Tom Kingsley of Bloomberg Tradebook examines the rationale for block crossing in Asia.
With many Asian markets trading lower volumes than years past and dark trading yet to assume a larger share of executions, block trades are a stubborn fixture of Asian order books.
When you ask the buy-side what they want, the answer is always liquidity, liquidity, liquidity. The challenge of the last few years in Asia has been generally lower volumes across the exchanges. There has however been growth in volume in Hong Kong, particularly with the Stock Connect and China has seen growth in volumes and volatility. Even India’s volumes grew.
However, across the board, volumes are down, including in dark pools. Fragmentation is quite limited except for Australia and Japan, so lower volumes mean wider spreads. Wider spreads mean higher costs. Crossing the spread creates opportunity costs such as how quickly a trader needs to complete a trade and what they are willing to pay for that speed.
Where are the Asian pools?
The ultimate Asian dark pool, if there was such a thing, would be a block cross, where orders are never sent to a dark pool and all trades execute electronically at the exchange. In the last 20 years it has always been difficult to find trusted partners to cross with. Now, it is even more challenging because of the risk of information leakage, which is very expensive in a market with thinner volumes.
While block crossing is not a new concept, it has become more important in Asia. Agency brokers maintain strong buy-side anonymity, which is why last year we began testing a combination of electronic trading platforms with traditional block crossing.
The end result is a system that pairs two sides of a trade in the traditional sense of upstairs block crossing, but the counterparties send the trade electronically to create the audit trail. The commitment to anonymity means if two buy-side firms are combined in a cross trade, no one knows who they are. It is anonymous and then the trade is printed on the tape using a local broker we designate.
Remembering how to speak
We are likely to move to more traditional block crossing because the dark executions as a percentage of Asian trades are down. Unlike the US or Europe where multiple venues created fragmentation, and yet homogeneity. Without greater fragmentation and dark pool proliferation or higher volumes, traders are forced to search for blocks.
The problem is, we have a new generation of traders that handle far fewer voice orders. Asking an electronic trader trained around algorithms and DMA to use the phone to execute a voice broker cross is quite different.
Many traders on the buy-side and sell-side do not have much experience trading blocks. Educating traders more comfortable using algorithms about making prudent decisions in a block opportunity is crucial.
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Building Blocks: In The Dark, On The Phone
Finding Liquidity In Australia
With Richard Nelson, Head of Australia and Japan Equity Trading, T. Rowe Price
In terms of block trading Australia is looking fairly healthy. Most of that is thanks to the agency brokers rather than facilitation; you can get facilitation but not in the sizes that we can when trading agency blocks.
Asia as a whole is a little bit different. Japanese domestic trading is still pretty much focused on hitting benchmarks, and it’s difficult to find blocks. Interestingly though, there is a new facility where people can send a watch list or allow access to what we are putting in our algos, which then allows a proper conversation. In addition, the penetration of dark pools and trading platforms in the region is getting better.
The situation is difficult though overall, and there are certainly difficulties with the current way we have to trade: breaking up orders into different pieces with algos. As big institutional buyers and sellers, if we can’t find blocks, we have to trade in smaller sizes, across multiple venues using algos. This just generates a lot more signalling, which leaves us open to being taken advantage of by HFT and other participants.
However, the situation for finding large blocks and getting trades in size done will get better. One reason for that is that asset allocation around the globe at the moment is still very much in fixed income and not equities. Once we see interest rates starting to rise we’ll see a move in asset allocation back to equities, which in itself means that there is more liquidity, with more people looking for liquidity and more liquidity being offered.
We’re probably on the high end of using dark pools to find liquidity. ASIC has been working hard on the issue of trading in Australia, and they have made changes to the regulations so when we are trading in the dark, we have to get meaningful price improvement. This basically means the buy and sell is done at the mid-price which works well for us. Further, we do minimum execution quantities to try and minimise signalling. ASX also has single counterparty fills so we can elect who we execute with. Unfortunately, this facility does not exist at all venues which means we can end up hitting very small orders. This is ultimately just giving a free tip-off to HFT firms to let them know what we are doing. If I could avoid those smaller orders I absolutely would; it doesn’t benefit me at all to hit them.
The market itself can do a great deal to help fix the situation and make it easier to trade more blocks and orders of a meaningful size. Fundamentally we want to be able to get executions done without creating too much noise. It’s a matter of using the right avenues and having the right counterparties available.
Every market can learn from looking at what’s happening in other markets, just as other markets can look to what Australia has done in terms of dark pools and insisting on price improvement, minimum execution quantities and single counterparty fills. They were smart, simple things to do and fair for everybody: some other markets have taken that on board.
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The Changing Face Of Technology: A Roundtable Write-Up
By Peter Waters, Managing Editor, GlobalTrading
On the 29th of September GlobalTrading hosted an executive industry roundtable in New York. The discussion was moderated by Donald Bollerman, Head of Markets and Sales at IEX, and featured a range of senior business executives, traders and technologists from across the buy- and sell-side. The event was kindly sponsored by CameronTec.
