Dr Christian J. Zimmer, Co-Chair Latin America Subcommittee, FIX Trading Community, Vice President, Itau Asset Management.
After the 2012 FIX Latin America Conference, the local subcommittee decided to make the conference a bi-annual event. The main reason for this was to organise a conference where relevant, new information can be discussed with the key participants of the community.
The decision was 100% correct: compared to previous, not only FIX Community events, but also other events for the financial market in the region, an impressive change in quality could be perceived. The focus was on content. The setup convinced BTG Pactual, who recently joined as a FIX Trading Community member, to host the conference in their new building, including all the breaks and technical installations.
During the introductory session, the future of electronic trading in the region was discussed including opportunities and challenges for the region’s trading desks. Additionally, the recent projects of the FIX Trading Community, like FIX and High Performance as well as the status of the new developments at the local exchanges, were presented and discussed.
New Markets for FIX in Brazil
For those who have followed the development of FIX usage in LatAm, it became clear in the last few years that the equity markets have achieved a certain degree of maturity. Most of the big players speak FIX nowadays, even though it may still be in a basic way. FIXatdl or questions like binary encoding are still exceptions.
Nevertheless, the community now looks forward to use FIX for other purposes than only equities. Solutions are demanded for stock lending, block trading and, especially, fixed income.
The session on Fixed Income in Brazil under the moderation of Thiago Pavesi, Head of Electronic Trading at Itaú Asset Management, had an intensive discussion between the two big players in this space – Ricardo Vit of Cetip and Dennis Floh of Bloomberg. Cetip, the main custody entity in Brazil for corporate bonds explained its new offering for electronic trading. Although their initial design for accessing their trading platform only previewed a web-service, the continuous pressure from the local trading community made them give a higher priority for a new FIX interface.
The advantage of trading on their CETIP|Trader platform is the perspective of STP for post-trading. Traditionally, middle and back-office systems in Brazil already have a connection with Cetip.
Bloomberg, on the other hand, explained that their trading platform can already be accessed via FIX staging. When it comes to the interaction with regulatory systems, it would be helpful for the whole trading community if there is further collaboration.
It was a special feature of this session that, with the technological help from BTG Pactual, the panel integrated a video conference from New York. This idea was highly appreciated by the participants and probably will be used even more in the following years.
To fragment or not to fragment?
As Brazil has a unique equity exchange, the local community always wonders if the introduction of competition would have a positive impact for the market. Of course, the expectation is that lower trading costs will be the result. But, what about the inconvenience of having fragmented liquidity? The Argentinian market, with much less volume, now has six exchanges in existence. Although the examples of MILA (Mercado Integrado Latinoamericano) and recent efforts from the EU showed that cooperation among rivals is not easy, Argentina has created a success case. During the session they explained some of the key factors: 100% use of FIX, focus on technical questions, and not bargaining over business questions. As Soledad Castro from Argentina’s SEC mentioned, the regulator’s vision was to keep the IT people doing their job and not to interfere. This session, moderated by Diego Anfossi from Mercado Abierto Electrónico (MEA), was very entertaining, especially because of the humorous anecdotes coming from the different exchange representatives and their interaction with Argentina’s SEC.
After the lunch break, there were three sessions that were more technical. These focused on a number of different topics and the initial presentation gave an overview of the IT trading infrastructure in the region. The final two sessions of the day looked at the consequences of fragmentation and what are the challenges for the participants, TCA, algos and market data as well as market participants’ views on ‘Best Execution’.
Thank you to our host, BTG Pactual, and to all the sponsors and panelists on the day. It was a successful event and we look forward to seeing you back in the region in 2016.
FIX Trading Conference back in LatAm
Strategic Imperatives For Trading Compliance Executives In 2015 And Beyond
By Cromwell Fraser, Director of Trading Floor Portfolio of NICE Actimize and Sherie Ng, Managing Director, South East Asia & Hong Kong of NICE Actimize.
Multiple high-profile probes into alleged market abuse cases are dominating headlines worldwide, across different asset classes that include currency markets, interest rates and commodity markets.
Breaches have become a norm with market manipulation, and rogue trading is proliferating. LIBOR-fixing scandals and instances of banks censured for fixing the Singapore Interbank Offered Rates (SIBOR) have made risk and compliance a recurring theme for market participants and regulators.
The call for greater transparency and accountability
As a response to the increasing malpractice transpiring in the markets, regulatory authorities have tightened their scrutiny on financial institutions, calling for greater transparency and governance across the entire trading process. This focused scrutiny includes such regulatory frameworks as Dodd-Frank’s new rules for over-the-counter (OTC) swaps, The Securities and Futures (Amendment) Ordinance 2014, as well as amendments to the Securities and Futures Act in Hong Kong.
The spirit behind all these new rules is that regulators want that increased transparency coupled with the processes that will mitigate risks and create a level playing field for market participants. Financial institutions are now being made to be more accountable for their traders’ rogue trading and misconduct; with punitive measures in place to ensure their compliance.
These scenarios have created a new urgency for financial institutions to radically transform current surveillance practices, to ensure that they are not lagging behind when compared to the speed of the 21st century trading environment.
Conventional trade surveillance has focused more on post-trade analysis. However, with trading platforms evolving digitally to allow for high frequency trading and real-time trade execution, surveillance must keep improving to be one-step ahead of this transformation.
