Run, hide, partner, or buy: Fintech, automation, and disruption in wealth management and capital markets

Readers of a certain age may remember Frankfurt's aspirations of surpassing London as the world’s leading banking center. While that vision has not come to pass, Frankfurt remains a powerful hub for global finance. Home to Deutsche Bank, the European Central Bank and the Deutsche Börse exchange among others, Frankfurt’s importance is reinforced by its location at the very heart of Europe.

With this in mind, Research Director Brad Bailey and I are excited to bring the next Celent Wealth and Capital Markets roundtable to Frankfurt on Tuesday, May 10th. Of particular interest will be the role played by fintech firms in disrupting an ecosystem long dominated by large financial institutions. Brad and I will share ideas and examples from recent research, while senior executives with banks and asset managers and other large institutions from Germany, Switzerland, the UK and Italy will offer their perspectives on the disruption and the technology strategies they have adopted in response.

To maximize the participatory nature of this event, Celent is capping attendance at 20 individuals. At present, we have a few seats still open and would love to hear from other clients interested in joining us.

Proof of artificial intelligence exponentiality

I have been studying Artificial Intelligence (AI) for Capital Markets for ten months now and I am shocked everyday by the speed of evolution of this technology. When I started researching this last year I was looking for the Holy Grail trading tools and could not find them, hence I settled for other parts of the trade lifecycle where AI solutions already existed.

Yesterday, as I was preparing for a speech on AI at a conference, one of my colleagues in Tokyo forwarded me an Asian newswire mentioning that Nomura securities, after two years of research, would be launching an AI enabled HFT equity tool for its brokerage institutional clients in May –  here it is: the Holy Grail exists, and not only at Nomura. Other brokers have been shyly speaking about their customizable smart brokerage, e.g. how to use technology so that tier5 clients feel they are being served like a tier1. Some IBs are working on that, they just don’t publicly talk about it.

Talking to Eurekahedge last week I realized that they are tracking 15 funds that use AI in their strategy, I would argue there are even more than that because none of those were based in Japan (or Korea where apparently Fintech is exploding as we speak).

All this to reiterate that AI is an exponential technology, ten months ago there were no HFT trading solutions using AI, and we thought they were a few years away but no, here they are NOW. And the same with sentiment analysis, ten months ago they were just a marketing tool, now they are working on millions of documents every day at GSAM. Did I forget to mention smart TCA that’s coming to an EMS near you soon?

Stay tuned for more in my upcoming buy side AI tools report.

NYSE glitch hurts, but no one felt it

Shooting yourself in the foot has to be painful. Thankfully, I have not done the fundamental research on this; Let’s just assume that it really hurts! The important thing about shooting yourself in the foot is that the pain is your own. We do not have to look very far to see some very notable examples of self-inflicted pain at companies with their technology. Software and hardware are glitchy and things go wrong. Nothing is better, though, when things go really wrong and no one else is hurt. Other technology failures in the financial markets have hurt many other companies, as well as many individuals. In some of these cases, pain rippled out from some point in a firm’s technology infrastructure and gained strength, as others in the networks were run over by the particular software or hardware failure. That is not really the case with the 3+ hour NYSE halt on Wednesday (July 9, 2015). The NYSE went down, and I am not saying it was not a big deal for NYSE. That’s a lot of nanoseconds to be off-line. However, it was just the loss of one small node in the entire U.S. equity trading network. There was concern at first that it might have been part of a cyber-attack (which is really scary, and who knows, what will be found out as forensic analysis continues but we will leave that to another discussion). A single point of failure in a robust network of dozens of equity trading venues, did very little to change trading. And it was a busy day, with Grexit and Chinapocalyspe in full swing. Plus, the Fed minutes were released while this was all happening! I was busy with a client when Bloomberg News reached out to ask me what was going on at the NYSE, minutes after the halt began. My mind began reeling – was it a cyber-attack? I quickly started thinking about the many experiences I have had with these types of situations: flash crash, failed IPOs, destruction of a firm. I reached out to my network to see what was happening. Yes, NYSE was down, but the other exchanges: (NASDAQ, BATS) were up; the network of darkpools, broker crossing engines, buyside crossing engines were trading. Even NYSE ARCA was up. This is what to I expressed to Pimm Foxx on Bloomberg TV. Something happened, but it was not a disaster, and people could still trade stocks. The robust and competitive web of interconnected venues can be a model for the market structure in other asset classes. The gun went off and wounded one small part of the system, but the fragmented network held.

IPOs for leading Indian exchanges?

