The Waiting Game: 5 Themes That Will Define Capital Markets in 2016
By Larry Tabb, TABB Group
Originally published on TABB Forum
Stuck between financial regulation and the next presidential election, 2016 will be a year of waiting – waiting on market structure reform, waiting on higher rates, waiting to see if disruptive fintech actually disrupts, and waiting on the next commander in chief. As the year plays out, the impact of these drivers will come into greater focus. Larry Tabb offers five themes that will define the capital markets in 2016.
2016 will be challenging for capital markets firms, but the challenges will not be insurmountable. Stuck between financial regulation and the next presidential election, 2016 will be a year of waiting – waiting on market structure reform, waiting on higher rates, waiting to see if disruptive fintech actually disrupts, and waiting on the next commander in chief. While few, if any, of these issues will be fully resolved in 2016, as the year plays out, the impact of these drivers will come into greater focus. Here are five themes that will define 2016.
1. The Election
It comes as no surprise that the majority of Americans believe our current election process is a mess. Virtually unlimited spending, the devolution of the Republican Party, and the rise of the anti-politician will make 2016 a year of political bombardment, as SuperPacs, political talk shows and late night comedians’ lampoons will make it impossible to ignore the US presidential election.
Through this rancor, I believe Hillary will wind up victorious – that is, unless a dark horse unexpectedly appears out of the shadows. While not particularly likable and viewed as untrustworthy by many, voter demographics, experience, name recognition, and the mess that is the Republican Party should enable Hillary to seize the mantle. Just look at the leading Republican candidates: Trump, Cruz, Rubio and Carson. Two are anti-politicians, one is less liked than Hillary, and the other is losing traction rather than gaining it. That said, even though the Republican Party is a mess, the election won’t be a landslide, with the victor winning by less than 5% of the popular vote. Who would have guessed that we would be pining for the days of Romney and McCain?
While a Republican would be better for the industry, Hillary shouldn’t be so bad. Given that Hillary is a Senator from New York, lives in Westchester, and has a history of working with the industry, and given the industry’s contributions to both her campaign and Clinton Global, it would be hard to see her take a drastic turn against Wall Street. That said, the good times of the ’90s and early ’00s are gone. It will be years before we see those days again.
Though she was tough on banks in her now infamous New York Times OpEd, this was more about political posturing and a call for campaign contributions. If elected, I believe she either will backtrack on many of these proposals or, more likely, have a very difficult time getting many of these planks through Congress, which will continue to be either Republican-controlled or -dominated.
The bottom line for the elections: The status quo will remain, with no sweeping victories, defeats and/or financial industry mandates. And we most certainly won’t be replacing the national anthem with Kumbaya any time soon.
2. FinReg – Still Dominating the Agenda
Regardless of who wins the election, gutting, or even rolling back, Dodd-Frank will be very challenging. And even if Dodd-Frank is gutted, getting the Basel Committee to reform Basel III/IV will be virtually impossible. While we may see some small changes to swaps trading regulation and some process changes (but not much) on extraterritorial regulation/substituted compliance, expecting the G20 derivatives rules for swaps to just go away or for the CFPB to pack it in would be like expecting the Mets, Jets and Islanders to all win 2016 world championships. Good luck with that.
Financial regulation will continue its push to make banks safer by boosting transparency, upping capital charges, increasing product standardization, ratcheting up stress tests, and generally limiting banks’ financial/capital markets activities. Basically, more of the same.
The focus in the US will be Basel III compliance, finalizing and adopting the SEC version of Title 7 swaps reform – which, by the way, is substantially different than the CFTC version – and what seems to be a never-ending stream of compliance challenges stemming from dark pool mischief, collusion, spoofing and market manipulation that the regulators will increasingly use to prosecute misbehavior (both real and perceived).
