Oliver Sung, Managing Director and Head of Electronic Execution, Convergex looks at the process for adapting to changing regulatory environments, and how this impacts the buy-side and sell-side desks.
In terms of regulatory developments, among the biggest changes expected is the SEC’s Tick Pilot Program that is scheduled to begin next May in the U.S. It is interesting to study this kind of event for its impact on our firm; even though it is relatively far off, it is something that we still have to plan for now. We have to start spending money to ensure we are well prepared prior to the date this program goes live.
We are constantly reviewing our development priorities, and any time there are regulatory changes in the marketplace, there is potential impact on our workflow. Whether it is happening in the US, Asia, or Europe, these are factors that all industry participants must deal with, and we are acutely focused on being up-to-date with regards to our algos in any sort of market. For example, the LSE is coming out with an intraday trading auction , and this is an area that we are looking into – including around how we read the data, how we participate and how our algos work with and around it. Any time there is something new, the marketplace requires us to spend significant time and effort to make sure our solution works seamlessly.
This process starts when we first hear that a change to an existing rule is being proposed. Once we have a broad outline of what is going to change in the market place, we bring in our tech guys and our developers to discuss the upcoming change at a very high level, including the potential impact on our technology. We then use that high-level analysis to start doing rough sketches of possible scenarios (i.e. if the rule says X, we can do Y; if it says A, we should do B, etc). We start by analyzing and planning for how we can tackle the various elements being changed; but, no development is done at this initial stage. In doing this exercise, we identify potential concerns; posed by the initial rule proposal, which gives us an awareness of possible issues when the final rule is released and becomes effective. This means that we can go into that situation with some form of prior awareness, as opposed to just starting to find a solution when the final rules are implemented.
Global impact
We have a global algo development team tasked with developing innovative tools for the 35 markets for which we offer algos. That team monitors all the new and potential upcoming changes for those market places. We closely follow ongoing regulatory trends and developments, and watch to see what other global regulators might do in response. While we may address a regulatory change in one local market, we are careful not to directly begin development on a global solution just because one regulator has implemented a new policy.
What our process often allows for is the realisation that, if we have dealt with a similar requirement and solution in one market, we can leverage our knowledge and experience towards the efficient and timely development of solutions for other markets. And so, having a global development team allows for some comfort, because there is a good chance that, if something changes in one regulatory zone, it is likely that regulators elsewhere will follow suit.
Our goal is to provide the best electronic tools for customers wherever they trade. Thus, we are always
trying to find ways to further improve the customer experience, whether that is by continuing to enhance our VWAP algorithm, by improving child order implementation, or by developing new algos. If a customer has a particularly specialised request, we will do our best to try and satisfy it. If it is a good idea that can be more broadly applied, we will definitely add it to our platform globally, to the extent it provides value across our client base.
The high touch trader
Customer electronic trading has historically been on an agency basis. In contrast, a decision to commit capital has traditionally been handled on the desk by the trader. The real value-add that a high-touch trader brings is giving color, and using their skill set to facilitate a block trade between two counterparties.
We continue to use our electronic tools to drive efficiencies and facilitate block trades where we can. However, it takes a lot of skill from the high-touch traders to put the large situations together. There’s still a need for human on the sell-side.
As the buy-side continues to develop, we have to foresee what we are going to do next. We have to build automated systems for what we anticipate happening in the future and, therefore, try to take more permutations into account. However, there will always be instances where human intervention is necessary to handle particular situations. The reality is that computers can’t react to situations until they are properly programmed. However, the technology is continuing to improve, and the buy-side is increasingly confident using those tools.
Buy-side changes
Our buy-side clients are increasingly using more variations of algos, and as a result, algos are becoming much more sophisticated every year. Clients are also becoming increasingly more comfortable with technology. Buy-side traders have moved past asking basic questions about how to use algos. They are now more sophisticated and are focusing more on understanding how the algos should work and how best to integrate them into their detailed workflow. The responsibility for technology is definitely moving from the sell-side to the buy-side. The sell-side is increasingly asking the buy-side about their workflow needs. It is using that information to develop solutions aimed at and addressing those buy-side needs, from the very basic to the very complicated, such as customising algos that the buy-side might require.
By asking more complicated questions, the buy-side is driving us on the sell-side to continue to improve our platforms, invest in the resources, and provide solutions for the trades that they would like us to do. The increasing sophistication of the buy-side is a good thing for everybody involved. It pushes us on the sell-side to continue to innovate, and allows the buy-side to use the tools set in a more informed, efficient and productive way.
The buy-sides’ increased sophistication allows them to better understand and anticipate their own needs and to narrow down the tools that they know are going to work for them. Even if everybody has a VWAP algo there is a continued drive for sophistication on the buy-side to understand the details of how the algo is actually working. This allows the buy-side to compare and choose the VWAP engine that best suits their needs.
The buy-side is still relying on its brokers for the information, but it is also going to exchanges to obtain it. As they learn and become more sophisticated, the buy-side is going up and down the chain to obtain needed information.
