintended valuable characteristic; it contains one response from each of the first four deciles of the Fortune 500 most recent ranking of Multinational Corporations (MNCs). The 26 responses obtained are certainly within the domain of a sound pilot study. Further, the sample size makes simulation research possible. The combined sample, which totaled 26 in this study, does not rule out the fact that some significant statistical conclusions can be drawn about the population parameters. The market-provider characteristics of the study are varied. Table 1 lists the background of the respondents for the stratified New York-New Jersey area. Our decision to speak with managers rather than researchers maximizes the effort of obtained normative information that, for the most part, characterizes cultural phenomena. According to Moorman et al. (1993), ‘Managers tend to process information more intuitively, employ heuristics that focus on specific performance indicators, use informal and interactive processing methods. Researchers, in contrast, prefer impersonal analytical models, process data more exhaustively to develop a consistent theoretical structure.’ The samples for the other areas also display similar characteristics.

1

It is well-known for its selection bias; i.e., if m respondents are selected, and r responses are required, then E(realized sample=n)=

m

Σ ri < m, and E(n)=mE(ri ) (Williams, 61)

i=1

114

2 A.C. Nielsen Corp ranked number one with U.S.$1.39 billion, of which 77.7 percent is from outside the U.S. (Marketing News, 32, No. 12, June 8, 1998). 3 The 1998 ARF/AMA tracking study surveyed 43 market user research firms in the U.S. The response rate was remarkably low, as only 13 percent responded. Based on this percentage of responses, a response of about 34 was needed for a 5 percent error. A response of 13 in the New York–New Jersey area of our study widened the

error interval to 15 percent, which is still smaller than the ARF/AMA error of about 37 percent. Its survey of market research directors was more successful, with a 50 percent response out of a sample of 85. Because the response rate was low, the ARF/AMA decided to have a brief follow-up question to key questions, of which they were able to obtain a 29 percent total response, which was combined with their original study. The study did not stratify for geographic concentration of user firms even though the New York-New Jersey area had a concentration of IMR firms. A national cluster study of Standard & Poor’s DRI for the Bureau of Labor Statistics indicated such a concentration. Another advantage of such stratification is convenience [Green and Tull, (1978)].

DD journal03.v.11

28-11-2001

19:15

Page 115


1. Marketing Research Director

8. IMR Manager

2. IMR Manager

9. Risk Manager

3. General Manager

10. International Sales Manager

4. Business Development

11. International Marketing Manager

In summary, our sample design targets a smaller-than-tradi-

5. International Development

12. Operation Manager

tional universe of the IMR population. Compared with the

6. General Manager

13. Global Research Director

recent ARF/AMA study, our study is first within the users of

7. Product Line Manager

IMR sample points; i.e. from the 43rd and not 85 sample

Table 1

points. Second, our universe is for firms that engage solely in

We may postulate linear relationships between the diversifi-

IMR activities. Third, we have stratified for the geographic

cation of culture and its integration. Diversity refers to such

area of most concentration of IMR firms. Considering the

items as the number of IMR functions (DM, SS, SR, IR) or the

small universe, the value of the information provided, and the

IMRs technological product responsibilities (CP, CS, IP, IS) that

expected low response rate evidenced by the ARF/AMA study,

the managers or firms embrace. Integration refers to the sig-

our overall response of 26 managers appears reasonable for

nificant linkages these functions and responsibilities have on

statistical analysis.

the research needs (RN) and the overall product responsibility (AP), respectively. We may also postulate a macroeconom-

■ Model

ic dimension of culture that looks at how the IMR manager’s

The model we investigate will explain and predict how MNCs

geographic responsibility (GEOWW), experience (AGE), specif-

doing marketing research in the global economy deal with cul-

ic office location (NY), and development trends (HDI) relate to

tural phenomena. The cultural phase of the model we investi-

its international position (INTL).

gate revolves around the works of Hofstede and others mentioned in the Introduction. Indices for cultural attitudes are set

We may specialize an equilibrium value of cultural diversity

side-by-side with growth and productivity initiatives. The

(Dcul) to be consistent with some level of centrality or inte-

information-seekers investigate a number of methods, and

gration (Ccul). Assuming that actual and expected diversity

scout the U.S. and worldwide domains to provide the least

(Dcul*) are achieved, then we can represent a dynamic linear

cost information to interpret and to prepare reports for their

relationship as: Dcul = Dcul* = a + b Ccul.

clients. Their cumulative knowledge is constrained by their years of experience and by their business location, which may

Modeling Lazear (1995), we may define bilateral gains from

be spread across several countries with a variety of cultures

trade. Assuming a common culture, R1 = the proportion of indi-

and in different stages of economic development.

viduals belonging to country 1 (p1) times the value of the trade in a bilateral situation (2). Similarly, R2 =

2p2 for country 2.

In symbolic form, we can characterize a country’s attempt at

Over time (T), the cost of assimilating into a new culture would

differentiation across cultural barriers (Y) by the following dif-

be C1=T2p1 for country 1, and C2=T2p2 for country 2, so that

ferential equation and associated initial conditions (Appendix

gains may be defined as 2(1-p1) for country 1, and similarly for

A provides a full description of the variable):

country 2.

D n Y = k (C U L -- H D I )

. . . . . . . . . . . . . . . . . . . . . . .Eq1

Returns to a firm can now be conditioned on the information

CUL = c(MAS-FEM, COL*IND,UA,PD) . . . . . . . . . . . . . . . . .Eq2

provided by the IMR, Σ=(T1, T2) for countries 1 and 2. As a

HDI = Given by the UNDP’s Human

country diversifies over time by assimilating into another

Development Index (HDI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Eq3

country’s culture, we expect its gains to be positive, i.e.

A1(Country 1|T1)= R1-C1=2(1-p1) - T2p2 >0. A similar equation Initial Conditions:

can be defined for country 2. In such a state of the global

Y(CP, CS, IP, IS, AGE, NY) = AP . . . . . . . . . . . . . . . . . . . . .Eq4

economy, we would expect the development (HDI) and cultural

Y(DM, SS, SR, IR, AGE, NY) = RN . . . . . . . . . . . . . . . . . . . .Eq5

(CUL) variables to be harmonious and displaying stable relationships over time.

115

DD journal03.v.11

28-11-2001

19:15

Page 116


Appendix B: data description Age10+ Age35 Age610 Agele3 AP COL CP CS DM FEM GEOWW HDI

= = = = = = = = = = = =

Experience of over 10 years Experience of 3-5 years Experience of 6-10 years Experience of less than three years All product responsibility Collectivism Consumer product Consumer services Design methodology Femininity World-wide geographic responsibility Human development Index

IND INTL IP IR IS MAS N NY PDI RN SR SS UA

= = = = = = = = = = = = =

Individualism International research manager Industrial product Interpret results Industrial services Masculinity The nth derivative A dummy variable for the NY-NJ areas Power distance index Research need Supervise research personally Select suppliers Uncertainty avoidance

Source: Authors’ survey

Appendix C: Criteria for cultural indices Construct

Variables

1. Individualism

I.2. I.3.

Supplier’s motivation to get the product finished correctly Supplier’s understanding of your research need

2. Collectivism

C.1. C.2. C.3. C.4. C.5. C.6.

Communication with supplier Developing representative samples Abilities of moderators or interviewers Interpretation of results Translation of research instruments Governmental regulation

3. Power Distance

P.1. P.2. P.3. P.4. P.5. P.6. P.7. P.8.

