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Corrected: Smile Curve Changes As Securities Value Chain Evolves, By Kelvin To, Founder And President Of Data Boiler Technologies

Date 30/10/2020

Smile curve is a graphical depiction of an industry’s value chain. The beginning (the rarely found strategies/ engineering skills/ intellectual properties) and the tail-end (multi-facets fulfillment/ services/ user experience) are supposed to command the highest values-added than the middle part (assembly/ matching/ intermediate). A healthy industry should have the curve in a U-shape (i.e. respective constituents are able to earn profits in accordance to values they contributed). Unfortunately, our capital markets’ smile curve has turned into a frown, an upside down U-Shape.

The green line in the graph below represents the time before digitization disrupted the inter-dealer brokers’ floor based trading model. The red dotted line represents today’s structure of a pure speed “drag race”.


A. Performance Optimizers

A1) High frequency trading firms (HFTs) have taken the mojo from principal trading

Discovering alpha or hidden trade patterns and gauging the right market timing is hard. Sadly the related profits are short lived because latency arbitrage takes a significant piece away. Market structure over emphasized pure speed and did not provide enough reward for originality of trade strategy attributed to the skewed profit favoring HFTs and causing prop trading firms to flee the market [1]. 

Suggestion: Learn from the music industry, moving to MP3 and streaming. Seek a second source of profit after optimization of alpha, lower cost, and growth in trade activities. 

A2) The number of hedge funds (HFs) drop as private equities (PEs) and venture capitals (VCs) rise

The traditional asset gathering or underwriting process is disrupted by the nimbleness of PEs and VCs. The regulatory burden has made public market not competitive with the private market. Not only is this a missed opportunities for average investors [2], the phenomena indirectly impacted HFs as an alternate investment vehicle to navigate between risks and rewards in a market trading mostly “FAANG” and other big names.

Suggestion: Rather than over finesse economic problems by government driven policies, let the market do its job to hedge and/or to fail those ‘Too Big To Fail’ (if they are poorly run); reignite some volatilities to embrace the modern era.   

B. Asset Gathering

B1) Bulge brackets hanging on via close ties with Exchanges/ trading venues and HFTs

Investment banks’ asset gathering or underwriting is eroded by PEs and VCs. Top bulge brackets are able to use their clout to negotiate for super tier rebates from the Exchanges to hold up profits. They also work closely with HFTs to remain competitive in the superfast paced equity market. They run dark pools, sponsor MEMX, and have businesses touch every facet of the value chain. So they are doing fine now. They will do better by working out new solutions with issuers.

Suggestion: Champion market reform to grow the overall pie in order to preserve leadership position in industry.

B2) Tier 2 and non-bank market makers starved with crumbs

The impending market structure under the National Market System (NMS) resulted in an increased number of trading venues that market makers needed to connect with. Although our US market has many market makers today, few of them are truly profitable given the rises in data, connectivity, low latency infrastructure costs, as well as other regulatory burdens, such as the original Volcker Rule [3].

Suggestion: The market needs the appropriate shake up (from pure speed straight line drag race to a little uphill/ downhill/ curvy). Thus the barriers to compete would not be as high and the runners-up will have a fair chance to compete.   

B3) Index futures are not as popular as ETPs, while risk modeling held up profits

MSCI, Moody, S&P and others in this space have mixed results. Their risk modeling business should be doing well, while index futures business could perform better but is overshadowed by growth in Exchange Traded Products (ETPs). People favored the convenience of ETPs as cash instrument in spot market for portfolio exposure rather than engage in forward-looking index futures for price discovery and hedge purposes. That being said, London Stock Exchange’s propose merger with Refinitiv has provided a roadmap to unleash profit potential [4].

Suggestion: Instead of artificially extending the period of financial stability that is disconnected with main-street economics, the US is better at riding waves in volatile markets – that is where index futures would shine and innovate. 

C. Intermediaries

C1) Costs piled in layers become barriers, venues compete but lack true innovation to benefit the industry

The opening of 3 new equity Exchanges in the US, on top of intense competition among existing Exchange Groups and dark pools, casts doubt as to whether diversified for-profit trade venues can work collectively as one to best serve the market needs. Surely digitization disrupted the traditional trading floor based inter-dealer broker model has made the US market more resilient. Yet, unhealthy competition on microwave, laser, or quantum technologies, followed by order type rivals, added unnecessary complexity to our market. Fragmentation caused the cost to participate in the market to rise substantially. Barriers to entry include data and connectivity fees charged by Exchanges and the whole host of liquidity sourcing, execution, transaction cost analyzer (TCA) and other tools that any serious market players have to rely on. The SEC’s proposed competing consolidator would be another layer of intermediary cost [5] causing further “frowning” of the smile curve.

Suggestion: It is about growing the overall pie. The music industry has shown us the pathway towards how to profit from MP3 and platform streaming and achieving mutually beneficial goals in a dynamic ecosystem. New technologies expanded the music industry availability and audience. Let’s seize the opportunity to expand the pie!

