By Shane Worner, Senior Economist, IOSCO
It is an interesting time for the financial markets. As the impacts of the most recent financial crisis recede into the background, regulators globally are still in the process of reforming the financial system. Additionally, markets are in an unprecedented position; awash with liquidity. No longer are prices for some asset classes set by the economic principles of supply and demand, rather, central bank operations now act as a market-clearing price.
Many jurisdictions continue to maintain a highly accommodative stance on monetary policy. In the US and Europe, the central bank policy rates remain at levels close to zero. While this accommodative monetary policy is great news for bank profitability, unfortunately loan provision to the real economy, characterised by loans to non-financial corporations, has been declining. Obviously, liquidity is not a ‘silver bullet’ if it does not reach where it is needed the most – the real economy.
It is not all bad news, however. The recently published IOSCO Securities Markets Risk Outlook 2014-2015 highlights that much of the funding slack has been taken up by securities markets, with the importance of equity and debt funding markets growing. Globally, equity markets have shown strong growth in initial and special public offerings; in debt markets, corporations have been increasingly tapping bond markets for operational purposes. In 2014, the level of corporate bond issuances is expected to double that of 2005.
Additionally innovation is taking place through such funding initiatives as crowdfunding and peer-to-peer lending. Funding volumes through such platforms stand to exceed US $12 billion by end 2014. Although a drop in the ocean when compared to the scale of bank lending, crowdfunding is an example of innovation that is able to channel funding to where it is needed in the real economy.
This extraordinary liquidity is also flowing into more traditional asset classes. Equity market levels have been trending well in many economies. Traditional valuation measures, such as CAPE and Tobin’s q, indicate that US stock valuations are above historical averages and Europe is at fair value, while Asian indicators show an undervaluation by historical standards. In corporate bond markets, spreads to US treasuries are compressed to historical low levels.
Not surprisingly, given the liquidity effects on the return in interest-bearing assets, there is a search for yield or ‘disregard for risk’ phenomena taking place in markets. Issuances in products such as high yield bonds; sub-ordinated bonds; convertible capital (CoCo’s) covenant-lite loans and payment-in-kind (PIK) bonds are at all-time time highs. In effect, investors are showing a willingness to trade away credit hierarchy protection for increased returns.
This is coupled with increased levels of leverage and complexity in the system, which is becoming apparent in equity, bond and securitised markets. Margin debt is at an all-time high as participants leverage their positions into equities. Some of this can be explained by the level of financial leverage in hedge funds, which is also slowing creeping up. Since the onset of the crisis many hedge funds have chosen to retain unencumbered cash on their own account rather than placing it with prime brokers. In debt markets, there is an increase in both financial and non-financial bond issuances. Interest in securitised products remains the main story in Asia, where issuances have increased since 2008.
Although securities markets have stepped in to substitute the reduced bank-led funding of the real economy, many questions remain. One of the concerns expressed in the IOSCO Securities Markets Risk Outlook is how resilient the financial system is when interest rates inevitably increase.
The Growing Importance Of Securities Markets
The Rise Of Technology
By Gianluca Minieri, Global Head of Trading, Pioneer Investments
Over the last few years, the debate around the growing role of technology in the trading space has been one of the hot topics in the industry. It is unfortunate that due to growing concerns surrounding the wider HFTs topic, this debate has very often generated a negative perception of the role of technology in the financial services industry. I am generally considered to be one of the most sceptical voices in the industry in the whole debate about HFTs. The fact is that some of the discussions around high-speed trading and HFTs have become pure science fiction. Last year a press agency published the news that companies had started to use laser beams military technology and microwave dishes in an attempt to shave milliseconds off dealing time while behind the scenes others were planning to trim thousandths of seconds off execution time using drones as platforms for wireless links. I genuinely find these discussions surreal and think that we have gone too far. We seem to have lost sight of the fact that the primary purpose of financial markets is not to offer a place where speculation and short-term profit can flourish but to serve the needs of those supplying and consuming capital. The final objective should be to create a financial system that is capable of supporting companies seeking to raise moneyto invest into the real economy, so that their business can grow, create jobs and bring benefits to people and society as a whole.
I am proud to work for a company that puts fundamental analysis and the value of companies we invest in at the core of the investment process. In Pioneer Investments, we are in favour of technology and we strive to use it to exploit opportunities with the aim of providing a better service to our clients.
Technology is not only about high-speed. The advent of technology in trading has brought many positive things. It has enhanced the efficiency of financial markets, improved transparency and increased the degree of control that the buy-side trading desks have over their orders, just to mention a few. One year ago, this strong conviction led us to embark on a significant technology investment, on-boarding a global multi-asset order management system (OMS) capable of bringing all our trading desks around the globe onto one common execution platform, thereby providing the capability for greater support and more efficiency across different hubs. The concept of the global trading model, inherent in our new OMS, is the capability, where needed, to route orders to local trading desks and execute them in local time zones leveraging local market expertise at no additional cost. This global model will eliminate some of the inefficiencies of the trading process and should ensure enhanced capabilities to support the growing demand for multi-asset global products with potential for an enhanced price discovery process and better quality of execution.