Language/translation Unfamiliarity with research techniques Unwillingness to respond Giving the expected response Understanding the rating scales Functional equivalence Conceptual equivalence Taboos against discussion of certain subjects

4. Masculinity

M.1. Adapted techniques for maximum respondent comfort in research technique (RT). M.2. Adapted techniques for maximum respondent comfort in respondent-related problems (RRP).

5. Femininity

F.1. F.2. F.3. F.4.

Lengthened scheduled in RT. Developed personal relationships in RT. Lengthened schedule in RRT. Developed personal relationships in RRT.

6. Uncertainty Avoidance

U. 1. U.2. U.3. U.4. U.5. U.6. U.7. U.8.

More selective recruiting of respondents: RT. Reworded discussion guides for questionnaires: RT Listened more carefully to in-country suppliers of consultants: RT Counteracted research bias through training: RT. More selective recruiting of respondents: RRP. Reworded discussions guides to in-country suppliers of consultants: RRP. Listened more carefully to in-country suppliers of consultants: RRP. Counteracted research bias through training: RRP.

Source: Authors’ survey

116 - The


DD journal03.v.11

28-11-2001

19:15

Page 117


Shahin Shojai

Liberating human capital: The search for the new wave of liquidity

Director of Strategic Research, Capco

Peter Gray Principal, Futurestep, a Korn/Ferry company

Charlie Keeling Partner, Capco

Samuel Wang Managing Principal, Capco

Abstract For most of our history, human capital was viewed as nothing more than a factor input in our analysis of economic development. It was judged to be no different from other factor inputs, such as land. This view of our world has now changed and many have come to recognize that it is in fact human capital that makes up most of a company's market value. In response, most companies have created departments that focus on nurturing and developing this highly valuable, yet intangible, asset. The technological revolution, with its focus on intellectual capital has further helped our understanding and has shifted the power base from buyers of human capital to its providers. In this paper, we look at how this shift will change the dynamics of the employment market and impact the development of the global economy.

117

DD journal03.v.11

28-11-2001

19:15

Page 118


Introduction

Hence, a major proportion of an organization’s valuation is

The contribution that human capital makes towards the devel-

rooted within the people that make up the entity.

opment of the global economy had not been fully recognized until the beginning of this century. Human capital was simply

As more people have become aware of this fact, power has

viewed as another source of factor input and it was assumed

shifted from those that employ human capital to those that

that abundance of labor, similar to other natural resources,

own it. Individuals have come to recognize that the knowledge

simply helped one country produce more labor-intensive

they own has a value and that they should demand compen-

products than others. In other words, abundance of labor was

sation that reflects that value.

in no way different to other factor inputs, such as land or textiles. With this view of the world, it was very difficult to explain

The growing recognition of the importance of human capital

why the U.S., with an abundance of labor, produced more cap-

as a factor input within an industrial organization, and the

ital-intensive products than labor-intensive ones.

economy as a whole, coincided with the Internet revolution, which was also accompanied by a major shift in power from

It was not until the beginning of the last century that labor

the large organizations to the individuals1. Suppliers of human

economists were able to explain this phenomenon. Eli

capital, workers, recognized they could demand the same

Heckscher and Bertil Ohlin explained that the U.S. is able to

level of satisfaction from their jobs as they currently do from

produce superior capital-intensive goods, because its labor is

the goods and services they buy. The Internet has allowed

simply acting as a conduit for the capital that is invested in it.

individuals to demand best in class and the ultimate experi-

In other words, economists found no link between the abundance

ence from organizations that aim to satisfy their needs.

of labor and production of capital-intensive goods because they

Human capital providers could, in the same vein, demand that

failed to account for the capital invested in U.S. workers.

employers provide them with a unique experience and a compensation that is commensurate with their talents.

Even though human capital became recognized as an asset in its own right, the fact that it is intangible made it very hard to

We believe that this shift in power will continue and suggest

quantify. As a result, the contributions it made to the global

that new disruptive technologies will further exacerbate this

economy were largely ignored in most scientific studies.

transition. These new technologies will help create global market places where individuals can compete with one another

It is only recently that attempts have been made to identify

and can demand that employers do the same. Through such a

the contribution of human capital to the underlying valuations

mechanism, individuals will be able to release their inherent

of major corporations. During the industrial revolution, work-

value much more efficiently.

ers were only deemed necessary to monitor the actions of the huge industrial machines that had replaced them. The world

This paper will discuss how these technologies will facilitate

was too focused on automating human processes and not so

the liberation of human capital assets and assess what the

much on the individuals that managed them.

necessary changes to the current system are to make this ambition a reality.

This trend was reversed in the 1980s, when the contribution of manufacturing sectors. As this gap grew, so did the impor-

How can new technologies help value liberation?

tance of the factor inputs that made up the services indus-

Though human capital has become recognized as an asset,

tries, human capital. Scholars realized that even though

the fact that it is intangible has made it very difficult to create

human capital is intangible, it drives the tangible assets.

a mechanism that can efficiently release its value. For one

the services sectors of the U.S. economy surpassed that of the

118

1

Ballester et al. (1999) find that 16% of labor-related costs incurred by companies is considered by the markets as investments in human capital. They also find that human capital assets make up 5% of a firm’s market value and explain 15% of the difference between the market value of a firm and its book value. Although these figures illustrate that markets have as yet not learned how to fully account for the true contributions of human capital towards the overall value of organization, it

does illustrate that they are beginning to recognize its importance. [Ballester, M., J. Livnat, and N. Sinha, 1999, ‘Labor Costs and Investments in Human Capital.’ Working paper, New York University]

DD journal03.v.11

28-11-2001

19:15

Page 119


thing, our inability to identify the constituent elements of

capital. This can be achieved through a better understanding

human capital makes it difficult to compare the capabilities of

of how employers value employees’ different traits. Further-

one person vis-a-vis another. It is also very hard to separate

more, by creating a highly competitive and efficient worldwide

human capital into its constituent elements and price them.

market for human capital, basic supply and demand will dictate the correct price. From the employer’s perspective, an

Previous attempts at creating proxies for comparing human

important determinant of the correct cost of human capital is

capital, such as aptitude and intellectual quotient tests, have

the cost of recruiting. As fluidity and flexibility of the market

been of limited value. Even if the proxies are correct, highly

increases, the costs associated with recruiting labor shift from

localized labor markets make the process quite ineffective.

being fixed, as they currently are, to variable. This shift could

Consequently, better proxies are necessary in order to help in

have significant implications for a company’s ability to meet

the value liberation process. In order to facilitate the value lib-

its optimal return on capital objective, since costs could be

eration process, four steps are necessary.

varied with significantly reduced friction.

First, even today’s highly liquid assets are being traded within

Finally, human capital has as yet not been recognized as a

inefficient market places. For instance, securities are cleared

financial asset. Many organizations are beginning to place a

and settled many days after they have been transacted,

very high value on the happiness of their employees, but they

removing billions of dollars from the market during this peri-

still consider human capital as simply the individual and not

od. Transactions in human capital will be hard to undertake

what that asset is worth within a competitive market.

until the current mediums of exchange become significantly more efficient.

