Financial Services Sector PDF

Introduction: The Financial Services Sector 1. Financial Services Sector 1 In this chapter, we will look at the role that the financial services sector undertakes within both the local and the global economy. The world is becoming increasing...

Introduction: The Financial Services Sector 1. Financial Services Sector 1 In this chapter, we will look at the role that the financial services sector undertakes within both the local and the global economy. The world is becoming increasingly integrated and interdependent, as trade and investment flows are global in nature. With this background, therefore, it is important to understand the core role that the financial services sector performs within the economy and some of the key features of the global financial services sector. The financial services sector plays a critical role in advanced and developing economies, and the services it provides can be broken down into three core functions: The investment chain – through the investment chain, savers and borrowers are brought together. Savers provide financing to businesses, and businesses that wish to grow offer opportunities for savers to take part in the growth and resulting potential returns. The efficiency of this chain is critical to allocating what would otherwise be uninvested capital to businesses that can use it to grow their enterprises, as well as the savings pools of the investors. This chain, therefore, raises productivity and, in turn, improves the competitiveness of those financial markets within the global economy. Risk – in addition to the opportunities that the investment chain provides for pooling investment risks, the financial services sector allows other risks to be managed effectively and efficiently through the use of insurance, and increasingly through the use of sophisticated derivatives. These tools help businesses cope with global uncertainties as diverse as the changing value of currencies, the incidence of major accidents or extreme weather conditions. They also help households protect themselves against everyday contingencies. 3  Payment systems – payment and banking services operated by the financial services sector provide the practical mechanisms for money to be managed, transmitted and received quickly and reliably. It is an essential requirement for commercial activities to take place and for participation in international trade and investment. Access to payment systems and banking services is a vital component of financial inclusion for individuals. The financial services sector provides the link between organisations needing capital and those with capital available for investment. For example, an organisation needing capital might be a growing company, and the capital might be provided by individuals saving for their retirement in a pension fund. It is the financial services sector that channels the money invested to those organisations that need it and provides execution, payment, advisory and management services. The Global Financial Centres Index is produced by Z/Yen1 and evaluates the rankings and future competitiveness of 111 major financial centres based on the following five areas of competitiveness: Business environment. Human capital. Infrastructure. Financial sector development. Reputation. The Global Financial Centres Index 30 (GFCI 30), published in 2022, showed that New York retained its number one place in the rankings, with London not far behind. Top Five Global Financial Centres 1 New York 2 London 3 Hong Kong 4 Shanghai 5 Los Angeles This chapter looks at how the financial sector is structured and some of its key participants. 1 GFCI 30 Rank – Long Finance (https://www.longfinance.net/programmes/financial-centre-futures/global-financial- centres-index/gfci-31-explore-data/gfci-31-rank/) 4  Introduction: The Financial Services Sector 2. Financial Markets 1 Learning Objective 1.1.2 Know the function of and differences between retail and professional/commercial business and who the main customers are in each case Within the financial services sector, there are two distinct areas: the wholesale and retail sectors. The wholesale sector is also sometimes referred to as the professional sector or the institutional sector. The activities that take place in wholesale financial markets are shown below and are expanded on in sections 2.1 to 2.5: Equity markets – the trading of quoted shares. Bond markets – the trading of government, supranational or corporate debt. Foreign exchange – the trading of currencies. Derivatives – the trading of options, swaps, futures and forwards. Insurance markets – major corporate insurance (including professional indemnity), reinsurance, captive insurance and risk-sharing insurance. Other activities that take place in the wholesale sector include: fund management – managing the investment portfolios of collective investment schemes (CISs), pension funds and insurance funds investment banking – banking services tailored to organisations, such as undertaking mergers and acquisitions (M&A), equity trading, fixed-income trading and private equity, and custodian banking – provision of services to asset managers involving the safekeeping of assets, the administration of the underlying investments, settlement, corporate actions and other specialised activities. By contrast, the retail sector focuses on services provided to personal customers: Retail banking – the traditional range of current accounts, deposit accounts, lending and credit cards. Insurance – the provision of a range of life assurance and protection solutions for areas such as medical insurance, critical illness cover, motor insurance, property insurance, income protection and mortgage protection. Pensions – the provision of investment accounts specifically designed to capture savings during a person’s working life and provide benefits on retirement. Investment services – a range of investment products and vehicles ranging from execution-only stockbroking to full wealth management services and private banking. Financial planning and financial advice – helping individuals to understand and plan for their financial future. 