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“ Preparing for the Future ” An outline of critical industry issues and emerging trends

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“ Preparing for the Future ” An outline of critical industry issues and emerging trends

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  1. “Preparing for the Future” An outline of critical industry issues and emerging trends Presented by Larry Tabb Founder & CEO TABB Group

  2. Agenda • The 4 Macro Trends • Hedge Funds • Regulation • Exchange Consolidation • Dark Pools • Cost • Conclusions

  3. The big picture – The 4 major macro market trends

  4. Net corporate equity issuance hit a 20year negative record as companies buy-back stock

  5. Foreign markets over the past 2 years have outperformed the US market India Korea China DAX Japan CAC HK FTSE S&P 500

  6. Derivatives business are all at record levels

  7. While mutual fund growth impressive, hedge fund AuM growth has not escaped notice Hedge Funds vs. Mutual Funds AuM CAGRs AuM growth of Hedge Funds vs. Mutual Funds (in $US trillions) Long Only Value Model .75 to 1.5% AuM Hedge Fund Value Model 1% to 2% AuM plus 10% to 20% of profits Source: TABB Group “Institutional Equity Trading 2006 – Preliminary

  8. Hedge Funds

  9. Over half of managers have hedge funds & 17% more plan on launching one in next 2 yrs Institutional managers launching hedge funds (2006) Institutional managers planning on launching hedge funds by ‘08 Source: TABB Group “Institutional Equity Trading 2006 – Preliminary

  10. 91% Individuals 93% 63% FoF 64% 47% Institutions 63% 45% Trusts 47% 41% Endowments 44% Corporate Pension Plan 32% 38% Public Pension Plan 17% 27% HFs inflows are becoming more institutional 2 Year Change Who are your investors ? 2006 2008 Source: TABB Group study “Hedge Funds 2006: The Quest for Alpha in an Increasingly Competitive World

  11. Market has been challenging for hedge funds as they look to alter their strategies Percentage of Hedge Funds Making Strategy Changes in the Previous Year Single vs. Multi-strategy Funds Source: TABB Group study “Hedge Funds 2006: The Quest for Alpha in an Increasingly Competitive World

  12. The bulk of hedge funds are adding strategies and looking globally for alpha What Changes Were Made? Source: TABB Group study “Hedge Funds 2006: The Quest for Alpha in an Increasingly Competitive World

  13. Funds are investing abroad and looking at other kinds of asset classes Additional Geographies and Asset Classes: Past and Present Source: TABB Group study “Hedge Funds 2006: The Quest for Alpha in an Increasingly Competitive World

  14. Most dramatic order flow shift will be from internal algos to DMA & broker-sponsored algos Unweighted Order Allocation (Equity Only) CAGR Source: TABB Group study “Hedge Funds 2006: The Quest for Alpha in an Increasingly Competitive World

  15. Regulation NMS

  16. What are the National Market Structure Regulations of 2005? • The NMS regulations revolve around 4 major platforms • Order Protection Rule (trade-through) • Access rule • Sub-penny rule • Market data rebate policy change Source: TABB Group

  17. NMS forcing exchanges to move toward electronic trading • NMS states that firms need to preference fast markets over slow ones • Need to route to hybrid or ECNs over floor • Incenting development / acquisition of a number of electronic exchanges and ECNs • Announced electronic exchange efforts • NYSE (hybrid), PHILX, BEX (Bos), Chicago, NSX (Cincinnati), Amex (hybrid & electronic) • New or newly acquired ECNs • Attain => Knight • OnTrade (NexTrade’s ECN) =>Citi • BATS

  18. The NYSE Hybrid-Market, while electronic, is NOT an ECN • Trading in parity • Specialist Algorithms • Reserve Orders • Speed • Pricing • NYSE already beginning to lose order flow • Market share below 70% • Lowest in the 29 years they have kept stats Source: TABB Group

  19. Unbundling / Soft Dollar Regulations

  20. PS 05/9 – FSA-based unbundling regulations • Limit commissions to the purchase of • Execution & research services • Requires IMs to disclose • How commissions payments have been spent • What services have been acquired with them • Promote competition between research producers by • Removing distinction between brokers (bundled services) • Third parties providers (soft services)

  21. Included / excluded • Excluded Services • Dedicated phone lines • Seminar fees • Subscriptions for publications • Travel, accommodations, or entertainment costs • Office admin software or word processing or accounting software • Membership to professional organizations • Purchase or rental of office equipment or facilities • Employees salaries • Direct money payments • Publicly available information • Custody services • Included • Research services (original research only) • Execution services • Excluded • Raw data feeds (without modification from the exchange) • Post trade analytics (to the extent that analytical software meets “research service” criteria because it assists in the making of an investment or trading decision, it could be paid for with soft dollars • Valuation or performance measurement software • Computer hardware • Dedicated phone lines

