Fixed income trading focus : Buyside profile : Lee Sanders

July 3, 2014

SWITCHING CHANNELS.

Lee Sanders, head of execution FX & MM and UK & Asia Fixed Income Trading at AXA Investment Managers explains the move to a new dealing system.

How has the market changed over the past year?

One of the biggest changes we have witnessed is financial institutions intensively scaling back their balance sheet and withdrawing from certain non-profitable businesses due to regulation and the need to extract shareholder value. This has meant a withdrawal of liquidity because they are only focusing on areas where they have the most expertise. The larger banks are also paying more attention to their biggest clients who account for 20% of their business but generate around 80% of their revenue. They are quite nervous over how the regulations, such as Basel III, are affecting their business models. However, the result is that there has been a drop in inventory and although the primary market may look good it is just a facade on the inadequacies of the secondary market. Take the corporate bond market, banks don’t want to commit as much capital as they did previously and the lack of supply and lack of balance sheet has meant that it is difficult for banks to support deals in the secondary markets.

What have been the drivers behind the changes made to the dealing system and move to TradingScreen for FX, and what will be the impact of this on fixed income?

There are around 33 fixed income trading initiatives in the market and one of the big questions that the buyside will ask is which one do you pick? To me these platforms fragment liquidity and we want to have an aggregated view under one umbrella. It is like Sky TV where you want to have access to every channel in one place. We will consider an execution management system (EMS) such as TradingScreen because it could provide a breakdown of the market, this snapshot will mean that we only have to go into one system to be able to take prices from any of the 15 or so banks that we deal with. Aggregation makes for punchier prices and more liquidity if it has support from all.

The EMS is more cost effective because it enables direct market access versus an order management system (OMS) which facilitates trades through an intermediary, which can be more expensive and time consuming. It has five or six different ways we can access fixed income liquidity and it gives us more flexibility in terms of order types than the RFQ (request for quote) protocol that had dominated market structure in the past. The advantage of an OMS is strong compliance but an EMS offers higher levels of granularity in execution control. Other benefits include anonymity and its ability to select execution venues through aggregation, including algorithms and cleaner and better transaction cost analysis (TCA may also be achieved and with potentially better execution).

Has it helped improve the TCA process?

Yes it definitely has. We are a trading organisation of 55 who are driven by best execution and getting the best price in the market. It is our mantra and as a result, TCA is more than just a ‘tick box’ exercise for us. We had developed our own proprietary systems and sets of historical data but one of the main reasons for switching to an EMS will be to further improve our TCA. We have worked with TradingScreen to develop a credible data set that we can distribute internally and also use externally and we would see this as a positive in fixed income as it has been in FX.

We evaluate our trading performance against three benchmarks in FX – the WM/Reuters foreign exchange fixing, creation time and execution time. The aim is to analyse the information to see where we could have added value. For example we ask whether we have added value to our benchmark for a particular trade or if we achieved the best price possible at execution. We also run through all the currency pairs and analyse all the funds and the trades that have been executed to identify what improvements could have been made. We also analyse different areas such as majors, exotics and Scandinavian currencies as well as peer group analysis.

Overall, TCA has been increasingly gaining traction in FX, do you think it will become as popular as for equities?

Yes I think FX TCA is developing quickly and there are more products on the market. Investment managers are increasingly looking at TCA as part of the process because the quality of that execution is key to their clients. The next stage is peer analysis and we are already using TCA to calculate average levels of added value in terms of identifying each counterparty’s strengths as well as weaknesses.

How has the relationship between the buy and sellside changed over the last few years?

This topic is continually debated and one question is whether it is empowerment or disintermediation? Most people would say the latter but I do not believe that has to be the answer. Every institutional investor has a good working relationship with the banks and we are entering into a model where we work together as an industry. The buyside has the inventory but the sellside has the liquidity. I think sponsored access is one way to keep them in the loop but banks will have to reinvent their models. In the future banks will realise the advantages of aggregation and this will lead to support for order book initiatives such as Bondmatch. We want banks to continue to facilitate liquidity and they will want to be paid for taking the risk due to regulation but this model would work better with aggregation for them.

There are also initiatives in the market place to aggregate all liquidity venues using FIX protocol which will join the whole market together and will enable aggregated liquidity. This is system agnostic but market structure focused.

What opportunities do you see for AXA IM?

It is all about the technology and pipes at the front end and the ability to capture more liquidity in order to develop additional products for both the retail and institutional space. We are also looking at developing execution services for third parties and expect the business to grow especially for smaller buyside firms who do not have the resources to navigate the changing environment.

Lee Sanders has been with AXA Investment Managers for over 20 years in different roles including head of FX and Money Markets for AXA IM in Paris and London. After 10 years as an investment manager, Lee moved over to trading to help set up an execution function for Fixed Income, FX and MM and this has slowly been rolled out to a more global role. He also has worked on TCA projects and many initiatives to improve the quality of execution in all the asset classes he oversees.

©BestExecution 2014

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Buyside focus : Multi-asset trading : Lynn Strongin Dodds

Ian Rycott

July 3, 2014

THE SINGLE TRACK.

