In a recent research report penned by Greyspark Partners, Consultant Willis Bruckermann identified top trends impacting trading of structure products and derivatives in the coming year and beyond. In this Q&A, we explore the top findings of the Greyspark research to reveal how sell-side firms are looking towards technology investments to support growing needs for a flexible derivatives trading franchise as required by keep competitive.
Q.In your report entitled “Trends in Structured Products & Derivatives Trading 2019” you lead by stating that derivatives trading business models have recalibrate in recent years due to both the regulatory change post-financial crisis and related changes. How have these changes impacted or driven current trends in 2019?
A: The first, top-line 2019 structured products and derivatives trading trend — from a market structure perspective — that our report highlights is the fact that, since 2010, the revenues garnered by Tier I to Tier III investment bank business models from trading the relevant contracts / instruments on either an OTC basis or on exchange have shrunk. At a macro level, historically-low G10 benchmark interest rates driven by quantitative easing sapped volatility from global cash equities markets, and while cash equities volatility has come back on in fits and spurts from time-to-time over the last 12-24 months, it remains low compared to pre-crisis highs. These low levels of equities markets volatility have a clear and understandable impact on the demand / desire of buyside investors to hedge risk using listed futures and options, thus lowering demand for access to liquidity on-exchange or off from bank brokers / broker-dealers.
The second top-line trend that the report highlights is that, in structured products trading specifically, non-bank entities — e.g. algorithmic and / or high-frequency trading hedge funds or proprietary trading firms — are now the largest market-makers by volume on the main European + US exchanges and in the most liquid issuances. This fact does not necessarily dampen buyside investors, and thus investment bank structured products exchange market-making brokerage franchises, from needing or wanting to assume a position in secondary markets for the instruments / products, but it nonetheless has a deleterious effect on banks being able / willing to compete for pricing against so-called ‘Flash Boys’ non-bank market-makers that can + do withdraw liquidity from the market as / when it suits them to do so.
Couple those 2 top-line trends with the impact of post-financial crisis re-regulation (i.e. the Basel III Accords, the US Dodd-Frank Act, MiFID II, EMIR, etc.) and what you find is that it is increasingly costly for banks to also be willing to maintain robust issuance / structuring shops within their derivatives or structured products trading franchises that allow them to be able to release new, bespoke products on-demand to buyside investor clients seeking alpha on a day-by-day / trade-by-trade basis. Additionally, these investment bank franchises are also now faced with a more competitive environment for structured products (and bespoke, complex derivatives) issuance / structuring services from specific types of asset managers that specialise in those services as a means of garnering end-investor AUM and which then often ‘lease’ or rent that pipeline of specific instruments / products types out to investment banks, which then — in turn — grant their clients access to that liquidity on-exchange.
As such, it is true that some Tier I and Tier II banks with historically robust structured products and derivatives trading franchises (supported by, primarily, in-house built brokerage / prime brokerage services e-trading platforms ) — both on- and off-exchange — have put off investing in upgrading their platforms for, in some cases, more than 7 years. However, low cash equities markets volatility + post-financial crisis re-regulation are not necessarily the overwhelming drivers of those business decisions by Tier I to Tier III banks to postpone new investment into existing e-trading / brokerage platforms. Simply put, the platforms originally built by banks pre-crisis to vend buyside clients access to pipelines of OTC or exchange-traded structured products liquidity were robust-enough for those banks maintaining universal or pan-regional / global trading or market-making franchises to remain competitive with one another; in some instances, those banks vertically-integrated into structured products and derivatives markets through ownership of asset management firms (e.g. Lyxor) specialised in structured products + derivatives issuance / structuring to supply the bank’s buyside client base with a pipeline of name-brand products on which the bank would pledge to make-a-market on exchange or on brokerage venues. Rather, the change driving the recalibration of the historical Tier I-Tier III investment bank structured products and derivatives trading / market-making franchise in recent years — highlighted in our report — is the increasingly level of competition driven by the growing technical sophistication of non-bank market-makers to compete on price on a trade-by-trade basis OR on the brokerage of access to on-exchange liquidity that is now forcing many investment banking franchises to re-examine the competitiveness of their business model from a technology perspective, specifically.
- What are the current challenges with trading technology that banks are looking to address in the next couple of years and why? How are firms addressing these changes?