Conclusion
There is much to value in the intuition and instincts of a skilled and experienced trader on a desk who handles special situations. We will continue to see equity desks and algos that become increasingly sophisticated. As other asset class algos start rolling out (depending on how much collaboration they have with their equity brethren), that level of sophistication will accelerate more than it did on the equity side.
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How Technology Reacts
One Year On: Hong Kong’s Algo Regulation
With George Molina, Director of Asian Trading, Franklin Templeton
Short term impact of regulation
Regardless of the transparency Hong Kong’s new regulations may achieve, participants always bear the burden of interpreting and translating it into existing workflows. This process typically resembles a mad dash. The impact to end clients is numerous requests for something similar, but slightly different.
Coming together as an industry and agreeing on a standard approach to defining the requirements made the difference in the implementation and execution of the SFC’s algo rules. Instead of the mad dash, we began a thorough search for a technology solution to facilitate more efficient management of interactions and disclosures.
Longer term impact of SFC’s algo regulation
The impact overall has been positive: there’s a forced awareness to understand your counterparties, and greater transparency created across the industry. We have not seen any slow-down in algos being created but more thought being put into in custom algos for clients. In terms of changes, going back to the transparency comment, we now require all brokers to send order execution trails on our executions and orders and certify this via our Markit system.
Impact on sell-side
Although the regs were focused on due diligence, the rules also spurred the comparison of services, back-up, and training offered by algo providers. In order to streamline the due diligence process, the buy-side worked with Asia Trader Forum and Markit to have a standardised due diligence questionnaire deployed online via the Markit Counterparty Manager platform.
By consolidating the information online in one location, the buy-side was able to make comprehensive comparisons across algo providers that would have been very difficult before. I believe this has built stronger more frequent relationships with our brokers and vice versa from their side. In this industry “Know Your Client” should be a gauge of your success.
Ongoing drive for transparency
A regulatory impetus was clearly needed. The timing of the solution rolled out in Hong Kong between the buy-sides, dealers, and Markit was done in less than a year. In other jurisdictions, where no regulatory driver exists, discussions are ongoing among industry participants around a similar process as a ‘best practice’, but progress is slow.
Without the SFC regulation, one could argue that nothing would have happened to even provide an example of ‘best practice’ for other jurisdictions to follow. At Franklin Templeton we are taking this certification globally and although we have done similar questionnaires with our brokers on both hi-touch and low-touch venues. We believe now that there is a platform we should leverage and expand among all our 13 equity trading desks globally.
This transparency push, as with the dark pool requirements, fits within the theme of regulators requiring greater levels of transparency and due diligence for market participants, both from a client and product perspective. The SFC are certainly ahead in the electronic trading certification space and are prompting buy and sell side firms to think about how they may want to apply similar processes elsewhere in the world as a best practice, irrespective of an active regulation.
Continuing to manually and bilaterally manage the increasing requirements and best practices associated to being ‘ready to transact’ is not sustainable, the industry needs to move towards more standardization, centralization and digitization of common and duplicate workflows.
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The Ongoing Role Of Multi-Asset Technology: A Roundtable Write-Up
By Peter Waters, GlobalTrading
On the 25th June, over 25 representatives from the buy-side, sell-side, vendor and exchange communities met in London to discuss the changing role of technology in breaking down silos and processing between asset classes.
The discussion included traders from across the asset class spectrum, and some with specifically multi-asset roles.
One difficulty that immediately became apparent and would stand as a constant barrier to true integration was just that markets are still very specialised. Fixed income traders that cover certain corporates need constant communication and effort to stay up to date on who holds what security. Conversations with brokers are paramount to capturing that knowledge. No electronic platform can replace certain esoteric asset classes and trading, and nor do the traders even want it to. But, what can technology achieve? The room debated the use of EMS technology and its potential role in combining multi-asset trading. However, the conclusion was reached that the buy-side doesn’t mind having different systems with specialist applications, as long as they work together and there is some cross functionality.
A perceived exception to this is the hedge fund community. As a specialist and nimble group of firms it was generally agreed that hedge funds were much more likely to request specific technology that allows them to build out multi-asset trades, including derivative elements, and want the functionality to do so on a single platform. Whether this technology then migrates upwards towards the larger asset managers remains to be seen. The room seemed to suggest that the buy-side doesn’t want it even if it were available, and the sell-side may not be willing to invest to scale the technology without specific demand.
One major area where all agreed more work was needed was in extracting the data from these systems. With increasing buy-side ownership of trading, and more questions being asked of the buy-side with regard to how they analyse their trades, the extraction of data from systems that sit on both the sell-side and buy-side desk remains a major challenge. As does finding ways to combine and manage that data and cross asset class boundaries to calculate proper TCA. This area would be worth exploring from a collateral management and overall risk position management perspective in the context of regulatory consequences as this appears to be an area of focus in Europe at the moment. It was generally agreed that the back office was an area that could benefit from multi-asset processing and technology, were such areas to be developed.