Within the same initiative, we have also implemented an advanced execution management system (EMS) embedded into the OMS, which has been designed to complement and enhance the execution functionalities of the OMS. The new EMS has not only dramatically increased the percentage of trading volume executed electronically but has also enhanced traders’ capability to source liquidity from all available sources, from low touch and DMAs to algo trading and dark pools and to make that choice with the speed that today’s trading environment requires. The latter is critical when you have trading volumes in excess of 500 billion Euro annually across all asset classes with a huge variety of requirements and criteria in terms of how best to achieve best execution.
We feel that centralising all our trading activity on a common technology platform has given us an edge in terms of improving our trading capability overall and could put us ahead of the curve vis-àvis our peers and competitors. We believe it can result in a quicker decision making process, letting the firm react faster to volatile market conditions which may require a quick change in the trading strategy. The latter will minimise our alpha slippage rate, reducing the cost of trading and will eventually help deliver better performances to our clients.
Cross asset-class trading should also be easier to manage on a single global platform, especially for those multi-asset mandates which provide for investments in both fixed income and equity across regions, sectors and currencies.
This is an example of technology that is designed to serve the need of end investors and not the other way around and is a confirmation that technology can be of mutual benefit to investment firms and their clients, by improving execution quality, cutting down on manual inefficiencies, and reducing risks and costs.
In our view, other market participants are eager to explore how technology can help them to achieve the above-mentioned objectives and increase the percentage of trading volume that goes through electronic platforms. In my view, the degree at which this process will unfold will depend not so much from financial budget constraints but the capability of regulators and policy-makers to satisfy the basic requirements to establish a level playing field amongst all market participants. It is of critical importance that these actors are unquestionably perceived to be impartial when setting the rules aimed at creating more transparency and increasing the percentage of trading volume on platforms. Our primary objective is always to achieve the best trading outcome for our clients and if we feel that such an objective can be achieved away from electronic market, we will continue to do so by trading in a high-touch fashion in order to minimise market impact and protect the confidentiality of our orders.
Pointless to say, the situation is very different between equity and fixed income markets. While equity markets have probably gone “too far” from a technology perspective, creating the need for regulators to slow down the pace at which orders are executed, the fixed income world is still at an early age of development from a technology point of view. Despite the increasing number of electronic trading platforms and dealers, in fact, the liquidity in the secondary markets of these instruments has been constantly reducing over the last couple of years, mainly due to the lack of information and communication between them.
When you have so many different venues each with a different set of communication standards, the search for liquidity becomes extremely difficult and creates a gap which only human intervention can fill. In our view, the role of technology in this space has to be aimed at creating some form of aggregation tool which can act as a source of liquidity. In order to do that, the creation and adoption of a common language by all venues in terms of standards and the development of a communication network between them is a prerequisitefor a real development of the fixed income market. Especially in the more illiquid instruments, where the need for more transparency is increasing, these challenges are harder to get addressed through electronic platforms. Well calibrated post-trade transparency rules for these types of instruments might be crucial to give market participants the confidence to rely more on what they see on the screen, which in turn will make electronic trading more efficient. This point is an obsession for me and I try to reinforce it every time I meet with brokers. There is still a lot to be done on RFQ protocol, where brokers still freely advertise prices at which they are unwilling to trade. This practise has to be discontinued and we, as buy-side, should all aim to put more pressure on to promote more reliability of prices and push for more automation. It is clear that no single company can afford to lead this by itself. That is why we continue to be very proactive with vendors,peers and the sellside on every proposal that is aimed at enhancing quality of execution by standardising connectivity through multi-participant networks. We believe that the buy-side should continue to have an active role in this space and together with all markets participants should push for an industry-led solution, including the sell-side and exchanges which so far have not always had a proactive approach to addressing these issues.
Fixed Income In Brazil – How FIX Can Help Organise The Market
By Dr. Christian Zimmer, Head of Quantitative Portfolio Management, Itau Asset Management.
Brazil is a tropical country with fruits that can’t be found in most other countries in the world. The jabuticaba is one of these fruits. The thing that makes the jabuticaba interesting is that it grows on the trunk of the tree and not on the branches.
This fruit is often used to represent an interesting part of Brazil’s culture when it comes to IT and financial solutions: things are done differently than in other main international markets. And sometimes the jabuticaba analogy is used to justify a status-quo. Change is never easy, and we can see this in the fixed income markets in Brazil.
The actual fixed income market is obviously more liquid for government bonds than corporate bonds. The average daily number of transactions from Jan/14 to Oct/14 of government titles was 2,680. This is equivalent to an average daily financial volume of ca 22.5Tri BRL. Compared to the same period in 2013, this represents a decrease of around 13.5%
All public papers are cleared at Selic, a unit of the Brazilian Central Bank. Private titles are not registered at Selic although private entities may receive permission to do so. However, corporate bonds are registered with Cetip, the local depository for OTC, private securities and derivatives, which as of Sept 2014, housed 5Tri BRL, representing 97% of the Brazilian market. The BM&FBovespa is their biggest competitor.
