Regional focus : USA & SEFs : Lynn Strongin Dodds

July 31, 2015

OLD HABITS DIE HARD.

SEFs made their debut over a year ago but they have not taken off as expected. Lynn Strongin Dodds looks at the obstacles in their way.

The US may be ahead of Europe on the regulatory curve, but there are lessons to be learnt from the unintended consequences of a new regime. Swap execution facilities (SEFs) is a case in point. They came into force with great fanfare last February but have yet to deliver on the open access trading promise. Volumes may be rising but they are still concentrated in the hands of a few top players.

“It is striking that this market is moving so slowly, but it is big and complex and the result is that we will not see a revolutionary but evolutionary change,” says Mark Brennan, head of Business Development, Americas at technology group ITRS, “There needs to be a cultural shift, but in the meantime the incumbents will continue to dominate for now.”

The latest FIA SEF tracker report published in June bears this out. It shows that March was the most active month since January 2014 with trading in interest rate products rising for the third month in a row while credit received a boost from the launch of new series for the major credit indices. Foreign exchange products also jumped almost 20% from February although this was still below the highs set in September and October last year.

Leading contenders

ICAP retained its pole position in interest rate swaps (IRS) and other non-forward rate agreements. Its two SEFs had a combined 24% market share while Tradeweb and Bloomberg, which primarily target dealer-to-customer trading, accounted for 14.7% and 13.4%, respectively, in March. Meanwhile, BGC Partners, which bought rival GFI earlier in the year, led the FX trail with a 44.8% chunk of the market.

Bloomberg continued to be the leader in SEF trading of credit default swaps (CDS) and options, but its market share slipped to 68.4% in March, the lowest since the first quarter of 2014. Tradeweb came in second with 12.1% market share in credit during March. Many new players have struggled to make their mark. One exception is MarketAxess which offers disclosed and anonymous request-for-quote (RFQ), central limit order book (CLOB), and click-to-trade functionality for credit products. Its SEF recently reported a hefty 390% year-over-year hike in volumes which led to a doubling in its market share to 8.7% compared to the same period last year, according to the FIA SEF Tracker.

The same trends are reflected in a recent TABB Group report – US Swaps 2015: Paradise Lost. “Only 40% of all US interest rate derivatives (IRD) trading is executed via SEFs today, but in October 2013 before the regulation went live in February, people expected it to be the majority” says Colby Jenkins, research analyst at TABB Group and author of the report. “We are also seeing the same incumbents compete for a narrowing market share. In early 2014 when Made Available to Trade (MAT) determinations went into effect, (mandating that certain swaps begin trading electronically), we saw around 24 SEFs vie for a ranking. Over a year later and half a dozen account for around 90% of the volume while two have 50%.”

Dr Anshuman Jaswal, senior analyst in Celent’s securities & investments group, adds, “Overall, MAT is not happening as planned and smaller SEFs, despite their advanced technology, are struggling. One of the biggest issues is that a lot of trading is still done over the phone and my view is that people underestimated the strong relationship between the broker and buyside. When they do use platforms, evidence shows that they go to players that they know such as Bloomberg and Tradeweb which trade on a RFQ basis. This explains why the central limit order book (CLOB) has not done as well as expected.”

Name give up

In general, SEFs offer two general methods of trading – the RFQ where orders are fulfilled by broker-dealers and the CLOB which operates in the same manner as a stock exchange. However, as sellside inventories shrink due to stricter capital and leverage ratios under Basel III, buyside firms want all-to-all trading through CLOBs to maintain liquidity in the swaps market. The main stumbling block is that SEFs typically require post-trade name disclosure on credit and interest-rate swaps which has enabled a cadre of big banks to dominate.

The disclosure of customers’ identities, known as “name give-up,” has its origins in the anonymous markets for uncleared swaps, where participants needed to limit the firms with which they traded in order to manage counterparty credit risk. The advent of straight-through processing for SEF-executed trades, including the pre-trade credit check process, has eliminated any need to use it to either manage counterparty credit risk or facilitate clearing submission.

The status quo has been allowed to remain because when developing the regulatory blueprint, the Commodity Futures Trading Commission (CFTC) didn’t include a requirement that would enforce anonymity for swaps traders who seek it.

Buyside trade groups such as the Managed Funds Association and the Alternative Investment Management Association (AIMA), argue name give-up is hindering their adoption of SEFs and they would like to see the two-tier market – dealer-to-dealer and dealer-to-client – be broken down. Their hope is for a framework where SEFs do not specifically exclude certain participants and they are encouraged by the recent White Paper issued from Christopher Giancarlo, a new commissioner and formerly executive vice president at GFI Group, an interdealer broker.

Giancarlo has called for a reworking of the Dodd-Frank Act and stated that the futures framework should not have been used for its OTC counterpart as the two generate products differently. He also notes that while high-frequency trading is common in futures markets, it is absent from swaps markets.

“Name give-up is cited as one of the big obstacles to the development of the market,” says Brennan, “It is a holdover from legacy practices and the regulations have not prohibited it. The CFTC is looking into this but I do not think an opinion will come any time soon – the earliest could be year end.”

Michael O’Brien, director of global trading at Eaton Vance, which manages $296 bn adds, “We knew it wouldn’t happen overnight and although we will get there, a few issues such as name give-up and average pricing have to resolved. There is no liquidity in the CLOBs because some SEFs demand users give up anonymity, which is the opposite of an order-driven market. Part of the reason I trade on an order book is to be anonymous. For example, in the futures market, I do not know who is on the other side.”

As for average pricing, buyside firms argue that CLOBs must develop the same level of functionality as that offered by cash equities and futures exchanges. In other words, calculations for a “parent” trade comprising multiple “child” transactions. “It is a big challenge for asset managers,” says O’Brien. “If I’m doing a trade across 20 accounts, there is a lot of operational work involved. It is easier to go to RFQ and do the one trade. If these two obstacles are addressed I do not think there will be a tsunami of liquidity but you would definitely see more asset managers trading on order books.”

Education is also needed, according to Grigorios Reppas, CDS Product Manager, at MarketAxess. “Old habits die hard, and many clients are still stuck in old legacy procedure and compliance processes, even though current regulations allow for all-to-all trading” he adds. “Clients are primarily using the current market structure, taking bids and offers from broker-dealers, but it is up to us to explain how we can provide alternative liquidity.

