Brokers brace for Mifid II squeeze

Further consolidation is forecast for the interdealer broker industry as Mifid II looms

Interdealer brokers are no strangers to a gamble. When Risk.net compiled its annual rankings of the industry four years ago, many bet the big five interdealer brokers at that time would be a big three within two years. They were too pessimistic: the industry managed to sustain five brokers for another 18 months before bowing to the twin pressures of increased costs and competitive dynamics.

Tullett Prebon’s £1.3 billion ($1.7 billion) purchase of Icap’s voice-based global broking business in December 2016 was the largest in a spate of deals that have reshaped the competitive landscape for brokers over the past year. Just over a month later, BGC Partners announced it had completed a deal to buy New York-based rival GFI Group, adding to the previous year’s acquisition of equity derivatives specialists Sunrise Brokers. Compagnie Financière Tradition was active too, striking a strategic partnership with local rival Gottex.

Yet there are some who think the industry has the potential to become smaller still. With the full impact of the revised Markets in Financial Instruments Directive still unclear, the cost pressures driving consolidation have yet to peak, they argue.

“For the smaller brokers, I think it will be difficult to maintain their current business model in their current independent status, unless they have something very unique or niche that gives them an edge,” says Dan Marcus (left), Tradition’s London-based global head of strategy and business development. “I suspect there are seven or eight medium-sized brokers who may well find life difficult in the world of Mifid II, alongside all the other global regulatory impediments.”

Mifid II is not the only reason brokers anticipate more mergers and partnerships in the year ahead. Now the dust has settled on the TP-Icap deal, rivals are setting out how they plan to take on a firm now boasting 3,425 brokers in 31 countries. In part, they say, that will involve investing strategically in smaller firms to fill gaps or strengthen expertise in a particular market niche. Consolidation, in other words, will beget more consolidation.

“I think you have to realise you cannot necessarily beat [TP-Icap] in size and scale or spending power – so you have to be clever,” says Marcus. “You have to be nimble and you have to be open to working in partnerships.”

Great British broke-off

On a day-to-day level, it remains very much business as usual for the broker desks and their clients at the newly created TP-Icap. “The landscape hasn’t really changed that much,” says a rates trader at a European bank in London. “They are still operating like two separate businesses.”

Brokers continue to work on the same desks and serving the same clients as they did pre-merger. Essentially, the company is running two competing brands, each with its own liquidity pools and separate central limit order books and request-for-quote systems.

This buy-and-compete model has long been Tullett Prebon’s approach to integrating newly acquired businesses. Even before the merger, the company was still running two separate euro rates desks, for example: one the Tullett desk and the other the old Prebon Yamane desk.

Clients want familiarity and certainty; if something is working on the client-facing front then we do not want to change that

Mihiri Jayaweera, TP-Icap

“When you bring two organisations like Tullett Prebon and Icap together, you don’t want to break up those successful desks,” says Mihiri Jayaweera, group head of strategy at TP-Icap in London. “So even at Tullett Prebon before the acquisition, there were instances where we had two separate desks in the same product but with different people and expertise. Clients want familiarity and certainty; if something is working on the client-facing front then we do not want to change that.”

What has changed is that the two brands now share one single back office across admin, legal and compliance, allowing it to cut costs. The integration of the two businesses around these functions is still a work in progress, says Jayaweera – but in the current environment it is here where the benefits of scale are most keenly felt, she adds.

On January 3 next year, Mifid II will enter force, a change that means interdealer brokers – whether they use voice, electronic or hybrid broking models – will be regulated as trading venues. Brokers say the level of investment required to be compliant could be a bridge too far for smaller firms.

To make the changes necessary to offer trading on an Organised Trading Facility (OTF) or Multilateral Trading Facility – two of the categories interdealer platforms may fall into under Mifid II – will require considerable investment; one study by IHS Markit put the financial services industry’s compliance bill at roughly $2 billion. Equally, managing the changes wrought by the UK’s pending exit from the European Union is likely to be costly too.

“The scale of regulatory changes such as Mifid II or Brexit are not to be underestimated. We’ll often hear people at smaller brokerage companies saying they require a full-time team to manage these changes but lack the resources,” Jayaweera says. “Some firms will just conclude it is easier to do all of that as part of a bigger firm.”