When it comes to trading, actual liquidity represents only a small fraction of overall volume. With the use of the Delivery for Payment principle, it is fundamental to have access to the registration of the paper’s owner. This explains why, contrary to the equity market, the electronic platform for bond trading of the BM&FBovespa does not show any liquidity. As alternatives, one might trade public and private bonds either on the 2013 created Cetip Trader platform, or the TSOX interface from Bloomberg.
Cetip’s platform has mainly flow from local Brazilian players. Regulation for Brazilian funds demands publishing trades of private bonds at the REUNE system from Anbima, the local fund regulator. The objective is to obtain more transparency on prices. Cetip Trader is, right now, the only trading platform certified for direct integration with REUNE.
Bloomberg’s TSOX solution has a better insertion in the international market and thus shows mainly north-south flow. Most of their clients are not subject to Anbima regulation so the integration with REUNE is not an issue for them.
Throughout 2013, starting from March when Cetip Trader went live, 100Bi BRL were traded at this facility. During the first nine months of 2014 93BiR$ were traded, thus showing signs of stability. Observe that this is not daily volume, but accumulated, thus representing a very low fraction of the overall market. Trading activity with the Bloomberg interface is higher, showing about 60Bi BRL in the last three months – equivalent to an estimated 180Bi BRL for nine months.
Curiously, the FIX Trading Community (FTC) best practices document for cash bonds – as of version 5 from May/2014 – interprets Brazilian bonds, as well as venue to buy-side connection as out of scope. Why is this so? Having Brazil not on the global landscape is not surprising, but the communication between venue and buy-side is a relevant practical issue in Brazil.
The trading situation in Brazil, until now, has been characterised by direct buy-side interactions. This is partially caused by the fact that a big part of the volume is traded by bank-held asset managers and moved via their own treasury firms. Within this universe, individual counterparty restrictions apply. The typical broker task of facilitating access to the exchange is thus not obligatory. The setup is more like in an FX market where the final counterparty is exposed. The possibility and necessity to define which counterparties can be traded with is a functionality that should be configurable within the platform.
The Cetip platform shows the dealers’ offers and not the final counterparty. This is an expected behavior. But, how can the buy-side be convinced to use a dealer when the actual buy-side to buy-side trading avoids any kind of brokerage fees? The flow at Cetip Trader is mainly caused by manual entry on Cetip screens giving the buy-side direct access.
Recently, Cetip released a FIX interface. It is expected that this helps to get more flow from electronic trading and portfolio management systems. The solution for Cetip Trader uses FIX 4.4 and is based on the ICE technology also used for Creditex Realtime and ICE Swap Trade. The two latter platforms are actually on FIX 4.2. For trading at Cetip, the custom tag 9883=IDB can be specified. The 4.4. FIX connection for bonds allows us to trade different instruments, identified by the custom tag 9802 for the trading sector: Brazilian Bonds (9802=BZD), Brazilian Casadas (CSD), Brazilian Corporate Bonds % DI (DDI), Brazilian Corporate Bonds DI+ (DIS), Brazilian Corp. Bonds price traded (DPU), inflation linked corporate bonds (IDI), prefixed corporate bonds (PFA), inflation indexed Brazilian Govt. Bonds (PIC), indexed Brazilian Govt. Bonds Long (PIL), prefixed Brazilian Govt. Bonds Long (PPL) and Short (PPC), and post-fixed Brazilian Govt. Bonds (PUP).
The 9801 tag defines the code of the instrument type, thus should be “B” for bonds. Finally, the 9701 tag has an interesting feature that might be used for contemplating the necessity of direct buy-side accesses versus dealer-intermediated trades. It is used to represent the trade source and can have, among others, “K” for block trade, i.e. an already arranged trade between two buy-sides.
As a result of low liquidity in the secondary market, position adjustments are often made by direct fund transfers. One possibility to achieve this is with RFQ, message type R. The quote request type would be “FundTransfer” (303=99).
In general, it can be observed that the Cetip FIX solution is making massive use of the custom tags in order to specify all the details the bond market has to offer. As this FIX interface is still new and now being promoted in the local market, it is this flexibility of custom tags that can and should be used to further promote liquidity. For example, it may be of help to converge the different interests of dealers to be the intermediator at the trading venue versus the buy-side interest to work on pre-defined counterparty position transfers.
With the help of the international standard from FIX, based on the ICE FIX-engine used for other markets, expectations of the local participants are that fixed income trading will not result in a new Jabuticaba tree. During the 2014-FIX Trading Community conference in São Paulo, it became clear that the strong and focused local community is highly inclined to plant something more like a coconut tree.
Buyside DIY : Lynn Strongin Dodds
At first glance, there may not seem a need for yet another execution venue in the US. As it is, equity trading is fragmented across 13 public stock exchanges and an additional 50 alternative platforms. However, Fidelity Investments has amassed a formidable team of nine heavyweights including BlackRock, Bank of New York Mellon, JP Morgan Asset Management and T. Rowe Price to launch Luminex. In part this may reflect disappointment with what is on offer but also a desire to have more control over their trading destiny.
