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The genesis of this article was an interactive session at an Institutional Investor TraderForum workshop in February 2003. The meeting was attended by senior dealers from European institutions, with just over half based in London, who anonymously answered a series of questions about factors influencing equity trading in the future. These responses are commented on here, but first I want to place them in context by looking at the experience of the past as a guide to the future.
In general, things change less than we think. Before looking at the recent past I want to refer to Joseph de la Vega’s 300 year old book about the workings of the Amsterdam Stock Exchange, Confusion de Confusiones.
It discusses short sales, agency broker/market maker conflicts of interest, price transparency, settlement, pre-opening trading, stock lending and equity financing, off-market trading, margin trading, clearing house processes and put, call and straddle options. These topics are still relevant today. Not much has changed: the technology, the methodology, yes, but the principles remain the same. I believe that in 2010 – which is only in six years time – more will be the same than different.
Let’s look back for a similar period of time. Of course, whatever else has changed the market indices seem pretty similar! Salaries and volumes were lower, however, and at that stage equity investment was really taking off.
Electronic order books were getting established but generally, apart from Germany where the floors retained a measurable influence, the only alternative trading method was capital commitment. Although the efficiency of order books had made most dealer markets uncompetitive, capital commitment was still very important for people who wanted immediacy. In those days, of course, transaction cost management and broker monitoring was something only a few Americans did.
Listed derivative markets were generally well developed but the issuance of OTC and listed structured products was really only just beginning, permitting the development of guaranteed products and creating a new influence over equity markets. Similarly, stat arb activity had started but was not fully developed.
The second wave of banking consolidation was underway.
And, turning to infrastructure, cross border investment remained expensive to handle although investment by custodians and CSDs was starting to make a difference.
So a different world – and yet not so different.
The main changes have involved technology and consolidation and their impact on regulation and market structure. Technology has permitted the automation of trading communication, the ability to process significantly greater volumes, the development of wider access to exchanges and trading mechanisms and therefore – perhaps most importantly – the development of alternative trading systems. Previously we saw a central order book with capital commitment – we now see trading systems selectively focused on particular types of investor or trading. This is removing many of the cross subsidies involved in one centralised trading system and creating fragmentation – which in turn requires more investment in trading decision support systems. Technology has also supported the major banks’ development of proprietary trading books, on the back of derivative issuance, and the management of capital commitment.
The consolidation in the industry has continued – there are fewer major intermediaries, with a greater market share, and similarly the buy side has become more concentrated – 20 players manage half the world’s investment in equities. This consolidation has created competition for market share and has placed pressure on performance and margins. The buy side has become more powerful, partly because of competition for its business, partly because of its own scale, partly because of the alternatives open to it.
The scale of these businesses, and the trend towards less variance in investment decisions (because they are more structured and because of the trend towards indexed investment) has caused the development of alternative asset managers giving economies of skill as opposed to scale.
On the demand side, Europe started to discover the cult of the equity and asset prices boomed – only for disappointment to set in. The boom supported increasing investment in technology and alternative trading mechanisms.
The regulators underpinned all of this by de-regulation in the sense of freeing up access constraints within Europe – not completely, but certainly as regards ownership of firms and access to trading mechanisms. This essential liberalisation was critical in creating a framework for an integrated equity market (although there is still much to do). Conversely, they have introduced tighter regulation on consumer protection issues – particularly as a reaction to the excesses – and are supporting market trends on questioning margins, transaction costs and investment bank conflicts of interest.
To conclude, we have seen in the last few years changes in the environmental factors – equity markets becoming more important but followed by a lack of confidence, European integration progressing, consolidation and automated trading leading to margin pressures but increased volumes. The intermediation model has largely remained, though with growing tensions based around alternative suppliers and the value of research and therefore bundling.
So how much of this will continue and how much will change?
The main factors which will impact equity trading are: the level of asset prices; European integration; the importance of retail investment; industry consolidation; market consolidation; margins; volatility; investment in technology; market structure; the future of research; and outsourcing.
These are the issues that were discussed at the Institutional Investor TraderForum workshop, and in the rest of this article I will look at each of these in turn.
