Far from signalling the end of single-dealer platforms, the impending raft of new regulation in the US and Europe will create a new business environment in which the direct online channel is more important than ever for both banks and their clients, says Paul Caplin.
Soon after the publication of the Dodd Frank act in the US, some early commentators suggested that the forthcoming prohibition of bilateral trading of liquid swaps signalled the death knell of single-dealer platforms (SDPs), the banks’ proprietary online trading offerings.
But, as with Mark Twain, reports of their death were greatly exaggerated. Far from backing away from SDPs, virtually all tier one banks – and many smaller firms – have responded to the imminent shift in market structure by increasing their spending on SDPs.
According to FX Week, the head of foreign exchange at a top-tier bank recently described this as the “secret weapons program now under development at most banks”.
The successful SDP of tomorrow will provide essential customer services in a fragmented multilateral marketplace. It will deliver swap execution facility (SEF) and organized trading facility (OTF) aggregation and smart order routing, integrate this smoothly with OTC trading of illiquid/off-the-run instruments, and link it to the clearing and collateral management services through banks will actually make most of their money as parts of their business switch from a principal to an agency based model.
Banks that understand and embrace this will establish a secure and profitable position at the centre of their clients’ trading workflow.
At the time of writing, around 40 firms are planning to register as SEFs in the US, and/ or OTFs in the EU. Some of these will fail, of course, but there seems to be a general expectation that at least 3-4 will survive and compete in each asset class in each region, and this number may grow over time with many expected fragmented liquidity as a result.
We have been here before: this combination of a transition to electronic trading plus market regulation is what caused the equities marketplace to expand from a handful of national stock exchanges in the late 1990s to a huge range of ECNs today.
The US equities market alone now has over 50 execution venues, and 37% of all US equity trading is now executed away from exchanges. In response to this, the buy side sends nearly 40% of its order flow through algorithms designed to aggregate the liquidity and manage it efficiently.
The same kind of outcome is widely expected in the OTC market. As liquidity becomes fragmented, users will need to aggregate and manage it across multiple venues to achieve best execution. Banks that want to retain their customers will need to provide this service.
Investment banks are in the business of providing clients with access to the capital markets. How they profit from doing this varies widely from market to market. In the OTC markets, they have traditionally made money on the bid/ask spread as dealers, and also – particularly in the case of “flow monsters” – from proprietary trading and internalisation of client flows, backed by visibility of client order flow.
This is about to change. Banks will no longer be able to act as dealers in the case of many instruments, and this and other provisions such as the Volcker rule will limit their scope for proprietary trading.
The commercial opportunities in these markets over the next few years will instead be mainly about providing added-value services such as SEF/OTF aggregation, clearing, financing and collateral management. However, bank SEF aggregation without an SDP makes very little sense.
SDPs are currently in a pretty healthy state. Figures are not available for all markets, but in the FX space Bank of England figures show that they attract around half of all dealer-client electronic flow.
The rate of growth on single-bank trading portals is expected to outstrip multi-dealer portals by almost seven to one.
However, with a few honorable exceptions, the majority of SDPs available today remain exclusively focused on trade execution, with at best modest links to pre-trade data and post-trade processing. And the pace of adoption in the fixed income markets has not matched that in FX. Both these things are going to change.
The successful SDP of tomorrow will offer SEF/OTF aggregation, integrate this smoothly with OTC trading of illiquid/off-the-run instruments, and provide the clearing and collateral management services through which banks will actually make most of their money.
Good SDPs will provide smart order routing (SOR) to SEFs and OTFs. Over time, they will add increasingly sophisticated algorithmic functionality for execution management.
Above all, they will harness all that forward- thinking banks have learned about user experience (UX) design in recent years to fully support client workflow and meet users’ needs throughout the trading lifecycle.
Paul Caplin is chief executive of Caplin Systems. To download the white paper Single-Dealer Platforms in a cleared world, visit: http://www.caplin.com/whitepaper_request_4.php