Finding Liquidity In Bond Markets
Luis Carvalho, Head of Investments, Credito Agricola Gest examines ongoing liquidity challenges in fixed income.
The trouble with liquidity
Sourcing liquidity is becoming more and more challenging every day. Five years ago a 20 million dollar position on a corporate issue would take two hours to get done. Now, it will take two weeks. These days the best answer you can receive when asking for a firm level on a euro government bond is “I can price you 5 million if you give the remaining balance to work”, but in truth, this preferred answer is rare.
“Can I work an order” or “my trader is out of his desk, tell me your size and I’ll get back to you as soon as they are back” are the most common responses I hear when I ask for liquidity. While we wait for the trader to come back, we just watch the price on screens being adjusted against us in 15-20 cent intervals before the trader arrives at their desk and replies with a price.
Since the global financial crisis liquidity has been severely impacted by regulation, which diminished a bank’s ability to maintain inventory. Also under the current low interest rate environment, combined with the positive impact of QE on credit markets not to mention low volatility, volumes have decreased. As a consequence, price transparency on the corporate bond market has also decreased. It is easy to find examples of issuers that saw their CDS spreads increase because of news that affected their business sectors, but the cash bonds of those issuers continued to grind tighter just because there were no sellers of bonds.
Regulation is forcing banks away from acting as a principal to acting much more as agency brokers, as their balance sheet size is severely reduced. Smaller broker balance sheets transfers the execution risk from the dealers to the investor. This is pushing the buy-side increasingly into reducing our limits per issuer to avoid being caught with an exposure size that will take too long to reduce.
Where to look?
As liquidity is becoming more fragmented, execution complexity moves in step. The challenge is not only where to find liquidity but also to print at the best execution price as liquidity fragmentation increases the risk of slippage against the price on the screen.
Finding liquidity means taking more time mining the list of axes we receive every day and checking the reliability of those published axes. Again, it is very common to call someone that published an axe on a specific bond and when we reveal the amount we need to trade, the answer is “oh my apologies, but my trader got hit a minute ago on that bond, they’re not axed anymore”. There goes the price on my screens.
Trying to achieve best execution price in this environment is difficult, even though we analyse all the data of previous trades. We are yet to develop formal transaction cost analysis as it is rather empirical, but by looking closely at previous trades we get a close idea who are the best counterparties for specific bonds or issuers. Of course, for certain issues, liquidity is more fragmented than others, and in those cases ideally the analyst has to find a similar risk by choosing another issue or issuer that has more liquidity.
Electronic trading platforms provide important help by incentivising dealers to publish inventories with firm prices that can be traded on a click-to-trade basis rather than on the traditional RFQ system. Electronic platforms have been developing information for trading cost analysis, which will not only be needed to meet MIFID II requirements but can also be used by the execution desk on a pre-trade basis. Last Deal information showing interdealer trades for a given time period is also a valuable indicator.
Buy-side on all-to-all
Buy-side investors still seem a little reluctant in adopting all-to-all trading venues. There have been efforts to develop this method but trading volumes remain rather small. However, all-to-all RFQ protocols that gather interest from dealers and investors would increase liquidity. Trading platforms featuring historical execution details are increasing pricing transparency.
A few investors claim that the behavioural change should be broader than just the buy-side. Fixed income markets are very fragmented in terms of the number of issues by nature. Those who seek behavioural change argue that issuance should be more standardised, which would allow for a reduction of the number of issues, hopefully increasing liquidity.
New measures, technologies
Technology is evolving fast, but electronic trading platforms still have a long way to go. For corporate bonds in particular, market fragmentation makes it very difficult to replace or reduce the interaction between execution and analysis, as per the example given above when an issue is found to be illiquid and a substitute has to be found. The technology to underpin an increase in electronic trading exists and there are already a number of different venues. The question, rather, is how to convince dealers to move towards a more transparent form of showing liquidity and potentially compromise firm pricing.
The aim of the buy-side is to analyse and implement investment ideas that will potentially result in positive returns for their clients or institutions. If those ideas include less liquid assets the premium demanded for holding those assets will be higher, which has a cost effect on issuers. The buy-side can, for instance, lead efforts that would result in an increase in liquidity by sharing more of their execution intentions on the available venues, be it on an auction platform or an anonymous RFQ, but the responsibility should be on those who charge fees for new issuance and benefit from a bid/offer spread. Issuers should also be persuaded towards a more standardised market. Then they would also not be penalised in times where the liquidity rarefaction can limit their ability to raise new financing on markets.
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China Crisis : Lynn Strongin Dodds
CHINA CRISIS.
CHINA CRISIS.Although Greece has been the centre of attention for the past few months, the travails of China were playing in the background and its problems came to a head over the past week when the country’s main index – the Shanghai Composite Index, skid 24.9% and plunged 44.8% since the bull market peak hit in June. The sense of déjà vu is palpable as it was seven years ago, around this time of year, when stock markets started to gyrate over fear of a debt and liquidity crisis in the West.
