Why have a cost-effective execution value chain?
Recent years have seen significant developments in financial products, regulation and technology which have fundamentally changed the institutional investment landscape and cost-benefit structure of the execution value chain. Investors have increased the use of passive investment products (such as index tracking ETFs) which in turn forces professional asset managers to examine and adjust their management fees, responding to competitive pressure.
Then came MiFID II, which forced further cost-benefit rationalisation on the use of brokerage services and specifically research. Both trends forced professional asset managers to itemise and rationalise their cost of doing business, more specifically the use of commission. This in turn translated to cost pressure on institutional brokers both in commission rates, as well as indirectly through the ability to “cost recover” against research analysts’ services previously sold as part of execution.
At the same time, trading operations of investment banks and brokers faced compliance issues (e.g. MiFID II, SFC ETD Regs) and regulatory scrutiny on top of new capital requirements originating from Basel III in the aftermath of the global financial crisis. This has increased operating costs as compliance departments added more staff and invested in regulatory technology.
At the same time, higher hurdle rates were applied to capital investments, putting IT projects and client onboarding under further scrutiny. The combination of these pressures has forced the sell-side to adapt and pursue a more cost-effective execution value chain.
This has fuelled automation and accelerated the migration of the traditional sales trading model (sometimes referred to as a high touch) to an electronic sales trading model (low touch). This trend started in the early 2000’s as means to improve execution quality and has peaked over the last five years as algorithmic execution proliferated and more brokers have migrated and merged their high touch trading desks with the low touch trading desks.
Aided by improvements in computing power, advancements in big data analysis and artificial intelligence (AI), firms cannot only reduce cost and increase efficiency, but also successfully manage an increasingly complex regulatory environment and the proliferation of new execution venues.
This first wave of automation of the execution value chain is now largely matured and we are about to enter the second phase: the outsourcing of commoditised components.
The evolution of the execution technology stack
The result of these “macro” trends yielded better efficiencies in the execution value chain, while improving overall execution quality and thus saving millions of dollars for investors. By some estimates investors have witnessed a 70-bps cost reduction in execution impact cost as a result of the more efficient execution value chain, even without taking reduced commission rates into account.
However, from a purely operational cost perspective, these efficiencies favour scale (i.e. large investment banks and brokers) as leveraging automation and high-tech trading for competitive advantage requires significant technology investments. The cost for developing custom, AI-based execution algos or an algo wheel is fixed, unrelated to the trading volume (and thus commission revenues) it generates. We see some evidence for the impact of these economies of scale in recent mergers of smaller Tier 2 & 3 execution brokers globally.
To understand the costs for developing an automated execution value chain, one needs to examine the components involved in creating it. Beyond the investment in developing an “in-house secret sauce” for the algo engine, a firm must also build a connectivity framework which enables its customers to connect to the algo and the algo to connect to target market(s). In addition, a monitoring framework is required to manage risk and compliance, and to provide IT and low touch sales traders the ability to manage and interact with the algos.
However, while the algo “brain” can be used as a differentiating factor for the firm, it is not as clear that the connectivity nor monitoring framework are; yet they carry significant development and maintenance costs. Until recently, most large firms rarely considered off-the-shelf software as a solution or as “building blocks” to accelerate and reduce internal development costs. But, as we are entering the second phase of the automation revolution, this is rapidly changing. Firms are adopting a more critical view on what should be built in-house vs. tools that can be acquired, and do so for good reasons.
Build? Buy? Both?
Examining why firms have opted to “Build”, i.e. developing proprietary full-stack algo trading technology rather than “Buy” the frameworks needed around the algos from software vendors, we have identified three main factors:
1) Availability – the fast pace of change in early years and the novelty of the automated execution desk meant that there were no built-for-purpose, off-the-shelf solutions available in the market.
2) Customisation – off-the-shelf solutions were not flexible or adaptable enough to easily onboard customers or manage changing exchange interfaces.
3) Performance – vendor products were lacking the throughput, capacity and latency required by an automated execution value chain.
These shortcomings are explainable, as most vendors have designed their offerings with serving the high touch execution value chain in mind. Such solutions were then augmented to address low touch monitoring as well, but implementations were typically awkward.
However, over the past three years, the automated execution value chain has matured, with a new generation vendor solutions emerging. Itiviti, for example, has developed a connectivity and monitoring framework, designed from the ground for low touch environments. With ample flexibility in the connectivity framework, onboarding has become much simpler and more configurable.
This framework is FIX-based but supports multiple protocols and is built to translate and enrich order flows. The monitoring framework is geared towards an “exception management” workflow, built to support automated execution systems with hundreds of thousands of orders and millions of executions.
With growing market complexity, increased competition and cost pressure, firms are looking to use their in-house development resources more efficiently. It no longer makes sense to build, maintain and manage a full execution technology stack unless this enables the firm to add clear value, draw competitive advantage, or leverage economies of scale.
Given the options at hand today, a more cost effective and business- focused solution is to focus development on areas where the firm can add value to customers, e.g. through intellectual property, and to source components where it does not.
There is a new generation of built-for-purpose tools which offer the flexibility, capacity, latency and throughput for supporting an automated execution value chain. This is a key reason why we are witnessing a rising demand for connectivity and low touch solutions from firms across different sizes. We expect this trend to continue over the coming years as the second phase of automation of the execution value chain matures.