Justifying Brokers In An Unbundled World

April 10, 2018

By Ian Mawdsley, Head of ETI Trading EMEA, Thomson Reuters

Brokerages will face tighter scrutiny from the buy-side after MiFID II, and will find new ways to add value.

As the effective date of Markets in Financial Instruments Directive (MiFID) II nears, the implications of its mandate to unbundle services are getting clearer. MiFID II aims to provide a level of transparency around certain practices in the financial markets, particularly the use of broker commissions. In practice, the regulation asks: What does the payment facilitate and who should really be paying?

Until now, a variety of services have been bundled into simple “pay-as-you-go” commission payments. Research, corporate access and technology services are in these bundles by default. The payments have been used, however, to provide clients with office space and furniture. Ultimately, though, commission costs were passed on to the end-investors – the people who MiFID II protects.

MiFID II requires firms to pay for research either in cash or through research payment accounts (RPAs). Order management and execution management systems technology must be paid for through a direct arrangement between a buy-side firm and a vendor.

This is a crucial difference from MiFID I, in which guidelines about how dealing commissions could be used were provided by National Competent Authorities (NCAs), but were not included in the overall European Union directive. In turn, the trading community largely misinterpreted or perhaps even ignored those guidelines as brokers subsidized the costs of vendor services as part of their distribution, effectively inducing clients to trade with them.

So, what do these distinctions about which types of services may be or may not be paid for with broker commissions mean for brokers? Adhering to broker scorecards is becoming more of a challenge. The RTS 28 technical standards in MiFID II obligate buy-side firms to report on why they chose a certain broker as their execution channel – and to explain why in both quantitative and qualitative terms.

Quantitative analysis
In a quantitative selection process, transaction cost analysis (TCA) is the key driver. TCA should be inherent in best execution analysis (BXA). The RTS 27 best execution provision in MiFID II requires venues and executing counterparties to achieve more granular reporting detail. This will vastly improve the depth and quality of data. By analysing historical trade patterns, buy-side firms can determine where they will get the best execution of certain orders.

Proving best execution is not as simple as looking at how a trade has performed in the past and replicating the instructions. Firms must account for current market conditions and the executing party’s goals. Is immediate execution required? Does deeper liquidity need to be sourced? What type of benchmarks will be used?

The buy-side can access about 1,500 broker algorithms to execute trades on just short of 600 venues. Choosing among these algorithms for thousands of trades will be arduous. The obvious way to address this problem is some form of automation, likely including basic machine learning capability.

Using software to perform pre-trade analysis of executions will present the trader with one or more ways to place the orders with brokers. This will not only ease the trader’s broker and algo selection, it will also help compliance officers show that their firms used a systematic approach to best execution.

When trades prove to be small compared to a stock’s average daily volume (ADV), the buy-side may automate execution through a rules-based order router, allowing traders to focus more on transactions that are larger or more complex to complete. Broker selection can easily be randomized to distribute resources equally across numerous broker counterparts.

Qualitative analysis
Qualitative selection processes are obviously broader and harder to measure, but these are no less important to defining the relationship between the buy- and sell-sides. First and foremost, access to liquidity is a large factor in determining which brokers will make the list. Whether they access lit or dark venues, some brokers may choose to act as systematic internalizers (SIs), using their own risk capital to act as a one-stop solution for filling large block trades.

Secondly, access to quality and reliable executions, coupled with the appropriate investment in the associated technologies, will be a must. MiFID II will undoubtedly increase electronic traffic. The performance of sell-side legacy systems may be important for determining where order flow is directed.

Finally, the high-touch desk will also continue to play a part, acting more like an execution consultant than like a sales trader who uses the outdated ‘fill-and-bill’ method. As the markets become more fragmented and the technology offerings more complex, someone will still need to be there to hold the hand of the buy-side trader.

However buy-side firms figure out compensation of brokers for their services, the value brokers provide – even in a changed compliance climate – cannot be denied.

(These views represent the views of Ian Mawdsley and not those of Thomson Reuters.)

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Measuring MiFID II: The Right Way To Judge Its Success

GlobalTrading

April 3, 2018

By Mark Northwood, Principal, Bips Global

A rigorous analytical approach is essential to quantify the impact of MiFID II on trade execution.

Much has been said and written about the challenges that all firms have had to overcome to comply with the numerous articles, technical standards and ongoing clarifications of the Markets in Financial Instruments Directive (MiFID) II, as well as the enormous implementation cost borne by the industry.

But that is only half the story, and now that we are in the post-MiFID II world, the European Securities and Markets Authority, the national competent authorities in each country, and the industry itself should begin figuring out how to assess whether or not the changes have achieved their objective.

The European Commission’s primary goal was to improve things for investors: the individuals, funds and other entities that put up the capital that the issuers of equity and debt securities need. Therefore, the cleanest approach is to measure the impact MiFID II has had on the investment outcomes for these investors, and ask: Was it worth the collective cost and effort in terms of measurable benefits to them?

