The Curious Case of the Trader–Vendor

Tradeworx, one of the pioneers of modern high-speed trading, has invested heavily in financial technology throughout its years in existence. Low-latency routes for orders, co-location with exchange mainframes, ever-faster switches and server boxes—none of it came cheap. But it had an ace up its sleeve: It developed its own proprietary technology—its secret sauce—which allowed it to be successful in the cut-throat world of high-frequency trading (HFT). 

Soon, it began offering this technology to others, slipping into a dual role as a technology vendor and an active market participant, trading millions of shares per day. At times, it became hard to distinguish where the technology began and the trading firm ended. That was until January 2018, when Tradeworx announced that it was no more—it had decided to abandon HFT and throw its lot in solely with its fintech arm, Thesys Technologies.

Tradeworx decided to break off from its trading arm and rebranded itself Thesys Group. The spin-off strategy was to allow the trading business to follow its own growth strategy, executives say, but mostly it was done so that Thesys could pivot specifically toward technology. Its trading business, now named Blueshift, was partly sold to a private equity firm.

The high-speed trading market is no stranger to consolidation. Strategies have been squeezed as it becomes harder to gain an edge, and a number of prominent shops have either shut down or have sold themselves to rivals. But Tradeworx was different. It chose to embrace its role as a technology provider, a phenomenon that has occurred with ever-increasing frequency with the growth of the fintech sector. 

Thesys CEO Mike Beller says the trading side of the firm had its own ideas for growth, ideas that might work better if the two sides were not part of the same entity. “The consolidation trend has been ongoing for a number of years, but firms have different decisions for doing deals,” Beller says. “Speaking specifically for Thesys, we started in 2009 and have experienced growth and transformation over the past nine years and decided to sell our trading business to further expand as a standalone tech firm.”

While this might not signal a trend quite yet—Beller says these decisions are often made on a case-by-case basis—Tradeworx is the latest in a series of firms that has decided to pull back from trading activities and focus on fintech. And it’s unlikely to be the last.

Codependent Relationship

With the rise of electronic trading, technology and trading have become intertwined. Financial services firms see themselves as innovators and early adopters, having embraced many innovations early as they can help address inefficiencies. Today’s trading environment forces firms to implement the most advanced systems, not just to execute transactions but also to correctly report to regulators. Even regulators themselves have an interest in using emerging technologies to better monitor markets. 

As the business environment has evolved, some financial services firms have started building their own innovations focused on their needs, while others were in the process of figuring out what exactly technology can do for their businesses. Trading firms realized that they needed to develop platforms capable of handling volumes and speeds, with extra functionality to provide a competitive advantage against off-the-rack software. It therefore made sense for them to build such technology in-house. Banks, in particular, have become so wrapped up in technology that they often refer to themselves as technology businesses first and foremost. Goldman Sachs and Deutsche Bank have both repeatedly described their businesses as technology firms, as have other top-tier banks and large buy-side firms like BlackRock. Innovations developed by banks are sometimes even sold as standalone products for use by the wider industry, similar to the traditional prime brokerage and white-labeling models.  

“We’re a tech company,” says a senior technology executive at a major US bank. “We have a $10 billion tech budget. There are 40,000-plus people in technology, which is larger than some [pure] tech firms out there, even like Facebook or Apple.”

But the relationship between finance and technology is not limited to capital markets firms building technology for themselves—the fintech sector in general is white hot at present, illustrating the capital markets’ dependence on technology. Investments in fintech firms reached $8.2 billion in the third quarter of 2017 alone, according to a report from KPMG. Reflecting this relationship, Thesys is not the only firm that has moved on from its trading roots to focus on a more lucrative business. And one of the more prominent examples of companies moving toward financial technology is NEX Group. 