[divider_line]©BestExecution 2015

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High frequency trading : Louise Rowland

Ian Rycott

July 31, 2015

THE CALM AFTER THE STORM.

Despite the hoopla, the HFT trader is here to stay albeit in a different form. Louise Rowland explains why.

It is probably no surprise that Michael Lewis’s Flash Boys sold 130,000 copies in the US in its first week of publication. It has all the ingredients of a blockbuster exposé: alleged market abuse on an eye-watering scale, toxic traders using speed-of-light technology to rig the equities markets, huge rewards for those who outwitted the system. The high frequency trader (HFT) was the new villain on the block and the media were baying for blood.

Yet, a year on from the furore, a more nuanced and balanced picture is emerging. Few question that market abuse took place at the expense of institutional investors. The FBI and the New York Attorney General’s Office both have investigations underway, and Navinder Singh Sarao, a Hounslow-based trader is currently facing extradition to the US, accused of helping cause the 2010 Flash Crash.

However, such predatory behaviour was carried out by 1% or so of HFTs, insists one market participant. Rogue cases have always been possible – and existed – in other types of trading, he adds. Far from being an unfair practice, HFT should be celebrated for creating liquidity and improving market efficiency, all part of a healthy ecosystem.

The subject has long been on the industry’s radar. Many HFT firms welcome the current debate because it brings the issue into the mainstream, giving the sector the opportunity to clear its name and regulators the spur to act. There is certainly work to do. A recent industry survey shows that many buyside firms harbour major fears about what they see as HFT’s negative impact on liquidity and their own order flows, even in dark pools.

Casting a light

The greater understanding within the industry of what HFT is and how it works, the more accepted it will be, claim its supporters. It’s all about transparency and the need to take ownership, says Rebecca Healey, senior analyst at consultancy TABB Group. “We need to establish a situation where people intelligently interrogate what’s happening to their order and ask ‘is it behaving as I wanted it to?’ All industry participants in every asset class need to understand their order flow, following through the best execution process and this will only accelerate under the regulators’ increasing focus on delivery of best execution.”

That process of engagement is already happening, agrees Anish Puaar, market structure analyst, Europe for Rosenblatt Securities Inc. “A positive from the book is that more buyside traders are taking a proactive stance on market structure. They are talking to their brokers about the way orders are routed on their behalf and then using that information to change brokers’ behaviour to improve their results. Long-term asset managers are better informed and their approach more evidence-based.”

Some argue that much of the market abuse was inadvertent and largely down to flawed market structures, particularly in the US, where RegNMS created a highly fragmented landscape, with best execution responsibility placed in the hands of brokers.

“I think the current debate focuses on just one part of the problem,” says Per Lovén, head of international corporate strategy at buyside block trading network Liquidnet. “Clearly it’s not ideal to have markets where participants can benefit from latency advantages, but it is the rules and market structure set-up that created these conditions in the first place, particularly in the US.” The role of the exchanges tends to be forgotten. “The exchanges were, after all, the enablers of HFT. By co-location, sponsored access and plethora of new order types, they created a new revenue stream, often to the detriment of long-term investors. This is the big issue and where the debate should focus its efforts on.”

Righting the wrongs

Both the regulators and the HFT industry itself are increasingly focused on corrective measures to maintain the integrity of the markets. Yet market practitioners warn against knee-jerk reactions, pointing to last year’s German HFT Act as a less than ideal response. European Securities and Markets Authority (ESMA) and the Financial Conduct Authority (FCA) have been working on the issue for some time, with an ESMA report appearing in December 2014, the first study into HFT across major venues in the EU.

The Bank of England produced a working paper in February, which found that HFT was not responsible for sudden price hikes in the market and generally helped price efficiency. However, the BoE also announced in mid-May that its Prudential Regulation Authority will test whether firms’ governance and controls around algo trading are ‘fit for purpose’ to protect market liquidity.

MiFID II, due to be launched in January 2017, will also introduce greater oversight on HFT. The directive has recommended new provisions applying to HFT as a type of algorithmic trading, including organisational requirements and market-making obligations.

In the US, the Securities and Exchange Commission (SEC) proposed a registration regulation in March and there’s an expectation that several additional rules may be issued, focusing on anti-disruptive trading, latency, co-location and risk management of trading algorithms.

Taking the initiative

More and better technology is also the answer, says the pro-camp.

Exchange fairness is achievable with the right technology, insists Dave Snowdon, co-CTO of Metamako, a technology company specialising in ultra-low latency solutions, where speed and determinism are critical factors, combined with high levels of monitoring functionality. “Accurate measurement is essential so that the market understands HFT’s role in that market. All orders and market data should be captured, time-stamped and recorded as they enter and leave every venue. There should be an audit trail through each venue showing where and when each order was delivered.”

Field Programmable Gate Array (FPGA) solutions – programmable microchips which can incorporate client-specific risk checks – are key. “FPGA technology is big news,” says Sanjay Shah, CTO of NanoSpeed, a provider of ultra-fast FPGA solutions to the trading community. “It narrows the gap between speed and risk. Our technology allows clients to do thousands of trades on the fly in parallel, with monitoring also built in and latency kept very low. Over the next few years, FPGA will become commoditised and used far more widely.”

Platforms such as ParFX are also gaining traction. The venue is a market-led initiative by a group of banks in the FX sector, utilising a randomised pause to nullify low latency behaviour. “The platform was designed to achieve a level playing field and is the only one built on this model with a material randomiser,” says CEO Dan Marcus. “There’s a strong desire for this kind of venue and it’s particularly relevant for Spot FX, which is a highly commoditised product. An environment like ours, where there is no latency benefit but assured firm liquidity, encourages firms to adopt a more intelligent approach.”

HFT, here to stay

How is the HFT story likely to unfold? Current volumes are calculated at up to 43% of equity volume traded, according to ESMA, although an accurate estimate is hard, as some investment banks engage in HFT activity as well as firms which flag as pure HFT. Volumes remain fairly static, but new players have emerged over the past few months, and HFT firm Virtu recently conducted a very successful IPO.

Observers expect to see increased specialisation and consolidation, as well as a growing HFT presence in other asset classes such as FX, derivatives and fixed income. There is also likely to be some exodus from the market by smaller firms, due to the inevitable hike in compliance and technology costs. Some of these may head for unregulated dark pools – an outcome not intended by the regulators.