The level of asset prices
There has been a lack of confidence in asset prices. Lots of factors underlie this – perversely, the world economy is generally in pretty good shape and has far less volatility than in previous times: the volatility of world GDP is about 0ne-sixth of that at the start of the century. This has happened as globalisation and technology has made the world much more diversified. There is much more micro instability but less macro. Governments cannot interfere as easily – they have run out of enough money to do so. But despite all this, people have lost confidence in valuation methods and confidence is weak. It is also not clear that Europe in particular has found the means to generate significant new jobs. Terrorism, a lack of consumer confidence and (in Europe) issues with the integration of the new countries could cause major problems.
The traders however were relatively confident: 76% thought that asset prices would increase steadily (it should be remembered that this survey took place when markets were near their recent lows).
European integration
Even in a broadly deregulated environment the framework of the business is set by regulation. The facts are well known – the market cap per GDP of EMU countries is half that of the US; Bank assets in Europe are 200% of GDP, against 62% in the US. There is plenty of scope for improving the efficiency of Europe’s capital markets. Efforts are going into a Financial Services Action Plan to create an integrated market by 2005 – but there are substantial cultural and structural differences between countries and so far the negotiations are so full of compromise that it is hard to see significant benefits accruing. The EU intends to make Europe the world’s most competitive economy by 2010. But there are over 50 regulators involved in securities markets in Europe. There are five different types of regulator dealing with exchanges, four with intermediaries. All these people have jobs to protect – and cultures to uphold.
So will Europe manage to create an integrated framework, or will the conflicts of cultures mean progress if any is slow? 76% thought there would be a slow convergence with increased harmonisation of regulation – 21% thought country factors would still dominate with only 4% seeing major convergence to one financial services market.
The importance of retail investment
Whatever the doubts over equity VALUES, there must be a question over Government abilities to fund social security. In 1990, there were roughly 3.5 people between 25 and 59 to support those over 65 years old. In 2020, demographic trends mean it will only be 2.5. So people need long term savings more than ever. But there is a crossover from there being more natural savers than dissavers (because of age) in 2025 – and the turning point in the demographic trend comes in 2005 in the US, Europe and Japan. This could have a major impact on the level of equity investment.
So will retail investors regain confidence in equities – and will there be an increase in equity investment despite the demographics?
65% of the dealers expected retail investment to increase, 55% through collective schemes and 10% directly.
Industry consolidation
The economies of scale are a major business driver, particularly in a business where technology spend and processing efficiency are critical. Conversely, equity trading is traditionally a people, relationship, business. On the buy side, most large asset managers are part of large multi-products financial groups, and there has been much consolidation activity – there are economies of scale, but also alternative asset managers have developed to give ‘economies of skill’. The consolidation is relatively small compared to some industries, and the industry is still largely country based.
A further pressure on consolidation will be the Basle 2 regulations which will increase capital demands for equity position-taking and increase the focus on credit.
92% of the dealers thought that there would be continued active, cross border, consolidation.
Market consolidation
The question of market consolidation has been around for some time and may appear boring – but it is a relevant factor in considering the future. Different markets add to cost and complexity and a reduction in trading costs leads to a reduction in companies’ cost of capital.
The dealers were evenly divided on likely consolidation options of Europe’s big three exchanges, but most expected the smaller markets to merge or be taken over.
As an aside, this article just considers Europe, although there is a lot to happen in the US: my guess is that the competition between Nasdaq, Instinet and Archipelago will be resolved well before 2010, as will the inefficient market structure of NYSE. This will reinforce US market efficiency compared with Europe.
Margins
The trouble is that a lot of people take a piece of the pie. In a bull, or bubble, market this didn’t matter so much because the end client still made adequate returns – but in a market which is more inclined to track sideways there is a competitive and a consumer protection focus both on margins and the transparency of margins.
Lower margins are not necessarily bad for the industry: reductions in trading costs lead to increases in trading volumes – and reductions in the cost of capital for listed companies.
