The accelerated evolution of connectivity, most notably the rise of the internet and smartphones, and recent advances in digital infrastructure, such as cloud computing and distributed ledger technology, has radically shifted business models. Organisations can now deliver products and services at demonstrably lower costs and scale accordingly, often in very different ways to traditional businesses.
The growth of global digital infrastructure sees scalability, accessibility, security, affordability and efficiency as the prime movers in the marketplace, with platform companies such as Google, Amazon, Netflix and Xero stand-out examples. This global digital innovation, like other industries, may also effect local financial services’ institutions.
For Australian investors, the typical Australian portfolio is overweight financials (with its heavy skew toward banks) and underweight information technology (platform companies deploying globally scalable business models) compared to the rest of world. This suggests that, with the rapid emergence global digitalisation, and its potential impact on the local financial services sector, exposure profiles for Australian investors may need a re-think.
Australian Investors exposure to global digitalisation
As highlighted in our previous insight on Transformative innovation, the acceleration of global connectivity and digital technology platform companies like Google, Amazon, Netflix, Airbnb and Xero are allowing organisations to deliver products and services at demonstrably lower costs and at increased scale, disrupting the economics of prevailing business models.
For example, in Australia’s media industry, domestic media stocks have been significantly impacted by the rise of global digital media benefiting from transformative innovation over the last decade (Figure 1).
Similarly, the progressive global digitalisation of financial services is likely to impact local financial services models that do not currently utilise the benefits of transformative innovation.
Digitalisation and financial services
The inefficiencies ailing the financial services industry worldwide stem from the growing complexities of dated technology infrastructure, opaque and costly intermediaries, and regulatory requirements that are increasingly incompatible with the pace of globalisation. There is now a concerted effort from financial institutions around the world to explore emerging technologies that can resolve some of these issues.
As the financial services industry is highly regulated, the pace of new digital infrastructure (such as distributed ledger and cloud computing technologies) adoption will depend on how the changes are supported by regulatory bodies across the globe.
However, there is increasing recognition that changing global scenarios and volatile financial markets need a solution to increase international transaction speed and reduce costs.
For example, by 2020, distributed ledger technology is expected to have a significant impact on the financial sector worldwide with widespread adoption. It is laying the foundation for a new global financial system that may revolutionise the current system to make it more secure, scalable, transparent and efficient – lowering costs for businesses and consumers and, ultimately, better net returns for investors.
In Australia, the Australian Securities & Investments Commission (ASIC, Corporate Plan for 2018-22: focus 2018-19) comments that Blockchain and distributed ledger technology is anticipated to bring significant change to the Australian financial services industry and are expected to increase efficiencies in settlements, data reconciliation and other middle- and back-office functions. For example, the Australian Securities Exchange (ASX) is expected to replace its Clearing House Electronic Sub-register System (CHESS) with a distributed ledger technology solution by 2021.
Further, ASIC affirms that innovations like crowdfunding, peer-to-peer lending, and digital currencies and tokens have created greater choice for consumers and increased competition within the sector. The adoption of financial technology (FinTech) in Australia has been high compared to global markets (ranked fifth out of 22 markets), with 37% of its digitally-engaged population having used two or more fintech services in the past six months. Also, FinTech investments in Australia have grown strongly, from US$53 million in 2012 to US$675 million in 2016. In 2018, Global investment into FinTech reached to US$111.8 billion.
The global need for better financial services delivery places increased pressure on Australia’s local financial sector to do likewise. However, the competition of global financial institutions investing in significant digital infrastructure and scaling power over local providers, may impact the Australian financial services industry.
Overweight financial services, underweight technology
Australia is one of the most exposed economies in the world to the developments of global digitalisation because of our significant overweighting to financial services and underweighting to information technology.
According to the Australian Bureau of Statistics (ABS), financial and insurance services, that include Australian Depository Institutions and other financial corporations, are the largest contributor to real industry gross value add for the Australian economy. They contribute around 9% to real industry gross value added at basic prices as at the September quarter 2017. This may not be surprising as Australia’s weighting to financials on the ASX is one of largest in the developed world, with the Australian banking sector being a significant proportion of the ASX relative to Global Indices.
