Poverty and Development Division
last updated : 20 December 1999
VII. FINANCIAL FLOWS
ICT has a crucial role to play in the financial sector in at least three main areas: improving the range and efficiency of banking services available to customers, lowering costs and increasing the efficiency of capital markets, and allowing for more effective regulation of all types of financial markets and related transactions. The use of ICT enables a better delivery of banking services to both depositors and borrowers within a country and between countries. ICT has a central role in the operations of various capital markets such as stock markets, bond markets and foreign exchange markets, and it is intensively used by market organizers, market professionals and investors in these markets. ICT is also an essential tool for supervisory or regulatory bodies of these various markets at both national and international levels.
The earliest commercial users of computerized systems were banks because of their daily repetitive-type operations. The computerization of banking operations in the developing countries in the Asian and Pacific region, such as the recording of deposits and withdrawals and the issuing of customer statements, started more than 20 years ago. There has been progressive computerization of other customer services such as reconciliation of inter-branch transactions of a bank using a LAN system, and preparation of management reports on accounts, calculation of interest received and paid, calculation of overdraft limits of customers, and other statistical reports, including those for the regulatory authorities. There has also been progress on the use of ICT to facilitate remittances and transactions between different banks and overseas transactions in foreign currencies. However, progress has been quite limited in practically all domestic banks in all developing economies of the region in the computerization of credit and risk assessments of clients and the processing of loans, whereas such use is at an advanced stage in major international banks. In this area, computerization can be very helpful in reducing the incidence of fraud and defaults.
In recent years, the use of automated teller machines has become significantly more wide-spread. ATM is an on-line system capable of reading ATM cards, verifying PIN numbers, counting and dispensing cash, and printing receipts. It is a prime example of financial service flexibility enhanced by ICT to allow customers to deposit and withdraw funds, check balances, pay for utilities, pay insurance premiums, or even settle equity transactions 24 hours a day throughout a country (or the world for some banks). The use of ATMs helps banks in reducing staff costs, speeding up transactions and providing a more convenient service for customers. ATMs started in urban areas and customers were restricted to using only proprietary ATMs. Now, in several countries, they are available in small cities and towns and there are interbank arrangements on the use of ATMs. These have been a significant source of income for many banks from the fees that they charge users.
In the early 1990s, the Asian Productivity Organization undertook a survey on the use of ICT in various sectors of selected Asian countries, including the banking sector.1 This report noted that, in Bangladesh, while almost every commercial bank and the central bank had computers, their use of the possible applications of ICT varied considerably. The most extensive use was by the large foreign banks such as the American Express Bank, with an emphasis on networks of computers to help with reducing costs and increasing the speed of settlement of transactions. All banks intended to extend the application of ICT to compiling statistical returns, payroll, provident funds, credit information, interbank clearing house activities, and so on. They recognized that ICT applications could help to spot fraud and reduce debt defaults. As many creditors tended to use the same collateral for loans from different banks, the banks had decided to share their databases on customer credits and liabilities to verify credit worthiness. On-line customer services also grew. The Central Bank used computers to collate and process the vast amounts of data collected from government agencies, commercial banks and other financial institutions. The output of that process was being used by the government in its formulation of monetary, fiscal and other related policies. This description applies to most of the developing countries in the region.
In Fiji, computers were used in the banks as early as the mid-1970s. Banks are now very ICT-oriented, with an emphasis on improving the efficiency of customer service and reducing queues at teller windows. The banking and financial sector in Hong Kong, China is very modern in its ICT applications, as befits its role as an international financial centre. In India, by contrast, the banks outside the main urban areas are still paper-oriented. According to a recent edict from the Vigilance Commission,2 there is an urgent need to introduce ICT into all banks to reduce the incidence of fraud. The Commission ordered that 70 per cent of all bank operations should be computer-based by the year 2000. Given the high costs of connectivity in the country, it has been suggested that satellites should be used to accomplish that goal. A large number of private software companies in India are ready to offer computerization automation to banks which wish to use it.
