Sell Side Story
22nd March 2017
As the capital markets have changed, so too has the relationship between the buy and sell sides. Mark John of BNY Mellon’s Pershing explains
Image: Shutterstock
Pershing recently released its capital markets technology paper, in conjunction with Aite Group, examining the relationship between the buy and sell side in the current market. How has the environment these firms are operating in changed?
If you go back about five years, there was a real sense of what buy-side firms wanted to get out of their service providers on the sell side. People got quite emotionally charged about this, and there was increasing frustration from buy-side participants that weren’t getting what they wanted.
We have monitored the buy- and sell-side agendas, and the two worlds have started to move in independent directions, but they still cross over at so many different touch points. It is becoming clear that, given the state of regulation, technology, the market, volumes and demands, there is a lot more pressure on the buy side, which leads to the buy side putting pressure on the sell side.
Those on the sell side are very capable at providing their services, but they have their own challenges in the face of regulation. In order for the sell-side to keep its house in order, it has to prioritise staying compliant. There is a finite amount of resources and capability, and while there is a huge amount of demand from the buy side, prioritisation means that this demand isn’t necessarily being met, and the buy side remains frustrated.
At the same time, the buy side is starting to develop into a more mature part of the market, taking more control and doing things itself without the support structures previously required from the sell side. We have seen a lot more buy-side firms taking control of their execution capabilities for example, and more client-to-client business and venues emerging where transaction liquidity can be traded. This almost disintermediates the sell side as a liquidity provider.
However, accessing these parts of the market carries obligation. It’s technically complicated, with more infrastructure in terms of the middle and back office, and things that were traditionally provided by the sell side and sold as a package service to the buy side will have to be provided in house. That level of sophistication is not there at the moment.
There is a clash of priorities, here. The buy side has historically led the market in outsourcing parts of its non-core functionality, however the next stage of evolution for them is to start providing these services for themselves. We are at a crossroads, and the paper highlights that conversation.
The paper states: “Compliance puts the brakes on innovation.” How?
Buy- and sell-side firms want to provide solutions for sophisticated audiences, generate more revenue opportunities and improve their service. All of this falls under the banner of innovation.
This is being stifled at the moment because in order for those firms to move to the next level they need to make sure they get the current level right. That means keeping up with the trend of changing regulation and getting ready for the second Markets in Financial Instruments Directive, the capital markets union, the European Market Infrastructure Regulation, and all of the reporting that goes with them.
That is where the industry is stuck right now. We haven’t come out of this chapter yet, and we have not yet quite delivered on all of the market regulation to become compliant under the new regime. The industry is struggling to get to innovation until we have sorted out this alphabet soup of regulation we have to get through.
Hasn’t the regulatory environment encouraged innovation as well?
This is forced innovation. If we look at technology as a whole, and bear in mind that regulatory technology is one part of that, technology in this space has advanced at a snail’s pace over the years, both on the buy and sell side.
Some of the core processing systems in use today have been running for well over 20 years. Previously those systems may have been upgraded once every few years but they can’t cope with the pace of change that is required now—the financial services industry has been hit with a tidal wave of change, and the technology is certainly feeling the strain.
Regtech was a necessary outcome of that, because these changes cannot be made on a manual basis. The level of automation, control and governance that needs to be employed in order to deliver a compliant service requires technology. Regtech and forced innovation go hand in hand.
How do big data and analytics fit alongside data protection regulation?
Big data is the product of all the information we are creating, and we are dealing with so much more information than we ever have before.
Anything and everything we do in the industry has to be transparent and efficient. The depths of information you must analyse and process in order to achieve that level of transparency are immense. Any data has to be protected. But when you have huge amounts of data, while the fundamentals don’t change, the complexity of protecting such a volume of data does.