Three priorities for heads of risk and trading compliance
Chief compliance and risk officers realise that in order to meet these new challenges, they need to carefully review their current risk compliance frameworks. In formulating an effective compliance strategy, they should keep the following three pointers in mind:
1. Business and regulatory alignment of the risk and compliance strategy
In order for firms to balance business objectives with regulatory compliance goals, a pragmatic and cost effective approach is crucial, especially in the light of the increasing volumes of transactions across geographies, development of new asset classes and the changing local regulations across the globe.
Therefore, when building their compliance framework, risk and compliance officers should adopt robust models that are able to adapt quickly to meet both global and local changes in regulatory standards.
Implementation of real-time system controls to minimise risk exposures and flexible deployment options on cloud-secured or on premise should also be part of the approach.
2. Direct line to CEO and board for compliance
With compliance and risk mitigation programs become a more urgent agenda item requiring attention of the Board of Directors, it is important that Heads of Compliance are empowered with sufficient resources to ensure corporate compliance and ethical conduct.
These resources should include a direct line to the Board of Directors, unfiltered access to specific information and the authority to carry out their work. It is also imperative for a compliance department to work closely with the risk department to effectively mitigate risk from a compliance perspective for all global initiatives.
3. Crafting a holistic and all-inclusive surveillance framework
The surveillance of communications is a huge capability that should be better leveraged by compliance teams. Combined with trade-activity surveillance, it can “connect the dots” between suspicious trade activities and communication interactions, allowing compliance teams powerful insights to detect and stop market manipulation or fraudulent behaviour much faster than ever before.
One of the leading financial institutions in Europe has started utilising new communications surveillance technologies. Using an innovative benchmark monitoring solution, they were able to discover connected conversations in about 30 minutes and complete the necessary evaluation in three days, where before, using other technologies and manual methods utilised at the bank, this same process had taken more than four months and 480 man hours to achieve. This resulted in a 160-times faster investigation process, along with significantly reduced costs.
Firms need surveillance technology such as this in order to match the sheer scale, speed, lines of communication and trade information present today, to allow comprehensive and accurate insight across multiple data sources. A single surveillance platform can help firms achieve a holistic view of unwanted behaviour with a single investment and lower the total cost of ownership.
The growing scale of trade volume, combined with and the new complexity of global regulations, has created an escalating need for surveillance technology across both trade communications data. A holistic and all-inclusive surveillance framework could potentially help financial institutions save billions of dollars in fines and reputational loss. And in the case of rogue trading, trade and communication surveillance does more than provide a timely intervention — it also acts as a strong deterrent compared to a post-trade investigation since a trader knows they are being monitored.
While regulatory requirements are still evolving and may pose additional challenges to market players in the future, the objective is clear: to protect the credibility of financial markets and prevent unlawful market abuse from damaging the confidence of market participants.
Tailor Made Technology
Glen Beamson, Chief Technology Officer at ADIA
One of the by-products of an evolving investment model is an acceleration in the rate of change. Our role is not only to provide a first class technology service today but also to implement processes and planning to react to a potentially different set of requirements tomorrow. As the breadth of investment products widens, this agility becomes ever more important.
The danger of agility of course is that you try to do too much, too fast in an unstructured way. To counter this, the approach that we have taken is to build business-specific units, able to move at a speed relevant to each business line. Our focus is on hiring and training individuals with proven front-line experience who can demonstrate a strong innovative flair, primarily in business analysis, architectural design and project management and we are actively hiring from both the buy- and sell-side to further strengthen our capabilities. In addition to people skills we are transitioning to a more pragmatic approach to architecture, buying products when our requirements are well known or market standard and developing our own software to add value when we have bespoke needs.
Public funds sit in a unique position. While many are large in terms of assets under management, they are often relatively light in headcount and thus perhaps suited to more nimble smaller vendors than more heavyweight providers. As such, there is definitely a space for mid-sized vendors who can provide a more tailored service whilst providing the economies of scale and re-use of best practice that a vendor implementation can bring.
In addition, whilst best of breed technology is desirable, the reliance that a smaller team has on external vendors means that best of breed support will be more important in the long run. Software vendors that grasp this will end up growing business for the long term.
The Accelerated Growth Of E-Trading In The Credit Markets: Perspectives And Challenges
By Fabien Oreve, Global Head of Trading, Candriam Investors Group
Large institutional investors have been trading with more electronic tools in the credit markets since the financial crisis. Over the last five years, the low interest rates that have stimulated investors’ appetite for yield have taken corporate credit issues to very high levels. Investors have never held so many bonds. As a result, multi-dealer trading systems have innovated and new functionalities have been introduced around pre-trade information and price discovery. Today, buy-side traders instinctively consult runs messages, indicative quotes and dealers’ axes in those platforms. Some asset managers have taken the opportunity to upgrade their order management system and enhance straight-through-processing to absorb large order flows without increasing costs.
The most popular electronic trading tools are the multi-dealer platforms that have attracted a large spectrum of dealers, from global banks to regional banks. Some regional banks have managed to increase market share in their home market. Technology has been important in helping asset managers gain access to a wider range of liquidity providers. More competition and more specialization in business segments have forced the largest dealers to improve efficiency and technology using dynamic pricing algorithms for small orders in liquid instruments. Unlike smart order-routing in equities, electronic trading is rather uniform in the bond markets, where small-to-medium size transactions occur mainly through requests-for-quotes (RFQs) to dealers. Despite a wider presence of dealers in these platforms, the reduction in secondary market liquidity has been more visible since asset managers started to focus on transaction cost analysis. Asset managers’ trading desks have also received more demands from pension funds and mutual funds for price improvement inside the bid-ask spread disclosed by the existing platforms.
