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Market opinion : The impact of regulation : Dodd Frank : Jannah Patchay

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IN THE SYSTEM WE TRUST.

Agora_JannahPatchay_770x375Jannah Patchay, partner at Agora Global Consultants, examines the Dodd-Frank Act.

The Dodd-Frank Wall Street Reform and Consumer Protection Act, to call it by its full and unwieldy title, hasn’t had an easy time of it since being signed into law by US President Barack Obama in July 2010. Beset on all sides by critics, it has faced the hurdles of implementation by no fewer than five different US regulatory agencies, accusations of regulation-by-footnote resulting in high-profile legal challenges, and criticism for its lack of foresight in dealing with the more nuanced aspects of market structure such as the credit intermediation prime brokerage model. Five years on, its threats are now more existential than ever: a slow, creeping repeal by stealth, combined with increasingly vocal criticism from insiders on the implementation track. Unhelpfully, many of its provisions remain as of yet unimplemented, making it even more of a target for opponents.

The global financial crisis of 2007-2008 highlighted the need not only for the creation of international standards and best practices in financial markets regulation, but also for effective mechanisms of supervision and enforcement. The crisis originated in a localised collapse of the US subprime lending market and subsequently spread to other countries, driven by a combination of the global interconnectedness of financial markets and the sophistication of financial instruments whose risks were near-impossible to fully ascertain. Along the way, it highlighted the ineffectiveness of existing regulatory transparency requirements and risk models in detecting systemic risk and preventing market contagion. The costs of the crisis to national economies, and their repercussions, are still being felt today. In the US, the collapse of AIG, Lehmans and Bear Stearns highlighted the on-going challenges of counterparty default risk, and provided increased incentives for a drive towards centralised clearing.

These and other recent national and regional regulatory initiatives were aimed at addressing the aforementioned shortcomings in the regulatory model. The Dodd-Frank Act is no exception, with Title VI (the Volcker Rule) focussing on separating out perceived high-risk proprietary trading activities from consumer deposit- and fund-holding. Title VII focussed on addressing the G20’s 2009 commitments to improving transparency, bringing OTC derivatives trading onto electronic, ‘lit’ venues, and imposing a clearing regime wherever possible, with margin requirements for un-cleared derivatives aimed at dissuading and, arguably in some cases, penalising such activity. Dodd-Frank’s first stumbling block was the regulatory infrastructure in which it must be implemented; even following attempts at structural reform, US regulatory agencies remain fragmented by function and product. The Federal Reserve, Securities Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation are all responsible for implementing overlapping parts of the legislation. This has led to a range of discrepancies and delays. All five agencies have differing definitions of a US Person, the fundamental unit of jurisdiction under Dodd-Frank. A sixth definition was jointly devised for the purposes of the Volcker Rule, which required a combined, collaborative implementation. The SEC lags behind the CFTC in its definition of the detailed Title VII requirements.

The CFTC, light-years ahead of other agencies in terms of both the detail and reach of its implementation, has faced an industry lawsuit for its perceived extraterritorial over-reach in applying transaction-level requirements (such as reporting, transparency and mandatory SEF execution) to branches of foreign banks located in the US. Under the guidance of former chairman Gary Gensler, the agency took its remit to safeguard US taxpayer and consumer interests to a level above and beyond anything anticipated by even the lawmakers. This was highlighted recently in CFTC Commissioner Christopher Giancarlo’s fascinating and bold testimony to a US House Committee, in which his criticism of the CFTC’s implementation of Dodd-Frank was scathing to say the least. Giancarlo noted the global market fragmentation caused by SEFs, and lambasts the concept of Mandated Trading on SEFs, which he maintains is not based on any actual legislative requirements. He also criticises the CFTC’s provisions on Margin Requirements for Uncleared Derivatives as being completely out of sync with those of the EU, and potentially detrimental to US firms and trade given its coverage of intra-group trades.

Giancarlo states in no uncertain terms his opposition to the rules, and his belief that they are fundamentally flawed, based on:

  • Adoption of an inappropriately US-centric futures regulatory model that “supplants human discretion with overly complex and highly prescriptive rules.”
  • The rules’ incompatibility with the “distinct liquidity, trading and market structure characteristics” of the global OTC derivatives market.
  • Driving fragmentation of derivatives trading on both artificial product and market lines.
  • Actually exacerbating the potential for market fragility and systemic risk through the adverse impact of the above on liquidity.
  • Most importantly, failing to live up to the original intent and letter of the Dodd-Frank Act as passed by the US legislators.

Giancarlo has not been alone in his vocal dissent. SEC Commissioner Daniel Gallagher’s closing remarks at that agency’s 24th Annual International Institute for Market Development were similarly critical not only of the agencies’ approach to implementation, but of the actual legislation itself, characterising it as a poorly thought through and inadequately planned “grab bag of legislative wish-list items, many of which had nothing to do with the crisis.”

Dodd-Frank’s weaknesses in both content and implementation have given its opponents ample ammunition and incentives with which to lobby hard against specific provisions on both practical and ideological grounds. Frequent political impasses between the Democrats and the Republicans have made it easier for the latter to use repealing amendments as conditions attached to their acquiescence on wider budgetary concessions. This is a poor outcome not only for the US, in terms of the failure to deliver a significant and much-needed piece of regulatory reform. Regulatory uncertainty is never healthy, and huge expense and effort on the part of UK and other non-US banks and market participants has so far gone into implementing Dodd-Frank’s onerous measures. Further repeal, for purely political purposes, will destroy much-needed trust in the system. However there is no doubt that a closer examination of the content and implementation of Dodd-Frank, wherever possible adopting a more consultative approach with the input of market participants and foreign regulatory bodies, is both necessary and desirable in order to deliver a truly workable solution to both regulatory and financial stability issues as well as cross-border challenges.

[divider_line]©BestExecution 2015

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Viewpoint : The impact of regulation : Cross-border transactions : Silvano Stagni

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Silvano Stagni

ONE LESS THING TO WORRY ABOUT?

