With the compliance deadline for the second Markets in Financial Instruments Directive fast approaching, Ullink looks beyond the immediate impacts that the new regulation will have on trading technology, and examines how the future of technology will be shaped by such a significant regulatory change
In a series of articles published this year in Waters’ Sell-Side Technology, Ullink examined the impacts of the second Markets in Financial Instruments Directive (Mifid II) on sell-side connectivity and trading technology. The purpose of these articles was to identify the direct and immediate consequences of this new regulation on existing technologies such as Financial Information eXchange engines, smart order routers and order management systems. Ullink highlighted the significance of extended data requirements, changes to business logic and completely new workflows—around pre-trade transparency, for example—which must be supported by upgrading existing technologies to achieve Mifid II compliance.
Mifid II has driven much of the technology agenda for the past two years—especially in Europe—and with implementation just around the corner, firms are focused on short-term tactical enhancements to systems rather than broad, strategic platform changes. In this article, Ullink casts an eye beyond Jan. 3, 2018, considering the long-term drivers of changes to technology on the sell side—factors that will direct sell-side technology spending in the coming years. Some of these drivers, such as an increasing focus on automation, have been in place long before Mifid II, but are accelerated as a result of the new regulatory landscape.
Cross-Asset Order Management System
Since the financial crisis there has been a breakdown in separate product-aligned technology silos on the sell side, with firms moving to a more consolidated technology base. The driver for this is primarily cost, but reducing the complexity of technology stacks and the associated technology risk is also a factor. Consequently, the sell-side order management system (OMS) has been extended to cover multiple asset classes, servicing more lines of business from a single platform. This is made apparent in a recent report by Greyspark Partners, which shows how four of the six sell-side OMS vendors surveyed have expanded asset class coverage over the past two years.
While this trend towards cross-asset class OMS support was in place prior to Mifid II, the sell side has lagged behind the buy side on this front. Most of the convergence has been around exchange-traded products (ETPs), including cash equities and listed derivatives. Over-the-counter (OTC) products and exotics—particularly in the fixed-income, currencies and commodities segment—have largely remained within the purview of specialized systems that support the different pricing and bilateral trading models employed.
The push to drive OTC products to regulated markets was started by Dodd-Frank in the US and continued in Europe under the European Market Infrastructure Regulation (EMIR), with a focus on the huge interest rate and credit default swap market. Mifid II contributes further by extending the universe of product types subject to pre-trade and post-trade transparency rules around best execution, quote publication and trade and transaction reporting, among others. Uniform treatment of these product types from a regulatory point of view will further drive development of common, cross-asset class capability in technologies such as the OMS.
While this homogenization will translate to the OMS, the impact on the execution management system (EMS) is less clear. For different types of products, alternative market models, order types, pricing conventions and screen display requirements will persist. Smaller sell-side firms that wish to provide a full service to their institutional client base will increasingly rely on market memberships and algorithms, as well as other execution capabilities of larger firms—and will be less concerned with deploying their own rich EMS capabilities. As such, the OMS and EMS may begin to diverge—reversing the trend of convergence seen in recent years.
The Emergence of the Automated Middle Office
Cross-asset focus extends beyond the OMS and into the middle office. The imposition of transaction reporting requirements for OTC and exchange-traded derivative products under Emir is extended to other asset classes by Mifid II. Firms must maintain a holistic view of their exposure to detect risk derived from their underlying firm-wide positions. Without this consolidated cross-asset view, it is impossible for firms to meet their capital provisioning obligations and maximise the efficiency of capital deployment. This focuses attention on the middle office as a ‘convergence layer’, where a near real-time view of firm-wide risk and exposure can be generated.
The importance of the converging role of the middle office is increased when one considers data capture and reporting cross-asset class. As the earliest point post-trade that a consolidated picture of trading activity can be produced, trade reporting will naturally move to the middle office. Similarly, trade surveillance and compliance processes—such as those mandated under European Market Abuse Regulation—will naturally gravitate to the middle office to provide the data required for their effective operation in real time.