Mark Spanbroek, Vice Chairman of the European Principal Traders Association, is optimistic about what lies ahead. “We’ve worked constructively with the regulators and made an enormous step forward. Our member firms welcome these developments because we’ve had the chance of a huge dialogue which has improved the market tremendously. HFT has been in the spotlight in a good way and the attention has been positive.”

[divider_line]©BestExecution 2015

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Technology : Cyber-security : Heather McKenzie

Ian Rycott

July 31, 2015

KEEP YOUR GUARD UP.

Cyber-security is one of the hottest topics but it is not just one of those passing fads. Heather McKenzie looks at the threats.

High-profile hacking attacks and revelations about online surveillance by state organisations have pushed concerns about cyber security to the top of the agenda of many securities industry firms. Financial regulators and market infrastructures are also raising the alarm about the heightened risk of cyber-crime.

A survey of Depository Trust and Clearing Corporation (DTCC) clients in the first quarter of 2015 revealed cyber risk as the main concern among members. A record 46%, up from 33% in September 2014, cited it as the “single biggest risk to the broader economy” and a total of 80% saw it as a top five risk. The others included geopolitical events, impact of new regulations, disruption or failure of a market participant and a US economic slowdown.

However, there is work to be done as reflected by the June poll conducted by FIX Trading Community of its security working group. It found that only 6% of members encrypted all of their messages while 25% encrypted none, partly because encryption can slow down algorithmic trading.

Ironically, given the torrent of regulation, trade groups are calling for tighter rules. For example, last October, the US securities industry group SIFMA published its Principles for Effective Cybersecurity Regulatory Guidance, which sets out its members’ views on how to harmonise and create effective cyber security regulations. “Cybersecurity is a top priority for the financial services industry, which is dedicating significant resources to protect the integrity of the markets and the millions of Americans who use financial services every day,” said Kenneth Bensten, SIFMA president and CEO at the launch. “Effective and consistent regulatory guidance is a critical component of the broader cyber defence effort, as it promotes best practices and accountability across the financial sector.”

Cyber-attacks are increasing in frequency and sophistication, he added, and it is critical that the industry and government collaborate to mitigate these threats. SIFMA’s paper included ten principles for cyber security guidance, including the US Government’s ‘significant role and responsibility’ in protecting the business community as well as recognition of the value of public-private collaboration in the development of agency guidance. Also on the list were harmonisation of cyber security guidance for financial services across agencies and basing cyber security on risk assessments as well as threat information.

State regulators in the US are also concerned over the threats. In February, Benjamin Lawsky, superintendent of financial services at the Department of Financial Services in New York State, said as a financial regulator cyber security “is likely the most important issue we will face in 2015 – and perhaps for many years to come after that”. He expressed concern that a major cyber-attack aimed at the financial system would occur, which would represent a systemic risk to financial markets by creating a run or panic that would spill over into the broader economy.

“Indeed, we are concerned that within the next decade (or perhaps sooner) we will experience an Armageddon-type cyber event that causes a significant disruption in the financial system for a period of time – what some have termed a ‘cyber 9/11’,” he said.

It is not only Europe and North America where concerns about cyber-crime are growing. The Securities and Exchange Board of India recently announced it was working on a cyber-security framework for the country’s stock market, covering exchanges, depositories and intermediaries. The Board is aiming to frame regulations before online trading – which accounts for 36% of all trades in India’s equity markets – becomes more widespread.

On the attack

Mark Clancy, chief information security officer at the DTCC, says while cyber-attacks such as distributed denial of service (DDOS) and hacking attacks have been around for a while, they are increasing in frequency and size. “Cybercrime is becoming more visible because the magnitude of the impact of such attacks is bigger and more pervasive,” he says.

Attacks are motivated by ideology – such as hacktivists who attacked credit card companies that stopped taking payments for Wikileaks – or by industrial espionage, whereby governments or corporates attempt to steal secrets for economic gain. Cyber attacks use malicious code to alter computer code, logic or data, disrupting systems and compromising data. The tools used for attacks are many and varied, including viruses, malware, DDOS, Trojan horses, worms and phishing.

DTCC has taken a two-pronged approach to challenge cyber-crime: raising awareness of the risks among its clients and a joint venture called Soltra which it set up with the Financial Services Information Sharing and Analysis Centre, a non-profit private sector initiative that facilitates the detection, prevention, and response to cyber-attacks and fraud activity. Soltra will deliver software automation and services that collect, distil and speed the transfer of threat intelligence from various sources in order to safeguard against cyber-attacks.

Clancy says the DTCC acknowledges that cyber-crime can never be fully wiped out, but the balance that is currently in the favour of the criminals can be changed. “There is an asymmetry when it comes to cyber-crime. Attacks are relatively inexpensive, but the cost of defence is very high,” he says.

The idea of Soltra, he says, is to increase the cost of cyber-crime for the perpetrators by standardising and automating much of the cyber defence. Soltra will enable firms to share information about what attackers are doing, which will enable other firms to be more nimble in their responses and know what to look out for.

“We are using the concept of straight through processing in fighting cyber-crime,” he says. “Of course attackers will always innovate and try to stay ahead. The idea we have is to try to tackle the underlying economics as well as the technical elements.”

Safety checklist

There are some basic ‘hygiene’ approaches firms can take to guard against cyber-attack. Australia’s Defence Signal Directorate (an Australian Government intelligence agency) recently issued the following recommendations:

application white listing (maintaining a simple list of applications that have been granted permission by the user or an administrator);
patch applications (ensuring software designed to update a program or its supporting data is updated in order to fix security vulnerabilities);
patch operating systems (as above); and
minimising the number of users with domain local administrative privileges (in order to prevent vulnerabilities related to phishing attacks, for example).

Speaking at a Sydney conference last year, assistant secretary of cyber security at the Directorate, Joe Franzi, told delegates that between 2011 and 2013 reported cyber-attacks in Australia had risen from 1259 to 2148. Banking and finance were among the five most commonly targeted sectors.

