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By Philippe
Buhannic
Electronic trading has arrived,
bringing dramatic changes to the structure of the financial services
industry. Different products are at different stages of development—futures
being at the top and some of the illiquid fixed income products
at the bottom.A large number of very successful dealer-to-customer
systems are already in use including multi-dealer systems like TradeWeb,
single dealer systems like PrimeTrade, and inter-dealer brokerage
systems like eSpeed and BrokerTec. In the electronic issuance area,
investment like Eurex, or ISV-based order routing sys-tems like
those offered by Trading Technologies and EasyScreen, are in use.
Some systems even allow a commonality of products such as cash and
futures for doing basis trading.
This electronic revolution has brought about a total dissolution
or disappearance of traditional models and loyalties, which have
been in place over the last 20 years. The financial services arena
is being reorganized and re-aggregated. Exchanges are becoming for-profit
entities. Heretofore unthinkable partners are working together in
consortiums. Firms are investing in a multitude of platforms because
the risk of not investing is greater than the risk of losing their
investment—if they miss the right platform, and that platform
gets a lock on the market, they are out forever.
While electronic trading has revolutionized the marketplace, the
biggest changes are yet to come as clients adjust to the world of
e-trading, firms reassess their roles and the financial services
industry shifts to accommodate the changes.
Are We in Tech Heaven?
Electronic distribution today is a very long way from offering
perfectly executed transactions, processed smoothly through the
clearing cycle from the client’s trading idea to its administrator.
Instead, it has created an enormous number of new challenges. While
firms have succeeded in creating systems to make the distribution
of their products cheaper, they have not necessarily made the life
of the client better.
The market has never been so fragmented. Initially, fragmentation
was limited to product—foreign exchange, fixed income, equity.
As different countries established markets and access became easier,
market fragmentation became geographical. Bonds, for example, could
be traded in many different countries—Treasury bonds, Eurobonds,
Japanese Government bonds. The proliferation of trading platforms
has now added a third layer of market fragmentation. Instead of
one or two or three liquidity pools, now there could be up to 20
per segment of market. According to the Bond Market Association
there are 67 systems in fixed income alone. And the electronic trading
systems are like t-shirts. They come in all sizes—small, medium,
large and x-large. They start from e-mail based systems—a very
primitive approach—to highly sophisticated negotiation and
pricing networks of servers with a wide range of analytical functionality.
It’s difficult for the client to keep current on all the systems
available, let alone decide which one to use.
And misconceptions abound. When people talk about the electronic
revolution, they automatically think that everything is happening
on the Web. This is still a dream. Ninety-five percent of the financial
services systems today are not Web-based. They are direct-line based
even if they are built using Java for instance. Contrary to what
everyone is assuming, very few systems make it to the Web.
The other misconception is straight-through-processing. Many claim
STP, few deliver. Most systems are still very hands-on, labor-intensive
processes. They are not real-time. They still batch trades in a
file to be recuperated and it can be a few days before the client
has a cleared position.
The idea that electronic trading saves money is also very often
an illusion. Many firms have to have two or three new assistants
on the desk to handle gaps in the electronic distribution system
(like allocation of trades for instance) or problems with individual
orders. In the electronic world, you shouldn’t have any reconciliations.
Some of the large asset managers have up to 100 staff members just
dedicated to doing reconciliations. The industry overall has huge
data mapping problems. Despite all this electronification, people
are still unable to agree that they bought or sold a certain set
of securities. Another frightening number is the failure rate of
cross-border trades—35 percent of fixed income trades and 20
percent of equity trades are failing, generating fail costs for
the asset management community in the billions of dollars.
The New Value Proposition for Wall Street
The business of major investment firms has changed. Historically,
financial services firms have operated like the Ford Rouge plant
of the 1930s. At that time, Ford was buying raw materials like iron
and coal and rubber, and controlled all the steps necessary to produce
the car—the steel mill, the tire factory, the company that
produced batteries and so on. Until recently, financial services
firms have owned product development, research, market making, clearing,
processing and distribution. Just like Ford with its vertical integration
approach, they offered one product. There was little market segmentation—financial
services firms generally delivered the same product to small and
large customers alike. The revolution in distribution with the advent
of the Internet has changed that model. Until recently, firms had
a lock on distribution through their massive sales forces. The cost
of building a distribution system—hundreds of sales people
around the world—was enormous. Today, electronic systems make
distribution relatively inexpensive and very precise in its targeting.
