By James Blackburn, Fidessa
It is widely acknowledged that the past couple of years have seen broad structural changes to the world’s financial markets. Less widely accepted is the fact that these changes have resulted in a permanent and profound shift in the role and operating environment of sell-side firms. Success can no longer be guaranteed simply by intermediating between clients and sources of liquidity: a change of approach is needed.
The complexity of the fragmented market structure is central to this required shift in thinking. Navigating a seemingly ever-changing liquidity landscape has become harder and more expensive. An increasing number of smaller and mid-tier brokers are electing to outsource execution to larger firms with all the necessary infrastructure and smart-routing capability. This creates short-term cost savings but also potential long-term risk: disintermediation is a real threat if outsourcing brokers cannot clearly prove the value they are adding.
There’s no escape for research specialists either. Despite early hopes, Commission Sharing Agreements have not produced what was expected: reports suggest that the pool for research-only providers is around five per-cent of the total client commission pot. With so much left to play for, operating and maintaining an effective transactional cash register remains the only viable mechanism to get paid.
Regulation is also driving change. The regulatory agenda has moved beyond increasing competition, fairness and transparency in how various asset classes – especially equities – are traded to encompass a range of other asset classes. It also seeks to reduce systemic market risk in the wake of the global financial crisis. Add to that the fact that regulators are increasingly looking beyond their native jurisdictions, and brokers are swamped with regulatory changes from multiple geographic centres. Where regulations overlap on the same issues, the potential for confusion and cost – though also opportunity – increases.
The final elements contributing to the perfect storm affecting brokers is that (for equities particularly) there is clear evidence that, from their peak in 2009, trading volumes have declined materially and the fiercely competitive environment has served to drive commissions down substantially. This potent mix has had severe implications for many market participants.
Loyalty, like liquidity, has been fragmented. The traditional relationship between buy-side and prime broker has all but disappeared. Buy-sides shop around for broker services and crucially demand more value from each of the firms to which they direct flow. As a result of all this, the volume of ‘free’ business has shrunk considerably, leaving sell-sides battling for a meaningful share of a far smaller pie.
Finding traction in this new business environment presents brokers with a real challenge. One possible approach is to go for scale, although this is not without its own issues and may not be a realistic option for the smaller and mid-tier brokers. For these firms, an alternative approach is to arm themselves with the right tools to exploit opportunities in the new environment, asserting their relevance through the provision of relevant, targeted and intelligent services that add real value to an increasingly discerning client base.
As well as dealing with a multi-market landscape, globalised trading and interconnected regulations, brokers are also faced with a deluge of data at each stage of the trading process. Fundamental and underlying technical data that have previously underpinned successful trading are now commoditised. They are no longer enough to secure optimal trading outcomes nor are they a source of competitive differentiation. The pressure is on to find ways of combining a growing universe of regulated and unregulated data with specific firm-wide intelligence regarding current and historic client activity, and using this to power a more valuable service to clients.
But finding relevant information, then extracting, normalising, translating and storing it in order to make it available in the most appropriate and suitable time period presents a significant operational challenge.
At the pre-trade level it’s all about ‘actionable’ data, embedded in brokers’ daily workflows enabling them to react faster than anyone else to revenue-generating opportunities. For example, on receiving an order, a broker could look at relevant stock holdings among buy-side clients as well as historical information about previous activity, trading patterns or expressions of interest. Done intelligently, this gives the sales trader an actionable list that provides the best chance of optimising the outcome. The tools to transform uncorrelated, raw data into weapons-grade information are critical.
This pre-trade visibility must also extend into the real-time execution process. As more brokers outsource their execution to larger firms, the real value lies in the ability to interpret and analyse the myriad of available execution offerings, in real time and without bias. Firms with the ability to communicate likely execution outcomes to clients in real time and make any changes mid-flight to secure the preferred outcome will be able to demonstrate real value. These real-time intelligent execution services can help turn the regulatory obligation of best execution into competitive edge, and are another way that smaller and mid-tier brokers can demonstrate their new-found relevance.
Post-trade, brokers can extend these principles to provide standardised, accurate and objective analysis of their own trading performance, supplementing the ubiquitous but subjective VWAP, TWAP and Implementation Shortfall measurements. Some firms are taking the concept of TCA further, using this greater internal visibility to better understand their own business. Monitoring and interpreting their own trading performance, and making the necessary adjustments, allow them to identify and improve areas of weakness and better manage cost and revenue dynamics. The same information can also be used to improve service levels through the delivery of better and more timely information, thus allowing brokers to forge deeper and more meaningful client relationships.
When combined, these activities allow for truly intelligent trading: carefully targeted activity that is informed and driven by accurate data and in-depth analysis. It improves profitability and enhances client relationships as efficiently and effectively as possible. But perhaps the real advantage is that it gives firms that choose to go down the outsourced execution route the ability to analyse and interpret the actual performance of the outsourced provider. In doing so, they create the value necessary to avoid disintermediation.
The structural changes in the marketplace have made intelligence the new super power and an ever-increasing premium is placed on ‘smart’ trading. Firms best able to adapt to serve their clients will be the ones that will prosper and grow. Those with the most intelligent tools at their disposal are best positioned to help their clients navigate the transformed landscape and turn the new challenges to both their clients’ and their own advantage.