Sell-Offs

NEX Group, formerly known as Icap, sold its voice-broking business in late 2016 to rival Tullett Prebon. Rebranded as NEX, it runs its foreign-exchange trading platform EBS, fixed-income platform BrokerTec, and is a financial technology provider through its NEX Optimisation and NEX Opportunities businesses. Better known before its rebranding as the world’s largest interdealer broker, Icap started to invest in financial technology in 2002 with a minority stake in TriOptima. Over the years, the company expanded its financial technology portfolio until it finally sold its voice-broking operation and fully embraced its transformation. “We are very much a financial technology company, with technology underpinning each and every one of our businesses, enabling us to provide our customers with electronic trading platforms and a complimentary suite of services across the transaction lifecycle,” says Michael Spencer, CEO of NEX Group.

Spencer adds that the firm “will continue to grow by providing clients with the data, tools and services to make better decisions, increase efficiencies, and de-risk their trading activities.”

For NEX, the writing had been on the wall for some time. A shift away from voice broking to electronic trading had characterized the interdealer market for some time, and its derivatives business had suffered at the hands of seemingly permanent low interest rates across major trading jurisdictions. Added to that, the Icap brand had become embroiled in a series of scandals following the financial crisis related to benchmark fixing and cabal-like behavior in markets.

In earnings calls leading up to the announcement, Spencer often emphasized the pivot toward electronic trading, and away from the traditional interdealer broker heartland of voice. Icap spokespeople were also known to call journalists to complain about references to Icap as an interdealer broker in their articles—instead, they wanted to be known as a “market infrastructure and post-trade services provider.”

Yet, others cite more prosaic reasons for the switch. “There was a very clear need for consolidation in the voice-broking business; there were five brokers and only room for three in a period of low volatility, declining revenues in this sector, and an increase in electronic trading platforms,” says a source familiar with NEX Group’s thinking at the time. “Because of the voice-broking business, Icap was subject to consolidated waiver requirements, which impacted the profitability of the company and held back the electronic execution and post-trade businesses. By selling this business, we no longer come under the consolidated waiver capital requirement of the Financial Conduct Authority (FCA) and so there was a material capital release for the company.”

Icap isn’t the only example of this metamorphosis, even if it is, perhaps, the most prominent. Day trading firm Trillium, after being censured by regulatory authorities for spoofing, began to sell its surveillance software, Surveyor, to other firms, while the ill-fated Twitter hedge fund, Derwent Capital Markets, grabbed headlines for the few short months of its existence in 2012 before it, too, pivoted in an anemic attempt to become a vendor by auctioning off its predictive analytics technology to little interest. It raised £120,000 of a £5 million target. The firm later became an investment manager, Cayman Atlantic, which appears now to be defunct.

Blame Game  

But is the trading environment really to blame for the consolidation and sell-offs, or is it the individual companies’ strategies that are at fault? Moving from a primarily trading business to one focused mainly on technology appears to be the more lucrative of the two options. But this is a strategy that has more to do with how each company manages to survive in a difficult trading environment than one solely influenced by the low volatility in the market. 

Taking the Tradeworx–Thesys example, nowhere has this been more evident than in the high-octane world of HFT. The sector has experienced a tumultuous few years. Amid a low volatility environment, it became harder for HFT firms to gain an advantage and returns began to suffer. Proprietary trading firms soon had to contemplate the decision of whether to remain with their current strategies, sell or even shut up shop altogether. 

In the past few years, several trading shops have either been sold or have abandoned high-speed trading. In April 2017, Virtu Financial bought rival KCG Holdings for $1.4 billion, a move that resulted in an earnings boost for the company based on its fourth quarter earnings report released on February 8. Another HFT firm, DRW Holdings, bought two other trading shops, Chopper and RGM in 2017, further fueling consolidation in the market. Other firms have abandoned many of the HFT policies they employed and have chosen instead to focus on more quantitative strategies, like Teza Technologies. Virtu bought some technology from Teza. 

But those mergers, says Monica Summerville, an analyst at Tabb Group, had more to do with the larger HFT consolidation. “Consolidation in the HFT world has been going on for a while. Those strategies are not as profitable as they used to be,” Summerville says. “The latency race to zero has largely been won so operating on pure speed is getting harder and harder as that technology becomes more affordable and widespread.” 

