Opening the doors on 12 months of change

Buy- and sell-side firms across much of Europe and North America face a period of austerity in 2012, as de-leveraging of the banks and a cooler economic climate combine to place pressure on business models, staffing levels and remuneration decisions.

Buy- and sell-side firms across much of Europe and North America face a period of austerity in 2012, as de-leveraging of the banks and a cooler economic climate combine to place pressure on business models, staffing levels and remuneration decisions.

Regulation is likely to be one of the key themes of the next 12 months, with Dodd-Frank and the Volcker rule in the US, and MiFID II and the European markets infrastructure regulation (EMIR) in Europe all contributing to the challenge ahead. And while political and regulatory developments will shape the coming year, many commentators believe so too will the fragmentation of trading venues and the restructuring of investment banking across much of the developed world.

In Europe, immediate concerns include the uncertain fate of the euro given the sovereign debt crisis, the possible introduction of a controversial financial transaction tax in France, and the potential loss of the UK’s dominance as a European financial centre following a UK veto of a new European Union treaty last year. In the longer term, low equity trading volumes are a cause for anxiety, especially since reforms conducted as part of government initiatives such as the Vickers Report, which will enforce a separation between investment banks and commercial retail banks, are already being severely criticised.

“The Vickers Report could cost the UK up to £8 billion per year whilst still potentially failing to achieve the reduction in risk it is intended to produce,” said independent financial markets consultant Chris Skinner. “The idea of keeping the commercial and retail banking system ‘safe’, by ring-fencing it from the investment markets, is not something most people accept or believe.”

This year will also see the finalisation of EMIR, which will empower regulator the European Securities and Markets Authority (ESMA) to take a more prescriptive role in supervising Europe’s securities markets. EMIR is also intended to help reduce systemic risk, by moving more OTC derivatives onto centrally cleared platforms.

European high-frequency trading (HFT) also faces legislative pressure, with potential constraints on HFT firms’ ability to participate in the market being considered under MiFID II. Despite a desire from regulators to ensure market stability, observers such as Societe Generale worry that anti-HFT measures could see liquidity could crash even harder.

Tough times ahead 

Simmy Grewal, analyst at Aite Group, believes that the months ahead are likely to be tough for many buy- and sell-side firms, especially in developed western markets. “I am fairly pessimistic about the outlook for the European markets in 2012,” she told “I am not confident that regulators have the resources or the expertise to deal effectively with the difficult financial environment that we currently find ourselves in.”

Pointing to already-low equity trading volumes, she suggested the impact of regulations such as the financial transaction tax, which may be applied across the EU except the UK, could be highly damaging to liquidity and trading volumes across Europe’s securities markets.

Many observers are agreed the cost of regulatory compliance has increased dramatically – and not just in Europe. Preparations for the US Volcker rule, which effectively bans proprietary trading by large banks, have been particularly singled out. Brad Hintz, an analyst at Sanford C. Bernstein, has predicted the Volcker rule will cost Wall Street’s fixed income desks a 25% decline in revenue and a 33% reduction in pre-tax margin, while Skinner points out that Wall Street already lost 200,000 jobs in 2011 and will likely lose more in 2012.

Other legislation has also caused controversy. The European Commission has suggested measures as part of MiFID II that could require any firm that operates a trading algorithm to remain in the market regardless of prevailing market conditions – a move that has been particularly singled out for criticism.

“Some of the more outlandish suggestions, such as the application of market making obligations to all users of trading algorithms, should really never have been proposed in the first place,” said Grewal. “Whilst regulators have said they are open to feedback from the industry on this issue, it is alarming when you consider with what little understanding some of these proposals are put forward.”

The politicisation of the market structure debate since the financial crisis has negative effects, according to Alison Crosthwait, director of global trading research at agency broker Instinet. “Motivated by media attention and the re-election needs of politicians, there can be little incentive to take the time to understand what is truly at stake in these debates,” said Crosthwait.

This often results in proposals that would have “dire impacts” on capital markets, including speed limits on orders, minimum order duration and regulatory charges on message traffic, as well as the financial transaction tax, which would likely dramatically increase transaction costs, she insists.

Fragmentation or consolidation? 

This year, many European markets are expected to become interoperable for clearing. Merged multilateral trading facility (MTF) BATS Chi-X Europe became the first venue to offer four-way interoperable clearing, on 6 January 2012, which offers the prospect of significant cost reductions in European equities trading through greater post-trade competition.

However, questions abound over the extent and desirability of trading venue and liquidity fragmentation – with BATS Chi-X Europe accounting for a quarter of Europe’s equity market share, it is possible to foresee both a temporary consolidation of liquidity, as well as a possible second wave of competition from smaller firms such as Quote MTF. But the current cloudy economic outlook in European countries could set back progress by a year or more, given the lack of available capital for new enterprises.

Europe’s dark MTFs and broker crossing networks increased their collective volumes by 50% over 2011. With market structure issues and greater transparency taking priority in the aftermath of the financial crisis and the so-called flash crash of the Dow Jones Industrial Average on 6 May 2010, the proper role of light versus dark trading is likely to remain a contentious issue. The creation of a new class of trading platform under MiFID II, the organised trading facility (OTF), and the introduction of new controls on broker dark pools, have led some observers to predict that more brokers will take up MTF status, leading to further fragmentation.

A new normal 

Turning to the west’s major financial institutions, with many firms cutting back staff across their investment banking businesses, uncertainty about the future remains widespread. Some observers have expressed hope that 2012 will be a better year than 2011. But to anyone hoping for a timely reversal of fortunes, Grewal has a warning. Drawing on comparisons with the layoffs 2008 and 2009, which were followed by a period in which many firms re-hired much of the staff they had previously cut, she suggested history should not be allowed to repeat itself.

“The banks need to understand that they are never going back to the days of abnormally high returns and high pay,” she said. “The whole risk culture in banking is changing, and we are no longer living in a period in which it is considered acceptable to glorify high risk by rewarding it with such high pay. Change is coming, but it will not be easy for many in the industry to accept.”

Crosthwait at Instinet agrees. Headcount reductions and consolidation of business may not be enough to counteract the collapse in profits, she suggests. Her verdict? “All of us in the industry will have to work harder and adjust to new compensation realities.”