The recent discussion of the possible pressure on the Indian government to list the leading Indian bourses can be considered in many ways including as a clash of civilizational management cultures. With a history of foreign rule, Asian countries that became independent relatively recently are generally suspicious of foreign interference and see control of the large domestic institutions such as exchanges (often termed national jewels) as vital. This is an important reason for the monopolistic or duopolistic vertical exchange market structure in these countries. It makes it easier for the government and the capital market regulator to control the activity of the exchange. Ironically, in the west, after the financial crisis, the need for control and stronger regulation has become an important focus of the respective governments and leading financial regulators, for obvious reasons. Listing the Indian exchanges would make their performance not only transparent, usually a desirable trait, but also more amenable to market forces and pressures from both the domestic and the international investment community, which can sometimes run counter to the respective national interests of the exchanges in which the countries are based. The Indian government and the capital market regulator SEBI would have to take a call on whether they see listings as the best way of making these exchanges transparent. The firms that have invested in the exchanges by taking minority stakes should be in a position to sell these stakes at any point in time, and hence an IPO is not the only way for them to realize their gains on past investments. If the exchanges are indeed listed, it has to be in order to make them more efficient, transparent and globally competitive. Of the two exchanges, probably the BSE which has tried to list in the past would be the most favorable to the process since this might put it in a better competitive position vis-a-vis the leading competitor in the NSE. The NSE would probably not want to disturb the status quo, or do it in a very controlled fashion if at all. But these are internal market dynamics the regulator would not bother much about, and it would mainly focus on issues such as systemic risk management in a post-listing scenario. The final decision, while not a ‘make or break’ one some vested interests are making it to be, would still be of interest to the casual observer of India’s journey as an important emerging global capital market.

OTC derivatives regulations in US and Europe

There has been an ongoing dialogue for some time now between the European capital markets regulator European Securities and Markets Authority (ESMA) and the Commodity Futures Trading Commission (CFTC) of the US regarding the requirements for clearing of OTC derivatives. In the opinion of market participants, the lack of agreement, over issues such as margin requirements and the period for which a transaction can be considered to be at risk, is highly detrimental to the efficient functioning of the global capital markets. The evidence has also shown that increasingly there are two separate pools of liquidity operating in the US and European markets respectively, a sub-optimal and undesirable state of affairs. However, from the point of view of the trading participants, the important thing to keep in mind for the future is that the two regulators are in ongoing discussions and the contentious issues are specific and not pervasive. There is also a great deal of respect and understanding that has been displayed by both regulators for the other’s point of view, all of which bodes well for overcoming their differences. An agreement would allow for greater liquidity and higher levels of market efficiency, and should also provide a much needed boost to global derivatives trading.

Another boost for the utility model

SunGard announced yesterday that it will launch a new industry utility for post-trade futures and cleared OTC derivatives operations and technology, with Barclays helping pilot the project by handing over some of its post-trade processing and regulatory reporting obligations to SunGard. This would not come as a surprise to readers of Celent’s coverage of technology and process evolution by capital market firms. In a number of recent reports (and blogs) we have highlighted how the evolution of the regulatory environment is forcing firms to look for new models for running operation and technology. The constantly evolving regulations have created additional obligations for financial institutions (FI), particularly in the areas of risk management, reporting and regulatory compliance. While all FIs need to adhere to these changes, the changes add very little in terms of competitive advantage to the FIs. At the same time keeping track of and responding to these changes need significant investment of resources on an on-going basis leaving them with little time or resource to focus on core activities. Therefore they are not only looking to outsource these non-differentiating activities to third part providers, but also looking to gain further cost advantages through shared service or utility model of engagement. Under such arrangement one service provider caters to the need of multiple players, at times even the full industry, which allows all involved parties to benefit from significant economies of scale as well as through reduction in duplication of efforts. In some areas (such as KYC utilities) we have seen banks coming together to form groups or consortium to develop industry wide utilities. In other areas we have seen individual bank-vendor partnership developing a solution with plans of making it available to the wider industry in the future. The Sungard post-trade utility therefore re-emphasizes our point of the industry’s desire for radical cost reduction by exploring new engagement models. It needs to be pointed out though that industry wide adoption of the utility model will take time. Many firms are still waiting to see the success/failures/pain points of those that are exploring with these new models. Some FIs at the moment are trying the utility model at an intra-firm level, i.e., across different divisions of a bank. Success of these efforts in the early days will expedite adjacent cost reduction opportunities as firms continue to explore emerging operating models beyond conventional captive operations.

