Technology is revolutionising wholesale financial markets
The Economist

May 20, 2000 - So FAR, this survey has concentrated on how the Internet is affecting the way financial firms do business with their retail customers-what in Internet jargon is known as the business-to-consumer, or B2C, market. But that is only one part of a broader transformation of the way those firms do business with each other and with their corporate clients. The whole industry is in a state of flux. Technology has made possible a global digital financial market where, in theory, any security in any currency be traded anywhere at any time, and where that trade could be settled instantly. But the world is not ready for such a market. Not only do national regulations get in the way; so do the structures of the financial markets themselves, and the competing interests of the various players.

Hence the bewildering reels currently being danced by the world's investment and commercial banks, stockmarkets and other exchanges. It is obvious to all that dislocating change is coming, but not yet what shape it will take, nor which institutions will emerge at the top of the pile. So every day, it seems, some new merger or alliance is being announced, or there is news of a forthcoming platform for trading American Treasury bonds, or euro-denominated shares, or whatever, that "will revolutionise the market". Often the same investment banks, hedging their bets, have invested in several competing platforms. Allies one day in one business, they are competitors the next in another.

As a result, the distinctions between the different sorts of institution are blurring. For years, mergers and takeovers have been creating institutions that bring together different specialisations: commercial and investment bank, stockbroker and trader, insurer and fund manager. Now, in America, the growth of electronic communications networks (ECN s) has seen broker-dealers turn into exchanges, and two have applied to be regulated as such.

For investment banks, and retail banks in their wholesale businesses, the Internet adds another twist to this already tangled skein. It offers enormous improvements in the distribution of information and products, but also makes it easier for the users of financial services to do without the banks' intermediation, and for new entrants to the market to challenge the big players' oligopoly.

Having been exhorted for so long to emulate the gung-ho adventurousness of American capitalism and the seemingly bottomless depth of its capital markets, investors in boring old places such as Europe and Japan have recently encountered another, less enviable trait of the American way of doing things: the ludicrously oversubscribed initial public offering ( IPO ) of shares in small technology companies. Typically, these companies' share offers are sponsored by a blue-chip investment bank. Only a small proportion of the shares is offered, at a very high price. Demand is such that the price soars even further, enabling the underwriters (said blue-chip bank and its chums) to "flip" the shares for a tidy profit in the grey market, before official trading begins. Retail investors often have no access to shares at all, or if they do, they find they are unable to sell them until off-loading by the underwriters has already depressed the price. In March, for example, this mechanism left some British investors in a much-publicised Internet start-up, lastminute.com, sitting on losses.

Inordinately Profitable Offerings
Scott Ryles, chief executive of Epoch Partners, a new online investment bank in San Francisco, says that in an American IPO, an average of 80% of the shares are held by institutions. A year later, however, that proportion has come down to only 27%, and most of the shares are in the hands of retail investors, many of them clients of discount online brokers. Often, especially in an Internet start-up, the online brokers' clients are allocated little of the IPO itself. The sense of grievance this causes led three of the brokers (Schwab, Ameritrade and TD Waterhouse) to link up with three venture-capital firms to found Epoch.

A handful of such online investment banks, concentrating on technology companies, are now up and running. Their market share is still tiny, but Ron Readmond, a founder of one of the biggest, Wit Capital, says that they are causing the beginnings of a panic among the "cabal" of banks that dominate the IPO business, which realise that the newcomers are threatening their business. Mr Ryles, who worked at Merrill Lynch until last year, agrees that the "cost side" of the IPO business on Wall Street has to change. But the big firms are once again hampered by channel conflict. Online distribution bypasses their branch networks.

Yet those old firms are themselves being forced to compete. At Merrill Lynch itself, for example, Michael Ryan, the firm's global head of equity capital markets, is proud to show off the "new-issue application" of "Direct Markets", an Internet-based syndication and distribution tool. He concedes that Merrill had some trouble establishing itself in the niche it thought it deserved in technology IPO s. Now it has the capacity to put almost all of the IPO process online-from the prospectus to videos of the company's management-instead of the traditional "road-show" tours to sell its services to investors.

Curiously (or perhaps not), one aspect of the "cost side" that neither Mr Ryan nor the new banks expect to come under immediate pressure is the standard fee charged for an IPO . But when companies have been able to raise capital at such a high price to the investor (ie, so cheaply to themselves), what is a 7% flat fee between friends? If capital gets more expensive, however, that juicy component of its cost will surely come under more scrutiny.

