Derivatives trading : The impact of regulation : Jannah Patchay

November 9, 2015

DOUBLE VISION.

Jannah Patchay, partner at Agora Global Consulting outlines some of the inconsistencies and incompatibilities of US versus European regulation and the potential impact on derivatives markets trading.

The relentless onslaught of new financial regulation, conjured up by an army of legislators and regulators with varying degrees of insight and expertise, continues its inexorable march across the global financial markets landscape.

In Europe, the traditionally relaxed northern hemisphere summer, customarily the preserve of month-long holidays, has been punctuated over the past couple of years by a fast-dawning realisation that the regulatory timeline most certainly does not take such niceties into account. Many in the industry expected to spend this summer poring over the Level 2 texts for the second iteration of the Markets in Financial Instruments Directive (MiFID II).

However, the European Securities and Markets Authority’s (ESMA’s) decision to postpone publication of these texts pending an early legal review by the European Commission led, this year, to something more approaching collective torture than a brief respite.

As the industry continued to agonise over the potential interpretation and impacts of the MiFID II Level 1 provisions on such arcane matters as the future of OTC trading versus systematic internalisation, the meaning of “liquidity” as applied to different asset classes and product sets, the nature and composition of prices to be published to clients versus the market, and what exactly constitutes a “commercial policy”, some of the key cross-border regulatory issues remain lurking in the shadows.

There is ample good reason for this: the US’ Commodity Futures Exchange Commission (CFTC) and the European Commission (EC) have yet to reach an agreement on substituted compliance for derivatives margining and clearing requirements, or on equivalence for central counterparties (CCPs), let alone considering the potential cross-impacts of MiFID II and Dodd-Frank on EU and US market participants.

Furthermore, these are not issues that have gone completely unrecognised by both sides; in July 2013, the CFTC and the EC agreed their “Path Forward” on harmonisation of their approaches to derivatives regulation, just in time to agree substituted compliance between the Dodd-Frank and European Market Infrastructure Regulation (EMIR) provisions on Risk Mitigation.

MiFID II creates new complexities in terms of both its scope and its potential impact on the efficient and effective functioning of global financial markets. For example, all multilateral platforms, including ECNs and brokers, must become authorised as MiFID trading venues – either regulated markets (RMs), multilateral or organised trading facilities (MTFs or OTFs) – by the regulatory deadline of 3rd January 2017, in order to continue their operations in the EU.

Furthermore, certain derivatives, deemed by ESMA to be subject to the Derivative Trading Obligation (DTO), may only be traded by clearing-eligible counterparties on a MiFID trading venue, with OTC trading in these cases no longer allowed.

If this is all sounding familiar, that is because it is roughly analogous to the concepts of permitted and mandated trading, respectively, on Swap Execution Facilities (SEFs), introduced by the CFTC in June 2013.

Before we get ourselves too comfortable though, it is worth bearing in mind that both the CFTC’s SEF requirements and MiFID II’s DTO have differing jurisdictions. The DTO applies to authorised European investment firms, and to all eligible transactions into which such entities enter. SEF requirements, on the other hand, apply to any eligible transaction, anywhere in the world, entered into by a US Person.

Take for example a European bank entering into a trade in a highly liquid derivative with a US Person. Suppose the derivative is subject to both the DTO in the EU, and has been Made Available to Trade (i.e. is subject to MAT determination) by a US SEF. The trade therefore falls under the jurisdiction of both sets of regulation, and must be executed on both a SEF and a MiFID trading venue, in order to fulfil both sets of requirements.

Currently, the US and the EU have not managed to come to an agreement on an equivalence determination for SEFs and MTFs (OTFs are a new introduction, and do not even appear to have been considered in discussions between the two sets of regulators to date). Therefore, if the trade is executed on a platform that is authorised in the US as a SEF, it will meet US requirements, but not those of MiFID II. And if it is executed on an MTF / OTF in the EU, it will not meet the US obligations. This problem already exists, as many interest rate derivatives have already become MAT on SEFs. It has been temporarily remedied by the granting of time-limited no-action relief, in which the CFTC essentially promises not to enforce a specific rule for a set period of time.

However, the conditions imposed by the CFTC have proven so onerous – both qualifying MTFs and participants trading on them must meet a number of CFTC reporting requirements – that only one MTF has taken advantage of this relief. Instead, European market participants have reluctantly accepted that, in order to carry on doing business with US Persons in MAT derivatives, they must trade on a SEF, with all the accompanying issues of liquidity fragmentation that have been so well-documented elsewhere.

All right, you may be thinking at the moment, but surely some platforms can become authorised as both SEFs and MTFs / OTFs, and that would solve the problem? Except, they can’t really. SEFs impose a number of requirements on the trade execution model that are completely at odds with existing platform trading models, as well as creating conflicts with MiFID II’s provisions around pre-trade transparency.

There is no Plan B, no contingency, in the event that the regulators do not reach a mutually agreeable compromise. In the very worst case scenario, a near-complete split between US and European liquidity could take place, necessitating the use of complex corporate structures, back to back trades and potentially new derivatives instruments for participants in one market to gain exposure to another. The only solution, then, is to continue in hope that one will be reached. With the hurdles of clearing and margining equivalence still in the process of negotiation, this is only likely to come late in the day.

Regulators on both sides of the Atlantic are tasked with improving the regulatory framework in order to achieve more stability and transparency. It is ironic, then, that so often, new regulation has the potential to create in itself new and dangerous sources of systemic risk.

[divider_line]©BestExecution 2015

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Derivatives trading : Sassan Danesh and Kuhan Tharmananthar

Ian Rycott

November 9, 2015

COLLABORATION IS KEY.

Sassan Danesh and Kuhan Tharmananthar ask what MiFID II & EMIR mean for the derivatives world, and will Europe follow the US lead where voice trading and RFQ remains firm fixtures?*

In the financial industry, at least, no one ever asks the question ‘what on earth do all those European regulators actually do?’ The hundreds of pages of legislation created since the credit crisis include Basel II, UCITS IV, EMIR and now MiFID II are an ample reminder of the constant stream of work produced by the regulators. The industry, whilst changing to meet the immediate market fallout from the crisis has also had to cope with change imposed upon it by those regulations. The challenge for market participants is to how best to adapt to meet the demands of investors, shareholders and regulators at the same time.

Derivatives remain an important tool for investors to isolate and hedge risk in a much more targeted manner than possible through cash products alone. However, this benefit comes at the expense of complexity and diversity of the product set. With MiFID II’s ‘non-equity instruments’ including derivatives, there is industry concern whether the regulations take sufficient account of the specific challenges regarding complexity and liquidity. There’s also the broader question of how to meet the regulatory requirements whilst minimising time, effort and costs.

One of the key objectives of MiFID II is to develop investor protection and transparency is one of the main tools being deployed to achieve this aim. The transparency principle reaches from price publication all the way to trade execution and will have a major impact in the way the OTC derivative markets function. MiFID II lays out specific transparency requirements for investment firms and trading venues. It also duplicates the idea of systematic internalisers (SI) that was applied to the equity markets by MiFID I. The SI concept will engender an important change in the derivative space – investment firms conducting business outside a venue over voice or through electronic means will now have a series of new transparency obligations placed upon them. There are various exemptions and waivers for these obligations but they involve relatively complex ‘calibration’ calculations using data that, at the moment, simply doesn’t exist.

An example that is causing significant discussion within the industry is the requirement for SIs to publish firm quotes to their clients and trade on those within certain ‘objective and non-discriminatory’ limits. Additionally, where an SI provides a voice quote on a bilateral basis to a single client, there is an obligation to make that quote available to their wider client base.

There are further pre-trade and post-trade transparency requirements that attempt to differentiate between the different trading approaches – including voice, continuous auction book trading and request-for-quote amongst others. Another high-level objective of MiFID is to promote orderly markets. This is implemented through regulatory reporting all along the price discovery and trading lifecycle in order to allow the competent authorities to monitor market behaviour for potential systemic risks and for abuse.

An example of new data the regulation requires is for investment firms to provide and maintain reference data with the competent authorities. This is a huge issue in the derivatives landscape given the lack of a standard means of classifying derivatives such as exists in the cash world through ISIN, CUSIP, CFI and other established identifier and product taxonomies.

Imagine if each trading venue and SI develops their own protocols for meeting the MiFID II pre-trade transparency requirements. The additional complexity in the market infrastructure, caused by proprietary publication and consumption of this data will result in a massive increase in both regulatory spend and ongoing technology costs within investment firms. Additionally, the ability to aggregate information across the marketplace as a whole will be hindered, creating challenges to price discovery – the exact opposite of the regulatory intent.

A standard would allow market makers and SIs to not only meet their pre-trade transparency obligations more easily across their different electronic channels, but also to allow all investment firms to consume this data more easily, thereby allowing the proper functioning of the price discovery mechanism across the European marketplace.