Switzerland’s Gottex Brokers – long the market leader in Swiss rates products – offers an example of the dilemma faced by smaller independent brokers. In December last year, it announced it was entering a strategic partnership with Tradition, with its larger Lausanne-based neighbour becoming a minority stakeholder in the company.

Cost factor

The costs of adjusting to the coming regulatory shake-up in Europe’s securities markets was a significant factor behind the firms’ decision to seek a partnership, says Spencer Nathan, chief executive of Gottex Brokers in Lausanne. The firm had to weigh up whether it had the resources and infrastructure to survive, long-term, in the new world; its experience during the 2014 implementation of Dodd-Frank in particular – when it lacked a licensed swap execution facility at the go-live – suggested it might be better to manage the coming changes under the umbrella of a larger firm, he says.

“At the advent of the Dodd-Frank US regulations, we were not Sef-ready,” says Nathan. “While many of our customers found themselves in a similar situation, the altered circumstances meant there were now a number of US clients that we were unable to provide a traditional service to. As a result, the decision was made to forge a partnership with a larger company and establish mutually beneficial synergies to navigate the changing regulatory landscape.”

I believe the future is electronic, and will be defined by adherence to and compliance with new regulations, and in particular Mifid II

Spencer Nathan, Gottex Brokers

After striking the deal, Gottex was immediately able to trade in the US markets once again by utilising Tradition’s Sef. Similarly, Nathan says the shared infrastructure with Tradition is easing the transition to Mifid II, and allowing the firm to become more competitive in a global market where flows become increasingly electronic.

“There has been much investment in electronic platforms, and having all that at our fingertips now is a game-changer,” says Nathan. “I believe the future is electronic, and will be defined by adherence to and compliance with new regulations, and in particular Mifid II. Now that this shared infrastructure is in place, I am very confident moving forward.”

Harold Uzan, chief executive of broker Square Global Markets in London, agrees compliance costs will make it harder for niche players to remain fully independent.

“Post Mifid II, we expect these micro firms – particularly those focused on OTC markets – will find it difficult to survive in the face of the OTF challenges and greater regulatory [burden],” he says. “The list of necessary changes is long: a complex variation of permission application [to UK regulators], increased minimum capital, new technological solutions for pre- and post-trade transparency, among many others.”

Ultimately, the changes wrought by consolidation and compliance should make the sector “more mature”, Uzan adds.

The shift in competitive dynamics by TP-Icap’s merger could yet spur further consolidation: close competitors see forming connections with other companies as a way of consolidating market share.

Tradition struck several such deals in the past year, for example. One was a strategic partnership signed with derivatives compression specialists LMRKTS in August 2016, to utilise the company’s technology and analytics to deliver an execution and compression processing tool for G10 FX forwards. In January 2017, the firm also agreed a deal with Nex Data, the market intelligence and price information arm of Nex Group – the firm that contains the rump of Icap’s electronic broking and post-trade services businesses – which will see it become the distributor for Tradition’s market data and information services division, TraditionData.

We chose not to go down the route of trying to build a brand new compression service ourselves because it requires specialist algo knowledge and capability

Dan Marcus, Tradition

Marcus argues it is often easier and more productive to partner with a specialist, rather than building up a new service or tool from scratch. “In many areas, I would hesitate to do it myself if we could partner with another firm where there are significant synergies and such a partner is a market leader in that specific symbiotic area,” he says. “For example, we chose not to go down the route of trying to build a brand new compression service ourselves because it requires specialist algo knowledge and capability. Instead, we partnered with LMRKTS, which had industry specialists working on the optimal solution for many years before working with Tradition to bring the solution to market.”

More consolidation to come

While brokers agree more mergers and acquisitions are unlikely among the three remaining firms at the top end of the market, many believe peak consolidation is some way off for smaller brokers. These are also the businesses most likely to be challenged by the compliance costs associated with Mifid II – making likely targets for the big three.

“You’ve now got three competitors globally across asset classes. There is a view, which I agree with, that for a wholesale financial market to be effective and competitive you need at least three infrastructures participants,” Marcus says. “All the big consolidations in the IDB world have now happened. But I think there will be continued consolidation with smaller players to some extent for the next couple of years – certainly until the European legislation has been embedded in to the market.”

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