The primary discussion throughout the luncheon was spent drilling down into the following areas:
• the development and implementation of technology in electronic trading throughout the last three years,
• how the changing budgetary environment has impacted development cycles and implementation,
• the changing desires of those using the technology.
A principal concern was the changing requirements of those developing the technology, and how responsibility for technology is shifting between technologists and the business side of the firm, and the effect this has on buy-side, sell-side relationships.
The financial services industry in general, and electronic trading specifically, are in a time of massive flux in how technology is developed and applied.
Throughout the debate the participants, coming from a range of buy-side and sell-side firms, discussed that while headcount reductions are continuing to take place, firms are hiring more people in technologist and compliance roles. The onus and responsibility is shifting between firms and departments, but it is continuing to build. Further, there is a growing realisation that financial technology is increasingly competing with other industries. The ability of financial firms to attract the top graduates and most innovative brains is ever increasing, and money is no longer the only motivator that new talent requires.
This is especially true in the US, primarily with competition coming from start-ups and Silicon Valley, but also this trend is impacting Canada, Europe and the emerging markets. The challenge is to make the most of the staff and resources a firm has, and the table quickly agreed that both are rarely sufficient. The true differentiator between many firms is in finding a unique competitive edge, and this is an area that will continue to remain paramount. As a consequence, it was put out that the business side should remain in charge of the competitive edge of the business, while the technologists build the common stack. There was consensus however that those boundaries are breaking down and evolving.
As a result of this shifting competitive edge, it was agreed that standardisation is a key area to look at. The parties discussed the potential for standardisation in areas as disparate as data for analysis, time stamps, wider technological standards and how exchanges bill their clients. There is a growing need to standardise data and the input that firms receive, so that they can better understand their trading and compare like with like. Whether this ongoing drive becomes the role of a self regulatory organisation or the regulators themselves remained subject to debate. All those present agreed the buy-side will start to generate and analyse more of their own data; how the sell-side continues to provide a competitive edge to those buy-side remains to be seen.
Pre-Trade FX Analytics: Building A New Type Of Market
With Scott Kurland, Managing Director, Head of Platform Solutions, ITG and Jim Cochrane, Director, Senior Product Manager, ITG TCA for FX.
The electronification and improvement of FX workflows entered a new phase with the advent of aggregators and algorithmic trading, but challenges still remain.
Deciding where to manage that workflow, from blocking and netting to allocation functions, is increasingly complicated because firms must first determine when and how to pass some of that information downstream to third party vendors. Should they pass it from the order management system (OMS) via the execution management system (EMS) or a series of third party platforms?
Today, netting across currency pairs is often calculated in the OMS in order to minimize transaction exposure. However, we are starting to see that functionality move into the EMS, which can offer more flexibility in advanced netting and trade block formation. This upgrade in FX workflows will require the EMS to receive and interpret account and trading counterparty restriction information passed from the OMS.
The second area of workflow improvement relates to FX benchmarking and execution transparency – specifically pre-trade analytics that can help drive decisions as to when, where and how to best trade FX.
Considerable development has occurred over the past three years in pre-trade technology and pre-trade analytics, which has been made possible through the wider availability and aggregation of FX pricing and custodial data. However challenges still remain in deciphering ‘What is tradable?’ versus ‘What is shadow liquidity?’
Pre-trade analytics
New pre-trade FX analytics can help a trader determine expected slippage of a currency transaction based upon the method of execution and time of day traded. What we have done at ITG is cull, arrange and analyse the data en-mass in order to build a range of pre-trade tools for 38 currency pairs. We collect and store over 125 million tradable quotes daily in order to create expected volatility and spread distributions as well as cost curves in the FX market. These cost curves are used to predict slippage under normal market conditions. The volatility and spread distributions help the trader define “normal”.
This next generation of pre-trade analytic tools will provide FX traders with the ability to manage their FX transactions more actively on an expected cost basis, and in turn make more informed decisions as to where, when, how and what size FX trades to execute. For example, a trader can place a Request-For-Stream (RFS) to buy $50 million of GBP/USD and receive real-time streaming quotes back from multiple bank liquidity providers. He can simultaneously compare these to pre-trade cost estimates for this particular currency pair and size, as well as view ECN prices via a consolidated order book. This allows him to determine whether to route the trade to an ECN, trade with one of the RFS bank counterparties, or wait to trade the same or larger block size at a later time of day, when more favourable pricing might be available.
As in equities markets, pre-trade tools provide decision support; through the concept of creating referenceable price and liquidity data around volatility, volume and the type of currency pair being traded.
Concurrent with the new analytics, referenceable prices and liquidity sources for trading FX, PMs and traders are also being pressured to move towards a more active approach for trading FX. Additionally, institutional investors are now asking their managers to demonstrate best execution for FX trades to ensure unnecessary slippage isn’t occurring after the equity trade has been completed.
