Capital markets: top 10 themes and trends for 2022
24 Mar 2022
This year, the world has been facing uncertainties that require careful navigation by market participants, governments, and central banks. Our capital markets team considers key areas for 2022.
The conflict in Ukraine has created severe geopolitical fragility on a scale not seen in Europe for decades. It heightens risks and also adds further pressure on energy prices, supply chains and inflation across Europe and beyond.
Global capital markets had successfully transitioned into the post-LIBOR era, while continuing to manage impacts of the pandemic on the economy, manifesting in price volatility and significant inflationary pressures on firms and central banks, which have made multiple interest rate hikes inevitable across jurisdictions.
As UK financial services adjust to operate post-Brexit, the new regulatory framework looks to promote market infrastructure, product, and technology innovation, aiming to attract investment and support competitiveness of the sector, as well as the government’s net-zero transition target and wider societal ESG objectives.
1 The macroeconomic environment
Governments and central banks of major economies responded with unprecedented relief packages to support businesses and consumers during pandemic lockdown periods, and successfully averted a lasting global recession.
Financial resilience and faster recovery in many sectors enabled growth in asset prices, but lockdown of the real economy caused significant disruption to supply chains and energy reserves, especially gas, as demand normalised. Manifesting in price volatility and increased inflation, both were initially considered transitory, driven by supply shocks. Deglobalisation and radical sanctions imposed on Russia, as well as labour market and housing market factors are however expected to contribute to longer-term inflationary pressures.
With soaring inflation levels not seen in decades, the relative contribution from demand and supply factors is still uncertain. Central banks are challenged to balance monetary policy intervention to curb inflation and risk of damaging fragile economies, with heightened uncertainties due to the Ukraine crisis, as well as the course of the pandemic. The Federal Reserve (FED) pivoted to winding down its asset purchase programme and signalled interest rate rises in the first quarter alongside its balance sheet reduction, while the European Central Bank (ECB) continued to take a more dovish approach, even with highest inflation since the Eurozone inception. The Bank of England (BoE) announced its second base rate increase, warning of entrenched inflation. Firms should expect to operate in a rising interest rate environment and factor this into their funding and commercial models.
2 The post-LIBOR era
The global LIBOR reform reached its pivotal LIBOR cessation milestone at the end of 2021, when panel bank submissions have ceased for all currency settings, except five remaining USD tenors.
During 2022, for three tenors of Sterling and Yen respectively, synthetic LIBOR will be published, based on term SONIA and term TONA rates, to facilitate transition of remaining legacy contracts. While firms have operationalised back-book transition, the large-scale global USD legacy transition also remains to be completed by mid-2023, with US authorities driving milestones for this year.
Crucially, new LIBOR contracts are already prohibited in any currency, with only few exemptions for risk management purposes. We particularly note the pivot away from USD LIBOR to SOFR products, with USD 360 billion SOFR notional outstanding at the beginning of the year. Regulators continue to caution against use of credit-sensitive benchmarks, some of which are not compliant with UK and EU benchmark regulations. Innovative approaches to determine credit spreads over SOFR and other risk-free reference rates and associated term rates are proliferating, which may better reflect banks’ funding costs. Liquidity funds transfer pricing will increasingly come into focus, particularly in the rising interest environment.
3 The ESG agenda
ESG has moved from commitment and conception to execution, after reporting obligations informed by the Task Force on Climate-Related Financial Disclosures (TFCD) have become effective this year. Shifting from a backward-looking perspective to understand forward-looking climate exposures with far out projection horizons and modelling scenarios aligned to net zero target dates and the Paris agreement remain challenges. Managing the financial, physical, and transition risks from climate change has significant data and model requirements. Climate change may be most progressed, but increasingly other environmental factors come into focus, particularly biodiversity and natural capital, addressed by the Taskforce on Nature-related Financial Disclosures (TNFD) and supported by the UK Environment Act 2021. Financial Institutions are instrumental for the ESG ambition, continuing to develop indices, derivatives, and structured products. Identifying new opportunities, pricing capital and products appropriately, and optimised decision making are at the core of an effective ESG business strategy.
Product development to hedge demand-driven buy-side products is particularly important for sell-side firms. Demand for green bonds is growing further, but greenwashing conduct risk has become a consideration. Methods to account for outcomes against broader ESG objectives aligned to the UN Sustainable Development Goals (SDGs) for a more equitable world are evolving too. Impact is becoming a factor that increasingly challenges conventional Risk-Return paradigms of asset pricing.
4 Financial and operational resilience
The pandemic has proven financial resilience in the financial system across jurisdictions, and that post-financial crisis prudential reforms have been effective in withstanding this major shock.
Implementation of remaining Basel III rules was deferred due to COVID-19, but key components analogous to those introduced last year in the EU have since become effective in the UK. Programmes delivering final Basel III rules should reignite after the EU published its Banking Package 2021, albeit announcing a 2025 timeline given the scale of the task.
US authorities acknowledged overdue rulemaking proposals and the need for international cooperation, and we expect progress alongside UK consultations and policies throughout 2022. In response to market disruption through the Archegos incident, UK and US regulators have made concerted efforts to review firms’ risk management practices, especially in equity finance and prime brokerage. Consistency across jurisdiction is crucial for Basel III and impacts of increased capital on firms’ ability to support the real economy and ESG objectives should be considered. EU authorities already remediated adverse risk weights for carbon credits, which is instrumental to incentivise the net-zero transition.