In Indonesia, the banking and financial institutions in urban areas are using computers for accounting activities of various sorts within each bank and for the settlement of interbank transactions, but it is not clear how much this has spread to more rural areas. In the Republic of Korea, ICT applications in the banking sector have a long history going back to the late 1960s. All banks had completed on-line savings accounts by 1977. Today, they are very up-to-date in the application of ICT. By 1988, customers of some banks could use cash dispensers or ATMs in any other bank in the network. As of 1992, there were 31 financial institutions in the network and the number of machines had risen to 9,720 from 1,192 in 1987. There is also an audio response service system, first installed in 1989, which allows customers to undertake certain banking transactions by telephone, as well as an electronic funds transfer system among a number of institutions. In 1991, selected banks started offering firm banking and home banking services. All these services have rapidly grown in the number of transactions completed and the number of financial firms participating.
In Singapore, the banking services available to customers are highly ICT-intensive. A grouping of seven major banks has been operating and further developing a network for electronic transfers between themselves and with their customers for the last decade or so. Home banking through the Internet started in 1997. In Thailand, considerable progress has been made in the use of ICT; a review of this progress was undertaken in 1997 and is summarized in box VII.1.
This cursory review shows that, while considerable progress has been made in the very useful application of ICT to the banking systems, there is still quite a way to go in many countries. Two other important considerations emerge. The realization is growing that the use of ICT can actively contribute to controlling fraud and debt default. Second, the increasing use of modern customer services such as ATMs can be affected by the costs of connectivity within a country. In some cases, banks have developed their own dedicated systems. The use of satellites to improve the spread of service in India is a novel approach.
A recent study on the spread of ATMs in the world reports that there were more than 700,000 machines in operation at the end of 1997 and that this figure should increase by almost 50 per cent over the following five years.3 The Asian and Pacific region was the largest market, with 245,000 machines installed, or 35 per cent of the world total. About 55 per cent of these were in Japan. Japan had the highest ATM density relative to population in the world at 1,080 ATMs per million inhabitants; the Republic of Korea was second at 791 machines per million persons and Singapore was sixth with a density of 547. In the forecasts to the year 2002, China is likely to become third on growth in the number of ATM installations, it is expected that India will have the highest rate at 652 per cent, China will grow at 275 per cent, Indonesia at 220 per cent and Thailand at 150 per cent.
A few developing countries of the region have started to use smart cards. For example, the Thai National Electronics and Computer Technology Centre, under the mandate of the National Information Technology Committee, has been working on developing an electronic commerce framework for Thailand that will encompass financial and payment issues. The Centre has led a group of volunteers, the Thailand Smart Card Working Group, in developing recommendations for smart card implementation in Thailand. Set up in February 1998, the working group has members from more than 50 government agencies, financial institutions, research and education institutes, and private companies. The working group believes in seamless smart card interoperability. It intends to propose a set of recommendations on standards for implementing smart card applications to the Thailand Industrial Standards Institute. It is also supporting cooperation among working group members to run a smart card pilot project that will demonstrate the usability of the recommendations.4 On-line debit service, ATM networks, cash cards and electronic settling of credit card payments have been progressively introduced in Singapore since 1986. Today, anyone in Singapore can get to school or the office, buy groceries or use a pay phone with a plastic card, a cash card, an ATM card, a prepaid card or a credit card. Telephone banking and using ATMs to buy shares or pay bills are routine, and the use of connections through the Internet is growing. The first electronic, Internet-based, billing service in Singapore was launched in November 1998 to allow customers to post bills and invoices through a secure Web site and for those billed to receive and pay their bills. The use of electronic banking services, including services which enable customers to do their banking and issue and pay bills through a touch-tone telephone, personal computer, videotex terminal or television have existed since the late 1980s in the developed countries, including Australia, Japan and New Zealand.
As discussed in chapter IV, the process of globalization has been realized to a large extent by the rise in capital flows of various forms, including through investment funds operating over the counter or through stock, bond or derivative markets. Advances in ICT have both supported and benefited from these developments in the financial sector. Although financial flows of loans, bonds and stocks may be small in relation to a developed country's total outward resource flows, they now represent a major source of funds for many developing countries, including several in the ESCAP region (see table VII.1).