Even greater challenges apply for investment firms maintaining reference data. Not only is there the issue of different participants attaching a different semantic meaning to the same fields but there is also a problem with a mismatch of the data values themselves. Both of these will not only make it more challenging for investment firms but also place a greater burden on the competent authorities who, after all, want to use this reference data to monitor and assess risk in the market.

FIX has already begun work on addressing the implementation challenges of MiFID II, with the creation of six working groups composed of experts from across the market, looking across Clock Synchronisation, Reference Data, Transparency, Best Execution, Microstructure and Order Data and Record Keeping. These groups are working through the MiFID II requirements and analysing how FIX is going to meet them. Other industry bodies such as AFME are also running market-wide workshops to examine the impact of MiFID II. The industry knows that the only way the multi-dimensional requirements of MiFID II will be met is through collaboration of this kind. Indeed, recently there was further link-up between the FIX efforts and AFME to help build a consistent approach by the industry.

Coming back to the reference data issues facing the industry, market participants have known for some time that the definition and use of data both within institutions and without is more often than not fragmented and incoherent. However, these complex taxonomies are often buried deep in the electronic architecture of market participants and their idiosyncrasies pervade across institutions and, as such, are expensive to resolve. MiFID II has provided the opportunity for investment firms and vendors – the market as a whole – to begin the long process of standardising both the semantic model for data in financial markets and the values themselves.

The new regulations offer both challenges and opportunities to the market. The challenges are understood: How can transparency be achieved without further damaging liquidity? How can an industry still undergoing change from the financial crisis continue to be profitable and innovate under all the regulatory pressure? But the opportunities, when approached through standardisation and collaboration, will allow those challenges not only to be met but also to create a richer market infrastructure, based on open standards that will improve the functioning of the market for the benefit of its participants.

*Sassan Danesh is Co-Chair OTC Products Committee, Reference Data Subcommittee, FIX Trading Community, Managing Partner, Etrading Software. Kuhan Tharmananthar is Product Manager, Etrading Software.

[divider_line]©BestExecution 2015

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The Strategy Of Two Global Heads

frank_loughlin

November 7, 2015

With Frank Loughlin and Emma Quinn, Global Co-Heads of Equity Trading at AB
Emma: Our joint global position came about because AB wanted to ensure that it was focusing on all aspects of the global business. We are a global firm and we wanted to make sure that the structure matched that outlook. We also saw the advantage of having people with expertise in different regions using that experience globally. Although day-to-day we each have responsibilities for certain regions, we had a clear mandate to run the trading team with a global philosophy as there are clear advantages for the clients and the firm for us to have a global outlook.
Frank: It really does need to be a global role – at a high level, a number of strategic decisions have to be made globally, including things like staffing, infrastructure, technology, commission policies and broker relationships; these decisions all have to be made jointly and with a global focus in mind. We can’t operate globally and make decisions regionally, so in terms of the role (notwithstanding that we are in different geographies) we do make decisions jointly and globally.
Emma: In an environment where regulation and market structure issues are increasingly global in impact, this does give us something of a philosophical head start in having a wider awareness. It also means that, because Frank and I have traded all of the regions and markets that we’re involved in, it gives us a depth of expertise and a different perspective – we can understand the detail of what the regulatory impact may be.
Key strategic concerns
Frank: In certain instances there are regulations and nuances that differ market by market and region by region. The strategic aspects where issues have to be thought through globally have to flow down from a global level to the team members. They have to think of themselves as part of a single global trading team and not a series of regional desks that happen to report up to the same management structure.
Our teams have to communicate and collaborate as a global entity. They have to behave in that way on a day-to-day basis otherwise it doesn’t work. It defeats the entire purpose if at one level you are trying to make decisions globally but on another there are people acting as if they are part of a local geography.
Emma: I think that has probably been one of the biggest changes that we have seen in the last year – encouraging the traders to develop a more global mentality.
From a quantitative perspective we have been able to learn from the different regulations that apply in different regions and this drove the restructure of our quantitative trading. There are often things that we do in one region that could work well in other regions and this area is one of our main focuses.
Frank: As an example, there are also regional nuances around how IPOs and after market blocks are handled. In terms of best practice, there are probably a consistent set of principles that we should all follow in order to maximise and optimise our outcomes when we participate in IPOs or other types of offerings or liquidity events that are not part of the normal course of secondary trading.
Technology development
Emma: This global outlook ripples through to vendor relationships and technological conversations, as there is that standardisation in how we communicate. It allows us to prioritise on a global level and we can make sure that there is a priority list that Frank and I are comfortable with. We are effective in that respect; everyone knows where we’re going and everyone’s moving in the same direction.
Frank: Having people like us acting as referees, so that vendors understand what the global needs are, is a much more effective way of deploying resources than having people from different regions who may not understand other regions’ needs, come to the table and just talk their own book. At AllianceBernstein we need people who understand the business globally to balance those disparate needs and global interests, and that requires real global visibility. The regions are not able to make those decisions on their own because they don’t have the perspective to compare their needs to the needs of another desk or regional group.
Emma: And to that effect, Frank and I can. We weigh up the issues using our ‘global heads’ and have the foresight to identify targets further ahead of time; for example in London we may need a particular sort of data for the regulations that apply there, and in Asia we may need something else. We’re not just adding on those tools as and when, we add what they need in a particular region and then we roll it out to the next one.
Furthermore, if we see what may be best practice from a risk or compliance perspective in one region, we can still roll that out from a regulatory standpoint (even though it may not be a problem in other regions). It allows us to choose where to roll out best practice even though it may not be a requirement in another region we see it as good management (particularly good risk management) to do so.
This feeds through into the certainty of the relationships we develop with our counterparties; they know we will adopt global best practices even when they are not necessarily a requirement.
Client impact
Emma: Our clients and counterparts benefit from the consistency of our structure; Frank and I make decisions on a global scale and there is consistency among the regions. We would never say that we want one thing done a certain way in Hong Kong and a different way in London and then a third way in New York. There is a consistency throughout in that respect and clients know that these decisions have been made at the highest level. Therefore, trust and transparency can be built around that global conversation.
Frank: This applies to clients for whom we manage global mandates, and for whom we trade everywhere, to the extent that we have a logical and consistent process globally. This helps them to understand how we operate in that it is consistent across the portfolio that we manage for them globally.
Our philosophy also makes it easier when we talk to brokers. We want to have a consistent experience with our top trading counterparties, wherever they are in the world and notwithstanding potential differences in their capability. We view our relationships with the brokers globally and holistically and so if we are united in thinking globally it makes it a lot easier to convey that message to the brokers.
Part of this is how the sell-side is structured. While it may be unusual, on the buy-side to have a shared global co-head role, it is not as uncommon on the broker side. Other top firms have global co-heads of equities or of electronic trading so they are probably far more comfortable with the idea than some of our buy-side colleagues.
The right attitude
Frank: There are benefits to having two people in different parts of the world covering the business as a whole, because the role is active 24 hours a day. Emma is in Hong Kong and I’m in New York. The time difference means that we have non-stop coverage from Monday morning Hong Kong time until the close in New York on Friday, which wouldn’t be the case if we were one person. We can get a lot more done when there are two of us working together.
Emma: But it does come down to those two people having to work well together. The structure wouldn’t work if we were unable to put our own personal agendas aside for the good of the team and then the clients.
Frank: With regard to the actual working dynamic, the two most important attributes are respect and communication. We have to view success as intertwined and seamless. The team’s success is our success, it’s not my or Emma’s success. It requires a certain mindset but if it works, it is very effective. Even with all the technology in the world you still need the right people and the right thinking to make it work.
Emma: Honesty between the two parties is also very important. Frank and I have very open and honest conversations. We debate things through because we don’t always agree with each other and that’s a good thing. But once we make a decision together, then we are committed to it whether we were for or against it during the debate.
Frank: It is very important that we present a unified front to the team, to other people internally and externally once a decision is made. There can be no uncertainty in people’s minds as to where we both stand on an issue.
Emma: Frank and I are very similar in how we think about ethics and morals, so when we discuss an issue I know about 90% of the time where Frank is going to stand. Frank is the same with me because we have very similar views about clients outcomes or how the team should function or counterparty relationship.
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Silicon Valley Meets FinTech

