DDK PRESENTATION TO ISSA
JUNE 7, 2006
Introduction
Thank you Judy. I am honored by ISSA’s invitation to this symposium. I am also eager to participate with all of you and to exchange ideas this week.
The symposium theme – competition, cooperation and consolidation – provides an excellent framework for this exchange of ideas.
I have been asked to provide a US view and to discuss “Consolidation Gaps” in the US. This is a subject I have found thought-provoking. I generally do not think in terms of consolidations or “consolidation gaps.” It is ironic that SIA itself is consolidating with TBMA with a Board vote later this month. Perhaps this is a first step in the trade association world. I will try to cover the question by discussing opportunities for industry-wide solutions.
I propose to talk first about the business environment in the US; second, about the US securities industry; and third about opportunities and challenges for industry-wide solutions.
Part I. The US Business Environment
The US business environment story echoes Charles Dickens’ A Tale of Two Cities- The Best of Times and the Worst of Times. (Please forgive the historical inaccuracy on the slide of placing the Eiffel Tower back to the French Revolution.)
It is the best of times because the US economy has been performing well in recent quarters – growing at approximately a 3 ½% annual rate. World GNP growth, for that matter, is growing nicely as well, and that is benefiting the US. It does not get much better than that.
Corporate profits have grown by double digits for eleven consecutive quarters. It does not get much better than that.
The so-called “jobless recovery” has, in fact, added over 5.5 million jobs since 2002. The unemployment rate is at a five-year low.
Core inflation has been running at approximately 2% - benign by historical standards. Interest rates have been favorable in spite of 16 consecutive increases in short-term rates by the Fed.
Consumer spending has remained strong and household credit, although much discussed, appears to be stable as consumers have benefited from the growth in jobs and appreciation in financial and home equity assets.
Much has been written about the negative savings rate in the US, and what it means, complete with social commentary on foolish American behavior.
The measurement is extremely misleading in a number of ways. First, the savings rate does not measure increases in net worth achieved through financial or home equity investment. This chart shows net worth as % of disposable income actually increasing.
Second, the entire decline in the savings rate can be explained by consumption in the wealthiest quintile of Americans who are spending part of the extraordinary gains in net worth they have earned in recent years. The remaining quintiles have been steady.
SIA would prefer a stronger savings rate – and we lobby for tax policies to encourage greater savings – but the negative savings rate is not the bad news that some critics assert.
The equity markets have recovered from their lows in 2001. The US is benefiting from the favorable demographics of the Baby Boomers experiencing their most productive years.
The Fed is anticipating a return to a healthy and sustainable rate of growth.
In short, Americans are wealthier and healthier than they have been at any time in their history.
BUT, it is also the worst of times. Americans are seriously troubled by the war in Iraq, the war on terrorism and, believe it or not, by the economy.
The Gallup Poll indicates a 72% disapproval rate with “the way things are going.”
A similar number – 68% of Americans - perceive economic conditions as getting worse.
The most important problem facing America, according to the Poll, is Iraq, followed by the increase in fuel prices, immigration and the economy.
Americans hate this war. The problem is no one has articulated a clear view of how to end it. Plenty of bashing and second-guessing of how we got into it – but not much enlightenment on how to get out.
Americans are concerned about oil prices. The Fed estimates that oil prices have reduced GNP growth by about ½ to 1%. The impact is less in 2006 than it was in the ’70’s oil crisis.
Americans are counting on the equity in their homes and are worried about a possible bursting of the “housing bubble.”
60% of Americans disapprove of the job their president is doing. In addition to the war, the President failed in his attempt to reform social security, was blamed for a poor response to Hurricane Katrina, the Valerie Plame affair, the Cheney shooting, the Dubai ports debacle and so on.
71% disapprove of the job that Congress is doing. 50% are convinced that both Republicans and Democrats in the Congress are corrupt.
Americans know that there is financial trouble ahead with respect to federal deficits and the long-term liabilities of Social Security and Medicare.
The Federal budget has gone from surplus in 2000 to deficit in 2006, as tax revenues have not kept pace with expenses. Democrats look at this chart and see the Bush tax cuts as the problem. Republicans look and see the Bush tax cuts as the solution and point to the imbalance in spending.
And the present value of the Social Security and Medicare liabilities is estimated to total $38.6 trillion – three times the size of GDP of $13 trillion. (President Bush was unable to solve the smallest part of the problem after his election in 2004.)