This time though the bumpy ride is not due to banks but concerns over the state of the world’s largest economy*. Although the slowdown in growth was well-documented, the panic didn’t seem to set in until recently even though June and July saw the government try to put a floor under the market. Goldman Sachs estimated that it spent as much as 900 bn yuan ($140 bn) to stem the tide while domestic brokers said they would refrain from selling shares until the Shanghai index returned to the 4,500 mark. Their efforts proved fruitless as investors rushed to the exit and started to offload shares in copious amounts.
Recent attempts to allay fears have also not been successful. The People’s Bank of China shaved 25 basis points off the interest rates to 1.75% – the fifth cut since November – as well as further loosened bank lending restrictions. It lowered the reserve requirement ratio for large banks by 50bp, which in effect means injecting liquidity into the sector which had become reluctant to lend. Analysts at Morgan Stanley forecast that around $105bn will be added back into the financial system as a result of the RRR reduction alone.
The actions only resulted in a temporary reprieve and in no time at all, markets continued their downward spiral. The big question of course is whether the government can deliver its promise and transform the economy from one reliant on high levels of investment to a consumer led model. It will not be an easy task as old habits are hard to change. In addition, China’s corporates, provinces and municipalities are highly indebted with many struggling to service their debts while the price of housing far outstrips average earnings, despite recent price falls.
Many analysts expect additional rate cuts and reductions in the bank reserve requirement along with targeted spending on infrastructure investment by local government financing vehicles and increased use of Public-Private Partnerships on various capital projects. It is still too early to predict though whether this will be enough to generate the expected 6% to 7% growth rate. If it fails, it will not only have implications for the country but also the global economy as a whole. The one thing that is certain is that lessons of the financial crisis still need to be digested.
Lynn Strongin Dodds,
Managing Editor
*Based on PPP (Purchasing Power Parity).
A purchasing power parity (PPP) between two countries, A and B, is the ratio of the number of units of country A’s currency needed to purchase in country A the same quantity of a specific good or service as one unit of country B’s currency will purchase in country B. PPPs can be expressed in the currency of either of the countries. In practice, they are usually computed among large numbers of countries and expressed in terms of a single currency, with the U.S. dollar (US$) most commonly used as the base or “numeraire” currency”
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A Changing Approach To Multi-Asset Management For Hedge Funds
By Phil Chevalier, Platforms Product Specialist and Clare Witts, Director, ITG Asia Pacific
Technology is constantly evolving to meet the demands of increasingly sophisticated asset managers and growing regulatory scrutiny. When it comes to multi-asset investing and the trading tools that go along with it, hedge funds are at the front of this curve and are looking increasingly ‘institutional’ in their use of technology to deal with the wide variety of asset classes they invest in. This is particularly important in today’s markets where the Asian hedge fund industry is growing at a rapid rate, and strategy diversification is an important part of generating alpha and attracting investment.*
At the same time, the global regulatory landscape is demanding higher levels of transparency and risk management than ever before. In Hong Kong, the SFC’s electronic trading regulations place risk and systems adequacy requirements directly on to hedge funds and asset managers across their use of electronic trading platforms. Singapore, Hong Kong and Australian regulators all have current consultations out regarding the reporting and management of OTC derivatives. There is a global focus on FX trading and a push to drive transparency in that market following high profile scandals. Furthermore, from a purely commercial perspective, reducing risk and minimising work by having operational and trading systems working seamlessly across asset classes is a top priority for many hedge fund COOs.
Learning from equities, building for multi-asset
In many respects, lessons can be learnt from the evolution of the equity markets and the technology tools that have developed. Trends from equities now flowing through to other asset classes include the increased focus on transaction costs, counterparty risk management and transparent business processes. This can be seen in the development of products such as TCA for FX, block crossing systems for fixed income, or automated quoting tools for complex OTC products.
Bringing a singular, standardised approach to multi-asset operational management is essential for hedge funds who are looking across products for investment returns. When it comes to selecting trading platforms, the integration of these analytics, execution and quoting tools into both the equities and the multi-asset model has now become an essential part of doing business. However, given how different the various asset class workflow requirements are from the more traditional equity-only model, multi-asset platforms must be chosen carefully.
Finding consistency in a multi-asset world
A key criteria is that systems need to be integrated from front to back with a straight-through process. This reduces both operational risk for the business, and the workload of those who use the systems day to day. The systems must link together, from the Execution Management System (EMS) which sends orders out to broker desks and algorithms, on to the order management system (OMS) that sets allocations and compliance rules, through to the position management system (PMS) that displays real time profit and risk while interfacing with prime brokers, custodians and fund administrators. Integrated systems ensure that data formats are consistent across asset classes and tools and are drawn from the same source, reducing the risk of errors in ‘translation’ between areas of the business and costly duplication of data sources.