The liquidity issues in the secondary corporate bond market and the number of “rejected” or “passed” orders have been more frequent recently – for a couple of reasons:
- Banks have reduced their inventory of bonds due to Basel III regulations: they have less capacity to take bonds in their balance sheet and they may have less willingness to trade sometimes due to more stringent risk management.
- Post-trade information in European bonds is insufficient: asset managers can only rely on their internal statistics to target the dealers that are most likely to transact specific instruments. Information is not optimal for investors on instruments they have never traded before.
As the new regulations require banks to take fewer risks with their own resources, it is important to add fluidity in the credit markets. Agency trading through order books can be an interesting means of gaining access to a wider range of participants in the secondary market; it can also add transparency to the calculation of transaction costs. However, agency trading will be a sustainable solution for asset managers only if order book providers continue to innovate.
For small-to-medium size orders, technology is the most important part of direct execution in equities, but you need a combination of technology and a relationship with the broker-dealer in corporate bonds. If you place a limit order and you are best bid or best offer, you will get some human support from the broker-dealer’s team behind the system, but at the same time your order should be reflected automatically across conventional multi-dealer platforms. As many bonds structurally are not for sale, the probability of an order fill in a particular instrument may be low. A smart device should therefore also suggest that you replace the current order with another one in a similar instrument available in the trading system.
The evolution of market structure in the European credit markets is on-going but it will take some time to make electronic trading in the less liquid corporate bonds more efficient. Post-trade transparency for this asset class is another important feature that will help investors improve transaction cost analysis. However, the challenge here is transparency calibration or how to produce publicly post-trade reporting with an appropriate time delay for less liquid trades and large-size transactions. There are many more corporate bond issues outstanding than equities, which would be a permanent challenge for any European entity in charge of providing post-trade data. The ESMA (European Securities and Market Authority) consultation paper about MIFID II & MIFIR regulations contains a section on the “post-trade transparency requirements for non-equity instruments” and is a great opportunity for asset managers to outline their practical views.
Making alternative trading systems coexist with conventional multi-dealer platforms and voice-trading will bring more flexibility and efficiency to the execution of corporate bonds. Adding transparency to the European post-trade data with different levels of information – depending on the nature or size of the trade – will make corporate bond liquidity more likely to happen in the secondary market.
This article originally appeared on the Candriam Investors Group blog
Multi-Protocol Automated Testing as Strategic Competitive Advantage
As financial firms in all tiers come to realize that trading technologies are the bridge between business ideas and client fees, those who can cross this bridge faster will inevitably win the clients and their fees.
The Technology Pipeline
The engine of profitability that turns ideas into profits is now a “Technology Pipeline” akin to an assembly line through which innovative business ideas are implemented and delivered to clients. The shorter the pipeline, the larger and quicker the fees.
Regardless of the tactical model, Agile or Waterfall, its stages are the same: business analysis, development and testing.
Building the shortest pipeline and guaranteeing its uptime, regulatory compliance and quality while pushing business ideas through is a challenge faced by many firms trying to remain competitive.
The Nozomi Enterprise Testing platform (ETP) shortens this Technology Pipeline by drastically reducing testing cycles from weeks and months down to minutes and across all business areas: capital markets, treasuries, wealth management, payments, retail and everywhere else technology is the fundamental driver.
Whether the owner of a sports car is engine-savvy or not, what’s taking him or her to the finish line faster is a well-tuned engine made of nuts and bolts. Similarly, regardless of whether the IT department is only considered a cost-centre, the modern engine of banking is made of interconnected software systems and a well-tuned Technology Pipeline will reflect business ideas to the bottom line faster.
The Nozomi platform gives users the means to deliver revenue-generating ideas faster to clients, transforming Test Automation from a cost harmonization exercise to a Strategic Competitive Advantage.
Future-Proof Extensibility
Nozomi is composed of client/server applications that centralize testing activities within one framework and can be leveraged across all business lines. Because of its unique multi-protocol capabilities it connects to financial systems across the widest range of technologies: FIX, SWIFT, Fidessa, Murex, TIBCO RV/EMS, Informatica UMS (29-West), Solace, MQ, ActivFinancial and proprietary protocols.
Nozomi protocol plug-ins enable the same toolset to be deployed to other areas of the business easily.
Front-To-Back coverage across all business lines is what makes Nozomi ETP unique in the market today.
The Nozomi suite of applications includes Nozomi Studio, a workstation application to create tests and system simulators.
The Nozomi Execution Server to schedule execution of tests and for data reporting.
The Nozomi Simulation Server to deploy system simulators that create a virtualized environment of downstream systems.
And the Nozomi Certification Server, where client on-boarding and certification is carried out automatically for FIX and other protocols.
As a case in point, a leading Japanese bank has integrated Nozomi ETP within their delivery pipeline. By achieving fast automated testing of strategic business applications they are able push trading ideas through their architecture faster than the competition.
Because of its modular architecture, Nozomi can be deployed to different business areas in stages: e.g. starting with FIX and moving downstream though the front-office, middle-office, back-office, and settlement systems; and then horizontally to F&O, FX, FICC, Risk and other verticals.