Be29-SilvanoStagniSilvano Stagni, Global Head of Research at IT consultancy, Hatstand explains why cross-border transactions with the US will no longer be a headache.

The United States is targeting non-US owned banks that do not channel their transactions with the United States through their US branch or subsidiary. The good news is that implementing Enhanced Prudential Standards (EPS) rules will turn cross-border financial trades with the US into US domestic trades. The bad news is that EPS will mean that those transactions will fall under US jurisdiction and therefore Dodd-Frank will have to be fully implemented.

If a financial company executes cross border financial trades from a non-US based entity as a normal part of business, it finds itself in an interesting compliance position. (Activities carried out through a US branch or subsidiary are not within the scope of this article). If the organisation meets the extraterritorial provision of Title VII of Dodd-Frank, as implemented either by the CFTC or by the SEC, it must comply with the European Regulatory obligation under EMIR or MiFID I (for the time being) and with a sort of “Dodd-Frank light” for the American side. If business is conducted away from the US office (branch or subsidiary), it is not subject to any restriction on proprietary trading.

The only headache is cross-border compliance. If the financial organisation is a large Foreign Bank Organisation (FBO) with a turnover of above USD 50 bn (that is 50,000m), with significant non-branch based business in the United States above USD 50 bn it will not have to deal with cross-border issues beyond July 1st, 2016. Non-agency business will have to be conducted through an International Holding Company (IHC). The Enhanced Prudential Standards (EPS) will force the organisation to set up an IHC, which will be a United States-based company.

If the Enhanced Prudential Standards are applicable to the financial organisation, the following deadlines have been laid down:

  • July 1, 2016         Deadline of formation/designation of IHC. IHC’s must comply with EPS
  • August 1, 2016    Notification to Fed of IHC and compliance certification of IHC EPS requirements
  • January 2017      Submission of IHC annual capital plan to the Fed
  • July 1, 2017         Completion of transfer of all remaining applicable assets from FBO to IHC
  • October 1, 2017  First Dodd-Frank stress testing cycle
  • January 1, 2018  IHC Compliance with US Basel III leverage ratio requirements
  • January 2018      Submission of IHC annual capital plan to the Fed
  • March 2018         Summary results of company run stress test to the Fed
  • July 2018             Submit mid-year Dodd-Frank stress tests to the Fed

So, what are the consequences for a European based FBO to set up an IHC? What does it mean for a financial organisation?

Another Legal Entity must be created and an LEI acquired. All assets will have to be separated; all the relevant transactions will have to have the new code. For operational reasons it might be necessary to build a trail that permits the history of that client across the two legal entities to be seen. This may have repercussions on Client Management, Order Management and possibly other reporting or monitoring workflows.

A gap analysis between what is actually happening for the whole company and what EPS requires should not highlight any major issue to remediate because the Capital Requirement Directive and Regulation in the EU imply a stricter implementation of Basel III than the one effective in the US. In any case the ‘gap-analysis and remediation plan’ should be on record, just in case there is the need to prove that a plan to implement EPS exists, even if it has not yet been completed.

Clients will have to be onboarded by the IHC according to US rules. Although KYC requirement are fairly similar, the classification of clients and the action to take to ensure that they receive the required level of protection may differ between the US and Europe

The IHC will have its own data. The corporate database must be ring-fenced to allow a view of the IHC data architecture separated from the FBO overall data. EPS has requirements on data accuracy and this needs to be taken into account together with any requirement on data that derives from Dodd-Frank. An IHC is a separate legal entity so any licence or contract, for instance Market Data, would have to be reviewed and amended to ensure that this new IHC is either covered by the existing arrangement or has its own contract or licence.

The IHC is a new Legal Entity in a different jurisdiction. There may be Connectivity issues, system issues or any other potential changes deriving from the location of users or systems, etc.

It is possible that any of the points above will not only generate remedial action but be the trigger for further changes. This needs to be verified and ultimately taken care of.

If the volume of non-branch, or non-subsidiary, related business in the United States is below USD 50,000m the financial organisation is not subject to these rules. If the organisation is subject to these rules, this must be implemented prior to the end of 2017. In a way, EPS is fairly straightforward to implement in itself. ‘Unfortunately’, an International Holding Company (IHC) will be a US-based financial legal entity and therefore subject to Dodd-Frank, Volcker and other US practices. In 2007, at the time of the banking crisis it was estimated that over 70% of financial trades across borders happened between London and New York. Things have changed but there are still a considerable number of financial trades between the two major world financial centres each day. If the organisation where you work contributes to their number, you’d better start reviewing the total volume of trades carried out outside your US office. July 1st, 2016 is not very far away.

[divider_line]©BestExecution 2015

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Post-trade : SmartStream : Collateral Management

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 THE COLLATERAL CONUNDRUM.

Be29-SmartStream_SImon-LillystoneSimon Lillystone, consultant at SmartStream explores the different hurdles to overcome and the options on offer.

Has the delay in EMIR to next year pushed collateral management down the agenda?

Not at all. The changes required for European Market Infrastructure Regulation (EMIR), International Organisation of Securities Commissions (IOSCO), Basel Committee on Banking Supervision (BCBS), et al by collateralising firms are incredibly substantial, and firms are simply using the extra time to introduce new functions, processes, and solutions to deal with the complex requirements in a controlled, rather than uncontrolled manner.

Estimates for the shortage of high quality collateral vary. What do you envisage?

It’s not the focus of SmartStream to be guessing future ratios and liquidities in certain instruments or assets types. Instead, SmartStream is concentrating on developing the optimisation capabilities of its collateral and margin management solution, TLM Collateral, to enable firms to make the most prudent choices of assets they can from their available inventory, especially within the context of their primary business activities (eg. securities versus cash, which obviously differs significantly between buyside and sellside). At the same time, it’s true to say that the new requirements for initial as well as variation margin, and gross instead of net exposure will severely test firms’ ability to manage the impact on capital and available assets.

What do you see as the greatest challenges given the regulatory requirements in this area?