As Figure 2 highlights, at the other end of the spectrum, Australian investors have very small exposure to the information technology sector. Consequently, through the compulsory superannuation system, Australian investors are overweight financial services and underweight information technology.
According to APRA’s 30 September 2018 quarterly performance release, the Australian Super System’s (excluding Self Managed Super Funds [SMSF]) allocation to Australian Shares and International Shares is 23% and 25%, respectively, as shown in Table 1.
This means Australian investors have nearly twice the global average equity weighting to the financial services sector (driven by more than twice the weighting in Banks) while being less than one fifth of the global average weighting in relation to Information Technology.
Relative to international equity benchmarks, Australians are approximately 3% overweight to financials in their Super Funds (Ex-SMSF), due mostly to the large bank exposures, while being approximately 3% underweight to information technology. Based on the A$1.7 trillion residing within the professionally managed super sector (Ex-SMSF) at 30 June 2018, this represents a $52 billion opportunity if funds started to reweight away from financials towards information technology.
For SMSF, the underweight to information technology may be even more apparent. According to the March 2018 ATO SMSF statistics, 29% of the $708bn in SMSF assets were allocated to Australian listed equities with less than 1% of assets in international listed equities. It may be likely that SMSF are in the order of 7% underweight in information technology in their superannuation portfolios. Based on the A$750bn in SMSF assets at 30 June 2018, this represents a $52 billion opportunity if SMSF started to re-weight towards information technology.
Furthermore, the strong response by SMSF investors to the Labour Party’s plan to reduce the benefits of franking credits suggest that SMSF account members are likely to be more overweight in the high yielding dividend paying stocks that benefit from franking, like many of the large financials that dominate the ASX. It seems probable that overweight to financials in SMSF may be greater than the professionally managed super sector.
Re-thinking about exposure in the global economy
The power of global platform companies deploying digital innovation (information technology) is being felt around the world, with its obvious impacts on local businesses. Financial services are not immune from such innovation, and while effort is underway to solve the ailing inefficiencies of its current infrastructure, potential disruption to prevailing business models may occur.
Interestingly, the typical Australian portfolio is overweight financials (with its heavy skew toward banks) compared to the rest of world, providing significant exposure to a sector soon-to-be impacted by global digitalisation. Conversely, the underweight information technology compared to the rest of world may shortfall the opportunities presented by global digital innovation. Overall, this suggests that, with the rapid emergence global digitalisation, and its potential impact on the local financial services sector, exposure profiles for Australian investors may need a re-think.
Footnotes  https://www.pwc.com/gx/en/financial-services/assets/pdf/technology2020-and-beyond.pdf  See further at https://www.ifc.org/wps/wcm/connect/aea347b3-d57d-457c-a34d-04cab3da3417/20180921_EMCompass-Note-57-Blockchain-Governance_v1.pdf?MOD=AJPERES  See https://www.wns.com/insights/articles/articledetail/534/how-will-blockchain-revolutionize-the-global-financial-system for further details.  Pages 8-10 at https://asic.gov.au/about-asic/what-we-do/our-role/asics-corporate-plan-2018-22/ https://www.asx.com.au/services/chess-replacement.htm https://assets.kpmg/content/dam/kpmg/xx/pdf/2019/02/the-pulse-of-fintech-2018.pdf  https://financialservices.royalcommission.gov.au/publications/Documents/some-features-of-the-australian-banking-industry-background-paper-1.pdf  https://www.apra.gov.au/publications/quarterly-superannuation-performance-statistics  https://www.ato.gov.au/About-ATO/Research-and-statistics/In-detail/Super-statistics/SMSF/Self-managed-super-fund-quarterly-statistical-report---March-2018/#Assetallocation  https://www.morningstar.com.au/smsf/article/impact-and-opportunity-bracing-for-labors-fra/171207