With Christian Voigt, Senior Regulatory Advisor, Lewis Richardson, Derivatives Product Manager, and Henri Pegeron, Product Manager, Derivatives and Compliance, Fidessa
Christian: Firms should start to think of regulation as more than just a headache. Regulatory change is not a one-time event, it is a continuous process – once MiFID II is out of the way, there will be new regulations rolling out across Europe, Asia and the US. Firms need to work out how they are going to deal with the changes to regulation on an on-going basis and those firms that set up the right processes to prepare themselves appropriately will be best placed for the future.
As an example, MiFID I never mentions the words smart order routing. However, if ten years ago someone had read the details and understood what it meant for the market, they would have anticipated the rise of smart order routing in Europe. Those kinds of market opportunities will always be there for firms who are able to understand the implications of regulation.
From a US angle, how are firms developing to stay ahead of regulation?
Henri: To add to Christian’s point, firms with people who understand global regulation and its implications are ahead of the game. Much of the time regulations are looking to create rules after the fact. By having a clear understanding of what the regulators are attempting to accomplish, a firm has an advantage and knows that it can prepare to operate under those rules. The firms that can suffer are those trying to be reactive to regulation, as opposed to working with it and understanding that regulation is about creating consistency and efficiency. A firm that is continuously upgrading its systems in order to meet regulatory criteria is very unlikely to find the regulation as much of a headache and it becomes more of a maintenance exercise.
In the US, for example, the regulators have seen that some companies are creating opportunities in the listed derivatives market, as they introduce rules around registration and risk controls; if you have read the comments of the CFTC this should not come as a surprise. Those firms that understand that regulation is cyclical, and part of the business lifecycle, can read into the regulatory changes and create positive opportunities for themselves.
How can Asia-Pac firms become more proactive with regards to regulation?
Lewis: In terms of being proactive, it is true that Asian regulators and the exchanges are not moving as quickly as their US counterparts, and that is something international exchanges are trying to leverage. ICE has set up an exchange in Singapore to allow clients to leverage the regulatory arbitrage between Asia and Europe and the US.
Asian brokers also see an opportunity to try and get ahead of regulations where they see things changing in Europe and the US; certain clients are no longer able to work with European or US brokers and so many brokers in Asia are taking on that business.
Do you think that the impact of regulation is more strongly felt by smaller firms?
Lewis: Some of the mid-tier Asian firms are seeing ahead of time what is likely to happen in a year or two once regulations such as MiFID II come into force in Europe. They are trying to be proactive now. However, it is probable that smaller firms will struggle to keep up with the new regulations and the opportunities they create, as they won’t have the same economies of scale as the larger firms.
Henri: What is also interesting is the way the regulation has been written globally means that the industry is becoming ever-more standardised. The regulators are trying to standardise aspects such as risk controls, exchange rules, trade processing, order monitoring, compliance and reporting. A lot of overhead is created with these types of regulatory requirements, especially for firms that may not have been the target of regulation in the past.
Standardisation brings with it the opportunity to call in third party providers who can design consistent industry solutions. Instead of falling behind because you can no longer keep up with the regulatory burden on your own, standardisation opens up an opportunity – firms might want to reassess how they tackle it. The smaller firms in all regions, be they brokers or buy-side firms, will start looking towards using solution providers for many of their regulatory concerns.
Moving Beyond the Regulatory Headache
Rationalising Global Connections To Drive Costs Down, Visibility Up
Craig Talbot, Global Head of Trading – Systems & Connectivity at Hatstand Consultancy insists a global connectivity review can identify options to reduce footprint, improve resilience, minimise complexity, eradicate duplication, and save significant costs.
Over the past fifteen years, investment banks have seen a massive expansion in global connectivity, encompassing hundreds of links to exchanges and buy-side clients as well as infrastructure to backup sites. This complex connectivity infrastructure is business critical, delivering reliable resiliency, but is also very expensive, from hardware to leased lines and exchange memberships. There is, without doubt, both significant duplication and under-utilisation of these key resources.
In an era of increased governance and demands for better resource utilisation, there are tangible opportunities to consolidate this infrastructure. But with poor visibility of the way in which lines are being used by trading and data applications, banks struggle to identify key areas for consolidation.
Cost and complexity
The days of generous Information and Communication Technology budgets are a very distant memory for any investment bank. In the post GFC meltdown era of limited resources and heightened regulation, every organisation is balancing demands for cost reduction and better resource utilisation with escalating compliance requirements for improved visibility, accountability and near perfect resilience.
Yet the legacy of those heady days of rapid expansion remains. Over the years every investment bank has connected to a large number of European, Asian and North American markets; while every asset class and each specialist area may have developed its own connectivity infrastructure with no reference to the rest of the organisation or the connections already in place. But does any organisation really need six separate connections to the Chicago Mercantile Exchange (CME) or four to EUREX? Is it really justifiable to have dedicated connections for each specialised trading function or asset class?
The issue is not only cost – although the unnecessary overspend runs to millions of dollars every year. Duplication and complexity add risk. Can an organisation be confident that it has eradicated every single point of failure? How can an investment bank respond to both internal audit and regulatory demands for improved accountability and resiliency without total, end to end visibility? And, to be frank, just how agile is the organisation when the global connectivity picture is so confused? In an era of increasing volatility, the lack of visibility across this incredibly complex, resource demanding connectivity infrastructure is becoming a major concern.
Application utilisation
The governance inspired sharing of resources and infrastructure between asset classes, from equities to bonds, fixed income to derivatives has become well established over the past few years. Yet in the majority of investment banks connectivity remains largely untouched. The problem is that while many organisations have a clear picture of the overall physical infrastructure in place, few, if any, have a detailed idea of the way in which that infrastructure is being used. Detailed physical to application mapping is lacking. Where are the areas of under-utilisation? Are there bandwidth problems that could cause downtime? How much duplication exists between asset classes and specialised trading functions?