What the global financial crisis was to financial resilience, the pandemic has been to operational resilience. New ways of working brought operational risks into sharp focus, and regulatory initiatives continue to focus on operational resilience assessments, extended operational risk and new operational resilience principles, as well as heightened conduct risk and robust market surveillance requirements. In light of the developments, identifying and managing exposure to Russian assets and addressing supply chain dependencies will be an operational focus, while cyber security threats will remain high on the operational risk agenda. Many organisations will address operational and resilience risks through accelerated digital innovation initiatives.
5 Reassessing the operating model
Throughout the previous year, numerous financial institutions have been refining the requirements on their respective operating models. Agility and resilience remain key to adapting to the changing business environment and being able to continue service delivery, especially where new COVID-19-variants risk impacting operational resilience and continuity of service.
With some specific exceptions, hybrid working has become the norm for many employees. Making the hybrid model work effectively will be the ongoing challenge throughout 2022. While the technology enablement is there, establishing norms across multi-location teams will place greater onus on leaders to find the sweet spot of workforce flexibility and productivity.
In the medium term, workforce flexibility will drive revised office space configurations to better match work and lifestyle requirements. Successful financial institutions will continue to experiment to find the most effective work environments.
6 Refocusing for growth
Despite the emergence of new COVID-19 variants slowing the transition to more normal times, many financial institutions are refocusing their business strategies for growth. In part, this is where cost reduction strategies have achieved most of the easier saves, but also where revised business strategies are repointing resources and energies on new markets, products and opportunities.
The refocusing on growth is supported, in part, by the release of conservative provisions made earlier in the pandemic to mitigate expected loan defaults, which are now not expected to crystallise in their originally expected severity. This is releasing more capital to finance new ventures and drive resurgence in the world economy.
Refocusing for growth is also being driven by greater prioritisation on preparing and meeting consumer demand for ESG investments and financial products. In order to support key commitments, including those made at COP 26, financial institutions will need to design, develop and trade financial products that enable a low carbon economy and more sustainable real-economy production capability and supply chains.
7 Wholesale Markets Reform
The government’s intended wholesale markets reform will progress with further FCA consultations to be converted into policies that enhance the effectiveness of the current regulatory framework. This is in line with the Chancellor’s vision for financial services, to deliver a framework that is fair, outcomes-based and supporting openness and competitiveness, reducing costs and burdens for firms, while maintaining the highest standards of regulation and market efficiency.
The regulatory perimeter will be redefined to ensure the market can operate in confidence, and to remove requirements that limit firms’ ability to access the most liquid pools of capital that yields the best outcomes for investors.
The transparency regime for fixed income and derivatives markets will be recalibrated to make it proportionate to characteristics of these markets, while reforms to the UK commodities regime and to the market data regime aim to avoid unnecessary restrictions to market activity and to enable participants to identify best available prices. These amendments will complement policy changes to UK MiFID conduct and organisational requirements published last year.
Provisions also address support in reaching the net-zero emission target by 2050, as the sector is instrumental for the transition to a low carbon economy and for wholesale markets to be sustainable and ethical into the future.
Measures further aim to encourage innovation and technology development to increase efficiencies and to reduce costs for firms.
The rapidly changing landscape is creating significant opportunities for innovation driven by three primary forces: technology, the ESG agenda, and potential regulatory optimisation. Each of these is creating opportunities for banks to develop new products and services and generate new revenue streams.
In the technology space:
Cloud enabled big data allows for more sophisticated models and tailoring of products and is of value to the complex climate models. It has also been interesting seeing how the models from Banks of COVID-19 have been used to challenge those with origins in the medical community.
Distributed Ledger technology is coming of age with many of the major market infrastructure providers now actively participating in experiments and many banks are developing pilot solutions with both conventional and new asset classes while central banks continue to look at Central Bank Digital Currencies (CBDCs)
The EU Commission’s Digital Finance Strategy brings opportunities for market infrastructure innovation based on distributed ledger technology (DLT), whilst their EU’s more conservative stance on cryptoassets could create competitive advantage for the UK.
9 Adoption of digital
COVID-19 has forced a rapid reassessment of ways of working and created challenges for banks with the need to monitor the distributed workforce. Coupled with more of a cloud first mindset, this is driving a rapid rearchitecting of the core desktop estate. Those firms with extensive virtual infrastructure were able to adapt rapidly.
Cloud technologies are now much more readily accepted, albeit with concerns around vendor lock-in and jurisdiction, but it's hard to see anyone adopting on premise first unless there are concerns around latency. The need to address technical debt and tackle legacy remains key to allowing technology functions to create the capacity to innovate. A failure to do this increasingly leaves a risk of being left behind. This is coupled with a need to have a very clear view on where bespoke build can add value vs vendor packages or component solutions.
10 Cyber security
Awareness of cyber events is more critical than ever before, but their material risk to an organisation may be less intrinsically understood due to modern digital complexities.
Effective management of access to systems, services, and data will continue to be a primary concern as cyber criminals look to capitalise on these uncertain times, compounded by the need to rapidly expand digital offerings to remain competitive.
Balancing the cyber threats to vulnerable legacy IT systems that historically have remained closed off in private corporate networks versus the desire to adopt a more agile cloud approach will require continued investment in cyber security management.
Looking outward from core business functions, cyber threats affect supply chains, with increasing risks and threats to their security and integrity.
Heightened risks highlight the need for internationally shared, adjustable, and scalable solutions to manage the global cyber threats through cooperative efforts of governments, industry, and the wider technology community.