As such, buy-side firms are beginning to re-evaluate whether they should use the same bank historically; do they go to the bank with the best immediate price, the custodian where the equity position is held, or do they execute on a DMA basis with an ECN?
These are the same types of best-execution decisions that are currently being made in the equity markets. Arming the buy-side with similar tools and liquidity access for FX trading will help them adopt the same best practices for FX as they utilise for equity trading.
Benchmarking
The challenge of gathering comprehensive, accurate data with reliable time stamps has been solved with the arrival of FX aggregation tools and the new openness found in the FX market. The benchmarks that ITG generates allow asset managers to estimate the value of their foreign exchange flows with greater confidence, measure implementation shortfall and provide a holistic view of their currency trading across several constituent groups in their organization. Compliance and “best execution” measures are merely the beginning. Our goal is to assist asset managers in driving transaction costs towards zero optimize their FX flows within a multi-asset trading dimension.
One area still needing significant study is in the matching of an equity trade or any underlying asset with the corresponding foreign exchange transaction. Should a buy-side firm hedge each equity transaction in real or near-real-time with a corresponding FX trade, or is there more benefit to waiting until a significant volume of equity trades have been completed before putting up the FX trade? Does the trader fair better in smaller size FX trades throughout the day, or a larger FX transaction at the end of the day?
The electronification of equity and FX trading combined with a series of FIX time-stamps will help us build better audit trails and collect more data to drive this analysis over time, tracing trades from PM idea generation and order creation all the way through to execution.
Better benchmark data in turn will enable traders to defend or re-evaluate their FX trading strategy to institutional investors, similar to how they do for equities today.
The driving forces
We are beginning to see a switch in mindset relating to market structure and the move from passive to more active FX trading. To the extent that the emerging best execution responsibility falls to the institutional equity trader, we expect to see a natural push of the FX markets towards an equity-like market structure.
At the same time, advances in technology are enabling this transformation to happen more organically; the electronification of FX transactions from OMS through EMS to liquidity providers, all the way through allocation and settlement processing, is happening.
Traditionally, each part of the buy-side trading desk has had a different view of the foreign exchange markets. The equity trader spent so much time on their equity transactions that the foreign exchange transaction was either given to a custodian or handed to the back office. This mindset is changing – equity traders are getting accustomed to the idea that they need to give more thought to how the foreign exchange transaction occurs because significant alpha can be lost on the subsequent foreign exchange transaction if not handled properly. FX TCA tools, as mentioned earlier, have been helping the buy-side quantify this loss and provide guidance on steps that can be taken to improve alpha preservation on the FX component.
Last but not least, one of the main drivers behind the focus on FX best execution is now regulation. The FX market is being more tightly controlled by the regulators and the industry is demanding and shaping more defined benchmarks to be held accountable to. This has led to greater pressure on the buy-side from their clients to ensure that best execution tactics are being put into practice.
The future
As the markets, electronic trading tools and venues continue to evolve, we expect to see more FX flow shift to a direct access model by the customer without as much bank intermediation, especially for smaller block trades executed in conjunction with corresponding equity transactions. This should also lead to increased adoption of algorithmic trading and ECN usage for spot trading, as well as the use of FX prime brokers and aggregators. For larger block transactions, we expect to see an increase in multi-bank Request-For-Stream (RFS) trading in order to keep traditional bank liquidity providers in check.
Just as the industry witnessed with the evolution of the equity markets, as the buy-side takes on a more proactive approach to managing FX transactions, they will demand increased transparency with their liquidity providers, and referenceable prices.
Good data will ultimately drive analytics and lead to better trading. This will enable firms to act as their own watchdog, monitoring performance, alpha preservation or slippage, and keeping liquidity providers in check.
It’s an interesting dynamic that should evolve over time, driven by increased regulatory scrutiny, better referenceable benchmarks, pricing and execution data, and a convergence of equity and FX trading on the buy-side desk. These trends, coupled with improved market transparency and analytics, will help the buy-side develop a cohesive structure for calculating the true cost of their FX transactions, and ultimately driving down the total cost of execution.
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The Blockchain: Capital Markets Use Cases
The Blockchain: Capital Markets Use Cases.
GreySpark Partners presents a report, The Blockchain: Capital Markets Use Cases, examining how investment banks and other financial markets firms could potentially utilise distributed ledger technology (DLT) in the future. The report characterises a wide variety of different forms of blockchain applications being developed by fintech start-up companies globally, and it discusses how those applications could eventually be used by capital markets participants as a means of replacing existing front- and back-office systems and processes within the buyside and the sellside.
Analysis : European equities : Market fragmentation
FRAGMENTATION IN EUROPE.
LiquidMetrix analyses consolidated performance figures for stocks on major European indices and the changes from the previous quarter.