There are significant opportunities to reduce the connectivity footprint to both cut recurring costs and simplify the infrastructure. From rationalising connections to each exchange to replacing expensive dedicated leased lines to vendors by leveraging the existing or upgraded internal network, the majority of investment banks could pay back the cost of a connectivity review in less than a year. In addition, a global review process should by default improve resilience by improving utilisation understanding and flagging problems of bandwidth redundancy.
The key is to map connections to utilisation, a process that requires a cross-function review and fact finding process that incorporates not only the known connectivity state but also detailed understanding of application utilisation across trading groups, client services, market data applications and institutional services. Furthermore, a thorough investigation that also includes an analysis and understanding of business trading requirements (across the full trade lifecycle) would result in the decommissioning of specialist platforms.
Simplify and consolidate
Given the over complexity of most investment banks’ connectivity infrastructure, it is important to start small, in one region, for example, rather than attempting a global project up front. Once the review process has gained true insight into the application utilisation across trading groups, client services, market data applications and institutional services, recommendations can be made, for example, to reduce connections, cut leased lines and reroute via the corporate WAN, or address an identified single point of failure. With confidence in the model the organisation can then expand into a global project.
For any Chief Technology Officer, the financial model is compelling: a global connectivity review should deliver not only payback within the first year but also recurrent savings.
Over and above the cost savings, the review provides on-going benefits. Consolidating suppliers and infrastructure reduces the footprint, and hence the need for extensive support staff. Critically, the business has a vastly improved audit trail as a result of improved visibility and gains the benefit of improved resilience. Furthermore, the holy grail of real-time application utilisation reporting can be factored in. With full transparency, it is far simpler and easier to meet regulatory and auditor demands for information about backup processes, resiliency and redundancy models and response plans. A global connectivity review and remediation not only saves significant money but transforms the speed and cost of regulatory accountability.
CTOs are, of course, wrestling with any number of cost cutting and compliance requirements. But it is worth considering: when was the connectivity infrastructure last reviewed? Ten years ago? Longer? From mergers to new business lines, the complexity for many investment banks is becoming untenable, and simply piling more connections on top of the existing infrastructure is not a long term option. In addition to the regulatory demand for better resilience and visibility, organisations face ever increasing demands for savings and better resource utilisation – a challenging requirement at a time when global instability is creating new pressures in areas of business change and agility.
Whether the priority is cost saving, compliance or agility, there is a huge opportunity for investment banks to review the state of global connectivity environments.
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MiFID II’s double volume caps : Michael horan
Will MiFID II’s double volume caps light up the dark?
Michael Horan, head of trading services, BNY Mellon Pershing
Michael Horan, head of trading services, BNY Mellon PershingDark pools play a vital role in the smooth running of equity markets.
What we have seen over recent years however is the emergence of a new style of dark pool trading whereby the trade sizes are not large, and in some cases lower than what we see occurring on primary exchanges. Both BCNs and MTFs are types of venues that accommodate small orders in the dark.
ESMA allows the use of ‘waivers’ to give permission to investment firms who want to trade in the dark. The ‘large in scale’ waiver is left untouched by MiFID II, which makes absolute sense. But it’s the treatment of the other two waivers that might complicate things.
For the smaller trades that occur on dark venues, it is the ‘reference price’ and ‘negotiated trade’ waivers that are most commonly used. And it’s these smaller trades that ESMA would prefer to see happening on lit order books instead. In order to achieve this, the two aforementioned waivers will have two new ‘caps’ applied, being either 4% maximum volume on one venue, or 8% maximum combined across all venues. Once breached, those waivers cannot be used for six months in the dark for the stock in question.
It remains unclear how we came to the 4% and 8% levels for volume caps.
If the general approach is to foster the migration of small trades from dark to lit markets, you can question if venues, vendors, and participants alike wouldn’t have preferred an outright ban in using the ‘reference price’ and ‘negotiated trade’ waivers. This blanket approach certainly would have been easier to deal with from a systems perspective. However, without a consolidated tape, and synchronised clocks which won’t have time to bed in for when MiFID II goes live, there is going to be a significant challenge for all involved to know exactly when the caps have been breached, or are close to being breached.
The other challenge we have is that the caps are going to be calculated on a 12 month rolling average, in which the majority of that calculation will include trades mostly done in a pre-MiFID II environment, where it’s not unusual for some stocks to trade way over 10% in the dark using the two waivers concerned. The resulting six month shut down in dark trading for the stocks concerned can be seen as a little unfair and a preferred option would have been to start the cap calculation clock on day one of MiFID II.
It will be interesting to see what happens on the first day when the double volume caps (DVCs) are introduced. It is very likely that there will be a rush to trade in the dark – like using up your ‘dark trading tokens’ before they all run out. And if that does happen, then as a result of liquidity being pulled away from lit markets and traded aggressively in the dark, spreads in the underlying lit market will widen for that period, or at best will suffer a level of instability.
Given the MiFID II implementation date has been pushed back, is it possible that there could be a revision to the double volume cap controls? There is still time. The sheer amount of data collection and management are mammoth tasks that not many people are looking forward to, and it’s no secret that in the trading world the DVCs are the least popular reforms under MiFID II.