Overall, it has been a hard time for dark pools. Regulators have shone an ever brighter light into their practices while the publication of Michael Lewis book Flash Boys brought unwanted attention. It argued that the market was skewed in favour of high frequency traders (HFTs) as well as banks and exchanges to the detriment of institutional and retail investors. While these factors may have been a contributing factor behind Luminex, the idea for a buyside venue has been germinating for the past two to three years. Asset management groups did not only want to increase their technology spend to avoid showing HFTs their hand but decided banding together could prove a more effective way of lowering trading costs and minimising the HFT impact.
The question now is how much traction will Lumina garner? The model bears a resemblance to venues already in operation, especially Liquidnet which opened in 2001 and serves 760 fund companies in 43 markets worldwide. It is also targeting the same segment as new kid on the block, IEX Group, which is hoping to gain exchange status and is owned by a consortium including hedge funds and mutual funds. There are also those waiting in the wings such as Plato Partnership, a venture backed by both leading fund managers and investment banks, which also aims to increase transparency, protect orders and lower trading costs in Europe.
It is of course early days to predict the future but Luminex does have some advantages. For example, it is owned and used by the buyside which should enable users to avoid exchange fees and exert the much sought after control of liquidity flow. Also, given the size of the participants, there should be deep pools to dip into and in some cases they will be able to cut HFTs firms off at the pass. However, most importantly, it will allow the buyside a ringside seat at the market infrastructure table and have a voice when rules are being formulated.
Lynn Strongin Dodds, Managing Editor
©BestExecution 2015
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Indicators Of Trust
UBS’ Ross Hutcheon Explains How Redesigned IOIs Help Modernise Liquidity Distribution.
Indicators of Interest (IOIs) were one of the first things traders used the FIX Protocol for, long before automating trades. It has been around the longest, but development has slowed the last few ye
ars. In the interim the focus switched to the order execution process: orders, execution reports and ultimately, trading algorithms.
Historically brokers sent out high volumes of IOIs, both naturals and also those indicating a willingness to trade. There was a large amount of resulting ‘noise’ and as a result the buy-side had struggled to gain as much value from IOIs as originally hoped for. As a result, some firms like Capital Group decided to turn off the traditional IOIs.
However, IOIs have more to offer. Investment banks and brokers are working out the best way to distribute merchandise and attract the other side of the trade. More than redesigning IOIs as a product, considerable effort has been given to the liquidity distribution infrastructure, with the goal that each IOI contains more information that is useful to our clients. To this end, we developed our centralised risk book (CRB) to centralise and hedge our risk and subsequently distribute liquidity to our clients. We are live with aspects of our CRB in all regions (Asia, Europe and the US) and we are piloting the use of aIOIs in the US, with plans to extend further.
This covers the spectrum from:
a. Natural IOIs – traditional order: a buy-side order in one hand the broker wants to match,
b. Risk unwind actionable IOIs (aIOIs) – the broker is showing liquidity that they are trying to unwind,
c. Brokers sending aIOIs, quoting risk/stop prices – the broker is making a market; taking on risk and unwinding it (e.g. subsequently trading out of).
The three scenarios above are treated differently by the buy-side. No single type of IOI is necessarily better than the other, but providing the added information empowers the buy-side trader.
This concept ties in to what some of our more forward thinking clients are doing with their internal processes. This can help clients determine, on an order by order basis, if they would benefit from interacting with that liquidity.
An IOI is a mechanism to distribute liquidity to your key partners; it is not a product in itself. Conveying more information in IOIs better enables the buy-side to decide whether to interact.
The fundamental business of stock broking is still the same; matching buy-side traders with the liquidity they want. The aim of the new infrastructure is to efficiently centralise liquidity and provide more transparency; we believe that is something the buy-side wants. Any process we put in place does not replace the trust and relationships developed over the years, but rather helps to systemise the process.
The last two scenarios, where the broker is making an automated risk price and unwinding risk, can be automated. In the first, where brokers actually have a traditional order in hand, those IOIs are always going to lead to a conversation. We would typically not send out an IOI showing the full size of an order, but typically show part of the order, to start a conversation. Net result is that we could end up trading substantially more than what the IOI shows.
Bottom line, you can augment that human relationship with technology but not replace it.
The Changing Use Of Client Commissions
Joe Kassel, Global Head of Dealing & Exposure Management at AMP Capital, outlines the effects of the FCA’s proposed rules for the usage of client commissions on the buy-side.
Recent joint statements from the UK’s FCA and Europe’s ESMA have re-focused attention on Commission Sharing Arrangements, asking the buy-side to revisit their relationships with research and execution providers across jurisdictions. In recent years the uptake in usage of CSAs has allowed asset managers flexibility in implementation, to meet their best execution obligations but has still not fully satisfied regulators that client commissions are being managed to maximum effect, nor fully resolved concerns about conflicts of interest. The FCA in their most recent discussion paper on this topic appears to be distancing itself from its principles-based approach in favour of a far stronger view. The FCA are arguing that the only way to eliminate any conflict between managers and their clients, as it relates to usage of client commissions, is to more or less eliminate using commissions for any research purposes with a limited exception for minor non-monetary benefits.
