The surge in fixed income electronic trading has significantly increased the importance not only of the ability to route trades to the appropriate market venue for execution but also of bringing efficiency to pre-trade and post-trade functions. This shift puts fixed income connectivity platforms at the center of sell-side market demand for a robust, customized, fixed income workflow.

There are four key reasons why firms making acquisitions are finding fixed income connectivity platforms attractive.

1. Dealers don’t replace incumbents, making this a sticky market. As the sell-side firms are migrating toward vendor solutions, the replacement market is limited. But that’s not to say there’s no opportunity. Vendors are growing organically via supporting new market venues, asset classes, and trading protocols to become clients’ primary way of accessing the market. Sell-side firms are avoiding the risk of undertaking large transformation projects to replace existing connectivity layers, but they are building additional subsystems or adding new vendor solutions.
2. As dealers demand more coverage and functionality, these platforms offer vertical and horizontal functional growth potential as well as corresponding revenue opportunities. Dealers are demanding the ability to manage trading connectivity with more venues, asset classes, and trading protocols while acting as principals and acting on an agency basis to meet clients’ order flow. There is an increasing demand from sell-side firms to support additional functions such as risk management, trade matching, post-trade processing, and position-keeping functions. Vendors are responding by providing support for algo trading and using AI and machine learning technology to support data analytics functions, by providing a range of product variations for fixed income trading, and by offering multiple custom tools to configure trading workflows.
3. Fixed income connectivity solutions are viewed as supporting growth. Sell-side firms maintain connectivity with more trading venues than they actually use so they can execute the orders at a particular venue when a client demands it. New venues are proliferating, and new trading protocols such as portfolio trading and all-to-all trading allow firms to effectively transfer the risk in the available liquidity pool with greater sophistication and improved execution workflow, such as trading a large illiquid basket of bonds in a volatile market. These changes make fixed income connectivity platforms even stickier and highlight the additional growth opportunities for providers.
4. There is high market growth potential; Aite-Novarica Group expects to see spending on fixed income connectivity solutions increasing more than 60% between 2022 and 2025. Sell-side firms are investing more than ever in fixed income connectivity solutions to improve monitoring of customers’ trading behavior and to discover how events such as market news impact order flow. Firms are looking to internalize order flows more efficiently across trading desks, to provide greater economies of scale for trading securities in which volume is particularly high, and to identify the best price and liquidity for the securities. The increases in fixed income electronic trading, demand for custom workflows, and support for new trading protocols are driving technology spending. The final estimates suggest US$295 million was spent on fixed income connectivity in 2022. Global spending is expected to increase by 60% to reach US$497 million by 2025.

Firms are avoiding the risk of undertaking large transformation projects to replace existing connectivity layers, but they are building additional subsystems or migrating to new vendor solutions.

To read more about the growing sell-side fixed income connectivity solution provider market, download my recent report Aite Matrix: Sell-Side Fixed Income Connectivity Solution Providers. You can also reach out to me at vjain@datos-insights.com.

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Aite-Novarica Group believes that some of the approaches and details in the regulations could be crafted in ways that achieve their goals while easing the compliance process by the reporting firms. The regulators and the industry have been working together since the 2008 credit crisis to bring clarity to the reporting rules.

Six areas where we believe ESMA could have provided more clarity and will receive significant input from the market are as follows: 