One area where it should be possible to build a sound, quantitative judgement of the impact of MiFID II on investors is in trading. Best execution should get better. Everyone from the chief executive officer and chief investment officer down (as well as investors themselves) should be curious to know the actual verdict. Traders will need to be ready to provide it, but how?

Analysing trade data
The answer will be found in each firm’s trade cost data, and is simply expressed as the change in average implementation shortfall for each order segment. However, these numbers will only be valid if the data collection and analytical approach is rigorous and sound.

For equity investors, this will be about ensuring that any comparison of implementation costs before and after MiFID II is statistically robust. This means having a sufficient sample size and controlling the execution process so that similar orders are executed in a similar way. In practice, this is only likely to be achievable at those firms that have adopted a systematic approach to their order handling, which provides a consistent strategy selection based on the characteristics of each order, thus narrowing the number of variables.

For other asset classes the analysis will be more dependent on the extent to which those firms have been collecting quote data in the securities they have traded in recent years, because the arrival price is the key reference data point that is required. Beyond that the analytical approach will be similar to equities and requires that the characteristics of each security and the individual order drive the sampling approach for building the cost comparisons.

Some data is of course better than none, and a judgment based solely on “feel” will no longer be sufficient.

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Improving Standards In The FX Market

GlobalTrading

March 20, 2018

By Brad Bailey, Research Director, Celent

The wave of legislation governing global securities markets has raised expectations for greater regulation and better surveillance of the foreign exchange industry.

Regulators and securities market infrastructure providers throughout the world are upgrading their internal surveillance capabilities and demanding more from their market participants. Meanwhile, trade surveillance is expanding into new instruments and asset classes, including foreign exchange (FX). Many firms are responding to the challenges, not least by deploying new technologies to improve oversight and ensure best execution for their clients.

The markets in financial instruments directive (MiFID) II and the market abuse regulation have set new standards in the European Union that will increasingly influence the behaviour of global sell- and buy-side firms. MiFID II, in particular, sets standards on the pursuit of best execution, requiring that all sufficient steps must be taken to obtain the best possible result for clients. It has driven a focus on transaction-cost analysis (TCA) technology for best execution, portfolio analytics, and pre- and post-trade analysis across the financial markets.

MiFID II has also been the impetus for operational, logistical and technology changes as firms prepared for how they will be trading FX products. They are forcing firms to remap workflows, build more robust connectivity, find personal information for trade tickets, and consider the geographical implications of all their counterparties.

Meanwhile, in the US, the Securities and Exchange Commission and the Financial Industry Regulatory Authority, and CFTC are also strengthening oversight. The CFTC has spoken about the fragmentation of liquidity in FX.

Several cases of misconduct have tightened scrutiny, and in part led to the publication of the FX Global Code of Conduct in May 2017. Arguably, this principals-based (rather than rules-based) code will struggle to prevent future market abuses because it lacks punitive remedies. National jurisdictions do possess legal powers of varying scope and severity, but there is still a heavy reliance on self-regulation within the industry.

FX market evolution
However, the future of regulation of the FX market must be discussed within the context of the evolution of electronic trading and the growth of new platforms and channels for sourcing liquidity and executing transactions.

Since the launch of the first electronic platform, EBS in 1992, the spot market has gone from 100% voice to 80% electronic. The FX technology space has seen considerable changes as a broad range of participants, from private individuals to central banks, continues to increase their electronic presence.

Yet, different market participants have diverse priorities, determined by the client base they serve. A firm that primarily transacts cross-currency payments for a corporate treasury department has a different perspective than one that is acting for a global fund manager making geographical asset re-allocations and from a firm competing with fast-trading dedicated FX funds.

Similarly, there is no single model for FX trading. Instead, participants can choose between order- and quote-driven models, single- and multi-dealer platforms, banks and non-banks: all are part of an increasingly fragmented ecosystem that offers alternative venues and trade strategies. As trading volumes are being dispersed, so there is a need for better and easier connectivity, aggregation, and access to co-location.

The market is faced with further technology demands as trading fragments and adapts to new obligations prompted by regulatory pressures on industry conduct. These trends are generating an ecosystem characterised by strong growth in data collection and analysis, and in new ways of measuring, transacting and accessing liquidity, as well pressures to reduce complexity and costs in middle and back office operations. It is essential to have analytics to understand exactly how counterparties are providing liquidity, their fill rates, time to fill, their risk positioning policies and its impact. Expectations on fair costs for execution and services and the type of markets expected by market makers remain a crucial theme for examination.

Innovative techniques
In addition, firms are looking at their technology choices in innovative ways. They are merging historically separate liquidity, protocols, and functionality, which should create opportunities for cross-FX product leverage and the merging of liquidity sources. And if the explosive growth in FX trading of the past two decades continues, then the market is likely to create new efficiencies to spot, forwards, options, and swaps, and drive better executions and cross-margining, while reducing costs along the operational cycle.