The ramification of the changes proposed by the various regulatory bodies are significant in every way – even just on a functional level – group thresholds, currency mismatch haircuts, initial and variation margin, gross rather than net, currency-specific margining, and so on. However, firms also need to have systems that can comfortably deal not only with the jurisdiction-specific aspects (eg. the differences between the Eurozone and the US being obvious ones), but also the timing aspects. For example, some regulations will come into force before others, and will apply to certain categories of institutions before others. Furthermore, these firms will still need to deal with the margining of their legacy OTC businesses, as well as their repo and securities lending activities. Therefore the greatest challenges are all about having multi-dimensional, flexible collateral and margin management solutions that can handle old-world as well as new-world business – and the impact on volumes and resources this brings.

How do you see financial service firms restructuring the way they allocate collateral?

As previously mentioned, the need to provide currency-specific initial as well as variation margin, combined with the restrictive opportunities for collateral re-use (the so called act of rehypothecation) and the denial of or meagre returns on interest on cash positions are going to cause all firms to focus on ‘optimisation’ – which will mean different things to different firms. For many, where volumes are moderate, and the business linear – this will probably amount to nothing more complex than preference management over the available inventory. For others, and some have already introduced this, they’ll be after fully-algorithmic solutions, such as TLM Collateral, that can simultaneously satisfy multiple margin calls with multiple available, eligible positions, utilising multiple optimisation rules.

How will it differ from the past?

If we’re talking about collateral (allocation), then in simple terms, in the past, collateralising firms would overwhelmingly use cash, since it was the easiest to handle, and the interest rates offered to one another were often very beneficial. Some even used term deposit structures since collateral might stay on account with one party for a considerable time without intermission. They would also structure their CSAs (credit support annexes) to include thresholds and other calculation parameters that would, in effect, limit the flow of collateral, and create a non-linear relationship between exposure and mitigation (which many would say was entirely legitimate, since the purpose of collateralisation is to mitigate credit risk – and no two firms are equal in this regard).

However, in the newly (over)regulated, and centrally cleared worlds, such things are made minor. Thresholds are largely out; currency-specific and gross margining are firmly in, and firms will need to dig deep into their available inventories to come up with the collateral to meet the new requirements, that would have been avoided in the past. Finally, they’ll also need to do this across the bifurcated derivatives business – simultaneously managing cleared and non-cleared margin requirements.

Will they continue to use a preference based system or opt for collateral optimisation?

SmartStream’s primary focus is to satisfy the needs of its customers and the markets in general. Our collateral management solution provides extensive and flexible integrated coverage for both simple optimisation (preference and priority-based functions) and complex optimisation (algorithmic, multi-threaded, calculation and allocation engines). To a large extent each firm, when they start to consider these options seriously will need to judge the cost-benefit analysis – and for many, at the moment, the preference-based route is still the most pragmatic one. However, there are many firms that are, or wish to be, heavily-inventory focused, and so the optimisation route is going to be the one for them.

If so, can you provide more detail on the inner workings, benefits and drawbacks of optimisation?

Since the goal of asset optimisation is to use one’s inventory in the best way possible (not just for the purposes of collateral management, but also for trading, liquidity, and capital management purposes), then it should be easily possible for firms to identify the benefits in their own context. The challenges (and perhaps drawbacks) are:

  • In the shape of re-designing the organisational structure. This means having a dedicated desk or function, whose primary focus is to use optimisation as a means of enabling all parts of the organisation to benefit from targeted allocation of available assets (inventory). In this regard, I could well see the traditional collateral management unit being the ‘margin managers’ – ensuring that all requirements for margin with counterparties are negotiated and agreed successfully. There is also the collateral manager who uses the optimisation engine to satisfy all the negotiated margins automatically, in the most optimal way (in contrast to the past where margin calls would be handled sequentially, in a single threaded, resource-intensive way).
  • That not only does the inventory change every day, but also the markets, and so margin requirements change. In other words, yesterday’s optimised inventory is not today’s, and so firms will regularly need to rebalance the inventory. This means looking at the existing allocations and comparing them with the current portfolio, market conditions, internal requirements and potentially generating multiple back-to-back substitutions. For example, recalling a now valuable asset, for one that is less valuable to the firm. TLM Collateral Optimisation can perform this rebalancing – but readers have to be aware that the act of re-balancing can not only create a lot of churn within the portfolio, but also generate additional costs to service the substitutions and introduce heightened settlement risks. The bottom line for firms is to spend sufficient time to develop an understanding of the net benefits and consider all the ramifications of entering into an optimisation programme.

What would the cost savings be?

There are two aspects to cost savings, if we are particularly focusing on the optimisation strategy. The first, which is maybe less tangible, is that the optimisation engine is trying to perform a multi-dimensional, multi-threaded method of allocating mitigants to obligations. Therefore one could say that each firm needs to decide what the criteria are for developing such a capability (and enshrining those parameters, metrics and rules within the solution), and then determining the cost-benefit in their own terms. The second, which is perhaps more tangible, or at least can be more easily quantified, is to compare the result from one day to the next of performing the rebalancing function and then seeing the delta. SmartStream has assisted clients with this sort of exercise on a number of occasions, and though one needs to see numbers in the context of the organisation concerned, it can point to a mid-sized European Bank that identified potential annual savings of some E8-10m. Furthermore, it observed that by performing the top ten recommended substitutions alone would deliver over 80% of the annualised predicted savings.

All this makes me recall my distant past in collateral management, when I marvelled at the audaciousness of the global collateral manager of a Swiss investment bank who rightly claimed, through his prudent selection and allocation of assets, that his department would be a profit, not cost centre. From then on few have explored this aspect of collateral management, where the value of the pools of collateral can reach many billions of Euros – and therefore the potential savings incredibly significant.