In the future, instead of internally producing all of the components,
firms are going to specialize in three key areas—advisory services,
which is an activity based on knowledge; market making, which is
really a risky activity based on the use of capital; and clearing,
which is an activity based on process management, technology and
capital. These three areas are all very concentrated on content—price,
market depth, research, calculators, and clearing information.
In the future, financial services firms will become more like movie
studios, which produce movies, but rely on other organizations to
distribute their movies to the theaters or to cable or network television.
Newspapers are distributed by distribution companies. Wal-Mart does
not produce any of the goods that it sells. Today, almost everything
major financial firms sell, they produce themselves. In the future,
we will see the creation of financial distribution supermarkets,
which will be possible now because it can be done on the Web. Like
other sectors of the economy, we will see a split between the content
on one side and the distribution of the content on the other side.
Firms who specialize in either distribution or content will be very,
very good at their specialty—a lot better than any non specialized
firm could be.
Firms will win by specializing which means they will forgo historically
integrated functions like “broadcasting,” or certain types
of distribution, infrastructure maintenance functions or even certain
market making functions if they are unprofitable. Secondary trading
of corporate bonds is relatively unprofitable so Merrill Lynch and
Goldman Sachs are creating an electronic exchange called BondBook.
They will keep the primary market, which is highly profitable, and
give away what is not profitable.
Firms will specialize in one or two of these three key strategic
areas. They will further act as an integrator of services. One firm
may not do any market making and instead rely on another firm that
is very good at market making, but it will still integrate the service
for the end-customer. Instead of hammering the same product to everybody,
firms will target the product very specifically to clients. They
will become a lot better at segmenting their customer base, an area
where they are currently relatively weak. Proctor & Gamble doesn’t
own the supermarket, but still targets certain audiences. When NBC
wants to reach teens, they produce a program for the teens. Banks
will do the same.
They won’t treat a small hedge fund like a large one or a
traditional asset manager like a CTA. They haven’t segmented
in the past because they didn’t need to—customers accepted
what they were offered. In the future, firms will have to be a lot
smarter to make the sale because customers will have more choices.
Like the software industry, firms will sell solutions instead of
products. A solution might be a mix of products. Or it can be on
the clearing side, a prime brokerage relationship.
Firms will need a different approach to pricing which reflects
this segmentation, offering tiered pricing by group of users. Firms
will sell the same basic service, repackaged slightly differently
with different prices, to different customers. This will become
more and more common in the market.
Sales forces will need to be organized in different ways. In this
new world, it is a lot easier for a client to switch firms. Without
personal contact, the product can become just another commodity.
Firms will need a new type of proximity with their clients. Firms
can’t just rely on their platforms. They will need a sales
force to provide daily coverage—talking to the client, showing
him the opportunities the platform provides. Strong technical staff
will connect the systems, making them work for the client, and responding
to their issues such as a client who is trading in three countries
wanting to have one statement. When a client has a problem, he will
call his technical representative who can analyze the situation
and offer a solution using all of the tools of the firm.
Client Demands
Clients want proximity. With platforms, proximity is lost, which
means talking to the client everyday. Instead, firms have to re-create
proximity through tools like research, distribution, chat and similar
methods.
The client is requiring more segmentation. A client doesn’t
want to be treated like everybody else. If he is a CTA, he wants
to be treated like a CTA. He wants to have something that is more
adapted to his needs instead of a global product, which is half-adapted
to his needs. What the customer wants also is flawless customer
support, deployment of systems and cross-selling so he can do a
lot of products at once. Clients want increasing interoperability—they
don’t want to be split having to call on five platforms in
five different ways. They want everything in the same place through
one distribution channel. They want to move from the very often
misused “Sraight Through Processing” concept to a “fire
and forget” concept—the client does the trade and everything
behind is done automatically, without any problems.
At least in the U.S., the customer is driving the revolution. Clients
are not going to allow the firms very much longer to create a maze
of communication links in their shop with 25 individual systems.
The multi-platform environment in each segment—three or four
in foreign exchange—three or four in treasuries—will stay
for the long haul despite a developing concentration. This calls
for a more cooperative approach between the buy side and the sell
side as everybody seeks more efficiency and reduced costs. A clear
need exists today...“build it and they will come.”
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