Power and ease-of-use
In order to deliver the most benefits to the largest audience the design principles underlying the Nozomi roadmap maintain the right balance between ease-of-use and powerful functionality. Nozomi achieves this with a simple and intuitive graphical UI that does away with scripting and programming, coupled with a modular architecture that permits the addition of new functionality via plug-in modules and packages for custom testing commands. This way both developers, business analysts and QA practitioners can use the same toolset for all testing activities.
A client-driven roadmap
Because support for new protocols and custom commands is added via plug-ins users can collaborate with Esprow to expand capabilities to proprietary systems and unique testing requirements.
The current technology roadmap includes integration of GUI testing applications, 3rd-party systems, mainframe connectivity and data reconciliation testing.
Nozomi can be deployed in enterprise, managed and hosted modes and is supported by Esprow professional services and our network of global partners.
ROI & Purchase Process
Typical ROI period for the Nozomi platform is 3 months from the go-live and during the purchase process clients have access to Cost/Benefit Analysis, Case Studies, Customer Testimonials, Proof-of-Concepts and Application Demos.
www.esprow.com
SWIFT, TIBCO, Informatica, Fidessa, ActivFinancial, Solace, Kaazing, HP, Murex and others are registered trademarks of their respective owners.
Their use in this advertisement is not meant to imply sponsorship or endorsement by the trademark owners.
Liquidity squeeze : Lynn Strongin Dodds
Just when you think the well has run dry in the regulator’s pool, a new piece of legislation is finalised that tightens the noose around the banks even more. This is certainly the case in the US where institutions are coming to terms with the Federal Reserve’s freshly minted set of stringent liquidity rules. The aim is to make the world a safer place but it may also mean that banks become even more constrained in their lending activity, which not only puts a damper on their performance but also the broader economy.
The liquidity rule is the first in a new series of restrictions targeting how banks fund loans and other daily operations. The US is taking a much harder line than the Basel III global agreement by forcing banks to hold enough safe assets to cover 100% of their net cash outflows to survive the worst day of a 30-day crisis. Under Basel they need enough liquidity to survive the last day of a crisis-ridden month.
There are different categories. The behemoths with over $250bn in assets will have to go the 30 day distance while smaller banks — those with over $50 bn but less than $250 bn — have a shorter time frame and will only have to keep enough to cover 21 days. Banks with less than $50 bn and nonbank financial firms deemed by regulators as posing a potential threat to the system will not be subject to the requirements.
The impact will of course be different. The Federal Reserve estimated that the systemically important banks would need to hold $2.5 trn in highly liquid assets by 2017, and that they would have a gap of about $100 bn if that threshold applied today. While the coffers of the behemoths such as Bank of America Merrill Lynch and their contemporaries are plentiful, the shortfall will largely affect super-regional banks and some asset custodians.
No one disagrees with the drivers. They are the same that have dictated much of the post financial crisis regulation – to ensure that the financial system is well protected and to prevent firms buckling like Lehman and Bear Stearns. The problem is with the inevitable unintended consequences. It is good to have a buffer but the stockpiling of ultra-safe assets could act as a drag on bank earnings due to the low returns generated. It may also trigger a loss of appetite to lend as the economy strengthens because banks would not want to divert any money away from their buffer.
The result would be weak market liquidity and significantly higher borrowing costs for local governments, businesses and consumers. It’s a fine balancing act between protection and growth but sometimes the pendulum can swing too far.
Lynn Strongin Dodds
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Beware The Effects Of Unintended Consequences
By David Rabinowitz, UBS Head of Direct Execution Services Asian Equities and Sanji Shivalingam, UBS Head of Algorithms and Analytics Asia Pacific.
The effects of a raft of exchange-led and regulatory inspired changes over the last 18 months in the Asia Pacific region is slowly filtering through not only to market microstructures themselves but also to market share compositions. Change is necessary for financial markets to maintain market integrity and stimulate liquidity. Catalysts, incentives, roadblocks and reversion metrics, will influence market participants as to the exchanges and venues in which they trade. Yet in addition to the desired outcomes, the changes have potential to bring about unintended consequences.
Over the past six months throughout Asia, exchanges have implemented structural changes and introduced strategic initiatives in an effort to entice market participants. They have included: tick size reductions in Indonesia (06 January 2014) and in Japan (14 January 2014 and 22 July 2014); an increase in continuous auction matching sessions in Taiwan (24 February 2014 change to 10-second matching from 15-second matching in July 2013 and 20 seconds prior to that); liquidity provider (LP) and market maker (MM) incentive schemes in Singapore (01 June 2014); lot size changes in Korea (02 June 2014); and the introduction of a stock connect mutual market access (MMA) program in Hong Kong and Shanghai.
Some initiatives have brought about positive outcomes, such as improved benchmark performance as a result of tighter spreads in the case of Indonesia (from 65bps in 2013 to 26bps in 2014) and an intentional focus on trading large cap benchmarked constituents in the case of the MMA scheme. However, others have led to increased costs. In response to a decline in ASEAN market share (Singapore now comprises 28% of the ASEAN market as opposed to 43% in 2009), the Singapore Stock Exchange (SGX) has sought to attract liquidity providers and market makers with incentive schemes (by offering rebates on clearing costs and exchange fees). A possible unintended consequence is that the institutional client base, a mainstay of the market, risks being disenfranchised and faces a rising clearing fee structure. A US$10m trade that, previously, would have cost US$468 to clear now costs US$3,250. A decision to change the composition of the market has unintended consequences.