5 2.1 Equity Markets Equity markets is the name given to stock markets where the ordinary and preferred shares of companies, such as Amazon, Apple, Facebook and Netflix, are traded. Equity markets are the best- known of the financial markets and facilitate the trading of shares in quoted or listed companies. The World Federation of Exchanges provides data from global stock exchanges. As illustrated in the following graph, global market capitalisation was over US$100 trillion at the end of 2022 (note that not all stock exchanges provide data to the World Federation of Exchanges so actual figures may well be higher). Global market capitalisation is the total value of shares quoted on the world’s stock exchanges. Market Capitalisation 120 100 80 USD Million 60 40 20 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Source: World Federation of Exchanges The following are some key statistics on the equity markets as at the end of 2022: The New York Stock Exchange (NYSE) was the largest exchange in the world, with a domestic market capitalisation of over US$24 trillion (domestic market capitalisation is the value of shares listed on an individual exchange). The other major US market, Nasdaq, was ranked as the second largest, with a domestic market capitalisation of around US$16 trillion, meaning that the two New York exchanges account for a significant proportion of all exchange business. The Shanghai Stock Exchange (SSE) is now the world’s third largest exchange, with a domestic capitalisation of over US$6 trillion. The Shenzhen Stock Exchange (SZSE) is the sixth largest exchange, with a domestic market capitalisation of over US$4 trillion. Japan Exchange Group, which includes the Tokyo Stock Exchange (TSE), is the world’s fifth largest market, with a domestic market capitalisation of over US$5 trillion. In Europe, the largest exchanges are the London Stock Exchange (LSE), Euronext, SIX Swiss Exchange and Deutsche Börse AG. In the Middle East, Tadawul – the Saudi Stock Exchange is the largest exchange, with a domestic market capitalisation of over US$2.5 trillion. 6  Introduction: The Financial Services Sector Rivals to traditional stock exchanges have also arisen with the development of technology and 1 communication networks known as multi­lateral trading facilities (MTFs). MTFs are systems that bring together multiple parties that are interested in buying and selling financial instruments including shares, bonds and derivatives. These systems are also known as crossing networks or matching engines that are operated by an investment firm or another market operator. We will look at equities and equity markets in more detail in chapter 3. Source: World Federation of Exchanges 2.2 Bond Markets Bond markets allow governments and companies to raise loans or debt finance directly from investors and then facilitate the subsequent secondary trading of the debt securities created. Although less well- known than equity markets, bond markets are larger both in size and value of trading. However, the volume of bond trading is lower, as most trades tend to be very large when compared to equity market trades. The amounts outstanding on the global bond market now exceed US$128 trillion, according to the International Capital Market Association (ICMA). Sovereign, supranational and agency (SSA) debt accounts for 68% of the global bond market while corporate bonds make up the remaining 32%. The bonds traded range from domestic bonds, issued by companies and governments, to international bonds issued by companies, governments, and supranational agencies such as the World Bank. Although the US has the largest bond market, trading in international bonds is predominantly undertaken in European markets. We will look at bonds in more detail in chapter 4. 2.3 Foreign Exchange (FX) Markets Foreign exchange (FX) markets are the global marketplace that determine the exchange rates for currencies around the world, and where one currency is traded for another. FX markets are the largest of all financial markets, with an average daily turnover of approximately US$7.5 trillion*, a volume 30 times greater than daily global GDP. The rate at which one currency is exchanged for another is determined by supply and demand. For example, if there is strong demand from Japanese investors for US dollars, the US dollar will rise in value relative to the Japanese yen. There is an active FX market that enables governments, companies and individuals to deal with their cash inflows and outflows denominated in overseas currencies. The market is provided mostly by the major banks, with each providing rates of exchange at which they are willing to buy or sell currencies. Historically, most FX deals were arranged over the telephone. Now, however, electronic trading is increasingly prevalent. As FX is an over-the-counter (OTC) market, meaning one where brokers/dealers negotiate directly with one another, there is no central exchange or clearing house. FX trading is concentrated in a small number of financial centres. 