The charts and figures below are based upon LiquidMetrix’s unique benchmarking methodology that provides accurate measurements of trends in market movements. Trading volumes on lit markets including auctions are taken into account, as well as dark trading on the major MTFs.
MARKET SHARE – Based on fragmented European stocks.
After the usual lull for the summer, market volumes picked up strongly in the last few weeks of August, driven by Chinese market volatility. Average daily volumes in the last two weeks of August were as high as any seen in the last three to four years.
MTF market share has remained more or less unchanged compared to Q2 2015 but is still close to the peak rates of over 32% recorded at the beginning of 2015.
SPREADS & EBBO LIQUIDITY – Based on fragmented European stocks.
Top of the book bid/offer spreads tightened overall at the start of Q3 2015 to reach the lowest levels seen for some years. However, the last two weeks of August saw a re-widening of spreads.
On book liquidity also improved overall in Q3 2015 showing the usual inverse relationship to spreads.
EUROPEAN MARKET BREAKDOWN – Major European indices.
For three markets (FTSE, CAC and OMX-S) the Primary exchanges increased their market share in Q3 2015 with the most significant increase on the CAC. Conversely, the DAX, SMI and MIB had significant falls in Primary exchange market share with a smaller reduction on IBEX.
This mixed picture explains the earlier data showing no significant net change in MTF market share Europe wide. Interestingly, the gap between primary share of most fragmented market (UK) and least fragmented (Italy) is at its lowest ever suggesting the level of fragmentation is increasingly converging across European markets.
There is a mixed picture across different markets for top of book spreads, UK stocks had narrower spreads across all trading venues whereas French and Swedish spreads generally widened.
Turquoise now has third place across all countries after narrowly overtaking BATS in Sweden in Q3 2015. Also of interest is that in the least fragmented market (Italy) the Primary Venue continues to enjoy a significant top of book spread advantage over its rivals.
The basic trend for depth weighted spreads is as usual similar to that of top of book spreads, i.e. UK spreads tightened whilst France and Sweden widened.
It’s interesting to note the very clear advantage the Primary Venues have over their MTF rivals in the depth weighted spreads category.
Resting order book liquidity changes were mixed in Q3 2015. There were quite significant increases in liquidity on Primary exchanges for UK, French and German stocks.
However for BATS and TRQX, on book liquidity fell across all countries. It is interesting to note that the Primary exchanges have more top of book liquidity than their rivals combined in all featured markets.
LIQUIDMETRIX VOLATILITY INDICATOR – Based on fragmented European stocks.
The LiquidMetrix Volatility Indicator provides a measure of high-frequency market volatility based upon 30 second price movements.
Volatility was generally lower over the summer months, however the Chinese related events towards the end of August saw a very large spike in volatility to the highest levels seen in recent years.
At the end of October, this volatility appears to have subsided somewhat, however, if it were to remain at elevated levels we might expect that to have a significant impact on spreads, liquidity and market shares in Q4 2015.
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Profile : Barry Hadingham : Aviva Investors
COPING WITH COMPLEXITY.
Barry Hadingham, head of derivatives and counterparty risk at Aviva Investors spoke to Best Execution editor, Lynn Strongin Dodds about the likely impact of regulation on a buyside derivatives trading operation.
Barry Hadingham who joined Aviva in 2005, was appointed head of derivatives and counterparty risk at Aviva Investors in 2010. He is also derivatives officer for Aviva Investors’ UK operations and is leading the work to evaluate the impact of the EMIR and Dodd-Frank OTC clearing regulations and implementation of the necessary infrastructural changes. Hadingham is a member of the Association of Chartered Management Accountants (ACMA) and has a number of years’ experience in financial services with a considerable amount of that time working in derivatives related roles within banking, insurance and asset management.
What has been the impact of the derivatives regulation?
Overall the regulations have made the banks safer but the client side of the market much more complex. On the one side, we have the European Market Infrastructure Regulation (EMIR) and on the other side is Basel III. I think the latter will have a much greater impact than derivatives regulation. This is mainly due to the capital ratios which are punitive for client clearing. Although regulators understand this, the big question is what will they do about it? At the moment banks are holding off on price hikes which could run in the multiples if the rules remain unchanged.
The other issue is the move to cash only credit support annexes (CSAs). Under ISDA (International Swaps and Derivatives Association) agreements, a range of collateral had been permitted but the new rules do not allow banks to use government bonds to offset their derivatives exposures. They have to use repo and they don’t want to do this because of the cost. It is cheaper if we post the cash ourselves.
As the regulators are still debating some of the finer points do you think we will see any significant changes?
I think there will be minor tweaks but we will not see any big changes. One possibility could be some clearinghouses offering direct clearing arrangements themselves. However, that would only be an option for a subset of clients such as standalone pension vehicles. It would be difficult for an organisation such as Aviva to do this because we have such a wide range of clients and it would entail orchestrating the arrangements on behalf of each client which would be extremely complex. There is also a question mark over the clearinghouse default funds. Some people believe the banks should continue to finance this as part of their clearing offering but it may be too costly unless the capital rules are amended.
