Regulation, technology, and process innovation are reshaping the capital markets. The size and scale that enabled incumbent banks to dominate equities in turn has saddled them with a legacy infrastructure, culture and regulatory environment that have made them uncompetitive with smaller and more nimble technology-led trading organizations, and a new breed of electronic market makers now dominates equities trading. TABB Group founder and research chairman Larry Tabb explores the transformation of market making and risk wholesaling and the restructuring of the trading landscape, across asset classes.
The future won’t look like today.
Regulation, technology, and process innovation are reshaping the market landscape.
Who is Wall Street? Think Goldman Sachs, JP Morgan and Morgan Stanley drive today’s equity markets? Fuhgeddaboudit. Today’s largest trading firms are Citadel Securities, GTS, HRT, IMC, Susquehanna/G1X, and Virtu.
While regulation (Basel III, the Volcker Rule and the Dodd-Frank Act) precipitated these changes, technology, operating models, risk management, and efficiency are the real drivers. The key to understanding the transformation is intermediation – not exchange intermediation, but the actual mechanism how liquidity is created, provided and absorbed. If we start at the end points, intermediation is the process of moving an asset from one long-term holder to another as liquidity is bridged by aligning a series of shorter-term investors with differing holding periods, investment strategies, and trading signals.
Historically, investment banks have been the major cog in the intermediation wheel. Banks bought securities from fundamental investors, sold off what they could, and warehoused the remaining risk until conditions changed. This traditional model was disrupted when markets fragmented and became more electronic, and technology became the glue to make them appear as one.
The improved price/performance curve of technology and connectivity has lowered trading costs and undercut large financial institutions that increasingly were unable to protect their margins and positions. The size and scale that enabled incumbents to dominate equities trading through the beginning of the 21st century in turn saddled them with a legacy infrastructure, culture and regulatory environment that have made them uncompetitive with smaller and more nimble technology-led trading organizations.
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Traditionally, investment banks made markets, worked with clients, managed risk, and processed trades. They were lightweight organizations that revolved around small, autonomous trading groups. These firms were less worried about cost than speed and agility, as the profits of being first outweighed the cost of being wrong.
This changed as investment banks became ever larger and their balance sheets became core to their mission. Capital-intensive asset classes became critical to Wall Street’s revenue structure, while highly liquid, turnover-dependent asset classes increasingly failed to sustain revenue thresholds. This change in the banking business model was matched with technology, analytics, and engineering investments from smaller and more nimble technology-led trading firms, and the equities business began its transition.
While this process seems inevitable in retrospect, it is a huge change to equity market structure that is reflective of larger changes on Wall Street, and it has reshaped the business of trading.
Currently, four market makers (none is a traditional investment bank) execute 63% of FINRA-reported non-ATS OTC equity volume (May 2019). Adding another six electronic firms increases the total of non-ATS OTC shares traded to 69%. Compare this to the 23% of OTC flow executed by the nine traditional bulge-bracket firms (see Exhibit 1, below).
Ten firms that most people have never heard of now execute three times more shares than the top nine global brands; and in reality, the bulge-bracket’s 23% market share is even lower, as banks have increasingly partnered with electronic market makers to provide their ATS liquidity. If the marginal cost of providing financial intermediation dictates price, then technology-forward, automated firms will dominate the industry.
Banks are not just relinquishing their market making roles; increasingly, they are outsourcing their intermediate risk wholesaling as well. In this new world, risk warehousing is being segmented by holding period. There are execution (+/- microseconds to hours), short-term (hours to days), intermediate (days to weeks), and longer-term strategies. While banks had played a role in the short and intermediate intermediation process, they increasingly have lost their ability to innovate as other, less regulated entities have sprung up to provide these services – i.e., quantitative and shorter-term horizon hedge funds.
As the cost of trading goes down, so does the friction of intermediation. Transactions that previously would have gone from one long-term holder to a bank/broker for risk warehousing, to another longer-term holder now turn over four or five times, as the long-term investor sells to a cash/ETF arbitrager, a quant fund, a longer-frequency quant fund, a long-short fund, and finally, to a long-term buyer, with shares crossing through an execution point with each and every transition. In this way, each part of the holding curve will have different specialists with their own unique capital, investment themes, and risk management strategies.
One size (i.e., banks) no longer fits all.
Just like equities trading has been outsourced to agile market makers, the warehousing of assets is being outsourced to a coterie of strategy-specific hedge funds. To equity market insiders, this may seem like old news; but in reality, it’s just the early days of what we see as a restructuring, not just of the US equity business, but of the whole trading landscape, across geographies and asset classes; the progression is not just occurring in major market equities, but increasingly across rates, credit, FX, and even munis.
While larger banks and brokers act as the “front door,” to many, this is changing, as the formal flow of trades that cross at large investor-connected banks is beginning to divert to specialized technology-enabled electronic trading firms which increasingly are catering to larger investors.
Electronic market makers are moving upstream as they begin to offer investors better engineered algorithms and increasing amounts of capital and liquidity. This is an agility play which has already occurred in the business of retail wholesaling, as Citadel Securities, Virtu, and Susquehanna/G1X are now the largest retailers. Electronic market makers are also moving into the institutional client-facing business, as Virtu acquired ITG, GTS acquired BGC Cantor’s ETF business, and Jane Street is increasingly catering to traditional institutional investors. We expect other market makers will follow suit as electronic market makers move closer to the client.
The disintermediation of the traditional market will also occur more quickly than expected. The more-liquid flow will be carved off as these new channels trade this flow more efficiently. As performance improves and the execution quality of more traditional channels deteriorate, it will effectively push more flow through these newer channels – liquidity begets even more liquidity.
This will take the banks out of the trading and risk business, but it doesn’t leave the banks without a role. Instead of absorbing market risk, banks will increasingly provide prime brokerage, cash management, securities finance, and clearing support for market makers, proprietary traders, and hedge funds. The banks won’t be risking their balance sheets, nor their depositors’ funds; but they will leverage their custodial capabilities to generate revenue from the cash and securities held for others. Banks are increasingly swapping market risk for short-term credit risk and interest income. While this reduces trading profits, it also reduces their regulatory exposure – and the risk of crisis-like loses.
So, where are we?
Unless banks can regain their agility and regulatory freedom, the nimble investment banks of the 1990s will be pushed out of the trading business by technology-enabled intermediaries and sophisticated hedge funds.
This new trading world increasingly revolves around a group of highly technology-enabled market makers intermediating large-sized orders between traditional institutional investors, through a host of deep-pocketed quantitative and strategy-specific hedge funds structured to hold assets for very limited periods. Any mismatch in order size will be efficiently and effectively traded out of via the public market infrastructure.
While this started in US equities, it is being replicated across asset classes and geographies, as the effectiveness of this process is reducing the cost of trading and risk intermediation. These new market makers are placing their technology at the center, directly facilitating hedge fund risk appetites on one side, with traditional asset managers on the other side, all done with the banks as supporting actors.
While post-crisis regulation didn’t overtly take banks out of the trading business, you may call the result an unintended consequence of both regulation and technology. Regulators wanted less risky banks, and through regulation, technology and business strategy, that is exactly what has happened. The trading business is shifting to newer and more adroit trading firms bridging traditional asset management liquidity pools with private and hedge fund capital.