Table VII.1 Annual average aggregate net long term resource flows to developing countries
Source: World Bank, Global Development Finance: Country Tables, (Washington DC, 1998).
The development of capital markets requires an increase in the intensity and dispersion of information among a wider group of market participants, both domestic and foreign (rather than just bank loan officers). For many countries with a small number of domestic participants, these include foreign banks and investment houses. The consequent flows of information rely heavily on the use of ICT. The application of ICT, coupled with the deregulation of banking and finance in the major industrial countries, has helped to establish a global market for finance. This has made it easier for the developing countries which are partners in using such technologies to access the global market for capital and credit. Increasingly rapid and efficient transmission of information has been a driving force not only behind larger and more mobile capital flows but also the decoupling of these flows from trade flows. As an illustration, cross-border transactions in bonds and equities in the major advanced countries grew from less than 10 per cent of GDP in 1980 to well over 100 per cent of GDP in 1995. Similarly, gross flows of portfolio investment and FBI in the advanced economies more than tripled between the first half of the 1980s and the first half of the 1990s.5 In addition, it is estimated that, on average, trade flows now account for only 10 per cent of the daily turnover on foreign exchange markets, the rest being accounted for by asset movements of various sorts. Several countries in the ESCAP region which adopted ICT relatively quickly have been active parties in this phenomenon.
In financial markets, the permeation of ICT can vary in both breadth and depth. Related to the type of capital market transaction, the relevant market-related systems can be divided into information systems, order routing systems, execution systems, and clearing and settlement systems.6 The extent of the automation of each of these has different rationales and implications for efficiency in the functioning of the market and the volume of transactions (that is, financial flows), as well as associated volatilities.
Because communication between the many participants in any capital market is very complex, there is a need for coordination mechanisms, and these create transaction costs. An exchange as a market organizer attempts to minimize these transaction costs by providing an appropriate transaction environment. The costs of provision of this service are charged by the market provider in the form of fees to market participants, including investors in financial markets. The impact of ICT on market coordination mechanisms can be divided into three parts.7 First, electronic communication allows for a faster, wider and less costly provision of information. Second, use of electronic technology allows the combining of different, formerly separated functions into a single one by avoiding media disruptions (for example, with such application a large number of market participants can send in their buying/selling orders simultaneously). Third, electronic brokerage cuts down on human interactions and reduces the role of middlemen. As a consequence, an increasing number of agents (including specialists and market makers) can be replaced by technology, providing a direct connection between partners in the original transaction. Ultimately, a computer exchange which electronically coordinates investors no longer requires human interaction at all, even in the price discovery (execution) process.8 Even in less advanced hybrid markets, the adoption of ICT lowers transaction costs,9 boosts efficiency10 of communication and improves coordination among the market participants.
With a significant reduction of communication costs, a tendency towards a centralization and integration of stock markets began to emerge. In the United States, for example, at the turn of the century, about 100 such markets existed. This number had declined to 35 by 1935, and to 15 by 1965. Today, only five regional exchanges and the New York Stock Exchange and the American Stock Exchange remain.11 In recent years, electronic trading has posed a direct threat to traditional floor-based trading, by reducing the latter's seat prices significantly.12 Indirectly, the threat of dual listing (that is, big corporations listing their stocks on more than one market simultaneously), together with the high fixed costs of modernizing electronic trading facilities, have encouraged a number of markets and exchanges to merge or at least cooperate closely. For example, the Philadelphia Stock Exchange proposed in mid-1998, and has agreed in principle, to join the American Stock Exchange and NASDAQ to enhance resources, state-of-the-art technologies and management strength to achieve a more efficient, transparent and low-cost market structure.13 A proposal is also under consideration to permit foreign stock markets with a significant number of American customers throughout the world, for example, the Sydney Futures Exchange, to set up electronic trading terminals in the United States.
