Electronic-trading volumes in the capital markets and Investment banking (CMIB) industry, having returned to precrisis levels, should continue to rise, This growth will be driven largely by pending regulations that treat electronic trading as essential for meeting tougher standards on transparency, execution, and reporting. Other factors will include the increasing need to service clients with cost-effective business models and the ongoing growth of high-frequency trading (HFT). Let’s take a closer look at each of these drivers.
Regulations. Regulators across the globe are intent on forcing trading in OTC products—valued annually at more than $600 trillion—onto transparent exchanges and centrally cleared platforms. This shift will certainly lead to an increase in electronic flow across all asset classes, most significantly for rates, credit, and foreign exchange. In our view, there is ample room for migration from voice to electronic. For example, in FX, voice accounted for just under half of daily trading volume in 2010. Overall, there is potential for growth in both single- and multidealer platforms. (See the exhibit below.)
However, the lack of clarity around some proposed regulations has created uncertainty. Most critical is the future of single-bank platforms relative to the expected rise in multibank-platform flow owing to multibanks’ natural positioning for central clearing and qualification as swap execution facilities (SEFs). The simple answer is that both sets of channels will benefit in terms of overall volume. However, dealers will likely find it increasingly difficult to remain profitable in what will be a tricky e-commerce-platform balancing act.
Central counterparty clearing (CCP) regulations will prove both a blessing and a curse to overall profitability. On the one hand, capital requirements will be reassigned to the CCP, providing a natural deleveraging force and significantly reducing costs associated with credit risk. However, any transfer of business from single-dealer to multidealer channels will lead to lower profit margins. Also, the developing dispute among regulators over CCP location requirements could result in considerable market fragmentation (if a co-op style oversight body for CCPs cannot be agreed upon), significantly reducing the expected volume increase.
Other issues regarding the impact of regulations on single-dealer platforms include the requirements for multiple quotes and credit value adjustments (CVAs). The most likely strategy for coping with multiple-quote requirements on single-dealer platforms is SEF aggregation. This option is no panacea, however, since displaying competitors’ prices to your own loyal clients is a bitter pill for any business to swallow. Moreover, the overall impact of any CVA requirements will certainly be less onerous on single-dealer platforms, owing to the longer pricing delays and variations expected across multidealer CCPs. Still, the rudimentary CVAs favored by regulators prove progressively more punitive to the client as one moves down the credit scale. Therefore, the ongoing development of price-friendly charging models will be critical to the overall profitability of the electronic-trading business.
Cost-Effective Business Models. For most banks, electronic-platform strategies and investment choices appear to be approaching a crossroads. They must decide whether to continue down the single-dealer-platform-driven scale model or move toward a full-service model offering a selective balance of products and platforms.
For flow providers, electronic trading will continue to play a major role, since scale needs high volumes and low costs. While electronic-trading volume drives negligible scale in revenue, it drives significant scale in costs. We estimate that scale players can gain a cost-per-trade advantage of up to 29 percent over the average player. (See the exhibit below.) By contrast, subscale players will be greatly disadvantaged. Investment in the electronic business will therefore be crucial, continuing to represent a relatively high percentage of both run-the-bank and change-the-bank budgets. The technical focus will be on proprietary platform development, automated risk management, stability, capacity, and speed. Less-critical functions can possibly be outsourced in order to lower costs even further.
Both relationship experts and smaller banks are likely to invest much less in their electronic-business strategy, potentially even decreasing their budgets. Since they cannot compete with large-scale players on complex in-house solutions, they will focus on connectivity and automated risk management, probably servicing clients with white-labeling solutions and selective multidealer channels.
HFT. Over the past decade, HFT has been one of the most significant drivers of CMIB volume. HFT currently accounts for more than half of U.S. equity-trade volume, up from 35 percent in 2005. This rise in volume, coupled with the market-making function of HFT, has deepened CMIB activity, tightened spreads, and increased liquidity. In our view, by 2015, HFT will account for about 70 percent of U.S. and European equity volumes and around 28 percent of Asian volume, providing a further illustration of the strong growth in overall e-commerce trading volume.