Choosing integrated tools can also have a significant effect on both the initial and future cost of multi-asset platforms – buying separate components from different vendors and then needing to manage and pay for interfacing and development work to connect them all typically results in a far higher set up cost and slower implementation. However, it is also important to choose platforms that deliver not only on the requirements of the fund today, but also for future growth. Many platforms are priced according to number of users, asset class modules, or by AUM of the fund, with additional charges added at every level of expansion. An EMS/OMS/PMS platform that may have an upfront cost of USD $50,000 per annum can end up costing many multiples of that after all the integrations are done with different counterparties, or after two years as the fund grows or adds strategies. Scalability across asset classes and size should be part of the decision making process for a hedge fund whenever they are reviewing their platforms, and understanding how costs will change with growth or diversification into different asset classes can save both money and time down the track.
Using technology to get, and stay, in the game
The rate of development in multi-asset technology is benefiting hedge fund managers in a number of ways. Particularly in Asia where hedge fund start- ups are typically smaller than those in the US or Europe, new, accessible multi-asset platforms are enabling them to compete with larger firms at an operational level from day one. This frees up portfolio managers and traders to focus on their day jobs of alpha generation; it allows their investment strategies to evolve over time without being limited by operational and systems constraints; and it positions them well when it comes to reporting to existing clients and fund raising with new investors. This last point is particularly important in the context of global investment and fund raising. In order to attract investment from institutional asset owners, hedge funds need to demonstrate ‘institutional grade’ systems and processes. Whether this relates to best execution, risk management or portfolio valuation and reporting, technology platforms that can help to automate these processes become essential.
When it comes to choosing a platform, there is little future for a non multi-asset system. It’s already possible to automate not just OMS/ PMS and EMS functions, but also embed functionality such as the ability to get STP request for quotes on complex OTC products, or stream FX. Around this there is a requirement for accurate analytics, access to different execution venues and streamlined reporting tools.
In many ways hedge funds are leading this integration of multi-asset tools as they drive their investment models forward. Choosing platforms that grow with them is an essential part of both their business and investment strategy, now and for the future.
*Total hedge fund AUM in Hong Kong increased by 39% between 2012 and 2014. Equity long/short and multi-strategy remained the most popular investment strategies. Source: SFC Report of Hedge Fund Activities, March 2015.
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Finding Liquidity: Today’s Greatest Challenge
Gianluca Minieri, Global Head of Trading, Pioneer Investments examines the main overarching theme in today’s debates around trading.
If there is one overarching theme today in debates around trading it is certainly the progressive and consistent erosion of secondary markets liquidity over the last few years. I do not think we exaggerate if we say that finding liquidity has become today the biggest challenge on trading desks. Especially for a large asset manager like us, it is becoming increasingly difficult to deal in large sizes unless a particular bank is “axed”. Markets have become very shallow and prices and sizes shown on the screens can no longer be taken as “firm”. The consequence is that moving large amounts of bonds without impacting the spread can prove very challenging. Traders have to be much more strategic than before and carry out a sophisticated activity of market intelligence and price discovery before they decide how, where and when to trade.
The European bond market has dramatically changed over the last few years mainly due to a tighter regulatory environment which enforced stricter capital requirements for market makers. This makes it extremely expensive to hold bonds inventory and has led to a severe reduction of leverage. Broker-dealers have responded by changing their models: the larger bulge bracket firms continue to commit capital but are much more cautious about the positions they take and for how long they keep them on their books. The smaller firms shifted more towards working client orders on an agency basis rather than making markets, progressively stepping away from principal trading. Overall, the level of inventory held by the sell-side has dramatically reduced. Although smaller inventories have been to some extent offset by an increase in inventory velocity, we think that the old market-making model is definitely broken and that banks will inevitably become agency brokers.
On the contrary, the buy-side has been consistently growing over the last few years. Buy-side firms are believed to hold in excess of 90% of bonds inventory in issuance today. This means that when we want to buy or sell a bond today very often the main challenge is to find another buy-side firm on the other side and a broker can facilitate the trade between us. The problem that we need to address is therefore not who is going to intermediate the bond but what initiatives can be taken to defrost that significant percent of bonds inventory currently held by the buy-side. We think that unlocking buy-side bond inventories can be done through a more efficient dissemination of pre-trade information between market participants.
So while we understand that electronic venues will not be a substitute for liquidity, especially on the less liquid side of the market, it is very much the future. In such a fragmented environment, we think that electronic venues should look at changing their objective and elect aggregation of liquidity as the most important service they can offer. One of the hot topics is the concept of all-to-all trading, i.e. not limiting the trading flow between buy-side and sell-side firms but to have a more open, all-to-all market.