Our view is if buy-side firms act ethically by managing and making transparent any perceived conflicts arising from turnover and ensure any use of client commissions for research meets a specific standard, and that brokerage fees are commercial and market based then this is in the client’s interest to do so. Where there are concerns pertaining to market conduct, they should be closely regulated in a transparent way to ensure information is available to all investors at the same time.
How to pay
Considering the usage of client commissions, the test should be whether the use of those commissions accrues directly to the client whose commissions are paying for that trade. The commissions that buy-sides pay to brokers for execution and research are known, but more importantly, they are an explicit component of the investment performance of funds in our portfolios. The buy-side must give account directly to the customer whose commissions they use for that purpose.
The FCA’s proposal is that investment managers must pay for research using their own resources, and then seek to recoup through increased investment management fees. What has not been fully acknowledged is that in practice this is already occurring. For example, if a firm is 90-100% reliant upon their own internally generated research, then the commission rate they pay for executing trades should be an execution only rate. If another firm uses varying degrees of third party research, which they pay for using client commissions, then that should be reflected in an incremental commission rate. Those numbers are all known and are provided to those firms’ clients. The money management model is part of a firm’s client strategy.
It is worth noting we differentiate between soft dollars and commission sharing arrangements. AMP Capital does not participate in soft dollar arrangements because it carries very specific connotations which we are strongly against e.g. paying for hardware or raw data. For value adding research we do currently use commission sharing agreements, and as a percentage of total firm commissions they account for approximately 15-20%. We consider this key to being able to meet our best execution obligations by only dealing with brokers which meet required execution capability criteria.
To pay for third-party research, the research must meet certain criteria, such as being capable of triggering an investment decision, representing original thought, having intellectual rigour and involving analysis to reach meaningful conclusions.
The application of those principles varies, but the principle is now well understood, certainly in Australia, that to qualify for payment, research has to be original and value adding and most specifically, for the direct benefit of the particular client whose commissions are being used to pay for that research.
The big point that should not get lost is the need for strong regulatory oversight to prevent the misuse of client commissions because in the past there have been clear examples of misuse. The very simple test should be that the use of a client’s commissions is in that client’s best interest.
Global conversation
The ideal solution is for globally agreed standards and requirements regarding CSAs because of the operational efficiencies of not having to create rules for every jurisdiction’s requirements. For example, IOSCO or various regulators could frame workable measures while honouring the original market-based, competition-friendly objectives they value.
The FCA and ESMA’s comments received so much global attention because they spoke collectively on the topic. After a period of silence on this topic, it is appropriate for the industry to have consistent guidance from all regulators. The quality of the measures they choose will determine the uptake of similar rules in other regions.
The technology gap
Historically, CSA’s were openly promoted by the regulator, particularly by the then-FSA, to encourage independent research and foster diversity in place of the investment banks’ oligopoly on the provision of research. However, it has not had success creating a single delivery mechanism to enable the proliferation of independent research.
At one extreme, where the usage of client commissions to pay for research is completely prohibited, that will impact trading commissions because the conversation is about the bundled commission rate. That application of technology has brought the real cost of trading down. For example, commission rates in Australia in the last ten years have arguably dropped the better part of 15-20 basis points in terms of a blended rate to the current single-digit level.
The point should not be lost that to the end investor, a significant outcome has actually been achieved in the form of lower costs and streamlined research requirements from investment managers, as well as the service research providers can afford to provide in a low commission rate environment.
Amongst the bulge bracket firms, the provision of research is more differentiated than in execution services. The idea of any one firm being better at execution can change quite quickly. No one firm has a natural advantage on execution services on a stand-alone basis, and if the industry moved to a place where execution was the only input as with whom buy-sides deal then it could be less stable than it is now.
As an industry we have come a long way. Our most recent internal review, conducted this year, focused on our role as a global asset manager rather than just Australia, and our approach was to find the highest common denominator. In that context, we leaned closely on the FCA’s previous CSA guidance from 2006, when they started clarifying what client commissions can be used for in terms of execution and research. Their principles-based approach anticipated that the industry itself would agree and standardise, and we still believe this can happen.
Constant Evaluation
With J.T. Cacciabaudo, Senior Managing Director, Head of Trading and Sales Trading, Sterne, Agree & Leach
In this world of regulatory scrutiny, as well as from a risk management point of view, it’s best for the buy-side to have FIX connectivity, no matter what the cost, with two main consequences. Firstly, there is never an error that cannot be identified as far as the broker is concerned, because if the order is on the wrong side or quantity, it was entered by the client. Secondly, as far as transparency is concerned, the buy-side see every execution: they follow every execution in this world of high frequency trading and they’re concerned about toxic order flow. They want to know whether it is being executed and what size of their order’s being executed in the exact executions.