There may be a lot of talk about multi asset class trading but Lynn Strongin Dodds finds the industry still trades in silos.

Buyside firms may have reconfigured their trading desks to offer a more centralised structure but seamless trading across different asset classes on one platform is still in the future. This is not necessarily down to the technology but the operational processes and inherent differences between the equity, fixed income and currency worlds.

These discrepancies were succinctly highlighted in a Tabb Report – MiFID II and Fixed Income Price Transparency in 2012 – which still rings true today. Simply put, equity is one asset class whether it is a small UK mid-cap, large European corporate or one block trade. By contrast, fixed income is not homogenous and comprises multiple investments that not only have different structures and trading methodologies but also issue and maturity dates, coupon rates, call and put features. Bonds are also segmented by issuer, such as government, sub-sovereign and corporate bonds and can either fall into the inflation protected, discount, coupon and zero-coupon camps.

“The execution across asset classes is not homogenous,” says Serge Marston (left), managing director, head of eCommerce sales at Deutsche Bank. “There is no central order book for fixed income which is why trading high yield bonds can be more of an art than a science. There is no solution in the e-commerce piece for illiquid credit. As a result people on the desk look at the relationships between different asset classes and the impact they have on funds from a cost perspective but the execution and order management systems are different. However, we are beginning to see combinations in for example, FX and rates, rates and credits.”

Another reason multi asset class trading has not taken off is down to structural issues at brokerage firms. It is not easy to trade a multitude of assets down one pipe because of conflicts of interest, and in the opinion of some multi asset trading will only gain momentum when the vendors can overcome the historic bias of specialising in one asset and deliver the right products.

Vincent Mooijer, senior equity trader at PGGM, the largest Dutch pension fund with €142.8bn assets under management Dutch pension, notes, “Through the years markets have developed in different directions for a number of reasons. On both sellside and buyside this required a different expertise and therefore trading desk were organised per asset class separately. Several parallel universes were created to cater for the execution and processing of trades

He notes though that a combination of technological progress, a regulatory demand for greater transparency and a growing cost concern will pave the way for a more multi-asset approach. “Cost efficiency by combining technology and people is however not as easy as it sounds. Multi asset class trading does not necessarily mean one trader should trade every product via the same trading platform. This may be a solution for some but there will also be a demand for experts in one area or another. For example, in a multi asset class environment the fixed income trader could sit next to the equity trader and it will create a broader view of the market and you can make a better use of your resources.

However, change will not happen until technology and markets become more alike and traders learn to speak each other’s language. The advantage of technology though is that it makes execution of trades scalable, efficient and with the proper measures it reduces operational risk.”

Frederic Ponzo, managing partner at consultancy GreySpark Partners, agrees adding, “multi-asset class trading may be driven by the consolidation in the buyside trading desks but essentially it hasn’t changed much over the past two years in terms of what individuals are actually doing. You may see some traders execute listed derivatives as well as the underlying cash equities, but you will not see one person trading bonds one minute, then commodities or equities the next.”

Stu Taylor (below), co-founder of Algomi, a company that sells fixed-income market data software, notes that the trend is more with multi asset class investing. “The portfolio management and order management systems may be used for cross assets but a large proportion of trading is still done on a siloed basis. There are still corresponding systems and individual specialists sitting on the desk at the dealer level due to the nature of the specific assets. This is not just with the buyside but also the sellside. Some banks are trying to present themselves as one stop shops with a semblance of uniformity but behind the scenes, they are using different market infrastructures to trade.”

There has been more progress on offering the buyside a bigger picture of the trading landscape. “There is a growing need for asset managers to take a holistic view and look at, for example, multiple trades across different asset classes at the aggregate level,” says Des Gallacher, vice president, product management, for Charles River. “The head of trading has more responsibility than in the past when there may have been separate heads of equity and fixed income while at a corporate level there is a need to more effectively manage commission budgets and trade performance analysis. A single order management platform facilitates this in a holistic manner. In general, execution venues continue be specific to asset type.

David Masullo (above), head of EMEA Sales at Bloomberg Tradebook, echoes these sentiments. “Clients want us to bridge the gaps not just between asset classes but also geographies. This is because fund managers are taking greater control over pre and post trade analysis. They are also getting better at segmenting the different brokers, As a result they are looking for a platform that offers an overlay or much wider picture of the market on their desktop.”

Masullo also notes that there has been development on the cross algo front especially in the futures arena. Instead of leveraging a successful product from the equities space and for example, apply it to the futures market, there are products that can help buyside traders hedge a cash position with an FX future or trade a future against a government bond.

One of the drivers according to a new report by Tabb Group and Fidessa, is that futures markets are becoming increasingly automated, with an ever-rising proportion of algorithmic execution and sophisticated multi-asset class strategies. It found that the buyside are employing futures algos to not only hedge positions but also to generate alpha.

Looking ahead, products are being developed that will enable fund managers to make decisions from conditional factors including structured and unstructured data, as well as correlated and uncorrelated trends. Pairs trading algos are also expected to gain traction while portfolio optimisation algos could also become more prominent, as well as matching trading strategies and product types based on the underlying investment strategy.

