Expect Continuous Change to Accelerate in 2008

The summer of 2007 credit crisis served as a wake-up call for the securities industry, and a host of business drivers and technology trends will reshape the markets in 2008.

As summer wore on this year, we all felt as though we were in for another record year in the securities and investment industry. Corporate earnings were healthy, the market was up nearly 10 percent on the year through the middle of July and poised to go higher, and the industry was bringing in record revenues on the heels of strong trading and investment banking activity.

Then it happened. The credit crisis came upon us seemingly out of the blue. August vacations were cancelled or cut short while the global capital markets saw huge spikes in trading volume, a surge in volatility and, if you were smart -- like Goldman Sachs -- a nice boost to the bottom line. Unfortunately, Goldman Sachs was the exception, as most buy-side and sell-side institutions felt the worst of the credit crunch, a reverberation that still is being felt today and likely will be felt into 2008.

It is with this backdrop that I present the top trends in the securities industry for 2008 -- not that we foresee gloom and doom on the horizon. Au contraire. We believe that the summer of 2007 credit crisis served as a needed wake-up call to an industry that was becoming too confident, too cocky. Lessons learned? We think so.

So here are TowerGroup's top business drivers, trends and technology initiatives, beginning with an ever-interlocked "Triumvirate of Change" that will work in unison to bring about tremendous change in the securities and investments industry.

Market structure gets white hot. If you think the last couple of years of market structure shifts have been hard to keep up with, in the words of Bachman, Turner, Overdrive, "You ain't seen nothin' yet." The number and size of truly global mergers, acquisitions, takeovers, hostile bids and buyouts will be seismic. The activity will span exchanges, ATSs and institutions; and it will be across all asset classes. We'll finally see the pullback in 2009 while the industry digests all the change.

Globalization. We're not talking about the typical small-time international expansion projects. This is a global remaking of the capital markets, led by the battle for global exchanges, which will allow the rest of the capital markets participants (the sell side, buy side and retail investors) to follow. It also means investors and traders will finally be able to trade securities across borders -- much more easily and cheaply.

All things electronic trading. If you're not trading electronically, you're dead. Purely automated trading (zero human intervention) will go mainstream; it won't be just the large hedge funds and advanced proprietary shops that "fly by wire." We'll also see continued expansion into new geographies and new asset classes for electronic trading techniques and methods. The old stalwarts will continue to grow aggressively: algos, DMA, programs, dark pools, etc. And with this expansion comes latency problems. Watch for the first major crash of an electronic trading system in 2008 due to volume, speed and performance issues.

Market Evolution

While the Triumvirate of Change will bring about relatively rapid change, other trends will shape the way financial markets evolve over the next year and beyond:

Retirement income planning. With the onset of retiring workers and the increased awareness around the need to save for retirement among the younger crowd, securities and investment firms hear the dinner bell ringing. The industry recognizes that providing superior returns and excellent customer service don't guarantee asset and customer growth. Firms also need to educate their investors on managing their investments and provide technology and tools to attract and retain assets.

Improved data capacity and bandwidth. The Triumvirate of Change above leads to the need for more bandwidth, lower latency and increased capacity. As we move to a global, fully electronic market, the underlying technology becomes the battlefield. The firms with the most robust, highest performing and most advanced real-time technology platforms will take the lead in 2008. Technology becomes the differentiator.

The search for high alpha and low-cost beta. At TowerGroup, we have been publishing on the drive for the separation of alpha and low-cost beta for several years. 2008 will bring a much more pointed focus to this strategy as traditional asset managers drive to separate from the herd. As witnessed by the simultaneous growth in passive (i.e., index) investments and alternative investments (i.e., hedge funds), there is no room for mediocrity. Investors are now demanding either low-cost market returns in the form of index funds and ETFs, or high-cost market-beating returns in the form of hedge funds. The traditional, active mutual fund is not long for this world, having been outperformed in 75 percent of the cases compared to the broad market.

Derivatives. Whether you're a buy-side firm looking to derivatives for the first time to achieve alpha, a sell-side firm trying to become the provider of choice to your clients or a prop shop extending your use of derivatives beyond the exotic to leverage up, derivatives are a "must have" in the world of capital markets. But the post-trade process leaves a lot to be desired. Look for a rush to automate the derivatives markets in 2008.

Global risk modeling. You can bet that the credit crisis has opened some eyes on Wall Street about what risk management systems are doing well and what they're doing poorly. Even before the crisis, the industry had shown a strong commitment to improving its risk-management capabilities. Now, however, attention has turned to more advanced risk modeling, helping firms develop scenario analyses to mitigate a number of risks given certain events. And now these models have to be global in their reach.

Portals. Make your services accessible and the customers will follow. We have seen several "evolutions" of client-facing portals -- retail and institutional -- over the years. What will make it different in 2008 is the combination of "revolutions" that further entrench the self-service model in financial services: account aggregation combined with high-speed trading combined with custom reporting combined with multimedia. Sound like a pipe dream? It's closer than you think.

New Drivers on the Horizon

In addition to the trends discussed above -- all of which have been around in some form or another -- there are some new, yet surprisingly strong, drivers on the horizon:

Green. We've never been band-wagon jumpers here at TowerGroup, and we don't plan to start now. But the green movement across all industries -- and across the globe -- no longer can be ignored by the securities industry. If you run a high-performance data center supporting a mega trading operation, you have to look at environmentally friendly technology in order to contain costs. And if you run a derivatives desk, you are looking at carbon credits as a way to participate in the green movement -- oh, and make a tidy profit while being a socially responsible investor.

IT governance. While IT governance has been a topic of interest in the industry over the last couple of years, it reaches new heights in 2008. Establishing a good rapport between the business and technology organizations begins with a strong governance structure. These structures become the hallmark of technology-savvy institutions while the business lines get more from their IT investments.

U.S. election year. At the risk of sounding too political, or too "colonial" to my U.K. and European friends, 2008 brings an election year to the U.S. And with the election comes a whole lot of uncertainty, posturing and positioning. It also brings a bevy of promises and commitments to keep the U.S. economy humming along -- and a near-certainty that the US markets will not be in the red in 2008. The incumbent party would never let that happen.

With all of the changes teed up for 2008, the securities and investments industry is poised for another strong year. In the words of Alfred North Whitehead, "The art of progress is to preserve order amid change and to preserve change amid order." Sage advice for Wall Street in 2008.