7 The Bank for International Settlements (BIS) releases figures on the composition of the FX market every three years. The latest report, published in 2022, shows that market activity remains concentrated in a handful of global centres. As you can see in the chart below, the main centre for FX trading is the UK reflecting its geographic position in the middle of the US and Asian time zones. Main Locations for FX Trading* The BIS survey also shows that the US dollar retained its status as the most dominant currency, being on one side of 88% of all trades. Additionally, it provided a breakdown of the main types of FX trading which we will consider in a later chapter and showed that FX transactions were on average split as shown in the following table. FX Trading by Type of Instrument Spot transactions US$2.10tn 28% Outright forwards US$1.16tn 16% FX swaps US$3.81tn 50% Currency swaps US$124bn 2% FX options and other products US$304bn 4% We will look at FX in more detail in chapter 3. *Source: BIS Triennial Central Bank Survey of OTC foreign exchange turnover 8  Introduction: The Financial Services Sector 2.4 Derivatives Markets 1 Derivatives markets trade a range of complex products based on underlying instruments, including currencies, indices, interest rates, equities, commodities and credit risk. Futures and options are two of the most well-known derivatives. Derivatives based on these underlying elements are available on both the exchange-traded market and the OTC market. An OTC market is where trading takes place directly between parties rather than on an exchange and the trading of derivatives is increasingly moving from OTC to trading on exchange. The largest of the exchange-traded derivatives markets is the Chicago Mercantile Exchange (CME), while Europe dominates trading in the OTC derivatives markets worldwide. Based on the value of the notional amounts outstanding, the OTC derivatives markets worldwide are about four times the size of stock quoted on stock exchanges. Interest rate derivatives contracts account for the vast majority of outstanding derivatives contracts, mostly through interest rate swaps and foreign exchange derivatives. In terms of currencies, the interest rate derivatives market is dominated by the euro and the US dollar, which have accounted for most of the growth in this market since 2001. The growth in the market came about as a reaction to the 2000–02 stock market crash as traders sought to hedge their position against interest rate risk. The next largest segment is FX derivatives, which are used to speculate on currency movements and to hedge the risks of currency positions. Equity-linked contracts, credit derivatives and commodity contracts form the next major segments and these are used to hedge against risk or for speculation. We will look at derivatives in more detail in chapter 6. 2.5 Insurance Markets Insurance markets specialise in the management of personaI risk, corporate risk and protection of life events. Globally, the US, China and Japan are the largest insurance markets. The following table shows the top five largest markets by insurance premiums. Five Largest Markets in 2021 (ranked by total premium volume) Rank Country 1 US 2 China 3 Japan 4 UK 5 France Source: SwissRe 9 The market is led by a number of major players who dominate insurance activity in their sector or region; some of the largest are China Life, Allianz and AXA. Another well-known organisation is Lloyd’s (the world’s specialist insurance market and historically referred to as Lloyd’s of London); with a history dating back over 300 years, it is one of the largest insurance organisations in the world. Lloyd’s is not an insurance company but a marketplace that brings together a range of insurers, both individuals and companies, each of whom accepts insurance risks as a member of one or more underwriting syndicates. A small number of individual members (traditionally known as ‘names’) are liable to the full extent of their private wealth to meet their insurance commitments, while the majority are corporate entities which trade with limited liability. Corporate members include companies, limited liability partnerships and some specialist vehicles. Lloyd’s names join together in syndicates and each syndicate will ‘write insurance’, ie, take on all, or part of, an insurance risk. There are many syndicates, and each name will belong to one or a number of these. Each syndicate hopes that premiums received will exceed claims paid out, in which case, each name will receive a share of the profits (after deducting administration expenses). Lloyd’s insures specialist and complex risks in casualty, property, energy, motor, aviation, marine and reinsurance. It has a reputation for innovation (eg, developing policies for aviation, burglary and cybercrime) and is known across the world as the place to bring unusual, specialist and complicated risks. Less well known to the general public is the reinsurance industry. Just as individuals use insurance to protect against the risk of needing to make a claim, insurers protect themselves by using reinsurance companies. An insurer may seek to hedge some of the risks associated with the insurance policies it has written by laying off some of that risk with a reinsurer. The reinsurance contract can cover an entire insurance portfolio or single risks; it may involve sharing all premiums and losses or just those exceeding a threshold, and it can also cover large one-off risks, such as major construction, satellites or large sporting events. Some of the largest reinsurers in the world are Munich Re, Swiss Re, Hannover Re, Berkshire Hathaway, and Lloyd’s. 10  Introduction: The Financial Services Sector 3. Participants 1 Learning Objective 1.1.1 Know the role of the following within the financial services sector: retail/commercial banks; savings institutions; investment banks; private banks; pension funds; insurance companies; fund managers; stockbrokers; custodians; platforms; third-party administrators (TPAs); industry trade and professional bodies; sovereign wealth funds; peer-to-peer/crowdfunding The number of organisations operating in the financial services sector is wide and varied. Each carries out a specialised function, and an understanding of their roles is important in order to understand how the sector is organised and how participants interact. Although each participant is described as a separate organisation in the following sections, the nature of financial conglomerates means that some of the largest global firms may have divisions carrying out each of these activities. 