It is inevitable that as microstructures shift, volume curves need adjustment, spread validations require recalibration, quote stability checks become more sensitive and smart-order routers require more sophisticated multiple level sweeping and posting logic. A potential knock-on effect of change is the dislocation of liquidity as the order book fragments. Many structural changes have been accompanied by a general increase in the velocity of trading (i.e. the number of interactions over a given period) and a continued reduction in the average trade size. For example, in Korea, SK Hynix, which traded 11k prints per day prior to the board lot change, is now printing an average of 20k orders. The knock-on effect has been for the average trade size to decline from 1.5m KRW to 1.1m KRW across the Kospi200 index. per day prior to the board lot change, is now printing an average of 20k orders. The knock-on effect has been for the average trade size to decline from 1.5m KRW to 1.1m KRW across the Kospi200 index.
Regulatory changes in Australia have been positive for local market structures. The Market Integrity Rule (MIR) changes, introduced in May 2013 by the Australian Securities & Investment Commission (ASIC), aimed at ensuring a level playing field for brokers and exchanges in Australia. While the regulator imposed a set of rules for all in dark, it has also prompted an increase in volumes in Centre Point over broker lead pools.
An unintended consequence of the dispersion of liquidity in Australia, given the increased activity within the alternative Chi-X Australia exchange and within Centre Point, is an inherent rise in market-making flow within the different venues. Such non-traditional systematic funds are “long agility” and are often able to capture inefficiencies in new environments that Institutional investors are generally slower to react to and compete. As broker offerings are enhanced and smart-order routing features are developed, a more accurate reflection of the true market economy should emerge as evidenced by the rise in passive posting on Chi-X which increased from 5% in May 2012 to almost 40% in May 2014.
The merger of the Tokyo and Osaka stock exchanges combined with the concerted effort on the part of the Japan Exchange Group (JPX) to level the playing field with the PTS (Chi-X, JapanNext) has had unforeseen effects on the market in Japan. In an effort to minimise market disruption, implementation is taking place in two phases. Phase I, which was completed in January, brought about a welcome reduction in spreads but it also resulted in a spike in the number of quote changes. In many cases, the number of market data events (new/amend/cancels) increased by 150% while the quote sizes declined by a factor of 10.
Phase II is clearly going to have a larger impact than the initial phase. Market data events are expected to increase to the point where the cost of the hardware required to implement the changes may become excessive. Furthermore, as mandated spreads contract, liquidity providers may find it more difficult to maintain current activity levels and profitability. It also remains uncertain how it will affect competition among the venues, with PTS volumes expected to decline in the affected names. Market structures in Asia Pacific are more diverse than in any other region. Spread costs in Thailand average 45 basis points relative to a 13 basis point spread in Japan. While the US is dabbling with a wider-spread pilot program to enhance liquidity in the small and mid-cap segments, Japan is moving in the opposite direction by seeking to attract institutions with sufficient technology spend to keep up with the structural changes.
Some investors remain concerned as to with whom they are interacting. In-house analysis of market-share composition in Hong Kong has revealed the emergence of new market share providers tied to the single-stock options market-making licenses granted by the Hong Kong Stock Exchange.
While roadblocks, including stamp duty and throttle mechanisms, have constrained the “high frequency” component of the market in Hong Kong, the structural changes created by new market entrants is becoming ever more apparent. These include an increase in the number of single-stock options market-making licenses where the cash hedge is entitled to a stamp duty waiver and a short-sell tick rule exemption. Similar to Korea, since December 2013, the unintended consequence of the license has been for average trade size to decline rapidly and the average number of trades to increase significantly as the increased velocity results in a disruption of liquidity on the order book.
China Mobile, for example, has observed 44 trading days in excess of 7.5k trades per day in the past six months. It took more than five years (back to December 2008) for China Mobile to register a similar number of executed trades. With respect to market making activity, we argue that such electronic market-making activity, while constructive in that it enhances market liquidity and stability has, nonetheless, changed the manner in which participants interact with the order book.
In June 2014, dark liquidity in the Hong Kong market accounted for just 1.8% of overall turnover. Concerns surrounding price formation and price discovery have more to do with the consequences of these licenses being granted rather than liquidity residing off-exchange in broker-led dark venues. The SFC consultation on alternative liquidity providers (ALPs) is attempting to redress imbalances in the dark trading segment in Hong Kong. The intentional effects of retail and non-institutional flow being excluded from interacting with broker-led ATS venues has resulted in a marked drop in Hong Kong ATS turnover.
It could be argued that such retail and non-institutional flow remaining on the displayed market is beneficial for price formation for all participants. Yet the unintended consequence is the creation of a two-tiered access model that excludes certain segments from participating in the ATS segment in Hong Kong; a move that runs counter to the global shift to prevent inherent conflicts in providing beneficial access to certain client segments.
As market structures change, liquidity will reside with those most adept at adjusting to the demands of exchanges and regulators. However, it is abundantly clear that efforts to increase market liquidity have a ripple effect on both the short and long term costs of trading. As exchanges compete for relevance, the most pertinent consequences of change may result from the unintentional effects of these strategic initiatives.
