Agency trading technology was traditionally very different from that used for principal trading. Greatly simplified, principal trading required extreme performance, while rich features and flexibility were key in agency trading. Now, this is about to change. But before we examine what is driving the convergence, let’s take a look at what originally drove them apart.
Principal trading involves a spread and trades are executed against the firm’s own inventory. Market making and arbitrage are two examples where extreme performance in terms of latency and capacity, and powerful position monitoring were key requirements. But as low-latency infrastructures became mainstream and the profitability of just being fast decreased, the cost of generating incremental speed became prohibitive and market participants started to seek new ways to differentiate their business. As a result, extreme performance is no longer enough and a more intelligent system is required.
Agency trading involves a commission and trades are executed externally. Also called customer-driven business, agency trading was originally less speed-sensitive than principal trading. Agency trading systems were designed for high flexibility and functional richness. However, as the complexity of trade processes and market structure increases and new regulatory requirements are introduced, more powerful agency trading technology is now required not only to remain profitable, but to remain in the agency trading business.
Regulation is now the biggest challenge facing the financial industry in general, and trading in particular. Regulation is also the main reason why agency trading and principal trading have recently started to converge, but it is not the only one. The following are some of the drivers behind this trend:
It is not a bold guess that MiFID II will profoundly reshape the markets when it comes into effect in 2018. The regulation will have a direct impact on both agency trading and principal trading. Some of the new regulations will affect principal and agency trading differently (High Frequency Trading will be a separate area, as will market making, affecting principal trading). However, most of the new regulations with have an impact on both agency and principal trading.
One example is the regulation concerning Algorithmic Trading (requirements to monitor the flow in real time); other examples are clock synchronization and pre-trade risk validation. MiFID II will also be an obvious and absolute driver for expansion to other asset classes such as derivatives and bonds. Regulation will also be a driving force to harmonize the market structure, making it possible to achieve economies of scope.
As always, market structure is constantly evolving. Historically, there has been a quantum leap every 7-10 years. It is not a bold guess that MiFID II will cause a quantum leap in market structure, due to the indirect effects of the new regulations. One example is the new Double Volume Caps and their immediate effect on market structure: innovation in terms of new trading models and a proliferation of Systematic Internalisers. These developments will make execution a considerably more complex exercise, both for investment firms engaged in agency trading as well as principal trading.
Remember Flash Boys and the heated HFT debate from a couple of years back? HFT was seen as the root of all evil, and terms like “fake liquidity”, “quote stuffing” and “gaming” were thrown around. there were probably some elements of market abuse involved in some cases. But the vast majority of the problems were caused by inadequate trading systems. Up against the extreme performance systems, many older systems instantly became obsolete, including those used for agency trading such as order management, market data and smart order routing systems. The rough awakening generated massive efforts to boost the performance of these systems by multiples of tens or even hundreds, in order to compete with the HFT-firms. Another way to compete was to build smarter systems, such as smart order routers with timing of orders and tick-data analysis in order to detect signs of gaming.
This expansion is both driven by regulations such as MiFID II and new market requirements. The latter became evident when the HFT space within equities became “crowded”, causing many HFT-firms to start trading FX. The change has been drastic; HFT is now estimated to account for roughly 80% of FX futures volume and two-thirds of both interest rate futures and Treasury 10-year futures volumes, according to the U.S. Congressional Research Service, April 2016.
It is clear that the boundaries between systems or platforms for agency trading and principal trading will be blurred going forward. Both categories must be flexible and functionally rich as well as fast, and here’s why:
To cope with ever-increasing demands on performance due to increasing transaction load, but also being able to make more decisions in a shorter time frame due to a more complex market structure.
In order to adapt the rules to different client demands and an increasingly complex market structure. Flexibility is crucial to achieve economies of scale and scope. Being able to adapt the system to accommodate multiple asset classes will reduce cost of ownership.
With any major shift in market structure, the competitive landscape will change. It is crucial to be able to adapt to new market models and leverage the firm’s comparative advantage. Flexibility is necessary but not sufficient. In order to be truly competitive, it is necessary to be able to adapt the system (components), while protecting the firm’s intellectual property.
For a take on the overall trends currently driving sell-side change, have a look at our recent trend overview “Sell-side evolution” here.
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