A: Costs related to the maintenance of legacy, in-house built e-commerce / e-trading platforms built for structured products / derivatives trading, specifically, is the main challenge for many Tier I bank and most Tier II bank franchises. Broadly speaking, sellside IT / technology spend budgets are now being slashed across the entirety of the industry, and only the largest, Tier I, universal banks remain committed — for the time being — to dramatic levels of spend on in-house built solutions / platforms for client-facing / markets-facing purposes. This general lack of commitment / willingness to spend anew is supported by the raft of vendor solutions specialised in derivatives and structured products trading that are now available that allow bank adopters to rapidly acquire or replicate the scale of business represented previously by in-house built technology assets in a manner that allows them to outsource the costs associated with post-trade processing and other manual, labour-intensive processes and workflows that previously could only be managed by banking franchises in-house and which were not easily replicable by vendor providers.
More specifically, our report shows how the functionality needed by a Tier I, universal bank derivatives + structured products trading franchise in 2019 is now largely commoditised, and that an understanding across the street of what represents ‘good’ or ‘best of breed’ from a vendor provider perspective in terms of solution functional capabilities is now fairly standard. What remains unstandardised — from a Tier I bank perspective — in terms of vendor-provided structured products + derivatives trading solutions are the non-functional attributes such as the flexibility of the solution, the extensibility of the solution, the general level of performance / latency of the solution and the solution’s scalability (i.e. how cross-asset or multi-asset can the solution be before key functional capabilities begin to break down into overtly manual processes and workflows). These non-functional attributes are, understandably, important components in any purchasing decision, and they do still vary from one solution provider’s offering to the next.
- What are the biggest ways you see firms investing in derivatives trading and technology in the coming years?
A: Generally speaking, Tier I + Tier II banks are likely to either invest more (not necessarily heavily or by going ‘all in’) in either experimenting with vendor solutions specialised for structured products + derivatives trading as strategic augments or bolt-ons to existing, legacy, in-house built platforms, providing new levels of automation to historically manual processes and workflows, OR by selling their in-house built platforms to private equity firm buyers and then potentially (or potentially not) replacing those in-house platforms with one or more vendor-provided offerings.
As such, yes, not all of the leading vendor solutions available to Tier I-Tier III banks in 2019 fulfil every need completely, functional or non-functional, but then this is part of the challenge for those vendors that are already strong in the derivatives + structured products OMS / EMS / OEMS space, as well as — more generally — for those vendors offering cross-asset or multi-asset trading solutions. Vendors can + do frequently upgrade the functionality of their offerings, adding new levels of sophistication in response to user / client demand, but they remain unable to be all things to all clients all of the time. Enhancement of functionality is a given; succeeding in doing so in lock-step with bank demand is not, and asset managers / hedge funds — maintaining a stable or end-investor AUM geared toward portfolios designed to yield alpha in an otherwise drab moonscape for volatility — remain willing + able to build platforms in-house.
- If this is the strategy going forward, will this be a way for banks to differentiate themselves? Will they look to ‘newer technologies” such as AI to support this?
A: For banks, it is more a case of what we’re calling in our report ‘built-and-bought’ solutions, i.e. the use of vendor solutions as strategic augments or bolt-ons to existing in-house platforms, rather than buy-and-build.
‘Newer technologies’ is a broad characterisation, so I’m a little hesitant to say too much to that point. Suffice it to say, yes — there is a role for AI in the post-trade arena (and we are beginning to see that now in both collateral management + OTC derivatives processing solutions offered by the leading vendors in those spaces), but it’s not really applicable within the front-office trading technology stack. Algo containers, programme trading functionality and high levels of scalability (i.e. cross-asset / multi-asset class applicability + functionality) matter more within the narrative of the need for banks to automate manual processes and workflows — OTC or in on-exchange market-making — than do clever apps / toolkits designed to predict user needs and act accordingly in response.
- Are there other trends or predictions you have for how this space will evolve in the coming years?
A: In short, increasing levels of automation in the post-trade space and the need for many Tier II banks, specifically, to make decisions sooner-rather-than later as to whether they wish to continue to defend structured products and derivatives trading franchises that are increasingly diminishing in the face of competition for on-exchange market-making services from non-banks and highly competitive issuance / structuring services for bespoke OR commoditised instruments / products pipelines offered by asset managers. To keep up, many Tier II banks (and some Tier IIIs) will need to either abandon the space entirely, or they will need to refocus on a client base + instrument / product set that is more suited to their capabilities from a budgetary, on-going spend perspective. Herein, opportunities for only some Tier II banks to specialise in an effort to garner client market share on-exchange or off from other Tier II bank rivals or from Tier I banks by competing directly on overall pricing for the services rendered is high, but time will tell on the willingness of that handful of (mostly European) banks to make that leap.
To read more from this report please go to the Greyspark Partners website.