I suppose the good news is that new regulations, and the squeeze on liquidity that comes with it, has prompted optimisation to become critical to business continuity and, ultimately, success. n

Simon Lillystone has been working in banking and technology for almost 25 years, and the last 18 of these have been focused on collateral and margin management: first with J.P. Morgan, and then Deutsche Bank, before positions with SunGard, Omgeo, IBM, and now SmartStream. Prior to SunGard, Simon designed and created one of the first vendor solutions for collateral management.

www.smartstream-stp.com

[divider_line]©BestExecution 2015

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Market opinion : The impact of regulation : HFT : Daniel Simpson

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Dan Simpson

HIGH FREQUENCY REGULATING.

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Daniel Simpson, research analyst at JWG Group explains the far reaching impact regulation in Europe as well as other regions will have on the HFT community.

Ever since the 2010 ‘flash crash’ in the US and the subsequent publication of Michael Lewis’ Flash Boys, high frequency trading (HFT) has been high on the regulatory agenda. What HFT is and how it can be made ‘safe’ continue to be hot subjects of global regulatory debate, and ever increasing pages of legislation. However, despite HFT being a globalised practice by its very nature, it seems regulators are opting for many differing tools to control it.

The piece of regulation that is set to have the most holistic impact on HFT is MiFID II which is now less than 18 months away, and the closer we get to the 3 January 2017 deadline the clearer the scale of the impact becomes.

MiFID II will radically reshape the European market, making seismic changes to market infrastructure, mandated systems and controls and the way in which algorithms can be used to trade. It will also impact how clients are on-boarded, the rules governing execution and a plethora of other equally fundamental market concepts.

In keeping with global regulatory trends, MiFID II addresses algorithmic trading, and more specifically HFT, head on, so much so that it starts by reshaping the definition. Algorithmic trading has been defined fairly broadly and will include any trade in which a computer algorithm automatically determines individual parameters of an order, for instance, timing, price or quantity with no, or limited, human intervention. HFT is defined as a subset of this, whether a trading activity is classified as HFT ultimately comes down to the speed at which it is done.

Leaving aside the issues of what rules apply when a machine sits outside the European Union (EU), this means that the scope of activity to which these new rules apply is potentially huge. If you have a spreadsheet summing a few columns, checking a reference table and doing a VBA lookup on a server, you might well now have multiple algorithms to consider and control as one system, with one set of data licences and operational risk controls.

Under article 17 of MiFID II, investment firms engaged in algorithmic trading will be subject to rigorous testing requirements, the cornerstone of which is mandatory use of testing in a non-live environment. This also includes ongoing testing of systems, procedures and controls, targeted at ensuring that algos will not destabilise the market.

The depth of testing that will be enforced in practice remains unclear, but the extent that such requirements, particularly rules around cautious roll-out and non-live initial testing, have the potential to constrict the adaptability that makes such trading practices so effective is a key question. Also crucial to this debate will be how significant a change to an algorithm is. If a ‘self-learning’ algo decides to upgrade its behaviours, is that meant to trigger a comprehensive set of testing procedures?

A closer eye

National competent authorities will be empowered, under MiFID II, to request regular ad-hoc descriptions of firms’ algo strategies for monitoring purposes. The European Securities and Markets Authority (ESMA) have made it clear that, in order for a firm to comply with this requirement, they must keep records of any material changes made to their proprietary software. This will allow them to accurately determine when and who made the change as well as who approved it and the nature of that alteration.

Clearly this will create a large amount of new papering requirements for firms. The more critical question, however, is how will they disclose such commercially sensitive information?

To add further complication in the context of the operational changes that firms will be required to make in order to comply with MiFID II, ESMA last month announced a three month delay in the publication of the Regulatory Technical Standards. Instead of being published in July, the RTS will now be published in September. This creates a real issue for the many firms that were taking the view that their implementation teams need more certainty in order to operate, and were therefore delaying until July to seriously kick-off their programmes.

The problem is that leaving it until July was cutting it fine as it was, but by September there will be only 15 months until the new regime goes live, and that simply will not be enough time to complete all of the necessary changes. Firms must begin to run now with the level of certainty that they have.

The German model

German market participants will know that BaFIN, the German markets regulator has already introduced a regulatory framework for algorithmic trading firms that includes some of the MiFID II provisions. In fact in early 2015, ESMA published a circular that declared that algorithmic trading rules in the EU were converging, heavily referencing the German HFT Act.

However, there remain a number of key differences; for one, the aforementioned testing requirements are largely not included in the German framework. Rules which govern direct market access/sponsored access (DMA/SA) providers are another point of divergence as the required due diligence under MiFID II is much more aggressive for example.

Additionally, France has reworked its framework for the regulation of HFT with amendments to its Law on the Separation and Regulation of Banking Activities. Pursuant to this law, those using HFT systems to send orders to trading venues in France have to notify the country’s regulator, the AMF. The new rules also comprise increased record keeping requirements in that records have to be kept for five years on each algorithm, including its features and the transactions and orders issued by it. Beyond this though the French rules are not nearly as far reaching as the EU laws.

In general, there are substantial variations in the ways in which regulators are attempting to control HFT practices. This is not just in the common market of the EU alone, but also between the US-based Commodity Futures Trading Commission (CFTC), the Canadian policymakers, and the Japan Financial Services Agency as well as others. A collective view across all of these jurisdictions is necessary to understand fully the implications of the high frequency regulating that we are seeing regarding HFT.

[divider_line]©BestExecution 2015

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Fixed income trading : ETFs : Enrico Bruni

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Enrico Bruni

TRADING FIXED INCOME ETFs IN EUROPE.

Be29-EnricoBruni-TradewebEnrico Bruni, head of Europe and Asia business, Tradeweb.

As the phenomenal growth of bond ETFs in Europe continues, market makers and institutional investors are increasingly taking advantage of the new approach they represent for fixed income trading and portfolio management. Electronic OTC execution venues can further boost adoption of fixed income ETFs, primarily by offering interconnected marketplaces to trade the instruments’ underlying securities.

There’s no doubt that since the European exchange-traded fund market launched in 2000, the pace of its growth has been staggering. Combined assets for ETFs and exchange-traded products listed in Europe have broken through the $500 billion milestone, according to ETFGI, reaching a new record of $511 billion at the end of April.

