We host with pleasure these interesting articles by Enrico Petocchi
As Digital Transformation redesigns businesses as big data systems, it will eventually blurs Continuing Operations into Strategic Finance, thanks to blockchain – based tokenization. The emergence of Digital Certificates on digitized items launches the Era of OmniFinance and will prompt banks’ repositioning, unleashing opportunities for a new breed of specialized Trading Venues providing liquidity to a much wider investible universe. Regulators will adapt to accommodate Generation-X and Generation-Y saving capabilities and Personal Finance attitudes. Cash will always be the Street King but on the floor Liquidity will be the Dancing Queen.
The Rockin’ n Rollin’ 20s Convergence Paradigm. Digital Transformation, OmniFinance & Secondary Trading
Monetizing Data-Driven Reality in the Era of Riskless Yields Disillusionment
Digital Transformation redesigns businesses as systems of multivariate equations releasing output data in large amounts; unprecedented calculus capabilities allow for assessing the economic utility of single data items; hence, each business process, activity, unit of output representing ownership, detention or exploitation of any tangible and/or intangible asset is valuable, subject to pricing and negotiable. Undisputedly, Digital Transformation turns Continuing Operations into Strategic Finance
The decade starting this week shows an unprecedented interest from investors in alternative investment, in a frantic survival effort to (i) escape from hyper-inflated traditional financial assets or (ii) stay clear of tax-inefficient/illiquid/hard-to-access real assets; thus, in the naïve proponents’ narrative, alternative investments would provide higher risk-adjusted returns (albeit in exchange for much poorer liquidity). The smartest Wealth Managers and Private Bankers ferociously compete to persuade their anxious HNWIs to take a belt-free front seat before the next bubble bursts (fair enough, until now they have been shying away from inviting their clients to buy Illiquids via margin accounts…..)
Yet, investors of any type face this horrendous contingency (i.e. negative real/nominal interest rates) and get easily lured by the promise of cashing-in hefty yields (under whatever form of coupon, dividend or any equivalent carried interest). Cash holders are pushed by the narrators to pursue a buy-and-hold investment strategy in territories which are for the most part unchartered; enthusiastic proponents either need to make a living by placing “paper” or do not bother to pay the same amount of attention to exit protection as they do to highlighting the speculative merits of unconventional purchases. A continuing trend of zeroing money market rates will certainly have an impact on the pace and magnitude of this unprecedented assets’ migration (i.e. the longer rates remain at current levels the more irreversible the migration will be), but a new ecosystem has seen the light of day. Let’s call the condition described above as “Vertigo from Financial Rollercoasting”
Piling up assets while awaiting second-hand liquidity to come usually ignites fires. Still, myopia won’t harm anyone as long as alternative assets represent an indecisive portion of investors’ overall financial wealth; however, as the Illiquids percentage increases, the investors’ propensity to trade off liquidity against returns will diminish: quite understandably, an asset value is what you actually cash-in when you can (and do) sell it (think of real estate…) and expected IRR computation requires accurate estimates of terminal/exit values.
Rock ‘n Rollin’ 20s: the OmniFinance Decade
The last decade witnessed a dramatic acceleration in Assets’ Securitization activities (in whatever shape – ownership, detention, exploitation, cash flows’ streams, etc..) mostly to do some cleaning up on the balance sheets of troubled major banks and – thinking positively – to enlarge the capital markets arena. In the last three years, the dominant role of Structured Finance in traditional Asset Securitization (compliant, cumbersome and expensive) has been gradually eroded by upcoming blockchain-based “tokenization”, i.e. issuing straightforward digital Certificates divided into transferrable units, each representing a digital fraction of either a digitized right or a digitized cash flow, or both. The “DSquared Derivatives” were born, with DSquared meaning “Digital Derivative on Digitized Underlying” and, from now on, referred to as Tokens, Digital Certificates or Assets Derivatives.
Still, wary regulators (and intermediaries wary of the regulators’ lack of courage) have not paved the way for massive adoption, yet. There are still many questions to be addressed before retail and institutional investors alike will start selling off their hyperinflated traditional financial assets to pad their portfolios with Digital Certificates providing exposure to real underlying assets.