Corporate Strategies

But that was not the case with the NEX and Thesys break, according to Summerville, because these were decisions made specifically in response to the individual companies’ corporate strategies rather than based on a wider industry trend. “Thesys clearly recognized that they have this technology component that can be leveraged for other purposes. They developed sophisticated technology, especially in data analytics for their trading business, and realized they could monetize that,” she says. “For NEX, that’s more complicated. Icap had a strong voice-broking business but that industry is another one that is under pressure due to the shift toward electronic trading, which is further encouraged by new regulations like Mifid II. Though voice will have a place for the foreseeable future, that market is going in a different direction than NEX’s electronic trading business.” 

In 2015, Manoj Narang, one of Tradeworx’s founders who became a face for HFT, left the company over disagreements with the board regarding the firm’s direction. By the time of the split, then-Tradeworx unit Thesys Technologies had already won two major contracts providing the Market Information and Data Analytics System (Midas) and the Consolidated Audit Trail (CAT) to the Securities and Exchange Commission (SEC), systems that were built to the specification of the regulator and the industry. 

This highlights another problem with firms that operate dual trading and fintech arms—any association between them is likely to raise questions about conflicts of interest. Ultimately, these are often resolved by cleaving the two apart. This was of particular relevance for Thesys, as it handled sensitive information from Midas and the CAT. While there is no suggestion that the trading arm would have benefited from this, it at least introduced the suspicion that an unfair advantage might benefit Blueshift had it remained with Thesys. “While no one is suggesting any impropriety, it came as no surprise to the people I have spoken to that Thesys have spun off their trading arm,” Summerville says.

Beller says that while at the start Thesys had to rely on the Tradeworx association to market itself, the company has been able to prove itself such that the “conversation around conflict of interest, at some point, isn’t even worth having anymore” particularly as the two units are considered separate.

Dismissive

For its part, Blueshift is dismissive of the impact this change will have. Mani Mahjouri, Blueshift CEO and chief investment officer, tells Waters that technology continues to be important for the firm—just not, perhaps, in the way it used to. Blueshift will focus on quantitative investing and HFT and will still continue to build technology—but solely for itself instead of offering platforms to other industry participants. The company also sold a minority share to a group led by White Oak Equity Partners, which helped fund the buyback of some intellectual property from Tradeworx. “Technology was a means to understand the changes in the capital markets, and in the early days it made sense to create technology resources built by traders for traders; but now the market knows how to build trading systems,” Mahjouri says. “Our goal, as a group of scientists, is to focus on specific elements of technology that are commoditized, where we feel our efforts produce outsized returns.”

Mahjouri adds that the cost structure of maintaining technology for HFT is a limiting factor for returns, though technology will continue to remain a large part of the trading world. Others agree.

Though other trading firms, like Virtu, also offer their technology to clients, there is a fundamental difference in that they have never evolved into fully fledged vendor organizations. A source at Virtu points out that the lack of customization being offered to clients allows the company to continue to focus on its core business—trading. “We also license our technology to clients like Bank of New York and JPMorgan, but that is the same platform that we use,” the source says. “The nature of Thesys’ products is that they use their expertise in the market to develop programs for others, while we build technology for ourselves.” 

The Virtu source explains that this strategy allows the company to focus on its core business rather than having to build a separate team focused solely on working for clients and essentially becoming a de facto vendor. 

As such, while it might not be a full-blown trend yet, the case of trading firms and their fintech interests continues to repeat with increasing frequency—and the scalps it claims are no small fry. As fintech continues to rise in prominence across financial markets—and, perhaps crucially, profitability—it’s unlikely that NEX Group and Tradeworx will be the last firms to cast an eye over their business lines and wonder whether one should be sacrificed in favor of the other. 

Correction: This story has been updated to amend the description of EBS, which is an FX trading platform and not an electronic broking business, as previously stated.