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The Future Of Trading In A Hybrid Marketplace

Single-dealer platforms are likely to play an ever-larger role in the markets of the future, especially for regional banks, by Paul Caplin, CEO Caplin Systems.
Trading was simpler in the old days. Some instruments, like equities and futures, were centrally traded on giant exchanges, while others, such as FX and rates, were traded in an OTC free-for-all. The distinction was pretty clear.
But as trading became more electronic, and regulation more complex, the picture changed. Crossing networks and dark pools have proliferated in the equities market, so that finding the best price now means searching many venues. Meanwhile Dodd Frank and MiFIR are forcing much of the traditional OTC flow in the opposite direction, on to centralised SEFs and OTFs.
The result is that the equity markets now look a lot more like the OTC markets used to, with complex, fragmented liquidity. At the same time, despite the efforts of regulators to force something like a traditional exchange model on to the traditional OTC markets, the large number of firms lining up to become swap execution venues makes it almost certain that a fragmented market will emerge there too.
In effect, both kinds of market are converging on a hybrid multilateral trading model where liquidity is found in many places simultaneously, and where sophisticated algorithms and smart order routing are required to achieve best execution. And it’s quite likely that, over the next few years, the partly centralised, partly OTC hybrid swaps market is going to look more and more like the partly exchange-based, partly off-exchange equity market. This is not really a surprising development in a world in which electronic communication allows everyone to trade everywhere all the time. This rapid change in the structure of giant markets is prompting a lively debate about the future role of single-dealer platforms (SDPs). It has been suggested that multi-dealer platforms (MDPs) will all evolve into regulated exchanges, and that therefore SDPs will become redundant. However it can be argued that the reverse is true: SDPs are set to become more important than ever –– especially for regional banks.
The right tools for the job
To think about the SDP versus MDP debate, we have to think about what business banks are actually in. Investment banks provide a range of services, but one of the most fundamental is providing access to the capital markets for their clients. Banks need to think about what the capital markets are going to look like in the near future and the kind of help their clients are going to need in accessing them. There were two fundamental models for this in the past: dealing and broking. In the dealing model, they made the market and warehoused risk; in the broking model, they provided access to a centralised market and took a commission. As discussed above, however, most markets are now converging on a hybrid model where liquidity is heterogeneous and available simultaneously from many venues.
What the buy-side now needs from the sell-side is an effective way of managing access to that increasingly complicated world –– a combination of OTC dealing, direct market access, smart order routing, collateral management and margining. This adds up to some pretty sophisticated tools that banks are going to need to develop rapidly over the next few years. The new regulations will not, as some regulators may have fondly hoped, create a situation in which the buy-side will simply go directly to a centralised trading venue and do all their business there, any more than they do now in the equities market. They will, instead, create a situation similar to that which has emerged in equities, where there is a proliferation of trading venues and where a lot of help is needed to access those venues efficiently in a way that provides best execution and optimal use of collateral.
Faced with the erosion of their traditionally highly profitable OTC franchise, thanks to mandatory clearing of swaps, banks have no choice but to move on to the new dominant profit opportunity: clearing and collateral management services. But they won’t have any clients to sell those services to unless they first immerse themselves in the client deal flow, by offering something that the clients badly need: powerful and convenient best execution soutions. And the only way to deliver these cost-effectively is via an SDP.
The challenge for banks is therefore to electronify the client channel, but without losing the advantages of “high touch”.
From global to regional
The tier-one banks embraced electronification much earlier than their tier-two and tier-three counterparts, because they are more forward-looking, more technically capable and have much bigger budgets. Those tier-one banks that most quickly and aggressively rose to the challenge of electronification have been hugely successful, at the expense of their slower competitors.
But in the tier-two regional banking marketplace, it’s even more important to maintain great client relationships, and to move to electronic channels in a timely manner. And this goes double in emerging markets, where web-enabled mobile devices will soon outnumber fixed-line telephones.
Many regional banks are grappling with the challenge of simultaneously meeting two very different goals. One is to provide their domestic client base with access to the global markets. The other is to sell specialist domestic products and services in a global marketplace. For most large regional banks, they’re both very important businesses, and both are dependent on electronic delivery.
In the domestic marketplace, the regional banks typically have a large base of captive clients, usually skewed towards the retail end of the spectrum. These are dominated by corporates that have come to them via retail banking, but have quite big requirements for trading in the capital and FX markets. The regional banks need to protect this franchise against increasingly aggressive predation from global banks that are using sophisticated SDPs to lure their customers away. The best way to resist this is by providing an electronic offering which is accurately targeted at those customers and provides the workflows that they specifically need. But those banks must move fast, while they still have a market to defend.
In the global markets, regional banks often have a good story to tell. They can offer unique access to, and expertise in, local currencies, commodities and capital markets, and there is likely to be a global opportunity for this. But they cannot reach that global marketplace without a sophisticated electronic delivery channel. The margins on MDPs are just too thin –– even if they are able to support the products and services in question –– and voice trading is too expensive and not scalable enough.
The smart regional banks are already aggressively investing in building high touch electronic sales channels to address both these needs. The ones that aren’t are likely to be in trouble very soon.
Every single tier-one bank already has an SDP offering across multiple asset classes. In the FX market, in particular, more flow now goes through those tier-one SDPs than through all the MDPs put together. Tier-two banks now need to build effective SDPs of their own, but of a very different type that appeals to their very different clients. How effectively they do this will be a major factor in the future success of those banks.