Issues with Multiple Utility Services in KYC

In a recent blog post we discussed about the emergence of utility model in the KYC, on-boarding space in the capital market. When one thinks of a utility model in KYC, one envisions a situation where a single utility will cater to the needs of the whole industry. That would be the optimal arrangement for a utility service, not just in KYC, but for any functions. 1 However, currently the situation looks a little different from what one would ideally want. We already have 3-4 utilities – from SWIFT, Thomson Reuters, Markit | Genpact, and DTCC and cofounding banks – catering to same, or overlapping areas within the KYC space. While SWIFT has positioned itself for the correspondent banking segment, the other three utilities are very similar in terms of their coverage. 2 The multiple utilities therefore give rise to some redundancies and duplications that ironically they intend to eliminate, which makes the situation sub optimal from an overall industry perspective. This raises a few questions regarding the future of the KYC utilities.
  • Why have multiple utilities for the same function?
  • Or Can FIs satisfy their needs by subscribing to a single utility, or do they need to subscribe to many or all of them? We have seen several banks have taken active role in developing more than one utility, so this is a possibility. But is it desirable for every fo every bank to have to do so?
  • Another question that is still waiting for a clear answer is in terms of geographic or jurisdictional coverage of these utilities. Will these utilities be mainly global in nature containing information on, and serving institutions in the developed global markets? Or will they also include coverage of local firms? Would they be able to sufficiently cater to regulatory and business requirement of each local market, or will their appeal be mostly restricted to the main developed markets?
These KYC utilities are still fairly new, some have yet to be launched, and the ones launched are still at an early stage of user adoption. So we will have to wait and see how the future unfolds for them.

The State of the Indian Capital Market

There are fundamental problems in the Indian capital market structure, such as lack of liquidity and limited depth and breadth. Many listed securities on stock exchanges are not traded; among the traded securities, not many are traded actively. The market is highly concentrated; a few companies dominate trading at the exchanges. This clearly narrows the breadth of the market, giving rise to liquidity problems for many stocks. Geographic breadth is another problem for Indian markets. Around 80% to 90% of total cash trading and 70% to 80% of mutual fund ownership come from the top 10 cities, with the top two cities (Mumbai and Delhi) accounting for about 60% in each segment.. These shortcomings can be addressed by technology development, better regulations, and focus on financial inclusion. India’s capital market regulator, Securities and Exchange Board of India (SEBI), has been addressing many of these issues. Although the equity market in India is relatively well developed, the debt market is lagging by some distance. The debt market is dominated by government securities. The corporate bond market is very small for a number of reasons, including lack of market infrastructure and adequate regulatory framework, low liquidity, lack of investor interest, etc. Efforts are being made to develop the corporate bond market. Some of the measures include increasing the limit for foreign participation, reducing issuance and transaction costs for corporate bonds, applying similar mark to market accounting requirements for loan and corporate bonds to discourage banks from relying heavily on loans, and setting up a basic framework of credit default swaps on corporate bonds in the country. Some positive results have been observed in recent years, but debt market development will require long-term efforts and commitment. By contrast, India has a healthy exchange-traded derivatives market. India started off with trading in derivatives in the early 2000s, initially allowing trading in index futures (2000) and index options (2001). Options and futures on stocks were allowed in 2001. Since then the product universe has expanded, as has the investor base, resulting in higher volumes and a robust trading platform with sound risk management practices. Index futures and options and stocks futures dominate derivative contracts traded at Indian exchanges. The investor segment is broadly classified into retail and institutional segments. The retail segment brings in the volume, but its trades are essentially low value. A key concern has been this segment’s drop in participation in the secondary market and also in IPOs. This decline began with the crisis in 2008, but the lackluster performance of most IPOs has contributed to what has become an alarming drop. Foreign institutional investors (FIIs) have been a dominant contributor to Indian markets. Since economic reforms started in 1991, India has focused on attracting foreign investment flows by relaxing eligibility conditions for FIIs, relaxing investment limits, and expanding investment instruments. The intermediaries in the market include the exchanges and brokerages. India has 22 stock exchanges registered with SEBI, with over 8,000 registered brokers and over 60,000 registered subbrokers. However, most of the trading takes place at the two major pan-Indian exchanges, National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). NSE is the largest exchange in the country, with around 70% of the equity volumes, while BSE is the second largest. A lot of revamp is happening within exchanges as they turn more competitive to gain market share. Brokers, both domestic and international, are competing in a highly fragmented market. The next wave of growth will probably arise out of technological capabilities, and hence brokerages are trying to outdo each other by providing advanced trading tools like Direct Market Access (DMA) support and algorithmic trading solutions. India has been an early adopter of the various technological changes occurring in the capital markets. With electronic trading picking up along with the adoption of the internet, booming retail equity business evolved in the last 10 years. Surprisingly, due to the market boom and IPO bonanza, retail adoption of technology initially outgrew technology adoption on the institutional side, where voice brokers still played a large part. As foreign participation in the Indian markets picked up, it brought in a rigor and technological requirement essential for international competition leading to adoption of the latest technologies by domestic market participants. A key reason for the success of the Indian capital markets has been the efficiency of SEBI, the capital market regulator. Four regulators control the participants in the securities market. There have been turf wars, and the future might see a super-regulator. India has a good regulatory environment regulating the capital markets, which shielded the economy, to some extent, from larger negative impacts of the global financial crisis and helped it regain its mark quickly afterwards. The regulator has been cautious in expanding the market, and transparency and investor protection have always been high on its agenda. This has sometimes created conflicts with industries as well as among regulators, but it has taken the markets along the right path of development.