D. Wholesalers Assets Maximizers

D1) Passive ETPs grew rapidly amid a war on retail shelf-space

Charles Schwab buying TD Ameritrade, Morgan Stanley is acquiring E*Trade. The retail zero-commission phenomenon has created new challenges and opportunities for ETPs. SSGA’s Spider ETPs used to be distributed through TD’s platform may run now afoul with Schwab’s offer when shelf-space is consolidated. Fidelity and Schwab would continue to do well with their vertical integrated platforms. IShares would be one of the top brands across channels for its performance. Vanguard would preserve their leadership position in bargain priced ETPs. Those being said, Wisdom Tree, Invesco, ProShares, Van Eck, IndexIQ, and Franklin Templeton would grow AUM by product innovations. Watch out for aggressive betting by HFTs to arbitrage between spot ETPs and index futures and potential conflict of interests with payment for order flow.

Suggestion: Do not lose focus on creating value and fulfilling customer needs jointly with others in the value chain. Our proposed market reform in MP3 and streaming would expand product availability and audience across asset classes.

D2) Buy-side’s AUM growth requires a true reform to the fragmented market

Asset management has experienced year-over-year decline with fee pressure, fallout changes in management, merger, meltdown and whatnot [6]. The buy-side is coming together to negotiate with the big Exchange Groups for lower fees and to expand data. A move to “flame weeds” that is eating into their profit. Nurturing growth of IEX, Luminex, and other buy-side pools of liquidity among themselves help fertilize the soil in the fields that they operate. That being said, the root of the problem is insufficient assets under management and “perceived” over charging of active management fees. Target date funds have been a success in the past. Would ESG be the raison d'être, we shall wait and see.

Suggestion:  Active Funds, Insurance and Pension Money must embark on a market reform revolution that will truly enhance the value proposition beyond asset allocation and moving blocks. To prevail, the value chain cannot be a straight line drag race [7]. It has to allow some to become specialties (e.g. previous mentioned index futures opportunities) and some growing the scale in enable average investors to trade like the pros. Last but not least, broker-dealers as, “Farmers”, ought to think about multiple harvests per year, e.g. a nationwide reform of retirement system

E. Retail Client Services

E1) Largest retail platforms stay afloat, smallest advisors have no boat

Economy of scale and mass customization is how larger firms or financial networks would pursuit to stay afloat. Smaller advisors are like taxi or Uber drivers before the day of autonomous vehicles become the mainstream. FINRA’s securities Exams, Registered Rep and RIA qualifications are largely out of line with quant driven market system.

Suggestion: Give them the boats (free open platform). Retrain them to trade like Pros. Ingenuity distinguishes human advisors with Robots.

E2) Securities processing’s margin is down, while performance measurement is in high demand

Clearing and settlement profits are protected because no one is challenging DTCC. Irony is DTCC, and other large encumbrances, have invested in block-chain thereby influencing how little it will change our industry. Custodian banks and securities processors may be pursuing front-to-back (F2B) or end-to-end (E2E) strategies to revive the business model for higher values business intelligence sales. That being said, the performance measurement business, such as GIPS compliance and Retirement Plan benchmarking will continue to thrive for years to come.

Suggestion:  Buying a new piece of equipment for automation will not be as helpful as in the past. Serious F2B or E2E players and assessors of investment performance must know where the new touchpoints are along the new value chain.

Some final remarks

Smile curve would put a smile back on every constituent’s face as long as they provide value added functions. New innovative technologies will spur economic opportunities and grow the overall pie with increase trade activities and liquidity. HFTs would stand up to the challenges in the proposed new market structure because a dynamic market environment that focuses on pattern recognition would still have appropriate interdependency with those who have the speed to execute.

More diversified market participants and enabling the crowd to engage in the process of detecting trade irregularities (e.g. positive market movement or a flash crash) would broaden the ecosystem. This is because value chain in our industry is indeed a mechanism to delineate asset rights (transfer ownership of assets in exchange for liquidity) at minimal cost. Price discovery would be more effective, efficient and sustainable if we can reduce the numbers of unknown unknowns.

Both hunter and farmer types of constituents shall come together in a more transparent market. Like the music industry eventually figuring out how to profit from MP3 and streaming, expanding the availability of music and its audience, the public market would flourish when resources are channeled to where it will yield the highest productivity (including thinly traded securities [8]) in support of the overall economic growth.

Last but not least, the financial transaction tax (FTT) would push the entire value-chain’s profitability down if enacted because it serves no value-added function.    


By Kelvin To, Founder and President of Data Boiler Technologies

At Data Boiler, we are more the Qualcomm than the Apple. Between my patented inventions (18 claims + more pending in the pipeline domestically and internationally) and the wealth of experience of my partner, Peter Martyn, we humbly seek opportunities if some of our skills can be put into appropriate use in driving forward meaningful market reform.