MARKET NOTE
Larry Tabb
2018: Turbulence and Pressure Intensify, But
Investors Win Big
Introduction
I don’t envy the current administration. While the
pressures in Washington have always been high, the
scrutiny on President Trump seems to be at levels not
seen in decades. As the Mueller investigation moves
forward, the partisanship on both sides of the isle
appears as fierce as ever.
While there may be increasing pressure to be
bipartisan, as the Republicans lost one (Alabama) of its
two seats that buffer its majority standing, it’s hard to
believe that we actually will see Republicans and
Democrats work together. But as I said last year, the
legislative process is not where the puck is going to be
– the majority of Trump’s successes will continue to
emerge from the regulatory agencies, which will drive
the administration’s playbook. While some of this
deregulation will get caught up in the courts, much of
the change will flow through fairly unfettered and will
provide the foundation for Trump’s longer-lasting
positive legacy.
MiFID II Changes the Game Globally
January 3 ushered in the MiFID II rules. On Day One,
we saw OTC volume decline, with a commensurate
uptick in exchange-traded and systematic internalizer
(SI) volume. That said, the double volume caps on dark
pools will not kick in until January 12. The volume caps
will shutter many traditional dark pools and will push
flow to large-in-scale dark MTFs, auction models, and
systematic internalizers. While exchanges will do well in
the near term, we expect that by the end of 2018 they
will not see the benefits that they expected when they
pushed the MiFID II agenda.
While Day One impact was limited, MiFID II will have a
tremendous long-term impact on the industry, not only
in Europe, but globally. After perhaps two years, we will
see:
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Founder & Research Chairman
January 2018
Key Industry Drivers in 2018
• The implementation of MiFID II
• The evolution of market making
• Growing importance of capital usage
• The active-to-passive transition
• Technological innovation
• New US regulation
• a decline in small- and mid-tier brokers and
investment managers
• an increasing percentage of off-exchange
trading (Europe only)
• wider bid-ask spreads (Europe only)
• a reduction in the breadth of investment
research, and
• a significant migration of assets from active to
passive management.
The winners of this battle will include: large, deep-
pocketed global banks that have wider distribution,
larger balance sheets, and a greater ability to offset risk
across geographies and asset classes than their
smaller competitors; large buy-side firms that will have
the scale to pay for the research they need; and
systematic internalizers and capital providers, as the
elimination of dark pools increases trading risk and will
push firms to try to capture alpha quickly through
capital, rather than wait for liquidity to appear on
exchanges.
While many industry players will be on the losing side,
investors will be winners, as the cost of research will
decline and its value will become increasingly
transparent to investors; competition will be beneficial
for those with both scale and talent; and more traditional
 2018: Turbulence and Pressure Intensify, But Investors Win Big | January 2018
investors will move to more passive vehicles, which
align more closely to benchmarks and come with lower
fees.
We don’t expect the SEC will advance any MiFID II-type
regulation; however, unbundling will spread from
Europe globally as larger global asset managers will
want a consistent global process. The market structure
changes catalyzed by MiFID II will also drift into the US
markets as SIs begin catering more directly to the
European buy side and as the buy side becomes more
comfortable/trusting of SI capital and direct interaction
with SIs. We also expect that SIs will build out a buy-
side algorithmic execution business.
The comfort of dealing directly with market
makers/systematic internalizers will make capital
commitment (and central risk book unwinds) an
increasingly important aspect of the execution business
in 2018. Not only will large banks increasingly offer
capital, market making firms also will increase their
capital commitment capabilities. This service will be
buttressed by improvements in firms’ central risk book
capabilities.
Buy-Side Algo Competition
As capital deployment efficiency changes the agency
brokerage business and research unbundling drifts to
the US, it will put increasing pressure on traditional
brokers, both large and small. Small brokers, which
increasingly will be muscled out of the research
business as firms unbundle, will view building out
electronic execution products as their only alternative to
shuttering; along with the increased push by electronic
market makers to build electronic execution
businesses, this will increase competition in the buy-
side algo space, which will drive lower prices and
improved performance.