One of the mysteries about the strength of the bond market is why there is not greater concern about these long-term liabilities. The usual explanation is that the liabilities are too far in the future for today’s markets to be concerned. Some say we can’t tell what anything will look like 75 years from now. There is also an expectation that “just-in-time” politics will deal with the liabilities before they become a serious problem.
We also hear of the impact of high global liquidity on the bond market. (The Greenspan “conundrum” speech.)
Americans know that financial solutions exist but that the leaders of both parties are unable to develop political solutions to the financial deficits.
They are hoping that Ben Bernanke and Hank Paulson are on top of their games.
These troubles set the stage for unusually significant elections for the Congress later this year.
Republicans now control the Senate by 10 seats out of 100 and the House by 29 out of 435.
Many believe that with the Republican administration held in such low regard, the Democrats have a chance to regain control of the Senate, House or both.
That would mean a major shift in leadership and ideology on the congressional committees that have the greatest impact on the securities industry.
Others believe that the Democrats have troubles of their own and a state-by-state analysis indicates that it may not be easy.
There are 15 Senate seats in close contention, for example, about equally divided by Republican and Democratic incumbents. The Democrats would have to win all of them.
The 2006 elections set the stage for a highly unusual and bitterly contested presidential election in 2008. The Republicans do not have an incumbent to run.
The Republican candidates preferred by the public today are Rudy Giuliani and John McCain.
The preferred Democratic candidates are Hillary Clinton and John Kerry.
A possible slate for the 2008 presidential election might look like this. All four candidates would be controversial except for Mark Warner – former governor of Virginia. He is there to help Hillary in the South. John McCain would be older than Ronald Reagan at the time of his election. Condoleezza Rice has never run for office. Hillary Clinton is the most controversial of all. Many believe she cannot win and American magazines are featuring a search for the “unHillary” – Al Gore or Chris Dodd, for example.
Of course, it is too early to tell how this might turn out. But the winners will deal with tax rate increases scheduled to hit in 2010.
What is important for the ISSA symposium this week is that the US will be dealing with unusual political uncertainty for the next three years. We would not expect any major legislation benefiting the securities industry or investors in this environment. (We may get cost base reporting.)
What is also important is that the US financial markets are nervous.
They are nervous about a slowdown in the economy, about inflation, oil prices, Iraq, Iran and about budget deficits.
To sum up the US business environment, it is the best of times and the worst of times.
- An economy that has been performing well in many respects
- Intractable problems in Iraq and perhaps in Iran and in the war on terror
- Long term financial liabilities
- A troubled populace
- Political uncertainty - and
- Nervous financial markets
Does this business environment help or hurt our efforts to deal with the problems on our agenda this week? You each have your opinion, I’m sure.
I would conclude that the business environment is neutral to somewhat positive for our work.
Part II. The US Securities Industry
The US securities industry reflects the strengths and weaknesses of the business environment generally. The industry is also in a period of extraordinary change. And that change is creating tipping points. (If I can use this term, popularized by Malcolm Gladwell.)
Domestic gross revenues have grown steadily since 2003 and are projected to reach record levels in 2006, surpassing the previous record set in 2000.
Domestic pre tax profits, however, have a long way to go to reach the levels reported in 1999 and 2000. But we believe that 2006 will exceed 2005 and have recovered nicely from the low in 2002. We are in a major profit squeeze.
We attribute the squeeze in profit margins primarily to regulation and to competition driven by technology.
Since 2001-2002 when the Enron, World Com and other corporate frauds were exposed and when the bursting of the tech bubble resulted in horrendous losses in market value, the regulatory response has been the most significant in three decades (and some would say the most significant in seven decades).
Legislative reform – Graham-Leach-Bliley, Sarbanes-Oxley, the Public Company Accounting Oversight Board, the Patriot Act, anti-money laundering legislation and regulatory reform, rating agency oversight, regulation of mutual fund disclosure, market timing, trading after the close and breakpoints, renewed focus on soft dollar practices, short sale regulation, 33 Act reform, and Regulation NMS have been powerful drivers of change.
The SEC’s budget and staff have grown at greater than 20% annually since 2001. We have had four SEC chairmen in the last six years – and considerable turnover in key staff positions.
The SIA released a study on the cost of compliance in March of this year, which estimated that the cost of compliance in 2005 had doubled in three years and now totaled over $25 billion, or 13.1% of net revenue. This is equivalent to an enormous 5-6 points in reduced profit margin.