steve_grob

November 7, 2015

With Steve Grob, Global Strategy Director, Fidessa
The whole financial technology industry is in the process of reshaping its approach towards technology. This presents our customers and prospects with a dual problem. First, how to develop and compete in a cost-constrained environment and, second, in this new super-transparent world, how do people demonstrate and prove their value add to the process?
When examining other parts of the technology universe, it is clear that many interesting think tanks and projects are emerging; for example blog teams, data visualisation and social media interpretation. The problem for our industry is how these firms find their way into capital markets, because the main issue of concern is credibility. What about information security? What about compliance resilience and viability? These firms do not have the capacity to answer these questions for large institutional clients.
As a result we identified an intriguing opening for Fidessa to get involved in this ongoing technology shift. It involved sourcing a number of firms that we could curate and carry out the necessary due diligence, in terms of their data centres, legal agreements, as well as embedding their technology into our workflow. This is a ‘win-win’ for all – the technology company gets access to all our customers, and our customers are able to access something that has already been pre-certified. OTAS was the first firm to go live on this platform.
Making the transition
The advantage for us is that these new and relevant technologies are entering our ecosystem and empowering customers to do what they do better. It marks a change from us having to write everything ourselves, to recognising that we have access to a great community of buy- and sell-sides, and we can help them find and utilise the technology they want to be able to access.
Our clients are happy because it gives them access to a new wealth of interesting technology, and allows them to demonstrate their relevance and to have deeper and more meaningful conversations internally and with their clients.
One of the challenges in making the transition from being an upstart Silicon Valley firm into a financial technology lexicon of the industry, is using full language and terms that mean very specific things. It has been necessary to educate the tech firms on how best to use their technology in a way that makes sense for our customers – this has been a steep learning curve. We have also learnt a great deal about how various types of firm approach technology and how different industries handle development and deployment.
We see this as a global platform and have had just as much interest from the US as we have had from Europe. Again, this is a way of helping ‘jumpstart’ some of these new firms into an area that might otherwise take them years to develop – they can do it with us in just a few days. And of course, we can also use our technology and reach to build something better, so for example we can provide global datasets that they might not otherwise have access to.
This is very different to an app store for example where, if you buy an app for $0.99 and it doesn’t work, you have no point of redress. Whereas our value added is in ensuring that the firms we bring in (a much smaller number than in an app store), really add value to our workflow.
Evolving technology
Another issue worth considering is that today’s industry needs to solve its cost and relevance problem. In any ecosystem, every member must benefit more than they would otherwise outside it, whether that be the providers of the service or the consumers of it.
It is very much becoming a reshaped industry and firms that can find their way to demonstrate that successful blend of technology and innovation are going to be more successful. In tomorrow’s super transparent world, simply getting in between a customer and source of liquidity will not be a viable proposition. Firms are going to have to collaborate and cooperate and each add value at every stage of the process.
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Viewpoint : The impact of regulation : MiFID II/MiFIR : Silvano Stagni

Ian Rycott

November 5, 2015

MIFID II/MIFIR – EVOLUTION OR DISRUPTION OF CURRENT BUSINESS PRACTICE?

How disruptive is the MiFID Review for the professional life of a European banker? Which workflows will stay roughly the same and which ones will change beyond recognition? Silvano Stagni, global head of research at IT consultancy, Hatstand investigates.

MiFID II/MiFIR are supposed to change the way financial instruments are traded creating a more transparent environment, a measurable execution quality, a structured playing field for all financial instruments and better protection for investors. The way people work will have to change to achieve this. Matters are further complicated by interaction with other sets of regulations such as Market Abuse or the forthcoming ‘European Long Term Investment Funds’ Directive.

What are the changes and how significant are they? The extension of scope to non-equity products means clients will be classified by asset class; this is a significant structural change. It is no longer a drop-down list with classification purely associated with the client but a matrix with the classification associated with client and asset class. From the perspective of a client onboarding workflow, the basic ‘Know Your Client’ steps will not change. The implementation of those steps will change because the data structure behind it will have to be modified to accommodate the fact that ‘Client Type’ is now tied to two entities: Client and Asset Class and not just one – the Client.

Business units that execute non-dark trades in cash equity will see some changes brought about by stricter definitions of best execution, execution quality reports (introduced by MiFID II/MiFIR) and the way orders are managed. The latter is mostly due to the disappearance of the ‘execute or cancel’ order (also known as ‘do or die’) since cancelled orders will have to stay in the order book for one reporting cycle. A different scenario awaits operators of dark pools since it will only be possible to execute trades without affecting market price (the basic concept behind ‘dark trading’) within the remits of two specific pre-transparency waivers (negotiated trades and large in scale trades).

Since pre- and post-trade transparency are the domains of a trading venue, dark trading can only take place within this environment. Financial institutions that currently operate dark pools will have the choice of registering as a MTF (Multilateral Trading Facility) or SI (Systematic Internaliser), of using third-party platforms, or leave the business altogether. In any case this will be a drastic disruptive change from the way dark pools are presently organised and each decision will affect the cost/revenue model of the unit, if not the institution.

The extension of best execution to non-equity will impact many aspects including client management, order management and execution. The biggest change will result from the obligation to trade liquid instruments on exchange. There will no longer be any choice as to whether to trade an instrument OTC or on exchange. This depends on the definition of liquidity for specific asset classes but if it is liquid it has to be traded on an organised execution venue (Regulated Exchange, MTF, OTF, SI). At the time of writing this article ESMA had not published the latest draft of technical standards and the definition may change. A sellside company could be considered an execution venue for a buyside company.

Any institution that currently operates a trading platform for non equity instruments where clients can trade multilaterally will have to register as an Organised Trading Facility (OTF) if they want to continue offering this service to their clients. This will result perhaps in one of the largest disruptions to the current style of operations. Registering as an OTF carries its own obligations and is asset class based. Some institutions may decide to drop ‘marginal business’, and others may decide to invest in ‘marginal business’ to profit from business that others have dropped.

Outside trading, the processes around the creation, distribution and use of financial research will also be affected by the requirement to ‘unbundle’ its cost from commission or execution fees. This will create a separate set of contractual relationships to provide/source financial research. At the time of writing this piece there is no consensus as to how research should be paid for. This part of the directive may even change from one jurisdiction to another when the directive is transposed into national legislation.

Unbundling will affect sellside companies as they will have to charge for research and they will be restricted to providing financial research only to those who are requesting it (and hopefully paying for it). The greatest issue will be putting a value on something that has been distributed ‘for free’ for a long time and now has to be priced. This may also lead to a review of what is actually being produced and whether it is worthwhile. Buyside companies will also look at what research they use and what is valuable to them. At the moment, there is the perception that financial research is free; in the future, buyside companies will have to pay for it, so it makes sense to pay only for what is useful and valuable.

The implementation of MiFID II/MiFIR will undoubtedly change the way financial institutions work. The changes discussed above are examples of some of the expected disruptions and alterations to current business practice. Although ESMA will have published the latest definition of technical standards for MiFID II/MiFIR by the time this article is published, those technical standards will still be subject to the approval of the European Commission.

Prior to any implementation work there are strategic decisions to make. These can already be discussed based on the principles included in the level 1 definition of the directive and regulations approved by the European parliament last year and therefore cast in stone. These decisions are necessary to implement the best solution from the range of available alternatives.

[divider_line]©BestExecution 2015

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Regulation & compliance : EU/US arbitrage risk : Mary Bogan

Ian Rycott

November 5, 2015

LINES IN THE SAND.

Mary Bogan explains the hurdles the US and Europe have to overcome to reach equivalency in clearing.

Right from the start, aligning the clearing regimes of the world’s major economies that govern the global derivatives market looked like a hard ask. Even back in 2009 in Pittsburgh, when G20 leaders still reeled from the financial devastation wrought by obscured derivatives trades, the potential to tilt the playing field and stimulate regulatory arbitrage if different territories used different rules for the newly created over-the-counter (OTC) market, was recognised. Only the most pessimistic though would have guessed that, six years later, a dispute over cross-border OTC clearing rules would still be raging and that the US and Europe would be entrenched in a long-running standoff which is fragmenting the market, damaging liquidity, increasing costs and compliance workloads.

What’s at the heart of the dispute isn’t easy to fathom. On the face of it, the disagreement centres on systemic prudence and which territory has the most robust derivatives clearing regime. According to the EU’s current position, US clearing rules do not meet the same standards as those set out in the European Market Infrastructure Regulation (EMIR). It has therefore refused to give formal recognition or full “equivalence” to the US.

If no agreement is forthcoming, then when Europe starts trading the first OTC contracts on exchange next April, US central counterparties (CCPs) will be unable to clear OTC derivatives in Europe. Meanwhile, European banks that would like to clear in the US will suffer a heavy capital penalty for using a “non-qualified” CCP in a territory that falls short of the EU’s equivalence test. As a result, European banks will simply choose to stay local.

“The primary concerns around equivalence rules are the amount of capital that would need to be held at EU-based banks in order to clear through US-based CCPs,” says Henri Pegeron, product manager, derivatives and compliance at Fidessa. “Trading with a qualifying CCP (QCCP), or the recognised equivalent in Europe, would typically be subject to a relatively low 2% risk-weighting plus margin at the recognised CCP. But that same transaction in the US could cost exponentially more given the 10-day risk requirements imposed on a product that may only be exposed on the market for days, hours, or even minutes So the cost of clearing outside of an equivalent QCCP in Europe will become prohibitively expensive, and banks will simply walk away.”