Given the above, many electronic venues and vendors have sniffed out the business opportunity and have come to the market with new ideas on how to find alternative sources of liquidity in such a challenging environment. Today there are probably in excess of 30 new fixed income trading initiatives being launched to the market, all with the same objective of sourcing liquidity. In Pioneer we are in favour of such initiatives and always try to be engaged as early as possible where we feel that the right business model is proposed. In fact, while all-to-all platform and buy-side-to-buy-side trading might be a potential solution, it is important to remember that the objective is to unlock and supply liquidity, not just bringing people together. I do not believe in a bond market that is completely disintermediated. Eliminating the sell-side tout-court is not a solution, because bond markets need some level of intermediation. Also, it is wrong to assume that bringing buy-side together onto the same venues will automatically unlock that frozen liquidity, for the simple reason that large asset managers do not want to share or disclose their trading intention to their competitors, especially on their larger positions. So the problem here is not to bring us around the same table but rather how to ensure a more efficient dissemination of the information. How do you create a method that gives the right information to the right people at the right time?
Shared initiatives will be a must in coming years because the cost of the necessary infrastructure to compete in such a fragmented market is too high to be borne by one single company. So everyone, including ourselves, is now looking at shared architecture or utility to reduce the cost and develop a new way of connecting between the sell-and buy-side.
Pioneer approach
We continue to be very proactive with vendors, peers and the sell-side on every proposal that is aimed at enhancing quality of execution by standardising connectivity through multi-participant networks. We believe that the buy-side should continue to have an active role in this space and together with all market participants should push for an industry-led solution. This includes the sell-side and exchanges, which so far have not always had a proactive approach in addressing these issues.
However, we cannot wait until the perfect solution is put in place. That is why one year ago we decided to centralise all our trading on a common platform by deploying a Global Trading Model. The concept behind this model is the capability to route orders to regional desks and execute them in local time zones leveraging local market expertise at no additional cost. This model will increase opportunities for synergies, enhance our ability to support growing demand for global products and allow for superior price discovery and market intelligence, leading eventually to less alpha slippage and better performances for our clients. It will also result in a quicker decision-making and improved execution, letting the firm react faster to market changes, which may require a change in the trading strategy.
Regulation
As said above, tighter regulations around the world have profoundly changed the financial markets landscape over the last few years. While in many cases new regulations have contributed to bringing more clarity, in many other cases they created more ambiguity and uncertainty. Usually the normal approach provides for evidence and argument being discussed among various parties through lobbying.
This is done with the knowledge that the outcome might not be optimal but the underlying objective is to make financial markets more competitive and more efficient. Instead, we observed the difference in the consultation and engagement process between Europe and US. In US there seems to be an open and ongoing dialogue between regulators and market participants to ensure that the regulations achieve their objectives and do not produce unintended consequences. In Europe, this has not been the case. We have tried to be as proactive as possible during the last regulatory reform approval process but the outcome clearly shows that hardly any of the feedback given by the industry to policy-makers has been taken on board.
Take transparency for example, which soon became a philosophical topic for policy-makers that worked under the assumption that transparency and liquidity are the same thing. The reality is that especially for large sizes, transparency can be the enemy of liquidity. If information is made public too early, you will have the market trading against whoever is trying to unwind the risk and that will eventually result in a worse execution for the end investor since it will force market makers to price under a worst case scenario. We are in favour of regulation but we hope that going forward market supervisors will support a greater interaction with all market players. Regulators needs to get more involved in the ongoing discussions with all parties to create and maintain a trading environment in which best practise is encouraged through greater transparency, comparability and choice between service providers.
Future thoughts
The hot topic nowadays seems to be the so-called equitisation of the fixed income market. If equitisation of the fixed income market means forcing full transparency, irrespective of the asset class traded, liquidity, the type of order or the market conditions, then I think it is wrong. It will deteriorate rather than improving the price formation process. We remain convinced that transparency, especially in fixed income, is strictly correlated with liquidity and would not work for all markets. We are in favour of the development of electronic books for certain very liquid bonds where the platform could operate in a similar fashion to an equities-style exchange driven order book which would take the noise out of the market and increase transparency. In the more illiquid markets these challenges are harder to solve through an electronic platform, because all you need is real liquidity. We feel that the extension of pre-trade transparency without a proper calibration to the less liquid part of the market could have a number of undesirable effects.
As things stand, we do not feel that the bond market is ready to handle a sharp correction. The combination of a few large asset managers holding the majority of inventory, the banks less able to absorb positions, and that we would all be on the same side of the market were there to be a problem in secondary liquidity is probably the worst possible mix.
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Portfolio Management Profiling
With Joe Sowin, Head of Global Equity Trading at Highland Capital Management
As pioneers and leaders in the asset management space over the past twenty years, we at Highland are committed to a world-class investment platform that drives results for our clients. Highland has had tremendous growth and success in the Alternatives space over the past five years. Highland Alternative Investors, the investment platform for our $6.3B in Liquid Alternative assets, has become the fastest growing segment of our $20.9B AUM. Our trading desk remains integral to the success of our investment platform, and below we outline trading challenges generated by multiple product offerings, and the solutions we believe best address them.
We believe managing the trading process as follows optimises process, time management, and execution:
• Organisation of order flow.