What impact do you think the regulation will have on the trading of the market? Do you think there will be a move to swap futures?
It is quite difficult to predict the usage of derivatives but I think we will see a move from OTC (over the counter) to listed products. As for swap futures, I am surprised that there has not been more take up in the US. There are bigger drivers there than in Europe such as regulatory arbitrage to avoid ‘major swap participant’ and ‘major swap dealer’ obligations, as well as the capital and margin implications. I would never say never, but our activity is generally directional and long dated in nature. We would not want to incur roll risk – i.e. rolling future contracts for 10, 20 or 30 years – which would mean having a constant maturity on a futures profile, even though the liability profile may be declining. This would be particularly true for pension funds. The other issue is that swap futures may give a pretty close hedge against liabilities but it is not a 100% match.
Do you think the new rules introduce other risks such as CCP concentration?
In my opinion, the rules introduce a new source of counterparty risk – operational risk. This is because of the complexity of managing the new margin requirements. There is also the issue of haircuts – the EU is imposing an 8% haircut for variation margin when the currencies of the derivatives transaction and collateral differ. It increases the amount of collateral received by the counterparty if for example, you don’t post the right currency.
How has Aviva prepared for the changes?
The length of time EMIR has taken to implement in Europe has not helped anyone in the industry. The deadline has kept moving, although there is an expectation that central clearing will start in April 2016. Our back office is outsourced to J.P. Morgan but we also had a specific project team dedicated to implementing EMIR and Dodd Frank for two years. We built the necessary infrastructure for clearing, trade reporting and risk mitigation but we got to a point where we closed the project and these activities have been transitioned into business as usual (BAU).
We are now operating on a BAU basis and have put clearing arrangements in place with two clearing brokers. We are also focusing on the front end to support the fund managers, which to my mind is the most complex aspect. You need to have an understanding of the margins, clearing limits, which clearinghouses to work through and the cost differential from a best execution standpoint between bi-lateral and cleared trades.
Are you concerned about CCP concentration?
Yes it is a concern in the industry. In Europe, LCH.Clearnet is the dominant player in interest rate swaps which gives the clearinghouse a significant advantage. The other issue is that there are differences to some degree in the way that continental European and the other (e.g. US) clearinghouses operate. For example, they are licensed as credit institutions in Germany and France which means that they have access to central bank liquidity and can allow a wider pool of collateral as long as it’s eligible at the ECB. This means that in the event of market turbulence or another Lehman event, the central bank will provide liquidity and smooth any potential issues. There is no such facility in the US although the Bank of England has said it would provide liquidity to CCPs operating in the UK via the Sterling Monetary Framework.
What lessons have been learned from the US experience?
The US has gone for a much more simplistic approach which I think is a good thing. The US has been clearing for three years down the line and has been far less ambitious in its aims than Europe. It has stuck much more to the original G20 principles whereas Europe has adopted a ‘gold plated approach’ in a number of areas. This can be seen for example in the requirement for both sides of a derivatives transaction to report a trade under EMIR. This is difficult to implement and the output for regulators has been poor. This is in contrast to the one-sided reporting in the US which is not as complicated and does not require less sophisticated derivative users to report, leading to more accurate data being reported to the regulators. The other key lesson is the need for an equivalent mechanism in Europe (as requested by ESMA) to the ‘no action relief’ adopted by US regulators which enables them to provide relief from certain regulatory requirements for a period of time where necessary.
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Profile : Phillipe Chambadal : SmartStream
LEADING THE CHARGE.
Phillippe Chambadal, CEO of Smartstream is a long‑standing proponent of utilities and the post 2008 industry is catching up to his way of thinking. Smartstream is aiming to mutualise the bulk of post-trade processes so that firms can focus more on their core businesses.
What were your initial goals after the company was acquired in 2007?
Our aim was to offer shared services in post-trade processing because we believe they offer the only way to increase efficiency and improve operational risk control. We bought SmartStream in 2007 because the company had a strong platform and client base. It was good timing in that until the global financial crisis happened, the financial services industry did not look at post-trade operations. It had been a bull market for the previous 30 years and it was not a major focus. They also underinvested in the technology, which meant that the post-trade processes had become very inefficient. For example, the cost of processing one derivatives trade typically ranged from $200 to $600. However, after 2008, there was a new focus on cost and a real sense of urgency to restructure the back office. This coincided with regulatory pressure to improve the quality and accountability of the risk data and reporting and to have a real time view of positions, liquidity and risk.
What benefits would a utility bring?
There is very little in the post-trade world that can’t be mutualised. Consultants estimate that there is between $50bn and $65bn waste in the post-trade world and that there is no value-add for companies to run these services internally. Even if banks did spend the billions of dollars to invest in their own systems, they would only be as good as their counterparty’s processes. If for example, a buyside client has weak post-trade systems, it has a significant impact on the operations of the bank. The other benefit is that utilities enable participants to concentrate on their core competencies and improve their competitive edge and quality of service.
