The financial services industry continues to be transformed by e-trading, trading pits closing, the popularity of passive/index investment products and the Dodd-Frank Act, among many other factors.
Five years from now, it will be unrecognizable from what we have today, according to Raj Mahajan, partner and the co-head of global execution services at Goldman Sachs who was speaking at the Trading Show Chicago 2016. This is how he thinks it will change.
The “electronification” of markets is big change that has lead to tighter spreads, says Mahajan. For example, the credit default swap (CDS) index was 90% electronic trading in 2015, while foreign exchange (FX) spot transactions were 80% electronic last year.
“The first step of the electronification of the markets is to replace a telephone,” Mahajan said. “You used to call up a broker and make an order; now we’ve created a universal protocol called the Financial Information eXchange (FIX) – a request for quote (RFQ) is similar.
“I’m going to send a message and solicit quotes – how do you go from that to a central limit order book? Is there a reference price?” he said. “They need a price they can lean on so that they can hedge. Anything in an RFQ platform, traders need to see the creation of a credible reference price so people will say ‘I don’t mind posting bids and offers because I know I can hedge it.’”
Mahajan noted the stratospheric growth of exchange-traded funds (ETFs) and index-tracking mutual funds. Of the $13 trillion in assets under management on the buy side globally, roughly 25% of it falls into the passive category.
ETFs seized 12% of buy-side AUM in 2005, which grew to 25% in 2015. Mahajan predicts that it will be 33% in 2020.
The advent of quantitative hedge funds and quant trading firms is another significant trend. They constitute about 14% of AUM, which has doubled since 2011.
Smart beta falls somewhere in between ETFs and quant funds, factor-oriented non-market-cap-weighted ETFs. It has been winning AUM largely at the expense of traditional hedge funds.
In addition, the rise of principal trading and e-market-making firms has had an impact.
“Rather than the traditional market-makers like Goldman, Merrill Lynch and Morgan Stanley, you have players like Global Trading Systems (GTS), IMC, KCG and Citadel,” Mahajan said. “What’s effectively happened, the role of liquidity provider has gone form specialists to those who can program servers.
“It’s become a computer science problem, rather than running an order book,” he said. “There’s a new generation of liquidity providers.”
“We’re going through a major disruption where data is allowing people to have leverage in the investment process,” Mahajan said. “BlackRock and T Rowe are launching or already have quantitative strategies.”
“Winning brokers will figure out how to capture revenues cost effectively using both technology and humans,” Mahajan said. “Is it possible to capture market share through leverage around technology?
“If the broker has world-class relationships, a prime brokerage arm and top-notch technology, the firm will figure out how to get operating leverage,” he said. “Those brokers will set the table for years to come and it will be impossible for others to catch up.”
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