The capital markets and the technology industry that supports them have a tendency to be highly concentrated. There are only a handful of brokers available to clear OTC swaps, for instance, while a few giant technology firms dominate market data and exchange access. As a result, firms often form partnerships with competing firms in areas where their offerings do not overlap. Kevin McPartland, managing director, head of market structure and technology research at Greenwich Associates, discusses the high levels of co-opetition on Wall Street, the causes behind it, and the role startups play in keeping the big players honest.
Q: In a recent article, you talked about the need for co-opetition on Wall Street to guard against a lack of competition in several areas. Why does this concentration exist, and can you give some examples where there is strong market concentration?
A: Wall Street consists of market centers where different parties wanting to buy or sell a product can transact. To make that function as efficient as possible, there need to be fewer markets, because the fewer markets there are, the more parties there are in a single place looking to do business with one another. As a result, there are often only two or three providers in a particular space.
When it comes to trading and clearing corporate bonds, swaps, or even equities, over half, and in some cases over 60%, of client trading goes through five or fewer dealers, because there’s an economy of scale. The vast majority—about 90%—of electronic trading of corporate bonds is done over only three platforms. If there were more than that, the liquidity would disperse. There would be no benefit to the end user, so that doesn’t happen.
Market concentration on the other hand provides a benefit to the customer—if a firm is a big provider of services, it is easier for a customer to go to that one place to get everything they need. This is particularly evident in retail—people shop at Amazon, for example, because they can get everything there, the prices are good, and it is easier than visiting multiple Websites. Even if the price isn’t as good, it’s just easier, so business stays concentrated there.
Q: Every market needs competition. But why has this environment given rise to high levels of co-opetition in financial services? Can you name some examples of effective co-opetition in the post-trade space?
A: Sometimes there are so few providers offering a particular service, they all need to work together. Even if on one side they compete, they have to partner up in different areas. It’s a bit like a Venn diagram, where these different services and use cases all overlap with one another. Also, because there are so few providers, they tend to be bigger players. For example, on the technology side, Bloomberg or Thompson Reuters offer so many services that one business might need to use a service from the other.
Index-related products provide another good example. One company might own the index, but another company offers a derivative product based on that index. Those businesses may well compete on different elements of what they do day-to-day.
When it comes to post-trade processing of OTC derivatives, a few small clearinghouses clear large numbers of swap trades, especially interest rate swaps. There are some new providers, but the vast majority of those trades hit the clearinghouses through the infrastructure provided by IHS Markit. A trading venue might need to use their post-trade services, while also offering their own.
With a few large firms all providing a very diverse set of services, the overlap between those services is not 100%, so one firm will often have to utilise one of the services from the other firm. It’s in the nature of an industry where the number of providers is relatively few, and the providers are generally pretty large, that they will need to work together.
Smaller firms and startups also end up in co-opetition with the big players. There has been a real focus over the last couple of years from an investment and innovation perspective on FinTech startups. Startups might look to compete with some of these bigger, entrenched players, but will also need to work with them if they want access to a market, and to market participants. In some cases, there is no other way to get that access. This is healthy, and it will continue. It is not good for anyone in the marketplace if one provider has so much control that there’s no room for new entrants and no room for innovation.
Q: Previous Greenwich Associates research pointed to the importance of startups in the financial markets. Why are they so important, given that many are destined to fail?
A: It’s a very, very hard thing to create a new business and have it be successful—in any industry. Looking at trading venues, for example, there has been a big boom across the whole variety of products and asset classes over the last few years. The majority of them end up failing. It’s very, very hard to create the network that you need to create a liquid marketplace. It is a lot like starting a social network—it’s no fun unless everybody is on it, but how do you convince everybody to pick up and move themselves, and start sharing whatever it is they want to share in a new place? That is a challenge that continues.
However, the innovation that comes with startups, the attempts at disruption that they bring to the marketplace, other than new technology and lower pricing, keeps the incumbents honest. It keeps the incumbents working harder to make sure they do not get supplanted by a new entrant with a new idea.
So, everyone benefits in the end. It is toughest on the founders of those firms that ultimately don’t work, but their contribution to the industry in most cases certainly can be felt and seen through changes of the incumbents and changes in those that do actually make it, and hopefully it creates a better market for the end consumers.
Q: Looking ahead, how do you see this dynamic evolving? Will we see more co-opetition, or will larger players acquire or build new capabilities so that they don’t need to partner up?
A: It’s a little bit of both. Even if a startup needs to work with a bigger player, and the bigger player ultimately acquires the startup, there is always going to be some months or years in between, where that startup will need the services of the larger player.
It is just a natural evolution of technology and innovation in financial markets, and a firm can’t have an economy of scale like that from the get-go. Technology has made it easier to get access to servers, computer power, programmers, and other things that firms used to need quite a bit of capital to get access to. Cloud computing and a host of other new technologies have lowered that barrier to entry. But there are still other things firms need access to—maybe they need to license an index, or get access to the pipes down to a clearing house. There is only one efficient way to do this, to get access to that customer base and show them a new service.
Co-opetition, and acquisitions by larger firms will continue. But it is important to encourage innovation and investment in startups—even if they ultimately don’t make it, most of them do leave their mark and encourage the incumbents or the other up-and-comers to step up their game and provide better servicing, better pricing, and hopefully eventually improve the market overall.