What was the first project?
Reference data. In the past, financial services firms thought reference data was unique to their organisations and a value-add, so they did it themselves. However, it was an inefficient process for many reasons such as the front and middle offices used different ID codes and external data sources could be incorrect. The utility normalises and cleanses the data coming in from external sources, as well as providing a cross-reference across all identifiers for the same base instrument and issuer. This means that organisations can consume consistent, high quality data based upon a common coding reference and aggregate risk data with proper governance in place. The result is improved straight through processing, fewer trade breaks and a lower cost per trade. We estimate that we can immediately cut direct enterprise data management costs by around 30% to 40%.
Can you provide more detail about the current reference data initiative with the banks?
J.P. Morgan Chase, Goldman Sachs and Morgan Stanley have come together to evaluate current data management offerings and create a reference data utility. They put out a tender to different technology vendors and SmartStream won the mandate. The utility creates a golden copy for each client and helps eliminate trade breaks by sharing a common data model and high quality data on both sides of the trade.
What other utilities have you created?
Reconciliations, corporate actions, as well as fees management. With the latter, we basically take over the whole process of the management of fees and invoices emanating from brokers, clearing and exchanges. Traditionally they have been managed using manually intensive and paper-based processes that create significant inefficiencies. Instead of taking many months for firms to check these invoices, we streamline that process depending on the client’s requirements. Our solution manages the matching of transactions and associated fees. Going forward we are looking to help the market by creating standard invoice formats between market participants to make the process more transparent and efficient.
What were the drivers behind the acquisition of IBM’s Algorithmics collateral solution in February?
It was the missing piece and a natural extension of our cash and liquidity management solution. The acquisition enables our clients to have a complete picture across the front- and back-office and a centralised view of their inventory and exposure, enabling greater transparency of funding and collateral needs. We have rebranded the company as TLM Collateral Management, and have integrated collateral management with our other real-time solutions and services which includes cash and intraday liquidity management, corporate actions, reconciliations, data management and exception management.
We recently built an Acadiasoft Adaptor to provide a complete integration of messaging and collateral management.
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Derivatives trading : Overview : Dan Barnes
UNCLEAR FUTURES.
Dan Barnes looks at the uncertainties and potential costs posed by the dramatic restructuring of derivatives trading and processing.
Macroeconomic factors are making markets choppy in the second half of 2015. Trading is consequently a trickier business, with a tight partnership needed between dealers and investment firms’ trading desks if execution is to be effectively managed.
“Listed derivatives can take longer to trade because markets are more volatile,” says Adrian Fitzpatrick, head of investment dealing at Kames Capital. “That means the price to get business done can be slightly wider. Instead of being a couple of ticks it can be three ticks which percentage-wise can be a big thing. If institutions are working the order they can get it done, it just takes slightly longer.”
Trading over-the-counter (OTC) derivatives has also become more costly, although largely as a result of rules set out under the Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR). These frameworks set out the plan for standardising contracts, introducing electronic trading where appropriate, and central clearing of OTC derivatives, all mandated by the G20 governments in 2009. Other jurisdictions such as Japan have made progress putting these plans into effect and even some non-G20 countries, such as Singapore, are viewing these standards as a benchmark for the global derivatives market.
However for participants in a global market the imposition of multiple different national or regional regimes, each slightly different is challenging. On 6 August 2015 the European Commission, under EMIR, made it mandatory for eligible OTC interest rate derivative contracts to be cleared through central counterparties (CCPs) in its jurisdiction, a process to be phased in over the next three years. That will align the European regime for OTC derivatives more closely with that of the US, which was introduced in 2013, however not perfectly.
“What is yet to be clarified is how the different regulatory regimes of Europe and the US will interplay,” says Sam Topper, head of operations at credit hedge fund JPS Alternatives, part of J.P. Morgan Asset Management. He adds “That is where there is a lot of uncertainty in the clearing landscape. Right now US clearing can be mandatory for eligible instruments, but European clearing is not. When both become mandatory, to what extent will there be equivalence?”
Wedded to the Basel III capital adequacy rules that have broadly increased the cost of capital for investment banks, the irregular nature and uncoordinated timing of trading and clearing rules for OTC derivatives between jurisdictions have thrown the capacity of banks to provide services into disarray.
Several sellside firms planning to offer clearing services, including BNY Mellon, State Street, Nomura and Royal Bank of Scotland, have withdrawn from the market in the last couple of years. BNY Mellon noted in an October 2014 statement, “EMIR mandatory clearing has been pushed back to late 2015 or early 2016, delaying the expected expansion of the over-the-counter clearing business, which was a key element of our derivatives clearing strategy.”