Crunching the numbers

Digging down into the technicalities of the dispute, it is the size and calculation method for initial margins needed to protect trades that separates the two sides. The EU thinks clearers should collect margins covering two days of risk that counterparty could default. The US, on the other hand, believes one day’s margin cover is sufficient. However, while the EU regime is tougher on initial margins, the US argues it is stricter on margin held in client accounts. That’s an argument that the EU though shows no sign of buying.

“There is an essential difference between margins collected to protect clearing members’ own account position and the one collected to protect client position since client margins cannot be used to protect the CCP from the clearing member’s default,” Verena Ross, executive director of ESMA said recently in London.

Pointing to the Lehmans default as a case in point, she added that, as margins collected on Lehman’s own account were insufficient to close positions in three asset classes out of five, it was pure luck the default fund was not impacted.

“In our view it is not prudent to assume that the portfolio composition of a clearing member will ensure that, if margins collected in one asset class are insufficient, the margins collected in others asset classes will be sufficient to compensate that.”

While margins are undoubtedly a bone of contention, many think its competition and protection of regional commercial interests that is really prolonging the transatlantic face-off.

“When you consider the regimes that have already been granted equivalence by the EU, I think this probably leans more towards being a trade dispute than a disagreement about clearing rules,” says Chris Ekonomidis, a director at Sapient Global Markets. “To say the US regime poses additional risk or has lower standards than these markets is incorrect. What it boils down to is a bit of gamesmanship.”

Granting equivalence

To date the EU has granted equivalence to Australia, Japan, Hong Kong and also Singapore, a territory which Terry Duffy, chair of US derivatives exchange group CME, recently noted testily, operates a very similar clearing regime to that of the US.

“The debate about equivalence has been burdened by context and the key issues here are extra-territoriality and the competitiveness of the US versus Europe,” says Luke Zubrod, director risk and regulatory advisory, Chatham Financial. “The question is about when US rules should apply outside the US. With OTCs, that’s challenging. Unlike equities, where relationships are severed on consummation of the trade, counterparties to derivatives contracts can be bound into an ongoing relationship for potentially years to come. Whose rules apply is therefore an issue that swells in meaning.”

The expansive view of US authority, taken by the previous head of the CFTC, Garry Gensler earned him the title of “Swaps cop to the world” and rattled regulators overseas who expressed their ire publicly in a joint letter to the CFTC.

“What this approach meant was that the US did not trust foreign regimes to police their own markets or do their jobs well despite G20 commitments and the considerable care and effort taken by regulators to govern markets in their own jurisdictions,” says Zubrod. “Not surprisingly, that’s something foreign regulators have taken umbrage at.”

Meanwhile, as the dispute leaves market participants fumbling in the dark, the costs of staying in the derivatives market and complying with the multiple rules of multiple jurisdictions, mount.

“From a trading perspective, we’ve seen smaller firms pull out of the US under the burden of regulation and increasing cost and, on the clearing side, LCH.Clearnet has created a US entity while CME has opened an operation in Europe to fall in with local rules,” says Ekonomidis. “The idea of centralised clearing was to create transparency and open up the market. But what seems to be happening is market complexity is growing and the number of market participants may well have shrunk.

And while the continuing dispute is creating opportunities for different market constituents on both sides of the Atlantic, many think the standoff between the US and Europe is a zero-sum game.

“Without a resolution, everyone gets hurt,” says Mahesh Muthu, associate principal, client engagement at eClerx, “Different players might be affected differently. In the US, CCPs will feel it. In Europe, anyone who currently trades at CME, potentially faces higher costs. But continued disagreement does neither territory any favours.”

According to the International Swaps and Derivatives Association (ISDA), cross-border differences not only increase compliance workloads but also split liquidity along geographic lines and could even make it more difficult for end‑users to enter into or unwind large transactions, especially in stressed market conditions.

In the meantime, the regulatory debate goes on. Although the arrival of Timothy Massad at the helm of the CFTC improved the mood music, promises by both sides to reach a settlement by the end of the summer have failed to materialise. However the EU’s decision to extend, for a third time, an exemption from capital charges for European banks operating in the US by six months, could indicate regulators expect a solution to be found in that timeframe, says Muthu.

However, even if the equivalence dispute gets resolved, aligning clearing regimes across borders is still a mountain left to climb. Starting as they do from a “guilty until proved innocent” mind‑set, regulators inevitably face some late nights ahead.

“The problem is every territory starts from the assumption that others’ clearing regimes are not equivalent and so equivalence needs to be proved. They don’t assume others’ standards are acceptable and check to see if exemptions should be made. That slows down the harmonisations process considerably,” says Zubrod. “There is still a lot for regulators to talk about. Equivalence is an important issue but it’s only one rule set. It’s just the tip of an iceberg.”

[divider_line]©BestExecution 2015

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Analysis : Dark pools and best execution : Robert Barnes

Ian Rycott

November 3, 2015

Dark pools and best execution

On the anniversary of the launch of Turquoise Block Discovery™, Robert Barnes, CEO of Turquoise, the European multilateral trading facility, reviews empirical evidence of the innovation shaped by asset managers and brokers to answer the call for electronic block trading in a fragmented European landscape.

With the average trade size of exchange order books in Europe standing at around €10,000, investors wishing to trade much larger sizes are calling for innovation in electronic block trading (See ref. 1). In addition to sourcing block liquidity, benefits include minimising pre-trade signalling risk, cost efficiencies via straight through processing, and compliance with regulations including simultaneous real time post-trade reporting.

Asset managers, like BlackRock (See refs. 2-9), Fidelity (See ref. 10) and Norges Bank Investment Management(See refs. 11-15), among others, are increasingly vocal in published viewpoints about the role of exchanges in well-functioning markets and the benefits of execution choice.

Using a series of case studies, this article presents real world results of Turquoise Block Discovery™, a service shaped by asset managers and brokers matching undisclosed block indications that execute in Turquoise Uncross™.

Turquoise Uncross™ is an innovation, rebranded in October 2013, that allows buyers and sellers to rest firm orders anonymously, with size priority and potential to match at the midpoint of the primary market best bid and offer (PBBO), at a time determined by a randomised function. This key feature of auction-like randomised uncrossings makes Turquoise Uncross™ ideal for larger and less time sensitive passive orders (See refs. 16-17).

LiquidMetrix, the independent analytics firm that specialises in venue performance metrics and execution quality analysis “reviewed a large number of transactions on Turquoise Uncross™ and found that trades occurring on Turquoise Uncross™ had a far lower correlation with sharp market movements on primary venues than trades occurring on other continuously matched MTF dark pools. This means that from an execution point of view, large orders left resting on Turquoise Uncross™ are likely to be far less susceptible to gaming or adverse selection than orders left on other continuously matching MTF Dark pools.” (See ref. 18)

Alongside Turquoise Uncross™ and with input and support from a wide spectrum of brokers (See refs. 19-21) and asset managers (See refs. 22-25), Turquoise launched Turquoise Block Discovery™ in October 2014 (See refs. 26-28).

The following intraday case studies show prices on the y-axis and times on the x-axis. Bubbles reflect sizes of each order book trade and venue by colours: light blue = Turquoise Lit, deep blue = Turquoise Midpoint Dark, grey = all other external lit and dark venues that list or admit to trading a particular stock.

Blue chip: Imperial Tobacco (Figure 1a)

In aggregate, UK stocks trade more value by external dark venues than those of any other European country.

Turquoise Block Discovery™ Block Indications are undisclosed and match in Turquoise Uncross™.

Turquoise Block Discovery™ facilitated the largest order book trades for this UK blue chip of all order book venues, lit and dark, during this day. These largest trades match in Turquoise Uncross™.

These largest trades matched inside the lit order book tick size, so both buyer and seller also achieved price improvement by matching at the Turquoise Uncross™ mid price. All Turquoise trades report with real time transparency, and are MiFID compliant.

While dark order books do not show price and size before a trade, in an automated world, post-trade transparency contributes to pre-trade transparency for the next trade. Turquoise Midpoint dark order book trades, including those matched in Turquoise Uncross™, are published to the market in real time, with no delay, enabling all the benefits of straight through processing, and compliance with trade reporting of trades matched on lit order books.

Blue chip: Imperial Tobacco (enlarged view – Figure 1b)

Turquoise Block Discovery™ facilitates trades in Turquoise Uncross™ that trade inside the minimum tick, and in significantly larger size than the average European order book trade size of E10,000 (= E0.01m per trade).