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Better Than Average
By Belinda Fong, AES Sales, Credit Suisse
In an ever-changing market place, we keep a close eye on trends and changes to better direct our business. For that we trove through a vast amount of data on a daily basis. Strategy selection is one of the key metrics we look at. There is one statistic that our clients are oftentimes surprised by: the popularity of VWAP. Last year, amidst widening spreads and dwindling volume, a whopping 53% of AES flow in the region was VWAP. Ever since its inception at the turn of the century, the humble strategy that aims to help you be average remains the cornerstone of any algorithmic trading suite. It is still the go-to strategy of choice for a passive over-the-day outcome that is mathematically the “Minimum Cost” way to trade.
Misconceptions of VWAP
For something used so frequently, there are nevertheless a couple of common ideas about VWAP that are misconstrued. The first thing is market impact. For a given timeframe, VWAP is the slowest possible way to trade for completion. It is also preferable over TWAP as it follows the well-established volume smile, so you are not too aggressive during the middle of the day, unnecessarily increasing market impact. All well and good if your size is small and can stay hidden. However, in the current low liquidity environment, most trades are of sizeable ADV percentage if not multi-day; as the ADV% of your order increases, so does the impact. Our numbers show that once you go above 5% of participation your performance on VWAP starts to deteriorate. But where does the impact come from? Most VWAP strategies run on a historical volume schedule with limited real-time consideration. This means that even though the bid only has 1,000 shares, a buy VWAP order that needs to trade 10,000 shares right now will go right ahead to post and subsequently cross the spread to keep to schedule, thereby impacting the price and signalling to the market.
Do price points matter?
The second key point is that the price you trade at is in fact irrelevant to the implementation of VWAP. This can seem counter-intuitive at first. One of the questions traders often have around over-the-day executions is, why did I miss VWAP if the market consistently came my way? I have been buying as the price got lower, should I not have beaten the benchmark? The answer is, of course, no. What drives VWAP performance is being able to accurately match the intraday volume profile. There is a fair amount of literature on price and volatility in the search for alpha, which has somewhat diverted the conversation from volume. Volume is one of the most unpredictable aspects of markets. The life of a trader would be vastly different if he or she knew how much a stock was going to trade on the day. You can think of a full day VWAP order as a series of smaller orders of 5-minute periods. How much is allocated into each bucket makes up the trading curve. Assuming that you match the average price of each period, you can still slip against VWAP if your 5-minute buckets are not distributed correctly over the duration of the whole order. VWAP execution can essentially be reduced to a problem of choosing an optimal trading curve and minimising volume slippage.
A dynamic and adaptive solution
Current VWAP tactics slice orders according to a stock’s historical intraday volume profile. In general the trading curve of a VWAP order is determined on order arrival and will remain static for the rest of the order life time. A departure from heavy reliance on historical data is inevitable for a smarter way to trade this ubiquitous benchmark. To accurately implement VWAP, algorithms will need to adapt and dynamically adjust your participation rate on the day. In this evolved form, VWAP algorithms will comprise of a historical component and a dynamic one derived from current market conditions. Additionally, trade signals can be captured and used to make adjustments to the trading curve to minimise the drift in volume trajectory versus the actual day’s volume.
The opportunistic framework
Much can also be learnt from the advance of more opportunistic algorithms for intelligently seeking liquidity. Encapsulated in our ongoing work on the Opportunistic Framework, an underlying structure for tactics that adapts to an expansive set of trading environments through smarts around the real-time order book; opportunistic tactics that are agile in their reaction to changing real-time conditions will help keep impact low regardless of size. These algorithms also have spread capture as their prime objective, given high spread cost in the region. This is achieved by dynamically posting at multiple levels to maximise queue priority and improving near-side fill rates. When it comes to paying the spread, tactics will only get involved when opportunities are right. In response to the faster and volatile nature of current markets, we have recently augmented and fine-tuned the behaviour to be more agile. Interval VWAP figures for our flagship strategy within this framework supersedes traditional algorithms with little deterioration as spread widens.
Opportunistic VWAP
Bringing the Opportunistic Framework together with dynamic scaling of the intraday trading profile, we get a VWAP algorithm that has the best of both worlds. Starting the day according to historical profile, it will use real-time statistics to continually adjust future participation buckets as the order progresses. A trading envelope will bind the dynamic trading curve depending on the liquidity of the stock while allowing discretion for best performance. For stock that has poor profile stability, this allows us to capture unpredictable volume. The dynamics of individual slices would inherit opportunistic behaviour, with the algorithm seamlessly weaving them into the order book reducing signals and spread cost to a minimum. Spread-crossing decisions are driven by proprietary quantitative logic and closely monitored for optimal results. With little volume slippage, this is a nimble and agile way to trade VWAP that we are confident will consistently produce significantly above average performance.
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The Global Impact Of LEIs
By Chris Pickles, Bloomberg Open Symbology Team
Identity Management is the most important subject for the financial community to address over the next ten years. So many different industry themes come back to the core topic of identifying the “who” and the “what” of financial services activity. This is critically important largely because financial institutions today are often unable to identify uniquely many of the elements of their business operations. Whether the headline is Cybersecurity or Blockchain or Regulatory Compliance, or simply Operational Efficiency, the topic of Identity Management is fundamental to any and all of the above being feasible.
When Lehman Brothers was in severe difficulties back in 2008 it was selling off high-risk trading positions in order to get itself out of increasing trouble. However, it wasn’t aware that the some of the counterparties to which it was selling off some of those high-risk positions were actually other divisions of Lehman Brothers. Ask a major bank if it has a single consolidated system for managing client and counterparty data, and the reality is that they may have hundreds or thousands of different internal systems for that purpose (two major global banks each said that they have over 4,000 systems for this). Identifying uniquely what they are trading is a further challenge, particularly as investment firms have each developed their own internal identification systems for many of the financial instruments that they have to deal with across all asset classes.
Making change happen in any industry sector is always a complex and lengthy process. Where change requires introducing standardisation across organisations, national borders and vested interests, the process can – and in the financial sector, too often does – take decades. However, one aspect of the financial services sector that today not only enables change but drives industry change is the fact that it is a regulated sector, and regulations have become an increasingly critical driver of industry change.
The global Legal Entity Identifier (LEI) standard and system was created in response to the demand by governments to have regulations that work and that can be policed effectively. This was not “demand” as in “customer demand” but an insistence by governments of major economies that a solution for uniquely identifying legal entities internationally should be generated immediately. Government representatives and regulators committed to including the requirement to use LEIs in future legislation and regulations, so financial institutions could ensure that they can amortise their investment in implementing LEIs across more and more of their business and compliance activities, ie LEIs would help to enable increased operational efficiency overall.
Some key principles of the global approach to LEIs have been different to those used for other standards. Good governance was a key issue from the start, and is often a topic that is easier to address when a new standard is created with no legacy. The Global LEI System was created with pan-industry international governance as well as effective competition as core characteristics. Its governance structure and principles were also created to allow for speedier change and improvement to the overall approach taken, so that as flaws or limitations were found they did not end up being “legacy” that held back the effectiveness of the system.
Data quality of entity identifiers has been a challenge from even before the beginning of the global LEI system. Market participants found that there were flaws and limitations in the approaches of existing national agencies whose function included identifying legal or business entities. In some cases these related to specific issues such as how up-to-date the information was, while in others they related to more general issues of data validation and of data quality management overall. Even under the existing Global LEI System there have been some clear issues related to data quality, and these are already being addressed by the Global LEI Foundation (GLEIF).
Gradually the use of LEIs by regulators is being increased as new national regulations are introduced, such as Dodd-Frank Title VII reporting. EU regulations, as the primary example of regional/multi-national regulations, are beginning to have perhaps the most significant impact on the growth of usage of LEIs. EMIR and MiFID II/MiFIR are both examples of this, but requirements to use LEIs now extend beyond the Financial Markets sector, eg in the EU for EBA reporting.
However, one should not look at LEIs as just an initiative to identify counterparties and clients. The aim of governments and regulators is to avoid a repetition of the 2008 crash, and identifying who is in the market is only one of the building blocks that is required. An ultimate aim of regulators is to have a multi-dimensional modelling environment that regulators internationally can use to monitor risks and what is happening in the financial markets. That modelling environment needs to include data not only about market participants but also about financial instruments that they are using and trading and about the nature of risks themselves. The need is also recognised for greater granularity of data, including identifying parent/subsidiary hierarchies and the relationship between the legal entities that issue financial instruments and the instruments that they issue. Having data of all types in a standardised format that can be fed easily and quickly into this environment is a fundamental necessity.
This is equally true for financial institutions. The world of market infrastructures and service providers today has a plethora of proprietary and uncoordinated data standards that have resulted in investment firms having to create their own internal approaches, processes and systems for identifying entities, financial instruments and risks. The move towards greater standardisation by regulators with real and effective governance of the way that standards are applied and identifiers are issued enables firms to take a more standardised approach themselves to data management. With regulatory requirements for the adoption of data standards already coming into force, now is the time for firms to plan their strategy and direction for how they apply data standards to manage data within their organisation to assure their future.
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Oases Forming On The Liquidity Landscape
James Cooper, Head of Execution at Troy Asset Management argues that institutional dealers are refusing to concede defeat in their struggle to cope with a challenging liquidity environment.
Barely a day passes without new commentary on the scarcity of liquidity in financial markets. Broker dealers in particular have been keen to point out how difficult it is nowadays for buy-side firms to implement trades quickly, efficiently and with minimal impact. This is especially the case for fixed income trades but the observation is made about equity markets too.
Recent flash crashes (such as August 24, 2015) have been seen as symptoms of the liquidity crisis and have shaken investors’ and regulators’ faith in the well -functioning market objective.
Ample liquidity and an ability to execute trades effectively are important for the broader economy as a robust market place facilitates capital formation by corporates both large and small. But the question remains, is there really a liquidity crisis or is there, as many observers have suggested, merely a problem with “the plumbing”? Is trader behaviour and market structure merely being slow to catch up with a changing regulatory environment? Are there grounds to believe the industry will adapt to solve the problem?
The reasons behind the perceived liquidity problem are well publicised but are worth quickly revisiting.
Volumes have declined since 2009 for a number of reasons. Firstly, the G20 rules on use of capital by investment banks have had a significant impact on volumes through different channels; the ability of fixed income broker dealers to hold inventory and offer acceptable spreads to their institutional clients has significantly diminished. The same rules though have impacted equity traders too and market-making desks are being much stricter about how and to whom they offer their balance sheet. Scarcity of bank capital is felt further down the chain too, as hedge funds – traditionally a good source of trading flow – find it harder to tap into those constrained prime broking balance sheets.
Secondly, the Volcker rule has decimated proprietary trading. There are virtually no “internal hedge funds” left among the London-based banks and these reliable commission payers have left a significant hole in trading activity compared to the pre-crisis and pre-Volcker years.
Thirdly, hedge funds have, on average, lengthened their average holding period. Ritesh Shah of Citadel (Asset Management) had this to say in a recent interview.
“More broadly, given the higher transaction costs resulting from these shifts, we have moved towards more fundamental-based, longer-duration investing as opposed to model-based, shorter-term investing; our strategies as well as our personnel reflect that new reality”.i
The move towards a buy and hold mentality by hedge funds like Citadel are generally leading to less activity than previously.
Finally, the activity of retail investors has slowed to a trickle in recent years. These participants used to demonstrate reasonable turnover rates but have now mainly entrusted their investment decisions to the lower turnover mutual funds.
But liquidity is not merely about volumes. Information leakage has been a large and ever growing problem. The recent advances in HFT techniques have meant that in 2016 an institutional equity order in the US must run at 3% of volume or less for it not to be detected by the more predatory traders. This is a seismic change on 2007, when institutional dealers were routinely passing orders with instructions to participate at 33% of volume.
Phantom liquidity
Impact costs have become almost impossible to control in the current environment because of the febricity of the Continuous Limit Order Book (CLOB); whilst spreads may be narrow, displayed order book liquidity is truly a mirage: cancellation rates have been a hot topic in recent years, but for as long broker algos are designed to deliver price improvement and dodge negative selection, and for as long as electronic market makers cancel at the first sign of momentum, the CLOB will remain a dangerous place from which to draw water.
It was hoped that dark pools would help with information leakage, but institutional investors have been badly let down. Trade sizes have plummeted and the short term reversion is little different from the CLOB reversion.
The final piece of the liquidity, or impact cost, equation is volatility. Here it is reasonable to expect volatility in its various forms (but best measured by the VIX) to start rising after recently hitting all-time lows. Heightened volatility widens spreads and increases total costs of execution.
So given the decline in volumes, the lack of order book robustness and a likely increase in volatility, it is difficult to see how the institutional dealer can adequately and safely quench his thirst.
Well in fact there are significant grounds for optimism on all these fronts.
Volumes on the uptick
The chart above shows how volumes as a percentage of total free float have actually been improving (modestly but steadily) for more than two years. The data above is for the FTSE but the pattern is almost identical for the S&P and Eurostoxx 50.
It is difficult to isolate exactly the reason for the modest inflexion in volumes but there are three possible explanations. Firstly, High Frequency Trading (HFT) firms are becoming significantly better capitalized. Companies like Jump Trading and Virtu have joined Citadel as robust, well-funded institutions in their own right. Secondly, the recent good health of CTA (trend following) businesses and other systematic strategies has meant greater assets under management in that segment and greater resulting trading volumes (especially visible in the first two months of 2016). Thirdly there is an inkling that institutional dealers are daring to come to the water’s edge more frequently.
There are two reasons why institutional dealers might be trading more. Firstly, they are benefitting from the impressive development of the investment banks’ Centralized Risk Books (CRB’s) that have been honed over the past five years. These have been particularly helpful for executing transition or programme trades but they also provide a useful source of liquidity when the bank’s risk is later unwound into the market. Secondly, institutional dealers are finding alternatives to the two main sources for European trading in the last 25 years, which have been the CLOB and the single-stock market maker.
We have already looked at the failings of the CLOB but it is worth remembering that the construct only came into existence to the UK with Sets in 1997 and arrived in the US five years later and so does not need to be a permanent fixture. As for the single-stock market maker, the value of this liquidity source has diminished as he or she finds it almost impossible to unwind his risk without creating impact and holding up the client from continuing with their business.
i Top of Mind Interview, August 2, 2015 – Goldman Sachs Global Macro Research
Broadening The Base: Using The Entire Trading Lifecycle To Improve Execution
GlobalTrading Hong Kong Roundtable Write-up
Regulatory developments are amplifying pressure on trading desks to offer their shareholders and clients greater returns. At the same time, a newfound willingness for collaboration and a restructuring of the trading desk from a human and technological perspective hold out hope for greater efficiency.
Generously sponsored by BNP Paribas Securities Services, and kindly hosted by the Hong Kong Exchange (HKEX), nineteen buy and sell-side participants gathered under the security of Chatham House rules to share their experience and insights into improving execution across the trading lifecycle.
Asian regulatory priorities: managing trading behaviour
Regulators in Asia are often short on experience and resources. They prefer to add caution in the form of further regulation while they catch up. For example, brokers in Hong Kong have to keep logs of changes to algos for 2-3 years. The onus is on the market to work with local regulators or the local regulators will be tempted to simply follow the US model.
The Chinese Securities Regulatory Commission (CSRC), for example, feels pressure to collaborate in ways they did not before the market crash of 2015. Discussions of instituting an ID market in Hong Kong, recent programme trading rules and the much maligned and quickly shelved circuit breaker mechanisms are all areas where the CSRC is more open to external input than before.
“It is important that the Hong Kong regulators appreciate how to rationalise the balance between the improved oversight of an ID market and the operational efficiency of features such as an omnibus account,” noted Stephanie Marelle, Executive Officer, Hong Kong Branch, Regional Head of Clearing and Custody, BNP Paribas Securities Services Hong Kong.
Because of the ID requirements in Korea, Indonesia and Taiwan, many traders prefer to work through Delta1 desks to create positions instead of trading directly on the exchange. The real question is whether the regulators want a pre-trade ID or a post-trade ID.
Legal Entity Identifiers (LEIs) in Europe offer a similar case study for comparison. Draft requirements for European LEIs include national insurance provider for each trader, trader’s home address and date of birth. The LEI discussion is all the more pressing given these rules are not far away, provided you believe the implementation dates.
Asian trading desks typically follow the same workflow as their US or European headquarters, but local data privacy laws can be an issue. Many trading operations would benefit from further integration of front, middle and back office data as real-time information becomes a norm.
For many Chinese asset managers, their small scale in Europe and high existing costs may lead to a withdrawal from certain non-Asian markets.
China is built on an ID market so the regulators can generate reports on trading behaviour with the push of a button. After the market crash in the summer of 2015, the Chinese regulators traced trades back to certain High Frequency Trading (HFT) players for prosecution.
The CSRC thinks HFT is bad and there are insufficient protections for investors in markets where HFT is prevalent. “The discussion of HFT in China is often inaccurate because many proprietary traders operating HFT or similarly sophisticated models are grouped into the retail trading basket because they are sole traders,” suggested Chris Lee, Senior Vice President, Global Markets Division at HKEX.
In China, the market is one-directional because of a lack of adequate hedging instruments. In Hong Kong, often more than one investor view will be active at the same time meaning HFT does not only push in one direction and amplify either gains or losses. Meanwhile, the CSRC’s focus on policing HFT to protect retail investors has encouraged as many as 250 HFT firms to start trading in Hong Kong
While most industry participants understand the issues with HFT, but there is no upside for the regulators to take risk and move markets forward. There is a culture of aversion to failure among regulators. Market participants understand the benefits of HFT, but there is no sufficient mechanism for sharing those benefits.
There is progress in the region, as evidenced by the Australian Securities and Investments Commission’s (ASIC) evolution from one of the most shrill HFT detractors to a more rational perspective on the strategy. Even Korea is beginning to open up to the prospects of HFT.
Even a cursory study of high and low liquidity events demonstrates the need for proper market structure research through fundamental analysis. The CSRC appears to be caught between pursuing greater knowledge or greater stricture.
Collaboration and Efficiency: a win-win for all
Fortunately, the market is now in the same room with the regulators when these issues are being discussed.
“The Shanghai-Hong Kong Stock Connect was a significant milestone for collaboration across borders within Asia. The Shanghai-Hong Kong Stock Connect was also a catalytic moment for HKEX to expand the size and scope of the counsel they receive. Within HKEX, there is a conscious shift to viewing Exchange Participants as clients and focusing more on service. The exchange is bringing additional intelligence in-house. Hong Kong aims to be an offshore risk management tool for China via HKEX futures and options,” observed Kevin Rideout, Managing Director and Head of Client and Marketing Services for HKEX.
In the past, risk management was always handled on the trading desk. Market risk, which is simpler to manage, is still handled on the trading desk while operational risk is much harder to manage and cannot be left to the traders alone.
Regulators will expand the total amount of data they manage, and as such their role is not to make conclusions from such data but to spur conclusions from market participants.
The fastest growing costs for trading firms are compliance and new technology, and unfortunately, the cost burden tempts firms to stall further investments which in turn breeds risk. The costlier risk, by far, is the long-term threat to poorly assembled compliance and technology systems. “Despite this, it is important not to view increased compliance costs as merely about meeting regulations, but as part of the investment needed to build a robust and sustainable business,” noted Jeff Sayed, Chief Operating Officer, Equities Asset Management Services, Asia Pacific for Bank of America Merrill Lynch.
The business side of trading is embracing greater technology in its processes. As they consolidate platforms into their Order Management System, more information can be readily shared within the firm. “Consolidation of platforms is also likely to lead to greater efficiency for trading desks,” suggested Patrick Shum, Head of Trading Systems Asia Pacific at Fidelity International.
“In addition, working with outside partners to handle non-core business tasks is one way asset managers are lowering their cost burden and acquiring best-in-class systems, however, business size will differentiate what is relevant and needed,” suggested Francis So, Head of Dealing, BNP Paribas Securities Services Hong Kong.
As a counterpoint, in Silicon Valley, for example, collaboration is in businesses’ DNA, while banking is unrepentantly competitive.
The New Look Desk
Responding to the lessons of greater collaboration and technological investment, the trading desk now has a ‘new look’.
“The human mix on the trading desk is changing in ways not previously seen. Unbundling means that the trading desk can define its own value. Where quants used to be a support function to sell-side trading desks, we are now seeing quants hired to both buy- and sell-side trading desks,” noted Andrew Freyre-Sanders, Head of Equities Electronic Execution Services for CIMB Securities.
“The technology team is part of the business process today, so the business can no longer make decisions on their own,” explained Shum. At the same time, new technologies such as blockchain will soon become an alternative to self-clearing solutions and banks today are proactively participating in the discussions.
The discussion concluded, for trading desks and the technologists that support them directly or indirectly, innovation is knowing where you’re good and focusing on it – sound regulatory practices, market collaboration, data integration and smart technology. Buy and sell-side are embracing a holistic view of the trading lifecycle more than ever before. This will be the key to satisfying changing regulatory demands, generate greater return on equity and provide improved execution for internal and external clients.
To see our video of the key takeaways click here
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Exchange of Ideas: HKEX Hosting Services Ecosystem Forum 2016
The prospect of a Shenzhen-Hong Kong Stock Connect hung over the HKEX Hosting Services Ecosystem Forum. While the market waits for the regulators and the authorities to finalize that plan, traders, technologists and solution providers gathered to discuss new exchange initiatives, trading technology and regulatory updates.
New platforms, data
Equities turnover originating from hosting services averaged 45% of total turnover in March 2016, with 49.5% of derivatives trading taking place via HKEX’s data center, reported Jonathan Leung, Senior Vice President and Head of Hosting Services, HKEX. 125 Exchange Participants are using hosting services currently, with the number of Category-C, or small, brokers rising, Jonathan Leung shared in his opening remarks.
After consolidating three legacy data centers into the only exchange-owned tier-4 data center in Asia Pacific, HKEX has continued with its 100% market availability track record. Furthermore, the exchange opened up to three telecom carriers to provide SDNet/2 service, Richard Leung, Managing Director and Co-Head of IT, HKEX explained. SDNet/2 is the network infrastructure supporting HKEX’s trading, clearing and settlement, and market data services and providing reliable and cost effective network services to all exchange participants, clearing participants and information vendors alike.