Moreover, as the FX market structure develops and the share of liquidity provision continues to be divided up between banks and nonbanks, greater intelligence is required by type of currency, time of day, and the fluctuations in workflows.

Liquidity constraints and fragmentation, combined with regulation in FX, are driving more firms to use TCA in order to determine which liquidity providers have risk-taking capacity and provide quality execution. We are seeing innovation in the delivery methods as well as the move from check-the-box compliance to real, actionable insights on trading performances for both internal staff and external counterparties. Best execution, and its demonstration, is the biggest driver of TCA.

Moreover, the legal ramifications from past scandals has altered communication methods within the FX market and is one of the factors driving a new wave of tools such as secure messaging, compliance-friendly instant messaging platforms, and voice capture systems. The legacy will continue to drive investment in more sophisticated and third generation surveillance. In fact, firms already conduct surveillance across multiple channels, incorporating rapid electronic trading with human voice transactions within a structured, disciplined process. Firms want to know how their traders are interacting with clients, and avoid liability for misbehaviour. That means prevention and, if that fails, catching transgressions quickly.

Individual FX trading firms are solving many of the problems, such as front-running, price fixing and “last look” exploitation, both internally and in partnership with third-party technology vendors.

Extending surveillance
Banks have traditionally focused surveillance efforts on executed trades in liquid instruments. But the evolution of algorithmic trading and high frequency trading has revealed that significant information on
potential misconduct can be found in order level data – for example, layering, spoofing, quote stuffing, multi-legged orders, high order to execution ratio. With the proliferation of order types and trading strategies in all asset classes, including FX, banks also have to understand how these can be used to identify and prevent misconduct.

However, few banks have adequate policy and governance structure in place to handle the scale and complexities of the challenge. This is because surveillance operations are often driven by how trading desks, asset-class based operation, or lines of business have already been organized in the front office; these are often siloed with each having its own systems and processes.

Artificial intelligence, machine learning and robotic process automation technology provide opportunities to significantly bolster surveillance operations by offering new insights through advanced analytics, as well as by improving costs and efficiency through automating parts of the alert investigation process. The cloud, with its low-cost storage and flexible computing capabilities, can be another potent tool for helping in surveillance.

The real revolution is likely to come in communication surveillance. Developed solutions in electronic communication have already emerged, and the next frontier of innovation will involve analysing voice. More advanced firms are moving toward a holistic approach, overlaying trade information on top of communication data and even other data that gives them a better view of employee behaviour and understanding of intent.

It seems clear that the FX industry is making significant efforts to improve standards of internal surveillance and self-regulation. The threat of legal sanctions within individual jurisdictions for misconduct is costly not only in terms of monetary loss, but also on reputations. Most of all, client expectations, reinforced by the availability of new technologies, are forcing FX firms to curtail opportunities for misconduct, increase transparency and ensure best execution.

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A World Without FIX

GlobalTrading

March 20, 2018

By Tim Healy, Global Marketing and Communications Director, FIX Trading Community

The FIX Protocol has transformed trading by increasing speed, reducing errors and improving efficiency. It also brings market participants together within a ruthless industry.

As someone of a certain age, I can indeed remember a world without FIX. I can remember quite clearly receiving faxes from clients with lists of orders and having to decipher what they said, calling back the client to confirm the details and then the small matter of trading them. I can also remember trading a new issue on the day of issuance and having multiple tickets spread across my desk and trying to allocate shares and price traded across multiple accounts. That was a late night!

I remember the errors – you never tend to forget those. That gut wrenching moment when you realised you had misheard the client and their ticker comment, and had traded something completely different. You see, a world before FIX was not easy. Phone and fax were the means of communication with the odd telex thrown in for good measure.

So, it is with these memories that I and many others can say with great confidence that FIX really has transformed and revolutionised the way the world trades. FIX’s origins lie in an attempt to solve all these pitfalls from the past. Fidelity and Salomon Brothers wanted to communicate orders and executions to each other electronically to reduce errors. Out of this initial conversation spawned the FIX Protocol, which then expanded as both parties realised the potential benefits of using the same protocol with other clients and counterparties.

Global reach of FIX
That was 25 years ago and the use of FIX is now widespread across all market participants and across multiple asset classes. Statistics are difficult to come by. FIX Protocol is open-source which effectively means that anyone can use it and there is no centralised database of FIX usage. However, looking at stock exchange data, and making some assumptions, over $8 trillion in value is traded on a monthly basis on global stock exchanges. A vast majority of this would be transmitted using FIX.

Imagining a life without FIX is not just a simple case of going back to the days of voice trading and broking. It would be safe to say that even without FIX, there is a high probability that other messaging languages would have been developed and used by market participants. This brings me on to another scenario of a world without FIX. What if there were multiple messaging protocols, all competing with each other? What if they were split geographically?

One of the most important facets of the FIX Protocol is its widespread use, both geographically and by asset class. The protocol is owned by the members of the FIX Trading Community. Any changes to the protocol are reviewed and approved by a technical committee and made available for all market participants.