Meanwhile in the US, Lawsky addressed the practicalities of protecting against cyber-attacks. The Department is not only looking to incentivise market participants to do more to protect themselves but is also revamping its regular examinations of banks and insurance companies to incorporate new, targeted assessments of those institutions’ cyber security preparedness. “If we grade banks and insurers directly on their defences against hackers as part of our examinations, it will incentivise those companies to prioritise and shore up their cyber security protections,” he says.

The Department is also considering steps to address the cyber security of third-party vendors, which is a “significant vulnerability”. The fact that such vendors often have access to a financial institution’s IT systems could be a weakness when it comes to guarding against attackers. Lawsky said it is considering mandating that financial institutions receive “robust” representations and warranties from third-party vendors who have critical cyber security protections in place.

Moreover, the Department is considering multi-factor authentication of system users which has requires username and password as well as a second layer of security such as a text alert additional password.

IT security specialists Kaspersky Lab points out that firms should not just pay attention to IT-based security solutions but also to the staff employed. This is because the majority of data security breaches occur due to employee actions, either intentional or unintentional. As a result firms should set out an employee’s responsibilities and accountability regarding confidential information and promote a greater understanding of working with and handling corporate information on mobile devices.

[divider_line]©BestExecution 2015

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Post-trade : Clearing & settlement : Mary Bogan

Ian Rycott

July 31, 2015

UNINTENDED CONSEQUENCES.

Too big to fail has become the mantra in the CCP world. Mary Bogan examines whether the concerns are justified.

They are the questions that tower over the clearing space: do central counterparties (CCPs) have adequate checks and balances to guarantee their resilience in another Lehman-scale crisis; are there enough deterrents in place to prevent reckless risk-taking and ensure a few gung-ho CCPs could never blow up the entire financial ecosystem?

Credited with bringing calm and order to the chaos that surrounded the financial crisis, regulators have turned to CCPs to bring transparency and greater safety to the over the counter derivatives market. Plans to move bilateral OTC trades into central clearing have created more opportunities as well as competition for these clearinghouses but some fear, as a result, a hitherto resilient piece of market infrastructure is about to be enfeebled.

“When we testified at a Basel committee meeting on clearing this past February, my first comment was, ‘Mr Chairman, we believe that in 2009 the G20 may have made an historic mistake in calling on CCPs to solve an interbank OTC problem’,” says Thomas Krantz, senior capital market adviser at consultancy Thomas Murray IDS. “The point is you just can’t solve a bilateral OTC counterparty risk by using a capital markets infrastructure.”

Others, such as University of Houston finance professor, Craig Pirrong, argue that instead of removing risk from the system, all regulators have done is simply reconfigure and redirect it to other vulnerable parts of the financial system; namely CCPs.

Systemic risk may be further heightened by forces that favour the strong and mighty. To take on new OTC business, CCP’s have had to increase capital, redo risk models and invest in new IT. “So what we’ve seen is a skewing effect where volume is helping the largest CCPs meet these costs. You now have four to six mega CCPs that have become too big to fail in their own right and others that are struggling with costs,” says Krantz.

That skewing effect is compounded additionally by the netting benefits clearing brokers enjoy when flows are channelled through a small number of CCPs.

On the other side of the clearing equation, business is also being concentrated in fewer but bigger hands. “Successive regulatory delays to deadlines for mandatory OTC clearing in Europe have put big pressures on brokers,” says David Field of clearing and collateral management specialists, The Field Effect. “They’ve invested heavily in infrastructure but there are still no revenues. The hope is valued added services, such as collateral optimisation and transformation, will plug the gap but in the meantime we’ve seen big cutbacks at the banks.”

Nomura is the latest bank to pull out of OTC clearing completely following in the footsteps of State Street, BNY Mellon and Royal Bank of Scotland.

The risk factor

If the creation of “too big to fail” clearing entities is one concern, fears there could be a “race to the bottom” on risk standards is another, especially as many CCPs have deserted mutuality in favour of for-profit status.

“The concern I have is about the ability of CCPs to resist commercial pressure,” says Krantz. “Banks have a strong incentive, through the sharply increasing cost of capital, to pass OTC bilateral risk into the mutual pool. Will a CCP be able to turn down a questionable request from its biggest clients? A CCP is as strong as its weakest member and as robust as the risk officer’s ability to be discriminating about what’s accepted onto the books.”

CCPs, not surprisingly, are loathe to accept that risk standards could be compromised and say strengthened regulation in Europe and market forces will curb any downwards drift on risk. “Within the new regulatory ecosystem, any changes CCPs make to the products they clear or their risk management structure must go through a college of regulators. EMIR (European Market Infrastructure Regulation) is pretty firm on how to handle these issues,” says Fredrik Ekström, president of Nasdaq Clearing.

In addition, lowering risk standards could only bring a short-term commercial advantage for CCPs, says Ekström, while inherently volatile or high-risk deals should be priced out of the market.

“The old joke is a CCP can clear anything but the margin might be the full value of the deal,” says Teo Floor, vice president, Eurex Clearing. “There are some bespoke trades, niches where it’s simply not worth, except for very high fees, clearing a product. What usually makes CCP markets so safe is that, as well as the margin, there is the added component of the clearing fund – this mutualisation where, to cover extreme tail losses, all members chip in together. The broader the market, the cheaper it becomes per member to achieve a high safety level. I think it’s this kind of business rationale that will keep CCPs focused on broad rather than high-risk, esoteric markets.”

Yet another fear about a possible race to the bottom is that, in a world where adequate supplies of eligible collateral remain uncertain, criteria for eligibility could be lowered.

Standards, set out in EMIR, governing the credit quality and liquidity of eligible collateral, should guard against a slide in risk levels, says Ekström. Beyond that, it’s important not to get too prescriptive. Categories for eligible collateral could and should be broadened. “Not all collateral can be cash or government bonds and, from a business perspective, it wouldn’t be wise: you’d create a squeeze and it would be costly. So it’s important we have diversified risk in collateral. In the Nordic markets, for example, we accept ‘AAA’ rated covered mortgage bonds because the market here is very liquid. It’s not the type of asset that’s important but its credit quality and liquidity.”

Skin in the game

However, if the chances of CCPs accepting imprudent risk are to be properly stemmed, say critics, they need to show the colour of their money. Kicking off a PR war between CCPs and their clients, J.P. Morgan, PIMCO and Blackrock are just a few of the market participants calling on CCPs to increase their “skin in the game.” J.P. Morgan wants CCPs to be tested, in a similar way to banks, against a similar “total loss absorbing capacity” (TLAC) measure. It also proposes CCPs make the same contribution as their largest clearing member to a recapitalisation fund to ensure CCP incentives are aligned with those of members.

