It’s Time to Re-Think Derivatives Platforms
The following is written by Gerry Turner, global head of platform-as-a-service at Vela.
Investment banks have generated impressive revenues this year, thanks in part to strong cash equities trading. But long-term trends in the derivatives markets tell a different story. Figures from the Bank for International Settlements show the market value for rate, currency and equity-linked contracts almost halving to around $11 trillion from more than $21 trillion during the latest two-year period for which data are available.
For any firm involved in derivatives markets, all of this boils down to two words: margin pressure. The margins for derivatives trading firms are razor-thin to begin with. The cost base is both high and inelastic. Revenues are highly correlated to volumes. So, in an environment where volume is falling, lower transaction revenue threatens to weigh on margins even more.
But what if firms’ assumptions about the cost side are out of date? One reason why many firms see their cost base as being so rigid is because the derivatives market historically has demanded in-house hardware and proprietary software in order to deliver unique selling propositions and trading advantages. Faster or better data analysis, superior trade execution, breadth of market access – these are all factors that in-house solutions in the past tended to favour.
Times have changed. First, speed is no longer the differentiator it once was. Firms now expect low latency as a standard pre-requisite for direct market access (DMA). Second, compute power can be supplied on demand so high-capacity proprietary infrastructures are no longer an absolute necessity for firms that may need to do high-level calculations on an occasional basis. Third, regulators are imposing a top-down approach to risk modelling, meaning there are fewer competitive advantages to be had from that aspect of trading.
What all that adds up to is an argument for adopting a PaaS (platform as a service) approach. Not only does a PaaS solution mean a firm can sharply cut costs and re-inflate margins, but also it lets companies focus on what they’re meant to be focused on: their core business. Whatever differentiator a company is offering its clients, chances are that it is not one that is based on connectivity technology. Building and maintaining a trading platform is simply not going to be high up on a firm’s what-we’re-good-at list.
For those firms that do want to build and maintain their own trading platforms, the time and money that will need to go into platform maintenance is resource that will get siphoned away from the parts of the business where they can make a difference with clients. The as-a-service model, on the other hand, mutualises costs and creates business flexibility.
Once a firm decides it’s worth exploring a platform-as-a-service solution, what factors should it consider in selecting a provider? There are three that stand out.
Performance is always going to be the first issue to consider. If your trade execution speed is such that you’re not getting your trades done, it won’t be long before your clients start banging on the door demanding better service. That is one reason why many buy-side firms have gone into the PaaS space: their brokers were not providing good-enough technology.
Another major determinant should be the scope for customisation. For instance, these days any DMA service would be expected to include pre-trade risk analysis. But companies do not want to be shoehorned into using a pre-trade risk service that doesn’t match their business practice or workflows. Firms – particularly those that are heavily focused on OTC products – need the ability to adjust and customise their pricing and risk management tools.
A third factor we can call community. Does the platform have other participants on it which you would want to see? For buy-side firms, the presence of multiple brokers on a platform can be decisive. Similarly, exchanges welcome platforms that have large numbers of clients because that translates into new business.
Community is not only about what firms are on the platform but also about global reach. The ability to link colocation centres together means a PaaS solution is more than a platform. It can act as a gateway to execution. As firms’ trading footprints get larger and begin to encompass Asia as well as Europe and the Americas, this last point becomes critical.
Doing more with less has long been the mantra in a market where regulatory pressures are taking a heavy toll on trading firms, both in terms of costs and revenues. What once might have been a differentiator in trading technology now is often considered standard. At the same time, firms need to focus on the things they’re good at. They need operational flexibility, fast time to market, and relief on the cost front.
Given all of that, there’s an obvious question firms need to ask themselves: Why not press the PaaS button?