The benefits to market participants are plain to see in the same way that both Fidelity and Salomon Brothers saw them 25 years ago. One protocol available to all enabling the world to communicate in a very cost efficient manner.

Collaboration in a competitive world
If FIX is at the heart of trading, the FIX Trading Community is as important to the market. The FIX Trading Community is the non-profit, industry-driven standards body at the heart of global financial trading. The Community owns the FIX Protocol in trust, which effectively means all initiatives are pursued in response to market participant requests.

This work is organised through a global network of committees, subcommittees and working groups that attract colleagues, peers and competitors who work together in a collaborative manner, free from commercial conflict, and in a way rarely witnessed in the capital markets to address core industry challenges. In a world where competitive advantage is key, FIX brings market participants together. Why? Because the cost efficiencies are clear.

MiFID II working groups
A great example of the collaborative nature of the Community has been the work the members have done to address Markets in Financial Instruments Directive (MiFID) II and the added regulatory requirements. Initially, the efforts focused on specific regulatory technical standards where it was felt that the use of FIX and standards could help market participants. A number of MiFID working groups were formed, calls for participation were made and co-chairs put in place.

One thing to note is that FIX Trading Community is an inclusive organisation. By that I mean that buy-side, sell-side, exchanges/venues, vendors and consultants are all welcome to join and be involved. The work on MiFID has been ongoing for over two-and-a-half years now and we have seen a number of best practices and guidelines documents and extensions to the FIX Protocol released in that time. Regulators and market participants alike recognise that the use of standards has never been more relevant.

FIX Trading Community continues to operate due to members and their annual membership fees as well as the global educational events that are held each year. If you are using FIX and are not a member, we urge you to find out more and join the effort. Without FIX, the world of trading would be a very different place.

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Best Execution – Adding Science To The Art Of Trading

GlobalTrading

March 6, 2018

By Kristian West, Global Head of Equity Trading, J.P. Morgan Asset Management

Best execution is not merely analytical oversight, but represents the complete order lifecycle, forming the essence of a trading function.

Best execution can mean different things to different people, from a high level policy to a core objective. Whether it is a goal, a benchmark or an ineffable aspiration, achieving best execution is a requirement for the whole industry.

Regulations imposed by the Markets in Financial Instruments Directive (MiFID) II, which take effect from January 2018, will require firms to demonstrate “all sufficient steps” have been taken to provide best execution, which is a strengthening of the previous rules that has created a great deal of consternation about how to create a factor-based approach to supervision.

From our perspective however, nothing changes. The objective of getting the best possible outcome for our clients is a personal, cultural and corporate goal that hasn’t altered over time. If articulated well, it should be a source of competitive advantage and increased client returns.

So how does one create a systematic, quantitatively-robust best execution framework? It is a practical rather than a philosophical challenge. Almost every component that touches an order through its lifecycle needs close attention, ensuring that the correct information is collected, stored and analysed.

People
Best execution starts with having the right people; specialists building the systems, executing the orders, analysing the flow and managing the overall process. Having a variety of skillsets is key: including people from outside of trading, and simply hiring quantitative experience is not enough. Having a diverse population form part of the best execution process stimulates creativity, perspective and challenge.

To have a robust, structured environment one needs an integrated system where technologists, traders and quantitative researchers work together, using modern techniques, to improve all aspects of order execution. The skills needed to be successful have broadened over recent times.

The role of the high touch trader continues to be critical in sourcing liquidity and enhancing capacity.

However, as markets have become more complex, technological and quantitative skills have become increasingly necessary. Additionally, the separation of these roles is being questioned, as the overlap between the three becomes more profound. Where does a trader’s role end and a technologist’s start?

Process
The trading environment should facilitate a systematic process. Giving traders access to more functionality and data allows them to turn intuition into informed – and importantly, evidential – decisions. Using machine learning techniques in such an environment leads to the creation of real-time “actionable analytics”. This allows one to reduce the variance of outcomes and systematically recommend the most suitable provider, execution strategy and parameters for a given order. This adds science to the art of trading by removing behavioural bias and introducing repeatable, quantifiably measurable actions.

Incorporating machine learning in this way also allows traders to focus on the aspects of the execution process where they are able to add the most value. Robustness to change should be core to the best execution approach, so the processes should be dynamic enough to accommodate market developments, such as tick size changes or the growth of systematic internalisers.

The review process should act as a feedback loop, continuing to improve the execution process. While robust oversight and evidencing is critical to best execution, it should not form the entirety of the framework. Traders, analysts and fund managers need to work together in a data driven process to continually look to improve the full implementation cycle. This needs to be holistic, covering everything from approval workflows to choice of execution venues. First and second line controls should be integrated and monitored by specialists with a deep understanding of the underlying trading processes and market dynamics.

