2013 Electronic Trading Outlook: More Pressure on Tap for the Sell Side

About this time each year, we pause to reflect on the critical issues the financial-services industry will face in the coming 12 months and how capital markets companies can position themselves to benefit.

The capital markets are a diverse segment, and it’s often difficult to make sweeping generalizations, but we are keenly watching several trends likely to have wide-reaching effects in 2013. These trends are continued sell-side cost pressure, central clearing and electronification of certain assets, shifting opportunities in Europe, growing demand for analytics, and pressure on management fees among buy-side firms.

Continued Sell-Side Cost Pressure

Sell-side firms are under intense pressure to trim costs. The traditional approach—across-the-board job and budget cuts—has been implemented almost everywhere but has not generated sufficient impact on the bottom line. Instead, banks must look across organizational silos to find process inefficiencies and redundancies that they can consolidate or eliminate.

In 2013, more firms will realize they need to rethink their operating models, geographic footprint, and even which businesses to pursue in order to align their cost structures with today’s business and regulatory environment. Some of these changes will require additional investments in technology—though successful firms will be able to fund these investments through savings realized from initial waves of cost cutting, thus showing continuous improvement in their expense base. While these programs are driven by the need to improve near-term financial results, successful programs will also industrialize processes that can enable future growth when customer risk appetites improve.

Central Clearing and Electronification

A major theme of 2013 will be the central clearing of over-the-counter (OTC) derivatives, as well as the increased electronification of trading. After several years of regulatory delays, we’re finally close to a concrete time line for moving OTC derivatives to a centrally cleared model. This shift will begin in 2013, forcing firms to adjust to tighter margin and collateral requirements. Complicating this transition is the fact that the new model will have to coexist with the old model, since some bespoke derivatives will still clear in a bilateral fashion.

Concurrently, plain vanilla OTC derivatives such as interest-rate swaps and index credit-default swaps (CDS) will begin to shift to transparent electronic venues in earnest in 2013. In 2010, just 10 percent of the index CDS market was traded electronically, but by 2015 we expect the percentage to increase to somewhere between 60 and 90 percent.

We also expect to see more electronic trading of corporate bonds in 2013. As dealer inventories continue to decrease, buy-side crossing solutions are being introduced to the market and established trading platforms are seeing more activity. In 2011, less than 20 percent of the corporate bond market traded on electronic exchanges, but in two to five years that could jump to 35 to 45 percent, led by the most liquid, investment-grade issues.

Shifting Opportunities in Europe

Another broad theme in 2013 will be significant new opportunities in European debt markets for Wall Street firms and some of the healthiest European investment banks. As the current macroeconomic challenges continue, bank lending—traditionally the dominant form of corporate finance in Europe—will increasingly be supplanted by bond issuance. This presents opportunities not only for investment banks but also for investors, who will be able to participate in the European corporate debt market in a more meaningful way than in the past.

Growing Demand for Analytics

Another 2013 theme that we believe will touch both sell-side and buy-side firms is a growing focus on analytics and data. The increasing complexity of the market—including greater risk and regulatory focus and more stringent reporting requirements—now requires more powerful analytics in order for market participants to do business. Underlying these analytics must be high-quality, consistent data.

None of this is simple, which creates both a burden and an opportunity. We recently sized the market for financial data and analytics at about US$35 billion. Ultimately, new products, such as real-time collateral management and intraday risk analytics, will allow companies to be more sophisticated in their ability to manage risk and deploy capital. Given the size of this market opportunity, we believe entrants will move aggressively into the data and analytics space in the coming year. Established players need to craft competitive responses.

Pressure on Management Fees

Finally, one key trend impacting buy-side firms is the intense pressure on management fees. The issue has been developing for some time but in 2012 seemed to reach a tipping point in which lower costs began to trump incremental performance. Performance is still important, but brokers now prefer low-cost funds even if they slightly underperform higher-cost funds.

A telling skirmish in the price wars took place in October 2012, when money manager BlackRock, the biggest provider of exchange-traded funds (ETFs) in the U.S., slashed fees on some of those funds and introduced new low-fee ETFs. A month earlier, Charles Schwab had cut fees on more than a dozen ETFs. Also in October, Vanguard announced it was dropping many of its MSCI indices for less expensive options.

The stakes are high to accumulate ETF assets and settle for their razor-thin fees because so many investors are abandoning actively managed funds. In the first nine months of 2012, actively managed stock funds saw outflows of about $58.5 billion while ETF inflows topped $136 billion. Given the tiny margins of ETFs, it’s imperative that buy-side firms drive efficiencies throughout the enterprise to lower their own costs.

We hope you find these thoughts helpful as you consider your strategy for 2013, and we would be happy to discuss our perspectives with you in further detail.