The rising popularity of ETFs, particularly among institutional investors, is hardly surprising. They are low-cost, tax-efficient investment vehicles offering diversification, scope for innovation, and access to a variety of asset class exposures. Unlike traditional open-end mutual funds, ETFs can be bought or sold at any time during the day, allowing for a multitude of trading strategies.

A recent study by Greenwich Associates found that 25% of European institutions had used ETFs last year. The study also suggested that robust demand for fixed income products, both in terms of number of users and size of allocations, will drive ETF expansion in the years to come.

Despite the dominance of equity-based ETFs, whose market share in Europe currently stands at 68% (ETFGI, 31st May 2015), fixed income instruments have gathered net inflows of approximately $17.2 billion year-to-date, just $282 million below their stock counterparts. In addition, “buys” for bond ETFs on the Tradeweb European-listed ETF platform consistently surpassed “sells” for seven consecutive quarters to the end of March 2015, until a sell-off took hold in the second quarter of the year, reversing the “buying” trend in both equity and fixed income-based funds (see Figure 1).

This shift towards bond ETFs is driven by a number of factors – ease of use, efficient market access and liquidity – increasing their appeal for institutional investors and market makers alike.

Institutional investors have long recognised the considerable advantages fixed income ETFs have to offer when implementing “cash equitisation” or interim beta strategies to make strategic or tactical adjustments to their portfolio allocations.

In the equities world, investors can choose from a wide range of instruments – including ETFs, index futures or index swaps – to invest their cash balances into the market. In fixed income, however, there aren’t as many options for investors wishing to buy in, or remain invested in a specific market; they have to either buy a fixed income ETF or all the underlying bonds. By selecting an ETF, institutional investors are able to instantly gain beta exposure to a particular sector of the bond market in a single trade, and then gradually fine-tune their portfolio allocation.

Using fixed income ETFs as hedging tools

For their part, market makers have been steadily integrating bond ETFs in their hedging toolkits, which were previously limited to derivative-based securities. This is thanks to ETFs’ flexible and versatile format, which enables dealers to take long or short positions quickly and efficiently.

When selecting a hedging vehicle, index replication is vital. Unlike credit default indices, for example, whose constituents are equally-weighted, ETFs typically replicate a fixed income index more closely, allowing market makers to synthetically hedge a long or short “beta” position.

A cost-efficient vehicle for bond investors

Data extracted from the Tradeweb European-listed ETF platform shows that the bid-offer spread on fixed income ETFs can be significantly tighter than that of the underlying basket of securities. For trades executed on the platform between 1st April – 20th May 2015, the average bid-offer spread on the iShares Core £ Corporate Bond UCITS ETF (Ticker: SLXX) was 27.82 euro cents compared to the average spread of 97.5 euro cents for its bond constituents on 20th May. Similar figures calculated for the iShares Euro High Yield Corporate Bond UCITS ETF (Ticker: IHYG), the iShares Euro Corporate Bond Large Cap UCITS ETF (Ticker: IBCX) and the SPDR Barclays 0-3 Year Corporate Bond UCITS ETF (Ticker: SYBD) tell the same story (see Figure 2).

Trading fixed income ETFs

The main challenge for the European ETF market is fragmentation: liquidity for the 2,116 European ETFs/ETPs currently available is dispersed across more than 6,473 listings on 25 exchanges. However, electronic over-the-counter platforms have bridged the fragmentation gap, while simultaneously introducing functionality enhancements, not just around trade execution, but around the availability of data and analytics as well.

Electronic trading venues have also introduced innovation aimed at the fixed income portion of the ETF business. Two years ago, we launched a tool that makes it easier and faster to price and trade the basket of bonds needed for the creation or redemption of shares in European fixed income ETFs. The solution has made it possible for all transactions to take place in a single venue, resulting in a seamlessly interconnected trading experience.

A promising future lies ahead

ETFs are easier to transact than ever. As institutional investors and market makers continue to appreciate the benefits of bond ETFs and incorporate them in their day-to-day workflow, the instruments’ growth, both in assets and trading volume, can only go from strength to strength. Electronic trading platforms can play an integral part in the development of the fixed income ETF space by adding new functionality to increase efficiency and transparency, as well as to improve market infrastructure.

[divider_line]©BestExecution 2015

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Fixed income trading : e-trading : Anna Pajor

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Be29-AnnaPajo

PUBERTY YEARS FOR FIXED INCOME E-TRADING TOOLS.

Be29-AnnaPajorAnna Pajor, Managing Consultant at GreySpark Partners.

The technology landscape for fixed income trading is still maturing. Indeed, none of the leading vendors provide a comprehensive suite of technology for all activities that comprise e-trading. However, all vendors interviewed by GreySpark are planning an expansion of their offered functionality.

Electronic trading in fixed income began in the late 1990s. There were a number of factors behind its adoption. In Europe the MTS Group successfully persuaded the majority of national debt management offices to follow the Italian model and introduce a primary dealership system with forced market making obligations on the primary dealers. In the US the largest primary dealers saw electronification of the Treasury markets as a way to reduce their dependence and fees paid to the Inter-Dealer Brokers (IDBs).

In last two years, the development and commoditisation of trading technology for equities, listed derivatives and FX was the main enabler of the shift toward e-trading in fixed income. In 2014, there was an overcapacity of trading destinations compared with the volumes traded*. This overcapacity will be reduced by the increased electronification and the overall change in the market structure, where all-to-all (A2A) venues will gain market share over IDBs and voice trading.

Electronification will continue to erode the traditional voice business. Many market participants expect IDBs to struggle to maintain relevance as Dealer-to-Dealer (D2D) flow potentially moves to Dealer-to-Client (D2C) platforms such as Tradeweb and Bloomberg who offer D2D type capability and who may eventually operate an A2A model with a central limit order book (CLOB). Automation of voice business will be further driven by sales trading automation and the creation of virtual inventory.