• Consideration of how portfolio manager tendencies should influence trading.
• Intra-day trading strategy adjustments.
• Identifying where automation works and where it doesn’t.
Order flow organisation
We recommend tagging each order with a reason code prior to order routing. This allows similar orders to be grouped and facilitates post trade analysis of execution and portfolio management decisions. We benchmark arrival price orders versus arrival price and over-the-day orders to Interval VWAP. Sub-sets of orders are sub-grouped according to order size relative to average volume, order seasonality, transaction side, and sector. Lastly, we compare the groupings and sub-groupings to the appropriate index performance to assess order momentum. We believe order momentum is a significant driver of trading costs. Individual order momentum and index momentum can be analysed by comparing such things as:
• Opening price to arrival price.
• Arrival price to order completion price.
• Completion price to closing price.
At Highland Capital Management, we use Transaction Cost Analysis (TCA) to quantify the value add of the execution process, a constantly evolving opportunity to improve the feedback loop from the trading desk back to the portfolio manager. The trading desk can continue to add value in 2015 and beyond by creating, maintaining, and constantly improving order flow organization.
Portfolio manager tendencies
Once groupings and methodology are established, the trading desk can analyse this data to detect patterns in portfolio manager tendencies and style factors across order size, sectors, and market capitalisation. In other words, traders should understand portfolio manager tendencies and apply that understanding to nuance the portfolio manager’s orders in the market. Is it preferable to work the order aggressively by crossing the spread or work passively over the day? Different paths of execution can be used, in each case guided by information gleaned from TCA, together with historical portfolio manager behavior. It is important to note, however, that the portfolio manager-based approach to trading may not be an effective solution for all trades. For example, we have found small-cap stocks are less likely to exhibit identifiable patterns as compared to large-cap stocks.
Intra-day adjustments
We believe implementing intra-day strategy adjustments to expand order duration through the closing auction, thus lowering order participation rate, will provide an ability to participate in intra-day mean reversion, thus combating fund growth and increased order size. Portfolio managers have a higher level of comfort with and understanding of the trading process following detailed quantitative trading analysis.
Automation
At Highland Capital Management, we embrace technology and view automation as an imperative and competitive advantage. We leverage our internal and external technology providers to conduct execution analysis and quantify data. The resulting analytical data provides insights that can be utilised to enhance trading workflow and thereby lower execution costs. This data can then be utilised to identify routine trades that can be automated, and those trades where the trading desk can enhance execution through direct involvement.
We view automation in two forms:
• Single point automation: Any function that can be fully automated at a single point and does not require modification, i.e. managing all emails with a single rule.
• Multiple point automation: Any function that requires customization and monitoring, i.e. our trading process.
Both forms of automation allow trading desk personnel to focus on value-add functions like sourcing liquidity for outsized orders relative to average volume, derivative trades, market color, and filtering research/trading ideas.
Looking ahead
The end result of these trading solutions is a successful and repeatable trading strategy for all applicable clients. Automation of over-the-day strategies enhances execution and extricates trading desk resources. Automation and use of technology can significantly improve resource allocation and personnel requirements. We envision a desk of traders, trading assistants, technical analysts, risk managers, and portfolio managers engaging in a collaborative process. Technological evolution will be rapid across all asset classes and the trading desk should implement technological enhancements that deliver better execution in a cost effective manner. Accordingly, buy-side desks must be staffed with technologically savvy investment professionals. We believe these trading processes optimise allocation of time and resources while also enhancing execution, and providing a strong basis for repeatability and consistency.
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The Future Of Securities Processing: A Roundtable Write-Up
Simon Osborne, GlobalTrading, writes on our latest roundtable examining ongoing evolution in post-trade processing
On 18 June 2015, industry participants gathered in Hong Kong to give their views on the state of securities processing in Asia. Having diagnosed a number of the issues that characterise the industry locally, they also looked forwards to conjecture about possible future changes.
Comparatively, there has been much heavier investment in Asian front offices than in the middle and back offices. Revenues in Asia are decreasing but regulatory and operational costs are simultaneously increasing.
The problems of Asian securities processing
The infrastructure in Asian markets, individual exchanges and central banks, drags the industry backwards. That is happening at the same time as there are demands to process ever greater volumes of trades.
At present, it seems impossible that in Asia a joint clearing platform between countries will evolve. Participants have to work with the current mentality between competing and accepting that there will always be a core equities platform (or more than one) in each Asian country.
A straightforward overlay of European or US systems in Asia seems inconceivable. There are too many discrete markets and national interests in the continent.
Problems come from disjointed services that are found not to be collectively efficient. That state of affairs has meant that multiple back offices have become, as vividly described by one panellist, as a ‘big bowl of spaghetti’. How to eliminate such log jams via good management and new technology is the question to be solved, but not one that lends itself to a straightforward answer.