In the Asian and Pacific region, the trend in the number of stock markets is in fact the opposite to that in developed countries, with a number of countries establishing their own stock markets over the last 10 years. Table VII.2 reports on the status of a sample of these markets. It is interesting to note that capitalization of many of these markets is small in terms of both absolute size and relative to the GDP of the country concerned. Only three economies have a capitalization larger than GDP (Malaysia; Hong Kong, China; and Singapore). Hong Kong, China and Singapore also serve as listing points for companies based in other countries. Six out of the 20 listed markets have a capitalization valued at over 50 per cent of GDP. In terms of number of enterprises raising money through the stock market, only Australia, India and Japan have more than 1,000 companies listed. The fact that practically all the developing economy markets are small implies that the prices of stocks on these markets are more easily subject to wide variations through the buying and selling of a relatively small number of stocks. For example, on the Jakarta market about 10 companies account for half of the market capitalization, and 80 per cent of market capitalization is related to only 45 companies. When these markets are open to foreign participation, which most are to some degree, they risk being overwhelmed by the activities of overseas institutional investors using amounts of funds which are small in comparison to their total portfolios.
Most of the stock markets in the region are intensive users of ICT for their operations and their reporting functions. Many are basically electronic markets. A few exchanges have now developed stock index futures to trade alongside their stocks. These are often seen as a good hedging vehicle for investors on the stock markets. The annex to this chapter and box VII.2 illustrate the progress made in this field and the experience to date.
There are very few bond markets in the region, and governments and enterprises from most countries continue to issue bonds on overseas markets denominated in foreign currencies. These bonds are then traded on developed country bond markets, which are themselves intensive users of ICT in order to attract a wide range of clients. The United States dollar has traditionally been the primary currency14 in which international issues of emerging market debt and bonds have been denominated. Reflecting market segmentation, this currency composition does not always correspond to the pattern of export earnings but is more aimed at satisfying groups of local investors - often retail ones in the developed countries.
Some foreign exchange hedging instruments exist within the international financial markets and demand has been growing for hedging exchange rate risk on emerging market investments. Since May 1995, the futures exchanges in New York and Chicago have offered a variety of products. For example, over-the-counter nondeliverable15 forward contracts in emerging market currencies are now available in both London and New York, with active trading in selected Asian currencies. Within the region, the markets of Hong Kong, China and Singapore also offer hedging instruments for New Taiwan dollars, Korean won, Philippine pesos, Indian rupees, Chinese yuan renminbi, and Vietnamese dong. The daily volumes are estimated to be between $500 million and $800 million, and are growing. Most markets offering foreign exchange hedging instruments are ICT-based, if not totally electronic, and further development of such hedging instruments within the region is likely to be based on modern electronic markets.
Volume of transactions
The enhancement of market intermediary functions by ICT has also encouraged a significantly larger number of matching quotes at lower transaction costs, contributing to the rapid growth in the volume of transactions.16 As a consequence, the share of trading accounted for by large financial institutions such as investment funds, pension funds or hedge funds has been increasing. Between 1975 and 1992, for example, the share of institutional trading at the New York Stock Exchange grew from 25 to 50 per cent of total trading.17 Since electronic or screen trading allows for anonymous trading, the relatively large institutional traders feel better protected against the strategic behaviour of the other market participants, who tend to observe their actions very carefully. Also, in normal circumstances, the use of the Internet may be levelling the playing field in the retail brokering of stocks, etc. by providing small investors with services previously reserved for corporate clients. However, such advice, combined with competitive pressures, technological developments and the relatively low level of investor sophistication, often provides little value added or can constrain these investors to be market followers.
In terms of globalization, the adoption of ICT has led to a significant increase in cross-border transactions of customized instruments through proprietary markets.18 Generally, financial markets may be divided into two types: exchanges and proprietary markets. Exchanges aim to organize a transaction arena so that members can experience financial gain. Owing to the privileges and rights provided exclusively for exchange members, it is not in the interest of any party involved to open the exchange to non-members. Proprietary trading systems, on the contrary, primarily aim to raise income by providing all potential customers with a transaction arena. This type of market has proved to be very innovative in taking advantage of ICT and accommodating an increasing volume of securities transactions. Proprietary markets have consequently become a key source of competition to the established exchanges by offering custom-made transaction services. Through the growing use of these trading systems, a large share of securities trading is across country borders. This type of competition has coincided with trends in reforms in some of the established exchanges. For example, on London's International Financial Futures and Options Exchange electronic trading was introduced for equity options in November 1998, and is to be introduced for all other contracts by mid-1999. Similarly, the Chicago Board of Trade is also considering a conversion of its "project A" to fully-fledged electronic trading.
