While I am not usually one for predictions (owning to my own record of poor timing), I think that this year will be particularly humbling for a great many people in the market. Many are predicting massive changes and I suspect that those will take much longer to occur than is the common wisdom. In addition, there is a major clash brewing between the “old guard” in D.C. and New York and the newer, techno-centric Silicon Valley crowd in the arena of financial products. The ground zero for this clash is crypto-assets, and there is certainly risk of major disruptions owing to the lack of knowledge from both sides. (Hint – the D.C. and NY leadership does not accept the premise behind many of these assets, so thinks that existing rules could suffice, while the Silicon Valley cohort has displayed ignorance of how financial markets operate. What is needed is better bridge building and cooperation between the two…)
Most of us are well aware of the backdrop for the beginning of 2018:
- MiFID II takes effect, forcing un-bundling of research from trading for firms servicing European investors, along with significant pre & post trade reporting requirements; both sets of rules apply to most asset classes.
- US rules are in flux, with increased focus on order routing from FINRA, SEC initiatives on maker-taker as well as enhanced reporting, along with market data reform.
- BitCoin, Crypto-Assets in general, and ICOs (Initial Coin Offerings) have dominated the news cycle for the past few months, leading to guidance from regulators in the U.S. and abroad that increased regulation of these assets is in the works.
With that, here are a few predictions. Note that I dont want to be correct on any of these, but my cynical nature makes me believe they will happen:
- Un-bundling will be much slower to evolve that anticipated, with both managers and brokers using relationships rather than research votes as a way to maintain the Status Quo in trading relationships. While research will be pared back by the large banks and brokers, I think that those firms will run those services at a loss, trusting that selling it for below cost will be compensated by other services, even without a quid pro quo. It will, however, be harder to earn money as a niche research provider, which will ultimately result in top analysts moving to the asset management and hedge fund community.
- Best Execution will remain more of a buzzword and a check the box activity at both asset managers and brokers until/unless there are significant enforcement actions by regulators either in the US or Europe. As a result, execution-only firms, will not see the windfall of trading volumes that they expect to win from the bulge-bracket. They will continue to find it difficult to prove better quality of execution when benchmarks such as VWAP remain the standard and firms continue to use TCA based exclusively on executions as opposed to new analysis of all routed orders.
- Regulators will be cautious in the enforcement of MiFID II directives as almost every firm will have failures in compliance with details of the rule. In addition, post trade reporting and execution quality reporting rules will not produce much useful data in 2018, as it is not well categorized or standardized for use. It will however, trigger a renewal in the importance of capital commitment and market making services in Europe across asset classes.
- US Regulators, who have signaled a willingness to examine broker conflicts of interest will go slowly as well, opting to provide the industry time to change their behavior, which will, of course, be very slow to change.
- Crypto-assets will move towards mainstream acceptance, but regulators will trigger a lot of volatility caused by their lack of understanding and desire to apply outdated or irrelevant rules to these assets.
I realize that none of these predictions are particularly heroic, and I would be happy if I was wrong on several. In particular, I would like to think that active managers would finally get the hint that their lack of focus on best execution is a major reason their performance has lagged passive funds, but doubt that it will happen overnight. It would be good if regulators in both the US and Europe prompted such a development by enforcement actions against firms that did not analyze their trading methodology quantitatively, but that seems unlikely in the short term. Finally, it would be great if the regulators showed an awareness of the shortcomings in current rules as they apply to newly emerging asset classes like ICOs, but suspect that the desire to have some regulation will win out.
However these events unfold, I am sure it will be interesting. So, stay warm (if you are on the East Coast of the US, you know what I mean), enjoy the rest of the holiday season, and prepare for a great new year.