With the exception of ICE, which recently broke ranks and announced it was increasing its contribution to its default funds in Europe, CCPs are resisting calls to raise their stake. European rules have already upped CCPs’ skin in the game to 25% of minimal capital resource, they say, and any further hike could undermine members’ incentives for prudent risk management.

“If CCPs were to put in substantial amounts to be used before the guarantee fund is tapped, members could become less concerned about keeping losses at initial margin because their own chances of being hit in the mutualised fund have been pushed further away,” says Floor. “Furthermore, after the default fund, you don’t want CCPs to cover the tail risk either because then they start to look like insurance companies, using their own capital to fully underwrite risk. The reason why CCPs are so stable is because they organise a system where the members are mutually liable beyond defaulter pays.”

Where there is broad agreement however is on the need for greater transparency and disclosure among CCPs. Proposals for a new disclosure framework, designed to help the market compare CCPs on the basis of risk and financial muscle, for example, have been put out for discussion by the Committee on Payments and Market Infrastructures and the Board of the International Organization of Securities Commissions (CPMI/IOSCO).

LCH Clearnet, meanwhile, has also taken the bull by the horns and proposed a framework for standardising stress tests, allowing a like-for-like comparison of CCPs. According to chief risk officer, Dennis McLaughlin, members have welcomed the proposals and some observers, too, see it as a positive step. “It’s set out a way forward and opens up a debate that other CCPs can build on,” says Field.

The latest hint from Brussels is that mandatory OTC clearing is likely to commence next April so the focus on how best to safeguard the resilience and integrity of CCPs is likely to dominate the clearing agenda at least until then. Which checks and balances are built into the system remains to be seen but, when it comes to risk and CCPs, Field says that the more conservative, the better. “History tells us that, however cautious we are with risk models, before long a black swan event comes along and you get a tail event that should only happen once every 10,000 years but turns up every 10 years. Given what’s at stake, we need to err on the side of caution.”

[divider_line]©BestExecution 2015

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Fixed income trading : Liquidity crisis : Dan Barnes

Ian Rycott

July 31, 2015

VAPOURWARE: FIXED INCOME LIQUIDITY.

Liquidity in high quality bond markets has taken a severe downturn, increasing cost and risk for fixed income traders. Dan Barnes looks at why structural reform may be needed.

Despite booming secondary market volumes, buyside traders are reporting a fall in liquidity of up to 80% in markets which have been more liquid than most. That has considerably reduced capacity to match large-in-size trades, and increased the need for buyside traders to work orders.

Marc Harrington, head of fixed income trading at F&C Asset Management, European hub of BMO Global Asset Management, which has £166 billion assets under management, says, “In investment grade, pre-crash we used to get bids and offers all day in £10m a side. Now that is more like £2m to £3m a side. You can still get £5m or more done, but typically you can [match] half an order and then you have to work the other half. For high yield orders there has been a reduction on liquidity for anything above £1m.”

This illiquidity stands in marked contrast to volume. Trading in US credit reached nearly $27trn in 2014 up from $14trn in 2008, according to data from the Trade Reporting and Compliance Engine (TRACE). Between 2005 and 2015, annual volumes for gilts have more than doubled to reach approximately $11trn annually, and US treasuries have bounced around the $25trn to $32trn range over the same period – with the exception of a dip between late 2009 and early 2010, according to a recent analyst report from dealer Citi.

A missing link between high volume and low liquidity was identified by Matt King, global head of credit products strategy at Citi in his May 2015 note, ‘The Liquidity Paradox – The more liquidity central banks add, the less there is in markets’.

He observed that the rates and credit markets have seen a massive post-crisis decline in turnover (see Figures 1 & 2), undermining the rosy liquidity picture painted by high trading volumes. He asserts that the environment reflects buyside firms who largely buy or sell in the same direction, high-frequency traders in the more liquid markets trading in the prevailing direction as well as central banks that are buying up assets and reducing the heterogeneity of the markets. Traditional sellside participation – which traded in the opposite direction to its buyside clients – has fallen away.

Corporate bond markets have a high number of debt instruments, issued by many firms, which multiplies the challenge of matching buy and sell orders, although illiquidity is now found across debt markets. David Blake, director of international fixed income at Northern Trust, which has $960bn in assets under management, says, “We certainly observed the deterioration in liquidity, and not necessarily in bid/offer spreads, but in the depth of the market. I wouldn’t limit that to credit markets; things like index linked markets are less liquid than they used to be and even the most liquid markets such as treasuries are not immune.”

Sellside traders report that, given the risk characteristics of investment grade versus high yield, the relative size of matches suggest that high yield is actually easier to execute.

Asif Godall, global head traded credit at HSBC Global Banking and Markets, says, “One would maybe have thought that the ratio would have been four-to-one or five-to-one given the spreads of high yield trades compared with investment grade, but that is not proving to be the case. I think part of that is that regulation is making it harder to hold nominal inventory per se.”

Changing shape of the market

Capital adequacy regulations have increased the cost for banks to hold inventory and the sellside holds less to compensate. As a consequence the buyside has to look elsewhere to find a match. The market has reacted. In the credit markets new firms such as Algomi and MTS/B2SCAN are offering pre-trade checks to identify where liquidity may exist amongst buy and sellside firms, while FIX protocol-based Project Neptune is underway to standardise messaging between market participants in order to facilitate identification of trading opportunities.

Trading venues are also opening up to offer innovative models for matching orders effectively. Where the dealer-client model is undermined by the reduction of inventory, all-to-all models are increasing so that buyside firms are able to trade with other buyside firms. For example, where capital is withdrawn from one firm’s funds the resulting sell-off of assets can provide another fund with the opportunity to fill buy orders.

Electronic trading is more prevalent in the government bond markets. Research house Greenwich Associates estimates that electronic trading of European government bonds has increased from 43% of volume in 2008 to 57% in 2015. However in the US there are serious concerns that the high proportion of high-frequency trading (HFT) volume has no depth, creating volatility spikes. A recent Federal Reserve working group report blamed the ‘flash crash’ of 15 October 2014 in US treasuries on this effect (see Louise Rowland’s article: click here).

