Standing on the Shoulders of Giants
Europe’s institutional sell-side firms have had a tough time in recent years. As well as the costly overhead of implementing and complying with MiFID II, the industry continues to grapple with a deteriorating economic outlook (compounded by the Covid-19 outbreak) and shrinking commissions, while structural changes have made equity broking and client facilitation ever more challenging.
Increasingly, capital markets trading would appear to be a scale game, with the top five banks commanding close to 60% market share in European cash equities. Competing with the large global investment banks might therefore appear daunting. The likes of JP Morgan, Goldman Sachs and Morgan Stanley have the client base, order flow and balance sheets to prosper, so how can smaller players survive? Well maybe the regional banks, national champions and domestic brokers still have a few cards to play.
A problem shared…
All banks, whether large or small, struggle with cost and complexity. Global sell-side firms want to offer their clients universal access to markets, but this one-stop shop strategy is economically challenging. Faced with liquidity fragmentation in the major European and North American markets, along with enhanced best-ex rules, the cost of offering comprehensive trading services has rocketed. Given this, even the largest firms struggle to justify the expense of exchange memberships, local connectivity and infrastructure costs outside of their core markets. As a result, top tier firms are increasingly offering regional market execution through ‘white label’ relationships with domestic brokers. Partnering with local counterparties can make sense, but only if they have the infrastructure and tools to facilitate the performance levels and order volume that a large broker dealer or execution specialist might demand.
Exchange membership fees, co-location facilities, network and infrastructure, support overheads, clearing and settlement are just some of the costs associated with offering access to a given market. Clients also expect their broker to offer local colour and execution consulting services that reflect the dynamics of a specific country or region. When adding up these costs, even the largest firms may struggle to model a compelling ROI, particularly if they don’t have a clear view on potential volumes of order execution.
So, leveraging the market infrastructure and expertise of local counterparties can be a great solution. Despite having to share commission, this approach can benefit all parties – global banks can cost effectively access secondary or developing markets, large asset managers can source a broad range of liquidity through their primary broker relationships, and regional/local brokers gain access to order flow they might otherwise struggle to secure.
Cuts both ways
These relationships can also work in reverse. One advantage that local banks and brokers have over large international firms is an intrinsic understanding of their clients’ trading strategies and investment mandates through personal relationships built up over years. For domestic asset managers who want exposure to international investments, their local broker can facilitate this by establishing trading connectivity with large global brokers, feeding them orders to be executed on markets around the globe.
The white labelling of algorithms is a further extension of this emerging symbiotic ecosystem. The larger sell-side firms and execution specialists have invested heavily in developing sophisticated algos, smart order routing logic and other proprietary trading tools. The cost and expertise required to build and maintain competitive algos can be a barrier to many organisations, so licensing can make sense and enables such firms to offer comprehensive execution services to their clients.
Are you ready for this?
Profitable equity trading remains challenging, as highlighted by the recent exits of Deutsche Bank and Macquarie. However, different participants in the ecosystem are learning to operate together to realize synergies, manage costs and expand the services they can offer to their clients. This is helping keep a broad spectrum of players in the game as firms of different shapes and sizes carve out their niche.
To be truly successful in this new environment, sell-side firms need technology that gives them the agility to implement such strategies. Regional brokers require the scalability and latency profile to trade with tier-1 firms and integrate with third party algos, while larger broker dealers will need the flexibility to quickly connect to new counterparty relationships. Whatever their size, all sell-side firms will want to simplify and speed up client onboarding and enhance customer experience by providing access to new services and sources of liquidity.