The markets in almost all instruments/asset classes have been very fluid in recent years. The fluidity of the markets should not be confused with liquidity, which is something entirely different. In this case fluid describes the changes in market structure, the setting up of new markets and how easily these changes seem to take place.
Behind these fluid changes, the primary regulation driver is Title VII in the Dodd-Frank Act. If we look at the trading marketplaces as a whole, some of the recent trends are:
- Many more instruments/products such as fixed income, OTC derivatives, credit derivatives are moving to e-trading.
- Transparency, cost efficiency and speed are some themes that are in focus.
Let's take a look at the markets as they are today and what changes are to come in the near future.
Observations By MarketEquities: The trading volumes aren't going up to the pre-2008 levels, and in fact they are at a 13 year low (share volume million/per day in 2000 in NASDAQ was 1,757 and in 2012 it was 1,740. Daily value in billions/day traded is even lesser at 80 and 53 respectively). The regulated exchanges continue to lose market share and a significant part of the trading has moved to alternative venues, ECNs and dark pools. The number of new issues/listings isn't growing much compared to the previous decade. There have been a spurt of trading glitches with exchanges and brokerages in the recent past, the most recent being the three hour shutdown at NASDAQ. This has prodded regulators to seek additional controls with exchanges and brokers like ‘kill-switches' (to stop trading) and prevent mishaps. The SEC is also proposing a new regulation called Regulation Systems Compliance and Integrity (Reg SCI) to prevent such issues. This could add extra costs and additional burdens to implementation. The race to trade at low latencies in micro-seconds and nano-seconds has slowed somewhat. The latest idea is to use microwave technology when communicating with exchanges instead of high-speed fiber optic cables. There is also an initiative to reduce the settlement period to T(trade day)+1, which can further affect the markets.
Fixed Income/Bonds: Trading is moving to e-trading. Unlike equities, in fixed income markets the number of instruments (varying maturity dates) being traded is much more -- this indirectly affects liquidity, which is essential for a successful marketplace. This hasn't slowed the migration and there is more standardization in the fixed income instrument types. In another case of radical change Blackrock, a buy-side firm, is trying to build an exchange putting its inventory for initial liquidity. Moving to an electronic platform has impacted the role of sell-side firms and interdealer brokers. Voice trading has also reduced significantly.
OTC derivatives: This is going through a big change. Starting this October, the first two SEF (Swap Execution Facility)'s went live. There are several entities -- SEFs, clearing houses, credit-hubs, clearing members and trading firms. There are pre-trade credit checks at the SEF before a trade is allowed. The SEFs have approached this differently, some offering only the high-volume derivative instruments and others offering a broader range. The regulator CFTC hasn't given any guidance on what instruments should be available from SEFs (called MAT – made available to trade). The initial margin and daily variation margin expected by clearing houses will also be new for market participants in OTC derivatives. The SEF regime has created opportunities for several new trading entities and most existing trading venues intend to have an SEF. Seeing the high number of SEF venues consolidate in the future is very likely, as liquidity will get fragmented. Since the Oct 1st regulatory deadline, there are 18 registered SEFs and about $250 billion being traded on it. This is significant for a market, which is brand new and more opaque than just a few years ago.
FX markets: There has been little or no change to FX markets. The major currencies and top five banks still have a significant share of the market. The market is growing year to year. The trading spreads are so narrow that it has to be high-volume business to be profitable. Settlements through CLS bank have been efficient and safe. In fact there hasn't been any new regulation in this space recently. The FX market was barely affected in the 2008 financial crises. Currently, CLS supports only 6 or 7 of the major currencies, but the addition of more are planned. This implies that the trading volume of other currencies (like Yuan) have gone up.
Listed Derivatives: The trading commissions have dropped. The MF Global bankruptcy increased market share of some of the universal banks (like JPMC and Barclays). There has been speculation that many smaller brokers may not survive. The ICE merger makes NYSE-ICE offer a broader range of instruments in one venue giving participants the opportunity to channel all trading needs to one exchange and reducing costs. There is going to be competition with OTC instruments moving to trading facilities. For the first time since 2004 global trading volumes dropped in 2012.
While traditional markets evolve, it's good to see many new markets being formed. This will make trading in these sectors more accessible to retail investors. Efficient markets are becoming less of a theoretical concept and more a ground reality in all asset classes. As the evolution and commoditization of markets happen over time, one can expect more transparency, better price efficiency and less risky markets. As the new markets mature, there are more lessons to be learnt and more regulations expected. The drop or flattening in volumes in some markets will be made up by other instruments ensuring trading markets are always active and in news. Winston Churchill once said – “To improve is to change; to be perfect is to change often.”
About The Authors: Senthil Radhakrishnan has 16 years of experience in Investment Banking IT, including experience covering various instruments such as Equities, Listed Derivatives and Rates in Middle/Back-office and in Enterprise Risk. He is currently VP for Capital Market Solutions Practice at Virtusa Consulting Private Ltd.
Rakesh Jangili is Senior Consultant in Capital Markets Solutions Group at Virtusa Consulting Services. His experience in capital markets includes risk analytics, compliance in Dodd Frank, MiFID and portfolio optimization. He graduated from Indian Institute of Technology Delhi and holds MBA from Indian Institute of Management Lucknow, he is a candidate for CFA Level III.