The buy side’s increased use of algo wheels, which
allow money managers to better measure algo
performance and facilitate the restacking of algo
providers by their value, will pressure not only smaller
players but larger ones as well. This is bad news for
brokers that have benefited from their marketing
strength over their execution capabilities. It will also
scare firms that are losing share into reinvesting in their
infrastructures.
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Algo wheels – in addition to the SEC’s approval of
enhanced “Institutional 605” routing transparency – will
highlight the ineffectiveness of white-labeled broker
algos, which typically employ poor-performing, cost-
sensitive routing strategies. Brokers that white label
their algos will have two options: invest in more
effective and expensive routing techniques and
increase the pricing of white-labeled algos; or
discontinue offering white-labeled algos as a service.
As this dichotomy becomes more pronounced in 2018,
it will hurt white-label algo providers and their smaller
broker clients, and it will push more firms to work with
technology providers such as Pragma, Clearpool, and
the EMS providers that enable brokers to develop their
own algo suite.
From a firm-specific standpoint, we will see an
increased push by market making-type firms such as
Virtu, Citadel Securities, Jane Street, DRW (RGM) and
others into the institutional servicing space. They not
only will develop and enhance their ping networks, they
will open agency algo businesses to compete with the
large brokers. While many buy-side firms initially will not
trust doing business with them, by the end of 2018, we
will see these firms become increasingly important
execution partners to many on the buy side.
As a result of the increased competition in the buy-side
algo space, the cost of algo flow will decline, from the
approximately 62 mils charged today to somewhere in
the mid-50 mil range, if not lower. This will be especially
true if there is a significant change to access fees (via
an access fee pilot or a holistic change), if the SEC
grants greater 28(e) research unbundling regulatory
relief, if back-end OMS routing fees are constrained,
and/or if the SEC changes its view on exchange market
data fees. These initiatives could force commissions
much lower – possibly into the 20 mil to 30 mil range.
We won’t see the average algo priced in the 30 mil
range in 2018, but if these four initiatives move forward,
we could see rate compression of 50 percent by 2020.
On the regulatory front in the US we will see the SEC
develop an access fee pilot; move forward with ATS-N,
which will provide greater transparency into how ATSs
operate; approve greater routing transparency through
what is known as the Institutional 605 reports; and put
forth a proposal to reduce the cost of exchange market
data – but this will be only a proposal, as we are unlikely
to see any finalized rulemaking on market data fees in
2018.
 2018: Turbulence and Pressure Intensify, But Investors Win Big | January 2018

2018 will also bring greater downward pressure to the
standard connectivity fees, typically 10 mils, imposed
by EMS/OMS providers on brokers in 2018. This will not
come through traditional EMS/OMS channels; rather,
as cloud-based EMS/OMSs and cloud-based execution
facilities become more popular, the need/demand for
bespoke and expensive execution networks will
decline, since cloud-to-cloud connectivity is much less
expensive than the facility-to-facility linkages we have
today.
Conclusion
While we may have thought 2017 was a challenging
year, 2018 is likely to push the trend, as the pressure
on the investment industry will continue in the year
ahead. Not only will MiFID II demands increase the cost
structure for industry participants, the march from active
to passive strategies and the need for technology
efficiencies will push the industry to be more
transparent, competitive, and creative. The active-to-
passive transition will continue pressuring buy-side
active players to push costs down, including by
implementing more quantitative/AI/machine-leaning
technology. This will further intensify the pressure on
many of the weaker players (institutional investors and
brokers) already distinctly challenged as research
becomes increasingly unbundled globally, execution in
the electronic space becomes more competitive, and
capital becomes increasingly important to business
models.
While this continues to put both buy and sell side in a
vice, the unequivocal winner is the investor, who will
receive better services, for lower fees. While much of
this enhancement will come from the transition from
active to passive strategies, the remaining active
players will be stronger, have greater facilities, and will
be supported by better equipped and strengthened
brokers deploying better and more efficient
technologies.


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