New technologies can help facilitate this value liberation process by creating new mediums of exchange. These

Second, the accuracy of information about human capital and

exchanges help increase the transparency within the human

the speed with which it is disseminated must be substantially

capital market, which will invariably result in increased

increased. Similarly, the speed with which the individuals can

salaries, as has been recently demonstrated in the sporting

monetize their human capital should also be increased. Cur-

world2. But how valuable would such an exchange be to com-

rently, individuals are able to receive money only at the point

panies that aim to recruit full-time personnel. We are of the

of sale. We believe that they should also be able to receive

opinion that the benefits of such a network are quite limited

money for potential future revenues that could be derived

for these organizations, unless they take advantage of the

over time. This process, known as securitization, has been

benefits of telecommuting3.

prevalent among major financial institutions for some time and individuals should be able to replicate it. Through securi-

The true benefactors of the Internet revolution and the sub-

tizing future earnings potential an individual would be able to

sequent creation of a highly efficient market for human capi-

value their potential earnings for a number of years and sell

tal, will be those individuals and organizations that wish to

that as a security to investors. That individual would be able

recruit people on a contract-by-contract basis. These groups

to access the capital injection from the investors immediately

can use this new medium of exchange to ensure that both

and the investors will be paid directly by institutions who

suppliers and buyers of human capital are fully aware of their

make use of the employee’s human capital.

existence and capabilities. The means by which this information is communicated will, however, determine the success

Third, the quality of valuation needs to be significantly

they have in attracting the other side of the transaction. It is

improved for both liquid and illiquid assets, such as human

for this reason that we will focus on this group in this paper.

2 Currently, employers keep information about salaries highly confidential. As this information becomes more widely available, then employees will be in a stronger negotiating position. This proposition was largely substantiated by the tremendous increase in salaries that athletes received once information about their income became publicly available. 3 The most important benefits of telecommuting are: Increase in employee productivity; decrease in absenteeism [by 63% according to figures released by International Telework Association & Council (ITAC)]; savings in real estate and overhead

costs up to 60% according to AT&T released figures; improved retention of staff; savings in staff travel time and expense; and greater flexibility for employees to manage their time. Employers are, however, concerned about certain aspects of telecommuting. These include: fraud, copyright infringements, lack of control over how trade secrets are kept, employer’s responsibility for how they are represented by the telecommuter, their lack of control over the actions of the telecommuter, and sabotage. According to data released by ITAC more than 23 million U.S. workers telecommuted in 2000, up from 19.6 million in 1999.

119

DD journal03.v.11

28-11-2001

19:15

Page 120


Parameters used by employers Is the individual suitably experienced in our industry/ sub-industry? For example: • Energy & utilities/ Electrical power generation • Consumer products/apparel • High technology/business software publishing • Etc.

Industry

To get a better understanding of the parameters employers look for in a candidate, employees should become aware of the four-step process that is used to select the most suitable candidates. Although these parameters are usually used for long-term employees, they can also be a very good starting point for contractors as well. One of the parameters that employers look for in an employee is industry knowledge. While it might be difficult to generalize about knowledge of a given industry across markets, the

Figure 1: Industry fit

number of years worked in that industry could be one of the parameters used to differentiate one candidate from another. It might also be possible to obtain a weighted average of an

Industry

Function

Is the individual suitably experienced in the function/ sub-function we are hiring for? For example:

individual’s knowledge of an industry by also evaluating relat-

• Accounting/Controller • Marketing/Brand management • Human resources/ Compensation & benefits • Etc.

The second important attribute of a potential employee is the

Figure 2: Functional fit

ed factors such as the country in which the individual has gained their experiences.

ability to operate within a specific function. While most tasks can fall within very large categorizations, such as marketing and finance, the new economy businesses have made this method of categorization outdated. As the types of functions for different posts become more heterogeneous, due to the technological revolution, this part of the selection process

It is crucial that participants within these transactions have

becomes even harder. It is therefore necessary to ensure that

access to very high quality information about the other side of

any market structure that is created is flexible enough to

the transaction. This becomes especially important as the use

incorporate these changing employment characteristics4.

of off-site staff becomes easier and more prevalent because of advanced technologies and broadening bandwidth. But

The third important attribute considered when hiring a candi-

what information would the suppliers of capital need to pro-

date is their rank or level. Creating benchmarks for people’s

vide in order to be attractive to the employers.

capabilities is very hard and it becomes even more difficult when people have accumulated experiences within similar

Understanding what recruiters look for should help in the

fields, in different markets, and at different stages of the

process of separating the differing elements of human capital

product life cycle. It is essential that some universally agreed

and subsequently pricing them. Using the many years of

parameters be established in order to aid in this process. The

experience accrued at Korn/Ferry, we have been able to iden-

parameters need to take into account not only the candidate’s

tify a four-step recruiting evaluation process. We aim to use

past experiences, but also their capability to evolve within

these parameters to establish some guidelines for creating an

their posts and the potential contributions they can make to

online system that provides a more accurate valuation of

the future development of the business.

human capital.

120

4 In the U.S., Bureau of Labor Statistics (BLS) has recognized the difficulties that new working structures introduce within their calculations of labor costs and productivity. They have had to make changes to how they measure labor costs many times during the past century. For example, in the 1950’s they began providing data for more specialized jobs, in the 1970’s they started accounting for

employee benefits (such as pension and healthcare contributions), and in the 1990’s they included stock option plans within their data. Sooner or later, they might start including the savings generated from telecommuting within their costs and productivity calculations.

DD journal03.v.11

28-11-2001

19:15

Page 121


Additionally, by using contract employees from overseas, Is the individual at the appropriate level relative to our hiring need? For example: Level

Industry

Function

• Managerial experience fits need • Compensation history and expectations match • Track record of dealing succesfully with the challenges of this job opening • Etc.

although the same logic would hold for local workers, employers can avoid the need to invest in training and personal development. Contract employees should be able to demonstrate a very good understanding of the company’s business in order to get the hired. But how can an employee get any training if those that employ them are not willing to make the investment? This is an area where an agent could become very important to a contract employee. An agent can and should take the responsibility for ensuring that the employees they represent are trained to the standards employers demand.

Figure 3: Level fit

Level

Function

Industry Geography

• Is the individual located a reasonable distance from our workplace?

It is very important for employers to ensure that they hire

• If not: is the individual to relocate? Are we?

bureaucratic or hierarchical characteristics within an organi-

people who are able to operate within an organization’s culture. Employers will find it hard to introduce a person who has

• Is telecommuting an option to consider? Level

• Does the individual's appetite for travel match the travel demands of the position? Figure 4: Geography fit

This is the universe of candidates for a given position opening

Industry

Function

Although geography should not play a big role in an employer’s decision-making process, in many cases it does. Selecting

Geography

an overseas employee usually means delays related to the employee’s work permit documents. Furthermore, given the huge costs of staff relocation and the significant period of time it takes to recoup this cost, employers are often reluctant to hire candidates from overseas. Given the growing fluidity of Level

the labor markets, most employers find it hard to keep an employee long enough to justify this kind of investment. This is not, however, a big issue when employees are hired on a contract-by-contract basis. In this case, the employee could be based almost anywhere in the world and deliver the product

Industry

Cultural assessment

via a secured network. With the potential bandwidth available in the very near future through initiatives such as the global

Geography

grid, it would be very easy for employees to be located almost

• Decision-making style • Interpersonal style • Career motivations

anywhere and operate as if they are based in the headquarters of the employer.

Within this universe of candidates, employers look for a strong fit between the individual's work style and the corporate culture. Function For example:

Figure 5: Cultural assessment fit

121

DD journal03.v.11

28-11-2001

19:15

Page 122


hope that after going through the aforementioned process,

Meeting the needs of the contract employee

they select the most suitable candidates.