While the US will be drowning in compliance and regulatory issues, however, Europe will assume the regulatory focus. With EMIR’s implementation gaining steam and the MiFID II rules in final stages of approval, Europe, while two to three years behind the US in terms of financial reform, will be entering that critical phase of rule finalization, on-boarding, and conceptualizing the reality of new requirements’ impact.
While the world embraces financial regulation, the market’s No. 1 question will be about liquidity provision. As banks get weighed down by the anchor of financial regulation, two things can occur: First, banks find a way around the regulations by creating new and different products, or by developing a new governance structure that enables them to circumvent the most significant rules and capital charges; or second, they don’t.
If banks can’t get around finreg, which is the most likely scenario, bank liquidity will continue to drain from the market and risk will be transferred to investors, while the intermediary function is taken over by firms that are not as heavily regulated. While intermediary liquidity pools will decline, the newer and less-regulated firms that fill these gaps will have much better technology and connectivity. This will leave the market with thinner capital cushions and faster turnover rates.
Though banks will be safer, we expect greater market instability and volatility, especially given the rising rate environment. While we expect more high-yield funds to crater, the impact will fall on investors, not financial institutions. We don’t expect anything nearly as pernicious as the credit crisis, but an increasing number of volatile moments will plague the markets like a death by a thousand cuts.
3. Rates and Fixed Income Market Structure
The Federal Reserve has finally raised rates, albeit by only 25 basis points. In 2016, according to experts, rates will go up by 100 or so basis points. This most likely won’t create panic in the streets. We will, however, see some of the more precarious funds fail, not unlike Third Avenue. This also will be a test for the vast array of new credit trading platforms. While we don’t expect these new platforms to take over the market in 2016, we do expect a few to gain traction. This will be the boost that they need to refine their business models, hone their matching modes, push the buy- and sell-sides to at least test their platforms, and keep them in business.
While the rising rate environment will float some of these boats, however, it will be harder for the others to stay in business. We expect liquidity in these platforms to centralize around a few winners. Platforms that obtain client traction will generate a buzz, attracting more players and more liquidity, and the old saw “liquidity begets liquidity” will be the operative phrase for 2016.
On the rates side, we will continue to see technology-enabled market makers displace traditional market makers. More flow will be electronically traded, and the market increasingly will look more like equities than bonds.
As both rates and credit become more electronic (albeit in different ways), we will see the role of regulators change. Securities regulators historically have kept their distance from traditionally OTC markets. As more bonds (and currencies) trade on-screen, it will be easier for regulators to see how well brokers/dealers are treating their clients and how best execution rules can be applied to OTC markets. This will put an increased focus on broker/dealer behaviors and increase the number of enforcement actions. “Last look” will end, and by the end of the year, we will be one step closer to an agency-style market for fixed income products.
4. Equities Market Structure – Change Around the Edges
Equities market structure, unfortunately, will remain in the headlines. Fixing the ETP challenges demonstrated by the chaos of August 24 will be the first priority for the SEC, following the very interesting fact-filled but analysis-void paper it put out in December. Though not extensive, we should see changes to the opening process, the calculation of indices, and the tinkering of limit-up/limit-down thresholds for ETPs. While not radical, these changes will challenge some existing businesses and create opportunities for others.
Talking about shifting opportunities, IEX will eventually become an exchange. It needs to. If it doesn’t, it will be hard to keep its investors happy. While I don’t think that the SEC will force IEX to eliminate the speed bump, I am not sure regulators will greenlight the exchange as it currently stands; IEX may have to put its router on the same side of the speed bump as other brokers, or make other concessions to comply with Reg NMS/fair access rules.
If IEX is approved with either the speed bump and/or the router bypassing the speed bump, we will certainly see a few of the smaller exchanges change their structure to encompass similar, but not exactly the same, features as IEX. This will create a mess and leave routing firms stuck trying to decipher the location of real liquidity, its current price, how to negotiate each market given their peculiarities, and how to compensate for all of these new market structures in their routing strategies. While IEX advantages are supposedly tipped toward investors, what is to stop someone from subtly changing the model deleteriously?