Competition, driven primarily by technology, has also driven profit margins down in trading spreads (decimalization), retail and institutional commissions and retail asset management fees.
As traditional product lines have been hard it, firms have responded with new business lines with higher margins.
Hedge Fund assets under management have grown tremendously, from $200 billion to $1.2 trillion in 5 years. And many observers project that growth to continue. Hedge funds generate one-third of institutional commissions these days.
Exchange traded funds have grown from zero to over $200 billion in 5 years.
Exchange traded derivatives (futures and options) have grown dramatically.
OTC interest rate derivatives have grown.
OTC credit derivatives (primarily credit default swaps) have grown.
OTC equity derivatives have grown.
Financial instruments made up 50% of futures and options trading fifteen years ago – and now make up more than 80%.
Mutual fund assets have also grown, although at more modest rates.
Proprietary trading has become more important at many large firms. Fixed income has been proportionately stronger.
Private equity has grown.
Emerging market equity and debt has grown.
REITS have grown.
And retail firms are focused on products and services for the Baby Boomers’ retirement market.
What is the market’s perception of growth, the profit squeeze in the industry and the industry’s ability to move from traditional to new product lines?
Stock prices of securities firms have more than doubled in the last three years.
The rate of change in the industry has been extraordinary. The drivers of regulation, technology and globalization have been so strong that they are creating “tipping points.” (Joseph referred last night to the speed of change “particularly in Europe” – I would say US as well.)
One obvious example of a tipping point is what has happened in the world of exchanges. Reg NMS was approved on April 6 and within two weeks both the NYSE and NASD announced significant mergers.
The NYSE’s decision to become a “for profit” with its merger with Archipelago, and its subsequent proposed merger with Euronext and the parallel merger between NASDAQ and Instinet and subsequent 25% investment in the LSE do not constitute “business as usual” in the exchange world. These decisions are very bold moves and represent the greatest change in the history of US exchanges.
I would submit that none of us (including the exchanges themselves) know what the outcome of these decisions will be.
There are important unanswered questions about the shift to “for-profit” status, and about self-regulation and a further set of unanswered questions about cross-border mergers. Their business synergies and their regulatory implications.
The developing answers to these questions will give symposiums like this one plenty of material for debate for years to come.
There are other examples of tipping points in the industry that are also worth noting.
The Legg Mason/Smith Barney deal was recognition by both parties of the inherent difficulties of managing a combination of asset management and distribution business models.
I think it also tells us something about scale in both businesses. Was it a tipping point of industry-wide significance, or an isolated case? I’m not sure.
The Merrill Lynch – Black Rock transaction in February also tells us something about the problems of selling branded asset management, the need for alliances (a fixed income manager combining with an equity manager) and the need for scale.
Was it a tipping point of industry-wide significance? I’m not sure.
Piper Jaffray’s sale of its retail brokerage business to UBS appears to be about the ability to manage multiple businesses within a broker dealer as well as about scale.
The consolidation of banking institutions Regions Bank and AmSouth indicate that more consolidation is still to come.
The consolidation of hedge funds and their acquisition by broker-dealers and banks also appears to be more than isolated transactions.
So the story of the US securities industry reflects the best of times and the worst of times of the general business environment,
And further, is about unprecedented rates of change, driven by regulation, technology and globalization that have resulted in “tipping points for many institutions, business models and firms.
As to the question of how the securities industry’s performance in 2006 might impact our efforts to improve infrastructure, I would say it is clearly positive.
It is increasingly understood by senior management that we must improve efficiency, reduce cost and build better risk management systems to be successful dealing with the squeeze on profits and competitive pressures in the future. We are part of the solution.
Part III. US Securities Servicing
I will turn now to securities servicing in the US – my approach is to look at the opportunities and challenges of industry-wide solutions.
The guidance given to me by ISSA includes a statement that “the US market is generally perceived in the rest of the world as one which went through infrastructure consolidation in the last 30 years and has its mission completed. This outside perception is probably wrong when judged from within your market.”
First let me say that I seriously doubt that anyone in this room perceives that the US has completed its mission on infrastructure development – but if that perception does exist, I can assure you that it is wrong.
We do not think of this issue necessarily as a matter of consolidating infrastructure organizations. We think of it as a matter of developing industry-wide solutions to problems. Consolidation may be one way to create solutions – but only one of many.
