We hosted our quarterly FinTech Central event last month and were joined by leaders across the financial exchange ecosystem. The panel included Brad Peterson, (CTO / CIO at NASDAQ), Joe Mecane (Global Head of Electronic Equities at Barclays), Ronnie Mateo (CEO and Founder at Trumid) and Jim Greco (CEO and Founder at Direct Match). This was a fascinating meeting of individuals because their experience spans across products (corporate bonds, treasuries and equities) and also type (incumbent + startup). It is very timely to be discussing the future of the exchange given an accelerating shift in regulation and technology. Startups are gaining official SEC approval as stock exchanges and it looks like there’s more coming.
Most people hear about exchanges and think they’re fairly uniform across products. This couldn’t be further from the truth and it’s important to make that clear up front. Ronnie described the relative stages in development of the different exchanges using the alphabet for illustration;
“You guys [equities] are in letters R or S. Corporate bonds haven’t even started the alphabet. People are like, “How do you get from A to B?”. We literally haven’t started the alphabet right now. It’s more Byzantine, this is like the 1970s as far as equities is concerned.”
While equities are nearly 100% automated via incredibly complex technology, corporate bonds are done over the phone and treasuries use an antiquated tech process called RFQ (request for quote). Popular consensus is that these lagging products will ultimately converge on the equity process. There’s also Brad’s thesis which is that platforms like Facebook, Google or Amazon may emerge to consolidate this fragmented space since they already own the customer relationships.
At the bottom of this post you can listen to the audio from the event. Short of that, below is a quick recap of the conversation.
Equities are at peak tech enablement and we’re now in the midst of a shift in focus from speed to stability. We had the financial crisis, a series of flash crashes and unsurprisingly a wave of regulation. While speed enhancements reached a point of diminishing returns, the SEC enacted Reg SCI (Systems Compliance and Integrity). This regulation creates the ability to bring enforcement action against a marketplace if they haven’t adequately tested their tech enhancements — the message to the industry is, you’re developing processes faster than you’re developing the tech behind it for proper support.
Enter IEX, who benefits greatly from this shift in public and government sentiment that stability is more important than speed. IEX got its start from Flash Boys and purposefully places a speed bump ahead of trades to slow them down to (in theory) give everyone an even playing field. According to the panel, in the short term, this ironically likely benefits high frequency traders more than anyone as there is a fundamental mismatch of exchanges with new and old school particularly as it relates to speed. The panel was also quick to point out that there isn’t any real tech innovation here, if it’s successful, everyone will simply replicate it. If IEX, or others like them are to be a new winner in the space, they must create a moat around other variables such as ownership structure and / or business model.
Corporate bonds are traded over the phone, and this hasn’t changed for 50 years. This antiquated process erases all competitive advantage for traders and is incredibly time consuming and expensive. We’re talking about an $8 trillion space where 250 institutions dominate 75–90% of the transaction flow. Less than 1% of corporate bond round lots are traded electronically. Using the 80/20 rule (because I’m a “VC guy”), that means ~50 human beings dictate the future of the $8 trillion corporate bond space. Given this astonishing stat, Ronnie and the team at Trumid took the approach of building relationships with the top traders to bring them to the platform as opposed to building the tech, and hoping traders come to them.
Liquidity has become a huge problem as well. The number of trading partners that buy-side firms have has gone down from 20 to less than 5. This is primarily due to the multiple flavors of banking regulation that now limits the amount of balance sheet capital that can be used at any point in time. This is the latest and probably most prominent catalyst that is pushing the market towards a true technology enabled exchange that allows for all-to-all trading, much like we find to be the case in treasuries.
[It is worth your time to go to 4:00 in the audio clip and listen to Ronnie lay out the current state of corporate bonds.]
Much like the corporate bond market, treasuries have long been hampered by lack of transparency and liquidity leading to inaccurate pricing, large spreads and outsized commissions. These inefficiencies are predominantly due to a fragmented ecosystem and in some cases perverse incentives by large players in the market (read: banks). The market is similarly massive with $19 trillion of U.S. Treasury debt outstanding and $500 billion traded per day. The universe of institutional market participants is slightly larger with 550 firms ranging from dealers to prop firms, HFTs and real money. However, contrary to the corporate bond market, 60% of trades are done over the phone while 40% are done “electronically”. Electronically is written facetiously here because while the process is done with a computer, it’s far from efficient and utilizes an easily front run process called RFQ. U.S. Treasuries are undergoing a rapid shift to independently owned and operated exchanges where buy-side and sell-side institutions are able to trade side-by-side, enabling greater price discovery and improvements in execution (see below).
Special thanks to Brad, Joe, Ronnie & Jim from your friends at Canaan Partners. Your time and insights are invaluable.