Richard Metcalfe, director of regulatory affairs for buyside trade association The Investment Association says, “You could take the view that it is micro-volatility and the question for real money managers is how much does it matter? Well a basis point on a large trade adds up to a lot of money and there is a lot of pressure on the asset management industry to keep costs down.”

Tough times ahead

New regulation is set to make things more difficult in Europe. In 2017 the review of MiFID II and associated MiFIR will introduce pre- and post-trade transparency for bonds, increasing market impact for orders not granted a waiver, available for certain request-for-quote (RFQ), voice traded and large-in-size orders.

Furthermore MiFID II imposes tougher best execution obligations on traders, with increased transparency for their end investors around both costs and execution quality, the latter requiring a revision of existing best execution policies.

Kristian Karppi, managing director at K&K Global Consulting says, “With MiFID II in Europe as of January 2017 fixed income head traders will have to manage increased amounts of operational regulatory risk, in addition to the investment risk, due to the new execution obligations under Article 27.”

In the US regulators have less concrete plans but are investigating possibilities. Frank DiMarco, head of fixed income trading at agency broker ITG says: “There are a lot of conversations going on citing concern that the fixed income market is ‘broken’ and needs to be fixed. However to date there has not been a lot of prescriptive rule making around what needs to change.”

The Financial Industry Regulatory Authority (FINRA) has issued a request for comment on disclosure of the capacity in which the dealer is acting to define riskless principal and transparency of mark-up or mark-down a broker receives. Also being discussed are aggregating trade prices for dark and lit venues to provide FINRA and the SEC with access to live market prices, potentially looking at equity market structures such as the Securities Information Processor (SIP) and the trade-through rule.

Fighting back

For the moment buyside traders are adjusting to the new landscape, having followed the Kübler-Ross model associated with loss*, says Godall. “There has been denial, anger and bargaining. This is the year of acceptance.”

Acceptance is taking the form of technological innovation. Of 27 buyside head traders surveyed by K&K Global Consulting, 30% already have or will commit to use a form of fixed income transaction cost analysis (TCA) system, including 3% who had developed in-house systems. In Europe this is challenging, as there is no post-trade data source, such as TRACE provides in the US.

To be effective, a TCA platform would need to provide comparable analysis of broker performance and venues, as well as peer analysis. However, to do this in a meaningful way (see Figure 3), Karppi observes that data from different trading models will need to be aggregated and normalised. “There are considerable challenges in capturing and time-stamping voice trading data,” he says. “One particular subject of interest is whether new electronic venues could be analysed for trading costs.”

Harrington notes that the use of electronic venues allows buyside firms speed and efficiency of trading as well as gaining access to better price transparency to avoid higher transaction costs. “Five years ago electronic trading platforms were 25% of my business,” he says. “Three years ago they were 30%, and in the first quarter of this year they were 45%, so I think that will continue to increase until at least half my trades are on electronic trading platforms.”

Despite the promise that these platforms offer, it is far from certain that removing a cog as significant as sellside liquidity provision can be overcome purely by the rest of the machine increasing its efficiency.

Blake says, “I think it’s going to be difficult to see a marked improvement overall in the secondary fixed income market unless the market goes through some sort of structural transformation. That’s difficult, as the model works extremely well from a treasurer’s perspective, who wants to issue bonds.”

Note: In the computer industry, vapourware is a product, typically computer hardware or software, that is announced to the general public but is never actually manufactured nor officially cancelled.

*The Kübler-Ross model is a series of emotional stages experienced by survivors of an intimate’s death, wherein the five stages are denial, anger, bargaining, depression and acceptance.

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Analysis : Dark pools and best execution

Ian Rycott

July 31, 2015

DARK POOLS AND BEST EXECUTION.

In the first of a series of articles for Best Execution and in the run up to the implementation of MiFID II, Robert Barnes, CEO of European multilateral trading facility Turquoise looks at the past, present and future of dark pools, dark liquidity and block trading.

With just over a year until MiFID II comes into force on 3rd January 2017, now is an ideal time for a review of its progress in Europe. Anecdotally, the term ‘dark’ first appeared in September 2002, when Island ECN, one of the first electronic communication networks established for trading equities in the US, decided it would stop displaying key ETF order book limit prices. It was a way to avoid connecting to the relatively slow Intermarket Trading System (ITS) while still complying with SEC Regulations. Rather than join ITS, Island went ‘dark’ and limit orders were no longer visible to any market participant.¹

Dark pools aim to reduce information leakage by allowing orders to reside that are not yet executed nor displayed to the market. This is hardly novel. Consider the hidden components of iceberg orders, or the traditional matching by brokers, of buy and sell orders on the way to the market. Dark pools effectively augment the traditional broker skills of finding the other side of a trade and automate the process with electronic pipes.

A consequence of electronification is a trend of shrinking trade size.² Figure 1 shows this clearly with a selection of exchange data collected by Mondo Visione.³ In the two years after the MiFID launch in November 2007, the average lit order-book trade size in Europe fell to approximately E10,000. This encouraged the development of dark pools to complement lit order books as electronic execution mechanisms, to facilitate larger block trading, and to avoid signalling to competitors.

Originally conceived as a way for investors to place large orders without moving markets, dark pools became just another venue that the new smart order routers of 2007 MiFID tapped. The result was that European external dark pools featured similarly low average trade sizes. Chris Smith, now Head of Trax and Operations, MarketAxess, and formerly head of NYFIX Euro Millennium, the first successfully active third party European dark pool, has said that average trade sizes in 2008 ranged between €6,000 and €11,000.⁴

As more dark pools appeared in Europe, members added each as an additional venue to their algorithmic smart routers. By the start of 2013, Fidessa recorded the Q1 value of average European dark trades at €8,201, up from €7,269 in Q4 2012.⁵ More recent analysis by Rosenblatt Securities’ European ‘Let There Be Light’ monthly report including external venue dark order book average trade sizes confirms a slight increase – correlating to the increase in stock price levels – to €10,409 in May 2015, which is still similar to the average trade sizes on the larger European lit order books.⁶

Even though most dark pools today yield small average trade sizes, mid point books can contribute to potential price improvement and a better investment result.