Dramatic advances in computer and telecommunications technologies in recent years in the developed countries have enabled a broad unbundling of risks inherent in trading and investment activities through innovative financial engineering. For example, conventional financial instruments, common stocks and debt obligations have been combined with complex hybrid financial products (various exotic types of swaps and options) to allow risks to be reduced. This, however, also made these instruments very difficult to understand, and vulnerable to human mistakes. Thus, while the financial system as a whole has become much more efficient, the price-setting functions of the markets have also become increasingly sensitive to subtle changes in consumer choice and capital efficiencies.
One serious emerging problem with electronic exchanges of various sorts is how to regulate the abuse of privileged access to information or insider trading. This involves the use of private information to undertake trade and affect prices before a market is aware of a development. Its effects can be magnified when large traders are involved, such as block traders. In all trading, a healthy balance is needed between production and distribution of information and the legitimate use of the information gathered. This leads to the debate over transparency versus efficiency issues that continues to dominate modern financial market regulatory and supervisory frameworks. If, for example, block traders were required to report a trade immediately, they would not achieve the same price compared with discrete small trades, partly owing to the strategic actions of other market participants.19 They are understandably reluctant to report their trades immediately. As a solution to this problem, the market makers on the London Stock Exchange have been granted a time-span of 90 minutes to report their trade.20 This results in a loss of market transparency because of heterogeneously informed traders. The intricacies in the timing of pre- and post-trade reporting thus prove to be critical and can significantly influence the efficiency of a market. Similarly, there are conflicts of interest between the secrecy (with the associated abuses by money launderers) granted to private financial services providers in offshore financial centres (often the notional location of the headquarters of the hedge funds) in order to attract business and the desire to operate efficient and transparent financial markets.
One consequence of the adoption of ICT can be increased price variations, particularly in the extreme situation that the price discovery process is fully automated and when trading orders are large. This is because the use of ICT tends to amplify market reactions to news and shocks in terms of both speed and magnitude, raising the short-term variations in prices and volume of transactions, but not necessarily altering the underlying long-term trend. There are many examples of this phenomenon in commodity futures markets and stock exchanges, in particular. For example, in 1987, the stock market crash in the United States was partly attributed to programme trading. Programme trading on a stock exchange involves both the use of price change triggers to start the buying or selling of a stock automatically and the use of futures contracts to provide portfolio insurance for spot positions through quasi short sales. When a spot market dips, it will trigger a downward spiral as programme trading will profit from a further market slump. Non-programme market participants, on the other hand, misinterpret these automated reactions during the initial period of the spiral as fundamental shifts, causing these investors to follow while the market maker specialists do not have sufficient resources to provide liquidity support for the market. During the 1987 crash, the five-day settlement period also prevented investors from evaluating their true positions accurately, and the phones did not ring through when they tried to communicate with each other, exacerbating the panic and the depth of the crash even further.
Some of these shortcomings have already been rectified, particularly in the United States, through circuit-breakers, near real-time on-line clearing and settlement, and open lines of communication and networking. In the context of the developing countries in the ESCAP region, the side effects of ICT on economic and financial volatility and security remain critical, particularly in the aftermath of the recent financial crisis. As described in more detail in the annex, some exchanges, such as that of Thailand, have recently introduced floor and ceiling price limits to prevent excessive fluctuations in share values. These circuit-breakers suspend trading for a fixed period of time if the main index moves above or below a certain percentage value of the previous day's trading. Other exchanges, such as that in the Republic of Korea, have placed restrictions on the use of programme trading. Yet others, including Singapore, have kept a tighter rein on the financial sector, closely monitoring stock movements, and taken an increased role in supervising investment advisers and regulating unit trusts.