Platform
Extensive connectivity, data, transparency and integration into the investment process are vital to driving optimal outcomes. Each event and action needs to be recorded, stored and made available for analysis. Only then will you be able to measure performance improvement. The platform required to build, monitor and enhance such an environment goes far beyond the traditional off-the-shelf order management system and transaction cost analysis platforms.

Traders, quants and technologists need to be able to build, refine and analyse in parallel. Systems need to be adaptable to allow workflows to be optimized and capable enough to handle the strains of modern quantitative techniques. While automation has featured in the trading landscape for some time it was initially leveraged for operational efficiency. Now it forms a key element of the best execution workflow and platform. A trader’s performance is proportional to the number of orders they manage, but this need not apply to automated processes. Combining automation with analytically driven recommendations establishes a controlled environment allowing one to quantitatively improve performance and client outcomes. It creates the ability to measure outcomes versus intention, a key element of “all sufficient steps”.

Best execution is not merely analytical oversight, but represents the complete order execution lifecycle, forming the essence of a trading function. To succeed, a combination of people, processes and platforms making continual, incremental improvements and adapting to market structure changes is required. Continuing to invest globally in these skills, processes and systems to enhance execution and investment performance regardless of what MiFID may bring in 2018 will differentiate the industry leaders.

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Artificial Intelligence And Equity Execution

GlobalTrading

March 6, 2018

By Ben Polidore, Managing Director, Algorithmic Trading, ITG

AI and machine learning can enable traders to manage trading risks better and enhance investor returns.

If you believe that variety is the spice of life, then maybe a career in electronic trading is for you. At last count, traders may choose from more than 1,600 broker algorithms and strategies, each with its own unique fingerprint. Despite this vast landscape of trading strategies, traders don’t necessarily see variety as a good thing.

A study earlier this year by Greenwich Associates found that only 7% of buy-side traders feel completely satisfied with the standard algorithms offered by their brokers. It is this discontent, along with advances in research and technology that present an opportunity to reinvent algorithms.

At ITG, we’ve been developing technology for self-directed trading algorithms since 1998, and are beginning to incorporate Artificial Intelligence (AI) into our algo suite following two years of extensive research. Given the growing popularity of the topic, the following is a brief overview of the evolving AI landscape and its growing application to the financial industry, particularly equity execution.

Gamers, techies and quants tear down the walls
The explosive growth of the video game market, which currently stands at $100 billion+ in global revenues, created millions of customers for graphics processing units (GPUs) and continues to drive rapid improvements in GPU capacity and functionality. Today, a commercial GPU with 9 TFLOPS of computing power (i.e. able to perform 9 trillion floating-point operations/second) is as fast as the 500th best supercomputer in 2008 and retails for just $5,000. Computationally intensive calculations, once requiring expensive and complex server farms, are now run on a significantly smaller footprint at much lower cost.

As advances in computer engineering quickly catch up with academic research in computer science, what was once considered theoretical is now achievable. Simultaneously, widely available research on AI and machine learning is leading to an explosion of interest across many industries in adapting this technology to solve real world problems. In addition to research in academic journals, vast amounts of information are freely available on the internet. Anyone seeking an introduction to advanced reinforcement learning concepts need look no further than YouTube to get started. Since much of this research is publicly available, this results in fewer patent entanglements which further reduces the barriers to entry and the costs to employing AI.

The challenge of equity execution
Despite these technological and intellectual advances, speed remains a challenge in applying AI to equity execution. In a market operating at microsecond latency, AI-driven execution models operating on a millisecond scale are too slow for certain tasks such as limit order placement or pre-market risk checks. Major advances in training models via horizontal scaling (both on-chip and across chips) haven’t done enough to improve latency at runtime for real-time, in-band trading decisions. This is why we have focused our efforts mainly on discretionary order planning, which isn’t as constrained by latency and may even have more upside for performance improvement.

The need for transparency in the execution process is another big hurdle to AI adoption. In short, AI-based strategies are less deterministic than traditional trading algorithms. On the one hand, this behaviour may prove valuable to a trader as less predictive strategies may reduce information leakage by minimizing the signaling risk caused by repetitive behavior. On the other hand, when you ask a model to find hidden relationships between many underlying fundamental factors, it may be difficult to understand and explain what motivates a specific action.

Although the motivation may lack transparency, the governing logic is easy to understand, since the goal and the context to achieve that goal are explicitly defined in the AI model definition. To effectively understand and explain AI-based strategy behavior requires traders to effectively reframe the problem and educate their stakeholders (i.e., investors and portfolio managers) making it necessary to equip the trading desk with the appropriate analytics required to facilitate this task.

Another challenge to adapting AI for execution products is that posed by the paperclip maximizer in AI researcher, Nick Bostrom’s, now-famous thought experiment: AI algorithms seek to fulfill their goals with maximum efficiency, and with no regard for consequences outside of their objectives. In Bostrom’s thought experiment, a super-intelligent AI tool tasked with maximizing paperclip production might try to turn all available atoms in the universe into paperclips. In an execution context, this means an AI algorithm set to a particular benchmark, say the opening price of a stock, might behave too aggressively in hitting that goal, essentially rediscovering practices already tried and discarded by human traders. Carefully considering the objective function and its second-order effects, is crucial when employing discretionary AI in the execution process.

