The cost of operating in the post-MiFID marketplace has become prohibitive for all but the largest brokers. There is, however, a new operating model that tackles these cost barriers head-on and makes it possible for regional and specialist brokers with a strong client service proposition to compete fully with larger firms.
When MiFID launched on 1 November 2007, its intentions were clear – to create a harmonised and transparent pan-European securities marketplace, where competition flourished, old monopolies vanished, trading costs tumbled and transparency thrived. But for brokers the reality is that the post-MiFID market structure has proved alarmingly expensive for all but the largest players.
The days when brokers could base the bulk of their business on a single exchange are effectively over. Now in the post-MiFID era, brokers have to connect to an increasingly wide variety of venues in order to meet their ‘best execution’ obligations. In London, more than 45% of trading on the FTSE 100 takes place on alternative venues such as Chi-X, Turquoise and BATS Europe. The Euronext markets (Paris, Brussels, Amsterdam and Lisbon), Germany and Switzerland are all fragmenting, and the launch of the Burgundy MTF has accelerated similar changes in the Nordic markets.
Those brokers still trading only on their ‘home’ exchanges are wondering for how much longer this business model will be sustainable. More and more buy-side clients are enquiring about best execution and using transaction cost analysis to verify the efficiency of execution. But if regional and specialist brokers were to follow the path of the largest firms and adopt a comprehensive multi-venue trading strategy, it could prove to be financially ruinous, given the extensive investments that need to be made. Consider the shopping list below, every item of which is likely to be necessary for an effective implementation approach:
- Membership of all major MTFs as well as the relevant exchanges
- Low-latency links to all of these venues
- Links to the clearing providers for every MTF and exchange
- Smart Order Routing to ensure best execution
- Transaction Cost Analysis to prove the quality of execution
- Audit database software to produce a five-year record of trading activity
- Greatly increased volume of market data and the different data formats of each provider
- Trading platform upgrades and updating gateways to execution venues
- Continual system change to maintain and manage all of the infrastructure and software listed above.
Should I stay or should I go?
So how can smaller brokers move forward, given that doing nothing is probably not a sustainable option? One option, which avoids large investment costs, is to outsource the execution side of their business to a larger broker, but there are long-term considerations that argue against this as a strategic choice.
Fortunately there is now an alternative option for brokers, where they can outsource many execution-related processes but still retain complete ownership of their client relationships through the selective use of pure-execution brokerage services.
The death of the traditional business model
The traditional trading technology model of LAN-based workstations and gateway links to the main execution venues worked well as long as there were a limited number of execution venues, but the post-MiFID securities landscape has made it too expensive for many brokers to maintain direct links to all venues.
The traditional trading technology model to manage fragmented liquidity
A solution for many firms, illustrated in the diagram, has been to employ their own smart order router and connect to hosted services delivered via the ‘cloud’ – SunGard’s global network being the example here. The network can provide all the physical links to trading venues via mutualised gateways installed close to each one, thus removing this burden from the brokers while leaving them with the responsibility of choosing which venues to trade with, courtesy of their own routers, algorithms and market memberships.
Adopting such a model gives specialist brokers the same capability as their largest competitors, and leaves them with the ability to make their own trading decisions. But by employing their own smart routers and algorithms, these firms are committed to significant and expensive maintenance and upgrade programmes as new venues emerge and the technology develops further.
A smarter route
The new operating model to manage fragmented liquidity
The operating model of the future, illustrated in the second diagram, addresses this challenge by moving the full trading technology complex into a software-as-a-service model. The broker will connect to a global trading network stored in the cloud which caters for all aspects of the trading process – smart routing, algorithms, and the links to all exchanges, MTFs and dark pools.
So, for example, the broker would be able to send a VWAP order to this network, requesting that the order be traded for best execution across four venues. The technology partner would then take care of all the algorithmic processing and trading connected to the order.
By using this model, brokers outsource some aspects of their execution service, such as the fine-tuning of smart-routing algorithms, but retain the service-based elements, such as their current exchange memberships. Meanwhile partnerships can be formed with other specialist brokers to execute on any new venues or markets, so the smart router effectively chooses the broker as well as the market for each order that it sends. Any costs involved in these third-party memberships and the associated smart routing can be based on trading volumes.
This is the first market offer that really opens up the fragmented securities landscape to regional and specialist brokers, enabling them to compete with larger rivals at a manageable cost. They gain access to all trading venues without having to add to their fixed costs, in contrast to the expensive ‘shopping list’ presented above. Further, these brokers will be well placed to respond to further change in market structure: they have no fixed investments in specific trading venues and smart routing logic, and changes are effectively ‘free of charge’.
If you want more information on this subject, visit www.sungard.com/globalelectronictrading and download a white paper on how to manage the fragmented European liquidity.
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