One challenge is that data privacy laws differ depending on the jurisdiction. We are seeing some alignment under the EU’s General Data Protection Regulation (GDPR), and it would help if rules were to increasingly converge on a global basis. Many buy- and sell-side firms operate cross-border, and have to understand the rules of every jurisdiction they are in, stay on top of any changes, and know how the rules apply to them.
Another point is that while firms are creating and storing all of this data, are they going to use it to try to better understand their clients and help them make decisions? There is some discrepancy between what firms have to do and what they could be doing, given the time and the resources to focus on their data rather than on the regulation. Again, resources are diverted from where they could be best used.
How are firms managing the costs of all these challenges?
All of this comes at a cost. Policing your own service, providing greater transparency, greater systems, greater controls, greater governance, plus the information that needs to be captured, monitored and reported on, all brings increased costs.
This is against a backdrop of volumes in the market that are going down, or at least remaining at historic lows, and so the opportunity to generate revenues and offset those costs through a highly lit, high-volume market just isn’t there. There’s an imbalance here.
I don’t think this can be addressed other than by creating, or trying to create, new ways of generating liquidity, and that is where the buy-side firms are trying to gain more control for themselves. If the buy side is able to generate access to liquidity on a buy side-to-buy side basis, that’s a way to stay in the game, as it could be much more efficient.
Again, however, this is new, and so it requires innovation, which requires cost. It becomes a vicious circle.
Between regulatory and cost challenges, and the shifting roles of the buy and sell sides, who do you anticipate will emerge victorious?
If a sell-side firm sees an opportunity to invest heavily in increasing the quality of the complex services the buy side requires, then that is a viable route it could take—providing a service above and beyond what is needed for regulatory compliance.
On the other hand, if a sell-side firm chooses not to do anything, then there is an opportunity for smart, sophisticated and innovative buy-side firms to step in.
Buy-side firms are not created equal. There are those that develop and invest in their future infrastructure and there are those that do not. Those that don’t innovate internally will likely find themselves trying to access a much smaller pool of sell-side liquidity. Buy-side firms will either pay out more money to invest in their own infrastructures or end up paying more for services they’re already getting, as those services become more commoditised and specialist.
We will see a changing landscape with some restructuring, refocusing and reprioritising, and there will be winners and losers on both sides.
If you go back about five years, there was a real sense of what buy-side firms wanted to get out of their service providers on the sell side. People got quite emotionally charged about this, and there was increasing frustration from buy-side participants that weren’t getting what they wanted.
We have monitored the buy- and sell-side agendas, and the two worlds have started to move in independent directions, but they still cross over at so many different touch points. It is becoming clear that, given the state of regulation, technology, the market, volumes and demands, there is a lot more pressure on the buy side, which leads to the buy side putting pressure on the sell side.
Those on the sell side are very capable at providing their services, but they have their own challenges in the face of regulation. In order for the sell-side to keep its house in order, it has to prioritise staying compliant. There is a finite amount of resources and capability, and while there is a huge amount of demand from the buy side, prioritisation means that this demand isn’t necessarily being met, and the buy side remains frustrated.
At the same time, the buy side is starting to develop into a more mature part of the market, taking more control and doing things itself without the support structures previously required from the sell side. We have seen a lot more buy-side firms taking control of their execution capabilities for example, and more client-to-client business and venues emerging where transaction liquidity can be traded. This almost disintermediates the sell side as a liquidity provider.
However, accessing these parts of the market carries obligation. It’s technically complicated, with more infrastructure in terms of the middle and back office, and things that were traditionally provided by the sell side and sold as a package service to the buy side will have to be provided in house. That level of sophistication is not there at the moment.
There is a clash of priorities, here. The buy side has historically led the market in outsourcing parts of its non-core functionality, however the next stage of evolution for them is to start providing these services for themselves. We are at a crossroads, and the paper highlights that conversation.
The paper states: “Compliance puts the brakes on innovation.” How?
Buy- and sell-side firms want to provide solutions for sophisticated audiences, generate more revenue opportunities and improve their service. All of this falls under the banner of innovation.