Unlike the typical long-term, or permanent, employee who

zation that has a very flat and open structure. The employers

relies on the recruitment consultants to simply make the An important question that employers need to ask them-

introductions with an interested employer, tomorrow’s highly

selves, however, is whether the aforementioned process can

affluent contract employees will demand a much higher qual-

also be applied in the future. On the one hand, employees have

ity of service than simple introductions. As the recent evi-

become empowered as a result of the technological revolu-

dence from the financial markets has illustrated, as the com-

tion. They demand a holistic package and need a greater num-

plexity of products increase, so does the demand for high

ber of objectives to be met. For example, during the late

quality advice. Many predicted the demise of financial inter-

1990’s, when the Internet revolution was in full-swing, employ-

mediaries when the Internet became a popular tool for invest-

ees demanded other forms of compensation than just finan-

ing in the stock markets. Recent history has illustrated, how-

cial, such as more flexible working hours and better working

ever, that new technologies simply provide another channel

conditions. Tomorrow’s employers will find it even harder to

for communication between providers of high quality advice

identify the parameters that their heterogeneous group of

and their clients. Similarly, within the human capital market,

employees will demand, since many will not even be located in

information and advice will be key.

the headquarters. On the other hand if, as many predict, future employees elect to telecommute, the question of cul-

Given the tremendous attraction of telecommuting, aided by

ture becomes less relevant. If the employer is able to decom-

the ever-increasing technological bandwidth, agents of the

pose the task accurately enough so that they can allocate

providers of human capital need to arm themselves with dif-

each part to a different person, then the cultural propensity of

ferent skill sets than they currently possess.

the employee becomes largely redundant. The growing trend towards telecommuting could result in significant changes in

First, as the number of people who telecommute increases, so

employment. An increasing number of people will sell all of

will the number of very high quality providers. Members of

their time to employers who contract them on a short-term

this group require their intermediaries to act more like agents

basis. Alternatively, they can work full-time for an employer

than brokers. They require their agents to be fully aware of

and also supply part of their leisure time to contractors. The

their capabilities and to try their hardest to find opportunities

implications of such moves would be that a great number of

that best meet their demands. High profile executives of

employees would demand more information about their

tomorrow will be similar to today’s movie stars and will

employers. A contract employee would wish to have as much

demand the same quality of service.

information about the organization that is contracting their services as today’s employers demand about their employees.

Second, employers will need to rely on the expertise of these agents to ensure that the people they represent are in fact

Additionally, tomorrow’s contract workers will need to find

capable of completing the required task. This capability

more interesting ways to supply their services than is avail-

becomes much more important when one considers that

able to them today. In the next section, we will discuss the

human capital exchanges would be open to people based

attributes that tomorrow’s agents will need to incorporate

almost anywhere in the world. As a result, human capital

within their systems to meet the needs of the more demand-

agents of tomorrow need to be truly international in their

ing and valuable providers of human capital.

scope and in all likelihood need to be focused in specific sectors, if not sub-sectors. They need to be truly proficient in the sectors they cover and be able to demonstrate a deep domain

122

DD journal03.v.11

28-11-2001

19:15

Page 123


expertise to both the suppliers and buyers of human capital.

butions. Consequently, they will also need advice on where to invest their pension funds. The agents might therefore be

The ability of the agents to represent their clients becomes

asked to take on the role of a financial advisor as well.

crucial as the number of telecommuters increases. This is because in many organizations there is a deep-rooted belief

This new style of highly proficient agent will therefore not

that contract workers are somehow inferior to those who take

only represent their clients during employment negotiations

up full-time employment. This could be associated with the

and ensure that they get the best possible deals from employ-

fact that contract employees do not need to feel loyalty

ers, they will also provide them with job security for the

towards those that employ them, whereas full-time employees

future.

do. It could also be related to the perception that if someone contract. This view is obviously overlooking the preference of

The economic impact of this new wave of liquidity

the providers of human capital to take on contracts when and

Access to internationally diverse high-quality staff could be

where they wish.

very beneficial to employers. By having access to a much larg-

is good enough they would more likely be offered a full-time

er pool of suitable candidates, employers might be able to One of the world’s biggest professional services firms tried to

reduce the salaries they pay their employees. This has some

overcome this inherent suspicion of contract workers by intro-

important economic and regulatory implications.

ducing a points accumulation scheme, similar to air miles. The scheme worked on the following basis. Depending on the

First, as competition intensifies, compensation levels will con-

amount of work a contract employee completed, they would

verge between those based within developed and developing

receive points. The number of points they collected would

countries. Whether the levels of compensation will actually

determine the level they reached. They would start at the low-

rise or fall depends on the degree to which competition is

5

est level, Bronze, and could reach platinum . Those that

open. Recent evidence from high-tech industries have illus-

reached the highest level would receive substantially higher

trated that as the number of competitors has increased, the

compensation and recognition than those at the lower levels.

price has fallen6. The experience in the labor markets could

In this way, full-time employees had a more tangible way of

also be similar. If employees from all parts of the world can

determining the contributions of their part-time counterparts.

compete for the same job, then the supply of labor goes up and prices should fall.

Third, contract workers might demand greater security from their jobs and might demand that their agents treat them like

Second, western economies that are looking to recruit young

consultants within a professional services firm. This would

labor from the east to diffuse their pension time bomb might

mean that during periods that they are not working, referred

be able to do so without the need to import them physically.

to as ‘sitting on the beach’ within professional services firms,

This pension time bomb has been ticking for several decades

they receive some sort of compensation from their agents.

and this may well form a viable part of the solution. But what

This type of agreement would provide the contract employee

does this mean for countries that own the skilled labor force?

with greater security and would help ensure that the agent is

Does this trend mean that their skill-sets remain within their

more incentivised to find work for its client. As the employee’s

home country, or will employees who no longer have

earnings increase, so will their pension and insurance contri-

geographical limitations locate to countries that have better

5 The scheme would work on the following basis. Based on the contributions made by a contract employee, they would receive points that would get them to a specific level. The more points they received, the higher the level would become. For example, the Bronze level might mean that the contractor had completed an assignment successfully to time, quality and budget parameters and as such was recognized as an approved contractor. The Silver level might be for someone who had completed 3 assignments successfully, or an equivalent number of days to allow for the variation in assignment type and length. In addition to their certification they could also receive 5 days training free of charge from the employing organization. The Gold level might be those having completed 7 assignments successfully, or the equivalent number of days. In addition to the silver tier they

could receive benefits like medical insurance, life assurance, pensions advice, car allowances etc which they might otherwise find difficult to but in the open market at competitive prices for them as singletons. The Platinum level might be for the 10+ assignment people. In addition to the gold tier benefits they might be allowed to charge a premium for their services. 6 Please note that this is referring to price of hi-tech equipment and not salaries. We are aware that salaries within the technology sector increased dramatically in the 1990’s. That can be attributed to the tremendous growth the industry experienced during the technological revolution and not necessarily with where the providers of human capital were born.

123

DD journal03.v.11

28-11-2001

19:15

Page 124


climates? Countries like Canada, who find that a major part of

In addition, telecommuting will increase the likelihood of tax

their skilled labor force is relocating to the south, should be

evasion. Tax authorities will find it very hard to monitor where

very interested in identifying the implications of such a trend

their citizens are earning their salaries from to assess how

on their skilled labor force.

much tax they should pay7.

