Lost in the supermarket

In the financial supermarket, some goods fly off the shelf more regularly than others. Equities and FX, traded in high volume, are similar to everyday groceries in that margins are slim, competition between providers is fierce and discounts are often available for bulk (buy two get one free).

The popularity of these small-ticket items might vary across the economic cycle or calendar year, like spring vegetables in season, but overall the retailers know they can get more stock from wholesalers at short notice, so at the high-volume end of the market the key value-add of the supermarket is to deliver access to a wide range of products at the lowest cost on a predictable and consistent basis. If the brokers are the supermarkets, and exchanges the wholesalers in this extended and possibly over-laden analogy, perhaps institutional investors are cast in the role of bulk purchasers of commodity products, increasingly forced to trawl a combination of retail and wholesale outlets, including the dark recesses of the cash-and-carry store, to minimise market impact. 

But some purchases are less frequent but no less essential. Credit and OTC derivatives instruments are perhaps more comparable to the deli counter (bear with me!). The retailer needs to offer a wide range of choice to attract a sustainable level of business because the goods must satisfy many a sophisticated palate. The average customer is going to be more selective when buying the Parma ham to go with his melon (and typically while a PM will have a particular bond issue in mind, a stock is just a stock). As such, retailers must offer a range of Parma, and indeed other hams, not to mention a smorgasbord of other meats, to establish and maintain their credibility to customers, because they know tastes vary both by customer and according to season. But the retailer expects to be compensated for holding a wider inventory by charging higher margins on the deli counter than in the fruit and vegetable hall. And because it is a premium, high-margin purchase, the customer is more likely to shop around rather than accept what's on offer at the supermarket. Just like independent delicatessens and butchers have survived longer on the high street than greengrocers, brokers in the fixed income or OTC derivatives markets trade on their ability to offer the best balance of range and price, either sourced or prepared on the premises. More variables, in short, add up to customised service and higher pricing.

But the economics of the fixed income and OTC derivatives markets are being turned upside down. After the global financial crisis, the financial supermarkets are no longer trusted to regulate themselves, either in terms of the range they offer, the prices they charge or the overheads they pay. The result could be a reduction in choice and a radical change in supply-side logistics and demand-side shopping habits.

Brokers identify at least three sources of change, not all regulatory. First, by effectively abandoning most structured product markets, buy-side clients have asserted a clear preference for flow products traded electronically, requiring brokers to make books and focus on managing risk more effectively. Second, the sell-side has seen volumes "sky-rocket" in the more established, most standardised, higher volume products like interest rate swaps and credit default swaps. Where there were perhaps five dominant liquidity providers in such markets there are now perhaps 15 serious players. This is forcing brokers to invest more in the technology required to advertise for and execute business electronically. Third, the ratcheting up of Basel's capital requirements over the coming decade is forcing banks to clear out their balance sheets, thereby reducing the ability or willingness of brokers to accept the execution risk represented by previous levels of inventory. Some brokers may quit making markets in fixed income and derivatives products altogether. The rest are reassessing their product range and delivery mechanisms at a pretty fundamental level. And everyone’s asking: who will fill the void?

With financial supermarkets in all probability offering a fewer products and less inventory in more of an equity-like ‘stack’em high, sell’em cheap’ client experience, many see a greater role for the buy-side in making prices as well as taking prices. Perhaps for whole swathes of more esoteric instruments, the future model might be less supermarket and more car boot sale.