This is being stifled at the moment because in order for those firms to move to the next level they need to make sure they get the current level right. That means keeping up with the trend of changing regulation and getting ready for the second Markets in Financial Instruments Directive, the capital markets union, the European Market Infrastructure Regulation, and all of the reporting that goes with them.
That is where the industry is stuck right now. We haven’t come out of this chapter yet, and we have not yet quite delivered on all of the market regulation to become compliant under the new regime. The industry is struggling to get to innovation until we have sorted out this alphabet soup of regulation we have to get through.
Hasn’t the regulatory environment encouraged innovation as well?
This is forced innovation. If we look at technology as a whole, and bear in mind that regulatory technology is one part of that, technology in this space has advanced at a snail’s pace over the years, both on the buy and sell side.
Some of the core processing systems in use today have been running for well over 20 years. Previously those systems may have been upgraded once every few years but they can’t cope with the pace of change that is required now—the financial services industry has been hit with a tidal wave of change, and the technology is certainly feeling the strain.
Regtech was a necessary outcome of that, because these changes cannot be made on a manual basis. The level of automation, control and governance that needs to be employed in order to deliver a compliant service requires technology. Regtech and forced innovation go hand in hand.
How do big data and analytics fit alongside data protection regulation?
Big data is the product of all the information we are creating, and we are dealing with so much more information than we ever have before.
Anything and everything we do in the industry has to be transparent and efficient. The depths of information you must analyse and process in order to achieve that level of transparency are immense. Any data has to be protected. But when you have huge amounts of data, while the fundamentals don’t change, the complexity of protecting such a volume of data does.
One challenge is that data privacy laws differ depending on the jurisdiction. We are seeing some alignment under the EU’s General Data Protection Regulation (GDPR), and it would help if rules were to increasingly converge on a global basis. Many buy- and sell-side firms operate cross-border, and have to understand the rules of every jurisdiction they are in, stay on top of any changes, and know how the rules apply to them.
Another point is that while firms are creating and storing all of this data, are they going to use it to try to better understand their clients and help them make decisions? There is some discrepancy between what firms have to do and what they could be doing, given the time and the resources to focus on their data rather than on the regulation. Again, resources are diverted from where they could be best used.
How are firms managing the costs of all these challenges?
All of this comes at a cost. Policing your own service, providing greater transparency, greater systems, greater controls, greater governance, plus the information that needs to be captured, monitored and reported on, all brings increased costs.
This is against a backdrop of volumes in the market that are going down, or at least remaining at historic lows, and so the opportunity to generate revenues and offset those costs through a highly lit, high-volume market just isn’t there. There’s an imbalance here.
I don’t think this can be addressed other than by creating, or trying to create, new ways of generating liquidity, and that is where the buy-side firms are trying to gain more control for themselves. If the buy side is able to generate access to liquidity on a buy side-to-buy side basis, that’s a way to stay in the game, as it could be much more efficient.
Again, however, this is new, and so it requires innovation, which requires cost. It becomes a vicious circle.
Between regulatory and cost challenges, and the shifting roles of the buy and sell sides, who do you anticipate will emerge victorious?
If a sell-side firm sees an opportunity to invest heavily in increasing the quality of the complex services the buy side requires, then that is a viable route it could take—providing a service above and beyond what is needed for regulatory compliance.
On the other hand, if a sell-side firm chooses not to do anything, then there is an opportunity for smart, sophisticated and innovative buy-side firms to step in.
Buy-side firms are not created equal. There are those that develop and invest in their future infrastructure and there are those that do not. Those that don’t innovate internally will likely find themselves trying to access a much smaller pool of sell-side liquidity. Buy-side firms will either pay out more money to invest in their own infrastructures or end up paying more for services they’re already getting, as those services become more commoditised and specialist.
We will see a changing landscape with some restructuring, refocusing and reprioritising, and there will be winners and losers on both sides.
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