A new cash trading platform, currently planned to be available for testing in 2017 and open for production around the end of that year, will reduce latency substantially, Richard Leung said.
The new Nasdaq Genium platform has increased capacity that allows the exchange to introduce new derivative products this year. The derivatives clearing system was also upgraded to shorten the day-end maintenance window, enabling trading hours on futures platform to extend to 11:45pm, and further, if needed, Richard Leung told attendees.
The Orion Market Data system for Cash and Derivatives markets offers low latency data service directly via the data center or information vendors as well as providing the market data of multi-asset classes, according to Winnie Leung, Vice President, Market Data Licensing, HKEX. With more and more exchange participants and buy-side firms pursuing low latency market data, HKEX introduced the OMD Free Trial Programme for Premium and Fulltick Datafeeds and Historical Full Book in November 2015 to allow this group of market data end-user to experience the OMD low-latency datafeeds for 3 months free of charge. “We have recorded a healthy increase in the subscription of our OMD premium datafeeds since then.”
The Shanghai-Hong Kong Stock Connect is seeing increased diversification, reported Christopher Hui, Managing Director, Project Management, HKEX. Southbound trading, which initially lagged northbound, is picking up while the stocks traded are gradually shifting away from A-H share arbitrage as investor preferences continue to develop, Hui noted.
Hui believes the Stock Connect plan will continue to thrive for four reasons: the redeployment of mainland wealth into capital markets from banking and insurance; rising mainland outbound capital markets investment; increased international participation in mainland markets; and Hong Kong’s unique position as mutual price discovery venue and offshore RMB risk management center.
Best Execution In MiFID II
With Arjun Singh-Muchelle, Senior Advisor, Regulatory Affairs, Institutional and Capital Markets, Investment Association
There are two main requirements which have an impact on the buy-side with regard to MiFID II and best execution. The first is within the MIFID-delegated acts, which look at our ability to ascertain best execution from our brokers. That means looking at the application of best execution to other financial instruments, as previously there were no requirements to demonstrate best execution for non-equity instruments. There is now an expansion of those requirements into cash bonds, derivatives, FX forwards and so on. We are now required to demonstrate best execution on those instruments as well whereas previously, it was not the case.
We are now looking towards third party providers to offer TCA for FX or TCA for cash bonds etc. To date, these service offerings have been somewhat lacking, so we have started from scratch for non-equity instruments. We are also wary of the application of equity TCA to non-equity instruments. One of the reasons for this is that equity TCA is often focused on using VWAP as the primary benchmark whereas (in our view) for equity best execution, VWAP should not be the only benchmark. It may also be difficult to simply copy these concepts across into non-equity instruments, but that is what is being offered by the third party TCA providers. In addition, the way one executes an FX forward contract or executes an illiquid corp or sovereign bond is different to how one would execute an equity instrument.
The regulators have also redefined best execution from all ‘reasonable’ efforts to all ‘sufficient’ efforts. It is not clear what the difference means but the regulators have purposely changed the definition. As a result, additional thought will have to be applied to the consequences of that linguistic shift; do we have to plug into every execution venue in Europe to meet that requirement, no matter how small the exchange might be?
There are many shallow books on exchanges and venues across Europe, and we need to know whether we must start plugging into all the execution venues in order to see whether we can get a better price. It would require new systems development to actually plug into, for example, the Bratislava Stock Exchange. Technically, it would also mean providing additional information to other market participants (which is not normally provided), which would increase the probability of information leakage. There is also the additional impact of the cost of market data in real time from the additional venues, which is a considerable political issue and without a consolidated tape this remains difficult and expensive. There are some provisions for a consolidated tape for equities in MiFID II, but there is no mention of a non-equity consolidated tape offer for bonds, FX or derivatives.
Reporting requirements
The second issue relates to the reporting requirements for best execution under RTS27 and RTS28. RTS27 is data that goes from the broker or venue to the asset manager. RTS28 is best execution data from the asset manager to the underlying clients – to the funds. The concern with RTS27 is the way it is currently formulated as unexecuted client orders will be made public. In our view, an unexecuted order should never be made public because it gives a false impression of whether a venue or broker is actually within our ‘Top 5’ or not. It also provides additional information to other market participants of holdings that we may have tried to execute previously (that may have been unsuccessful) and/or where we have used an RFQ for a fixed income order, as we would use the RFQ process as a valuation tool.
Another issue with RTS27 is that a Systematic Internaliser Operator would have to disclose all transactions (in aggregate format), even if they were large and had benefited from the large in-scale order protections – all that information will now be made public. Even though there is an in-built delay of at least three months, it is not a sufficient amount of time for brokers to unwind the positions they have taken to facilitate our trade, which then has a downward impact on asset managers. If brokers are going to be exposed to additional or undue market risk, that impacts upon their ability to make markets for us at efficient prices.
The concern we have with RTS28 is more technical. At a high level, the concern relates to who is ever likely to read this information. In the UK there is a ‘pension disclosure code’ – an annual statement given to our providers and everyone with a holding in the pension fund, which in reality is very rarely read by anyone. We will now be required to provide them with an additional 35-40 pages of best execution data. This would contain information about whether the firm acted in an aggressive or passive capacity, what percentage of the trades were with the Top 5 etc. We are also required to disclose any close links with brokers or venues without having any comprehensive definition of what ‘close link’ means. For example, does a shareholding in the London Stock Exchange now need to be disclosed as a close link?