One notable aspect of dark order books is their ability to execute at the midpoint of the Primary Market Best Bid and Offer. Furthermore, there are times when this midpoint price may be at a level inside the tick size, that is, the minimum price increment that prices can move in the lit order book. Figure 2 shows some benefits of this approach.

In the chart, the y-axis is price and the x-axis is time (intraday) for one security. The blue diamonds are prices traded in the lit order book and follow the primary market tick size regime. The black circles are post-trade prints of successful matching in the Midpoint dark pool.

On the right hand side of the graph, you will notice the price is rising. The question is: if one is building a position and only purchasing at the increasing lit order book price increments, is one really achieving ‘best execution’ when it is possible to trade potentially some of the order in the dark? Even if just some of the order is matched in the dark, it is apparent that one is more likely to achieve a better long-term investment return by benefitting from the price averaging of price levels inside the tick size of the lit order book.

While many electronic algorithms contribute to dark pool average trade sizes similar to those of lit order books, innovations are appearing to allow users to realise the ability to trade larger blocks via scalable order book mechanisms. These innovations can serve as another channel to complement those of the traditional human sales trader associated with larger-sized trades, and the electronic channel that accesses a single virtual pool of liquidity, across a physically fragmented market, associated with many smaller-sized trades. These I shall explore in next issue’s article.

Footnotes:

1. Terrence Hendershott and Charles M. Jones Review of Financial Studies vol. 18, no. 3 (Fall 2005):743–793. www.cfapubs.org/doi/pdf/10.2469/dig.v36.n1.1822.

2. Jeremy Grant Financial Times Smaller orders breed dark pools and higher post-trade costs, 22 Feb 2010. www.ft.com/intl/cms/s/0/768b4e12-1f52-11df-9584-00144feab49a.html#axzz3eU8QLIxH.

3. Data provided by Mondo Visione Managing Director Herbie Skeete, collected from respective venues.

4. Communication with author, 11 June 2015.

5. Fidessa European Dark Trading Analysis, April 2013, page 2. www.atmonitor.co.uk/content/researchimages/European-Dark-Trading-Analysis-April-2013.pdf.

6. Rosenblatt Securities Inc. Trading Talk, Let There Be Light, Rosenblatt’s Monthly Dark Liquidity Tracker – European Edition, 23 June 2015, page 8, www.rblt.com/lettherebelight.aspx.

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News review : Regulation & compliance

Ian Rycott

July 31, 2015

NEW UTILITY TO REPLACE PROJECT COLIN.

Thirteen major global banks, ICAP and market infrastructure groups, the Depository Trust & Clearing Corp (DTCC) and Euroclear have joined forces with AcadiaSoft to create a new utility aimed at reducing the number of disputes over margin flows for over-the-counter (OTC) derivatives.

BNP Paribas, Citi, Société Générale and UBS are the newest members, joining existing investors Bank of America Merrill Lynch, Barclays, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, J.P. Morgan, Morgan Stanley and State Street.

The venture replaces ‘Project Colin’, which was set up by Goldman Sachs earlier this year but failed following the departure of its architect, Paul Christensen, in March. The utility will leverage AcadiaSoft’s MarginSphere, its electronic messaging service for OTC derivatives, ICAP TriOptima’s triResolve, its trade reconciliation service, and the Margin Transit Utility operated by the DTCC-Euroclear GlobalCollateral Joint Venture.

The new hub will provide workflow support for participants to issue and respond to margin calls, compare necessary inputs that include risk factor sensitivities, and enable participants to identify and minimise disputes at the input level before issuing margin calls. It will deliver operational efficiencies and improved risk mitigation processes and avoid considerable in-house proprietary platform adaptation and development costs. Moreover, it will reduce costly market fragmentation and drive standardisation, transparency and automation where it is currently lacking.

Regulatory changes that come into effect in September 2016 are driving the push to a fully automated margin process, including calculation and matching of margin, comparison of necessary inputs and agreement of calls and collateral movements. Market participants will be required to improve the quality of their collateral processes and reduce collateral disputes or be subject to substantial new capital requirements.

“The joint solution between GlobalCollateral, AcadiaSoft and TriOptima brings together many critical collateral management services, each designed to address industry needs around evolving regulatory requirements and increased collateral management operational burdens,” said Michael C. Bodson, President & CEO, DTCC. “The offering will be a significant step forward in the efficiency of the non-cleared OTC derivative markets.”

Tim Howell, CEO of Euroclear, noted, “As an open, industry-led market infrastructure committed to ensuring that operational platforms and services keep pace with regulatory intent, we are delighted to be part of this key initiative for the industry.”

He added: “The creation of this new open platform reinforces the importance of collaboration across the capital markets to reduce risk, increase transparency and improve operating efficiency for our clients.”

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News review : Fixed income

Ian Rycott

July 31, 2015

POLL SHINES BRIGHTER LIGHT INTO FIXED INCOME CONCERNS.

A straw poll of 200 buy and sellside market participants at the European Capital Markets Forum hosted by MarketAxess and TRAX found that 72% believe that there is not sufficient transparency in the European fixed income markets. This is in sharp contrast to last year’s poll where just over half believed further post-trade transparency was required.

The survey also revealed that 56% of respondents felt that pre-trade transparency under MiFID II will harm European fixed income markets, although 55% saw the post-trade equivalent rules as beneficial.

The delays to MiFID though have impacted their level of preparation, with nearly three quarters or 73% currently putting their plans on hold while finalisation of the level II text remains pending. The European Securities and Markets Authority (ESMA) recently postponed its review of standards for the regulation until September. This will cut the amount of time the industry will have to assess proposals ahead of implementation.

The final regulatory technical standards (RTS) were due to be submitted to the European Commission this July, with final guidance to be submitted in December ahead of an implementation date of January 2017.

Commenting on the results, Scott Eaton, Chief Operating Officer, MarketAxess Europe and TRAX, said: “The results of our annual European Capital Markets Forum survey show that there is still significant concern about the impact that pre-trade transparency proposals set out under MiFID II/MiFIR will have on fixed income market liquidity. However, it is clear that there is a growing consensus for further, well-calibrated fixed income post-trade transparency in Europe. We remain an active participant in dialogues with industry working groups and regulators to explore proposals which benefit the wider institutional market and ultimately end-investors.”