Fear the robots?
To some, the term artificial intelligence elicits feelings of deep despair at the rise of the machines and the inevitable decline of human work. It is beyond the scope of this article (and its author) to speculate on the potential socio-economic impact of AI on the financial industry. However, it is worth recalling that similar fears arose with the introduction of trading algorithms and direct market access. In time, they simply became weapons in a trader’s arsenal and a way to manage an increasingly complex market.

We view AI in the context of equity trading in two ways: first and foremost, as an opportunity to improve trading performance and second, as a pathway to simplify a landscape of trading strategies that has grown in complexity over many years. Used appropriately, AI can enable traders to effectively manage trading risks and allow them to focus on the tail events that adversely impact trading performance and, ultimately, investor returns.

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FX Market Supervision And Surveillance

GlobalTrading

February 27, 2018

By Rupert Walker, Managing Editor, GlobalTrading

The FX market should continue the dialogue that led to its Code of Conduct, identify ways to share data and examine initiatives that promote efficiency.

Summary

FX Global Code is principles-based rather than rules-based, contrary to the trend across other financial services
Prosecutors struggle to win cases against malpractice in the FX markets and often have to rely on inadequate legislation
The regional centres of FX trading are shifting
Electronic non-bank market makers are proliferating and trading is becoming more relationship-based
Private initiatives enhancing transparency and fairness might establish normal practices that be formalised in regulation
Regulation can be selective rather than wholesale
It is important to maintain a constant dialogue within the industry and promote the issue of regulation as a discussion topic in the media

Proposal
The world’s financial markets are continuing to adjust to a vast array of new regulations and tighter levels of scrutiny imposed in the wake of the global financial crisis almost a decade ago and amid its disclosures of abusive activities. Legislation, especially in the US and Europe, aims to improve transparency and risk control, reduce market distortions and extreme volatility, and eliminate malpractice and fraud.

Meanwhile, the global FX market has largely avoided rule-based regulatory oversight. However, following several scandals, in May 2017 the Bank for International Settlements (BIS) issued a new code of conduct for foreign-exchange trading.

The 78-page code, developed by a partnership of central banks and market participants from 16 jurisdictions around the world, complemented a version that was released a year earlier. It is not designed to replace local laws, but the 55 principles were compiled through consultation with all the major stakeholders. Central banks have made it clear they expect fairness, discretion and high ethical standards. (1)

In addition to a general exhortation to ethical behaviour and good governance, the standards incorporate principles and processes for trade execution, information sharing, risk management and compliance, and confirmation and settlement.

The Code is expected to apply to all FX market participants, including sell-side and buy-side entities, non-bank liquidity providers, operators of e-trading platforms as well as other entities providing brokerage, execution, and settlement services.

However, its principles are guidelines; they are not legal obligations and there are no explicit punitive consequences for breaching them. Instead, they are “intended to serve as a supplement to any and all local laws, rules, and regulation by identifying global good practices and processes.” (2)

Guy Debelle, deputy governor of the Reserve Bank of Australia, explained at the launch of the Code of the Code on 25 May, that it is principles-based rather than rules-based, because “the more prescriptive the Code is, the easier it is to get around. Rules are easier to arbitrage than principles…If it’s principles-based and less prescriptive then market participants will have to think about whether their actions are consistent with the principles of the Code.” (3)

Arguably however, this embrace of self-regulation and reliance on peer-pressure to encourage good practice is inconsistent with the trend for the strict, detailed regulation and legally accountable measures being imposed on other sectors of the financial industry.

For instance, the Markets in Financial Instruments Directive (MiFID) II, which will be introduced across the European investment services industry in January 2018, is unambiguously rule-based. Moreover, the MiFID II regulations will cover the trade execution of most FX instruments, with the notable exception of spot transactions.

In this context, and against a background of historical and topical malpractice among FX market practitioners, it is debatable whether or not a principles-based code is sufficient, desirable or even feasible.

There is no single regulator of the global FX market. Instead regulation is dispersed among national central banks, and activities at the institutional level are also closely monitored and supervised by government bodies.

Prosecutors have often found it difficult to pursue criminal cases against banks or individual employees for market malpractice.

But, there have been notable successes. An international investigation into currency misdeeds saw seven banks, including Citigroup, Barclays and JPMorgan Chase agree to pay about $10 billion in fines for sharing confidential information about clients. The UK Serious Fraud Office closed down its own investigation into currency rigging in 2016, so the US has been the sole authority to bring individual charges. Three former HSBC employees are awaiting federal trial in Manhattan and, separately, a former London-based currency trader at HSBC is on trial in New York for his alleged role a front-running scheme. (4)

However, it is uncertain if the Code and current regulation will be enough to deter and identify future malpractice.