According to official data released by StatCan (The Canadian

As the number of people who telecommute increases, the

government’s official source for statistics) the average num-

benefits of being headquartered within a financial center

ber of scientists and engineers migrating from Canada to the

diminish. Many argue that over time, technology will make it

U.S. is equal to around 20% of all graduates in these disci-

possible even to replace face-to-face contacts, and that most,

plines. According to the same source, the 27,500 Canadians

if not all, communications will take place over cables. Gilder

who moved to the U.S. in 1996 had paid U.S.$226 million in

(19958) even proposes that cities will sooner or later die and

federal and provincial taxes the year before.

that ‘cities are leftover baggage from the industrial era.’ Gordon and Richardson (19979) and Negroponte (199510) agree

In total, 601,000 Canadians currently reside in the U.S. Using

with Gilder’s view and suggest that over time, office locations

the salary breakdowns available for the year 1996, it would

will become irrelevant and that cities, as we know them today,

mean that they are earning approximately U.S.$30 billion a

will decentralize and not exist in their current form for much

year in the U.S. Additionally, the government of Canada would

longer. Gaspar and Glaeser (199611) do not agree with this

have spent over U.S.$4 billion on educating the Canadians

hypothesis and propose that technology complements rather

who moved to the U.S. during the 1990’s. Combined, the

than replaces personal contact. They refer to the growing

investments made by the Canadian government in its citizens

number of business travelers as proof that technology simply

who moved to the U.S. and the loss of taxes equates to over

aids in the process of establishing face-to-face activities.

U.S.$10 billion a year. No matter which side of the argument one stands, it is very If compensation differences were the only reason for moving

hard to deny that as bandwidth increases and people become

abroad, telecommuting should help countries like Canada

able to communicate face-to-face through clear communica-

retain its skilled labor. But, if taxes are one of the main reasons

tions networks that the number of physical meetings will

for emigrating, then telecommuting will not help. In this case,

decrease. This makes the process of working offsite simpler

maybe the U.S. will also find that its most talented employees

and more attractive for those employees who either wish to

begin moving to tax havens. Telecommuting will therefore

telecommute on a contract-by-contract basis or those who

raise the same type of debate that the Internet itself has gen-

wish to telecommute on a permanent contract basis.

erated. Where should the taxes for a service provided be paid? Should an employee based out of Malaysia who is on a con-

■ The financial implications

tract with a U.S. company for 6 months pay his taxes to the

Although the liberation of human capital will impact every

U.S. government or the Malaysian government? Given that he

country and sector in the world, it is difficult to place an accu-

has not left Malaysia physically, the natural expectation would

rate number on its magnitude. It is, however, possible to deter-

be to say the latter. But what will happen to the taxes the U.S.

mine how a certain sector within a major city, like New York

government needs? If a large number of U.S. companies hire

City (NYC), can be impacted by the cost-efficiency improve-

people from overseas and do not pay the tax on their payroll

ments that telecommuting provides. It is for this reason that

to the U.S. government, then the U.S., being the world’s

we have opted to limit the scope of this study to examine how

richest country, will lose out. It would seem unlikely that the

the commercial banking and securities & commodity trading

U.S. government would sit back and let this happen.

organizations based in NYC will be impacted by a greater use of telecommuting.

124

7 Recent efforts to thwart money laundering might help governments identify the sources of funds.

8 Gilder, G., 1995, Forbes ASAP, February 27. 9 Gordon, P., and H. W. Richardson, 1997, ‘Are Compact Cities a Desirable Planning Goal?’ Journal of the American Planning Association, 63 (Winter), 1 10 Negroponte, N. 1996, Being Digital, (ed.) Alfred A. Knopf: New York 11 Gaspar, J., and E. L. Glaeser, 1996, ‘Information Technology and the Future of Cities,’ Working paper, Harvard Institute of Economic Research, Harvard University, April

DD journal03.v.11

28-11-2001

19:15

Page 125


Average salary

Cost of Cost of living living adjusted

New York, NY

$197,340

231.8

San Francisco, CA

851

employees. But the question is, will all the salaries fall towards that of St. Louis’s, the lowest, or rise to that of NYC?

$190,845

187.1

1,020

Chicago, IL

$116,817

111.3

1,050

St. Louis, MI

$67,321

97.8

688

gence towards the center rather than a move towards either

$96,858

112.5

861

extreme, causing a large number of major city dwellers to

$82,271

96.3

854

move to less expensive locations. If we assume that the over-

$74,611

97

769

all cost of living converges towards the national average of

Cleveland, OH Birmingham, AL Baltimore, MD

We believe that the most likely scenario would be a conver-

Table 1: Analysis of compensation at U.S. Security and Commodity Brokers Source: Department of Labor for salaries and Money.com for cost of living information

104, then the average salaries within cheaper cities will

To investigate the potential benefits of telecommuting on the

Although a perfect equilibrium would not be achieved, the gap

aforementioned sectors, we analyzed annual pay information

between the cheapest and the most expensive cities should

obtained from the U.S. Department of Labor’s Bureau of

decrease. We would also see a comparable change in popula-

Labor Statistics (BLS) for employees working within 7 metro-

tion density as the workforce migrates from more expensive

politan areas.

to less expensive cities.

increase and those within more expensive cities will fall.

We found that those financial executives who are based in

■ But what does this mean for value liberation?

NYC and San Francisco are paid significantly higher salaries

What it means is that not only would employees be able to

than those based within the other 5 cities, with institutions

achieve higher disposable income by moving to cheaper cities,

based in St. Louis paying the lowest amount (Table 1). Howev-

their employers could make significant savings in the salaries

er, being paid the highest salary does not necessarily mean

they pay. Based on our calculations, by reducing the salaries

that you are better off. When these salary figures are adjust-

paid in NYC and San Francisco by 20% and allowing their staff

ed for the cost of living, we find that workers based in NYC are

to move to less expensive locations, the major financial insti-

actually positioned 5th out of the 7 cities analyzed. When

tutions can double their employees’ disposable income. In

compared to Chicago, which comes first in our analysis, NYC-

fact, if they enable their staff to move to a cheaper location

based employees earn on average 20% less12.

and maintain their net disposable income, the employers could cut their staff’s salaries by 50%.

Employees should therefore take these factors into account when deciding to relocate to a city that pays a higher salary. For example, even brokers based in Birmingham, AL (not the most renowned financial center) have higher disposable incomes than those based in NYC.

■ But what does this move towards a national

average mean in terms of actual value release? In order to answer this question, we first obtained the number of people employed in the securities and commodity broking

Taking this logic to its natural extension, we can see that by

organizations, which for the year 1999 was 689,725. Out of

simply increasing the salary of an employee who works for a

this total, 166,582 were based in NYC. The salaries received by

NYC-based firm out of St. Louis by 20%, to U.S.$83,000, we

all employees within this sector were U.S.$88.8 billion, with

can provide them with the same disposable income as those

those based in the NYC earning U.S.$32.9 billion. Based on

who physically live in NYC.

these figures, we can compute that the average salary for a NYC-based securities and commodity broker is U.S.$197,000,

These findings show that if workers were allowed to decide

as compared to U.S.$107,000 for the rest of the country.

where they lived, employers could pay significantly lower salaries and still maintain the same quality of life for their

12 In fact, on an all-industries basis, NYC-based employees earn on average 4% less than the national average, when adjusted for cost of living. This is in sharp contrast to London, England, where residents change or reduce the number of sub-advisors to lower fees and pocket the difference.

