DIGITAL TRANSFORMATION IN EQUITY MARKETS.
Saoirse Kennedy, Senior Consultant, GreySpark Partners.
|The percentage of US and European equity trading, covering cash equities and equity derivatives, that takes place electronically has plateaued as a percentage of total market volume. While the high-frequency trading (HFT) share of the market has declined since the 2008 financial crisis, this decline is levelling off in both the US and Europe, with US equity markets remaining ahead in terms of total market volume executed via HFT. Since 2008, algorithmic trading continued to capture an incrementally larger share of the electronic equity markets. The regulatory environment that has shaped equity market structure since the 2008 financial crisis pushed trading towards electronic mediums, such as swap execution facilities, multilateral trading facilities and organised trading facilities, ensuring the expansion of algorithmic trading and bringing the efficacy of dark trading venues into question. At this point, equity market structures are not expected to further undergo such fundamentally significant changes as a consequence of regulations.|
Volatility within equity markets plays an important role in the growth of algorithmic trading and HFT as a percentage of all equity trading. Between 2012 and mid-2015, US and European equity marketplaces were characterised by an extended period of low volatility. While markets did persist in rallying over that period, growth was slow and heavy. HFT relies on volatility to drive trading and profits, and without volatility the ability of high-frequency traders to act quickly on markets brings no advantage. As volatility disappeared from markets over the 2012-2015 period, profits from equity HFT declined. Today, equity markets, in both the US and Europe, are characterised by a return to volatility as evidenced in Figure 1 and Figure 2, that show the primary volatility indices in each marketplace, the VIX and the VSTOXX, respectively.
The so-called ‘double dip’ in US equity markets – with a first dip in August 2015, followed by a January 2016 dip – is a market correction in response to falling commodity markets, particularly oil prices. Meanwhile, market analysts do not forecast a near-term economic recession.
As equity markets become opportune for HFT, moves are being made by some market participants to position themselves favourably to capture an anticipated upswing. Global Trading Systems, a high-speed electronic market maker and technology firm, have agreed to purchase Barclays’ NYSE equity market-making business, which will make them the largest designated market-maker on the NYSE. The agreed purchase also represents the departure of the last investment bank from the NYSE trading floor, which is a significant development with respect to market structure and the continued weakening position of investment banks in financial markets. In buying Barclays’ NYSE equity market-making business, Global Trading Systems will join high-speed market makers VIRTU and IMC on the exchange’s floor, entrenching the trend of non-bank market-makers that specialise in market-making technology as providers of brokerage services. Additionally, the hedge fund Citadel is in talks to buy Knight Capital Group’s market-making business on NYSE.
Moves are being made by some structural participants in equity markets to mitigate the impact HFT may have. For example, the Investors Exchange (IEX), a buyside-owned equity securities trading venue, that uses a ‘speed bump’ designed to discourage aggressive trading strategies, recently applied for full stock market status with the US Securities and Exchange Commission in a move away from its alternative trading system origins. Though the IEX platform’s speed bump would appear, thus-far, to be ineffective, it is controversial as it represents an unfair advantage for attracting market makers. Allowing venues like IEX to gain full stock exchange membership would change the nature of equity markets. Further to this, the European equity trading venue Aquis Exchange wants to ban predatory HFT tactics. Aquis’ platform would send aggressive trading away from the venue in an attempt to lure in block-traders. Aquis is also authorised by the Financial Conduct Authority to introduce a speed bump on its venue, similar to that of IEX, though it is not yet clear if the company will choose to do so. These considerations by IEX and Aquis are further to regulations on co-location and high order-to-trade trading strategies in the US, and regulatory action on flash crash measures and clearer definitions on market manipulation in the EU.
These changes to equity marketplaces are indicative of three emerging trends:
- Innovative technology-based market-making firms are paving the way forward for the next generation of electronic trading venues and the direct market-maker business, not investment banks;
- Buyside firms are reinforcing their desire to trade on equity exchanges without perceived interference from non-bank algorithmic or HFT market-makers – this is causing them to gain ground in areas where investment banks are losing ground; and
- HFT is expected to make a resurgence, but structural market participants, such as IEX or Aquis, are preparing to create new competitive spaces in a retaliatory move that is already supported by US and EU regulations impeding the most aggressive elements of HFT.
These three trends are a strong indicator that equity markets are at the early stages of a digital transformation, which, in the capital markets space, is generally seen as being driven by regulation, technology innovation and the strength of buyside institutions.
The buyside space is now characterised by institutions that have amassed assets under management the scale of which was previously unheard of in capital markets. Their grip on liquidity, coupled with investment banks that are struggling to manage Basel III capital requirements and leverage ratios, leaves the buyside in an enviably powerful position. Liquidity in equity markets fragmented as a consequence of market structure changes, leading global investment banks to rationalise their operations and embark on a process of regionalisation. Fragmented, regionalised markets are difficult for investment mangers to trade in, and this pushes them from executing with investment banks due to cost considerations. This has encouraged non-bank providers of equity brokering services to come to the market, widening the supply of service providers to the benefit of cost-savvy investment managers. Buyside firms also have the capacity to bring services such as transaction cost analysis (TCA) and risk management in-house, further ostracising investment bank-provided services.
The strength of investment managers is again apparent in the development of Luminex, a buyside-only trading platform launched at the end of 2015. It is a product of a consortium of investment managers including BlackRock, BNY Mellon, Capital Group, Fidelity Investments, Invesco, J.P. Morgan Asset Management, MFS, State Street Global Advisors and T.Rowe Price. The development of Luminex is in line with a move away from dark, or grey bank-run alternative trading venues.
As investment banks struggle to find a position in the evolving equity market landscape, they must look to the post-trade space and focus on developing innovative service offerings. Digital transformation translates as the restructuring of the manufacturing and distribution of products and services, and it will be evidenced as multi-channel, straight-through processing. The days of cost cutting are numbered; equity market participants must on-board digital capabilities that will require internal re-organisation and investment in business processes alongside investment in product and service development. E-commerce business and technology offerings must be brought in line with the digital ecosystem, which requires agency-centric equity trading units and an orientation towards post-trade services, which is the last nook of competition for banks. The demand for post-trade services is seen in the Australian Stock Exchange’s upgrade of its equity clearing and settlement system in tandem with Digital Asset Holdings, a US blockchain technology provider. This is part of a wider intention to upgrade all trading and post-trade platforms over the next three years.
Equity markets are poised to go digital, but the readiness of the investment banking elements of this market is questionable. If banks do not find plausible answers to the questions being asked of their equity trading business and technology models, then they will be left behind.