The world of financial markets technology is changing. Regulation, technology and institutional trading preferences are shaking the industry by its roots. These changes are forcing the industry not only to upgrade technologies but also to reevaluate its mission.
The changes, many seemingly innocuous, are cascading throughout the community. Investors, tired of single-digit returns, are searching for higher yields. Regulators, focusing on the problems of the '90s boom, are forcing investment managers to be more responsive. Money managers, pressured by investors and regulators, are looking to be more broker-independent and reduce costs. And brokers, taking their queues from their clients, are providing direct-access and algorithmic-trading technology to both their institutional and hedge fund clients.
All of these changes not only put pressure on the buy side and sell side, but also on exchanges, execution venues, the settlement infrastructure, market data providers and virtually all of the financial markets ecosystem. This event chain begins with the way money is managed. Less driven by the hot stock, money managers now are style driven. Governed by style bands, portfolios are typed and classified (e.g., growth, value, technology, biotech, etc.). This enables investors to classify and rate portfolios by style, allowing the development of indices and benchmarks that enable investors to gauge a manager's style and performance.
While the development of indices and style templates is logical, it forces the portfolio manager to make investments based upon style or index construction (since that is how they are measured), not by overall performance. Hence, managers may need to eliminate winning investments that fall outside the style or index parameters.
As indices increase, funds become aligned to beating the index, forcing funds to look at their portfolio in two portions: beta and alpha. Beta is the benchmark or index return, and alpha is excess return above benchmark. As portfolio managers begin to manage money this way, they come to the realization that matching the index is easy. They just buy the index. It is the above-benchmark returns, or alpha portion, that is difficult to achieve.
This turns money managers into investment allocators. They need to allocate a segment of their portfolio to achieve beta and a portion of the portfolio to obtain alpha. This is where hedge funds come in.
Hedge funds are all about above-benchmark returns. These funds have fewer restrictions and can use traditionally advanced investment techniques (e.g., quantitative strategies, short selling, novel asset classes, overseas markets, etc.) to achieve these extraordinary returns.
However, what does that make the portfolio manager who buys an index for beta and gives the alpha to a hedge fund? Does this eliminate the need for actively managed portfolios? Should all portfolio managers just throw in the towel and buy exchange-traded funds (ETFs)? Hopefully not, but money managers certainly are facing these pressures.
This challenge forces traditional investment managers to move toward passively managed vehicles, or work with very restrictive investment guidelines pitting them directly against ETFs. This changes the manager's focus to cost. The drive to reduce cost pushes buy-side traders to use crossing networks, direct-market-access tools and trading algorithms to drive down execution cost. Currently, approximately 31 percent of traditional investment managers' order flow and 46 percent of hedge fund order flow is routed via no- or low-touch trading channels. Brokers typically charge less than one-and-a-half cents a share on these orders, compared to three to five cents a share for orders routed to the sales trader via the phone or FIX.
The reduced cost structure forces brokers to look at their business under a different light. Brokers traditionally have looked at their business in six general categories: research, origination, distribution, trading, processing and proprietary trading. However, as more order flow is moving electronically, these six categories are changing shape.
Research, post-scandal, has been downsized. Many firms have reduced coverage to the point where, in reaction, Nasdaq and Reuters announced a few weeks ago a new venture to begin covering companies no longer covered by a major broker. Origination still is a major channel and increasing in importance. While the IPO market is not back to pre-bust levels, investment banking activity, as well as fixed income, derivative and structured product origination, is a high-margin, low-capital, very profitable business.
The big shake-up will come in the distribution, trading and processing. Electronic trading is consolidating these functions. The traditional sales trader is being replaced with algorithmic and advanced execution consultants. Models are replacing traders, and the operations and technology become the factory, which is an extremely capital-intensive, high-scale, low-margin business. To fill the factory, firms begin to price at marginal cost, propagating a price war that only the largest and most-efficient players can survive.
These large firms also are looking at monetizing their order flow. To do this, firms convert risk principal to fee-based revenue. They do that by converting market making to agency, spinning off hedge funds and converting their trading-revenue flow to commission-driven fees. Also, we are seeing the largest firms' prime brokerage profits equal 30 percent of firmwide profit as we see trading profits fall.
The push toward monetizing flow also forces firms to spin off their proprietary trading desks and convert them into hedge funds, as trading risk is converted into low-risk commissions, and good traders have a more difficult time being compensated through the low-fee/high-volume-oriented factory paradigm. While it may have been only a year from our last SIA Technology Management Conference, the industry is in a very different place than it was a year ago. While direct market access and algorithms were just hitting the stage a year ago, they have hit their stride today.
But, while conclusions look secure, it is just the beginning. There still are many questions to be answered. What does the new market structure have in store? How will under-performing hedge funds increase yield? What will be the impact of a new SEC chairman? Will Reg NMS and Sarbanes-Oxley remain on the books? How will brokers consolidate operations across asset classes to take advantage of new opportunities? And how will the push for alpha change the way money is managed?
While the future may look clear, it never is. As I look back on the industry, it never looks the same twice. While time moving forward always seems to stand still, the business mandate, technology, ingenuity and creativity always change, making this the most exciting, most dynamic and certainly most interesting of industries. Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio