June 28, 2005

So, what IS the next big thing in the financial services technology space? What can every CIO and business line manager expect in the coming year? Looking into a crystal ball and making predictions is never easy, but these four analysts have had their ears to the ground and they reveal below what shape they believe the future landscape will take.

Year of Market Structure

By: Sang Lee, Cofounder & Managing Partner, Aite Group
http://www.aitegroup.com/index.php

Not too long ago, electronic trading was viewed as a novelty. Well, things certainly have changed. Driven by factors such as decimalization, spread compression, adoption of FIX, availability of affordable and reliable third-party trading platforms, declining average trade size, proliferation of ATSs, best execution obligations and pressure on tighter compliance, electronic trading has transformed rapidly from a curiosity into a competitive necessity.

Now, with the passing of Regulation National Market System (Reg NMS), the U.S. securities industry and its regulators explicitly have staked the future of the U.S. equities market on electronic trading. In 2006, we can expect a tremendous amount of structural changes within the U.S. equities market that fundamentally will change the way business is conducted.

Rise of the Machines

The machines indeed have risen and their reach will expand as markets continue to embrace the virtues associated with electronic trading. In the post-Reg NMS world, we can expect to see the following key industry trends and opportunities:

- Greater consolidation. As electronic trading becomes the industry standard, execution venues with less-than-stellar technology platforms will have to seek a partner with proven technology. Since the initial proposal of Reg NMS, the market has gone through two major consolidations, led by the NYSE and Nasdaq. Most regional exchanges will have no choice but to go electronic or look for a partner to ensure their survival.

- Proliferation of small pockets of liquidity. In contrast to the first trend, the post-Reg NMS world may create an attractive competitive environment for new ATSs to emerge. There are two reasons for this: 1) Broker-dealers with enough internal liquidity may opt to create ATSs to display quotes and match trades, and also to distribute market data to capture an additional revenue source; and 2) potential Reg NMS exemption (in particular to the fair access rule threshold of 5 percent) obtained by leading block trading networks, such as Liquidnet, may push large broker-dealers to create competitive private networks to execute large block orders.

- Increasing market data sources. Reg NMS will increase sources for market data substantially, as market centers and their members (i.e., broker-dealers) will be able to package and distribute their own market data. Multiplication of data providers will, of course, lead to compression on price of data. On the other hand, market centers may aggressively institute rebate policies to broker-dealers in order to dissuade them from disseminating their own market data packages.

- Data explosion. As the total number of publicly listed companies increases and overall trade volume of equities and equities-related derivative products rises substantially, the industry has witnessed a massive increase in market data flow. In the post-Reg NMS world where electronic trading will be expected to play an even bigger role, the rapid growth in market data flow is expected to continue unabated.

- Thirst for direct data feeds. As larger markets consolidate and smaller alternative execution venues emerge, the need for fast access to execution destinations will become even more important. As a result, the total number of firms requiring direct raw data feeds will increase.

- Need for compliance. A major part of Reg NMS is not only the implementation of new rules, but also enforcement of those rules. Compliance will become the most important component of Reg NMS as it rolls out in June 2006. All major market centers and their member firms will have to develop, deploy and maintain robust compliance platforms.

As with most regulations, there are always unintended, unforeseen consequences that will no doubt create new opportunities - and challenges - in the post-Reg NMS world. Regardless of the ultimate consequences, however, one thing that Reg NMS has done is to institutionalize electronic trading within the U.S. equities market structure and begin the process of entering an uncharted territory that will no doubt impact the current competitive landscape dramatically.

Sang Lee is a cofounder and the managing partner at Aite Group, a research and advisory firm focused on business, IT and regulatory issues and their impact on the financial services industry. Lee's expertise lies in the securities and investments vertical, including electronic trading technology and market structure.