3.1 Investment Banks Investment banks provide advice and arrange finance for companies that want to float on the stock market, raise additional finance by issuing further shares or bonds, or carry out mergers and acquisitions. They also provide services for institutional firms that might want to invest in shares and bonds, in particular pension funds and asset managers. Typically, an investment banking group provides some or all of the following services: Finance-raising and advisory work, both for governments and for companies. For corporate clients, this is normally in connection with new issues of securities to raise capital, as well as giving advice on mergers and acquisitions. Securities-trading in equities, bonds and derivatives and the provision of broking and distribution facilities. Treasury dealing for corporate clients in currencies, including ‘financial engineering’ services to protect them from interest rate and exchange rate fluctuations. Investment management for sizeable investors, such as corporate pension funds, charities and very wealthy private clients. In the larger investment banks, the value of funds under management runs into many billions of dollars. Only a small number of investment banks provide services in all these areas. Most others tend to specialise to some degree and concentrate on only a few product lines. A number of banks have diversified their range of activities by developing businesses such as proprietary trading, servicing hedge funds, or making private equity investments. 11 3.2 Custodians Custodians are banks that specialise in safe custody services, looking after investments such as shares and bonds on behalf of others, such as fund managers, pension funds and insurance companies. Activities they undertake include the following: Holding assets in safekeeping, such as equities and bonds. Arranging settlement of any purchases and sales of securities. Asset servicing – collecting income from assets, namely dividends in the case of equities and interest in the case of bonds, and processing corporate actions. Providing information on the underlying companies and their annual general meetings (AGMs). Managing cash transactions. Performing FX transactions when required. Providing regular reporting on all activities undertaken that affect the holdings in a portfolio, including all trades, corporate actions and other transactions. Cost pressures have driven down the charges that a custodian can make for its traditional custody services and have resulted in consolidation within the industry. The custody business is now dominated by a small number of global custodians who are often divisions of major banks. Among the biggest global custodians are the Bank of New York Mellon and State Street. Generally, they also offer other services to their clients, such as stock lending, measuring the performance of the portfolios of which they have custody and maximising the return on any surplus cash. 12  Introduction: The Financial Services Sector 3.3 Retail/Commercial Banks 1 Retail/commercial banks are known by different names in different countries. They are the financial institutions that provide services, such as taking deposits from, and lending funds to, retail customers, as well as providing payment and money transmission services. They may also provide similar services to business customers. Historically, these banks have tended to operate through a network of branches with physical locations, but increasingly they operate through telephone and internet-based services. As well as providing traditional banking services, larger retail banks also offer other financial products, such as investments, pensions and insurance. Banks that offer multiple services such as this are known as ‘financial conglomerates’. The BIS defines a financial conglomerate as: ‘any group of companies under common control whose exclusive or predominant activities consist of providing significant services in at least two different financial sectors (banking, securities, insurance)’. More recently, competition to traditional banks has emerged from ‘challenger’ banks. These are smaller banks, specialising in areas underserved by large, traditional banks, and which distinguish themselves from historic banking by deploying modern financial technology with no community branches. 3.4 Savings Institutions As well as retail banks, most countries also have savings institutions that started off by specialising in offering savings products to retail customers, but now tend to offer a similar range of services to those offered by banks. They are known by different names around the world, such as cajas in Spanish-speaking countries, credit unions in North America and building societies in Australia and the UK. They are typically jointly owned by the individuals that have deposited or borrowed money from them – the members. It is for this reason that such savings organisations are often described as ‘mutual societies’ or ‘mutual savings banks’. Over the years, many savings institutions have merged or been taken over by larger ones. More recently, a number have transformed themselves into banks that are quoted on stock exchanges – a process known as demutualisation. 