COMMENTARY: The Choice Is Efficiency, or Deficiency

As electronic trading becomes more widespread and revenues are more compressed, commodity products firms need to do two things: reduce costs and expand into more complex, more inefficient products, where they can find greater profitability.

Efficiency is critical. As electronic trading becomes more widespread and revenues are more compressed, commodity products firms need to do two things: reduce costs and expand into more complex, more inefficient products, where they can find greater profitability. As they both automate and extend, the idea is to reduce costs to be able to out-price, out-deliver and out-service their competition. We have called this process many things: straight-through processing, operational effectiveness, etc. But all of these terms really define efficiency.

The challenge with efficiency is that it is not absolute; it is relative. You can't say that you are absolutely efficient. There is always more to do. A firm's efficiency level is dictated by price, cost, product complexity, margin and desire. While efficiency has increased the demand for and implementation of newer technologies, easier connectivity and more robust standards will continue to push industry efficiency even further.

While economics and revenue structures have always dictated efficiency targets, the advances of electronic, algorithmic and direct access technologies are pushing efficiency to a greater extent than we have seen in years. The big push, while technology-enabled, is really driven by the resulting low cost of trading that is forcing brokers, investment managers and custodians to search for new ways of processing higher trading volumes at much lower costs.

The battleground for much of these efforts has been located in the equities space, but it is quickly crossing asset classes. Trading platforms such as TradeWeb and MarketAccess and inter-dealer fixed income platforms like eSpeed, BrokerTec and MTS in Europe, as well as currency platforms such as EBS, Dealing 3000, FXall and HotspotFX, are bringing efficiencies and electronic trading to traditionally phone-based markets. As connectivity to these platforms improves, they will become more popular and more competitive. Both of these factors will force commissions and spreads to decline-leaving firms with only three choices: increase efficiency, control costs or switch businesses.

How Will We Get There?

The age of the industry initiative and consortium has come and gone. With the twin failures of T+1 and GSTPA, we don't expect any mega industry-wide efficiency initiatives, however, we do anticipate rapid gains in efficiency. These improvements will be needs-driven. Just as direct access technology and algorithmic model-based trading have forced providers to increase bandwidth and process an increasing number of transactions with fewer people. Cost will be the mother of necessity.

Firms that perceive market need and offer a solution will blaze the trail toward more robust protocols, processes and workflows. As these technologies and pricing structures catch on, investment managers, brokers and custodians will be forced to adopt the newer efficiency mechanisms to play, thereby pushing the industry to greater efficiencies and more streamlined processing.

The larger players with greater budgets will be able to compete more easily in this model, while the smaller players will initially be at a disadvantage. Smaller players will need to be creative and be willing to invest, or they'll risk being relegated to servicing a shrinking market. However, that is not to say these smaller players will fold. Initially, more manual players will survive by servicing the higher-margin, more relationship-oriented, and more lightly covered businesses. Eventually however, efficiency and cost pressures will require firms to adapt. As the business becomes more commoditized, service providers will grow, vendors will offer new technology, and the price point for entering the market will decline. Thus the efficiency curve will jump.

Major Trends and Prognostications

As mentioned, electronic and model-based equity trading will migrate from U.S. equity markets into the U.S. options market and across the globe to Europe and Asia. As this occurs, brokers, followed by investment managers and custodians, will be forced to work out much of their cross-product equity/options challenges. Following cross-product and border electronic arbitrage, cross-border communications inefficiencies will be resolved.

As cross-border and global electronic trading increases, firms will be forced to look for FX solutions that will draw upon the CLS Bank infrastructure and will better coordinate global funds transfer and securities settlement.

Fixed income processing will also improve, drawing on newer distribution technologies as well as market infrastructures that are making both the market data and trading process more transparent.

While much of this advancement is product-specific, hedge funds -- those small investment partnerships that wield tremendous clout -- will continue to push the industry toward efficiency across asset classes. Hedge funds invest cross-border and cross asset class. As these funds look for arbitrage and investment opportunities, brokers will drive cross-asset integration and efficiency.

These business-driven goals will force operations and technology professionals to create innovative solutions to either push the envelope or respond to competition. It is our industry's circle of life -- business innovation spurs operational and technology advancement, which provides the infrastructure for further business innovation. All of this innovation is predicated on efficiency. And while efficiency may not be sexy, when spreads and margins collapse, there are only two options: efficiency or deficiency.

This commentary is part of an analysis that The Tabb Group did in conjunction with Omgeo and is based on interviews with 53 global investment managers, broker/dealers and custodians across the U.S. and Europe. The report "Efficient Markets: Measuring and Monitoring Efficiency in Today's Global Financial Markets," provides an in-depth look at firms' direction, progress, and challenges in making the global financial markets more efficient. The report is available at www.tabbgroup.com/research and www.omgeo.com. Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio