Passive trading
The changes taking place due to unbundling are also linked to the longterm shift towards passive trading, which has been underway for some time but which has accelerated in recent years.
From January 2015 to June 2016, there have been $688 billion outflows from active to passive funds. There are now over 5,100 ETFs, with $3.1 trillion assets under managements. Meanwhile, the top five most active names on the S&P 500 have seen their average daily volume decline by 46% between 2011 and 2016.
This change has been met with some consternation by the global buy side community. While some parts of the industry are seeking to find ways of benefitting from it, others are concerned that the increasing use of passive investing and passive products creates a market more vulnerable to dramatic swings at times of volatility, and one less efficient and less able to adapt in times of crisis, since passive strategies usually just track an index.
“If the world carries on, the way things are going, the active managers are going to struggle and the passive managers will go execution-only,” said Fitzpatrick. “That then places greater pressure on the active managers because people will ask why they aren’t doing the same to cut costs.
But the reality is we need a diversity of participants in the market because we need buyers and sellers. The passive players are all going the same way, it’s the nature of their business. A market where everybody is doing the same thing is not in anyone’s interests”.
If these trends were continued to their logical conclusion, with the majority of market participants made up of passiveinvestors that operate on an executiononly basis, equities might face the prospect of becoming a spread-based market, similar to FX and fixed income.
Such an outcome would probably not be aligned with what the European Commission originally intended with MiFID II. But the theme of unintended consequences is one that is very familiar to the buy side when considering the
impact of global regulation in recent years. The phrase itself has almost become a fixture of discussions on the topic.
“If you look at the unintended consequences, HFT is a great example,” said Fitzpatrick. “That came out of the Dutch auction market. Due to MiFID one, virtually overnight they found an opportunity and they’ve not looked back since. The same applies to fragmentation of trading venues, which makes the market worse because it increases cost and complexity and fragments the liquidity making it harder to get an order done.”
However, that’s not to say that current trends will continue indefinitely. Fitzpatrick believes that there has been a bull market ever since 2008 – a situation
which must come to an end eventually.
And when it does, it could well be the active asset manager that is best placed to take advantage.

“We’ve had a phenomenal bull market since 2008,” he said. “People may not have realised it at the time, but it’s true and it’s stayed a bull market ever since. Sooner or later, we will get a bear market. And when that happens, as stocks move down, the active guys will be able to outperform again as they can react more effectively, whereas the passive traders are just tracking an index.”

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Market close
One of the other factors linked to all of the above is the shift towards greater trading activity at the market close. Among other signs of this, K&KGC discovered in our
algorithmic research earlier this year that one of the most popular strategies
is market on close. At the same time, sources on both the buy side and the sell
side report greater activity in the close, while liquidity is thinning out in the intraday
period. For more detail on this, see the Credit Suisse article on page 26.
According to Fitzpatrick, traders like to trade at the close because there’s no information leakage, and because the HFTs don’t play there. A similar factor lies behind the popularity of new platforms such as IEX in the US, which uses speed bumps to ensure that there is no advantage to be had from lower latency.
It also may be a factor in the plans at Bats Global Markets to launch an auction separately from the traditional one operated by the London Stock Exchange and other national exchanges, such as Hong Kong Exchanges and Clearing,
which recently introduced its own closing auction.

Biased lobbying power
Regulation has been a major impact on the industry for a number of years, and in Europe MiFID II has been a central point of debate ever since it first began to be
discussed in 2009/10. While the three main elements in the market may be the
buy side, the sell side and the trading venues, the influence of the three groups
is not equal. On the buy side, it is often felt that despite the European Commission’s
ostensible aim of helping the investor, it is the asset management community that
holds the least influence – while other vested interests seem to hold much more
sway with regulators.
“It’s very true that the lobbying is unbalanced,” said Fitzpatrick. “If I were to
go down to Brussels, I’d be lucky to get a meeting to see anyone. If an investment bank went down there, they’d have a much better chance because they’ve got more clout. But the exchanges are literally based in the next room, and they’ve got the regulators’ ear. They can influence the regulation and they have done and that’s a problem. They want a market that suits them, not necessarily
one that is in the interests of investors.”
Recent political events will also play into the debate. The election of Donald Trump as president in November 2016 was a surprise to many. But from a financial services perspective, Trump has indicated that he intends to deregulate the US banks, including watering down or reversing parts of the Dodd-Frank legislation. The end result of such a move would likely be a boost to the US banks, which would then be well-placed to increase their profits and potentially become acquisitive. At the same time, there is little to no prospect of European regulators following such a route, despite the struggling situation of many of the major EU economies.
“The EU banks are really going to struggle, because they will be tied down by the burden of EU regulation and MiFID II. If the US banks surge ahead, they won’t be able to compete and that’s going to be bad for the outlook for Europe. It could be that it’s the US and Asia that are going to be leading the way in the future and Europe will fall behind. My question to the industry would be, should the market be driven by regulation? Is that really the sort of market we want to have?”
The relatively severe European regulatory approach can also be highlighted by
actions designed to make bank executives personally liable for mistakes and failures.
Regulators in Europe have systematically targeted the top executives and made
them terrified of draconian punishments including bonus clawbacks, fines and
even jail time. But there is (and has been for a long time) a sentiment that the regulatory changes may be going too far. This editor recalls a conversation with Anthony Belchambers, at the time president of the Futures and Options Association, back in circa 2012 when he mentioned that the regulatory train may be running away out of control. It is a sentiment shared by Fitzpatrick.
“Would you encourage your kids to go into this industry? Knowing that salaries are getting cut, bonuses are being capped, and if you make a mistake you could end up in jail? It’s good that people are accountable but this goes too far,” he said. “The result is that banks are struggling to get the talent they need. No one wants to be on a bank board. They don’t want to be hung drawn and quartered if something goes wrong. I think the government will realise eventually the damage all this regulation is doing.”