Other findings show that the overwhelming majority (90%) expect the number of counterparties they trade with electronically to rise over the coming 12 months. Furthermore, efficient trading technology is seen as the most important attribute in achieving best execution followed by strong dealer relationships and robust market data.

Around 65% of respondents also believe that the proposed Capital Markets Union (CMU) will play an important role in growing and deepening Europe’s corporate bond market. Only a small minority (8%) disagreed with the potential importance of the CMU initiative.

In addition, 74% indicated that they currently do not have a transaction cost analysis (TCA) tool but are planning on implementing a solution in the near future. A significant majority also stated they would build-out or buy a reference data solution, in order to satisfy instrument eligibility for transaction reporting.

Participants were split on their confidence to meet the Central Securities Depositories Regulation (CSDR) mandated settlement rate of 99.5%, with 56% either somewhat or very confident and 39% not confident at all.

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News review : Equities

Ian Rycott

July 31, 2015

RESEARCHPOOL MAKES ITS DEBUT.

As unbundling moves closer to becoming a reality, James Woodley, previously head of investment funds and Pedro Fernandes, former head of European exchange traded and structure products at Euronext have launched ResearchPool, a European research venue aimed at small to medium-sized asset managers, hedge funds and family offices.

The platform, which has over 2,300 research reports covering 800 companies on 42 exchanges, is hoping to create a pan-European marketplace and open-community for financial research, allowing producers to commercialise and distribute their content while also getting a better understanding of both retail and institutional investors’ needs.

The platform will operate on a fully transparent “pay-as-you-go” basis. In other words, the company will only get paid if a transaction takes place. This would be a small transaction fee of 75 pence per download and a commission of 15% of whatever the price is set at.

“ResearchPool brings research distribution into the 21st Century. For the first time, we combine open access and a transparent pay-as-you-go pricing model to research using digital technology,” according to Fernandes.

Although unbundling has been mooted for the past decade, MiFID II and the UK’s Financial Conduct Authority would like asset managers pay specifically for any analyst research or services they receive. In the past, sellside research was financed by the commissions that clients paid each time they bought or sold shares via a bank. In theory, this removes the potential for traders to give orders to brokers in exchange for additional incentives such as research, and not necessarily because it is the best choice for that order.

The proposed rules, drafts of which were published in December, have generated extensive debate both in the European Parliament and the wider market with critics claiming that this will harm smaller research providers and limit coverage. The UK, French and German governments wrote to the European Commission on May 22, arguing that the research rules go too far. However, despite the opposition, the rules are likely to be passed which is why existing players are exploring different configurations while new players such as ResearchPool are hoping to fill in some of the gaps.

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News review : Derivatives

Ian Rycott

July 31, 2015

GMEX SETS LAUNCH DATE.

Global Markets Exchange Group (GMEX), which is backed by Eurex has set 7 August for the launch date for its Euro-denominated interest rate swap (IRS) Constant Maturity Future (CMF) for trading and clearing on Eurex.

Market participants such as French bank Société Générale and broker RJ O’Brien, as well as high frequency trading firms Financial Markets Engineering and Virtu Financial will be live on day one, while Chicago-based Trading Technologies will allow connections to GMEX through its XTrader platform.

In addition, Eurex Exchange members can trade and clear the GMEX IRS CMF under their current membership. As of April 2015 onwards, market participants have had access to Eurex’s trading and clearing simulation environment to test internal systems and processes.

GMEX CMF is based on the Interest Rate Swap Index Average (IRSIA) and accurately tracks the interest rate exposure at each point on the yield curve by removing the expiry date and marking the contract to market against an IRSIA Constant Maturity Index on a daily basis. The result is that the contract facilitates the management of interest rate exposure without a constant need to re-adjust, and maintains the liquidity of a given maturity from two to 30 years.

The company was established in 2013 by CEO Hirander Misra, a co-founder and former chief operating officer of Chi-X Europe. It sells technology to other exchanges through its GMEX Technologies arm, and will offer trading in the new constant maturity futures contract through its London derivatives exchange.

Misra said: “On launch we expect the first levels of activity to be testing and watching things settle, and then pick up as volumes increase, but we expect to have trades from the outset. In my mind it’s a process rather than an event, and I see it as a soft launch.”

He expects interest to pick up over time: “When we went live with Chi-X, we were 5% of the market with eight participants, and for this market it’s no different. You need to get the sand in the oyster that creates the pearl,” he added.

Interest in swap futures has been gaining traction as new regulations have come into force pushing standardised over-the-counter derivative contracts, such as swaps, onto electronic trading platforms, with increased compliance and collateral requirements. Swap futures mimic the economic benefits of swaps and can be used for hedging in broadly the same manner while sidestepping some requirements.

The market is getting crowded with Atlanta-headquartered Intercontinental Exchange (ICE) having introduced trading in swap futures based on a methodology from Eris Exchange on June 29, while the Chicago Mercantile Exchange Group is a well-established player in the swap futures arena.

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OLD HABITS DIE HARD.

SEFs made their debut over a year ago but they have not taken off as expected. Lynn Strongin Dodds looks at the obstacles in their way.

THE CALM AFTER THE STORM.

Despite the hoopla, the HFT trader is here to stay albeit in a different form. Louise Rowland explains why.

KEEP YOUR GUARD UP.

Cyber-security is one of the hottest topics but it is not just one of those passing fads. Heather McKenzie looks at the threats.

UNINTENDED CONSEQUENCES.

Too big to fail has become the mantra in the CCP world. Mary Bogan examines whether the concerns are justified.

VAPOURWARE: FIXED INCOME LIQUIDITY.

Liquidity in high quality bond markets has taken a severe downturn, increasing cost and risk for fixed income traders. Dan Barnes looks at why structural reform may be needed.

DARK POOLS AND BEST EXECUTION.

In the first of a series of articles for Best Execution and in the run up to the implementation of MiFID II, Robert Barnes, CEO of European multilateral trading facility Turquoise looks at the past, present and future of dark pools, dark liquidity and block trading.

NEW UTILITY TO REPLACE PROJECT COLIN.

POLL SHINES BRIGHTER LIGHT INTO FIXED INCOME CONCERNS.

RESEARCHPOOL MAKES ITS DEBUT.

GMEX SETS LAUNCH DATE.

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