Tick size refers to the minimum price increment that prices can move in the lit order book. This figure shows Turquoise Uncross™ trades that provide price improvement by matching inside the tick size of the lit orderbook minimum tick size price levels.

Post-trade costs often relate to the number of trades. Consider the €1.5m trade, successfully matched by a member in Turquoise Uncross™ in this example. €1.5m is 150x larger than the average European order book trade size of €0.01m. The €3.3m trade is 330x larger than the average European order book trade size.

The insight from this is that Turquoise trades at a size of E1m or more will save ~100x or more in post-trade clearing costs compared to an average dark pool trade size of €10,000, where clearing costs relate directly to the number of trades.

Less liquid stock: Jardine Lloyd Thompson (Figure 2)

This case study was presented to Turquoise by a buyside dealer highlighting a successful strategy in sourcing and matching a less liquid security. Understanding that trading a size of approximately 1 x average daily value (ADV) can take time and face potential adverse selection, the dealer rested anonymously and undisclosed as a Block Indication in Turquoise Block Discovery™. The dealer used his Execution Management System (EMS) to access his choice of sellside broker algorithm, designed as a direct channel to Turquoise Block Discovery™.

Notice the small size of infrequent trades that characterise normal order book trading of this stock. On the day of this example, the total traded value by Turquoise was more than 74% of all value traded on all order books, lit and dark.

While value traded in the Turquoise Uncross™ midpoint dark order book trades are large for this stock, the dealer emphasised the reason for presenting this example as successful, was to highlight that the undisclosed block indication was resting in Turquoise not for 90 seconds, nor for one hour, but for four days. And this was without information leakage, referencing benchmark metrics used by the dealer to evaluate execution quality (See ref. 29).

Therefore, the buyside dealer, while exercising more control over the order, continued to use his chosen sellside broker to direct the order to Turquoise, to benefit from the broker’s services including management of settlement allocation, and pay commission to the buyside dealer’s choice of broker.

Less liquid stock: Hexagon (Figure 3)

This example was presented to Turquoise by another buyside dealer highlighting a successful strategy in sourcing and matching large order book trades in a less liquid, Nordic security.

Turquoise Block Discovery™ facilitated the largest order book trades of all venues during this day. These largest trades match in Turquoise Uncross™. The large €5.7m trade matched inside the lit order book tick size of 0.1 SEK, so both buyer and seller achieved price improvement by matching at Turquoise Uncross™ mid price, and this trade size represented 2246% of the ESMA large in scale (LIS) threshold for this stock.

Why do LIS thresholds matter? Because they relate to MiFID II double volume caps.

MiFID II double cap calculations start in January 2016, building to 12 month rolling averages. MiFID II double caps will be effective from January 2017. MiFID II double caps could prevent a stock trading for six months via a relevant dark mechanism in sizes below the LIS. MiFID II double caps can prevent investors realising the benefits of such trading.

Currently, ESMA defines LIS thresholds per stock, based on a range of average daily trading values. For example, there is a greater LIS threshold for blue chip shares that trade over 50 million a day compared with micro-caps that may match less than 500 thousand a day. MiFID II will create more granular bands compared to MiFID I.

The potential salvation is the LIS waiver in MiFIR Article 4(1)(c), which allows authorities to allow dark trading for orders received by a venue that are LIS compared with normal market size and not include them in the double volume cap calculations.

In the next issue, we shall explore how investors and market participants should address these impending challenges.

References:
[1] Barnes Robert. “Dark Pools and Best Execution” Best Execution Magazine, Summer 2015, pages 79-81. https://globaltrading-lscura.dev.securedatatransit.com/analysis-dark-pools-best-execution/

[2] Novick Barbara, Prager Richie, de Jesus Hubert, VedBrat Supurna, Medero Joanne. “US Equity Market Structure: An Investor Perspective” BlackRock Viewpoint, April 2014. https://www.blackrock.com/corporate/en-gb/literature/whitepaper/viewpoint-us-equity-market-structure-april-2014.pdf

[3] Novick Barbara, Goldstein Rob, Nair Sudhir, Tevet Shirlee. “The Role of Technology Within Asset Management” BlackRock Viewpoint, August 2014. https://www.blackrock.com/corporate/en-gb/literature/whitepaper/viewpoint-asset-management-technology-aug-2014.pdf

[4] Novick Barbara, Prager Richie, VedBrat Supurna, Riaz Kashif, Medero Joanne, Rosenblum Alexis. “Corporate Bond Market Structure: The Time For Reform is Now” BlackRock Viewpoint, September 2014. https://www.blackrock.com/corporate/en-ae/literature/whitepaper/viewpoint-corporate-bond-market-structure-september-2014.pdf

[5] “The European Capital Markets Union: An Investor Perspective” BlackRock Viewpoint, February 2015. https://www.blackrock.com/corporate/en-gb/literature/whitepaper/viewpoint-cmu-investor-perspective-february-2015.pdf

[6] “Securities Lending: The Facts” BlackRock Viewpoint, May 2015. https://www.blackrock.com/corporate/en-gb/literature/whitepaper/viewpoint-securities-lending-the-facts-may-2015.pdf

[7] Novick Barbara, Golub Ben, Prager Richie, Walters Kristen, Riaz Kashif, Rosenblum Alexis. “Addressing Market Liquidity” BlackRock Viewpoint, July 2015. https://www.blackrock.com/corporate/en-gb/literature/whitepaper/viewpoint-addressing-market-liquidity-july-2015.pdf

[8] Novick Barbara, Wiedman Mark, Prager Richie, Madhaven Ananth, Fisher Stephen, Shapiro Ira. “Bond ETFs: Benefits, Challenges, Opportunities” BlackRock Viewpoint, July 2015. https://www.blackrock.com/corporate/en-gb/literature/whitepaper/viewpoint-bond-etfs-benefits-challenges-opportunities-july-2015.pdf

[9] “BlackRock Worldwide Leader in Asset and Risk Management” BlackRock Viewpoint, August 2015. https://www.blackrock.com/corporate/en-gb/literature/whitepaper/viewpoint-blackrock-worldwide-leader-in-asset-management.pdf

[10] “Modern Markets: benefits and challenges” Fidelity Viewpoints, 2 February 2015. https://www.fidelity.com/viewpoints/investing-ideas/modern_markets_benefits_and_challenges

[11] “Well-functioning financial markets” NBIM Discussion Note, November 2012. https://www.nbim.no/globalassets/documents/dicussion-paper/2012/discussionnote_13.pdf

[12] “High Frequency Trading – An Asset Manager’s Perspective” NBIM Discussion Note, August 2013. https://www.nbim.no/globalassets/documents/dicussion-paper/2013/discussionnote_1-13.pdf

[13] “Sourcing liquidity in fragmented markets” NBIM Asset Management Perspective, April 2015. https://www.nbim.no/contentassets/1b25761cb30e4025b627865627610dab/asset-manager-perspective_1-15.pdf

[14] Shanke Øyvind G. and Emrich Simon “Trading in Dark Pools – An Asset Manager’s Perspective” Global Trading Magazine, 18 April 2015. https://fixglobal.com/home/trading-in-dark-pools-an-asset-managers-perspective/

[15] “Role of Exchanges in Well-Functioning Markets” NBIM Asset Management Perspective, August 2015. https://www.nbim.no/contentassets/03b3c386e08a4b59ba24bfc7d44d77e1/asset-manager-perspective-2-15.pdf

[16] https://www.lseg.com/turquoise-uncross

[17] https://www.lseg.com/sites/default/files/content/documents/Turquoise%20Uncross%20Factsheet.pdf

[18] Communications with authors, Dr Sabine Toulson & Dr Darren Toulson: “After 500 milliseconds following a continuous dark order book execution the PBBO mid changed approximately 50% of occasions, compared to less than 10% of occasions following a Turquoise Uncross™ execution. Also, the proportion of Turquoise Uncross™ trades executing outside of the prevailing EBBO is lower than continuous dark order book trades.”

[19] https://www.neonet.com/sv/Pressroom/Press-releases/Neonet-to-provide-access-to-new-Turquoise-Block-Discovery-at-launch/

[20] https://www.lseg.com/sites/default/files/content/documents/Turquoise%20Block%20Discovery%E2%84%A2%20Broker%20Access_1.pdf

[21] https://www.liberum.com/news/2014/november/liberum-libblock

[22] https://www.lseg.com/resources/media-centre/press-releases/turquoise-block-discovery%E2%84%A2-goes-live-seven-major-brokers

[23] Stafford Philip. “Turquoise aims to lure institutions’ block trades to dark pool” Financial Times, 20 October 2014. https://www.ft.com/cms/s/0/88294b24-585a-11e4-b331-00144feab7de.html#axzz3nuAYvXlY

[24] Laurent Lionel and Hutchison Clare.”Fund managers push for safer trading waters in dark pools” Reuters, 21 Oct 2014. https://uk.reuters.com/article/2014/10/21/us-dark-pools-funds-idUKKCN0IA0S220141021

[25] Cooper James. “Disintermediation? Don’t Bank On It” Global Trading, 29 March 2015. https://fixglobal.com/home/disintermediation-dont-bank-on-it/

[26] https://www.lseg.com/turquoise-block-discovery

[27] https://www.lseg.com/documents/turquoise-block-discovery-brochure-pdf

[28] https://www.lseg.com/markets-products-and-services/our-markets/turquoise/turquoise-video-resources/benefits-turquoise-block-discovery%E2%84%A2

[29] Communication with dealer.