1. ISIN vs. UPI: ESMA is mandating the reporting of ISINs generated from ANNA-DSB and UPI, but the CFTC and SEC are relying on UPI and not mandating the ISINs. Without a clear strategy for aggregating trading data from the venues, the use of ISINs is limited in the reporting process and is not used in any trade processing functions. Similarly, the ISIN does little to create broader transparency as access to the ISIN data field definitions is currently restricted.
2. Reconcile before reporting or after reporting: Regulators need matched data from the counterparty, so the submissions of both parties to the trade should mirror each other. ESMA has adopted reporting on T+1, but the data quality is still an issue. It could be more effective if the regulators allow the industry to reconcile the submission on T+1 with other counterparties and then submit the details on T+2 to the trade repositories. Further consideration of the mandated use of electronic confirmation platforms’ capability to report the trade details would have reduced the errors in submission.
3. Valuation reporting: ESMA specified a tolerance limit of 5% on the mark-to-market trade valuation of outstanding notional exposure against the counterparty. Ideally, the valuation exposure calculation model involves measuring counterparty credit risk. All other factors being the same, a firm with a higher credit rating views its probability of loss more against a lower-rated counterparty. Thus, the valuation reported to regulators with a 5% tolerance may not be the same as the one used by firms to value the exposure in the risk models. Again, there is an opportunity for the confirmation or collateral technology solutions to match the valuation numbers on T+1 and then report to regulators, leading to a reduction in submission errors.
4. A missed opportunity to build confidence in regulatory data quality: Regulators could consider publishing weekly data quality statistics to indicate the progress in improving the data quality. A set of simple indicators, such as the number of times the trade could not be matched due to the buyer/seller mismatch or the number of times the execution date/time stamp does not match, would provide key performance indicators and highlight opportunities for market improvement.   
5. Rules interdependency: Regulators should publish the interdependency of the message types mandated under the regulation for reporting. For example, message type – Correction, is used to reinstate the various life-cycle events for a period instead of at a point in time. A rule at the trade repository level to identify the dependency of the correction message type on valuation and collateral messages could have generated alerts for firms to resubmit the updated valuation and collateral messages.
6. Correcting regulatory reporting lacks guidance: Regulators have shared excellent guidance on daily reporting. But U.S. and EU regulations are less clear on how to support corrected trade data reporting. Regulators are mandated to receive every data element correctly, and this means reestablishing the entire trade history day over day. Though there is no easy answer to this problem, a dedicated regulatory and industry discussion on this could lead to some basic principles to support a consistent and streamlined way to correct trade history.

We look forward to more guidance from the regulators such as Q&A and reports on data quality to comply with the regulations. Have thoughts on ESMA’s announcement? Let me know at vjain@datos-insights.com.

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A lot more will be uncovered in the coming days as regulators step in. The ripple effects will certainly extend well beyond naming conventions for sports stadiums. Though there are many facets to FTX and the crypto-exchanges business model, here are the three key takeaways we are watching today.

Entity, Subsidiary, Brand

Financial institutions have a responsibility to understand their vendors, service providers, and counterparties. FTX was the brand, but the business was carried out by more than 130 companies across the globe. Though crypto-trading was one part of the business, FTX had built its trading firm and other businesses to increase the velocity of investment brought into its ecosystem.

• FTX’s non-U.S. business is not regulated for day-to-day operations in the U.S., but the company filed for bankruptcy in the U.S. for roughly 130 affiliated companies. Its U.S. business under LedgerX LLC and FTX Digital Markets Ltd. is outside bankruptcy. The impact of the bankruptcy of these affiliated companies will take time to be felt by the market. The Legal Entity Identifier (LEI) was created for institutions to easily identify the entity and its legal status. With only a handful of FTX entities registered as LEI, the market will likely see a significant increase in institutional crypto-market participants registering for an LEI.
• In January 2022, FTX was planning to launch stock trading and video games and had looked to acquire Robinhood, the online brokerage firm. Had FTX succeeded as planned, the impact and potential for market contagion would have been much greater.
• FTX trading relied on leveraged loans and increased its valuation by holding a variety of assets in the ecosystem. Traditionally, an exchange value was driven by volume and price discovery. The market can expect to see more scrutiny by private market investors exploring investment opportunities in cryptocurrency firms.

It’s Collateral Management. Again…

Collateral management is key to opening the doors to the next business day. FTX created FTX Tokens (FTT), promoted FTT via rebates, and then created a centralized collateral pool mostly of FTT. It was interesting to note statements such as, “Unrealized PnL from open futures positions is settled in USD every ~30 seconds” on FTX’s website demanding a high reserve balance on the clients to meet any calls. FTX seems to have used clients’ funds as collateral for its own business to mitigate losses while simultaneously bringing on more investors. 