3.5 Peer-to-Peer (P2P) Lending and Crowdfunding A more recent development in the banking sector has been the emergence of competitors to the traditional role of banks in the form of peer-to-peer lenders and crowdfunding. P2P Lending In the traditional banking model, banks take in deposits on which they pay interest and then lend out at a higher rate; the spread between the two is where they earn their profit. Peer-to-peer (P2P) lending cuts out the banks so that borrowers often receive slightly lower rates, while savers get far improved headline rates, with the P2P firms themselves profiting via a fee. 13 In exchange for accepting greater risk, savers can earn higher returns. Available rates vary depending on the type of borrower that the P2P site lends to and the risk the lender is prepared to accept. The deposit is lent out to individuals and businesses, but it may take time before all of a large deposit is lent and interest is earned. No interest is paid while it is waiting to be lent out. Immediate withdrawals are not always possible and, where they are, may take time and incur a charge or a reduced interest rate. Most of these loans are unsecured, meaning that they are not backed by any collateral in the event of default. Crowdfunding Crowdfunding is the practice of funding a project or venture by raising small amounts of money from a large number of people. Traditionally, financing a business, project or venture involved asking a bank or a few people for large sums of money. Crowdfunding switches this idea around, using the internet to access many potential funders. Crowdfunding can take the following forms: A donation – people simply believe in the cause. Debt crowdfunding – investors essentially lend then receive their money back with interest. Equity crowdfunding – people invest in exchange for equity or shares in the venture. In terms of equity crowdfunding, it usually involves a start-up seeking funding from a large number of people. Some start-ups may even seek to convert its fans and customers into investors in order to enhance brand loyalty. To the founder, one advantage of having a large number of funders instead of one or a few key investors is that large investors may have different ideas and seek to influence how the business is run. Having a diverse source of funding may help to diffuse pressure from such investors. Moreover, small investors can be turned into brand ambassadors for the company. 3.6 Insurance Companies As mentioned above, one of the key functions of the financial services sector is to allow risks to be managed effectively. The insurance industry provides solutions for much more than the standard areas, such as life cover and general insurance cover. Protection planning is a key area of financial advice, and the insurance industry provides a variety of products to meet many potential scenarios. These products range from payment protection policies designed to pay out in the event that an individual is unable to meet repayments on loans and mortgages, to fleet insurance against the risk of an airline’s planes crashing. Insurance companies collect premiums in exchange for the coverage provided. This premium income is invested in equities and bonds and, as a result, the insurance industry is a major investor in both equity and bond markets. Insurance companies will also hold a large amount of cash to be able to satisfy any claims that may arise on the various policies and, if required, will liquidate investment holdings. 14  Introduction: The Financial Services Sector 3.7 Pension Funds 1 Retirement schemes (or pension funds) are one of the key methods by which individuals can make provision for their retirement needs. There are a variety of retirement schemes available, ranging from ones provided by employers, to self-directed schemes. Traditionally, company pension schemes provided an amount based on the employee’s final salary and number of years of service. Nowadays, many companies find this too expensive and risky a commitment, given rising life expectancy and volatile stock market returns. Most companies offer new staff defined contribution (DC) schemes in which the firm and, in most cases, the employee contribute to an investment pot. At retirement, the accumulated fund is used to provide a pension. Many individuals are not members of company schemes and instead provide for their retirement through their own personal retirement schemes (self-directed schemes). Taken overall, retirement schemes are large, long-term investors in shares, bonds and cash. Some also invest in physical assets like property. To meet their aim of providing a pension on retirement, the sums of money invested in pensions are substantial. 3.8 Fund Managers Fund managers, also known as investment managers, portfolio managers or asset managers, run portfolios of investments for others. They invest money held by institutions, such as pension funds and insurance companies, as well as individuals. Some are organisations that focus solely on this activity; others are divisions of larger entities, such as insurance companies or banks. Fund management is also known as asset management. The global asset management industry has more than doubled in size since 2000, with the Organisation for Economic Co-operation and Development (OECD) and the International Monetary Fund (IMF) estimating that there are over US$90 trillion of funds under management. Investment managers will buy and sell shares, bonds and other assets in order to increase the value of their clients’ portfolios. They can be subdivided into institutional and private client fund managers. Institutional fund managers work on behalf of institutions, for example, investing money for a company’s pension fund or an insurance company’s fund, or managing the investments of a mutual fund. Private client managers invest the money of individuals. Obviously, institutional portfolios tend to be larger than those of regular private clients. Fund managers charge their clients for managing their money. Their charges are often based on a small percentage of the value of the fund being managed and may also have charges linked to the performance achieved. Generally, brokerage costs tend to be reduced for larger volume trades. Other areas of asset management include running so-called hedge funds and the provision of investment management services to institutional entities, such as charities and local government authorities. 