Because of that, a firm like ours has to factor in a much larger expense on FIX connectivity. The buy-side client has their capital line, the buy-side Execution Management Systems (EMS), and then they have their OMS, the complexity of which will be based on that firm’s size and the expense of the system. Chances are when launching, a firm wouldn’t go for the most complex system. There are a lot more of the smaller networks entering this space to provide differing levels of functionality to the buy-side, and therefore, for the sell-side, the number of providers that they have to connect to and maintain contact with is growing. There are a lot of smaller OMS or EMS providers for the buy-side, and I have to deal with an ever-growing list of providers. Following this the competition started between the internet providers rather than direct FIX connectivity, and subsequently there was pricing competition, in terms of the more connections you send my way, the better pricing I’ll give you. That was a result of the network providers having their fixed costs and realising that they can offer better pricing if I have bigger market share; I’d still make more money because my cost will not increase.
A full time job
As a result, I found myself managing all these relationships, and having to have constant meetings because with each one I wanted to get the best pricing. Basically the biggest expense that I had running a sell-side operation became FIX connectivity. Because of that, I was dedicating a lot of time to it. I could meet with a FIX provider once a day, and then I could try to rework the way my connections were sent based on the next best deal I got. I found myself inundated with dealing with FIX connection providers and it became a significant distraction from my primary responsibility, so we started looking at outsourcing.
And what I realised was that for the amount of money it was going to cost me to have a FIX provider, it was almost the equivalent to hiring someone to do this full time, and in my mind and based on studies and reviews I examined, there were potential cost savings and services that a provider can give me access to that I would never have been able to attain.
The second area is that this provided a value proposition from a regulatory point of view. I had someone that was now monitoring this on a regular basis from a risk management point of view. And it was a lot easier for me to interact with one provider that could represent me, and this one provider had access to more solutions than I did because they were in this business on a regular basis, and they were acting with the end client on a regular basis.
When I evaluate the spend on my income statement on the business that I’m responsible for, I look at it from a Tier 2 point of view. This is not necessarily a fit for a bulge bracket in my opinion because they have much larger infrastructure, a much larger spend, and also they have a much more scaled technology. However when I look at my overall technology budget it drives me to outsource a number of different services and then have the ability to take advantage of knowledge and experience in those firms’ specific fields to realise the technology, rather than trying to work with my own technology budget or internal technology staff. It is far more cost effective when I am willing to consult with the experts in this specific field, and that pertains to FIX connectivity, it pertains to the OMS, and it pertains to data information flow.
A rolling review
How often we change providers and analyse the services we are outsourcing depends on the evolution of my specific firm. If my firm’s revenues grow five-fold and that allows for a larger technology spend, then at a certain point, it becomes more cost effective to bring various pieces of the tech stack in-house.
That’s when firms can maximise the technology services that outsourcers can provide versus what we can do in-house. As a firm we have to be constantly monitoring what is becoming a commoditised offering or function that I need to take advantage of. For my firm, it will benefit us to utilise outsourced providers for some time to come.
Basically, when it becomes scalable internally, it will be worth it for me to bring any given piece of technology in-house.
What I do look for constantly is alternative providers for the technology I have outsourced. I’m always reviewing the providers we utilise and could utilise to ensure that I’m getting, first, the best price and second, the best service.
As I grow revenue in a specific product, I’m looking to make sure that I have the correct technology and capacity for the growth of that business. For example in the options world, we’re slowly adding FIX connectivity for a lot of our options clients. When we were a smaller business, it wasn’t worth it. Our options business has tripled in size over the past five years and now it’s worth it for me to pay more attention to FIX connectivity; that’s going to be part of the service that I’m going to expand and I may want to look to upgrade my OMS and look for the optimal provider based on the size of my business.
When I need a top-of-the-line offering because of the amount of business I’m doing, I’ll buy it, but I think in that 3-5 years, it’s more of a matter of constantly looking at the upgrade cycle and the service providers that I use. It’s an ongoing analysis and a constant conversation to be looking at the different providers and different offerings and different price points.
With contracts lasting anywhere from 12-24 months on an auto-renewal basis, it’s our job to be in front of it, to be on top of it. One of the things is that the bigger we get, we look for providers that offer multiple services, as then I have more pricing power; rather than using six different providers for six different things. If I can get one provider for three of those things, it’s usually more cost effective.
This is a more and more a commoditised business. Execution is more efficient than it’s ever been. Every 15 basis points on income statement makes a difference and I pay attention to it because it allows me to make sure that I have the money to re-invest in my business and keep growing our offerings.
IOIs Evolve As Buy-side Demands Greater Specificity
Capital Group’s Christopher George lays out the case for improved IOIs and the technology upgrades required.
Indicators of Interest (IOIs), a staple on buy-side trading desks, are due for an upgrade. Across buy-side trading desks, the IOIs traders interact with, either through Bloomberg or older OMS systems, were not meeting traders’ needs. Our head trader and a few of lead traders from multiple regions met to figure out what made the current IOIs less desirable and what we could do systematically and procedurally to make them more useful: in other words, to actually provide clear indications of interest.