  22. 7% 7% 10% 17% 7% 21% 33% 20% 33% 18% 30% 40% 17% 13% 25% 17% 26% 70% 47% 47% 36% 33% 26% '04 '05 '04 '05 '04 '05 Large Medium Small Down None Stable Up Greater number of large firms banning soft dollars Money Management Soft Dollar Trends Source: TABB Group Institutional Equity Trading 2005

  23. Bundled & soft payments to brokers expected to drop while internal, indy, and hard $ payments to rise Expected Volume of Research by Payment Type Source: TABB Group “The Future of Equity Research”

  24. Exchange Consolidation

  25. From whence we come NYSE NASDAQ Brut Instinet Knight Instinet NASDAQ Island Citi Arca Arca Attain Redi Strike Brut TradeBook NextTrade BATS

  26. Where we are headed

  27. Order flow to sales desk continues to decline as traders direct more flow to e*channels Shares by execution venue (share weighted) 2 Year CAGR Source: TABB Group “Institutional Equity Trading 2006 – Preliminary

  28. A convergence of events forcing exchanges to look outside of themselves • Exchanges are going public • Forces these organizations to • Be more efficient • Grow revenues 10% to 20% annually • Can’t do that, trading the same old products • Crossing networks are expanding significantly • Liquidnet has hit 60+ million shares per day and Pipeline over 25million • Internal crossing • Brokers matching order flow internally • Market share stats • NYSE loosing almost 1% market share per month dropping from 90% in ’04 to less than 63% Sept ’06 (including Arca volumes)

  29. Reg NMS, economics, and technologies are poised to change exchange economics • Incentives set up for NYSE / NASDAQ to lose share • Top of book protection incents more market centers • 6 protected orders are better than 2 • Market data rebate changes allows exchanges to rebate tape revenues • Greater tape rebates by regionals will incent brokers to put limit orders in regionals • Routing engines work from fastest to slowest • High speed exchanges trade at 5 to 10 milliseconds • Hybrid project to be 500+ milliseconds • Routing engine can ping Inet 100times before NYSE responds • If limit orders move to edge and routing engines execute from edge in • Fewer shares in center • Liquidity will even out • NYSE & NASD will lose share • That is why LSE / Euronext is vitally important !!!!

  30. Because of this, US market centers are in global expansion mode • Elephant dance • NASDAQ acquired 25%+ of LSE • NASDAQ has veto ability to kill any acquisition deal • NYSE for Euronext • Challenged by Deutsche Bourse • Price expected to escalate • Both exchanges paying top dollar • Other activity • Significant investment in new equity exchanges in US & a little in UK • New Equity Exchanges • ISE, Phila, Boston, CBOT, & Plus Markets (UK) • Moves to develop derivatives exchanges • New Options Exchanges • NYSE/Pacific, & NASDAQ

  31. Europe is the next battle ground because • European markets are basically still a monopoly • Little inter-market competition • Sarbanes Oxley forces firms to list overseas • NYSE / NASDAQ need marquee names • Out of the IPO gate they need a big name • Asia is too far away to make a big splash except for Tokyo • Japanese will not give up the TSE – no way • LSE & Euronext are the marquee brands • Euronext has many valuable pieces • Euronext Liffe – 3rd largest derivatives exchange • MTS – Largest sovereign debt electronic trading platform outside of US • LCH Clearnet – London & Pan-European securities depository (45.1% interest) • Paris, Brussels, Lisbon, & Copenhagen Stock Exchanges • GL Trade – provider of order management software • Joint venture with Atos to sell and implement exchange technology and provide general trading technology integration services • LSE is the largest European stock exchange

  32. LSE/Euronext are however – very expensive Euronext & LSE 1 year performance • Euronext / LSE performance +60 to +100% over last 12months • Acquirers performance weaker than targets • Deutsche Boerse up 40% NYSE performance up 20% • Nasdaq down 20% • NASDAQ acquired 25.1% making it difficult for NYX • NYSE being out flanked by Greifield and NASD • NYSE turn sites to Euronext • Significant questions on whether Regulators and Politicians will let this happen at all NYX, Nasdaq & Deutsche Boerse 1 yr performance

