When the lobbying dust has settled and new rules are legislated, Brussels will have a far firmer hand on the future of the markets although many new rules will not come into effect until 2014-2015. In our view, one of the most significant developments is the creation of the European Securities and Markets Authority (ESMA), which will gain the power that Committee of Securities Regulators (CESR) lacked.
As the EU seeks to create a single rule book – and directives give way to regulation thereby restricting interpretation – ESMA will play a pivotal role. For example, it is proposed that ESMA’s responsibilities include playing the central role in determining when and which derivatives will be eligible for central clearing or trading on an organized venue and monitoring the use of pre-transparency waivers. In addition, it will deal with technical implementation details, which is where many of the greatest bones of contention and daily decisions lie.
Meanwhile, a focus by the UK’s FSA on moving to the auspices of the Bank of England raises the risk of the largest European market being soft-voiced at the EU table and swept along by the Brussels tide.
The second shift will come from the repositioning by market participants and we anticipate some M&A activity as a result. Already Chi-X is in exclusive talks with BATS and this merger would position the pair as the biggest player by trading volume in the lit markets – most importantly, owned by the banks and brokers. As the latter are forced to re-examine their business models under new regulation, the competition between banks, brokers, exchanges and MTFs is bubbling up.
Two MTFs – Nomura NX and UBS MTF – have already been launched by banks and more will follow. If existing profit avenues for brokers are curtailed by new regulation, business models must change and new products will be launched to create new revenue streams.
This will have a knock-on effect on the markets to which the brokers are essentially the gateways. The MiFID II proposals may appear to favor transparency and exchange models, but the banks and brokers remain the engine room of trading innovation. In essence, banks and brokers will always come up with innovative ways to continue to conduct business bilaterally, even as regulators turn more spotlights and attention to the murky world of the OTC market.
Among trading venues, the exchanges are jostling for position as they both reinvent themselves and seek to take advantage of imminent regulation, particularly derivatives regulation. In addition to extending businesses, some are expanding their capabilities as technology and infrastructure providers – such as Nasdaq’s purchase of SMARTS adding to the arsenal of products and services in the critical space of surveillance – or the provision of software, services and facilities of NYSE Euronext’s technology arm for a new trading platform owned by Goldman Sachs.
Downstream of trading venues, interoperability among CCPs is expected to make progress. While interoperability may provide a choice, it will not provide free choice at a pan-European level until a single CCP can service every venue that a broker wishes. We expect consolidation amongst CCPs for two reasons – first, Europe does not need 10 or more CCPs clearing the same fungible stocks, and second, due to the accelerated creation of pan-European, multi-asset exchanges with vertically aligned execution and clearing services.
Necessity will also be a driver of change; if the economy remains depressed and markets remain thin, the burden of regulatory change will be too big for some, either because their level of business does not provide a big enough return on investment in a highly commoditized market, or because their business model cannot grow organically or sufficiently quickly.
Pressure comes also from new players continuing to enter the arena – such as the LSE and Plus Markets in derivatives markets and CME Clearing. As the number of lookalike products increases, nobody wants to be the one without the chair when the music stops.
The details are still in the making but the regulatory writing on the wall is clear and this increases the likelihood of consolidation this year. While we all hope for better days and busier markets, if the sovereign debt crisis continues, assets do not return to the market, order flow is thin and innovation is backed up behind regulatory changes, we will see consolidation occur sooner rather than later.
At the very least in 2011 we will see the commencement of shifts in power, opportunity and cost as new business models emerge in anticipation of the changing regulatory environment, and this will create a very new dynamic in the European marketplace.