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Employees Retirement System of Texas (ERS) Discuss Managing Their Own Assets

GlobalTrading

October 31, 2015

Neil Henze, Chief Trader, Michael Clements, Chief Trader and Rob Newhall, Equity Trader, at ERS discuss their technology, commission spend, and development of trading.
Neil Henze: Employees Retirement System of Texas’ (ERS) defined benefit plan currently has assets under management of approximately $26.5 billion. ERS’ history of managing our own assets internally goes back at least 17 years. The difference today is that over the last 10 years we have increased the percentage of assets managed internally to approximately 63%.
Why did we do it? Internal management is less expensive at an average of just 10 basis points to manage funds internally because we have an impressive team of equity and fixed income portfolio managers, analysts and traders. This team has considerable experience generating competitive risk adjusted performance at a reasonable cost.
Our primary rationale for using external managers is attributed to the fact that we do not currently have the capability to manage certain alpha generating assets, but we are constantly learning. In addition, it goes without saying that a lot of our success is attributed to our Board and Investment Advisory Committee, which are very engaged and proactive.
Learning the manager’s role
Neil Henze: We trade for both our internal portfolios and most of our external advisors’ portfolios, and this makes ERS unique. ERS trading for external advisors promotes better transparency into the advisor’s portfolio for monitoring purposes, retains control over all trading commissions generated and our trading strategies usually add to the performance of our external advisors’ portfolios. Overall dispersion from the advisor’s composite performance is generally low.
However, when an advisor has a niche trading advantage over ERS, we recommend the advisor trade the portfolio.
The commissions generated are then applied towards broker research. ERS has a broker commission vote that is based on the quality of broker service and research. TCA performance is measured daily across all of our trades. We trade versus different benchmarks depending upon our portfolio managers’ instructions. We measure trading performance using arrival price, VWAP and closing price benchmarks.
Value of technology
Rob Newhall: One reason we believe our trading adds value is that ERS has always been extremely progressive towards trading and is very advanced technically. We test and then implement the best trading tools available, and have access to most sources of liquidity. We are quick to reach out to algo trading providers to offer feedback on quality of execution and request changes to algo settings to suit our trading style. Our traders are experienced market technicians that trade currencies, futures and options, in addition to global equities.
Meeting in the dark
Michael Clements: We believe consolidation of US dark venues would benefit block trading in this market. These dark venues remain too fragmented and many institutional participants do not have the same access to the block trades as well as the same priority of accessing each dark venue. It is not uncommon for institutional traders to encounter each other in several dark venues at the same time and then have to figure out which venue the counterparty wants to use to execute.
On this subject, we believe there are no significant differences between what pensions and asset managers want. We want the best of both worlds. We want a healthy competitive marketplace where bid/ask spreads are low, and a level playing field where rules are transparent and fair competition among all participants promotes vigorous markets.
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TCA Across Asset Classes : Sam Shaw

Ian Rycott

October 23, 2015

BUYSIDE LOOKS IN‑HOUSE FOR SOLUTION.

Best Execution looks at how asset managers are developing their own tools.

Multi-faceted regulatory pressure combined with heightened competitiveness is prompting the buyside to look further afield for its transaction cost analysis (TCA). However, in some cases, looking ‘further’ actually means looking inward, as asset managers are honing their own solutions.

Pure reliance on the sellside could beg questions over an asset manager’s credibility as well as become more onerous at a time when TCA needs to be more prevalent, detailed, accurate and immediate. The need for real-time instruction and analysis form the backbone of this argument, although in a more complex landscape, blended solutions may be a better route as the landscape changes.

There is no doubt TCA is evolving. Put simply, what was once pre-trade analysis of what might happen, used retrospectively by compliance departments is morphing into a real-time, dynamic process of trade monitoring with an impact on trading behaviour, consequently informing better judgments, or such is the view of Simon Maugham, head of operations at OTAS Technologies.

Creating the analysis to do this effectively though is both time-consuming and expensive and to date, neither buy nor sellside firms have led the charge. Yossi Brandes, formerly EMEA managing director, ITG Analytics explains, “The asset managers are looking for third parties because it is harder to aggregate and standardise across 15 different brokers, methodologies and datasets – it is a nightmare to compare otherwise. The TCA vendors offer a form of standardisation across brokers, from an independent perspective.”

As well as the practicalities, there is a fairness argument for introducing an independent view. Despite the FCA’s recent thematic review on best execution focusing on sellside obligations, it highlights the need for all parties to take greater responsibility to ensure optimum trading conditions, with MiFID II and its various aspects a key driver.

According to the Investment Association, a trend is emerging of asset managers hiring dedicated personnel acting as liaison between TCA vendors, sellside and internal stakeholders, demonstrating the fund manager’s commitment to the cause.

The trade body notes that greater emphasis on TCA means asset managers are not only more focused on achieving best execution but are demonstrating to clients they are enforcing a policy that is signed off by senior management, effectively monitored and backed by supporting data.

Sabine Toulson, managing director at LiquidMetrix, says regulation has propelled impartiality up the buyside’s list of priorities. “In the last year and a half we have been approached far more by the buyside, which has been more interested in independent analysis,” she adds. “They want to be able to compare their brokers in a more standardised way rather than getting individual reports, which may not contain the same benchmarks and cannot be compared on a like-for-like basis.”

While a broker report might provide in-depth examination of trading activity, it only offers a single perspective. LiquidMetrix notes the growing penetration of its reports across the buyside allow an interrogation of all the brokers, their chosen venues, algorithms and performance comparison.

While MiFID and the FCA can be blamed – or rather, thanked – for shining their light, the media also has a role to play, according to Toulson.

She says the publication of the Michael Lewis book ‘Flash Boys’ and stories around high frequency trading as well as arguments over venue toxicity, and coverage of the various dark pools under investigation in the US have collectively driven TCA up the agenda.

Beyond equities

As the industry shifts away from just high-level TCA measures around order routing, implementation shortfall, volume-weighted average price (VWAP) and post-order price reversion towards more granularity, MiFID II is also expanding its reach beyond equities.

Fund managers are happy with the broader view. For example, while Investec Asset Management recognises the maturity of equity market TCA, drawing on a broad church of benchmarks and analytics, Mark Denny, its head of dealing, global markets sees the need for “meaningful execution analysis across all asset classes”.

Denny adds that while foreign exchange TCA may now be established in the major currencies, it is not the case in the emerging markets space, which holds greater importance for the South African based fund manager. Further, as bond TCA progresses in the more liquid and regularly traded markets he says it also struggles to find relevant benchmarks in less liquid instruments.

At BNY Mellon subsidiary Newton, head of dealing Tony Russell is also keen to branch out and says he has been working with long-term TCA provider ITG to roll out FX this year, with fixed income capability to follow. However, he concedes data accuracy and availability is difficult.

“We need to get to the point where the fixed income data gives a true representation of the marketplace but at the moment there is not enough data and it is not clean enough. It is a challenge for a number of reasons – liquidity is an issue as well as price transparency – the investment banks hold less than 10% of the liquidity in the market, which is why there are huge calls for buyside to buyside trading platforms to aid clearer price formation, to help improve transparency and liquidity.”

Counting the costs

While the explicit costs – commissions, counterparty trade novation data, data around venues – can be sought externally, implicit and opportunity costs are harder to measure. As such, asset managers might be better conducting some, if not all, of their TCA internally.

Robert Henry, director at GFT says more common is the bifurcation of solutions – combining the critical information found internally and externally. “It is very hard for them to assess opportunity costs – the time between the fund manager’s decision to trade and executing that trade comes at a cost that needs to be assessed.”

He believes there is value in both options. “While the widely held view is that third parties provide the best chance for independent analysis of trades, the issue is they cannot provide pre-trade or real-time intraday market activity that is critical for TCA.”

Kames Capital’s head of investment trading Adrian Fitzpatrick goes even further, saying external TCA is too backward looking. He has turned away from third-party TCA altogether, favouring proprietary tools such as execution management systems, which negate the need for external provision and improve the real-time capability.

“At Kames we no longer take third-party TCA because we utilise other metrics including our EMS to monitor trades as we are actually trading them,” he adds. “If I do a trade and it is incorrect I can see if a broker is trading it today, so if I give various parameters, such as I want to be 15% of the volume and they are only 5%, I can get them to adjust it to make sure they are in line with my instructions.”