In Europe and the US central clearing is already a market consolidating around five to ten clearing members, reducing competition on pricing. There are considerable costs involved in the process. Initial margin, a deposit held by the CCP against the value of an OTC swap, will have to be paid in high quality fixed income assets or cash. Variation margin, to account for any change in the value of a contract, will typically have to be paid in cash. Those instruments need to be sourced and funded using existing assets.
For dealers that are still involved in the clearing space the challenge of accurately determining their returns from clearing services has limited their capacity to support clients in a transparent manner. When asked about the validity of the prices they have quoted in their EMIR disclosures, several tier one brokers found serious problems in determining their actual range of prices. One was unable to determine who was responsible for the disclosed prices. The spokesman at another said, “The disclosed prices are simply not prices we would charge” while another said, “our charges have since changed” but was unable to say what they had changed to.
“It’s fair to say that pricing has been increasing due to the higher capital associated with this business,” said another.
The breakdown
The process of posting cash as variation margin requires investors to either have buffers of cash in-house or to have some type of collateral transformation or repo facility to exchange securities for cash. The latter seems to be the natural option but the worry is, if the market becomes stressful will there be enough players, for example in repo, to execute a transformation?
“We see liquidity dropping and parties withdrawing in repo,” says Ido de Geus, head of treasury and client portfolio management at asset manager PGGM Investments. “Pension funds normally have enough high quality liquid assets available so initial margin should not be much of an issue, but tend to repo them for cash where necessary to cover variation margin.”
A consequence of the shifting regulatory sands is a caution among the majority of the asset managers to commit to operational changes. The larger and more apparent preparations have been made by the majority of firms say market observers.
Jacqueline Walsh, managing director at Derivati Consulting, says, “Most have a clearing member and central counterparty so they can clear trades. A lot of those decisions were made six months ago or more, so there is a real desire now to revalidate those decisions with the changing scope of clearing members. I am just starting to see firms looking at optimising their model, now that they can be compliant.”
As firms look at the more specific operational pieces of the puzzle, the level of preparation undertaken varies in terms of the size and sophistication of the firm. Dealers report that the larger buyside firms have the resources, and dedicated departments to help cope with change and complexity.
Pierre Lebel, global head of client collateral management at broker-dealer SGCIB says, “They have project management teams to reorganise their processes whether for the listed derivative markets or OTC bilateral trading. If you go toward the lower tier-one firms and below, you have firms that will have to drastically change the way they do business. Some of them are completely unprepared.”
Making it work
The first priority for firms to address is their systems, argues de Geus. Increasingly trading technology must be able to capture granular data. Regulators are increasingly pushing banks to provide a single view of finance and risk data, as under the Bank of International Settlements BCBS239 rules, while Dodd-Frank, EMIR and MiFID II all demand trade reports from firms that will require both buy and sellside trading desks to capture granular data.
“Firms need monitoring at three levels,” says Christian Voigt, senior regulatory adviser at trading platform provider Fidessa. “The first is around the order in real time for the trader. The second is around T+1 analysis for the compliance function, looking at the same data from a slightly different angle. The third is a view for senior management. I would say those requirements are multi asset.”
Addressing the most pressing regulatory challenges with point solutions, which is how many firms have been meeting these challenges is starting to give way to a bigger picture around technology investment, says Noel Montaigue, senior sales manager EMEA at trading and risk management technology provider OpenLink Financial.
“That got them out of trouble on small budgets,” he says. “Now they are taking the longer term view. They still expect an ROI inside of 18-24 months but they are buying for the business, rather than the business unit.”
There is also a need to understand how a firm’s derivatives trading operation fits in with its counterparties, in order to ensure that it is viable as well as valuable. That requires investment in relationships as well as technology, says Miles Courage, chief operating officer at JPS Alternatives. “We spend a lot of time and effort understanding the requirements of different counterparties so that we can be an optimal client,” he adds.
[divider_line]©BestExecution 2015
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Trading : Unbundling : Lynn Strongin Dodds
UNTYING THE COMMISSION PACKAGE.
It’s been a long time coming but the separation of research and execution is inching ever closer. Lynn Strongin Dodds looks at the latest chapter.
Although there is a lot of buzz around the unbundling of research and execution, it is far from being a new item on the regulatory agenda. The Myners report in 2001 started the ball rolling and there have been many fits and starts since. MiFID II has firmly ensconced the topic but the final edict has been pushed back to November from September although the changes are expected to be fundamental.
“Whilst regulators may see unbundling as a progressive move for the industry, I think they may have underestimated the depth and breadth of its impact,” says Steve Grob, who is responsible for Fidessa’s global strategic development. “It will certainly alter, permanently, the traditional relationships between the buy and sellside.”
The European Securities and Markets Authority (ESMA) is proposing that fund managers buy research using either direct payments out of their own revenues or from a separate research payment account (RPA), which can be funded by a specific charge to a client. In other words, the buyside would no longer be able to direct execution work to a particular broker as a way of paying for research they had received from that firm via the commission.