Furthermore, the nature of the FX market is changing rapidly with the adoption of new technologies and a proliferation of bank and non-bank electronic trading platforms. In addition, reduced risk appetite is affecting trading behaviour, and there is also a shift towards booking FX trades in regional centres such as Hong Kong and Singapore.

In order to assess how the global FX markets could be more tightly and uniformly regulated, an understanding of its current structure and composition and trends in liquidity provision and trading patterns is essential.

The industry should continue the comprehensive dialogue that led to the creation of its May 2017 Code, identify ways to share data and information on both a formal and informal basis, and critically examine private sector initiatives that promote greater market transparency and efficiency.

The BIS Quarterly Review, December 2016, contains a detailed analysis of the composition of the global FX market, and the latest developments. (5)

FX Market Activity
For the first time in 15 years, FX trading volumes contracted between two consecutive BIS Triennial Surveys. Global FX turnover fell to $5.1 trillion per day in April 2016, from $5.4 trillion in April 2013. In particular, spot trading fell to $1.7 trillion per day in April 2016, from $2.0 trillion in 2013. In contrast, trading in most FX derivatives, particularly FX swaps, continued to grow.

The decline in global trade and gross capital flows in past few years partly explains why FX spot activity has fallen. Different monetary policies in major currency areas and the rise of long-term investors in FX markets have also played a significant role.

The volume of trading for hedging and liquidity management rather than for taking currency risk (by leveraged traders and “fast money”) has risen, so spot and FX swaps, have moved in opposite directions. The decline in prime brokerage has been associated with a fall in trading by hedge funds and principal trading firms, with spot market volumes contracting as a consequence.

Trading In A New World Order

GlobalTrading

February 22, 2018

By Rupert Walker, Managing Editor, GlobalTrading

Regulatory and technical changes are rapidly reshaping the trading landscape and all industry participants need to adapt.

The growth of the exchange-traded fund (ETF) sector, preparations for the launch of the Markets in Financial Instruments Directive (MiFID) II and the potential of artificial intelligence (AI) were dominant themes at the Singapore FIX Conference, held on 10 November 2017.

Speakers and panellists included senior executives from buy-side firms: BlackRock, Eastspring Investments, Janus Henderson Investors, Nikko Asset Management and UBS Asset Management; sell-side firms: Bank of America Merrill Lynch, CLSA, Deutsche Securities, J.P. Morgan, Société Générale and State Street; from the Singapore Exchange, Hong Kong Exchanges and Clearing, and alternative trading platforms; as well from leading trading technology vendors.

ETF efficiency
ETFs offer investors liquidity, transparency and wide market exposure, and are cost effective. Asian money managers are raising their exposures to US and European ETFs, often trading them in the same manner as individual stocks. It is important to understand that the liquidity of ETFs is determined by the liquidity of the underlying shares, and that the stated volumes traded on exchanges are not truly reflective of the liquidity that is available, argued speakers.

However, Asian home-grown ETFs are 10-to-15 years behind the US and Europe in development. The region needs to create new, unique products in order to attract investor interest, rather than simply replicate existing forms. The Singapore Exchange recently listed three innovative Reit ETFs, and the exchange is also trying to make the tax regime for retail investors more attractive, and promote ETFs to the country’s Central Provident Fund. Other segments targeted by leading ETF sponsors include private wealth management.

Although the Asia market is fragmented with competing jurisdictions, many investors are suspicious of the true value added by active strategies and continue to support the growth of passive funds. Issuers and sponsors can tap into this demand by offering new types of ETFs, such as inverse and fixed income funds.

MiFID II preparations
The approach of MiFID II implementation on 3 January 2018 is inevitably preoccupying many buy- and sell-side firms. The unbundling of research and trade execution commissions is forcing money managers to choose the most appropriate method to account for research costs under the new regime. Competitive pressures suggest that many buy-side firms will feel compelled to absorb broker research expenses directly through their profit and loss accounts, rather than pass them on to their clients.

Best execution methodology for non-equity asset classes is also a major consideration across the industry. There seems to be a consensus that simply replicating the process used for equities is insufficient and inapposite for other types of securities, particularly fixed income. The regulators appear to recognise this, and the intention of the new rules points to firms showing a clear methodology that consistently aims to achieve best execution, rather than best price in all circumstances.

Furthermore, it is widely agreed that greater automation and electronification of trading, which MiFID II implies, will be beneficial. Processes will be more efficient, transparent, auditable and professional.

Nevertheless, there are still areas of uncertainty. In particular, the role of systematic internalisers will need to be assessed and there is likely to be pressure to ensure there is equivalence with other liquidity sources, such as exchanges.

New technologies
There are clearly important megatrends that will affect the future of stock trading. Most notably, the wealth of information increasingly available is prompting the formation of new technologies and the development of systems to process, analyse, understand and apply these swelling data sources, both structured and unstructured, to enhance trade execution. Meanwhile, cloud technology is also changing the nature of connectivity between counterparties.