A comprehensive technology stack for fixed income trading covers six areas: connectivity; trading; pricing and risk management; sales-trading tools; and e-commerce and client tools (see infographic). GreySpark’s survey of the leading technology vendors showed that none of them has a fully comprehensive suite (see figure; as of 2014). Connectivity is the most mature part of the offering, although it is not yet fully commoditised. This is explained by the fact that the early entrant to the fixed income technology space – ION – is specialised in the connectivity area and set a benchmark for all other vendors. Client structuring and risk tools are the least developed among all trading tools. That relatively low level of development is the reality for all asset classes, not only fixed income.

Connectivity is a ‘cash cow’ for fixed income trading vendors. In 2010 benchmarks showed that the fixed income divisions of the major banks were spending approximately five times as much on connectivity as their equity counterparts due to the high number of proprietary protocols and the absence of a standard such as FIX.

In 2010, the Fixed Income Connectivity Working Group was established bringing together a consortium of leading sellside banks, to initiate a collaborative project to establish industry connectivity standards for fixed income trading using open standards such as FIX and FpML. There were 21 Cash Bond ECNs and 17 SEFs with at least 18 different protocols between them that the Connectivity Working Group was tasked to address, getting them to convert their proprietary APIs to FIX or to promote the FIX API to be equally as performant as their proprietary API.

Not every ECN has adopted FIX as a protocol but enough have that it makes it easier for new vendor entrants to build connectivity tools at a much lower investment. Adoption of FIX is also helping those banks that are committed to getting off vendor solutions, who had a smaller number of gateways, to accelerate their migration. There is an expectation that under MiFID II a large number of aggregators will build connectivity capabilities out and they will do so in FIX.

Another challenge for trading tools providers arose from changing market structure for fixed income trading. The emergence of new trading models is an opportunity to review and rethink the technology infrastructure that supports fixed income trading businesses.

An emergence of new electronic trading venues – for example, swap execution facilities (SEFs) and A2A venues for bonds trading – will require new connectivity, aggregation and distribution engines. The plummeting price of data processing power, combined with the adaptation of data science to improve client services and bank profitability, will also create demand for a new category of analytical tools.

In addition to the challenge to keep up with the shifting market structure, e-trading technology providers should consider the risk of new entrants to the market. Equities and FX trading technology vendors look to differentiate their offering, and an entrance to the fixed income space is seen as a viable option.

Banks are reviewing their platforms on a regular basis, both in-house and vendor solutions. Cost pressures, commoditisation of technology, new markets or business functions, service and stability are factors for banks to consider when examining their platform, and look for alternatives to components, or entire areas, of their trading architecture. For example, uncertainty about the emerging SEF landscape and the leading liquidity venues has delayed decisions within banks on taking vendor solutions and commitments to lengthy contracts. Additionally, the historic monopoly of the biggest vendor on some markets has encouraged dominant banks to keep gateways in-house. However, management of market gateways can become a significant overhead; some markets require more than one gateway and gateways are updated on average twice a year.

The market for fixed income e-trading tools is going through a period of rapid development and change. This is a result of electronification, the adoption of FIX and changes to the market structure. There are at least three more years ahead of us before this part of FinTech industry will reach a plateau. n

Detailed assessment of Fixed Income E-trading tools is available at: https://research.greyspark.com/2014/buyers-guide-fixed-income-e-trading/.

*Trends in E-commerce 2014, https://research.greyspark.com/2014/trends-e-commerce-2014-2/.

[divider_line]©BestExecution 2015

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Fixed income trading : The electronification of trading : Sassan Danesh

Be29-Sassan Danesh
Be29-Sassan Danesh

A MARRIAGE OF TECHNOLOGY AND STANDARDS.

Be29-Sassan DaneshSassan Danesh, co-Chair of the OTC Products Committee of the FIX Trading Community, and Managing Partner, Etrading Software.

Innovation, they say, drives change. In capital markets theory, that change should improve efficiency and transparency whilst reducing transaction costs and risks. That’s the theory anyway. The technology revolution and its use in the fixed income market is a demonstration of how this actually happens in practice.

The bond market has changed from the days when salesmen travelled America, knocking on doors and inviting folks to invest in bonds. This retail element moved to trading ‘good bonds’ (now called Investment Grade) on exchange but mostly in odd lots. For institutional investors, round lots were easier to find over the counter and this latter model has endured to this day.

The size of the bond market, despite its traditionally old-fashioned trading approach, has continued to grow, reaching $100 trillion in March 2012. Both the government and corporate bond markets have contributed to this rise as they responded differently to the crisis in 2008: governments increased their issuance to fund their growing deficits whilst companies used the market, with its low interest rates and a decline in direct bank lending, to raise money.

The main effects of electronification to date have been in post-trade processing. The impact on the market has been as theory would have it: firms invested in reducing risks, settlement processes improved – banks created straight-through processing systems to settle the increased number of trades with minimal human intervention; standardised messaging protocols developed such as SWIFT to instruct custodians when and where to move newly dematerialised securities.

The impact of this electronification on pre-trade and trading itself has been more mixed. For other asset classes, such as FX and equities, electronic pricing, order matching and auto-execution have all taken hold. Trading itself has been given to algorithms that can seek out opportunities across multiple markets, driving prices towards ‘fair-value’. Bond markets have not followed that model. The heterogeneity of the bonds themselves and the particular needs of institutional investors have meant that anyone searching for the best execution in a large, round lot size often has to call dealers to find out the price to fill the order for the portfolio manager. These dealers either quote from their own inventory or source the inventory from other banks or investors.

Any market that grows with such rapidity is bound to create unnecessary risks and costs – not just for individual companies but also across the whole market. One of the ways these risks and costs manifest themselves is through proprietary or custom technical approaches that have created further fragmentation. These issues have been magnified by the credit crisis in 2008 and the continuing direction of regulation which has further impacted the resources of the banks. This fragmentation, together with the proliferation of proprietary technical standards has created high barriers to entry for new ideas and processes to take hold that could accelerate automation and increase efficiency.