Ultimately the primary objective of using TCA is to ascertain the impact of various trading practices on investment returns, and asset managers – especially the ones delivering quantitative strategies – are increasingly well-informed. More data, plugged into independent analysis, and used to complement the sellside may well create an optimal solution.

“We now see more and more trends into understanding the effect on fund returns; more from quant side fund managers trying to understand the associated costs and what percentage of return is lost due to the implementation of investment ideas,” says Brandes.

“You will never know how much the processes hurt your fund unless you measure it.”

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TCA Across Asset Classes : Michael Sparkes & Kevin O’Connor

Ian Rycott

October 23, 2015

MIFID II AND BEST EXECUTION ACROSS ASSET CLASSES.

By Michael Sparkes, Director, and Kevin O’Connor, Managing Director, ITG Analytics.

Summary

While best execution and transaction cost analysis (TCA) are well-established in equity trading, other asset classes have been slower to adopt such techniques due to limitations in market data and market structure characteristics. In over-the-counter (OTC) markets there has typically been no requirement for central reporting, making it difficult to demonstrate best execution in the same way as for equities. This is beginning to change due to pressure from regulators and end investors who require higher standards of information. Market structure changes, with more electronic platforms taking increasing shares of trading, are also enabling more precise analysis. Over the last three or four years, foreign exchange (FX) TCA has become increasingly mainstream for asset managers, while one recent survey shows that in the past year, fixed income TCA has become the fastest growing category of analysis1. These trends are expected to continue, not least in the light of MiFID II regulations.

Regulatory pressure

It is a truism that an asset manager should be expected to execute orders on terms most favourable to the client as opposed to the benefit of themselves or any third party. It is also reasonable that they should be expected to demonstrate this on a systematic basis across all types of trading that they undertake, whatever the asset class. In the real world this has not been as easy as it sounds. Increasingly, regulation is raising the bar of expectations and imposing obligations which the industry is struggling to implement, particularly in markets which have historically traded OTC.

Under article 27 of the EU Directive 2014/65/EU, “Member States shall require that investment firms take all sufficient steps to obtain, when executing orders, the best possible result for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order. Nevertheless, where there is a specific instruction from the client the investment firm shall execute the order following the specific instruction.”

The asset manager is obliged to take these key factors into account as part of their measurement and monitoring processes to be able to show that their trading has indeed met the regulatory requirements. Random sampling of a few trades per quarter is unlikely to be considered adequate in the way it would have been in the past. In this new regime firms will have to introduce processes to record details of every trade and its characteristics, together with the market conditions, and any relevant instructions received from the client.

The largest asset managers have in some cases developed in-house processes to undertake this kind of monitoring, but for many firms the cost of such developments is prohibitive. Hence, third party suppliers have increasingly been called upon to assist, not just in the well-developed field of TCA for equities, but in other asset classes as well.

It is a major challenge, even for such vendors, to offer the same granularity and accuracy of analysis in all asset classes. Although much can be learned from the equity experience2, it is simply not possible to apply exactly the same techniques that have been developed in equity markets to FX, fixed income or derivatives, where market structures are less transparent and electronic platforms only penetrate certain parts of the market.

While the details do vary, the broad approach is consistent from regulators, and the expectation that the asset manager should assess the different execution factors still applies, based on a stated execution policy, taking into account the context of the trade. The asset manager should aim to minimise the implicit and explicit cost of trading for the end investor – other things being equal – while avoiding any conflicts of interest or hidden charges.

Asset managers have typically been required for many years to have a stated execution policy. The new regulations go further however, stating: “Member States shall require that investment firms provide appropriate information to their clients on their order execution policy. That information shall explain clearly, in sufficient detail and in a way that can be easily understood by clients, how orders will be executed by the investment firm for the client. Member States shall require that investment firms obtain the prior consent of their clients to the order execution policy.”

Crucially, the policy should deal with all asset classes that fall within the MiFID II definition of a financial instrument, and should be more than simply a routine reporting process. It should be the subject of prior discussion and understanding on the part of the investor. It should include an explanation of trading both on execution venues (stock exchanges and MTFs) and outside a trading venue (typically OTC). It is the asset manager’s responsibility to monitor it on an ongoing basis, and report on it periodically to demonstrate its effectiveness.

Typically, such monitoring entails the identification of outliers or anomalies in trading, with an expectation that the manager will investigate such outliers in more detail, recording the circumstances which led to the good or bad performance. A key point about best execution is not that every outcome is within a narrowly predictable band, but that those occasions which are identified as outliers can be explained, based on either the execution strategy employed or the market conditions in which they occurred. It is at the overall level of performance that best execution is ultimately evidenced, with individual trades (and even more so individual fills) being subordinate to the process.

“Member States shall require investment firms to be able to demonstrate to their clients, at their request, that they have executed their orders in accordance with the investment firm’s execution policy and to demonstrate to the competent authority, at its request, their compliance with this Article.”

Hence it is the policy that is key, and the ability to demonstrate compliance with it to clients. This is expected to ensure a closer and more open level of communication between asset manager and client than in the past, bringing enhanced transparency throughout the investment process.

The regulation is more specific about the reporting of execution venues than in the past: “Member States shall require investment firms who execute client orders to summarise and make public on an annual basis, for each class of financial instruments, the top five execution venues in terms of trading volumes where they executed client orders in the preceding year and information on the quality of execution obtained.”

This particular statement has been a cause for concern on the part of some asset managers who initially believed it to mean that they needed to install expensive systems to record every single fill to determine where their brokers were routing their orders, whether to primary stock exchange or MTF, whether in the lit or dark markets. The interpretation has evolved however, and it is now widely considered that the buyside need only to monitor the brokers that they use. The brokers in turn are expected to monitor the underlying execution venues on which the trades occur, and make this information available to the buyside on request.

Nevertheless, the more progressive (and financially able) buyside firms are already recording the execution venue data as well as the brokers. This enables them to understand in far greater detail the ways in which their broker is routing the order, whether to their own liquidity pools or elsewhere, and the relative performance due to such routing. It can also potentially help identify the value of any rebate or other third party payment or non-monetary benefit from an execution venue to an investment firm.

While this type of granular analysis is likely to become the norm it is something to be used with care. Individual fills are rather like looking at each of the dots of a colour TV: individually, they can tell a picture of sorts, but the real story is only understandable by standing back and looking at the overall effect. The fact that an order was traded in one thousand pieces is all very well, but the timing, the sizes and the locations of the fills when taken in aggregate are what determines the overall result. Best execution is not about where and at what price 100 shares traded out of an order for 100,000 shares. In addition, research has shown that factors such as the strategy used to access the venue are critical to the overall evaluation of the execution venue. [3]

The proposed regulations require execution venues to publish significantly more detailed information on trades that take place on their venue. This includes expectations of the required fields, format and frequency, plus additional requirements for quote/order driven execution venues. This requirement for more data is part of a move towards greater pre- and post-trade transparency that continues to be a core theme in the regulatory direction, both explicitly spelt out in the regulations and as interpreted by market practitioners.

One phrase which is open to interpretation in the draft regulations is the definition of the “quality of executions obtained”. This is intrinsically a qualitative benchmark which requires interpretation by the user. One proposal which is emerging, is the possibility of an industry-led definition of best execution which could include some outline of the qualitative features that should form the basis of such a definition. The FIX Trading Community published a document of Best Practice in TCA in 2014, and there is scope for the document to be extended to incorporate key definitions regarding Best Execution as well. Within such a framework the onus would still remain with the asset manager to define its own policy based on their investment process, asset mix and circumstances.

Equity TCA

So perhaps a useful approach to defining the road map to meet MiFID II requirements for other asset classes is to look at the current state of preparedness of a typical (or “median”) asset manager versus those at the leading edge in the field of equity trading, where typically such analysis is most advanced. Clearly not all firms have the resources to be at the leading edge in terms of IT infrastructure, personnel or external service provision, but those firms who are able to pioneer the use of such approaches perhaps indicate a direction which others can reasonably be expected to follow over time. And as such trends become mainstream, the standards tend to become expectations from end clients and regulators alike. Best practice can become the minimum expected standard (or a “hygiene factor”) remarkably quickly.

From the table it is clear to see that typical managers have the ability to monitor the costs at parent order level, with aggregate metrics available to assess broad factors in reports. Outliers are monitored at least quarterly, including assessment of broker performance. Leading edge firms go beyond simple reporting, using data on a daily basis to monitor and document outliers, drilling down to execution venue at fill level to understand how brokers are routing the order, and using the various outputs to fine tune the investment process.