  33. Darkpools

  34. Dark pools & crossing networks match order flow on its way to the exchange Proprietary External Order Flow Retail Institutional Market Making Transient Flow Dark Pool Prime Broker Resident Flow Traditional AM DMA Algo Phone Matched Unmatched FIX Executions Market Centers Source: TABB Group

  35. Dark pools change market structure from exchange to OTC market • Benefits • Price improvement (generally mid-point pricing) • Lower execution cost – no exchange fees (only printing) • Less market impact (no one see order) • Larger executions (average print < 400 shares) • Challenges • No or less visibility • Can be difficult to interact with order flow • Less price discovery / competition

  36. Pipeline Pipeline MatchPoint NYSE LeveL BIDS Pool Goldman Sigma X Citigroup, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, UBS Citigroup, Lehman Brothers, Merrill Lynch, Credit Suisse , Fidelity Brokerage Credit Suisse Cross Finder UBS PIN ACE Citadel Ex Svs Citadel CitiGroup Arca Opening Cross Lehman ATS Lehman ATD Liquidity Ping State Street Knight Lattice Knight Match Dark pools & crossing nets are fragmenting as at least 29 are in or near production in US Open Intraday Nasdaq End of Day Cross Merrill Posit Now Block Alert Posit Match ITG Instinet VWAP Cross Intraday End of Day Continuous Natural Millennium NYFIX H20 Liquidnet Liquidnet Morgan Lava Lava ATS Source: TABB Group, Companies, Fidelity Capital Markets

  37. Market 83% 9% Structure Liquidity / Fragmentation Lack of 9% Transparency 8% Algo Overload Cost 8% Regulatory 4% Environment Trade Size 25% Fragmentation will increasing be the key industry challenge Buy-side trader most significant challenges • Fragmentation • 12 exchanges or significant ECNs • 29 unlinked dark pools • Countless algorithms • Inability to do size • Solutions are • Crossing networks help but… • Too much of a good thing • DMA/Aggregation technologies • Cost of market data and infrastructure make development difficult • Algorithms • Cause further fragmentation 2005 Source: TABB Group – Institutional Equity Trading in America 2005

  38. There is a new business in developing dark routing strategies • CS, ITG, Instinet, Piper, Lava, and other have developed dark routers • The challenge is • Crossing logic • Different for all dark pools • Transient orders • Taking liquidity is easier than placing • Resident orders • Need to be careful with resident orders • Who is in the queue ahead of you? • What happens to the order if there are multiple resident orders? • Time Priority? Commission Priority? Broker Priority? Parity?

  39. It about cost

  40. The cash equity business is becoming about cost Share Volume By Destination • No and low touch trading comprises over 40% of share trading • Price per share of low touch trades can get below .5cents per share • Broker loss ratios getting increasing • Exchanges are raising their prices Source: TABB Group – Institutional Equity Trading in America 2006

  41. Commission pressure over past year has been significant (especially in electronic channels) % Decrease ’05 to ‘06 Average per share costs (pennies) -4.0% -21.0% -10.0% -28.0% -38.0% Source: TABB Group “Institutional Equity Trading 2006 – Preliminary

  42. Thinning broker ranks • Because of economics and regulation • Brokers can’t make significant money in cash equities • Lose ratios up • More volume going through low touch • Research model is broken • SEC pushing best execution • Buy-side firms are conflicted between • SEC Best execution obligations • Fiduciaries looking for commission recapture • Portfolio managers looking to pay research bills • Changing dynamics • Largest brokers will manage executions • Medium brokers will be challenged • Smaller brokers will become research houses paid by larger brokers

  43. Broker Executions Allocations 10 10 10 10 10 10 10 10 10 100,000 Custodian 100,000 400,000 40 100,000 Trading desk 100,000 Broker Executions Accounts/Portfolios Allocations 100,000 100,000 Aggregation 400,000 10 100,000 Trading desk Custodian 100,000 Buy-side clearing – just smoke or is there heat? Accounts/Portfolios

  44. Conclusions • Flat yields and lack of US Investment returns forcing funds to change investment strategies and mechanisms • New markets, products, strategies and technologies • As clients change, exchanges are changing as well • Dealers don’t want to be locked in so they are investing • This is fragmenting the market, making it more difficult to trade & settle • Fragmentation pushes firms toward electronic solutions • As trading becomes more electronic, efficiency and cost becomes much more important • As cost becomes primary driver firms into more complex and lucrative products

  45. “Preparing for the Future” An outline of critical industry issues and emerging trends Presented by Larry Tabb Founder & CEO TABB Group