We have learned that the opportunities for industry-wide solutions are quite significant. (DTCC/Y2K/Euro/Decimals/T+3/T+1/STP)
We have also learned that the challenges of building consensus to achieve them are quite significant. The difficulty is first – how to decide when a problem should be solved with an industry-wide solution and when it should be solved by a free market solution. And second, who makes the decision?
Sometimes the decision maker is a regulator – most often the SEC, the NASD or the NYSE. Sometimes it is a services provider – most often DTCC or OCC. Sometimes the decision maker is the firms themselves, acting through an industry group – like SIA or TBMA. And sometimes it is a vendor with multiple client relationships.
The decision between industry-wide and individual firm solutions is in itself a “free market” decision – rewarding creativity, political skill, capital investment, hard work and leadership. We know that share volumes and trade volumes in all our products are increasing dramatically.
We also sense that I/T spending, which has been declining for the last five years is now turning up.
The US Securities Industry Agenda for Industry-wide Solutions
I have categorized the agenda for industry-wide solutions by product line and in accordance with the primary responsibility for the initiative.
Institutional Trade Matching has been a frustrating project for the SIA STP team.
Five years ago they were engaged in an intense effort to build a new Institutional Transaction Processing model to support T+1.
There were long and bitter discussions between Omgeo and GSTPA to create “interoperability.”
Today, the T+1 goal is no more and GSTPA is no more.
And efforts to take even a first step to improve trade affirmation at T+1 have not gone well.
We are now seeing greater interest from large buy side firms in reducing cost per trade as blocks are being broken into smaller trades in the search for Best Execution.
Providers like Liquidnet and Pipeline have focused on the need to serve block traders in the new NMS environment.
So I see a fresh effort in the institutional trade matching project in the coming year.
CDS Clearance and Settlement
I am embarrassed about the industry’s performance with credit default swaps.
With all our task forces, work groups, Vision 2010 efforts, we essentially were fighting the last war while new problems were surfacing in the documentation and control of CDS.
The regulators have now interceded – led by the Federal Reserve Bank - and the Group of 14, with the active participation of DTCC, is fixing it.
But the fact is, the industry missed it. (Like agency lending.)
Counterparty Risk Management Policy Group
I am a fan of Gerry Corrigan. I first worked with Gerry when he breathed life into our Y2K contingency planning effort in 1999. And I have followed him through his work with G30, the Counterparty Risk Management Policy Group I and now II.
We need leaders like Gerry to put a sense of context and urgency into the work that sometimes goes unnoticed by senior management at the SIA Board, for example.
Gerry’s message to the SIA’s Operations Conference last month was that there is a hell of a lot of work to do – and I agree with him.
1. This work will entail substantial commitments of resources by individual firms and on an industry-wide basis.
2. Enlightened leadership from the top of firms.
3. Collective action by private and public sectors.
4. The need to attract highly skilled personnel into risk management.
5. Continued efforts by trade associations in addressing infrastructure issues.
You can see that our mission is far from complete. That the industry-wide solution agenda is very active, is rich with opportunities, but continues to have formidable challenges.
CONCLUSION
I would like to close with four conclusions:
First, it is apparent that what we are talking about this week is really about managing change.
- Change driven by competitive business considerations
- By regulatory drivers
- By technology
- And by globalization
This means that we are in the business not only of developing new ways of doing business,
But also that we are in the business of destroying old (and perhaps profitable) ways of doing business.
Second, what we are talking about is really about finding consensus for industry-wide solutions vs free-market or firm-by-firm solutions.
- How do we evaluate and allocate the costs and benefits of a given solution? We need to do a better job with business cases.
- Who builds the consensus to act?
- Who decides?
- Who implements?
Third, what we are talking about is really about leadership.
The industry in the US and globally, has many organizations that deal with infrastructure and common solutions – SIA and ISSA among them.
Trade associations, industry utilities, for-profit service providers and regulators of all sizes and shapes.
These groups are highly fragmented – they do not communicate well with each other. We need to work more closely together on common solutions.
Fourth, the general business outlook in the US and in other countries and the specific outlook for the securities businesses in each of our countries – while not without significant problems –
Are positive enough to make further investment in infrastructure and common solutions that make sense.
I would like to think that both the SIA and ISSA could play important roles in that process. And to that end I invite ISSA to participate in SIA’s next cycle of strategic planning in November.
Thank you for your invitation today and for your attention.