Emerging and well-proven technologies will certainly help (as was the case in the late 1990s to open the market for on-line brokerage); as a matter of fact, regulators will continue to accommodate a new breed of early adopters (i.e. young adults, women and gamblers) in their attempts to overrule a static, reactive and anachronistic self-referring financial establishment.
Blockchain may be the best technology for setting up and trading such Tokens but it is not the cornerstone of the Financial revolution: blockchain-enabled features (decentralized research activities, news origination & broadcasting, order matching and settlement mechanisms) would mostly impact on the authenticity of newsflows and assets governance; smart contracts would provide transparent economic (monetary and non-monetary) utilities’ accountability and appropriation; conversely, optimization of order management, execution costs and minimization of trades’ latency would favor centralized systems. Most likely, different technologies will support integrated investment cycles, form issuance to divesture.
AI-supported enhanced versions of well-known Black-Scholes option pricing models will help diffuse handy pricing methodologies, thus providing better than expected management of volatility patterns (hence, increasing investor confidence in assets whose pricing is driven by real metrics, well beyond accounting).
As digital transformation absorbs business processes into its algorithms and shifts focus from demand/supply imbalance to need/solution interaction, the development of AI predictive patterns will help spot, earlier and better, new market opportunities. Market intelligence will not be driven by demand (explicit or latent) and supply/demand imbalances; instead, the focus would be on fine-tuning businesses to effective needs.
Traceability will make it possible to create securities to fund a Specific Solution to Specific Needs. Investors might experience the beauty or the thrill of OmniFinance, i.e. (i) overruling corporate governance costs and (ii) directly accessing the underlying assets best suited to their investment preferences. Research-driven investment firms will view corporates as portfolios of assets, run by dedicated teams and supervised by industrial portfolio managers.
Asset Managers running huge pools of liquidity will continue to give too much importance to traditional securities and they will be reluctant to join the new frontier because of disproportionate cash holdings and/or commitment to an investment philosophy strictly focused on alpha neutral strategies. However, Investors aiming at outperforming markets, will appreciate that risk free is averaging a solid zero, industrial expected ROIs are still in low to mid double digits space, expected ROEs on listed equities is 6 – 8 % and private equity IRRs blinks low 20s. Certainly, the inherent corporate diversification effect – thus reducing risk profile – accounts for part of the expected returns’ negative delta on listed securities vs. Assets Derivatives. However, the more comprehensive view indicates that most of the superior returns on Assets Derivatives – as compared to their equivalent bundled listed securities – are the result of the converging impact of several factors:
· information asymmetry in favor of corporate investment committees
· lack of access for investors to segregated assets via traditional securities
· corporates enhanced performances via general purposes financial leverage.
· G&A burden weighing on traditional securities’ attributable ROEs
If (i) the quantitative relevance of the two elements at the top of the above list progressively diminishes and (ii) a substantial corporate general purpose deleverage occurs, then there will be much less room for redundant G&A to secure a Corporate competitive stance vis-à-vis investors- Investing in Assets Derivatives will become more practical, Digital Certificates’ expected yields will tend to align with those earned from the correspondent financial security and the market values of Digitized Assets will increase.
Disrupting the Financial Markets Dominance of Banks
Very few seem to realize what’s at stake, i.e. the extinction of banks (at least as we have known them for centuries). With diminishing incentives for investors to lend money (why should they without an acceptable risk premium ?), investors would shift towards full equity investment behaviors, forcing banks to accelerate business reengineering by enhancing the advisory and custodian businesses; in turn, this will cause credit markets to retrace in favor of capital markets, unleashing potential for an array of alternative marketplaces, whose combinations will offer (i) the widest investible universe and (ii) adequate and suitable exchange and settlement mechanisms.
Is it your wildest dream or a real mess? The jury’s out and it may depend on how many sides you are.
