SELLSIDE CASH EQUITIES TECHNOLOGY AND WORKFLOWS CONVERGE.
In 2018, the role of the sellside equities trader is still undergoing change, driven by regulation, technological progress and the utilisation of new business models. These changes are cascading through every tier of the investment banking equities execution franchise industry, affecting buyside clients and the structure of the equities market at large. Willis Bruckermann, GreySpark Partners Analyst Consultant, examines how high- and low-touch trading have changed in the past decade, and some of the implications thereof for the future structure of the flow equities market.
The shifting sands of equities trading desk risk-taking
The equities market, particularly cash equities and listed derivatives, has nearly completed its transition to a fully electronified state that is largely dependent on low-touch business models. This transition away from the dominance of high-touch order flows and corresponding business models was largely driven over the last 10 to 20 years by regulatory mandates, which have increased significantly since the onset of the financial crisis, as well as by the compressed margin environment faced by banks over the past decade that drove both business and trading model cost-cutting measures. In response, most Tier I-III sellside equities execution franchises retrenched away from attempting to offer the widest possible range of equities markets products and services to their clients to instead focus on the development of more niche business models; in some cases, banks have exited the flow equity markets entirely, leaving only a small group of banks offering full cash equities and equities derivatives instruments, products and related services coverage globally.
Concurrently, the rise of e-trading over the past decade, combined with the growing automation of e-trading services at the margins in light of continual cost pressures, has led to significantly lower front-office equities trading business headcounts in 2018 compared to headcount levels in 2010. We believe that the radical headcount reductions that took place over the past seven years have now largely concluded; however, some banks continue to seek out even more automation of their business and trading models – as well as their ancillary processes and workflows – and will thus likely continue to reduce headcounts gradually over the coming years, with staffing levels likely plateauing near 70% of 2010 levels (see Figure 1).
Sellside equities trader workflows are also shifting as proprietary or advantageous risk-taking is further moved off equities desks in response to post-financial crisis regulations. Specifically, in 2018, the majority of banks globally no longer trade cash equities on a proprietary basis, having shifted entirely to agency or riskless-principal business models in light of the US Dodd-Frank Act’s Volcker Rule and Basel III’s capital requirements. In anticipation of the Basel Committee on Banking Supervision’s (BCBS) forthcoming Fundamental Review of Trading Book (FRTB), risk-taking of any kind across any asset class will instead likely become concentrated within central risk desks (CRD) rather than remaining within the purview of individual trading desks. Consequently, equities trades now compete against those of other asset classes and business lines for access to the balance sheet.
Changing equities trading technology imperatives
In 2018, the drivers for maintaining separate high- and low-touch platforms to service equities clients are weakening. When full straight-through processing (STP) and equities market e-trading became possible in the 1990s, banks found that traditional high-touch solutions could not service the demands of clients seeking low-cost, high-throughput, low-latency execution services. In response, early-stage low-touch trading solutions were built in-house to run in parallel to bank high-touch systems. Later, entrants leveraged low-touch vendor solutions but continued to run parallel high-touch systems.
The historic drivers for banks to maintain separate high-touch and low-touch solutions are largely anachronous. Low-touch solutions vendors are starting to compete directly with traditional high-touch providers and are continuously enriching the functionality of their offerings to meet the needs of high-touch clients. Therefore, trading platforms are largely commoditised in 2018 (see Figure 2). As banks look to reduce costs, there are strategic incentives to simplify technology platforms and consolidate where possible. Over the next 18 to 24 months, GreySpark believes high-touch and low-touch vendor platforms will continue to converge from a functionality perspective, eliminating the need for a bank market-maker to maintain two separate platforms.
Nonetheless, some exceptions to this consolidation will persists among large multi-asset prime services providers that require multi-asset order and execution management system (OEMS) capabilities. These prime services providers still need a distinct order management system (OMS) and execution management system (EMS) to differentiate themselves from their competitors, but with cost implications. Also exempt from this change will be the remaining high-frequency trading (HFT) sellside players that will continue to seek out bespoke, low-touch platforms to compete in the market, and will not need high-touch solutions or OMS capabilities.
