A vital cog in the world’s financial industry – financial exchanges have always been an interesting segment within the broader capital markets ecosystem. They primarily serve as a vehicle for household savings with nearly 50% of households directly or indirectly holding investments in the stock market as well as governments & corporations relying on them to raise capital. This two part series of posts explores the structure of the financial exchanges, the competitive pressures they’re under and how Big Data can help create new business models thus ultimately driving profitability in a tremendously competitive marketplace.
The Capital Markets value chain encompasses firms on the buy side (e.g wealth managers), the sell side (e.g broker dealers) & firms that provide custodial services as well as technology providers who provide platforms for post trade analytics support. The crucial link to all of these is the execution venues themselves as well as the clearing houses.With increased globalization driving the capital markets and an increasing number of issuers, one finds an ever increasing amount of complexity across a range of financial instruments assets (stocks, bonds, derivatives, commodities etc.).
The primary exchanges for equity (stock) trading have been majors like NYSE,NASDAQ and LSE (the London Stock Exchange). Futures and Options are dominated by CME and EUREX. However, deregulation has also resulted in increased fragmentation i.e the above traditional leaders now have competition from non traditional exchange operators like Electronic Communication Networks, Crossing Networks (e.g. investment banks developing their own internal crossing systems to match buyers & sellers etc) & Dark Liquidity Pools etc.
Various other moves like decimalization of stock prices have led to smaller commissions, after hours trading leading to increased adoption of cutting edge technology. Buy side players now have multi-varied access to venues that can give them the best price for their trade. A case in point are Dark pools which are forums for trading securities in a private manner – typically not available to the retail investor & thus named for their lack of transparency. Dark pools facilitate block trading by highly sophisticated investors who do not wish to indicate their trade strategy to the wider market – by placing their large orders in an open exchange (which then needs to report the trade to the regulators like FINRA for instance).
Dark pools directly execute orders without routing them through traditional venues and some of them even use their own clearing operations. These Dark Pools could be owned by multiple institutions – investment banks (e.g Credit Suisse’s CrossFinder, Goldman’s Sigma X etc), Exchange or ECN owned (e.g Instinet) or owned by specific trading firms themselves.
The impact of these new trading avenues has been disruptive to the traditional exchanges due to the below reasons –
- Increased competition leading to loss of liquidity and trading volumes
- The use of electronic trading now means that systems match buy and sell orders technology without manual intervention thus taking away trading volume from the above incumbents
- Low cost operations as opposed to a personnel intensive business (this is true as of a few years ago) , running their facilities with heavy reliance on technology & automation thus resulting in minimal headcount
- New model of “Maker/Taker Pricing” i.e just paying members without having them to pay the usual exchange fees to trade on the platform as long as their trading adds liquidity rather than takes it – upends the traditional membership route for the traditional exchange ; (ref – Wikipedia)
- Volume based trading incentives that were initially offered by the upstarts – offering discounts to institutions & traders that generate higher volumes
Thus, shrinking margins, new upstarts & regulatory pressures are further fragmenting trading venues thus leading traditional players to look into how existing business processes & systems integration could be made more transparent, efficient and agile. Players across the board also facing significant profit pressures as volumes have decreased in recent years (thus dropping commissions as well), following the market drops in the 2008 financial crisis.
The response from the exchanges can be summed up in four broad categories –
- Consolidate by mergers & acquisition (e.g NYSE/Euronext-ICE, CME-CBOT,BATS-DirectEdge etc) to achieve better economies of scale,
- Vertically integrate Clearing functions into their business operations (e.g NASDAQ’s launch of Genium)
- Launching new products based on data and applications
- Creating more efficient business processes
Given #1,#2 and #3 above, the problem (#4) of creating new revenue streams still exists and continues to bedevil the business. While creating highly efficient business process can definitely drive operational experience it certainly does not create a sustainable competitive edge by itself.
Given this backdrop, the World Federation of Exchanges (WFE) just published their report for the first half of 2015 and things are looking up for the industry as a result of sustained global economic expansion.
The main trends were: (Source – WFE)
– The value of share trading rose 36% worldwide to 59 trillion USD in H1 2015 from the second-half of 2014 (+58% year on year).
– The number of trades also rose 36% from the second half 2014 (+67% year on year). – Global Market Capitalization rose 8% to 73 trillion USD from the second-half of 2014 (+6% year on year).
– Strong increase in IPOs and in investment flows. The number of IPOs increased by 19% year on year. Total investment flows increased by 42% year on year.
– Exchange Traded Derivatives (ETD) volumes decreased by 3.5% compared with the second half of 2014, mainly driven by commodity and currency derivatives.
It is interesting that a huge percentage of this surge is being led by the Asian market – which grew 219% YoY from an Order Book trading value perspective.
Given all of the above & the increasingly regional flavor a global market is acquiriting, how are firms to expand to more business focus/value generating areas? What are they to do from a strategic perspective?
And more importantly how do they avoid becoming a casualty in an increasingly commodifying industry?
A succinct technology response is that firms need to tap into the vast reserves of data that they have to create new value added services that tap into their vast computing infrastructures. At a high level, there are a few ways to make high profit margins on existing or new product lines – creating very sophisticated trading infrastructures for certain kinds of financial instruments, increased adoption of execution automation while guaranteeing clients best price, speed and the lowest transaction costs. On the other side of the equation, providing a human interface to cater to the needs of high value clients is key – thus enter the 360 degree view of customer.
The next blogpost will expand on the above themes from a strategic innovation framework standpoint. We will throw up some interesting ideas for players in light of the substantial data assets the incumbents possess. Finally, we will examine how all of this can be leveraged to create a sustainable competitive advantage via continuous innovation.