Fragmented Markets Call for Proper Tools01.31.2019 By Rob Daly Editor-at-Large
By Gerry Turner, global head of platform as a service at Vela.
Financial market participants, it appears, are getting more intrepid by the day.
In search of fertile new trading environments, many firms are looking further afield than ever before and entering markets that only a few years ago would not have seemed feasible. From Asia to the Americas, buy-side and sell-side institutions are eyeing opportunities for proprietary trading, market-making, broking and other activities. Highlighting the trend, the Bank for International Settlements, in a recent report, said trading activity in fast-paced electronic markets was becoming increasingly fragmented across new venues.
This fragmentation of liquidity is having a profound effect on business models for firms in the derivatives markets as an example. One of the most notable changes is that a new breed of intermediaries, mostly made up of principal trading firms (PTFs), have sprung up. “In recent years, a number of PTFs have moved from high-speed trading on an anonymous basis … to the direct, disclosed provision of liquidity to a network of clients,” the BIS report said.
The new breed, as well as more established players, are justifiably focused on the potential revenue and margins they may be able to achieve with a successful business strategy. However, in a fiercely competitive market place, this is also dependent on them having the right technology and platform strategy.
A firm’s platform strategy can play an outsized role in determining everything from the scope for flexibility to the health of its bottom line. And what not every company realizes is the degree to which technological change and outsourcing trends have opened up new possibilities, allowing firms to be more agile, quickly validate new markets and strategies (fail fast) and focus their limited resources on building their businesses’ unique selling points. Platform-as-a-service (PaaS) used to be a buzzword, now it’s a sensible strategy for ambitious trading firms looking to differentiate their offering and increase their profitability.
Trading trends and the bottom line
The growth of direct market access (DMA) provision has allowed PTFs to proliferate. Trading directly with an order book has become commonplace, even for buy-side firms that rely on brokers for clearing. But as these firms look to capitalize on a quickly shifting liquidity landscape, they need to be mindful of the business challenges that becoming a liquidity provider in electronic markets presents.
Liquidity provision is all about volume. The margins are thin, so firms looking to make money this way need either consistently robust volumes or the requisite flexibility and agility to enable them to scale their businesses accordingly based on internal and external factors such as a shifting regulatory, commercial and macro-economic landscape.
With regards to the first condition, volumes in many markets have been falling. Global trading as measured by total rate, currency and equity-linked contracts outstanding has fallen by nearly 50 percent to around $11 trillion during the space of two years.
At the same time, the cost base for liquidity providers historically has been fairly rigid. Electronic trading traditionally has demanded in-house hardware and proprietary software in order to guarantee low latency, high performance and the scalability required as firms seek to move into new markets quickly. The do-it-yourself mentality also dominated because trading firms needed best-in-class risk tools and execution.
Building such a platform is expensive to begin with, but total cost of ownership goes well beyond capex. A sizeable cost comes from maintaining a trading platform and opex costs like these get baked into the budget. There is also the lost opportunity cost of deploying valuable resource to running these systems in-house. Operating in this fixed cost mode means any hit on the revenue side – for instance, whenever a trading downturn occurs – will immediately translate into lower margins.
If a firm is going to spend that much time and money, it should go towards activities that clients will recognize and value. The fact that your firm may be best-in-class at maintaining a platform is generally not the first thing customers will ask about. Worse yet, all of those resources devoted to platform maintenance end up getting taken away from aspects of the business that clients actually do care about, such as execution, relationships and service.
That’s all the bad news. The good news is that advances in technology, coupled with broader trends in the marketplace, have created opportunities for firms to transform the way they access markets. Outsourcing trading technology has become not just a viable option, but a desirable one. It can provide the cost flexibility needed to cope with sudden shifts in the trading environment while still offering the advantages that previously only came with proprietary solutions.
Top of the list for any firm looking for a trading platform will be performance. In fact, for many buy-side firms that had relied on their brokers’ technology, the execution performance they were getting was just not good enough. Trades were not getting done. Presented with the option of building their own platforms, a rising number of these firms have opted for a PaaS approach.
There are some structural changes in the marketplace that have made this trend possible. Since DMA has become so commoditized, speed is not the issue it once was. Nor, for that matter, is bandwidth. These days, compute power can be supplied on demand, so firms that may want sudden bursts of compute capacity need not be forced into proprietary infrastructures.
Meanwhile, the onslaught of regulation witnessed in recent years has resulted in a top-down approach to risk modelling. The upshot from that is that there are fewer competitive advantages in the form of differentiators from a platform that has proprietary risk modelling systems.
But just because a firm may not need exclusive risk modelling capabilities does not mean it does not want choices at all. It’s commonplace for DMA services to include pre-trade risk analysis, but companies still have their own business practices and workflows that they will want their platform to support. This is particularly the case for firms that strongly focus on OTC products.
Another big factor firms will want to consider is what other market participants are using the platform. Can it handle multiple brokers? Are there trading firms you want to see? Is the onboarding process relatively painless?
The community on a platform acts much like the community in any trading ecosystem – it facilitates liquidity. So, a platform needs to be able to attract trading venues as well as sell-side and buy-side players alike. These three types of participants want to know the others will be there on the platform. As firms look to trade in multiple colocation centers, the community of users on a platform thus becomes critical. A PaaS solution in this way becomes a bridge between centers and a gateway to execution.
The as-a-service approach – encompassing Infrastructure as a Service and Software as a Service in addition to PaaS – has gained in popularity in a broad swathe of industries as cloud computing costs have come down and major organizations have taken on board the benefits of mutualizing costs. Virtually every major consultancy firm, in its annual report on top IT trends, now features some discussion about the future growth of this way of doing business. Capital markets has by no means been an early adopter, but it’s catching up fast.
Some of the embrace comes down to long-term trends. While much has been made of the regulatory environment, there are at least two other major factors that have the potential to shape longer-term decision making on where and how to trade. One is global monetary conditions and the other is the steady electronification of world markets.
As the 10th anniversary of the global financial crisis has now come and gone, global interest rates are finally on an upward trajectory. All of that is creating more volatility, which inevitably has an effect on cross-border and cross-venue liquidity conditions. For some firms that spells opportunity. But if a firm wants to seize those opportunities, it needs a platform that is nimble, customizable and ultimately cost efficient.
Meanwhile, the BIS report cited earlier notes how the share of electronic trading for fast-moving markets has inexorably marched higher. As market data services have spread and participants of all sizes grow more comfortable with electronic trading, this has increased the ability for liquidity to move quickly from one venue to another.
At Vela, we think the as-a-service approach is ideally suited to these conditions. Some firms may be daunted by the prospect of such a major strategic decision. After all, this is far more than a number on a balance sheet. A PaaS solution means a firm is essentially adopting a new business model. But because it is a model that is based on flexibility and potential to scale, such a change ends up bringing less risk, not more.
Apart from the initial benefit of reducing a bloated cost base, opting for a platform-as-a-service approach has one other significant strategic advantage. It has the potential to future-proof a company’s operations. The flexibility that is gained immediately – in terms of footprint, balance sheet and trading partners – can extend into the future since companies are no longer locked into strategic decisions or bogged down by legacy technology.
About the author: With over 30 years of derivatives experience, Gerry Turner leads the Platform as a Service (PaaS) business at Vela and is primarily responsible for the support and delivery of its award-winning, high-performance market access technology platform.
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