It is not all bad news. The tighter purses and increased regulations are starting to lead banks and investors to think differently about how to address the problems the market faces. Increasingly, bond market participants are turning to open standards such as FIX in order to accelerate electronification in the pre-trade and trading spaces. Long established in other markets, FIX is a relative newcomer to the fixed income space but it is rapidly gaining favour. This is because FIX is a non-proprietary, free and open standard maintained by the non-profit FIX Trading Community under a balanced governance of the membership that comprises the buyside, sellside and vendor communities.

Market participants are also starting to work together in other ways to solve common problems. Collaboration to address common problems and share the cost of the solutions has been done before – a number of market utilities have been set up to solve market infrastructure issues. However, occasionally these have created problems of their own by capturing a larger than expected proportion of the value for themselves at the expense of the end-user community.

But banks and investors are learning. With projects such as Neptune they are building utilities that have non-profit embedded in their principles. Electronification, with its associated costs and risks across the whole technology stack, is starting to reach the point of commoditisation – this allows new utilities to be structured to allow end-users to capture the value from this commoditisation for the benefit of the community. It is a new approach that will no doubt have its own teething problems, but in the bond market, as in other markets, the old for-profit monopoly approach is no longer the main option being considered.

Furthermore, with an ever larger proportion of bond inventory residing with investors, the buyside community is also becoming involved in such ventures to ensure they are fit-for-purpose for the broad market community and to help work out the balanced governance such utilities will require.

To summarise, electronification so far has had only partial success in the bond markets, with the greatest impact to date being in post-trade processing. However, looking forward I am confident that by marrying the use of technology and open standards with industry-wide engagement to agree the required processes and controls, we will see much greater electronification in the pre-trade space as well. Furthermore, with the creation of non-profit technology utilities that involve the broader marketplace and contain balanced governance, the industry can ensure that the value creation from further electronification is passed through to end-users. With a bit more effort, we can prove the capital market theory correct in the pre-trade space as well.

[divider_line]©BestExecution 2015

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Fixed income trading : MiFID II : Gherardo Lenti Capoduri

Be29-Gherardo Lenti Capoduri
Be29-Gherardo Lenti Capoduri

LEARNING BY EXPERIENCE.

Be29-Gherardo Lenti CapoduriIn Italy the e-trading of bonds has a history of more than a decade, but is still quite new to the rest of Europe. Best Execution speaks to Gherardo Lenti Capoduri, Head of Banca IMI’s Market Hub, to find out about the implementation of MiFID II from the Italian perspective.

How would you characterise the buyside response to MiFID II’s transparency obligation?

MiFID II is casting its net much further than its predecessor, reaching beyond equities to a wider set of asset classes including fixed income and over-the-counter derivatives. We have observed a shift in the industry over the last two years; from resistance to the regulatory proposals, to increased buyside attention and the creation of communities to discuss the MiFID II proposals; then more recently to propose and support innovative solutions, which in some cases are being rolled out.

Since the introduction of MiFID in 2007, not every client has taken advantage of the implementation of the reform as announced, and not every European country has adopted MiFID in the same way. New regulations like Basel III, Dodd-Frank and MiFID II reach across the board and limit the liquidity of the markets. The buyside is concerned that as bank capital rules and structural reform increase the cost for banks to warehouse risk on their balance sheets, market making will become increasingly unattractive.

How has the dialogue between clients and sellside firms changed as a result?

I do not believe in a real ‘equitisation’ of fixed income markets. However, we are entering a new world. Due to the enormous number of bond issues and strict capital requirements, we expect a movement on the sellside from purely proprietary trading models to a hybrid approach, with proprietary market making wedded to an agency model.

We expect a shift from global players towards regional players where, due to the intrinsic nature of fixed income markets, systematic internalisers (SIs) or a web of SIs will play a primary role.

Buyside firms are concerned over the progressive weakening of their sellside counterparties. The classic and central market trading model, characterised by customer/sales-trader workflow, is going to be reshaped. It will still play a central role but more weight will be placed on flow generation and third-party order execution.

As buyside firms hold most of the inventory, they are looking at new execution models and new ways to provide liquidity, through ‘indications of interest’, information aggregation and new market models such as the central limit order book.

What is the greatest risk that clients face under MiFID II?

In my opinion, there are two main risks: lack of liquidity and increased costs. The risks related to the wrong calibration of the transparency rules together with an increasingly fragmented market environment might affect fixed income market liquidity for some financial instruments and markets, and lower levels of order execution. More efficient intermediaries have tried to mitigate these issues by offering customers an integrated book with more than one level of prices according to the relevant trading venues during the pre-trade phase. Smart order routing systems can dynamically direct the order to the best venue according to MiFID criteria, properly weighted in the post-trade stage. One of the main problems is that market data sources throughout the trading cycle have become increasingly expensive and would benefit from a consolidated pan-European post-trade tape.

While MiFID offered flexibility in determining and establishing the main characteristics of their execution policy, MiFID II is more deterministic in terms of defining instruments’ liquidity definition, transparency rules and threshold concepts such as large-in-size orders. MiFID is concerned with the full process-based set of requirements (including market structure as well as investor protection) that might be implemented by investment firms and intermediaries to fulfil the new obligation of establishing all reasonable steps for achieving the best possible net results for the client, when executing orders.

Best execution systems will work if the pull in different liquidity providers and different markets models is aggregating rather than fragmenting liquidity. In our view, this approach is especially interesting for clients, especially if combined with the additional liquidity offered by the broker on its systematic internaliser.

To ensure they can limit that risk, what do you they need to do?

Intermediaries need to set up the proper execution policy for the best execution of clients’ orders. The flexibility to manage and compare the different types of orders, market models, settlement instructions and client classifications, introduced by MiFID and developed in MiFID II, together with strong control over the entire execution chain represents the real added value for customers.

Some intermediaries are developing smart order execution tools to take in – in the same execution policy – traditional markets and OTC and to compare different execution models – request for quote (RFQ), central limit order book (CLOB), voice and many others. Clients could access regulated markets and OTC liquidity through innovative solutions that are provided by the sellside.