If the NYC-based firms could reduce the compensation they

125

DD journal03.v.11

28-11-2001

19:15

Page 126


pay their staff by U.S.$45,000, the mid-point between what

investments in real estate.

they currently pay and the national average, they could save around U.S.$7.5 billion a year. In addition, employers could

Overall, on an all-industries basis, we find that NYC-based pri-

save U.S.$1.7 billion a year in reduced absenteeism and around

vate-sector employees earn on average 4% less than the

U.S.$1 billion a year in occupancy costs. In total, therefore,

national average, when adjusted for cost of living. This is in

even very modest benefits of telecommuting result in annual

sharp contrast to London, England, where residents earn on

savings of around U.S.$10 billion. The NPV of this figure is

average 30% more than the national average, when adjusted

U.S.$100 billion, which could be released into the U.S. econo-

for cost of living. Nevertheless, the gross salaries in London

my. Obviously this figure would be substantially bigger if

are on average 50% less than those of NYC. Should telecom-

applied to all of the U.S. cities.

muting become a viable option, it would even make sense for many London-based employees to offer their services to NYC-

Average salary

Cost of living

Cost of living adjusted

New York, NY

$124,957

231.8

539

San Francisco, CA

$78,599

187.1

420

Chicago, IL

$55,649

111.3

500

salaries by U.S.$16,600, then they could save U.S.$31 billion a

St. Louis, MI

$47,687

97.8

488

year. Keeping in mind that London is one of the most expen-

Cleveland, OH

$46,898

112.5

417

sive cities, one can appreciate the magnitude of savings that

$38,168

96.3

396

could be generated when NYC-based employers could employ

$30,689

97

316

staff from the many highly educated yet poorer countries,

Birmingham, AL Baltimore, MD

based companies. If all the NYC-based employers could bring their prices down to the mid-point of the difference between the averages of their own city and that of London, i.e. reduce

Table 2: Analysis of compensations at U.S. Commercial Banks Source: Department of Labor for salaries and Money.com for cost of living information

such as the former states of the Soviet Union.

A similar analysis for the commercial banking industry

Conclusion

illustrates that unlike the securities and commodity brokers,

In conclusion, therefore, we can state that as technological

those who work for commercial banks in NYC are substantial-

advancements increase the dynamics of the relationships

ly better off than their peers within other cities, mainly

between employees, their agents, and employers will change.

because they are paid 60% more than the second highest

There will be an even stronger power shift from buyers of

paying city, San Francisco. This means that if NYC-based com-

human capital to providers. Employees will expect the ulti-

mercial banks could bring their pay closer to the national

mate experience from their jobs, in the same way as they do

average of U.S.$40,984 they could save significantly. In fact,

from any other relationship they have. As bandwidth increas-

even if they brought their pay down to the mid-point of the

es, employees will be more likely to telecommute, putting

difference between the current level of pay and the national

greater pressure on their agents to identify the right posi-

average, they could save U.S.$42,000 a year per employee. In

tions, ensure that they are adequately trained for them, and

total, if all the NYC commercial banks could cut on average

provide the type of job security that management consultants

U.S.$42,000 per employee, they would save U.S.$2.2 billion a

receive from their employers. Employees whose services are

year. They would also save U.S.$540 million a year in reduced

in great demand will expect their agents to provide them with

absenteeism.

the same level of service that movie stars expect from theirs. The growing number of telecommuters will help companies

As a result, therefore, by simply moving the compensations

reduce the salaries they pay their employees while at the

paid by NYC commercial banks and securities & Commodity

same allowing them to maintain the same level of disposable

brokers to the mid-point between what they currently pay and

income. As the number of telecommuters increase, govern-

the national average, they could save around U.S.$10 billion a

ments will be forced to address the issue of where taxes should

year. Including the savings generated from reduced absen-

be paid, since an overseas employee might pay their taxes to

teeism associated with telecommuting, the total would be

their local government while earning their income from

U.S.$13 billion. This would mean an NPV release of

another country.

U.S.$130 billion, excluding the benefits of being able to reduce

DD journal03.v.11

28-11-2001

19:15

Page 127


Intangible asset and value-creation reporting… increasing transparency at Skandia Scott Hawkins Sustainable Synergist, Skandia

Abstract Skandia, a 145 year-old company that’s transformed itself from a regional insurance company into a global financial services company in the last 15 years, presents an interesting case study of why increasing transparency into intangible asset management and value-creation leads to better longterm value creation and human capital development.

127

DD journal03.v.11

28-11-2001

19:15

Page 128

Intangible asset and value-creation reporting… increasing transparency at Skandia

The value of intellectual capital

This need led to the company’s involvement with intellectual

For most of its existence Skandia was a traditional life insur-

capital management and reporting.

ance company. Like many industrial era insurance companies, Skandia had an integrated supply-chain that developed and

Intellectual capital is the intangible resource used, in addition

administered insurance products sold by its own sales force in

to a company’s financial capital, to produce value-added prod-

a tightly regulated local market, in Skandia’s case Sweden. The

ucts and services. Skandia breaks its intellectual capital into

company managed all the assets generated from these sales.

three main categories. There is its human capital, the knowledge and skills of its staff. There is its customer capital, the

In the mid-1980’s, as a result of changing demographic and

relationships it has with its customers and partners. And final-

political trends, Skandia dissolved its integrated supply-chain

ly there is its process capital, the software and methods the

and changed its product mix to reflect new consumer

company uses to produce value-added goods and services.

demands for investment products, which allowed the company to transform itself from an industrial era insurance compa-

Intellectual capital management is how effectively the compa-

ny to a global financial services provider.

ny is utilizing these resources to create value. For its human capital, management means focusing on attracting, retaining,

On its transformation journey, Skandia became one of the pio-

and developing its staff. For its customer capital, management

neering companies to develop new forms of communicating

means increasing the number of relationships and the quality

its stewardship of the intangible resources it uses to create

of those relationships. For its process capital, management

long-term value. Its pioneering work was driven by the fact

means continually improving the quality of these processes.

that its main resources, other than financial capital, are intan-

Many companies see these forms of management as separate

gible. The knowledge and skills of its staff enable Skandia to

activities and conduct them under labels such as HCM, TQM,

develop highly competitive financial products and services. Its

and CRM. The intellectual capital approach sees each as an

distributors, partners, and customers are the additional intan-

inter-connected part of a company’s larger intangible

gible resources Skandia uses. The ability of the staff to man-

resources.

age the relationships between independent distributors and money managers determines how well the company can deliv-

Intellectual capital reporting is the communication of man-

er its products to the investor.

agement’s efforts to improve, increase, and utilize these resources to create financial value. Its purpose is to increase

As it transformed itself, the problem Skandia faced was how to

the transparency between the company and its shareholders

better communicate, or to increase the transparency of, its

and analysts so they can better understand how the entity

management of these key intangible resources to investors

creates value on a long-term basis.

and analysts. Because traditional financial accounting and

128 - The

reporting lacked the tools and processes to adequately verify,

How intellectual capital can be reported

attest, and report the management of its intangible activities

When Skandia began looking into how companies report their

and resources, Skandia developed its own methods and tools.

intangible resources there were few examples it could look

Skandia’s concern was that if these crucial stakeholders did

towards. So it assembled a small team to develop its own

not understand the company, and how management was

approach to this issue. This work on intangible assets led to

working to continually improve it; then they might attach a

the creation of the IC Value Scheme and, starting in 1994, the

risk premium to the Skandia share, thereby making it more

publication of several ‘Supplements’ to its annual and interim

expensive to raise capital or adversely affect the share price.

report.


DD journal03.v.11

28-11-2001

19:15

Page 129


Our research into intangible assets and intellectual capital

Market value

revealed that a company’s business context was crucial to determining the value-creating potential of its intellectual capital. For example, if the company applied its intellectual

Financial capital


capital to producing automobiles its value-creating potential would be drastically altered. However, its financial capital would remain unchanged. So as a result, there were no

Human capital

attempts to have the Supplements report the financial value

Structural capital

of its intellectual capital, but rather to report the company’s success at managing its intellectual capital.

Organization capital

Customer capital

The first report attracted great interest from other stakeholders — such as academics, employees, investors, and regulators

Process capital

— as well as the shareholders. Many were interested in improv-

Innovation capital

ing their understanding of intangible assets and how they might be reported.