FX TCA

While the concept of best execution has developed over the last two or three decades in the world of equity trading, in other asset classes it is arguably only in more recent years that it has come into sharp focus. The structure of OTC markets, without centralised recording and publication of trades and little or no reporting of volumes, has made it far more challenging to develop the kinds of sophisticated monitoring and analytical tools taken for granted in equities. As noted by Aite in their 2014 survey of the FX TCA market, “one immediate challenge is to first define what ‘best execution’ in foreign exchange is all about, and then to reach a consensus agreement on that definition among all market participants on the buyside and the sellside alike.” [4]

Spot FX trading is not within the scope of MiFID regulations, either currently or in the proposals for MiFID II, but the various scandals of rigged markets and law suits against custodian banks have led many participants in FX trading to look for ways to systematically monitor the achievement of best execution – whether as a client or as a provider of the service. Thus, for the purposes of this qualitative assessment, spot FX is included.

Electronic platforms are increasingly used in FX trading, and can provide good data for analysis, but they are not a panacea as far as providing a panoptical view of the market place. Competing quotes provide some limited context against which to assess a trade, but they do not on their own go far enough to ensure that the selected subset of counter-parties are a true reflection of the wider market. The best of three quotes may simply be the third worst quote of dozens available. And if an asset manager maintains an unchanging list of counter-parties over time they will have no way of gauging whether their selection remains optimal.

It is not uncommon for firms to have such competitive quote comparisons recorded for spot trades, although fewer currently have a systematic process in place for assessing forwards or swaps. Nor do firms typically tend to link the timing and cost of the FX transaction to the related transaction – for instance the buying or selling of a stock or a bond. This can hide implicit costs or inefficiencies in the investment process, which over time can lead to a significantly weaker investment return than would otherwise be the case. Leading edge firms have started to assess forwards and swaps, but true linking of FX to a related event is in its infancy.

While those firms that have monitored FX trading have tended to do so on a monthly or quarterly cycle it is highly likely that this will evolve into a daily process. It will also entail far more granular analysis based on data inputs from a variety of sources, not just representing those that are currently employed. The different channels will be assessed to determine whether ECNs or banks or algorithmic strategies are most appropriate for a given set of trade characteristics, bringing together post-trade and pre-trade analytics. Precise timestamps and a record of the investment objective will allow more accurate benchmarking and fine-tuning of the process.

Where an external full service vendor is used, they should be able to incorporate price and volume information from a variety of execution venues and price feeds, including leading ECNs, bank platforms, interbank platforms and so on. The vendor should also be able to analyse not just spot trading but also forwards, swaps and non-deliverable forward (NDFs), as well as being capable of granular intra-day analytics, including algorithmic analysis. Benchmarks should be size-adjusted (as opposed to simply referencing top of book) and be capable of measuring performance against multiple different timestamps to reflect the different stages in the investment process. Leading firms already expect to use data to evaluate the benefit of active trading versus netting, and such analysis is expected to become the norm across the majority of asset managers.

Similarly, there is growing interest in market movements in OTC markets immediately after a trade (sometimes referred to as footprint analysis). And given the scandals of recent years the ability to assess the benefit or cost of trading on the 4.00pm London fix is expected as a standard metric in any best execution or TCA process.

Derivatives TCA

Currently, listed derivatives are largely treated in a similar way to equities for TCA purposes, although under the current reporting regime not all trades are reported, meaning that certain metrics such as Volume-Weighted Average Price (VWAP) are unreliable. In the future, it is expected that reporting requirements will be more rigorous, allowing more accurate analysis. It is also likely that asset managers will start evaluating the performance as an offset to other asset transactions and the related delay costs which are currently being incurred. An example might be the switching of an index-based instrument to the underlying constituents: it may be that a cost on one side is offset by a gain on the other, or if handled badly, costs may be incurred on both sides of the trade.

OTC derivatives pose a greater challenge, as with all OTC markets. Currently they are at best measured manually using laborious recording which is not always reliable or insightful, for instance comparing competing quotes. Leading edge firms are starting to look at RFQ (Request For Quote) automated software to provide audit trail and analytical records to provide more robust surveillance and the ability to adjust processes to iron out inefficiencies. A range of metrics are already available for post-trade analysis, including hit ratios, product statistics, size statistics, and links to underlying assets within a basket. Notional hit ratios can be measured, as can response ratios, bid-offer spreads, alpha versus quote average, alpha versus listed price and broker assessment measures.

Fixed Income TCA

While FX TCA is in its early stages fixed income TCA is in its infancy. The challenges of an OTC market without a central record of prices or volumes, and in which large numbers of securities do not trade at all for weeks or months, are considerable. In fixed income, as in FX, a widely used approach to best execution is a manual comparison against competing quotes from a limited number of counter-parties. Alternatively the use of indicative valuation data is used, based on the prices used for portfolio valuations. The latter approach is indicative but not necessarily a tradable price. Despite the challenges there is a pressing need for good analytics in fixed income trading. A recent report by Greenwich Associates claims the use of TCA in fixed income markets is growing faster than in any other asset class, with over one third of asset managers interviewed using TCA in the sector, up from 19% two years earlier. However, of those who do anything at all, 54% use internally developed tools. This is likely to move towards third party solutions over time.5

More advanced firms have developed automated comparisons of market quotes to their executions, or use the TCA reports provided by electronic platforms. Best execution can also be assessed for fairness compared with similar products, although such approaches are still relatively simplistic and lack granularity. For rarely traded securities the best available reference price is likely to be based on securities with a similar mix of characteristics (credit rating, coupon, maturity, liquidity and so on) and which have traded in similar size. At best this is likely to be patchy, a sort of shadow play which is as good as the bucketing of those characteristics. The more homogeneous the bucket, the more accurate the price indication is likely is to be.

A number of initiatives are underway which will help develop more sophisticated fixed income analytics and best execution reporting, starting with market structure. If more fixed income trading moves to centralised electronic venues and away from the OTC market makers this will provide more transparent sources of post-trade data on trades (although the effect on liquidity remains to be seen). Similarly, a move to more standardised instruments may to some extent mitigate the issue of bucketing similar securities, at least for commonly traded instruments.

The FIX Trading Community initiative Project Neptune is also expected to provide more granular data which could be used for best execution and TCA purposes.

It is likely that most firms will implement manual or partially automated processes for comparing rates to dealer quotes, using daily or potentially intraday data. More advanced firms are likely to want to compare performance against a range of price sources – actual market quotes and trades, peer data and intraday evaluative pricing. Cost measurement can be expected to develop, similar to the implementation shortfall types of metric used widely in equities, along with difficulty-adjusted, liquidity-based assessment of counterparties.

Challenges clearly remain in best execution for fixed income trading. In the near term the determination of a fair price will continue to entail a degree of inaccuracy. Over time it is possible that developments in market structure and data availability will finally allow the same level of analysis that is widely employed in equities.

Footnotes:

“Fixed-Income Transaction Cost Analysis Continues Strong Growth Trend”, Greenwich Associates, Q2 2015.
See “Multi-asset TCA”, TCA Across Asset Classes supplement, Best Execution Magazine, 2013.
Ian Domowitz, Krisit Reitnauer, Colleen Ruane, “Garbage In, Garbage Out:An Optical Tour of the Role of Strategy in Venue Analysis”, August 2014.
FX Transaction Cost Analysis Providers:Brave New World!, Aite, May 2014.
“Fixed-Income Transaction Cost Analysis Continues Strong Growth Trend”, Greenwich Associates, Q2 2015

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DOUBLE VISION.

Jannah Patchay, partner at Agora Global Consulting outlines some of the inconsistencies and incompatibilities of US versus European regulation and the potential impact on derivatives markets trading.

COLLABORATION IS KEY.

Sassan Danesh and Kuhan Tharmananthar* ask what MiFID II & EMIR mean for the derivatives world, and will Europe follow the US lead where voice trading and RFQ remains firm fixtures?

MIFID II/MIFIR – EVOLUTION OR DISRUPTION OF CURRENT BUSINESS PRACTICE?

How disruptive is the MiFID Review for the professional life of a European banker? Which workflows will stay roughly the same and which ones will change beyond recognition? Silvano Stagni, global head of research at IT consultancy, Hatstand investigates.

LINES IN THE SAND.

Mary Bogan explains the hurdles the US and Europe have to overcome to reach equivalency in clearing.

Dark pools and best execution

BUYSIDE LOOKS IN‑HOUSE FOR SOLUTION.

Best Execution looks at how asset managers are developing their own tools.

MIFID II AND BEST EXECUTION ACROSS ASSET CLASSES.

By Michael Sparkes, Director, and Kevin O’Connor, Managing Director, ITG Analytics.

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Sassan Danesh and Kuhan Tharmananthar ask what MiFID II & EMIR mean for the derivatives world, and will Europe follow the US lead where voice trading and RFQ remains firm fixtures?*