The FIX Protocol currently allows for some generalisations or ambiguity. For examples, small, medium and large size labels without a definitive price were not particularly useful to buy-side traders. At a minimum they were noise. At their worst, they were outright fishing. We constructed some in-house rules of engagement, outlining the messaging requirements that would allow IOIs to be shown in our OMS, thereby dictating which IOIs could be viewed and acted upon by Capital Group traders.
Our goal was to make this as seamless and as painless as possible, leveraging the FIX Protocol’s standard tags and the existing Bloomberg IOI specification for sell-side firms. Essentially, we required pieces of information the FIX Protocol deemed optional, and more rigidly defined them. In particular, we drew up very stringent rules around categorising whether IOIs are a true natural, a principal-natural hybrid or a true principal IOI offering. We also set fairly rigid rules around pricing to support tagged or limit-priced IOIs.
Lastly, we wanted the sell-side to provide as much colour as possible, so within our rules of engagement, there are ways the sell-side could indicate the IOI’s origin, the desk or type of transaction we are handling as well as pre-formed comments. We encourage sell-side brokers across the globe not only to meet the minimum standard outlined, but to provide us as much rich detail as they can because the more information they can provide to buy-side traders, the more likely traders are to engage.
Our trading partners around the world support and understand the broader buy-side’s need for greater transparency and accuracy around IOIs. While most are enthusiastic about working with us to tailor the flow coming to our traders, other firms are concerned about being left behind in terms of exploring this as an opportunity to engage. The firms we reached out to or at least conversed with have all seen the need and been willing to partner with us.
The response depends on the amount of transactions they want to expose to us. Based upon our definitions of the type of flow, some firms send IOIs for anything they can. Others are only willing to send indications of interest for pure natural orders. The engagement is cautious but the sell-side understands the need and that is most important.
The main impediment we have encountered is technological. In a lot of cases these firms adapt their EMS, OMS and IOI systems to adopt a different set of business rules. Willingness, however, does not remove technology and budgetary constraints, which has made some roll-outs more lengthy than others.
Initially this was something Capital Group was driving for our needs, as well as to leverage other firms to clean up the IOI messaging flow and make it a more meaningful tool on “the street”. The FIX Protocol IOI sub-group is spinning up, and as a member, we espouse a philosophy of IOIs and improved IOI transparency among the sell-side and more broadly among our peers. Better IOI transparency can only improve trading opportunities and streamline the location and execution of block trades.
This is truly a global effort for the buy-side. It is more mature in North America, but we are beginning to implement it both in Asia and Europe. Some sell-side firms may follow our suggestions in North America but legacy systems in other regions and the regulatory constraints around markets make it a little more challenging.
Capital Group built our IOI systems in-house, but we engaged other sell-side partners. We are beholden to whatever technology solutions they offer, and depending on the size of the firm and the technology choices they made, in some cases they have direct control over their platforms. In other cases we must engage with vendors.
In addition to the brokers who help us flesh out this approach, we work directly with NYFIX, Fidessa, various EMS providers and a few others groups in the middle to get all the hoops connected together that they need to get this to work right too. It has been rather a daunting, challenging road that we only recently walked down from end to end.
When dealing with brokers that have a third party relationship with their platform providers, it becomes a game of telephone. Buy-side traders are actively involved with the sell-side in this approach, and I am actively engaged in dealing with the business and the technology provider on the other side. The sell-side then funnels our rules of engagement to their third party providers, who then interpret and implement what they received. Simply meeting a timeline has been a challenge. Like any other IT businesses, these vendors are spread thin and have multiple demands, and this is just one of many. But once these third party providers are certified, economies of scale will appear fairly soon and future engagements with the vendors should proceed much quicker.
One step I take in this process is to ensure our trading desks are in conversations with their peers on the sell-side. Before we do anything with a new partner or region, I want to know the traders sitting on our desks in their respective regions are talking to their peers and everybody understands the process and flow. That way, the sell-side talks to their IT partners and makes sure they have the collective understanding and we’re all executing in the same way. All parties involved should have a mutual understanding of the type of IOIs that will be sent, what happens when we respond, and who to work with when questions or issues arise (both business and technical).
From an IT standpoint, we can point to this effort with pride and say this is providing real value to our business partners. On the sell-side I have engaged with, they all seem to be operating in concert.
Efficient Access To Emerging Markets; The ETF Conundrum
By Jesse Sherman, Portfolio Manager, RenAsset Management.
The debate over the most efficient way to access emerging markets has intensified with the development and diversification of ETFs. The ETF value proposition is to provide easy and cost effective access for investors to a specific asset class, sector and/or geographies. While we do not dispute that ETFs provide an easy and low cost solution, the question remains whether the basket is attractive when applied to emerging markets. ETFs for emerging markets remain inefficient relative to actively managed funds due to existing structural issues, which could potentially ease but only over the long term.
