Intertwined markets add complexity
Kevin McPartland, Head of Market Structure and Technology Research at Greenwich Associates, talks about how intertwined markets and new regulations are adding complexity on the buy side, spurring innovation and driving new investment strategies
The low-volatility environment that followed the financial crisis is over. Equity market volatility is up roughly 150% in the past year, with turmoil in Europe and China driving FX volatility to jump nearly as much. A potential rate increase from the US Federal Reserve has market participants increasingly on edge, with a low liquidity backdrop adding to the anxiety. And the continued presence of regulatory uncertainty around the world, despite progress with the Dodd-Frank implementation, leaves market participants at a crossroads. Is the current market structure here to stay, or will cyclical economic factors and still-unseen regulations further reduce returns and impact the banking business model?
Despite the uncertainty, institutional investors cannot wait until the final chapter is written before moving forward. Keeping cash on the sidelines is imprudent and, in many cases, impossible. This means portfolio managers and traders have to conduct business against an uncertain backdrop, with key questions around regulatory compliance, collateral costs, new product choices and liquidity risk.
The top-tier investment community is a smart bunch that is most certainly up to the challenge, but going at it alone isn’t prudent or necessary. With buy side headcounts holding flat, technology needs to step in and play a supporting role.
“Gone are the days when individual market investors can stick to their own silo”
Greenwich Associates estimates that the buy side spent $4.4bn on technology last year, including software, hardware, and infrastructure. This is up a modest 5% from the previous year, with each buy side trading desk now spending an average of $3.6m annually. Fixed income traders are the big spenders, accounting for 60% of that total. Persistent investor demand for fixed income exposure is driving the acquisition of both electronic trading and risk management systems.
Technology has played a major role in the life of an institutional investor for twenty years or more – this is nothing new. But as stated above, portfolio managers have a lot more to digest in 2015 than they did in 1995.
For instance, initial margin was once of very little interest to the front office, with the operations team ensuring money was moved as needed to confirm trading could continue. It rarely played a part in the investment decision; fundamentals or quantitative models drove trading with little heed paid towards the need and cost for posting initial margin to a clearing house. In fact, it can safely be said that not many on the buy side trading desk even knew what initial margin was.
“Greenwich Associates research reveals that over 80% of traders use derivatives alongside the cash products they primarily trade”
This is no longer the case – margin costs are a big part of investment choices for many institutions, particularly for funds that don’t generally hold much eligible collateral. Whereas portfolio analytics once measured the cost of trading as the bid/ask spread, today the cost of initial margin and other related fees must also be examined.
Lots of Products, So Little Time
This newfound focus on collateral costs has also driven investors to think harder about the best product to gain the exposure needed. Whereas a bond might have been the best option previously, today a future might be more suitable. And the buy side is increasingly using technology to help them make and execute those decisions.
Greenwich Associates research reveals that over 80% of traders use derivatives alongside the cash products they primarily trade. Traders are heavily leaning on futures, options, and swaps – in that order. Increasing regulatory and risk management concerns should continue to drive this trend. Derivatives are an ideal way to hedge positions, and with the rapid move to mandatory clearing of what were OTC derivatives, the transparency of pricing and the ease of straight-through processing are only going to grow.
The study also shows that, when broken down by asset class, the most frequently used products by traders are options for cash equities, futures for spot FX, and swaps for trading bonds.
There is no doubt that the evolution of trading desks over the past decade has pushed many buy side participants into new asset classes. More connected and efficient markets have opened up new investment frontiers for traders looking to maximize their desks’ potential.
“Portfolio managers and buy side traders care about things they didn’t care about before. They now need not only new data to ensure they’re fully informed, but more importantly tools that turn that firehose of information into actionable ideas”
And while product choices within each asset class expand, investors are increasingly looking to multiple asset classes to find returns and hedge risks. Gone are the days when individual market investors can stick to their own silo – the global economy is now so intertwined that trading equities while ignoring FX, credit, or rates can significantly reduce returns.
Greenwich Associates research shows that 68% of equity, fixed income, and FX traders operate in multiple asset classes. The most diversified among these groups were equity traders, with 72% trading more than one asset class, while only 62% of FX traders reported doing so. Ironically, our research also shows that FX is the asset most frequently traded with other classes, with nearly half of the equity and fixed income traders involved in FX as well.
Innovation from Crisis
Portfolio managers and buy side traders care about things they didn’t care about before. They now need not only new data to ensure they’re fully informed, but more importantly tools that turn that firehose of information into actionable ideas. The financial crisis of 2008 caused a lot of headaches for institutional investors, but it was also the catalyst for a tremendous amount of innovation that will ultimately leave the buy side more informed and better able to generate returns for their clients.