• Expect more hair cut on securities issued by an entity and used as collateral. Using clients’ funds as collateral for business works only in the regulatory environment, and regulators would have to address the jurisdiction aspect when dealing with global crypto firms.
• Expect significant global regulations around collateral management such as Uncleared Margin Rules in the cryptocurrency market.

Regulators, Lawyers, and Accountants Are Going to Be Busy.

A precipitating event is generally followed by a bold initiative by a regulator to take the risk of developing the rules. The risk refers to understanding the complexity involved in the market and defining the rules since these rules then act as a baseline guide for other global regulators.

The CFTC rules that emerged after the 2008 financial crisis under the Dodd-Frank Act emerged to help global regulators bring transparency in business.

• There is a lot of work for regulators to unpeel the layers of FTX’s business model and review audits that would have shown Alameda Research’s balance sheet assets were in FTT.
• More work for auditors is on the horizon, as every crypto-exchange is in the race for a Proof of Reserves (PoR) audit to ensure that a custodian holds the assets it claims to on behalf of its clients. The market can expect an increase in activities related to reconciliation and break resolution. 

Fortunately, cryptocurrency is not the main economic currency, and thus traditional finance has seen little impact and no signs of market contagion to date. Time will tell if regulators will promote the integration of cryptocurrency into the traditional market infrastructure or keep those assets in their current ecosystem. Have more thoughts on cryptocurrency and regulation in the wake of FTX’s collapse? Contact me at vjain@datos-insights.com.  

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There are four general strategies: private equity, venture capital, private credit, and real assets (with debt and equity as two separate investment categories). Private debt has proven to be an especially good financing option when compared to its public alternative. Public debt typically has higher fees, a longer diligence process, and more rating and regulatory requirements attached to it. The private credit market has more than doubled in size over the last decade and is expected to reach more than US$12 trillion worldwide in 2025.

Key Components of a Private Credit Strategy

Private debt is much more flexible than public debt—the amount, duration, terms, and conditions can all vary dramatically. This flexibility is appealing to both investors and borrowers, but it can come with added operational burdens, including administering the loan and managing the data associated with that loan.

In addition, private debt has numerous regularly occurring cash transactions, necessitating continuous maintenance, calculations, and reporting. Processing this ever-increasing amount of data cannot be managed at scale by manual processes alone. Firms need a centralized source of data and interoperable systems right from the start. Outsourcing can help firms consolidate their third-party relationships and ensure the presence of trained resources to facilitate business continuity.

Preparing to Enter the Private Credit Market

Firms working to build out their private credit market should keep the following in mind:

• Streamline operations to facilitate growth.
  Private credit transactions require an especially high amount of monitoring, both of the events of the deal’s life cycle and unstructured data from loan documentation. Streamlining the many processes involved, sometimes even into a single platform, can ensure that a firm’s operating model will scale with future growth.
• Adopt an effective integrated solution.
  Any integrated solution being used to manage private credit market transactions should utilize a single sign-on process and offer near-real-time processing, either through API or messaging, rather than batch processing. A cloud-hosted solution can ensure that all users receive the necessary software enhancements in a timely fashion.
• Keep watch on market events.
  Market events can teach the entire industry lessons that can then be incorporated into their own practices. Data analytics tools should be equipped to handle such changes—for example, they could monitor loan details at a bilateral level rather than monitoring individuals at all lenders.
• Be prepared for more complex deals.
  Staying competitive in this growing field will mean firms need to handle more complex credit agreements and deals overall. Added complexity will require more agile, rapidly functioning technology. Relying on overly complicated manual processes leaves too much room for error.

To learn more about how the private credit market is changing, please contact me at vjain@datos-insights.com and download the Aite-Novarica Group and IHS Markit case study Private Credit: Achieving Operational Scalability for a Growing Asset Class.