Since the first ETF was launched in the early 1990s the industry has experienced phenomenal growth to over $2 trillion in assets as the product offering has evolved, providing access to significant portions of global markets and increasingly specific geographies and segments. The push of ETFs into emerging markets has sparked similar growth, with ETFs now over $330 billion in assets and representing 25% of EM Equity Assets Under Management (AUM) and 7% of EM Bond AUM based on JP Morgan data. The key structural issue for emerging markets is that liquidity is scarce and as such emerging market ETFs, in order to have mass appeal, are liquidity seeking, resulting in more concentrated benchmarks and potentially lower sectoral or geographic diversification.
Emerging markets, due to their earlier stage of market development, tend to be market cap and liquidity dominated by larger state and former state enterprises. Indices which are often created using market capitalisation and liquidity metrics are primarily constituted of these lower quality or less interesting investment opportunities . Often this means ETFs capture a smaller portion or miss completely the more interesting sectors under development and growth. In contrast active managers have the opportunity to sift through a broader investment universe and therefore potentially capture the returns from the more attractive segments of these markets. As a result diversification can become a serious issue for ETFs, for example the MSCI Russia 10/40 index has reduced to just over 20 securities from over 30 a few years ago and there are current concerns that Saudi Arabia if included in Frontier indices would likely comprise over 60% of the index.
One of the disclaimers often mentioned on ETFs is that performance can differ from the underlying markets that it is attempting to replicate, even when it is physical holding, because the ETF might have differences in holding weights; often because of liquidity constraints. Even when you compare ETF performance to the underlying market it is replicating, you see dramatic differences in performance. The Egyptian, Greek and Turkish ETFs have already underperformed the markets by over 12% in their short histories, while the Indonesian, Argentine and Taiwanese ETFs are already over 65% behind their respective indices. While ease of investment cannot be disputed, the performance differential is stark.
Emerging Markets are economies with relatively low income per capita facing rapid market development, regulatory change and growth. In such a dynamic environment active management is able to add value through identifying not necessarily the biggest businesses, but rather those which will evolve and exploit the every changing environment best. Active managers are able to add value through the hands on fundamental research approach spent meeting management teams, understanding their business models and strategy which can deliver superior levels of growth and profitability over the medium term. This is in contrast with Indices and ETFs which by definition are more limited to current liquidity and market capitalisation. An example of this dynamic is Magnit in Russia, absent for a long time from indices, which has seen its revenue increase over 7x and earnings rise nearly 20x since 2006 and gone from an off benchmark stock to up to a 9% weighting in major indices currently.
As emerging markets evolve the market depth and liquidity should continue to improve, but in our view this will be a gradual trend which means active strategies should continue to provide a better efficiency in accessing emerging markets than that of ETFs. As fundamental investors, we focus on cash flow generating businesses with minority alignment and solid corporate governance within our strategies which we believe can deliver sustainable growth, profitability and returns. While these companies are not always exclusively non-state enterprises, the majority tend to be and often are largely under represented or non-existent from benchmarks. ETFs in our view are efficient only in markets where the depth and liquidity extends deep into the small and midcap universe which today remains a largely developed market phenomena. In the absence of this investors are better served to seek out the leading actively managed funds in order to maximise the efficiency of their investment.
Lip service? : Lynn Strongin Dodds
As with every new year that dawns, a crop of studies emerge predicting upcoming trends and 2015 is no exception. FX, which has rarely been out of the spotlight, will continue to dominate the headlines and the legal costs will continue to mount.
In fact, a new report from Morgan Stanley reckons that US and European banks could be forced to fork out an additional $70bn by the end of 2016, on top of the $230bn they have paid since 2009. The 20 largest European banks are expected to be the main contributors to the litigation pot. Breaking it down this would include $7.5 bn related to alleged foreign exchange rigging, $6.5 bn from interest rate benchmarks Libor and Euribor and $9.4 bn tied to U.S. mortgages.
A recent study from Greenwich Associates believes that the real question to emerge from the 2014 FX fixing scandal is why, in a market with over 80% of volume executed electronically, is a model developed decades ago, still used to set the “official” price. It is not clear if the regulators will move fast enough or hard enough on the industry to drive real change to this process in 2015.
The hardware though is not the only focus. What perhaps is the most surprising thing about the FX scandals is that they occurred after the financial crisis. Trading rooms have always been the bastion of male locker room behaviour but after the meltdown in 2008, there had been hope that humility and reserve would have replaced the bravado that often dominates activity.
Regulators and industry observers though see little evidence that banks have truly changed their pinstripes. As Financial Conduct Authority chief executive Martin Wheatley recently said at the regulator’s enforcement conference in December 2014, “With every new conduct crisis, it becomes harder to credibly talk of lessons being learnt.”
Author and former investment banker Philip Augar, in a lecture at the House of Commons also acknowledged that while stronger deterrents and structural reforms helped the banking sector turn a corner since the crisis, he doubted whether cultural change had yet taken root throughout banks’ ranks of staff despite their leaders’ efforts. He expressed concern about ongoing efforts by the industry to lobby for less stringent rule changes.
Cultural change of course takes time and it will not happen overnight. There may be freshly minted mission statements pinned to the walls and popping up on screens, but they will need more than lip service.
Lynn Strongin Dodds, Managing Editor
[divider_line]©BestExecution 2015
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