Outside of the exchange brouhaha, regulators will continue to push transparency. We saw the SEC put out a proposal in November on ATS-N, and there are discussions around extending Rule 605/606 reports to cover institutional flows. Hand in hand with global regulators, equity transparency issues will continue to be front and center.
On the dark pool front, we will see regulators finally tie up the loose ends on outstanding dark pool settlements, but that won’t be the end of it. We will see a number of other dark pool investigations/settlements, as there are rumors of other enforcement actions circulating. The SEC also will finalize and implement ATS-N dark pool disclosure rules, which, of course, will create more compliance challenges and fines.
On the “kick it down the road” side, I am not optimistic that we will see much progress on the CAT. While regulators winnowed the field from six to three bidders in 2015, we still don’t have an SEC CAT czar, and it just seems as if the CAT has not been a major SEC priority.
With the delay of MiFID II, we see debate, confusion, and eventually some finality. Regulators will relent on strict separation of payment for research and trading commissions by allowing CSAs, but that won’t alleviate the challenges that European investors, brokers, and providers will have in ascertaining cost, quantifying value, and paying providers. The double volume caps will remain, but they will be very hard to enforce given the inability to collect data and to manage the reference price and large-in-scale exceptions, not to mention the lack of clean and consolidated data.
While MiFID will challenge the equity business, the European fixed income markets will be thrown into a tizzy as they come to grips with what transparency and accessibility really mean in the fixed income markets. This will be especially poignant given a US rate rise and the increasing pressure Basel III will place on European banks. This will certainly come back to bite Europe, especially if volatility picks up.
While the talk around the industry will continue to revolve around regulation and enforcement, the excitement around fintech will increase. Though we are years away from a credible blockchain alternative, we will see factions develop in various target markets – including smart contracts, clearing/settlement, payments, securities lending, and back-office automation. While the smoke from blockchain initiatives will increase, however, we are still too early to see much fire. There will be deals, and proofs of concept, but wide-scale adoption is still years away.
Robo-advisors will continue to gain traction, but again, true disruption remains years away. Given it has taken almost 20 years for ETFs to hit the $2 trillion mark, we won’t see robos pressuring traditional managers in 2016. That is at least five to 10 years off, if at all.
That said, cloud, compliance, cyber security, and big data will continue to push ahead. While not the most sexy of topics, many of these technologies are battle-tested and can demonstrate realistic value propositions today.
Opportunities for the Fleet of Foot
In the macro, 2016 will be a challenging environment for banks, as regulation – including capital rules and the Volcker Rule – and enforcement actions will keep them on their heels. This will also impact hedge funds. Hedge funds had a pretty lousy 2015, and 2016 will remain challenging. Leverage will be hard to get and expensive. While the direction of rates will be more certain, it will be harder to take advantage of them without prime brokers’ balance sheets opening up. Long-only funds will continue to be pressured by ETFs, whose low cost structure will continue to prove problematic for traditional brokers.
As banks’ and brokers’ comp models remain under pressure, talent will continue to move toward firms without the heavy regulatory burden, oversight, and hurdles. This will push market making and HFT firms to begin courting traditional investors. While this won’t reach a flood in 2016, it will be the start of a long process as the industry shifts away from a banking model to the more traditional brokerage/investment banking model popular in the 80s and 90s.
One thing that can derail this process (and improve the industry outlook) is a way of better obtaining leverage, outside of the traditional bank/repo model. If we can develop/create leverage outside of the large banks/prime brokerage model, or novate financing risk through repo clearing or another mechanism, market making/dealer desks and other intermediaries will be able to be more active in the market without as much counterparty risk. This would be a significant help not only to banks, brokers, and hedge funds, but also to investors of all stripes, who would enjoy greater liquidity, better asset pricing and less execution risk. That said, we don’t expect this problem to be solved before the 2017 ball drops in Times Square either.