Europe's leading electronic market makers (EMMs) have cemented their presence in global markets and are now chasing new growth opportunities. Sophisticated algorithms and low-latency execution capabilities have given Europe's EMMs a solid position in global capital markets--generating strong returns on the back of high volume, low-margin trading models. The European EMM universe spans firms such as Netherlands-headquartered Optiver Holding B.V. and IMC Global Holdings LLC, European franchises of major U.S.-rated entities such as Citadel Securities L.P. (BBB-/Stable/A-3), Jane Street Group LLC (BB/Stable/--), and Hudson River Trading LLC (BB-/Positive/--), as well as U.K.-domiciled XTX Markets Limited.
Recent bouts of high market volatility, notably the pandemic, have turbocharged Europe EMMs' capital bases and solidified their global franchises. In their next growth phase, we expect them to expand their lit, high-frequency cores while deploying capital into new asset classes and less liquid products in over-the-counter (OTC) markets. OTC products include securities that trade directly between counterparties as opposed to on centralized exchanges.
What's Happening
To support growth, many EMMs are expanding into new regions, OTC markets, and longer-term trading strategies. This is a reaction to fierce competition and tightening margins in on-screen, low-duration trading. Consequently, Europe's options market makers are seeking attractive and underpenetrated markets, most notably India as the world's largest options market (by volume). Some EMMs are looking to deploy proprietary datasets and models they've built to target statistical arbitrage-like opportunities whereby average hold positions range from hours to days as opposed to fractions of seconds and minutes for low-latency market making and require more manual oversight. Options-focused firms are also seeking to expand into the delta one space, using both high-frequency and directional strategies.
Why It Matters
Growth and diversification will increase risk and require capital. The addition of OTC and longer-duration trading will help EMMs diversify their income sources away from purely low-latency market-making revenues, which are heavily correlated to market volumes and volatility. Indeed, this next growth phase, if successful, will likely improve absolute earnings gradually, and subsequently create revenue stability and diversity through the cycle.
That said, longer duration, less easily hedged and more illiquid positions add incremental market risk. They also require a stable base of funding and liquidity to support them. Moreover, they accentuate operational risks in what are already complex pricing and trading models.
In addition, internationally diversified operations in emerging markets are often more capital-intensive than existing market-making activities. This rising complexity and widening risk profiles in narrow, but highly effective, franchises may affect EMMs' earnings and risk profiles.
What Comes Next
Evolving business models will create new risks and opportunities for Europe's EMMs. Earnings will continue to skew to Europe's historic core of low latency, electronic market-making, underpinned by the sector's dominant focus on index and equity options. Even so, we expect the next few years to involve concerted growth and revenue diversification. EMMs will unveil new strategies in their heartlands and expand into emerging markets, fueling a new phase of growth.
The flipside is that longer-duration, less liquid strategies introduce new risks for firms dominated by trading in the world's most liquid products at hyper-frequent durations. For ratings to remain stable, rising capital intensity and increasing market risk will need to be met with expanding capital, but the amount and range of risk EMMs face will rise nonetheless. Incremental market risk and more complex risk exposures generally weigh on ratings under our framework.
This report does not constitute a rating action.
| Primary Credit Analysts: | Joe Hudson, London +44 2071766743; joe.hudson@spglobal.com |
| William Edwards, London + 44 20 7176 3359; william.edwards@spglobal.com | |
| Secondary Contact: | Giles Edwards, London + 44 20 7176 7014; giles.edwards@spglobal.com |
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