Getco comes into light

We all have seen Getco take a stake in the US broker Knight earlier this Summer, when a trading algorithm put its balance sheet $440m in the red. As part of the cash and share deal announced this week, however, Getco would pay around $540m for the remaining part of the company, and become a public entity. This to us is final straw that puts Getco into the light from the shadow of its non-banking activities. The first was when it started going after client business, which apparently has started taking place since the beginning of this year. What is behind this strategy? Historically Getco has always been trading on its own account with proprietary algorithms, more high than low frequency usually, in any asset class where active listed markets enable them to do so. But liquidity has dried up in many asset classes with the crisis, alongside increased volatility and less predictability of markets, hence their historical revenue streams have become more uncertain. On the other hand, investors are seeking algorithms to help them execute orders more automatically and electronically across asset classes, at a lower cost. Their brokers are not able to provide them with the principal capital that they were used to getting because the Basel III regulations make it now too expensive for their balance sheet, pushing some to develop a different niche around algorithms. Which algorithms are the buy-side going to choose? The ones that are built by a historical prop trader that has built its track-record on algos? Or the ones of their bank? The answer is not that obvious as some banks will keep providing some capital to their good clients through sophisticated internalization matching systems, and as they also provide their clients with access to primary issues.  We will certainly keep watching this space.

Recent Developments in Indian Capital Market

India’s Multi Commodity Exchange (MCX) is going for IPO starting tomorrow (22nd February). This development touches on a range of issues pertaining to the Indian capital market and regulations that Celent has been discussing for some time. First, pricing of IPOs has been a cause for concern for many market players and also the capital market regulator, Securities and Exchange Board of India (SEBI). In the past SEBI had expressed its displeasure regarding overpricing of IPOs in a number of cases and asked the underwriting banks to be more prudent regarding IPO pricing. To protect investor interest, SEBI last year proposed that underwriting banks must disclose to investors the performance and track records of their earlier issues in their prospectus and on their websites. Consequently, the merchant banks (Edelweiss, City and Morgan Stanley) involved in the MCX IPO have all publicly disclosed their track record. The past details (IPO size, listing price, comparison to movement in benchmark indices for different periods for individual IPOs) are made available in the IPO document as well as on the websites of the merchant banks. Second, this is the first IPO of the year in India and is eagerly watched, after a lackluster 2011 when companies raised less than 10bn US$ through share sales (compared to 24bn US$ in 2010). This is also interesting as MCX would the first Indian exchange to be listed. This may pave way for the other exchanges, though that is unlikely to happen in the near future. Third is the case of transaction taxes. It is learnt that the finance ministry is considering imposing a commodity transaction tax (of 0.017%) in its budget proposal for 2012-13, initially on non agricultural commodity futures. The government had proposed commodities transaction tax before, in 2009, but this was not implemented because of objections raised from some quarters. India already charges transaction tax on equity derivatives. There is also speculation that this move will be coupled with a cut in securities transaction tax – the motivation behind this being boosting the cash segment and extending the scope of taxation to other asset classes. Familiar arguments have been expressed from both supporters and opponents of this new transaction tax. Supporters argue this will raise revenues for the government and also check speculation in the commodity markets. Many have argued that speculation in commodities had significantly contributed to the rising food prices in the recent past and needs to be curtailed. Also it is argued that cut in STT will attract more investment to the cash market. Opponents argue that this move will increase cost of transaction, reduce volumes at Indian commodity exchanges, result in migration of trades to international exchanges (commodities being global assets), reduce liquidity in Indian markets, impair price discovery and increase volatility. It has also been mentioned that some vested interests may be behind such move; the argument being bigger exchanges strong in cash segment are trying to grow their business at the cost of commodity trading business. This reflects the competitive landscape of Indian exchanges that Celent has discussed in the past.