Dealers know the focus now played on transaction cost management, both by themselves to control brokers, by their employers to control them and by their clients to control their employers. I think the pressures driving this will continue and more sophisticated measures (by which I mostly mean the use of many measures) will develop. This in turn will focus people’s minds on different trading options.
For this discussion, however, I asked only one question – what is the future for bundled commissions? Will commissions be deducted from the management fee?
Almost two-thirds of the dealers thought that bundled commissions would be gone by 2010. This raises the question that if practitioners think it will happen anyway, why has the industry been fighting so hard against it rather than adapting to it?
Volatility
I mentioned volatility earlier; it has increased with the speed of information dissemination. This makes the management of order flow and dealing costs even more important. There is more micro uncertainty, more noise, more information and the question is whether this will be dampened by alternative traders and trading mechanisms or whether this is a trend that will continue.
45% of the dealers thought volatility would continue to increase – only one-fifth thought it would fall.
Technology
Technology spending has increased substantially over the last decade and allowed the introduction of new trading techniques and increased volumes. Competition has meant there has been little scope for a post Y2K/euro decline in technology spend. Recent focus recently has been on connectivity and on order management systems, which have effectively been automating existing processes.
Where will the next phase of spending be focused – on increasing automation of basic tasks to reduce headcount and improving trading capabilities with execution management tools, or on settlement processes, or on improving risk management? Another option: much investment at the broker and exchange level has been on single product systems but of course investors need multi products. Will this become the next new thing?
Half the dealers thought that the main focus of spending would be on execution management, with a quarter opting for risk management tools.
Market structure
There are major benefits in a central limit order book and liquidity tends to flow towards one. There is a resulting stickiness of liquidity so people who just try to copy that market model tend not to succeed. But there are types of business for which it is not suitable, such as large trades (especially those requiring immediacy), trades where there is a high cost of settlement, and for certain types of trader who would be prepared to be patient, receive a passive price or who do not want to disclose their intentions.
In Europe, market structures have tended towards about 70% of business being on a CLOB, with the rest being subject to capital commitment. The US is moving in this direction also – but in both cases, alternative trading mechanisms are growing as technology encourages solutions for different types of trader or order.
Only 7% of dealers saw an increasing role for capital commitment – the balance were more or less evenly divided over an increased use of CLOB and the development of alternative liquidity pools.
Research
There has been much criticism of the investment banking model, and the place of research within it – but it evolved for a reason, clients accepted it and the regulators have so far made a lot of noise but done little to materially change it. Nevertheless, sell side research is costly. In a lower margin – and particularly unbundled – business, will it become less important?
Only 11% of the dealers thought investment bank research would be the most important to their organisation – most saw internal research as being the most important.
Outsourcing
This factor relates to trade management, the question of intermediary conflicts and the need to ensure cheap transaction costs.
So far outsourcing has focused on technology, back office and accounting processes. Trading/order management is largely managed internally although actual trade management is outsourced to brokers. There are two alternatives to the current position: taking more ownership of flow, or recognising that there are resulting costs of doing this and outsourcing execution.
Almost 60% of dealers thought they would take more control of trade management, with only 15% thinking it would be outsourced.
Conclusions
These answers fit into the same patterns that we have seen over the last few years, with technology driving greater efficiency and consolidation, offset by inevitable delays in adapting to change.
I see the trends discussed above as fitting into the following pattern.
Those with a cyclical pattern within the underlying trend are asset prices, volatility, the scale of retail investment, the perceived value of research and outsourcing. I see market structure as a steady state position (being largely focused on a limit order book complemented by alternatives which may come and go), with consolidation, margin decline and the use of technology as being continuous.
So what will equity trading look like in 2010? As suggested earlier more will be the same than different – but:
- There will be substantial consolidation in the industry, and continued centralisation of trading.
- Technology will further enable quantitative decision making and there will be much greater volume of trading.
- Intermediation will continue, but commissions will be much lower (and be of the nature of a transaction process fee), and consequently the volume and cost of sell side research will be reduced. I think this will increase its value.
- There will be more automated trading and alternative mechanisms although the need for scale will drive consolidation here also.
- And it will be less fun – with more consultants.
