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M&A surge dominates the year in market structures

M&A: back with a bang

Deal activity was vigorous with much of it concentrated just below the level of the industry’s biggest companies. Nasdaq bought International Securities Exchange for $1.1bn, while CBOE Holdings announced a $3.2bn deal for Bats Global Markets in September. Of most significance, the pending €24bn tie-up between London’s LSE Group and Deutsche Börse, which will create Europe’s largest exchange. As the chart above shows, rising equity valuations have lifted all market capitalisations among exchange operators, however the size of the big US companies makes mid-level operators, including Europe’s two suitors, look vulnerable. That deepens the determination at the LSE and Deutsche Börse to get their deal through. Another big question for the year ahead is how Nasdaq responds to either outcome under new chief executive Adena Friedman.

Where next for high-speed trading?

High-frequency trading firms have become key players across financial markets, using sophisticated algorithms to trade at lightning speed and benefit from price movements. Companies like KCG Holdings, Global Trading Systems and Citadel are now accepted as electronic market makers as banks have retreated from such a role due to higher capital costs and greater regulation. But with competition fierce and volatility low, how will these companies keep growing?

One example may be Virtu Financial, which offers and executes millions of deals every day on more than 235 venues in more 12,000 instruments. Over the summer it finalised a deal with JPMorgan to provide bank with smarter technology to trade in the interdealer market for US Treasuries.

Declining spot foreign exchange trading

The Bank for International Settlements recently noted that the value of daily currency transactions slipped from $5.4tn in 2013 to $5.1tn this April, largely down to a 15 per cent slowdown in spot trading.

Some of that reflects changes in global trading flows but, as the BIS noted, the composition of the market is also changing rapidly. High frequency firms and hedge funds have faced barriers to market access, while institutional investors such as banks and pension funds have increasingly looked to FX swaps markets to hedge at a time of monetary policy easing.

‘Flash events’

One consequence of the changing market composition said the BIS is “indications of rising instances of volatility outburst and flash events.” During such episodes the tentative evidence suggested that participants head towards anonymous multilateral trading venues, it said.

A dramatic example was the ‘flash crash’ in sterling in October. Trading at $1.26 at an illiquid point of the global trading day, it slumped in a matter of minutes. To what price it fell to depended on where you were trading, as the graph shows. As the BIS further noted, there could yet be consequences of big moves for corporations, asset managers and even day traders as they find their access to the market squeezed.

Derivatives reform: the final brick in the wall

A radical overhaul of derivatives regulation in the wake of the financial crisis pushed clearing houses — the third party platforms that act as insurers to both counterparties in a trade — to the fore in 2016.

September saw the introduction in the US of a final set of rules. Bilateral over-the-counter trades would essentially cost banks more if they did not go through a centralised clearing house; the same rules will apply across Europe from January. The impact of the so-called uncleared margin rules was almost instant, with the value of cleared inflation swaps jumping sevenfold. With another set of rules coming into effect on March 1 — expect more OTC business to go through clearing.

The rise — and potential fall — of dark pools

European stock trading in “dark pools”, the controversial off-exchange platforms used to hide large orders from public markets, has continued to climb through 2016. But that trend might not last much longer.

From 2018, the venues will be subject to new rules under Mifid II that limit the amount investors can trade in them. Nevertheless, the legislation allows waivers for investors who execute deals of certain sizes. As a result, exchanges such as the LSE’s Turquoise and Bats Europe have already launched services to tempt investors to trade large orders in this way. But the calculations for the caps will be based on 2017 numbers so brokers and venues alike will be watching to see if and how investors begin to adapt their behaviour.

Margin calls and Brexit

Clearing houses have become a vital part of the market’s post-crisis infrastructure and a repository for ever-rising sums of margin that back derivatives trades. An ultimate test of this system still awaits, although the clearing infrastructure did experience a good run-out in June when the UK’s vote to leave the EU shook markets, causing an increase in margin calls for derivative traders.

Five of the largest clearing houses globally demanded an extra $27bn in collateral across derivatives products on June 24, five times more than the previous 12-month average. One conclusion is that the infrastructure worked as planned; another was that Brexit was a “known” event for which institutions had months to prepare. Expect regulators to focus on this topic even more next year.

China’s derivatives boom

Futures trading has experienced stellar growth on transatlantic markets since the 1980s, even if it has been crimped in recent years by persistent low and even negative interest rates. Not so in China, as regulators increasingly approve new products and open up markets to more foreign participants.

Commodities trading is a particular draw, and after a crackdown on stock index futures, markets like Zhengzhou and Dalian Commodity Exchange are thriving. For the big western trading venues, including ICE, CME and Deutsche Börse, it remains a tantalising prize just out of reach. Some have established a physical presence in Singapore to set up a beachhead in Asia, but it has yet to convert into the type of boom that others in the region are enjoying.

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