Markets weren’t built in a day

26 march 2014

The TRADE, 2014, issue 39

Vladimir Kurlyandchik, business development director, ARQA Technologies, puts the case for financial markets participants and providers focusing on long-term growth.

If the last decade has taught us anything it is that rapid growth is not sustainable growth. Moreover, it has reminded us that rapid growth has a habit of ending with a crash. Whether we’re talking about an economy, an industry or a company, sustainable growth comes from investing time and effort to achieve incremental gains over the long term.

The global financial markets are recovering from an unprecedented crash, particularly in developed markets. Both market participants and market infrastructures must come to terms with a regulatory framework and economic environment which makes growth of any sort uncertain. In developing economies, there are also major structural changes to the financial markets. New legislation and new market structures are being introduced to facilitate new financial services and new investment flows. In all cases, from west to east, the emphasis is on building for long-term growth. But there is plenty of evidence that we have not yet found the right balance.

Competitive advantage

Perhaps understandably, risk management is most commonly discussed at present in terms of compliance with regulation and changes to market structure. But we should not forget that it can also be a powerful source of competitive advantage. Sophisticated risk management techniques are required, for example, to optimise collateral requirements relating to client trades. The more able a broker is to manage market and other related risks, the greater its appetite to take on more business and execute it cost-effectively.

Indeed, in the prevailing economic climate, it is hard to generate alpha consistently in a single asset class, sector or geography. To provide returns for the end-investor, intermediaries must be flexible and nimble enough to identify and pursue many different investment ideas across the globe. As such, collateral optimisation is a vital support for any cost-effective diverse investment strategy. Any portfolio that contains a wide range of instruments must be risk-optimised to identify offsetting exposures and opportunities to minimise collateral requirements in order to pass on maximum value to investors.

There is a particular opportunity for sell-side firms that can estimate the collateral requirements of clients’ trades on pre-trade basis. For example, there may be an opportunity to arbitrage between correlated instruments, e.g. an equity and an index future. But if market risk is not calculated correctly, the broker might artificially limit the transaction, thus limiting its upside potential.

Healthy rivalry?

Another feature of today’s financial markets that threatens long-term growth is the profit motive of exchanges. No longer member-owned infrastructure operators, but listed entities with commercial imperatives, exchanges have pursued various strategies to drive revenues in the face of falling volumes, many of which have put them in conflict with their core client base, the brokers. A mixture of regulatory and competitive developments mean that both brokers and exchanges offer risk management services to ensure clients’ trades are safely handled. As a result, it can be hard to identify who has control of or responsibility for the client order. Gaps in the chain remain unaddressed, leading to potential risks across a global financial market infrastructure which has not proven able to handle the race for speed.

Exchanges and brokers are treading on each others’ toes in other product areas too. Brokers have become venue operators, withdrawing liquidity from exchanges to trade instead on internal crossing networks, while exchanges have become algo providers, with Nasdaq, for example, offering VWAP and TWAP algos on its main US equity trading venue.

Competition – both between exchange operators and with broker-owned crossing networks –has contributed to a fragmented equity market, characterised by smaller order sizes, reduced volumes, less liquidity and lower levels of transparency. Incremental shortterm ebbs and flows in market share for providers must be set against a general, long-term decline in market size and a failure to recapture the trust of the endinvestor. We cannot turn back the clock of course, but a market in which safety and efficiency are sacrificed for the sake of nanoseconds is not built to last.

Sourcing technology

In the financial markets landscape that is rapidly emerging, there are few short-cuts to growth. Volumes might be down, but margins have disappeared almost entirely. The OTC derivatives, high-yield bonds and proprietary trading desks of high-rolling legend have no future in today’s brokerage. Differentiation, therefore comes through client service and product innovation, the latter especially being driven by technology. But investment in technology can be a high-stakes game when traditional sources of revenue are scarce and regulators are imposing new liquidity and capital requirements.

Perhaps it is time for banks and brokers to reevaluate how they source technology and, specifically, whether they should develop closer, longer-term partnerships with the vendor community.

Even for tier one banks, it is no longer possible to rely on in-house resources for all technology development and maintenance needs. Rather than outsourcing lower value-add requirements, banks may find a partnership strategy yields better results in the long run. A close working relationship with a third-party technology provider can reduce costs and time to market, improve product design and make easier implementation and subsequent upgrades. Such partnerships work best when the vendor has a long-term interest in supporting the bank’s strategy, rather than a pure profit motive.

The path of any relationship never runs smoothly or consistently. Like any economy there are peaks and troughs, but these can be overcome by a commitment to the end goal of both parties.

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