Intellectual property

Intangible assets

Figure 1: How intellectual capital can be reported

How intellectual capital thinking can transform internal management Having published the Supplements, the company realized that, while increasing transparency to its analysts and

The Value Scheme was its way of communicating that its

investors was important, it was even more important to

share price is made up of both financial and intellectual capi-

increase the transparency of its future value creation within

tal. It broke its intellectual capital into several components,

the company. And to help communicate and explain this con-

the primary ones being the company’s customers, employees,

cept within the company, the IC Navigator management

and processes. More importantly, it communicated the con-

model was developed.

cept that a firm’s market value is more than just its financial capital. This concept formed the basis for producing an intellectual capital report. Financial focus

The company wrote the Supplements for financial analysts; and designed them both to explain its intellectual capital management efforts and to educate the reader about the new

Customer focus

Human focus

Process focus

field of intellectual capital. Language was chosen that the financial reader could easily relate to, such as asset, property, capital, and value. These supplements were missionary, in that

Renewal & development focus

they focused on getting the analyst and investor comfortable with these new ideas; and they were exploratory as they tried

Operating environment

various ways to report the company’s intellectual capital management.

Figure 2: How intellectual capital can be reported

129

DD journal03.v.11

28-11-2001

19:15

Page 130


It was felt that too often there was little connection between

form of change process (either a management team transition

a budget and what was being done to improve the company’s

or a significant growth phase). Companies with a low score

long-term ability to create value. Unlike a budget with its focus

tended to be more established with existing business planning

on financial resource management, the Navigator asks a man-

systems or methods in place.

ager to understand how managing today’s intellectual capital affects the company’s future value creation. As a result, the

Implementing the Navigator

language used in the Navigator, while similar in subject to the

An example of the Navigator in action, and how it transforms

Value Scheme, is different in action. Instead of assets, capital,

management thinking from short-term financial results to

and property the Navigator uses ‘focus’. The choice of focus

long-term value-creation, can be seen in its application by our

was made to remind the manager that this is a management

American call center management team. This team is com-

model not a financial model.

prised of front-line, first-time managers. They average about 25 years of age and for many it’s their first management job.

With the Navigator the manager addresses the following

Before becoming managers they were often phone represen-

question: Within the context of a local operating environment,

tatives in the call center, a job where they answered incoming

what is being done to renew and develop the company’s cus-

calls from investors and brokers. The people they manage are

tomers, employees, and processes to assure long-term finan-

in an entry-level position and tend to be young people begin-

cial success? This directs the manager away from a short-

ning their careers.

term perspective of deciding what financial resources they need to meet next year’s financial objectives and towards

Beginning in the fall of 1999, this management team worked

what they need to do to achieve future value-creation.

to develop their business plan and budget for the year 2000. During a series of weekly meetings, lasting one-to-two hours

The Navigator, and its focus on renewing and developing the

each, they developed their Navigator. The process took

company’s intellectual capital, has become the standard busi-

approximately 3 months to complete, and began by asking

ness control model for all local business units. The company

‘What’s the important information you need to know to effec-

developed a software tool, Dolphin, to support its implemen-

tively run your call center?’

tation and created a global support resource to help each local unit adopt the Navigator. The global business control

The initial responses were the following:

unit, based in Stockholm, has overall responsibility for the implementation and follow-up of local Navigators.

■ The number of calls received. ■ The number of calls abandoned (a call where the caller

The implementation team developed its own internal rating

hangs up before being answered).

system to judge each unit’s progress. The rating consisted of

■ The average call queue time.

two distinct parts. The first was how well the Navigator con-

■ The assets under management of each call centre team.

cept was being used. The second was how well the Dolphin

■ The breakage incurred by each team (breakage is the

system was being used. Following the culture of decentralized

financial cost of correcting a mistake).

management, the implementation team gave greater weight to the use of the concept rather than the system.

By mapping these onto the Navigator focus area the managers realized that they were missing important information

The Navigator implementation team examined these results

about their customers, employees, or their renewal and devel-

and found that companies scoring high in both concept and

opment activities.

software implementation were likely to be involved in some

130 - The


DD journal03.v.11

28-11-2001

19:15

Page 131


Vision and objective

Critical success factors Excellent customer service

Activities

Indicators

High product knowledge

Improved and increased employee training

Customer satisfaction rating

High industry knowledge

Industry licenses

% of employees receiving training

High sales appeal

Avg. hours/employee spent in training Product knowledge rating Industry knowledge rating

Increased assets Reduced breakage

Sales appeal rating Process effectiveness

Control breakage

Automate more transactions

% of transactions automated

Ability of customers to ‘help themselves’

Increase number of IVR transactions

% of transactions available through IVR

Process efficienty

Efficiently handle call volumes

# calls Abandon rate Queue time Breakage rate

Figure 3: Skandia’s process model

The managers began to investigate what information about

As the company began to implement the Navigator, manage-

their customers and employees they needed to know in order

ment and staff quickly came to realize the value-added bene-

to effectively run their call center. To answer that question the

fit of encouraging continuing education for the staff. Employ-

managers worked with the global Navigator support unit to

ees began to take evening and weekend courses. On-line train-

develop their Process Model. The process model is a method

ing during work increased. And the companies began to

to identify and link actions to long-term value-creation.

reward these efforts at knowledge improvement by paying bonuses for attaining certifications and degrees.

The Process Model revealed that customers wanted high-quality service and that this came from employees who had high-

Navigating human capital development

levels of knowledge about our American products, the invest-

The Navigator makes transparent the linkage between human

ment industry, and customer service skills. To meet customer

capital development activities and the company’s strategic

needs, employees should spend more time acquiring the skills

and tactical needs. Within the Process Model, the strategic

they needed to satisfy their customers and better systems to

needs are the high-level drivers of long-term value-creation

process customer requests.

found in the ‘Success Factors’; while tactical needs are the operative actions and plans implemented to achieve strategic

With the Process Model in place a more complete Navigator

needs.

could be built. And the new Navigator would form the basis for budget requests and project planning.

Investing in human capital development is expensive in financial and intangible resources for both the company and the employee. Providing both with a clear and strong strategic

131

DD journal03.v.11

28-11-2001

19:15

Page 132


and financial ROI is crucial to continued investment. The Navigator process, and the increased transparency it provides, allows both groups to understand their ROI on human capital development.

■ The Navigator planning methodology, supported by software. ■ The corporate universities, tuition reimbursement programs and the Competence Account that provide the resources to implement the plan.

The increased emphasis on improving the Swedish units’ human capital had an unexpected effect. Staff began to leave the company. Because of the company’s understanding of the importance its human capital had on long-term value creation,

■ The Competence Marketplace where employees implement their competency development plan. ■ The Navigator Insight that generates employee feedback into the planning process.

not to mention the time and money spent acquiring and developing this human capital, its loss was an issue for concern.

The Employee Competence Development framework is built

Interviews with these former employees revealed that they

upon the concept of Plan-Do-Act-Check. These were renamed

were feeling ‘burned out’ from the pressure to work full-time

in-house to Plan-Allocate-Implement-Feedback.

and engage in continual learning. Many of these employees were sacrificing their home life to meet these work and devel-

A manager and an employee work together on a periodic

opment demands, leading to stress in families and individuals.

basis to plan the employee’s strategic and tactical competency development. The company allocates resources to enable

The solution was a Competence Savings Account into which

these competency development plans to be implemented. The

employees could pay part of their salary. The local company

employee implements them and generates feedback that

matched the amount paid in. In the case of employees with

influences the subsequent round of competency development

only minimal education, 15 or more years of experience, or

planning.

age 45 and over the matching was 3 to 1. At some point in the future, funded by his or her Competence Account money, the

This new human capital development framework is in the

employee could take time off.

early stages of development, but holds much promise to bring together all efforts at managing human capital.