Note: All data sourced to UBS unless otherwise stated.
Hong Kong Connect: More Questions Than Answers
With Emma Quinn, Head of Asia Pacific Trading, AllianceBernstein
There was a lot of excitement when the Hong Kong-Shanghai Connect scheme was initially announced because QFII and RQFII have a lot of restrictions. It’s difficult to get quota, and for repatriation, the daily or monthly flows depend on which licence you have. Everyone was very excited to hear of another mechanism to access China, but once people got into the detail, there were some things about the structure that would mean that QFII and RQFII are definitely going to remain a key element of institutional access to China. The Connect will stay as a second product, simply because there are things that the long only buy-side need clarified or changed in order for them to actually transact using the Connect.
The A-shares will sit in China within the Hong Kong Securities Clearing Corporation’s custody account, with their name on the share register. Under Chinese property law, the share register is the way to legally recognise ownership and, there is no concept of beneficial ownership being different to legal ownership. This means that if I ever had to get into a dispute in the Chinese courts, it is unclear how my ownership rights would be treated. It has not been confirmed that I will have control over the voting rights. Capital gains tax is still to be clarified by the tax authority.
Even if I wanted to use the Connect, I can’t physically do so. Say hypothetically I have 15 accounts with different global custodians. First of all I need to set up some sort of sub-custodian relationship across the board. Since there is a requirement to have the stock in the brokers account pre open on T, I’ve got to get all these accounts to agree that I can set up a sub-custodian relationship so I can transfer my shares to that sub-custodian, probably on T-2 depending on where the custodian’s located.
This is not a process that we have in place here, or in any other market. It makes it almost impossible to implement because we ask, “Is this really how we want to be spending our time and resources when we have QFII?”
So there are the structural challenges, and then there are the technological challenges as well. For example, if I have my QFII account and then the same account also wants to deal in Shanghai on the Connect, I have to then differentiate between those two holdings. So when it comes onto my blotter, I then have to know that some are .HK and some are .SHH in the same names. The Shanghai holdings I can only trade through one broker even though it says I can trade it with three. The Hong Kong holdings I need to have some way to show which broker (if I decided I wanted to set up a multiple sub-custodian relationships to get best execution and trade with more one broker) I actually placed shares with one or two days before I can sell. I also just don’t know two days before what we’re going to sell and as a consequence, I can’t react to market events when I’m selling.
And, my personal view is that many of these will remain outstanding for a while.
Because of the MSCII decision not to include China in the emerging market indices there is definitely more time and a firm incentive to have a look at the structure. I think the long only buy-side managers would say that this doesn’t give them a clear way to access the Chinese market, especially with concerns around the capital gains tax and the ownership questions that remain.
Broker challenges
October is not very far away. From a broker point of view they’re trying to ready themselves because there are a lot of hedge funds that can trade on swap, so they’ll do it that way and get around the pre open position check requirement. The fact that they can work around having to set up the custodian relationships by using swaps is something like a prime broker relationship. For a long only account this is something new; for hedge funds, it’s not. So for hedge funds this is probably an easier way to access the market, and for brokers it may be a way to free up some quota capacity for their QFII to redeploy into the fixed income markets. So the brokers are trying to work it out but I haven’t had a broker yet come to me and say “I’ve got the answer”.
I think we also want clarification on what stock codes will be used and how we’ll make sure of that in our systems. There is also the Free of Payment (FOP) issue. I transfer my shares, will I get the cash the next day? Do I have to go back and check to see whether I’m allowed FOP and what technicalities follow, whether I need some sort of legal document around that? Do I just set up a Renminbi cash account for each client account? How much more counter party risk, ownership processing, and paperwork is there around the beneficial owner in China? How can I ensure that we don’t buy and sell the same day? What happens if, in the morning, I buy for an account, then, in the afternoon, I get a cash float and I have to sell out? Am I allowed to do this under the rules?
Quota and benchmarking
One key area is around the quota, and around benchmarking on the MSCI index includes China; you benchmark to the close because you want to have the position by the open of the next day. The daily quota gets used up in the morning, so therefore you can’t enter any more buys orders, what do you do? You can’t put in any market price on close orders. There could be a chance that there is still quota left for the close but if everybody piles in on an inclusion day, or the day before an inclusion day and the quota is gone and you cannot get your buy orders in, you can’t meet any benchmark.
The daily quota is based on buy orders minus sell executions with an adjustment made for unexecuted buy orders once the order has been cancelled. There are concerns that some could enter out-of-market buy orders to use up the quota, even though the exchange are going to be monitoring.
There is progress on many of these issues, and the industry and all the associations are working together. We all like the concept and we all want an easy way to invest in China, but we have to think about alternate ways of achieving it and improving on the process.
Beyond Equities: Evolution Of Technology And Concepts Into Fixed Income And Currencies
With Chris Rice, Global Head of Trading, State Street Global Advisors
How can concepts from equities evolve into other asset classes?
At State Street Global Advisors I head up a global trading team with desks in Boston, London, and Hong Kong. Our trading philosophy is based on one really basic concept – to trade in the best interest of our clients as efficiently as possible. This philosophy was a core tenet that drove us to bring our global desks onto one common technology platform, across regions and asset classes for equities, currency and fixed income.
The primary focus of our traders is on client and portfolio manager objectives and market context and designing a strategy to accomplish their goals.