Such fees are important because so much bank income in recent years has derived from volatile sources: trading securities and venture-capital investments. So investment banks are devoting enormous efforts to finding ways of protecting their profits from online encroachment. J.P. Morgan, for instance, has formed LabMorgan to give a high-profile unifying theme to its e-finance ventures.

The fees investment banks earn for arranging bond issues are also vulnerable. In fact, though they would never admit it, so obligatory is e-enthusiasm these days, in private some firms in the bond business probably curse the Internet. It is set to change the whole bond market, from underwriting to secondary trading. Already, top-ranking bond-arrangers need an online syndication system, if only because some of the world's most important borrowers will demand it. "All our bonds", claims Afsaneh Mashayeki Beschloss, of the World Bank's treasury department, "will be e-bonds."

The beauty of e-bonds
Ms. Mashayeki Beschloss, who concedes that some borrowings with complicated structures may prove e- exceptions, has been delighted by the experience of the Bank's two online bond issues this year. In both, arranged by Goldman Sachs and Lehman Brothers, part of the deal-30% of the first, 50% of the second-was offered direct to investors over the Internet. Usually, such issues are syndicated among the small (about 400-strong) group of global investment houses, which place them with their clients or hold them in-house.

From the borrower's point of view, the online transaction offers two big advantages: transparency, in that the borrower can see who the end-investors are, and what commitments they are making; and access to new investors. The World Bank, although well-known in the international markets, was less familiar to the American retail investors it wanted to reach. The online issues gave it access to that market (although "retail" is a relative term: the smallest purchase was $1,000, but one investor turned out to want $250m-worth of one bond).

In the secondary market, too, upheaval is already under way. The market, which covers 4m separate issues of widely differing kinds, many of them rarely traded, has been less susceptible to electronic trading than have the stockmarkets. Bond-trading has long been dominated by institutional investors. They have placed their orders through dealers, whose pricing is opaque. But now America's Bond Market Association has counted 39 different firms and alliances that offer-or plan to-secondary electronic trading. These include proprietary systems, such as Goldman Sachs' Web. ET ; trading networks sponsored by single firms, such as State Street's Bond Connect, which hopes to create liquidity by allowing participants to trade bundles of different bonds; electronic interdealer-brokers, such as BrokerTec, aimed purely at firms that already make markets in bonds; joint-venture arrangements, such as TradeWeb, an ECN set up in 1998 by Goldman Sachs, Lehman Brothers and others for trading in American Treasury bonds; BondClick, a European equivalent for government bonds launched this year; Tradebonds.com, an Internet-based system offering access to prices for thousands of Treasury, municipal and corporate bonds; Securities.hub, which will allow investors access to research and price quotations from six big firms (Goldmans, Lehmans, Merrill Lynch, Morgan Stanley Dean Witter, Salomon Smith Barney and J.P. Morgan) without having to log on separately; and LIMIT rader.com, an online marketplace for trading corporate bonds.

TradeWeb, which operates in the very heavily-traded treasury market, has been the most successful of these so far. Larry Buchalter, of Goldman Sachs, thinks that the level of liquidity in particular markets will continue to determine their development in the future. For much-traded issues, such as Treasury bonds, a central liquidity pool will form to create, in effect, an electronic exchange. For less liquid bonds, however, more is needed than the systems that have emerged so far. Most are matching or "crossing" networks, where sellers hope to meet buyers, but have no market-maker to guarantee them a price. What is needed, says Mr Buchalter, is "crossing with capital". But in the bond markets, as elsewhere in finance, a revolution is under way. "It is a once-in-a-career thing," says Mr Buchalter. "It's going to redefine our business."

anyfinancialproduct.com
Since the Internet offers such obvious advantages for investors and lenders, it is tempting to ask if it will become the medium through which all financial products are traded. Certainly that seems to be the way some other industries are going-witness the proliferation in recent months of online business-to-business exchanges, in everything from motor parts to plastics, bandwidth to chemicals.

But finance is different, in the sense that many of its markets are highly automated already, but using non-Internet systems. For large interbank dealings in deposits and foreign exchange, for example, there is no obvious reason to move to the web when existing systems are doing the job perfectly well. Indeed, new ones are being introduced, such as FX Connect, part of Global Link, an "extranet" run by State Street, an American bank that leads the world in providing custody services. It specialises in catering for large investors, many of whom would prefer to rely on established services rather than take a chance on a new website. In Sweden, SEB 's web-based foreign-exchange service is used by corporate clients, not by the much larger interbank market.