The goal is to aggregate and normalise, as much as possible, these two very different sources of liquidity. Concepts such as large-in-scale orders and products such as ‘order sweeping’ from one execution venue to another are also being developed. A virtual book, composed of bids and offers, coming from different venues and market makers, would be the best instrument to consider.

Consistent with the idea that there will not be an execution model winner, Banca IMI has developed its RetLots Pit non-systematic internaliser solution that is already active and is moving forward in the direction of integrating OTCs versus traditional markets.

On the buyside roles are changing, with the execution desk evolving from a pure order-taking model to a value-driver model. Innovation is essential because managing complexity requires technological support.

Are there precedents for the incoming model that can provide guidance?

Italy implemented MiFID reforms in a strict way, particularly regarding the retail market structure. It anticipated the inclusion of non-equity instruments, which is now part of MiFID II. Italy’s Banca IMI runs Market HUB, its multi-asset electronic trading platform covering equities, fixed income, listed derivatives and FX. In the fixed income space, the bank offers a high-touch service as well as best execution, and access to over 20,000 bonds by connecting to trading venues, OTC liquidity providers and offering additional liquidity on Banca IMI’s systematic Internaliser, RetLots exchange. Any EU country where bonds were traditionally a favoured investment instrument for the private retail investor will likely be better equipped and set-up than others where equity instruments, for whatever reason, were or are the instrument of choice for individuals. It is not surprising that Italy can teach the rest of Europe some useful lessons and export solutions based upon its history. The difficulties come in convincing people less familiar that this is the case.

There are many different market protocols in the Italian bond market which show that the ‘one size fits all’ is the wrong approach. With threats come opportunities and there are lessons to be learnt from Italy’s various solutions including EuroMTS, BondVision, EuroTLX, MOT but also Banca IMI Market Hub, a true pioneer in this space. Some are applicable elsewhere in both rates and credit. An often forgotten factor behind the healthy liquidity of the Italian bond markets is the liquidity of its repo market, at least in the government bond space. Again participation goes beyond pure inter-dealer.

Can both sides work together in preparation for the new regime?

Yes, they should work together to create a better execution model solution for credit and for large orders particularly. The use of electronic trading venues is welcome and the automation of smaller trade sizes in liquid bonds helps to process trades and reduce operational risk, while helping to promote transparency. I don’t see that a shift to an equity exchange model will be the way forward for credit because of the sheer number of bonds issued, many of which trade infrequently, at wide bid-offer spreads and which are inherently illiquid. Some of the solutions that have been suggested and developed attempt to bring order-driven markets to fixed income but that just doesn’t work. These markets are not feasible without market makers, except possibly perhaps for the most liquid, shorter-dated and risk-free government bills and bonds.

A consolidation in the future of the many venues currently operating will be needed to support liquidity. What will change is the flow generation process. Regulation will force standardisation and this lends itself to the automation of processes which up until today have been labour intensive

What are the key stages that firms must be aware of looking ahead?

MiFID II’s formal approval process will not begin until later in 2015, so at the moment the implementation measures are still under analysis. By the end of 2015, EU legislation on MiFID II implementation measures will have been adopted, with the formal approval process in motion. They will be finalised in the summer of 2016 and on 3 January 2017, MiFID II rules come into effect for all investment firms.

The correct calibration of the criteria to separate liquid and illiquid bonds with a periodical review (two different methods are under evaluation); and the criteria for the pre- and post-trade transparency obligation will be a key factor for the future development of the fixed income market.

[divider_line]©BestExecution 2015

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A Look Back: Unbundling

GlobalTrading tracks the issues that matter to you. In this special feature, we look back at the evolution of the unbundling conversation from 2013 to today.
Rudolf Siebel
David Lawton
Martin Ekers
Carl James
Clive Adamson
Edward StockreisserPaul Squires
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Traders’ Guide to Global Equity Markets Q3 2015

Convergex Biography Portrait

Convergex Biography Portrait
Troy Draizen

Welcome letter from Troy Draizen, Managing Director of Sales, Convergex:
Hello and welcome to the 2015 Q3 edition of the Traders’ Guide to Global Equity Markets. We are halfway through the year and there is a lot of change on the horizon.
Since Reg NMS eight years ago, there haven’t been any significant changes to the US market structure, until now. In the past couple of months the equity markets in the US and Europe have begun undergoing and planning a lot of major regulatory changes. The goal of Reg NMS had been to foster competition that would ultimately lead to price formation and efficiencies (democratizing US markets). But it did not cover everything— and obviously, the markets are constantly growing and changing, demanding new regulation to deal with unpreceded problems. The need for new regulations stems from the growing need for transparency and more limits on the potential abuse and gaming in the markets, as
well as:

  • Assuaging concerns about HFTs and front-running.
  • Meeting an increasing demand for transparency, especially into order routing.
  • Adjusting data requirements in dark pools.
  • Increasing level of protection in data feeds to avoid information leaks (ex: ITCH Feed).

But is there really a need for greater regulation? The easy answer to that is that there are always things in which we can do better. Interestingly, whereas before the regulation changes were driven by the US government, this time it’s driven by industry participants. In other words, the industry is no longer waiting for market structure to change based on regulation alone, they are beginning to drive change themselves. For example, NASDAQ launched an experimental access fee program, the buy-side launching Luminex, government launching Tick Size Pilot (despite the fact that the majority of industry professionals do not see this as constructive). In Europe, ESMA is now leading large scale updates of MiFID regulations, which will become MiFID II –about which Philip Gough talked about briefly in our previous letter.
With all these regulations, the markets are bound to change, hopefully for the better. But it’s not the intended consequences that are of great concern; it’s the unintended consequences that will keep us up at night – only time will tell.
A new edition in this guide is a chapter on Transparency: Net of Fees.
-Troy Draizen

Read the guide in full at: Traders’ Guide to Global Equity Markets Q3 2015

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