1 Asian Productivity Organization, National IT Strategies and Economic Development (Tokyo, 1996).
2 Central Vigilance Commission of India, Ordinance 1998, section 8(1)(h)/98(2), New Delhi, 27 November 1998.
3 Retail Banking Research Ltd., The Global ATM Market to 2002 (e-mail: email@example.com).
4 See "The roles of the National Electronics and Computer Technology Centre and the National Information Technology Committee on electronic commerce development in Thailand" by Thaweesak Koanantakool, Director, National Electronics and Computer Technology Centre, Ministry of Science, Technology and Environment, paper presented at the Expert Group Meeting of Trade Promotion Policy Experts, held at Bangkok on 2 and 3 December 1998.
5 IMF, World Economic Outlook (Washington DC, May 1997), p. 60.
6 United States General Accounting Office, Global Financial Markets (Washington DC, 1991), p. 4, cited in A. Picot, C. Bortenlaenger and H. Roehrl, 1995, "The automation of capital markets", Journal of Computer-Mediated Communication, 1 (3) <http://jcmc.hujl.ac.il> (15 July 1998).
7 T. Malone and others, 1987, "Electronic markets and electronic hierarchies: effects of information technology on market structure and corporate strategies", Communications of the ACM, 30 (6): 488-497; and A. Picot, 1986, "Transaktionskosten im Handel: zur Notwendigkeit einer flexiblen Strukturentwicklung in der Distribution", Der Betriebsberater, 13: 1-16, cited in Picot and others, "Automation".
8 The transformation function of price discovery through interaction of the market intermediaries (matching risks, time, place and information) is then supplied by a computer. Within this system, the computer independently quotes the spread in a market maker system, balances out order disequilibria in a hybrid system and assures, within the auction system, a deliberate making of the market for the provisioning of liquidity. (Cited in Picot and others, "Automation".)
9 The United States Cotton Exchange, for example, is undertaking a study on electronically trading United States government debt futures, partly because of competition and the need to reduce trading costs.
10 For example, when NASDAQ was introduced in 1971, the quotation from different market makers could be observed in real time on the screen. Therefore, transparency, reaction time and efficiency of the market greatly improved. See J. Hamilton, 1978, "Market place organization and market ability: NASDAQ, the stock exchange, and the national market system", Journal of Finance, 33: 478-503, cited in Picot and others, "Automation".
11 M. Blume and M. Goldstein, 1995, "On the integration of the US equity markets", University of Pennsylvania, working paper, cited in Picot and others, "Automation".
12 "Value of seats on the major exchanges declines", The New York Times, 12 June 1998.
13 "Philadelphia Exchange to join NASDAQ, AMEX", The Wall Street Journal, 10 June 1998.
14 The share of dollar issuance by all emerging market borrowers rose from 57 per cent in 1995 to 69 per cent in 1996, about the level that it was in the period 1990-1994, despite some shifts in currency composition across regions.
15 Settlement is usually in US dollars to bypass any exchange control imposed by authorities of the respective currencies.
16 For example, on 19 October 1998, Japanese securities companies began offering on-line trading services using the Internet (see "Japan seems ripe for on-line trading", International Herald Tribune, 22 October 1998). It was anticipated that the shift would cause lower trading fees and a dramatic increase in the number of Internet users (traders).
17 A block trade is defined at the New York Stock Exchange as greater than 10,000 shares. The figures are quoted from J. Shapiro, 1993, "US equity markets: a view of recent competition development", New York Stock Exchange working paper, cited in Picot and others, "Automation".
18 Picot and others, "Automation".
19 For example, in the context of the Asian crisis, the price of houses and properties would have declined earlier and more rapidly if the real estate agents had honestly informed all their potential customers that there was a glut in the market. Analogously, when a car dealer tells his potential customer of his unusually large stock, his customer's bargaining power is strengthened, resulting in a price reduction.
20 A. Rottenbacher, Die Zukunftsaussichten deutscher Boersen (Berlin, 1991), p. 37, cited in Picot and others, "Automation".