There are other technical issues around delegated executions. If a fund manager is managing a fund domiciled in Luxembourg on behalf of a US client and the order is generated in London but the execution was delegated to the in-house dealing desk in Hong Kong, then is that included in the fund manager’s RTS28 reports or not? We don’t know. If amongst the top 5 brokers, three of them are Morgan Stanley (Morgan Stanley New York, Morgan Stanley London and Morgan Stanley Singapore) can they be aggregated into one as Morgan Stanley? These are the sorts of issues and concerns we have around the best execution reporting requirements.
Global ramifications
In our conversations with regulators across the EU, we have referred to the potential impact on global asset managers and other regulators. And whilst talking about US, Asia-Pac brokers and regulators, I don’t think they fully understood the ramifications of the best execution requirements on their zones either.
In addition, RTS27 rules say that the asset manager is legally obliged to receive the information, meaning that a broker must provide it in the first place in order for it to be received by the asset manager. But there is no legal compulsion on a US or an Asia-Pac broker to provide that information. So if a US broker refuses to provide that granular data, then who will be held legally responsible – will it be the US broker or the European-domiciled asset manager?
These issues give the impression that the policymakers have not necessarily appreciated the extent of the technical and financial challenges that will be faced by asset managers in order to achieve best execution, or at least to demonstrate their achievement of best execution.
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Changing Workflows, Changing Roles
By Tony Cheung, Head of Quantitative Analytics, Liquidnet, Asia Pacific, and Lee Porter, Head of Liquidnet, Asia Pacific.
The start of 2016 has proven difficult for most investors in APAC, to say the least. Not for a decade has the Hang Seng Index seen a worse first two months to the year, with the drop universally slamming large and small cap stocks alike. China followed up a botched attempt to install circuit breakers with a significantly dialled down GDP target – hardly a sign of confidence. And now Japan is showing signs of Abenomics fatigue with negative interest rates not helping to boost markets. While it might be easier for mom-and-pop investors to wait out the storm, institutional investors are faced with tough decisions on what to do with their positions today. And equally important, how to do it.
According to results from a recent HKEx survey, institutional investors made up a major part of the trading in Hong Kong – coming in at 51% of all market trading. Retail and proprietary trading (bets placed by brokers’ using their own money) made up the balance, and actually became more active in a very volatile 2015. There is a strong likelihood that some of this was from the residual euphoria associated with Shanghai-Hong Kong Connect but with indices on both sides of the border plunging, volumes dried up.
Daily Southbound trading via Connect fell to less than 1.7 billion HKD from a peak of about 13 billion. Barring a significant turn of events this year, trading by institutions should clock in at a higher rate than last year with retail and proprietary flow stepping back. We believe this reduced pool of liquidity will make portfolio manoeuvring by institutions significantly more difficult.
In absolute terms, the ownership of Hong Kong companies by major fund managers may not be high, but relative to trading volumes the holdings can be staggering. For the constituents of the Hang Seng Index, the top 20 major shareholders (excluding family members, strategic partners, and government entities) own anywhere from about 30-days to 400-days of shares in Average Daily Volume (ADV). Normally, an instruction from a portfolio manager to buy or sell a single day’s worth of ADV is enough to make traders cringe at the potential market impact. Needless to say, liquidity becomes a major concern when wholesale changes to portfolios are required. And this is just the story for Hong Kong.
Other markets in the APAC region have not been spared the problem of lower activity, and its impact is especially pronounced in emerging markets with volumes dropping anywhere from 15% in India to 37% in the Philippines compared to the first two months of 2015. In these days of lower trading volumes, head traders are increasingly searching for new ways of unlocking liquidity.
The role of the head trader
Surprisingly, a head trader’s involvement with day-today-day trading has also been on a downtrend despite the increasing workload of trading in tougher markets. Head traders nowadays approach Liquidnet to discuss workflows and trends rather than haggle on prices and shares. This shift away from the traditional “handset on each ear” image of the head trader is an indication of structural changes within buy-side organizations.
First, as the markets covered by the typical trading desk in APAC become increasingly complicated, buy-side desks can no longer digest and react to every single rule and regulation change in an efficient manner. This is where the heads of desks create value by liaising with peers and brokers to ensure all available information is looked at from every angle, drawing on their collective knowledge and experiences rather than going it alone.
Second, and more important, money managers are more than ever emphasising operational efficiency, realising that the difference between a good and an average year can very well be reduced to how smoothly a desk is run. To achieve this efficiency, more resources are now being invested into systems and processes. The holy grail of each head trader is to establish a platform where his or her team can focus on sourcing the best liquidity in any types of markets.
While it is widely accepted in the buy-side circle that the best liquidity comes in the form of block trades (a single trade in large quantity as opposed to a handful of smaller lots), from our experience not all blocks are quality liquidity. A recent study we conducted in Australia uncovered that some block trades reported by brokers can cause the stock to swing as much as 40-50% more than its typical trading pattern over the short term. If information about a potential block trade hits the market, it will send signals to predatory traders who can trade in front of that block and adversely affect that price. The only proven way to execute a block without signalling the market that there is a large buyer or seller is for the two trading parties to negotiate directly with each other.
Buy-side traders in APAC will need to continuously adapt their workflows according to trends in money flows both locally and regionally. For example, while solely relying on algorithms might have worked well for last year’s “Big Era” in Hong Kong’s market volume boon, executing in larger blocks today will serve traders better as liquidity reverts to the norm. For head traders, we believe broker evaluations will place increasing emphasis on block crossing successes in addition to algorithm performances. Advanced transaction costs analyses can be used to measure block qualities not just on a P&L level but also on the degree of signalling around the print. Especially for overnight APAC traders, there is nothing better than the ability to place an order confidently expecting both quality block and algorithmic executions.
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