Curiously, considering the size of its resources, the financial industry lags behind other industries in its application of new data analysis techniques – although tighter regulation compared with the controls on pure technology companies might explain its loss of ground.

For instance, a failure caused by the unsupervised use of AI would likely arouse widespread political fallout, so it makes sense for the financial industry to incorporate it more slowly and in a more circumspect fashion. Moreover, respect for client security means many front office applications must stay outside the cloud, while economics dictates that investment in technology is determined by immediate client demand rather than long-term research projects that are not guaranteed to garner a financial return.

The application of AI and machine learning has become a regular discussion topic at finance industry conferences. However, as several speakers pointed out, these are not new technologies. Instead, a confluence of factors has made them more significant in recent years. These include the expansion of computer processing power, democratisation in the investment industry, increased information accessibility and the development of different skillsets among a new generation entering the industry.

Certainly, AI and machine learning technologies will have an increasingly important role in the trading cycle. The more controversial issue is whether or not they will eventually take over the whole investment process.

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The Future Of Trading Technology: Building A Resilient Stack That Supports Business Growth

GlobalTrading

February 13, 2018

A GlobalTrading Roundtable Discussion.

Regulation and technological innovation are forcing the industry to re-position their existing trading systems, according to participants at a thought leadership discussion.

The trading landscape is experiencing rapid transformations and is faced with further disruption. Regulatory imperatives, cost pressures, innovative technologies, vast new data sources, and a constant requirement to deliver competitive services to clients are forcing all industry participants to reassess the quality, efficiency and sustainability of the technology stacks they use or promote.

In order to meet the challenges and opportunities ahead, close collaboration between the business and technology departments within each firm is essential, agreed participants at a roundtable discussion held at London’s Royal Exchange on 5 October.

Clearly, the Markets in Financial Directive (MiFID) II is concentrating minds. The regime, which comes into effect on 3 January 2018, will force buy- and sell-side firms to implement trade processes more rigorously. Notably, there will an obligation not only to achieve best execution in all asset classes in re-structured markets, but to do so in a transparent and auditable fashion.

Prioritisation
Brokerages and fund managers have to determine priorities, avoid wasteful duplication and assess the relative merits of building their own systems internally or buying technology from third parties. It is critical that they streamline processes and install efficient and cost-effective technology stacks, be able to access data throughout the trading cycle, and recalibrate in response to changing market conditions and regulation.

Vendors also must prioritise to ensure their time and resources are not wasted on unproductive projects. A client’s request for a specific bespoke product might be commercially unviable if there is little likelihood that it can be cross-sold elsewhere, and even less worthwhile if there is no guarantee of final purchase and payment. However, vendors need to be flexible and able to offer both customised and standardised technology. They understand the regulatory obligations of their clients, and can tailor their products and services accordingly – but only if it makes financial sense, which typically means being able to offer them to other clients and for use in other asset classes.

As a panellist pointed out to general agreement: “You can’t get away with doing the same thing twice these days: you have to get it right the first time, otherwise it’s too expensive.”

At a basic level, technology prioritisation is simple: focus on regulation and the issues that all clients care about most, such as stability with flexibility, and systems that are fit-for purpose. However, beneath the surface prioritisation is highly complex. Different groups within a firm have their own particular urgencies, as well as disparate views about what technologies should be scaled, and sometimes agendas that might favour an in-house investment rather than buying products from third parties.

Shared interests
Fortunately, many firms now recognise the importance of collaboration and integrated project management. Instead of the traditional segmentation between functions, technology and business operations are cooperating more efficiently, because the selection of appropriate technology is central to the success of their overall success. Business leaders need to understand the role of technology and developers need to place their systems within a business context. Both must recognise that the aim of technology is to enhance capability. The increasing status of the chief technology officer reflects and affirms this trend.

Similarly, access to and use of data is a theme shared by monitoring regulators and the commercial ambitions of buy- and sell-side firms. Data is both the substance of trade transparency and a source of competitive value, so their interests are compatible.

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Justifying Brokers In An Unbundled World

Measuring MiFID II: The Right Way To Judge Its Success

Improving Standards In The FX Market

A World Without FIX

Best Execution – Adding Science To The Art Of Trading

Artificial Intelligence And Equity Execution

New post for Fleur

PATRICK FLEUR TO JOIN SOLID FX AS CHIEF EXECUTIVE.

Patrick Fleur, former head of trading and execution at pension fund PGGM (see Best Execution interview), is set to become the new chief executive of Dutch ECN Solid FX on March 5.

FX Market Supervision And Surveillance

Trading In A New World Order

The Future Of Trading Technology: Building A Resilient Stack That Supports Business Growth

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PATRICK FLEUR TO JOIN SOLID FX AS CHIEF EXECUTIVE.

Patrick Fleur, former head of trading and execution at pension fund PGGM (see Best Execution interview), is set to become the new chief executive of Dutch ECN Solid FX on March 5.

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