15 3.9 Stockbrokers and Wealth Managers Stockbrokers arrange stock market trades on behalf of their clients, who are investment institutions, fund managers or private investors. They may advise investors about which shares, funds or bonds they should buy or, alternatively, they may offer execution-only services, when the broker executes a trade on a client’s instruction without providing advice. Many stockbrokers now offer wealth management services to their clients and so are also referred to as wealth managers. The services offered by stockbrokers and wealth managers can be divided into four main categories: Execution-only stockbrokers – these offer telephone or internet-based trade execution and settlement for retail clients. No advice is offered and commission is charged per trade. They are aimed at day traders and investors who are confident in making their own investment decisions and, typically, investors with small portfolios. Robo-advisers – a recent innovation, a robo-adviser is an online wealth management service that provides automated, algorithm-based portfolio management advice without the use of human financial planners. The robo-adviser typically charges a monthly or annual fee based on the size of the portfolio (amount of assets under management). Advisory and discretionary wealth managers – these offer a wealth management service to private investors – either advice only or a fully managed (discretionary) service. Their target market ranges from mass affluent to high net worth clients with large portfolios and they charge fees for management of the portfolio based on the value of the portfolio. Institutional brokers – these are stockbrokers who arrange trades on behalf of large institutions. Their skill lies in their ability to execute what are typically large trades in the market, without having a significant adverse effect on the share price. This may involve breaking up a large order into smaller trades and executing them through a variety of different trading venues so as to minimise their impact on the market. Institutional brokers usually charge basis point fees per trade. Like fund managers, stockbrokers and wealth managers can also look after client assets and charge custody and portfolio management fees. Stockbrokers also advise investors about which shares, bonds or funds they should buy. As a result, the traditional distinction between the two has blurred and is rapidly disappearing. These wealth management firms can be independent companies, but some are divisions of larger entities, such as investment or commercial banks. They earn their profits by charging fees for their advice and commissions on transactions. Also, as with fund managers, they may look after client assets and charge custody and portfolio management fees. 3.10 Platforms Platforms, sometimes known as fund supermarkets, are online services used by intermediaries, such as independent financial advisers (IFAs), to view and administer their clients’ investment portfolios. They offer a range of tools which allow advisers to see and analyse a client’s overall portfolio and to choose products for them. As well as providing facilities for investments to be bought and sold, platforms generally arrange custody for clients’ assets. Examples of platforms include those offered by Cofunds and Hargreaves Lansdown. 16  Introduction: The Financial Services Sector Platforms tend to offer wide ranges of mutual funds, but also ‘wraps’ such as pension plans and 1 insurance bonds. Wrap accounts enable advisers to take a holistic view of the various assets that a client has in a variety of accounts. Advisers also benefit from using wrap accounts to simplify and bring some level of automation to their back office using internet technology. Platform providers also make their services available directly to investors, and platforms earn their income by charging for their services. The advantage of platforms for fund management groups is the ability of the platform to distribute their products to financial advisers. 3.11 Private Banks Private banks provide a wide range of services for their clients, including wealth management, estate planning, tax planning, insurance, lending and lines of credit. Their services are normally targeted at clients with a certain minimum sum of investable cash, or minimum net worth. These clients are generally referred to as high net worth individuals (HNWIs). Private banking is offered both by domestic banks and by those operating ‘offshore’. In this context, offshore banking means banking in a jurisdiction different from the client’s home country – usually one with a favourable tax regime. Competition in private banking has expanded in recent years as the number of banks providing private banking services has increased dramatically. The private banking market is relatively fragmented, with many medium-sized and small players. The distinction between private and retail banks is gradually diminishing as private banks reduce their investment thresholds in order to compete for this market. Meanwhile, many high street banks are also expanding their services to attract the ‘mass affluent’ and HNWIs. 3.12 Sovereign Wealth Funds (SWFs) A sovereign wealth fund (SWF) is a state-owned investment fund that holds financial assets such as equities, bonds, real estate, or other financial instruments. Examples of SWFs include the Norway Government Pension Fund, Abu Dhabi Investment Authority, SAMA Foreign Holdings of Saudi Arabia and China Investment Corporation. SWFs are defined as special purpose investment funds or arrangements owned by a government. Their key characteristics are as follows: They hold, manage, or administer assets to achieve financial objectives. They employ a set of investment strategies which include investing in foreign financial assets. The assets of an SWF are commonly established out of balance of payments surpluses, official foreign currency operations, the proceeds of privatisations, fiscal surpluses, and receipts resulting from commodity exports. 