Not surprisingly unbundling is controversial and it was left off the list of recently published technical standards. Instead, the Paris watchdog published its technical standards on new transparency requirements for bonds, position limits on commodity trading positions and open-access provisions for derivatives clearing houses. More time was needed to debate and discuss the issue.
One reason is that although ESMA and the Financial Conduct Authority (FCA) are broadly in line, there is dissension on dealing commission use. The French regulator, the Autorité des Marchés Financiers (AMF) is a strong advocate of the classic commission sharing agreement (CSA) structure whereby end clients bear the brunt of the research cost albeit with stricter transparency and reporting rules under MiFID II. The argument is that asset managers using the system would only have to tweak their existing frameworks for budgeting and disclosure. By contrast, the FCA is a proponent of the new RPA scheme which ensures that the end clients do not shoulder the cost burden. However, it would entail investing in new infrastructure and processes.
Doing the sums
Despite the uncertainty, consultants and research houses have been busy crunching numbers. According to a new report from Greenwich entitled Payment for Research: The Calm Before the Storm, the larger European institutional investors generated an estimated €3.4 bn in cash equity commissions for the 12 months to 31 March. Roughly €1.7bn or 52% of that amount was directed to pay brokers and third-party research providers as compensation for research.
Although the percentage was lower than the 54% in the previous 12 months and the figure spent on research is well below the 2007 and 2008 peak of €2.5 bn, it still represents a large chunk of revenues at risk, according to John Colon, author of the report and managing director of the firm’s market structure and technology practice. “Should regulatory changes drive down institutions’ overall expenditures for research, even a modest reduction will likely have a substantial impact on the availability of research,” he adds.
The consultancy canvassed 200 European equity portfolio managers and 185 European equity traders about their commission spend, allocations for research and advisory services and their relationships with brokers. A majority of UK firms questioned believe that the changes wrought by MiFID, which takes effect in 2017, will leave no room for research to be funded by commission. They expect instead to see a rise in hard-currency payments or a greater reliance on in-house research at the same time as spending drops on commission payments.
“Many agree with the mantra of increased transparency and accountability to protect the end investor, but there are still mixed views on how to pay for research,” says Adam Toms, chief executive officer of Instinet Europe, the equity execution arm of Nomura Group, which recently received approval to allow clients to pay for research in cash, rather than using trading commissions. “We would like to see CSAs (commission sharing agreements) continue to be used as they only need marginal enhancement to meet the residual goals of the regulators. We are also seeing much more proactive management of CSAs in the run-up to MiFID II.”
Juan Pablo Urrutia, European general counsel at ITG, adds, “One of the big questions is how RPAs would work? For UK asset managers they seem pretty inevitable bar a U-turn from the FCA. The problem is that they are extremely clunky and asset managers do not have the technology, people or infrastructure to do them. They could outsource it to a custodian or a third party specialist.”
Another challenge, which Colon points out in his report, is the sourcing of the research. “Shifting research expenses to investment managers’ clients via higher management fees, charging an explicit fee to fund a research payment account, or expecting brokers to simply continue providing research at lower margins will be tough options to sell”.
Putting a price on the research will also not be easy, according to Matt Gibbs, product manager of Linedata. “The sellside is having conversations that they never had before and asking questions about the cost and the boundaries that they should put around the product. There is no magic number and the pressure moves to the buyside in terms of what value they put on it.”
The research downsize
The sellside is not waiting for the MIFID gauntlet to be laid down and has already started to downsize or, in investment banking jargon, “juniorise” research and distribution teams. “Banks started to right size their research departments a long time ago,” says David Masullo, head of EMEA sales at Bloomberg Tradebook. “One of the good outcomes of this will be a greater focus on execution quality and I think we will see more resources dedicated to tools such as transaction cost analysis.”
Grob agrees that there will be a greater focus on best execution and that it will make the process much more transparent.
However, the downside is that the reforms will lead to a further reduction in the provision of small to medium sized enterprise coverage as banks restructure their research teams to concentrate on profitable research, predominantly the large caps.
“It seems inevitable that the total research pool will dry up and ‘less fashionable’ stocks or sectors may not be covered which, at the end of the day, will reduce investor choice,” says Grob. “For example, cyclical industries like coal may fall out of favour and then there will not be any research produced for these areas. It seems most likely that the sellside will develop a tiered pricing model, based around a platinum, gold and silver service for different clients which may leave some disadvantaged.”
Colon echoes these sentiments in his report by noting if “regulatory changes drive down institutions’ overall expenditures for research, even a modest reduction likely will have a substantial impact on the availability of research.”
Although acknowledging concerns that certain companies and sectors may become neglected, Per Lovén, head of international corporate strategy at Liquidnet Europe believes the proposed new rules could give rise to new independent research providers and distribution networks. “I also think we will see a more bespoke research which could lessen the herd mentality and lead to more diversified pools of liquidity.”
[divider_line]©BestExecution 2015
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