Distributed ledger technology and the future of the mutual funds market

Retail banking today is unrecognisable compared to what it was like ten years ago, as banks have moved away from manual processes on a path towards digitisation. This decision has improved customer experience, allowing them to interact and consume products with their bank as and when they wish, whilst also having the advantage of driving down cost for the banks. By leveraging the lessons learnt from this, and other sectors that have similarly transformed, the mutual funds industry can begin to prosper in a digital age.

The funds world, however, has seemingly been isolated from the same level of technological innovation observed in other industries, meaning elements of the distribution model have remained unchanged for many years. The distribution ecosystem that operates today is a fragmented one, often involving a significant number of intermediaries to facilitate the buying and selling of funds. Each intermediary needs to undertake their own processing, checks and balances along the transaction chain.

While there has been significant progress across the industry in increasing transaction process automation, the frictional cost of trading remains high. This has contributed to inefficiencies in the industry, whilst generating unnecessary headwinds for consumers.

Managing change

The historic lack of innovation in front-end digital channels leaves the market exposed in the face of changing investor requirements and demographics. Similar conditions in other market sectors have given rise to new sources of competition and disruption.

Regulation continues to have a significant impact on today's distribution. Both Retail Distribution Review (RDR) regulation in the UK and MiFID II across the EU ban inducements, forcing consumers to pay to receive investment advice that was previously perceived as free. Although the intention behind this new regulation is positive, a consequence of this change is anticipated to lead to significant client segments being left unadvised.

A further bi-product of explicit pricing is the additional pressure being placed on the total cost of ownership throughout the value chain. Active managers are being challenged by low cost passive funds, whose performance is directly correlated to indices. Calastone research found that 57% of respondents felt passive funds would likely overtake active managers as the core investment product for retail clients. This is already evident in the US where, for the first time, passive fund sales are set to soon overtake 50% of US fund equity assets. Active managers need to identify a method by which they can compete with passives as the need to deliver alpha increases. Reducing the frictional cost of trading (operational alpha) will play a key role in allowing firms to achieve this.

New business models

The industry isn't standing still, with strategic investment being made in new direct to consumer (D2C) and robo-advisory services. This is a move to help address the needs of the growing unadvised client segments and younger investors. The new generation of investors expect immediacy of service, and will look to those platforms with the best end-to-end user experience. Recent Calastone research predicts significant growth in use of robo-advisory services, with 42% of respondents citing the technology would "become the main distribution channel for raising assets from the mass retail market".

Investors are beginning to identify more cost-conscious solutions for asset accumulation because of a lack of modernisation in the industry. It's important that the industry also looks to scale up their back office to align with any new front-end technologies being deployed. Without addressing both sides of the business, it will be difficult to have a seamless end-to-end customer experience.

There is an opportunity now for the funds industry to embrace change, and to modernise the traditional distribution model from the back to the front-end.

The consequences and the enablers

By brushing aside innovation or disregarding consumer and technological evolution, the funds community is at risk of becoming uncompetitive. Digitising the funds world will be central to ensuring that it can remain ahead.

Innovation in transactional processes from front-to-back is a good place to start, as automation allows for efficiencies and rationalisation of operations. More advanced D2C initiatives such as robo-advisory will likely also cause a significant increase in fund order flows, and greater levels of automation will ensure that the industry can support this.

The digitisation of transactional processes will help increase the fund industry's longevity but it will not be easy to achieve due to its fragmented nature and the volume of participants that participate across the chain. The fragmented fund distribution model is where Calastone believes distributed ledger technology (DLT) could have a lasting impact, through the development of Distributed Market Infrastructure (DMI) by which different parties (fund provider, administrator, regulator) could participate, a point made in our white paper.

A DMI could assist the industry in minimising frictional costs, scaling down charges, allaying financial services regulators and could support the new business models which are required to attract more investors in a low yield environment.