Supporting Responsible Innovation: Three Key Ideas from the 2023 STA Annual Conference

The securities markets have been on an exciting but tumultuous path over the last few years, during which market participants and institutions have benefitted from higher trade volumes while navigating increasing regulatory oversight, technological innovation, and new disruptors. More recently, bank failures and shifts in liquidity from rising interest rates have shaken up the balance sheets of many financial institutions.

Aptly named The Next Era, the 2023 STA Annual Conference brought these themes into focus with discussions around the proliferation of ETFs and options, a global shift to T+1, and the challenges posed by the most active SEC in decades.

Many conversations also centered on the introduction of new disruptors, with Commodity Futures Trading Commission Chairman Rostin Behnman calling for responsible innovation that disrupts, changes, and challenges industry incumbents.

Three ideas stood out as key takeaways from the conference:

#1 Increasingly sophisticated retail trading makes waves for institutional investors

The number of traded US options contracts surpassed the 10-billion mark in 2022 for the first time ever, driven by explosive growth in short-term contracts and increasing participation from professional traders and algorithmic-powered institutions (i).

In his fireside chat, Benham referenced zero-day-to-expiration options, or “the fantasy football of retail,” as another example of reduced barriers to entry creating higher demand for new asset classes and products. Technology is an important additional driver in the creation of new products.

Similarly, ETFs are having a moment in the active trading world as some investors become more comfortable leveraging ETFs to look for opportunities in derivatives and fixed-income investing. Actively managed ETFs, in particular, are drawing investor attention. An estimated 20 percent of ETF inflows go through active ETFs, which represent only six percent of the market.

This attention has raised concerns that recent SEC proposals could have unintended consequences for the growing ETF industry. Participants on the ETF Perspective panel expressed that the tick size proposal could mean less incentive for market makers to support ETFs and that the rise in highly specific ETFs can limit available market makers and affect liquidity profiles and marketplace viability.

In addition to retail, demand for ETFs from institutions is growing - pension funds, asset owners, and asset managers are now adopting the asset class, and record growth in US ETFs is projected to power the industry’s assets to $15 trillion by 2028 from roughly $7 trillion currently (ii). And despite the overall record volumes, the year-on-year growth in options trading is now slowing as the meme stock frenzy dies down and markets balance out.

As retail investors better understand these new asset classes, steady, consistent trading across varying asset classes is expected to benefit the market in the long run.

#2 Industry-wide cooperation is necessary to implement T+1

As I said during my panel discussion last week, T+1 is a topic near and dear to Clear Street. Adopting T+1 will be a coordinated effort across the entire industry, and the speed of internal processing and external recall will be crucial. Under a shorter settlement cycle, investors can access their funds more quickly and utilize that capital earlier, increasing market liquidity.

While the move to T+1 initially seemed to follow the shortening process from T+3 to T+2, the technical and operational issues for both the buy-side and the sell-side are shaping up to be more challenging than anticipated.

Fails-to-deliver and global and overnight trading are top issues that are making many market participants feel uneasy about the transition to T+1. Settlement fails, in particular, can lead to a buildup of counterparty credit risk and negatively impact market liquidity. Although some believe that T+1 will reduce failures, resolving settlement fails and stock loan breaks will become more challenging on a tightened timeline.

The demand for modern clearing platforms with throughput and integration will not be easily met by larger firms with legacy technology. Firms that answer the call to modernize and spend 2023 coordinating with compliance, working with regulators, and upgrading and testing their end-to-end systems will see fewer bumps as May 2024 approaches.

Overall, while the shorter settlement cycle will present some challenges, it will ultimately improve liquidity, reduce risk, and create a ripple effect for innovation and operational efficiency at every step of the trade lifecycle.

#3 An active SEC calls for modernized data infrastructure

T+1 was far from the only regulatory proposal on attendees’ minds at the STA conference. Amid macro- and micro-economic changes, the SEC has proposed almost 50 new rules over the last two years. While 94 percent of institutional investors agree that U.S. equity market regulation could be updated to keep better pace with changes in technology and participant activity, complying with the new regulations will require many firms to modernize their data infrastructure.

At the STA conference, three rule proposals in particular came into focus:

• Rule 605 Enhancements: These amendments to enhance disclosure of order execution information will expand the scope of entities that must produce monthly execution quality reports to include broker-dealers with a larger number of customers and will require an increased amount of data and better reporting.
• Best execution: Today, equities often trade on off-exchange dark venues, which have different business models and are regulated differently than the familiar lit exchanges. Such developments in our markets make focusing on best execution that much more important. The sheer number of potential venues also raises a number of questions about how brokers handle their best execution obligations in light of conflicts of interest that may lead broker-dealers to place their own interests ahead of their customer’s interests. Proposed Regulation Best Execution would require broker-dealers to establish, maintain, and enforce written policies and procedures reasonably designed to comply with the proposed best execution standard but also has implications for brokers that handle customer orders in asset classes other than equities.
• Tick sizes: Adopting variable minimum pricing increments, or “tick sizes,” for quoting and trading NMS stocks is intended to reduce trading costs for investors, decrease access fee caps for protected quotations, and increase the transparency of the best-priced orders available in the market. Current rules prevent exchanges governed by the SEC from quoting in increments less than a penny in stocks priced over $1, which can create artificially wide spreads for heavily traded names. The majority of institutional investors agree that modest updates to Regulation NMS will create a more transparent, efficient, and competitive marketplace (iii).

The three areas highlighted require considerable attention to front-to-back workflows, operations, and data processing. It's clear that a move to modernization continues with great speed and urgency, including demand for structured data reporting.

Clear Street’s infrastructure is built on modern technology and operates with robust, real-time data sets. Our tech stack utilizes modern cloud-native infrastructure, including resilient service orchestration, event-driven real-time processing, and scalable data warehousing – a sharp contrast to the batch processing offered by mainframes.

We’re building the prime brokerage that reimagines the legacy workflows and silos that are essential to increasing access to the financial markets, all while transparently decreasing risks and costs. Our cloud-native clearing, settlement, and custody stack can work in a shortened settlement regime and provide investors with the real-time data they need.

Our goal is to give all market participants, from emerging managers to large institutions, the tools and services they need to compete in today’s fast-paced markets. It’s never been more apparent that the forces of volatility, regulatory change, and speed are demanding tools that allow firms to make sense of the markets in real-time.

A version of this article originally appeared on TabbForum on October 18, 2023.