Forget high-& low-touch – in 2018, the focus is ‘how-touch’
There is little that universally differentiates bank high- and low-touch workflows in different regions and with different client types. Instead of set service offerings and workflows that are broadly applicable across many different types of equities trading banks, how bank traders interact with client orders is very situational and can take a wide range of forms.
Indeed, with the exception of DMA / SMA clients that send their orders directly to the bank EMS – often a separate ultra-low latency system, reserved exclusively for these clients – all orders take the same path and can be interacted with at the same points.
The difference between high- and low-touch traders in 2018 is the frequency and level of interaction with the orders, and therefore value-add, they are expected to have at different points in the trading lifecycle. High-touch traders are expected to review and, if necessary, bring their market knowledge to bear on client orders before they pass from the bank’s OMS to its EMS. Both high- and low-touch clients expect any electronic or algorithmic execution to be monitored in real time. Indeed, more technologically sophisticated clients may even demand that information about execution is streamed back to their buyside OMS or PMS during the execution process.
However, trader interaction during EMS execution is only necessary – or even acceptable – if the interaction serves to adjust execution parameters in light of unexpected market conditions, trading outcomes or other anomalous events.
Figure 3 depicts a generic cash equities workflow, demonstrating trader interaction and value-add in the order handling process.
The difference in expectation for how a sellside equities trader interacts with an order, and the level of value-add they contribute, varies by region. In Europe and North America, clients largely accept the dichotomy between high- and low-touch service models and accept that the cost difference between them is reflected in the service delivered.
In APAC, on the other hand, clients demand a greater level of service for low-touch orders than clients in other regions, creating further cost pressures for execution franchises. Although only charging for low-touch service levels, traders are expected to provide what is, functionally, high-touch service.
One order pathway, two types of traders
For the most part, today’s sellside equities traders fall into two categories: market traders and technology traders.
Market traders are traditionalists – they take risk when appropriate, or at least are comfortable with the idea that they could trade on their own book if permitted to do so. These traders have a deep understanding of the market, including counterparties, norms of behaviour both in the abstract and under specific market conditions and historic market performance. This understanding is both borne of and complemented by the close relationships traders build with their clients and other market participants. Consequently, market traders have the understanding and relationships to work an order manually and find a counterparty on behalf of their client, even for illiquid instruments, block-size orders or under adverse market conditions.
Technology traders are the new breed of traders that are primarily focused on electronic and, particularly, automated execution, i.e. the use of algos to trade. These traders understand the detailed ins and outs of e-trading systems and are highly adept at managing and monitoring algo execution in real-time. They do not trade outside of algo systems and are, in most cases, focused on attending to low-touch order flow. For these traders, the EMS is a necessary toolkit.
Some broker-dealers leverage the technology traders’ expertise in electronic trade monitoring, and they give them monitoring and intervention responsibilities for all EMS-only executed orders, even where these originate with high-touch clients normally attended to by market traders. Even in those cases, however, technology traders do not take on risk outside of the parameters set by their trading systems and the algo parameters therein.
So far, so good … or so we think
As the very nature of sellside equities traders continues to change due to risk-taking market traders being slowly replaced with technology traders, a question remains on how this profile shift will impact the structure of cash equities and listed equities derivatives markets. During equities’ long unidirectional bull run of the past few years, the shift in the nature of traders seemed rather innocuous in terms of the larger implications.
However, the equities market swoons at the beginning of February 2018 demonstrated that this new generation of technology traders, due to either a lack of ability or agency, cannot and will not backstop markets by absorbing risk when their algo execution retrenches in the face of unusual market behaviour or excessive volatility.
We observed that this effect stood in marked contrast to market traders, who perceived the swoon as an opportunity and, where permitted, deployed their balance sheet to soak up under-priced assets.
GreySpark believes that the implication of this shift to non-risk-taking traders for the equities market as a whole is that the return of any volatility to equities markets can become self-perpetuating over the short- to medium-term. This unstable market dynamic will persist until a different segment of market participants takes on the risk-warehousing, counter-momentum function that broker-dealers traditionally did by providing pricing signals and absorbing risk at the margins.