In tandem with consolidation, pressure is increasing on the middle office to automate post-trade workflows to the greatest possible extent. Shortening settlement windows—such as the recent move to T+2 for cash instruments in the US—will further emphasise the need for same-day affirmation, where trades must be confirmed then affirmed on the day the trade is executed. Failed trades are not only subject to costly settlement delays, but also imply position adjustment and extra collateral requirements.
An additional driver of automation in the middle office is the rise of ‘low-touch’ trading, driven by the buy side looking for more efficient and cheaper execution, across asset class and brokers looking to handle larger volumes of lower margin flow. This larger volume of flow translates to higher volumes of booking and allocation activity in the middle office, particularly for exchange-traded derivative products where higher numbers of smaller fills are common. As well as straight-through booking and confirmation, automated aggregation of fills will become a must-have requirement to reducing clearing and settlement costs.
High Touch? Low Touch? No Touch?
The rebalancing of high-touch to low-touch trading flows is a trend established with the electronification of trading in the 1990s. Since then, waves of regulation in different geographies have introduced strong requirements for pre-trade risk controls and best execution. Mifid II adds more requirements to pre-trade compliance, kill switches and the like, but the increasing weight of regulation shows no sign of reversing the trend towards low-touch or ‘electronic’ trading.
In a recent investors’ presentation, JP Morgan Chase & Co. highlighted a 31 percent increase in low-touch revenues in its cash equities division between 2014 and 2016—driven by a multi-year investment program in its electronic trading platform. There are similar trends in other firms across all electronically traded products, with many smaller and regional brokers establishing new ‘electronic desks’ to offer low-touch trading capabilities to their clients. Looking forward, it is possible to envision the electronic trading desk becoming the dominant style of trading for a growing universe of ETPs.
The nature of low-touch trading is itself in transition. What Mifid II refers to as ‘direct electronic access’ encompasses a range of trading mechanisms from sponsored market access to automated order routing. The term ‘direct strategy access’ (DSA) is also becoming more common. It refers to the use of sell-side execution algorithms to trade high volumes of client orders, but with rich analytics and trader controls for monitoring and intervention—similar to those found in a high-touch OMS. With such DSA desks already in existence today, the terms high-, low- and zero-touch may soon become anachronisms.
Managed Connectivity Services
As with the rise of low-touch trading, the trend of outsourcing both the provision and management of technology has been in place for many years. One effect of far-reaching regulation such as Mifid II is that it highlights the eternal ‘build-versus-buy’ debate, which weighs the cost of maintaining proprietary technology against the moving target of regulatory compliance. Nowhere is this more apparent for the sell side than in the connectivity space, which encompasses data flows with clients, exchanges and regulatory reporting venues.
The need to upgrade and re-certify connections to trading counterparties and exchanges is a consequence of Mifid II—as is the raft of new connections required of venues operating under an approved publication arrangement for trade reporting. This emphasis on connectivity will accelerate the trend towards outsourcing these capabilities to vendor-managed services, allowing for economies of scale as vendors amortize the costs of maintaining and operating tens—if not hundreds—of external connections on behalf of each sell-side firm.
Outsourcing is not, however, a means to fully delegate responsibility to managed connectivity service (MCS) providers. As sell-side firms carry ultimate responsibility for regulatory compliance, management and control is of paramount importance. This requires MCS vendors to provide their sell-side customers with the tools to make the data needed to provide assurance of compliance visible, and the means of managing the customer relationship throughout the onboarding process and beyond.
Ullink has looked beyond the immediate impact of Mifid II on technologies—and technology providers—that support the business of trading. There is no doubt that this business will be profoundly affected by the new regulations and the resulting structural market changes. However, some trends—such as automation and the need for cost efficiencies—predate Mifid II, and will remain major drivers of innovation in our industry for many years to come.