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With so much to offer, it looked revolutionary—and it still is. But the meme stock event in January 2021 challenged the business model and revealed deficiencies that were exploited by a new generation of super broker retail trading platforms.

In June 2022, the U.S. House Committee on Financial Services published a report on the Meme Stock Market Event (MSME).

The report shared insights on various aspects of this incident, including:

• Payment for Order Flow (PFOF): Retail trading platforms provided commission-free trading to customers by routing customers’ orders to selective market-making firms in return for a fee, which is called PFOF. Most broker-dealers calculate PFOF rebates as a flat fee per share, but Robinhood had an innovative approach, calculating PFOF rebates on the spread between the purchase and sale price of each security. During the MSME, the spread between buy/sell widened, forcing the broker-dealer to rush and renegotiate the PFOF amount with Robinhood.
   
• Retail Trading: Robinhood routed retail client orders to six market makers for equities: Citadel Securities, G1 Execution Services, Morgan Stanley & Co., Two Sigma Securities, Virtu, and Wolverine. During the MSME, Robinhood was not a member of any stock exchange and was not able to access public exchanges for liquidity to fulfill large orders. It was not under the regulatory burden to prove the best executions to its client. It took Nasdaq membership in April 2021.
   
• Client Onboarding: Institutions’ client onboarding systems struggle to onboard a single client on the same day, but Robinhood was able to attract 300,000 new account opening applications on January 28, 2021. This increased to 730,000 new accounts opening applications on January 29, 2021. The super-broker system enables an immediate account opening and approval process, but the super broker also needs to be able to throttle that process during volatile market conditions.
   
• NSCC Risk Management: NSCC manages the credit risk posed by its members by calling for margins from members, maintaining a “Watch List” and an “Enhanced Surveillance List,” and levying Excess Capital Premium and Value-at-Risk charges. On January 28, 2021, NSCC charged Excess Capital Premium, aggregating US$9.7 billion to six firms: Robinhood Securities, LLC; Axos Clearing LLC; Instinet, LLC; Wedbush Securities Inc.; LEK Securities Corporation; and Vision Financial Markets LLC. Robinhood managed its risk exposure based on the NSCC’s Value-at-Risk charge, but it did not consider NSCC’s Excess Capital Premium charge in its calculation. NSCC charged a US$3.7 billion collateral charge to Robinhood on January 28, 2021, comprising the Value-at-Risk charge, which totaled US$1.3 billion (US$850 million from AMC and US$250 million from GameStop stock), and the Excess Capital Premium charge, which totaled US$2.3 billion. The intriguing event happened when NSCC was able to provide a waiver to Robinhood on these charges, from US$3.7 billion to US$1.4 billion, which resulted in a net margin deposit of US$734 million. Looking at historic data, from January 1, 2019, through February 12, 2021, eight firms accounted for about 90% of the Excess Capital Premium charged across 307 occasions. Such a high number of waivers tends to create an atmosphere of acceptable practices.
   
• Trading Restrictions: The fine print in the account opening terms and conditions allows super brokers to have unlimited power over the account holdings. This was evident when Robinhood placed Position Closing Only (PCO) restrictions wherein account holders were not allowed to purchase certain stocks but could only sell the stocks. Along with Robinhood, other firms such as Interactive Brokers, Apex, Axos Clearing, and E*Trade also placed PCO restrictions on certain volatile stocks.

Next comes the series of regulatory measures and industry initiatives to be better placed in the future to oversee similar MSMEs—such as SEC regulations on PFOF, T+1 settlement, examination of the role of market makers, transparency in short-selling, and review of the gamification super-broker business model targeting retail investors.

The list is not over yet; the recent volatility in the cryptocurrency market has also impacted institutional and retail investors. Expect more regulations and more industry initiatives to emerge in this market, too.

Hopefully, these regulations will facilitate more innovation in retail trading.

Interested in learning more about how the super-broker model has impacted the trading world?

Reach out to me at vjain@datos-insights.com.

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