There has been a vast change in the technology and regulatory environment over the last 15 years which has helped to decrease transaction costs in US equities, which we look at as an evolutionary model that could be applied to other asset classes.
How does this feed into technology?
We look at asset classes in terms of liquidity. The listed market is the most liquid asset class because of the market structure that has evolved over time. So we approach other asset classes similarly and if you’re in currencies, for example, you can create something similar to the concept of a virtual limit order book, simply by working with various vendors.
It is a bit more difficult within fixed income, but if you cut across the top and look at liquid instruments that are exchange traded or over the counter, a common approach would be to electronify them to the greatest extent possible. If you have the equivalent of a central limit order book for an exchange or virtual limit order book for currencies within fixed income, you create the potential for a whole universe of bonds to trade.
On credit in particular, there are very liquid corporate issues that will trade, but for every equity issue there can be hundreds of debt issues. For example, General Electric common stock is very liquid (daily average value traded is roughly $750MM USD) but their debt issues are very fragmented; you can’t think about trading the debt in the same way.
Generally electronification makes the following more possible on these markets:
• Improves transparency.
• Increases order control and execution.
Moving to the second tier of less liquid instruments: small cap equities, emerging markets currencies, high yield corporate bonds; price and size discovery isn’t going to necessarily happen in a screen-based way, or a virtual limit order books, or a central limit order book. You have to take a different approach by picking up the phone a bit more which takes more time but you have to get more creative.
More buy-side content
This then starts feeding into the technology and to the Order Management System (OMS), because the OMS is the control station for all the trader’s activity. The OMS allows you to build your strategy, but it also gives you a glimpse into the future. When you ask “What is possible within fixed income?”, even if you have a Request for Quote (RFQ) market, there may be other order deployment methods that could be created to push orders from a fragmented dark space into a more communal and transparent space for execution.
Because fixed income is not exchange traded, there are many order characteristics we’ve talked to dealers about in terms of gaining more insight to their inventories in a streamlined fashion using simple software which would allow them to present their inventory in a way that enables us to react and respond electronically, or at least to better understand the breadth and depth of it.
What is the progression across asset classes?
Greg Berman from the SEC likened the equity market to the operating system for an iPhone, and the apps that iOS handles as the instruments that go through the exchange of the iPhone. For non-equities, there is no iPhone equivalent – no central operating system or nerve centre. There’s over the counter for currency and over the counter for fixed income.
Currency appears to sit in the middle; if you’re thinking of G10 currencies where dealers can provide streaming prices into a virtual limit order book, currencies are actually the nearest cousin, if you will, to equities.
There is sufficient liquidity at a touch to virtualise and create a screen-based market because liquidity is there. When looking at topics around market structure challenges for equities, a lot of them relate to currencies: for example the high frequency presence or fill ratios. This “equity recipe” can then be integrated into currency in the same way, through electronification and equitisation.
“Currency appears to sit in the middle; if you’re thinking of G10 currencies where dealers can provide streaming prices into a virtual limit order book, currencies are actually the nearest cousin, if you will, to equities.”
We are trying to stay on top of that efficient frontier of electronification and to push that frontier out by being very active with market participants, with vendors, and also regulators, because a successful solution will rely on all of these groups. We have engaged in very productive dialogue with our regulators across regions on these topics.
How does this feed into conversations with the sell-side and vendors?
Everything we do at SSgA is technology-enabled and we have primarily taken a buy versus build approach. John Wysocki, our Head of Cash, Compliance, Fixed Income and Trading Technology and I are attached at the hip so we can realise our vision for technology and aggregation of liquidity. We have a strong foundation with our order management system, and have stayed with one vendor as we’ve expanded out into currency and fixed income. This is a global discussion within the firm; liquidity issues and secondary market liquidity are big challenges. Revolutionizing an industry that is nearly 150 years old will take time and teamwork.
Shanghai-Hong Kong Stock Connect: An Unprecedented Challenge, An Unprecedented Opportunity
By Nick Ronalds, Managing Director, Equities, ASIFMA
China is about to throw open the door to its equity market to the world. Just as investors today in Tokyo or Toronto, say, can invest in each other’s stock markets, soon they and other like-minded investors will be able to add to their portfolios shares of Aolus Tyre, Zijin Mining and any of the other 566 eligible companies of the Shanghai Stock Exchange (SSE). The other half of the initiative is that Chinese investors will get access to shares of the Hong Kong Stock Exchange. Announced on April 10 with an expected lead-time of six months, the “Shanghai-Hong Kong Stock Connect” initiative should go live in October.
What could be simpler than opening a stock market? A lot it turns out. All the players — brokers, investors, the Shanghai and Hong Kong Stock Exchanges, regulators and other government authorities in Hong Kong and the Mainland, are engaged in intensive preparations. Along the way they’re finding enough quirks in the Stock Connect scheme to present some challenges.
Technical and legal challenges
One unique aspect of the scheme is the method of access. Elsewhere, if an investor in say, London wants to buy shares in a stock on the Tokyo Stock Exchange her London broker will execute the order by using a correspondent broker in Japan who is a member of the Japanese exchange. The Japanese broker executes the trade and provides clearing and related services for the London correspondent broker. For Stock Connect, however, the London broker would use a correspondent not on the Mainland but in Hong Kong, and the Hong Kong broker will execute “Northbound trades” (those headed to the SSE) via a special purpose vehicle (SPV) of the Hong Kong Stock Exchange rather than a mainland broker. In effect, the Stock Exchange of Hong Kong (SEHK) becomes the agent to execute and hold the SSE shares for all transactions.