17 SWFs have emerged as major investors in the global markets over the last ten years, but they date back at least five decades to the surpluses built up by oil-producing countries and, more recently, to the trade surpluses that countries such as China have enjoyed. SWFs have colossal funds under management and are predicted to grow beyond the US$10 trillion mark within a few years. They are private investment vehicles that have varied and undisclosed investment objectives. Typically, their primary focus is on well-above-average returns from investments made abroad. Their size and global diversification allows them to participate in the best opportunities, spread their risks and, by diverting their funds overseas, stabilise their local economies. They may also use part of their wealth as reserve capital for when their countries’ natural resources are depleted. For some of the wealthiest SWFs, it should be noted that the term ‘sovereign’ is not synonymous with public ownership. SWFs are becoming increasingly important in the international monetary and financial system, attracting growing attention. This growth has also raised several issues: Official and private commentators have expressed concerns about the transparency of SWFs, including their size and their investment strategies, and that SWF investments may be affected by political objectives. There are also concerns about how their investments might affect recipient countries, leading to talk about protectionist restrictions on their investments, which could hamper the international flow of capital. In response to these concerns, the International Forum of Sovereign Wealth Funds has been formed and has published a set of 24 voluntary principles, the Generally Accepted Principles and Practices for Sovereign Wealth Funds, known as the Santiago Principles. This is leading to increasing transparency, with a number of countries now publishing annual reports and disclosing their assets under management. 3.13 Industry Trade and Professional Bodies The investment industry is a dynamic, rapidly changing business, and one that requires cooperation between firms; this ensures that the views of various industry sections are represented, especially to governments and regulators, and that cross-firm developments can take place to create an efficient market in which those firms can operate. This is the role of the numerous trade bodies that exist across the world’s financial markets. Examples of these that operate globally are the International Capital Market Association (ICMA), which concentrates on international bond dealing, and the International Swaps and Derivatives Association (ISDA), which produces standards that firms that operate in OTC derivatives follow when dealing with each other. 18  Introduction: The Financial Services Sector 3.14 Third-Party Administrators (TPAs) 1 Third-party administrators (TPAs) undertake investment administration on behalf of other firms, and specialise in this area of the investment industry. The number of firms, and the scale of their operations, has grown with the increasing use of outsourcing by firms. The rationale behind outsourcing has been that it enables a firm to focus on the core areas of its business (for example, investment management and stock selection, or the provision of appropriate financial planning) and leave another firm to carry on the administrative functions which it can process more efficiently. Note that ultimate responsibility remains with the outsourcing firm. 4. Investment Distribution Channels Learning Objective 1.1.3 Know the role of investment distribution channels including: independent and restricted advice; execution only; robo-advice 4.1 Financial Planning Financial planning is a professional service available to individuals, their families and businesses, who need objective assistance in organising their financial affairs to achieve their financial and life style objectives more easily. Financial planning is clearly about financial matters, so it deals with money and assets that have monetary value. Invariably this will involve looking at the current value of clients’ bank balances, any loans, investments and other assets. It is also about planning, ie, defining, quantifying and qualifying goals and objectives and then working out how those goals and objectives can be achieved. In order to do this, it is vital that a client’s current financial status is known in detail. Financial planning is ultimately about meeting a client’s financial and life style objectives, not the adviser’s objectives. Any advice should be relevant to the goals and objectives agreed. Financial planning plays a significant role in helping individuals get the most out of their money. Careful planning can help individuals define their goals and objectives, and work out how these may be achieved in the future using the available resources. Financial planning can look at all aspects of an individual’s financial situation and may include tax planning, both during their lifetime and on death, asset management, debt management, retirement planning and personal risk management – protecting income and capital in the event of illness and providing for dependants on death. The Chartered Institute for Securities & Investment (CISI) offers qualifications and related products at all levels for those working in, or looking for a career in, financial planning. Further details can be found on the CISI’s website (www.cisi.org). 19 4.2 Independent versus Restricted Advice Investment firms describe their services as either independent advice or restricted advice. Firms that describe their advice as independent must ensure that they genuinely do make their recommendations based on comprehensive and fair analysis of all products available in the market, and provide unbiased, unrestricted advice. If a firm chooses to only give advice on its own range of products – restricted advice – this must be made clear to customers. 