Study Foresees Four Trends Impacting on Capital Markets

The coming year will be one of adapting to increasing market complexity and weathering a cycle of creative destruction to achieve trading efficiency and lower risk according to Object Trading, an independent provider of global direct market access (DMA).

The firm said that insights collected from trading venues and its global buy-side and sell-side client community in reaction to regulatory and competitive forces, suggest four factors will shape the global capital markets landscape in 2014.

  • The Effects of Exchange and Product Hyperfragmentation: Global regulators tend to foster exchange competition in order to achieve market benefits of increased transparency and innovation, as well as reduced risk and costs. However, exchanges tend to voice more nuanced opinions about the competition these reforms create. Some embrace natural market fragmentation, and innovate by further fragmenting their own offerings with multiple products. In contrast, other exchanges are integrating services across asset classes and resisting additional competition on the basis that fragmented liquidity will lead to a higher cost burden for the buy-side. The debate will become increasingly polarised with particular enthusiasm once swap execution facility (SEF) trading becomes mandatory for centrally cleared swaps made available to trade (MAT) beginning early this year.
    “Competitive markets are good for traders and investors alike,” said Gerry Turner, executive Director at Object Trading. “Market hyperfragmentation, however, potentially increases underlying costs required to access the markets in general. Market consolidation is inevitable in 2014, particularly in the US swap execution facility (SEF) market system, but cost containment can only go so far. In Europe, preparations for the rise of organised trading facilities (OTFs) are not far behind the SEF market. And as the exchange traded futures market continues to create products to compete with the burgeoning swaps market, the need to participate in both markets will increase. So hyperfragmentation is here to stay, and firms will need to simplify their approach to connectivity to keep pace.”
  • Capital Efficiency remains the industry’s best worst-kept secret: Although competition in clearing futures may have once centered on cost efficiency, some clearers believe this is changing due to the unintended consequences on capital efficiency stemming from new over the counter (OTC) market regulations. If buy-side firms are unable to allocate their capital effectively and have to fragment their margin in efforts to comply with regulations, the resulting increased transaction costs and necessary reduction in overall trading volumes may inadvertently stifle liquidity. Sell-side firms that were once concerned with reducing overhead costs in order to attract customers are slowly realising that helping clients allocate capital more efficiently will be more valuable.
    “The unintended consequences of regulations are forcing firms to examine their use of capital,” said Steve Woodyatt, Object Trading’s chief executive officer (CEO). “With significant new collateral requirements around OTC swaps and other asset classes, the cost of doing business is rising dramatically while profit margins are increasingly squeezed. The industry continues to develop mechanisms such as cross-margining to stretch scarce collateral resources further, and generally streamline trading costs. Brokers are working to determine how to manage the risks inherent in new market innovations while simultaneously struggling with a shifting market landscape. The impetus will fall to the sell-side to quickly shed the operational complexities of market access and risk in order to turn their resources to innovations in capital-efficient trading operations for their customers.”
  • Anti-Globalisation in the Futures Commission Merchant Ranks: Futures commission merchants (FCMs) increasingly believe regulations are making survival difficult. Regulations, along with the increased costs from the rise of SEFs and OTFs, may eventually make it financially impossible for smaller FCMs to survive. This phenomenon will continue to concentrate risk globally across a shrinking number of the largest clearing firms in 2014.
    “The cost of participation in the new market environment will make it increasingly difficult for all FCMs to sustain profitability,” added Woodyatt. “Clearly this is not what the regulators intended. In order to maintain a healthy, vibrant marketplace, the FCM community will need to innovate or suffer contraction. Whether global clearers are dominating volumes or regional clearers are specialising their services, in all cases these firms need scalable trading solutions as markets become more complex.”
  • Going Back to Technology Fundamentals: The technology-led race to zero has been replaced by a need to manage risk and cost. In the current marketplace, firms are focused on technology-assisted rather than technology-led innovation. Market participants are going back to the fundamentals, favouring investment in reliable products over cutting-edge or risky ones. Overall, the demand for technology in the market will be focused on stability, integration, simplification and business-supporting functionality to manage today’s highly competitive and hyperfragmented trading climate.
    “With so many moving parts and new cost centers in the global futures and OTC markets, firms will look to identify clear opportunities to cut costs without diminishing business performance and client service levels,” added Ian McLeod, chief technology officer at Object Trading. “We’ve seen a clear shift in firms looking to simplify all aspects of their business, thus we believe trading infrastructure rationalisation will be a key focus area in 2014. By decoupling order generation systems from market access infrastructure, firms will be able to dismantle data centres full of infrastructure silos. Once this is achieved, firms can go about the process of replacing cumbersome legacy technology with a wealth of customer-centric, front-end system options, powered by a single enterprise market access platform for all trading desks. The standardisation model will enable firms to be focused on innovation in their business, instead of struggling to manage non-scalable legacy trading infrastructure.”

 

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