Southbound trades, transactions by Mainland Chinese investors buying or selling shares on the SEHK, work analogously. A Chinese investor’s broker executes the trade using an SPV of the Shanghai Exchange. (See illustration)
The path an order takes to be executed may seem like a minor variation, but in this case it gives rise to some not-so-simple questions. Take the Hong Kong broker, who is subject to Hong Kong laws and is regulated by the Securities and Futures Commission. The Northbound trades are executed in Shanghai and are hence subject to Chinese law and regulation by the China Securities Regulatory Commission (CSRC). How will the CSRC exercise regulatory oversight over the Northbound trades originating from traders outside the Mainland? The CSRC and SFC will without doubt strengthen a cooperative relationship to address such novel regulatory challenges.
Another jurisdictional quirk stemming from the structure of the scheme has to do with what lawyers call “security interest in property ownership”, which means, “how do I know the shares being held are legally mine?” What gives rise to the question is that the shares will be held, not by the investors themselves or their custodians, but by CCASS, the SEHK clearing entity, on behalf of the ultimate investors in an account within the Shanghai Exchange’s clearing entity Chinaclear. Developed country legal systems have long recognised such “nominee account” structures, where Bank A, for example, holds property such as securities that are recognised as belonging to the customer, the beneficial owner. If Bank A goes bankrupt, creditors can’t lay claim to the securities because they are not assets of the bank but of its customers. However, no such nominee structure exists under Chinese law. Hence investors and intermediaries are grappling with the question of how to protect their security interest in the shares.
This ambiguity can and doubtless will be resolved. The SEHK has made clear in public and written statements that it disavows any ownership claim on Stock Connect shares held by CCASS. The ambiguity will likely be dispelled when Chinaclear publishes provisions in its rules addressing the question. The CSRC approves Chinaclear’s rules so such a provision would have the sanction of Chinese regulation and settle the matter.
Another rather technical quirk has to do with the fact that shares bought and owned via Stock Connect are not fungible with those purchased onshore via such vehicles as QFIIs or RQFIIs. Brokers and customers need to treat Stock Connect A shares as separate from QFII and RQFII A shares all the way from execution through the middle and back office so that no possibility of intermingling exists. Aside from the need to re-program systems, this in turn calls for new “symbology” on the part of data vendors such as Thomson-Reuters, Bloomberg and others who have to create unique codes for the millions of securities traded around the world, such as RICs (Reuters Identifier Codes), SEDOLs codes, and MICs (Market Identifier Codes).
Uncertainty about taxes has also raised questions. A capital gains tax of 10% is in Chinese tax law but Chinese tax authorities have not been enforcing it for some years. In principle the authorities could announce retroactive collection of the tax. The trouble is should that happen, the investors who incurred the tax may or may not be in the market any longer, and brokers may well lack the information they need to calculate the tax even with the best will in the world. Customers can switch brokers, after all, or use more than one, so that none of the customer’s brokers have the full picture. Similar issues apply to business (VAT) taxes. The possibility that brokers could be held liable for customer back taxes that they can neither verify nor collect is an off-putting prospect for brokers’ risk and legal teams, to say the least. Clarification from the State Administration of Taxation would lift the uncertainty.
Differences in settlement and infrastructure will also call for some adjustments. In the Mainland market, Chinaclear knows the location of all stocks down to the client level. When a client sells, the shares in the account are earmarked. This prevents accidental sales beyond the amount owned and means delivery fails are impossible. However, Chinaclear will not be able to see through to the ultimate client accounts for Stock Connect because the shares are held in an omnibus account by CCASS, as described above. Hence, to prevent fails sellers will be required to pre-deliver stocks to their brokers at least one day prior to the sale. This runs afoul of customary practices and in some cases institutional investment policies. It also creates significant operational challenges for clients, brokers, and custodians—as well as additional costs.
Then there’s the settlement cycle. Chinese stocks settle and transfer from seller to buyer on the trade date, but money settles the following day, on T+1, a cycle known as “Free of Payment” (FOP), in contrast to the more usual Delivery vs. Payment (DVP) where stock and cash move simultaneously. Institutional clients accustomed to DVP have to decide whether one-day’s exposure to their broker is acceptable commercially and consonant with their investment policies. Alternatively the broker could finance the proceeds of a sale and pay clients on the trade date, creating synthetic DVP, but then the broker is out the money for a day. Brokers and clients can adopt various fixes, such as T0 payment and delivery, but any fix comes with some combination of credit risk, operational headache, and cost.
Dealing with quota
Stock Connect is a pilot project and initially, at least, a daily quota of 13 billion RMB and an aggregate quota of 300 billion RMB will set limits on Northbound purchases. (The Southbound limites are 250 billion and 13 billion RMB respectively.) The SEHK plans to disseminate remaining quota balances every five seconds. This creates execution risk as investors will have to take into account the possibility that an order may not be executed if either the daily or aggregate quota might breach its limit. As the pilot demonstrates success, the quotas will doubtless be expanded and eventually eliminated altogether. In addition, foreign investors may hold at most 10% of any company stock and must report their holdings to the CSRC when their holdings reach 5%.