4.3 Execution Only A firm carries out transactions on an execution-only basis if the customer asks it to buy or sell a specific named investment product without having been prompted or advised by the firm. In such instances, customers are responsible for their own decision about a product’s suitability. The practice of execution-only sales is long-established. To ensure that firms operate within regulatory guidelines, they need to record and retain evidence, in writing, that the firm: gave no advice, and made it clear, at the time of the sale, that it was not responsible for assessing the product’s suitability. 4.4 Robo-Advice Robo-advice is the application of technology to the process of providing financial advice, but without the involvement of a financial adviser. A prospective investor enters data and financial information about themselves, and the system then uses an algorithm to score the information and decide what investments should be chosen. The system then presents the investment strategy, which is usually passively focused around index funds or exchange-traded funds (ETFs), and allows easy implementation. 20  Introduction: The Financial Services Sector Robo-advice can be fully automated or provide guidance and tools to enable investors to choose their 1 own solutions. The approach uses an asset-and-risk model, as well as the construction of risk-targeted portfolios or funds to achieve a client’s objectives, and then the ongoing monitoring and rebalancing against those objectives. Robo-advice is already established in the US, with some of the industry’s largest players involved. 5. Technological Advances and Other Developments Learning Objective 1.1.4 Know about the following themes: Fintech; environmental, social and governance (ESG) 5.1 Technological Advances Technology and the demand for greener solutions are changing the way that the financial services sector operates. Technology is embedded in everything we do, changing the way we live, work, and experience the world. Advances in technology have radically altered how we use the internet and communicate which, in turn, are disrupting traditional industries. Financial technology, known as Fintech, is impacting on the traditional banking and wealth management industry and, therefore, requires the development of new digital services and platforms across a range of financial institutions. People are becoming more digitally proficient, and they desire constant access to sophisticated tools and services, with clients of financial services firms being no different. We have already looked at how challenger banks, P2P lending and robo-advice are challenging the long-established provision of banking and investment services. Technological developments in communications are also changing the face of the industry. Today, as the use of apps and artificial intelligence (AI) recommendations from providers is increasing, customers are demanding the same range of digital capabilities that they have become used to for other products and services. As an example, China’s fund management industry has gone from fledgling asset management to global pioneer in a short number of years in terms of how fund purchases take place. In 2012, only a handful of investors made fund purchases online but, according to a survey by the Asset Management Association of China, more than two-thirds of investors now subscribe to funds via mobile phone apps. 21 5.2 Environmental, Social and Governance (ESG) Investing The emergence of a more conscious investor has contributed to the development of the latest theme within the financial sector. ESG factors are used by these investors to determine if an investment suits their objectives: Environmental factors and concerns include sustainability and climate change. Social factors and concerns include consumer protection and diversity. Governance factors and concerns include employee relations and management structures. In the investment industry, the expressions ‘ethical investment’, ‘environmental investment’, ‘green investment’, ‘responsible investment’ and ‘socially responsible investment’ are often used interchangeably and so can be quite confusing. Together, these strands are often brought together under the label of environmental, social and governance (ESG), which includes a range of approaches that includes various issues; it may also be referred to as ‘responsible investing’. Broadly speaking, ‘responsible investing’ reflects the ethical, moral, religious or socially responsible beliefs of the client, and can heavily influence their choice of investments. Also included in this group is the growing number of Shariah investments, which meet the rules of Islamic finance. A key trend in recent years has been the increasing debate on environmental and social issues and the scale of concern about environmental change is being reflected in the asset management industry. Green finance and sustainable finance are becoming increasingly important topics in the financial services sector. Sustainable finance refers to the process of taking due account of environmental and social considerations in investment decision-making, leading to increased investments in longer term and sustainable activities. Climate finance is an emerging form of green finance available for projects in developing countries that helps reduce emissions or adapt to climate change. This is achieved either via increasing the revenues available to public and private development projects (such as tariff support or carbon finance) or by improving project capital structure; for example, by reducing the costs of debt and equity. Research suggests that, by 2025, 50% of investment funds will have an investment mandate requiring them to invest in accordance with ESG principles. 22