A Shift In Mindset
The traditional sell-side execution model is being re-examined, resulting in the consideration of scenarios that were at one time unthinkable. Instinet’s Managing Director Glenn Lesko and Celent’s Research Director Securities and Investments Group David Easthope discuss.
There’s been a lot of talk lately about the expected increase in the outsourcing of equity trading technologies. Why do you think that is?
Glenn: It’s no secret that there are significant economic pressures on equities groups these days. Volumes have stagnated globally, regulatory compliance costs are increasing, commission rates continue to be compressed, revenue drivers that were once able to subsidise banks’ equities business have shrunk and the cost of maintaining trading infrastructures grows.
That has caused many on the sell-side to very critically examine legacy business models in an effort to right-size their cost bases in light of this new reality. Businesses lines that have historically been loss leaders but at the same time considered untouchable, like capital commitment or wide research coverage, are now being reconsidered in favour of scaled back offerings that are profitable in their own right.
As part of this process, one of the biggest cost centres, technology — is also being examined. From hardware and software costs to data centre charges, connectivity and trading platform development, technology-related costs comprise a substantial portion of overall equities budgets and this number is only getting higher as markets continue to grow more complex. And while only a few years ago the prospect of outsourcing parts of this infrastructure was unthinkable, the secular shift we find ourselves in has caused firms to consider ideas that were once anathema.
What are the economics driving this shift?
David: As Glenn noted, persistently low revenues, stubbornly high costs and capacity challenges are currently confronting sell-side equities businesses. On top of that, the derivatives and prime services businesses that once subsidised equities units are no longer capable of doing so. As a result, most banks’ management groups are no longer tolerant of expensive IT supporting a business with sub-par returns. Furthermore, because revenues are going to be hard to find amidst low volatility, we believe radical expense reduction programs have become necessary among not only mid-tier broker dealers, but also the largest broker dealers as well. In short, we believe brokerage firms must start to think the unthinkable – it is far better to assume that any and all IT can be outsourced than to assume none can.
With the increasing commoditisation of technology, how can banks and brokers differentiate themselves?
Glenn: Consider for instance the execution management system (EMS) that a trading desk uses to access the markets. Four or five years ago, most of the major banks offered their own proprietary platforms, which were viewed as a way to make client business “sticky” and also serve as a true differentiation point. Since then, however, we’ve seen the number of trading venues globally increase dramatically as dark pools have gone from a US-only phenomenon to globally prevalent; message traffic that must be processed has grown exponentially as HFT has become such a considerable part of the overall market; and multi-asset trading functionality has become a must. All of which has created a scenario in which it’s hugely expensive to develop and maintain an EMS, meaning that the true upper echelon EMS platforms are all offered by technology vendors; Goldman, Barclays and Citi – all of whom until relatively recently had proprietary EMS systems – have exited the space at least directly. To me this is a reflection of the increasingly prevalent attitude on Wall Street where firms say “we’re not going to try to be all things to all people – instead we’re going to focus on our strengths and make sure we’re profitable where we operate.”
Is the overall trend towards cloud computing services playing a role?
David: Cloud computing is definitely part of the solution here, particularly when we are referencing infrastructure as a service (IaaS). IaaS can include proximity services, co-location, hosting, storage and network services from players like NYSE Technologies, Savvis and OptionsIT, among others. In addition, managed services from a player like Thomson Reuters or Interactive Data, who can provide real-time content and data management, makes a lot of sense in this environment. Moreover, if we think even more radically, the outsourcing of certain compliance functions through offerings such as NASDAQ’s FinQloud can be attractive. That said, some trading applications and other front-office activities may never be cloud appropriate.
What other aspects of the execution value chain are currently being evaluated?
Glenn: There’s definitely a range, from small and mid-size firm’s looking to offload their execution offering in its entirety to bigger banks seeking to outsource what they view as non-differentiating aspects of their platform. For the latter, EMS/OMS has probably been the most obvious example thus far but we’re starting to see other aspects examined as well. For instance, several years ago, certain trading algorithms were distinctive and consequently real unique selling points for the firms that offered them. But as they’ve become not only more commoditised but more expensive to operate as well, brokers are beginning to “white label” all or parts of their algo offerings.
Another area is market connectivity. Developing and maintaining connectivity infrastructure is not a trivial undertaking and consequently something that many firms are looking to outsource.
Still another is the provision of multi-asset functionality. Offerings such as futures and options trading capabilities are extremely challenging given the tremendous amount of market data that must be processed and the separate registrations and licenses that are necessary.
Then there’s the other end of the spectrum where the whole offering is white labelled. For these firms, the ability to provide value through research, management access or even ownership structure while ensuring that clients get the best possible trade execution via partnership is a scenario that all stakeholders – clients, outsourcer and outsourcee – find compelling.
How much of the execution services process could you foresee being outsourced in five years?
David: Ideally, any portion of the infrastructure that’s non-differentiating will ultimately end up being outsourced. However, brokerage firms may lag and differ in how they interpret non-differentiating. Using an environmental analogy, we think brokerage houses should look for radical ways to lower costs throughout the equities franchise, by the mantra of reduce, re-use and recycle. Let me give you some examples. Equities franchises must reduce the number of trading applications supported and also reduce not only operations staff but also the number of sales traders supporting more mundane types of execution. There are also opportunities to invest in further development of client portals to replace some equities sales/traders with cross-asset regulatory/execution consultants, which is what the market is increasingly asking for these days.
Continuing the environmentalist analogy, re-use is a more difficult concept than reduce since much of the technology supporting equities execution is actually being repurposed to support trading in other asset classes, including fixed income. In fact, many top tier brokers have actually moved equities trading executives over to fixed income. In this context, re-use may be more about applying execution methodologies and algorithms to other asset classes to earn returns from scale.
If we can torture the analogy further, we believe the greatest appeal is in recycling. By recycling, we mean outsourcing not only infrastructure, but also adopting a managed services mentality for high performance trading applications. A managed service is a service offering in which operational functions are taken over by an external provider who can use its scale to lower the cost of ownership of those functions. Let us not forget that the mentality is key because the technology options have been available for mid-tier brokerages for some time now.
Was the recent decision by Nomura to make Instinet its execution services arm related to this trend?
Glenn: Yes, by all means. Nomura took a good long look at the current environment and determined that we’re in the midst of a true secular shift rather than a cyclical bump in the road, necessitating a fundamental change to their business model. As a result, we’ve spent the last 10 months or so working to migrate the Group’s entire equities execution services offering outside of Japan to Instinet. At the end of the day, Nomura made the decision to focus on its strengths: execution services (cash, program and electronic) on an agency-only basis through Instinet, and focused research coverage and focused research coverage and capital intensive products via the Nomura branded broker-dealers.
The other significant portion of this migration that’s worth noting is Instinet’s new role as the defacto trading technology services division of the Group by providing EMS and other execution technology solutions through the organisation. In this way, Nomura is very much “outsourcing” critical components of its technology infrastructure to its Instinet subsidiary.