Nevertheless, various online exchanges and aggregators aimed at the wholesale market are in operation or under construction. Creditex, for example, founded by two former Deutsche Bank traders, is designed as a platform for trading credit derivatives. These form a rapidly expanding segment of the derivatives market, enabling the credit risk associated with a loan or bond to be traded separately from the underlying asset. Creditex aims to provide an Internet-based marketplace where traders can negotiate anonymously (up to the point of agreement on price). The aim is to improve liquidity, standardisation and price transparency in a new and fragmented market.

Trying to reach a much broader market is CFO web.com, due to be launched later this year by Integral, an American software developer. Its target market is people running corporate finances. It plans to offer a range of financial products, such as spot and forward foreign-exchange dealing, currency and interest-rate swaps, by linking corporate buyers of these products with a range of providers. By April, it was claiming 2,300 registered members and a range of "providers" that included Bank of America, ABN Amro, a big Dutch bank, and the derivatives-trading arm of American International Group, a huge insurer. Clearly the viability of such a system depends on the number of firms using it, and changing existing corporate behaviour will take time.

However, over the next few years some such model seems likely to succeed, including perhaps a big increase in direct trading of financial instruments between non-bank corporations. If, for example, a large online market in currency and interest-rate swaps were to develop, then banks' role as intermediating counterparties may be called into question. So wholesale banking, too, may eventually have to move towards "open finance".

The same goes for the more mundane bread-and-butter businesses of commercial banks. The web threatens their hold on their core corporate customers (especially the smaller ones) seeking access to business loans or trade finance. Many small businesses have, understandably, tended to deal with their local bank branch. Many banks have taken advantage of this to charge them near-monopoly rents. In Britain, for example, it is the need to retain competition in this sector that has been the biggest obstacle in regulators' minds to mergers between banks with overlapping branch networks. The Internet offers such small firms access to far wider sources of credit.

Some banks have recognised this danger, and tried to turn it into an opportunity. In America, Citigroup has a website, bizzed.com, which describes itself as a "portal of business services", aimed specifically at the small business customer. Similarly, in Britain, Barclays is working on a B2B site in conjunction with Oracle, a software firm, and Andersen Consulting. Ian Arthur, of Andersen, argues that banks "need to control the point of relationship with their corporate customers". In other words, in this market banks do need to be portals. Barclays's idea is to expand into the e-procurement field, using their site as a "horizontal" B2B exchange where firms can save money on buying non-production items such as office equipment, or even recruiting staff, and which will also provide the settlement services and financing if required.

Big Internet banks, such as Bank of America and Wells Fargo, have also identified the large potential in providing financial services for participants in the proliferating "vertical" B2B exchanges (ie, those serving one industry), of which there are already several hundred. Steve Ellis, of Wells Fargo, for example, says that his bank, a leading agricultural as well as online lender, has been combining these two areas of expertise in providing services to an online almond exchange. Although B2B exchanges have the potential to cut procurement costs impressively, they expose participants to credit, transaction and settlement risks that they are ill-equipped to handle. Banks, on the other hand, have been coping with them for centuries.

The same is true for trade finance, a huge market worth trillions of dollars each year, which used to entail the destruction of great swathes of forest-in letters of credit, bills of exchange, certificates of origin, invoices, bills of lading, insurance certificates and so on. Often it still does, but big banks have managed to automate much of the process, for example by scanning documents into their computer systems. Now a number of systems are trying to take this process further, and are vying to become the online standard for trade processing. Bolero.net is a joint venture of SWIFT , a global payments network, and The Through Transport Club, a shipping insurer. It provides a system for trade data to be exchanged via the Internet. Another approach comes from TradeCard, which in March signed an agreement with Thomas Cook, a travel and financial- services company, to offer an electronic alternative to traditional letters of credit. Thomas Cook will act as an intermediary for payments around the world.

This market is so inefficient that it is not unusual for trade debt to be priced at a much bigger margin than the same borrower is paying for, say, a bond issue. The founders of LTP, a London-based boutique consultancy set up by trade financiers formerly at Deutsche Bank, believe that besides streamlining the cumbersome process of documentary credits, the Internet may also help shake up their financing, through its natural flair for syndication. At present, many trade-finance assets are hardly traded at all. Often they simply sit on a bank or exporter's balance sheet, subject to the scantiest of risk analysis.