Permanent and profound changes to the trading environment have affected market participants across the board. To continue to win the scale game, global and super-regional sell-side firms – for which simply intermediating between clients and sources of liquidity no longer is a guarantee of success – must develop a more intelligent relationship with technology.
The growth in market complexity, combined with decreasing trading volumes and an unrelenting churn in global regulation, has had a fundamental effect on traditional sell-side business models. Downward pressures on revenues are accompanied by the soaring costs of servicing client demand. Simply intermediating between clients and sources of liquidity is no longer a guarantee of success.
Just staying in the game requires ever greater investment in technology. But the growth in infrastructure has to be efficient so that revenue increases at a faster rate than the simultaneous rise in costs. This is challenge enough for any firm; but for scale players, with multiple lines of business to support, it is replicated many times over.
One response has been to consolidate technology provision so that discrete operational silos are collapsed into horizontal layers that support order management, connectivity or risk management. A single platform that can provide both depth of capabilities – managing workflow throughout the front, middle and back office – as well as breadth across an increasingly diverse array of asset classes reduces the risk of inefficient technology growth.
But the new climate means that firms must go further still and challenge the traditional idea that all technology investment is a source of value. In fact, serious questions are now being asked as to the viability of this approach in today’s market conditions.
[Related: “Technology in Our Markets: A Conversation With Citadel’s Jamil Nazarali and TABB’s Larry Tabb”]
The role of trading technology is primarily to enable brokers to develop, protect and deliver their IP – the unique features that create true competitive advantage – whether that is highly engineered algos, complex basket trading capabilities, the quality of a firm’s people and relationships, or its international reach and capital base. However, not all technology contributes directly to creating and delivering IP to market. A substantial proportion of technology deployed bysell-sides around the world is largely commoditized – it fulfils a necessary function, but delivers no real differentiating value to the business.
Instead, this commoditized infrastructure plays a supporting role to the main attraction – the IP layer that sits above it. But because venue proliferation and regulation continue to up the ante, the amount of infrastructure needed to deliver the same IP has increased greatly – the very opposite of the efficient growth that firms need.
To achieve really efficient infrastructure growth, the focus has to be on maximizing IP. For everything else, the goal is to ensure that the service is delivered to the right standard and at the right price. This is the underlying argument behind outsourcing, and one that is proving increasingly attractive to the financial services sector.
As long as the right level of cost and competence is maintained to support the IP layer, and the reputation and inherent brand value of the firm is not compromised by external providers, then outsourcing can deliver fairly immediate benefits. The replacement of fixed capital expenditure with variable costs allows large firms to easily and quickly adjust the scale of their business in response to client demand and market conditions. It also gives them the flexibility to experiment with new services or business lines, safe in the knowledge that less successful initiatives can be easily and cheaply exited.
Ensuring this efficiency is dependent on two factors. The first is provider selection. Global and super-regional brokers will need to ensure they work with third-party suppliers that can deliver on the same scale, with a global reach, multi-asset capabilities and, crucially, a workflow-centric approach to technology. However, since the commoditized infrastructure is not a source of competition, it can also be provided in partnership with peers or even competitors.
There are a number of areas where such a collaborative approach could be applied in practice. The legally required storage of trade history files is one: a shared, central storage utility could eradicate the duplication that currently plagues data storage and minimize costs for the industry as a whole. Alternatively, post-trade affirmations and confirmations — where demands for shorter settlement cycles, skyrocketing costs of capital, and a proliferation of buy-side approaches has driven up cost and systemic risk for larger sell-sides — is also a potential candidate for a community-led approach based on a single open standard.
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The other critical success factor is making the right decisions about where to innovate and where to commoditize. One firm’s IP is another’s commoditized service, and the relationship between the two will eventually become a factor in a firm’s actual IP. For example, the way in which firms interpret the new MiFID II rules that require broker crossing networks to evolve into either MTFs or SIs will have a serious impact on competitive differentiation and, hence, IP. How this flow is matched internally could also be a potential candidate for creating IP, as could global program trading or algorithms, the provision of capital and liquidity, and the security of greater risk-checking and compliance capabilities.
In contrast, exchange connectivity is less likely to deliver competitive advantage, as the race to zero has reached a point where the effect of a few extra micro-seconds is negligible for those outside the extreme HFT community.
But the critical point here is that the line between the IP layer and the commoditized infrastructure below it is not set in stone. In today’s markets, IP needs to be dynamic and responsive. A unique source of value today may very well be a commodity service tomorrow. Making the distinction between innovation and commoditization is an iterative process; like blocks falling in a game of Tetris, the arrival and integration of new sources of value can and should push the old differentiating factors into the realms of commoditization. As the cycle of innovation continues to shrink, the more ruthless a firm must be in managing the line between the two.
Equally, the movement from innovation to commoditization is not always a one-way street. As markets change, parts of commoditized infrastructure may come back as competitive factors. The Dodd-Frank Act, with its emphasis on central clearing, up-front margining for OTC instruments and introduction of Swap Execution Facilities (SEFs), gives brokers new opportunities to manage risk intelligently on their clients’ behalf. By offsetting margin between net-flat exposures either over different SEFs, or between SEFs and futures exchanges, clearing brokers can help buy-sides manage capital more effectively.
There may also be services that are partially IP and partially commodity: shared storage of historical data may in fact be a source of value with the tools to back-test algos and analyze trading patterns. In this case, the mechanics of a combined database are commoditized, while analysis that powers intelligent trading sits firmly in the IP layer. Whichever way the IP tide is moving, managing its ebb and flow is another way in which firms will be differentiated.
This intelligent approach to scale a business — which is more relevant, more efficient and more focused — clearly resonates in today’s world order, where tolerance for inefficiency is fast being dialled down to zero. The greater the trust in suppliers and third parties, and the more capable the management of the two layers of infrastructure, the more responsive a firm can be. Innovative ideas can be sent to market with speed and efficiency and deliver IP rapidly around the globe, giving scale players the agility and flexibility typically seen in much smaller businesses. Circumstances may have forced its adoption, but those firms that fully embrace the intelligent scale model will be the winners in the long term.
For more on the evolving sell-side technology model, see Fidessa’s white paper, “Survival of the Fittest Part II – Walk the Line: Evolution of the Intelligent Flow Monster.”
Carl A R Weir's Blog 