Source: www.breakingviews.com is Europe’s leading financial commentary service.
Europe’s equity industry is preparing to replace people with machines. Some trading floor chiefs are even talking about an impending arms race, as firms vie to offer the latest execution capabilities so that their clients can make, or lose, that million euros a nanosecond faster.
But will the industry really concentrate into a few execution powerhouses?
During the bear market, investment banks saw little point in investing in the equities business. If boards are now drawing up ambitious plans, it is not because stock prices are ticking up. It has taken the threat of a regulatory shake-up to galvanize this inefficient industry into technological reform.
The UK’s Financial Services Authority has proposed making brokers charge separately for execution and other services, such as research, instead of bundling them into a single commission charge. This may only be a proposal, but fund managers are already using it to justify demands for greater power over the quantity of services that they buy from brokers. So Europe’s equities industry is planning for a future in which its clients shop around for trading and research far more aggressively than today.
The priority for the larger equities desks will be to safeguard their existing market share. Most equity trading is a bulk business, and competition for run-of-the mill orders in liquid stocks will come down to offering the lowest-cost service.
The overall cost of the trade, taking into account market impact as well as commission charges, is easy for the client to see. Chief executives may hire Goldman Sachs bankers to do M&A deals because of the house’s name, but fund managers will only go with a big-name broker if it offers the lowest-cost execution. And increased automation of vanilla trading will generate scale economies because the cost base will be fixed. Better technology might also enable desks to price more efficiently those orders that demand the bank risks its own capital by acting as a principal.
Of course, machines bring another benefit over people. They may cost a lot to build, but once plugged in they do not take a salary. Many of the tasks currently undertaken by traders – such as inputting whether the trade is to be executed “at market” or within certain limits – are simply executing instructions from a buy-side dealer who could, in theory, enter the same instructions into a computer wired up to the broker’s systems.
So is it goodbye to the flesh-and-blood broker? It isn’t quite as simple as that. Laying people off is costly. And there are some costs, such as office leases, that are hard to eliminate overnight. That means equities desks must weigh up whether the cost of buying new kit, hiring programmers and paying severance packages will pay off quickly enough to satisfy shareholders. Taking action before equities revenues really begin flowing again is quite a leap of faith.
Indeed, those investment banks that are beefing up their trading technology – most visibly, Goldman Sachs and Merrill Lynch, but also UBS and ABN Amro – are taking a bet. This is that the number of execution houses will shrink from several hundred to fewer than 10 – a sort of traders’ premier league. And these firms will receive a disproportionate share of business from fund managers. With such a concentration of order flows, higher volumes should offset lower margins.
But it is hard to believe that fund managers would allow that to happen. They certainly should be worried if a bulge-bracket bank ends up with 10% of the day’s order flow, especially if it is using the knowledge gained from that flow to trade profitably on its own account around client orders.
In some senses, technology may lower barriers to entry as much as raising them. Most innovations are replicable, and the cost of replicating them tends to fall quite quickly over time. And falling capital costs could encourage start-ups into the market. If anything, a start-up operation is better placed to take on the market because it is not saddled with a legacy costbase, although its ability to invest may be constrained by the absence of a legacy revenue stream.
And there is clearly scope for smaller, local or specialist operators to chisel away at the premier league’s revenues around the edges. Hedge funds do not only trade in mega-cap stocks. They also buy and sell less-liquid, hard-to-trade stocks. They will go to the broker that can find them liquidity. That means handing business to a human being who knows which fund managers hold what, and at what price they might sell them.
As with any market that opens up to greater competition, the equities business is likely to accommodate different players with different strengths. The traditional houses, for example, will be able to offer access to IPO allocations. And not all players will be able to risk capital. The arms race might turn the industry on its head, but it might not become quite as concentrated as bulge-bracket banks’ investment plans assume.
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