The costs of development
With the Shanghai-Hong Kong Stock Connect market participants witnessed how expensive it was to build new systems. Stock Connect’s problem was not only about its cost but the short time frame required for implementation which led to pressure on IT and operations departments.
The expenditure budgets to implement the Stock Connect systems had not appeared in firms’ development plans, as the commencement of the project began in mid-year.
At least with the Stock Connect, the programme did offer, and ultimately delivered, the promise of significant future revenue, which after a shaky start did start to flow through as China markets flourished. There was therefore a profit incentive to invest in the processes and systems that provided the backbone of a firm’s service offering.
What though if there was no obvious pay-off? If it was a mandatory regulatory change, such as FATCA, with no profitable implications, would the industry’s response have been as vigorous and enthusiastic?
It is hard to explain to accountants and head office CFOs in the financial industry that delivery of projects has to be completed intra-financial year. They, in response, pose the question why, for example, does a simple, straightforward fee change need so much work and expenditure. It is up to the back office to justify internally why there are additional hidden complexities.
The panel observed that Hong Kong is, in terms of vendors, geared towards funds rather than to the sell-side. Furthermore, if one buys off-the-shelf systems, developers sometimes have had no Asian experience. Decisions about systems development are being made elsewhere, with Asia being treated merely as an afterthought.
The end of the ‘one-stop-shop’
The days of all-singing, all-dancing investment banks are numbered according to the panel. Processing is either a core business, or if that is too expensive, then one can think about outsourcing it to external providers.
The Triple Convergence Of Credit Valuation Adjustment (CVA)
By Alvin Lee, Director, Product Specialist, Markit
The Basel Committee on Banking Supervision (BCBS) issued a consultation document on July 1st 2015 to revise the current CVA risk framework under Basel III standards for counterparty credit risk. Under the existing standards, the CVA capital charge captures credit spread volatility but not exposure volatility, which is inconsistent with front office pricing and financial accounting.
The revision proposes two different frameworks:
- FRTB-CVA,which requires regulatory approval and consists of an internal model (IMA-CVA) and standardised (SA-CVA) approach.
- Basic CVA, calculated using the equation defined in the regulation and applicable to banks that are not using FRTB-CVA
Convergence of front office, accounting and regulatory CVA with industry best practices
The document recognises that the current regulatory CVA approach is outdated and proposes an update that converges front office and accounting CVA calculations.
Recognising that banks may use different methodologies for accounting CVA, the document outlines conditions for the accounting exposure models used.
The document’s observation that different banks may adopt varying approaches, and the explicit imposition of best practices, is an indication that simplified CVA approaches will no longer be sufficient for regulators. Although some bank auditors may still be tolerant of simplified methodologies, regulatory scrutiny is increasing and requirements are becoming more stringent.
Explicit requirements for credit spreads of illiquid counterparties
One key challenge in CVA calculation is the ability to determine the credit spread of illiquid counterparties.
The document outlines specific requirements CVA calculations for illiquid counterparties, stating that credit spread curves of illiquid counterparties should be estimated from credit spreads observed in liquid peers and should be based on “an algorithm that discriminates on at least three variables: a measure of credit quality (eg rating), industry, and region.”
The rules highlight a need for credit spread datasets that cover not only liquid counterparties, but also illiquid ones. That the BCBS is now explicitly defining these requirements in the consultation paper is an indication of closer scrutiny of CVA calculation for illiquid counterparties.
Modelling requirements for internal models and standardised approaches
Capturing both exposure and credit spread volatility in IMA-CVA will require risk systems that are faster and more sophisticated by several orders of magnitude.
The consultation paper’s new modelling requirements include:
“Expected shortfall for CVA risk must be computed on a daily basis… [using] a 97.5th percentile, one-tailed confidence interval”
“Calculation must be based on at least the following inputs: (i) term structure of market-implied probability of default (PD); (ii) market-implied expected loss given default (ELGD); (iii) simulated paths of discounted future exposure.”
Furthermore, market risk factors must now be simulated as stochastic processes for the appropriate number of paths, based on future time points, capturing effects of margining collateral including margin period of risk.
The paper also states that risk factors driving exposure should be simulated for time horizons equal to the liquidity horizons as specified in market risk FRTB requirements. In addition:
“The dynamics of market risk factors must be calibrated to a period of stress… 12-month time period… which should go back to at least 2005.”
“A bank must calculate its internally modelled CVA expected shortfall charge with no supervisory constraints on cross risk factor correlations… A bank must also calculate six partial expected shortfall values for each of the following [six] risk types”
To provide a simplified illustration of CVA calculations based on these new requirements, if we assume that CVA is calculated using 100 timesteps with 10,000 scenarios per timestep, 1 million simulations are required just to compute the value of CVA.
Calculating CVA risk would require 250 daily market risk scenarios over the 12-month stress period. CVA has to be calculated for each market risk scenario, resulting in 250 million simulations. These calculations have to be repeated across 6 risk types and 5 liquidity horizons, resulting in potentially 8.75 billion simulations.
View the complete paper here.
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