The markets are in a state of shock. The VIX is hovering between 35 and 50, with no sign of subsiding. Europe is negotiating a Greek bailout and trying to stave off catastrophe. Investors are bailing out of U.S. equities in droves, having pulled more than $400 billion from U.S. equity mutual funds since January 2007. And ETFs -- which were lauded (by me and others) as the best thing since sliced bread -- now are being used to drive equity correlations toward 1.0, where both good and bad stocks are moving in tandem as traders, who seem to have little or no patience for single stocks, seek either broad exposure or to be "out" altogether.
In addition, both the SEC and the new European Securities and Markets Authority (ESMA) are contemplating how to rewrite market regulation, while the CFTC, SEC and a panoply of European regulators are restructuring the OTC derivatives business. Further, the Basel III group of banking regulators is threatening to reduce bank leverage and increase capital requirements from 2 percent to as much as 10 percent.
Fun, huh? No wonder the VIX "fear index" is elevated, investors are nervous and banks are on edge. And next year likely will bring more of the same. 2012 will be a year of re-regulation, political uncertainty, and a time for financial firms to rethink their businesses and business models.
In the next six months there will be more financial regulation delivered to this market than at any time since the Great Depression. Dodd-Frank legislation will be finalized, OTC derivatives reform will be issued, the Volcker Rule will be nailed down, Basel III will be announced, the MiFID Review and EMIR will be completed, and the SEC will finalize equity market structure rules.
All of these rules will have one effect: They will make it more difficult and more expensive for all financial markets participants. Shifting the trading of OTC derivatives to swap execution facilities (SEFs) and central clearing, while increasing the turnover of fairly illiquid products, will reduce the customizability of these products as well as bank profitability. Higher capital ratios mean less leverage, and a restructured equity business means greater investment chasing fewer commissions.
Just like reducing credit card merchant fees for debit cards resulted in increased consumer banking fees, the additional regulatory costs and burdens will make it more expensive to trade, invest and manage risk. Trading fees will increase, risk that was typically warehoused by banks will be shifted to investors and corporations, and the large banks will be turned into processors instead of financial intermediaries. Expect banks to provide plenty of technology and pipes, but less capital and market expertise.
And while firms spend mightily on technology, IT actually is a nominal expense compared to experienced people. So over the next year, unless vast new business opportunities are discovered, expect firms to trade people for technology, proprietary technology for vendor-based solutions, and vendor solutions for cloud-based infrastructures.
Sharp data governance also will be key to managing in this age of increased transactional automation and regulatory scrutiny. First, clean, fast and accurate market data is needed to drive automated trading technologies and strategies, which are driving not only high-speed market making but also cross-asset-class and global electronic execution tools. Second, the amount of technology and reference and valuation data that will be needed for risk management must not be underestimated. Third, extensive integration is needed to obtain a more real-time and robust picture of where the bank is at any time, given both the real threat of regulatory-induced resolution as well as the insight to stop multibillion-dollar threats from rogue traders. But as profits are constrained, expect a greater amount of infrastructure to be outsourced and managed on an expense, rather than a capital, basis.
Unfortunately, short-term uncertainty will be the only certainty. Until the U.S. Congress becomes functional, budgets are brought under control, European stability becomes more definitive and the consumer becomes more job-certain, economies will be growth-challenged and investors sideline-bound. And traders with cast iron stomachs will rule the Street.