Banks will have fewer and fewer reasons to actually transact money as telcos, retailers and fintechs will crowd the payment arena and the credit market will face fierce competition from the combination of (i) a surge of equity/carried interest investment instruments and (ii) the absence of reasonable incentives to lend money: banks will eventually evolve and become customer-centric. They will focus on trust & credibility and leverage customer legacies to promote custodian and advisory functions. Eventually challenger banks will leverage incumbent banks’ infrastructures to offer banking-like services without the cost of being a bank
Investors can be grouped in two segments (plus those who combine the two approaches in one comprehensive investment strategy):
a) Beta, asset allocation-driven, scouting for best performing index trackers and decorrelated assets’ management teams, to optimize the relationship between returns and volatility. Accessing real assets with real returns outperforming financial assets with comparable volatility may attract attention in the “tactical” allocation process.
b) Alpha, absolute returns-driven, mostly specializing in industry, assets’ selection processes and/or risk management strategies; potentially attracted to direct exposure to underlying industrial assets with superior absolute returns
The opening up of various new marketplaces for Digital Certificates will impact the two Investor groups’ investment strategies in different ways, each appreciating the potential for a group’s specific strategic KPIs: the former, portfolio volatility compression; the latter, extra returns at hand by being at the forefront of underexploited investment themes
3. Investment Firm (Asset Manager)
Investment firms can be split into two categories, which cross in a 2 v 2 matrix with Investor segmentation
a) Broadliners, covering most investment segments through balanced and/or specialized products (proprietary and third parties’); mostly, not very interested in innovative capital markets (save for mere marketing purposes) and often hesitating because of disproportion between (i) investible cash and (ii) alternative products’ sustainable inflow (before excessive attention may unwillingly causing counterproductive target assets’ inflationary pressures).
b) Specialized, boutique asset managers focused on sector verticals and/or products/strategies
4. Product Specialist (Research, Capital Markets’ Engineer, Fintech Platforms, Exchange, Clearing Services)
The wider investible universe will create room for a new breed of product specialists in all stations of the intermediation process; R & D and the product deployment (research, capital markets engineering and legal) will be mostly driven by industries’ expertise whereby regulatory and technology know-how will address the disruption process via platform applications
5. Issuer (private, public, communities, foundations, NGOs, political parties and associations…)
For the first time – since organized capital markets served as the money pipeline to fuel private capital accumulation – issuers’ CFOs and Board of Directors will have a full menu of options to attract resources by issuing Assets Derivatives representing well identified utilities on such segregated assets.
Embedding into such Digital Certificates the right to receive a reward through a transparent allocation mechanism is the most revolutionary act disrupting century-old capitalist resource governance
From the above, regulators will have to address a very different agenda: in a Capital Markets industry reshaped by the inevitable repositioning of commercial banks’, dominance in financial markets will be selectively gained by numerous newcomers and/or refocused players able to aggregate (as a Broadliners or Specialists) the strongest buying power. Quite a U-turn in comparison with current understanding of market leadership, i.e. command of distribution channel. Essentially, the capital market winners will be those better representing (return vs. risk) investors’ interests. Broadliners and specialized players will co-exist, and investors and issuers will mostly deal directly
The Capital Markets’ Royal Couple
The prospect of more pervasive capital markets, within a full-equity economic system and with lots of middlemen substituted by providers of data-based value-added services (e.g. research, financial engineering, etc.), seems like a dream come true.
Here we have one major BUT.
From an educated investor protection perspective, all these exotic, alternative assets may be seen as tactical tools to raise funds, spoiled by an unsustainable disregard in relation to protecting investment value at exit by securing an ordered price formation process. Neither surprisingly nor differently from traditional investment instruments, Asset Derivatives need liquidity to compete with traditional Securities in the overall allocation processes. Hence, marketplaces are needed where such Digital Certificates can be negotiated and transferred.
The unflagging attraction of secondary trading (i.e. counteracting alternative asset liquidity discounts) stands up if two key pillars are secured: widespread investor access to price-sensitive relevant information and well-tested pricing techniques. Any assets without a solid newsflow and reliable pricing methods will suffer from investor caution and therefore demand higher rates of return to buy and hold. Plus, scarce liquidity would emphasize the risk of greater than reasonable capital losses in case of concurrent and impulsive fight to quality.
The convergence paradigm towards OmniFinance – i.e. turning finance into a strategic weapon making digital transformation much more than a buzzword – thus requires the establishment of specialized liquid marketplaces to trade such Digital Certificates (Assets Derivatives) representing the estimated economic cashflows of data-based business solutions satisfying customers’ current and future needs
If Cash (investors) is the Streets King, then Liquidity (platforms) is the Floor Dancing Queen.