As employees began saving towards their sabbatical, an interesting development occurred. Employees began asking how they should best spend their Competence Account money.

Strategic competence planning

The company responded by creating a web site that allowed the employees to develop their own competence growth plan. The site contains links to Swedish universities and learning providers so employees can find the courses and programs that help them fulfil their competence plans.

Competence development feedback

Competence resource allocation

Over the last decade, methodologies and tools were developed to address specific intellectual capital management needs. What is now clear to the Competence Account and marketplace teams is that these separate tools can be integrated into the competence development framework. These

Competence development implementation

methodologies and tools are: Figure 4: Navigating human capital development

132 - The


DD journal03.v.11

28-11-2001

19:15

Page 133


increasing transparency for stakeholders. And it was found Financial

Financial

that it can easily map its customer, human, and operating environment onto these stakeholder groups. The company used financial and intellectual capital to produce

Skandia

financial and intangible value. And like its earlier Supplements, increasing stakeholder transparency is necessary to sustain the company’s long-term success. This thinking is mirrored by standard setting bodies such as: the Institute of

Intangible

Intangible

Charted Accountants for England and Wales, or the Canadian Institute of Chartered Accountants.

Figure 5: Moving from financial value-creation to stakeholder value-creation

Summary When Skandia began its journey into understanding intellec-

Moving from financial value-creation to stakeholder value-creation

tual capital and the role it plays in creating value it was a pio-

The Navigator, and the Value Scheme always take place with-

financial benefits of nurturing intellectual capital.

neer. Over the last decade, many others have recognized the

in the context of an ‘Operating environment’. The operating environment is the local business unit’s economic, political, and social community. The importance of the operating environment to both intellectual capital management and reporting led the company to begin to consider how non-financial stakeholders would also benefit from increased transparency. The original idea behind intellectual capital reporting was to make more transparent how the company used its financial and intellectual capital to create financial value for the shareholder. The Navigator process showed that the company created more than just financial value, it also created intangible value. An example of this is seen when the call center managers examined what their customers really valued from the call centre staff: highly knowledgeable and skilled personnel. And only by creating this type of value would the company be able to differentiate itself from competition. It was also noticed that many of the other types of ‘supplemental’ reports being produced addressed how well these companies were meeting their environmental, ethical, or social obligations. Such reports could be broadly aimed at

133

DD journal03.v.11

28-11-2001

19:15

Page 134

Guidelines for manuscript submissions Guidelines for Authors

Manuscript Guidelines

In order to aid our readership, we have established some guidelines to ensure that published papers meet the highest standards of thought leadership and practicality. The articles should, therefore, meet the following criteria:

All manuscript submissions must be in English

1. Does this article make a significant contribution to this field of research? 2. Can the ideas presented in the article be applied to current business models? If not, is there a road map on how to get there. 3. Can your assertions be supported by empirical data? 4. Is my article purely abstract? If so, does it picture a world that can exist in the future? 5. Can your propositions be backed by a source of authority, preferably yours? 6. Would senior executives find this paper interesting?

Subjects of Interest All articles must be relevant and interesting to senior executives of the leading financial services organizations. They should assist in strategy formulations. The topics that are of interest to our readership include: • • • • • • • • • • •

Impact of e-finance on Financial Markets & Institutions Marketing & Branding Organizational Behavior & Structure Competitive landscape Operational & Strategic issues Capital Acquisition & Allocation Structural Readjustment Innovation & New sources of liquidity Leadership Financial Regulations Financial Technology

Manuscript submissions should be sent to Shahin Shojai, Ph.D. The Editor [email protected] Capco Clements House 14-18 Gresham Street London EC2V 7JE Tel: +44-20-7367 13 21 Fax: +44-20-7367 1001

134

Manuscripts should not be longer than 5000 words each. The maximum number of A4 pages allowed is 10, including all footnotes, references, charts and tables. All manuscripts should be submitted e-mailed directly to the [email protected] in the PC version of Microsoft Word. They should all use Times New Roman font, and font size 10. Where tables or graphs are used in the manuscript, the respective data should also be provided within a Microsoft excel spreadsheet format. The first page must provide the full name (s), title (s), organizational affiliation of the author (s), and contact details of the author (s). Contact details should include address, phone number, fax number, and e-mail address. Footnotes should be double-spaced and be kept to a minimum. They should be numbered consecutively throughout the text with superscript Arabic numerals. For monographs Jensen, M., Corporate Control and the Politics of Finance. Journal of Applied Corporate Finance (1991), pp. 13-33. For books Copeland, T., T. Koller, and J. Murrin. Valuation: Measuring and Managing the Value of Companies. John Wiley & Sons, New York, New York (1994). For contributions to collective works Ritter, J. R., 1997, Initial Public Offerings, in Logue, D. and J. Seward, eds., Warren Gorham & Lamont Handbook of Modern Finance, South-Western College Publishing, Ohio. For periodicals Griffiths, W., Judge, G., 1992, ‘Testing and estimating location vectors when the error covariance matrix is unknown’, Journal of Econometrics 54, 121-138. For unpublished material Gillan, S., and L. Starks. Relationship Investing and Shareholder Activism by Institutional Investors. Working Paper, University of Texas (1995).

DD journal03.v.11

28-11-2001

19:15

Page 135

Request for Papers - Deadline January 18th, 2002 The world of finance has undergone tremendous change in recent years. Physical barriers have come down and organizations are finding it harder to maintain competitive advantage within today’s truly global market place. This paradigm shift has forced managers to identify new ways to manage their operations and finances. The managers of tomorrow will, therefore, need completely different skill sets to succeed. It is in response to this growing need that Capco is pleased to announce the launch of the ‘journal of financial transformation.’ A journal dedicated to the advancement of leading thinking in the field of applied finance. The journal, which provides a unique linkage between scholarly research and business experience, aims to be the main source of thought leadership in this discipline for senior executives, management consultants, academics, researchers, and students. This objective can only be achieved through relentless pursuit of scholarly integrity and advancement. It is for this reason that we have invited some of the world’s most renowned experts from academia and business to join our editorial board. It is their responsibility to ensure that we succeed in establishing a truly independent forum for leading thinking in this new discipline. You can also contribute to the advancement of this field by submitting your thought leadership to the journal. We hope that you will join us on our journey of discovery and help shape the future of finance.

Shahin Shojai [email protected]

For more info, see page 134

© 2001 The Capital Markets Company. VU: Shahin Shojai, Groenenborgerlaan 16, B2610 Antwerp All rights reserved. All product names, company names and registered trademarks in this document remain the property of their respective owners.

135

DD journal03.v.11

28-11-2001

19:15

Page 136

Design, production, and coordination: Cypres - Van Gorp & Verboven, Hilde Princen, and Pieter Vereertbrugghen Printing: www.stockmans.be © 2001 The Capital Markets Company, N.V. All rights reserved. This journal may not be duplicated in any way without the express writ ten consent of the publisher except in the form of brief excerpts or quotations for review purposes. Making copies of this journal or any portion there of for any purpose other than your own is a violation of copyright law.

Mexican flowers. Perfected by the Dutch. Private Wealth Management. Perfected by Deutsche Bank. Van Gogh sought perfection, combining powerful imagination with outstanding technical skills. And transformed simple sunflowers into a masterpiece. At Deutsche Bank, we’ve built our reputation in much the same way. We begin with a highly personal, perceptive understanding of your needs. Which we creatively link with financial products that only a worldclass bank can offer. A unique blend. And results that speak for themselves.

Talent. Leading to results.

www.db-privatebanking.com

www.capco.com