TABB Group predicts that the proportion of buyside futures orders specifically identified as algorithmic could reach 20% by the end of 2014 and 30% by 2015. Usage has already increased to 12% last year from 4% in 2012. The figures only count orders where the buyside firm specified to the broker that an algorithm should be used – not the total amount of algorithmic activity that actually took place on the market.

©BestExecution 2014

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Analysis : European equity derivatives markets : Fragmentation

Ian Rycott

July 3, 2014

VOLUME & FRAGMENTATION.

Continuing the series from last issue, Ben Calev, Chief Technology Officer at Transaction Auditing Group, Inc., (TAG), provides an analysis of the European derivatives markets.

With significant product changes underway from Eurex, and the ongoing discussions surrounding clearing and reform of OTC derivatives in Europe, 2014 continues to be an interesting year.

Market share – Covered series

Beginning in April 2014, we saw both TOM and Euronext dropping approximately 3% of market share each over March 2014, while Eurex showed a commensurate increase to just under 18% (see Fig 2).

In May, we saw a major shift with Euronext gaining a highly significant 13% over April, bringing them to almost 64% of the market, a high point for this exchange. Both Eurex and TOM shared significant decreases to 10% and 28% respectively (see Fig 3). .

In the first two weeks of June, we saw a new record set with Euronext showing approximately 65% market share, the highest to date. Both TOM and Eurex continued a small yet significant decline to just below 27% and 8% (see Fig 4).

Market share – AEX-based options

AEX Options showing stabilization and an almost even division of market share between the players.

In April 2014, TOM made a significant increase to almost 50% market share. Euronext showed a marginal decline, effectively splitting the “AEX based” business at 50-50 for the first time ever (see Fig 6).

During May 2014, Euronext gained approximately 5%, edging out the somewhat equitable split with TOM at just under 45% (see Fig 7).

During the first two weeks of June 2014, we observed Euronext resuming a gentle but steady climb to an almost 58% share of these highly contested products (see Fig 8).

The statistics continue to show that 2014 is shaping up to be the year of stabilization that TAG predicted. In the second half of the year, it will be interesting to see how the introduction of new derivatives products and increased competition affect the marketplace.

Be25_TAG_Graphics

• Eurex is operated by Deutsche Börse AG and offers a broad range of international benchmark products. On a combined basis with the International Securities Exchange, (ISE) they are a global market leader in individual equity and equity index derivatives.

• Euronext is the first pan-European exchange, spanning Belgium, France, the Netherlands, Portugal and the UK. NYSE Euronext Amsterdam supports the flagship AEX Index, which reflects the performance of the 25 most actively traded shares listed on NYSE Euronext Amsterdam.

• TOM MTF is a Multilateral Trading Facility located in Amsterdam, The Netherlands offering trading in shares, derivatives and ETFs.

DISCLAIMER: All data derived by TAG from publicly available sources utilizing proprietary tools. Although TAG believes the data to be correct, we do not guarantee its fitness for any purpose. TAG shall not be held liable for incorrect data under any circumstances. Any opinions expressed are solely those of the author.

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News review : The impact of regulation : PJ Di Giammarino

Ian Rycott

July 3, 2014

THE NEED TO ENGAGE.

PJ Di Giammarino, founder and CEO of JWG-IT Group assesses MiFID II’s new conduct requirements.

The new conduct requirements that MiFID II is set to bring into the European market often get overlooked. On the face of it, the high profile issues such as transparency, transaction reporting, HFT and derivatives obligations appear more challenging. But make no mistake; the way business is conducted with clients will be radically reshaped. In fact 18% of the 860 questions in ESMA’s MiFID II recent consultation and discussion papers focus on investor protection. The requirements laid out by the politicians are set to have a substantial impact on the order and execution process. The biggest deltas will be in client handling, pre-trade and execution. Now that the process of defining the letter of the law has kicked off in anger, it’s time to get your views in.

Client handling

The way a firm exchanges information with a customer is set to become more complicated – in other words more time-consuming and expensive. The provisions regarding client disclosures and classification are set to become more substantial. These changes are in line with an ongoing trend; before MiFID I, firms’ relationships with their clients could be characterised by the phrase ‘my word is my bond’, but then firms were compelled to implement rigid suitability checks, and then they were compelled not only to do the suitability checks, but also to prove that they did them – not, in many cases, as easy as it sounds. With MiFID II, the suitability checks will have to become more arduous and the proof more detailed. MiFID I established the need to classify all clients in standard categories, with the objective of levelling the playing field. MiFID II maintains the same objective in this respect, but moves to achieve it more comprehensively by tightening the pre-existing rules. This means that the process of classifying clients and assessing their knowledge is going to get more complicated and difficult. This will be expensive in terms of the systems and workflow updates that will certainly be necessary, not to mention how time-consuming the process of fully understanding, identifying and then implementing these changes will be. For example, municipalities will no longer be able to be classified as eligible counterparties or professional clients. This has the potential to cause problems for firms due to the difficulty, in certain cases, of identifying regional governments and getting them to sign bits of paper. MiFID I also brought in rules around reporting to clients, designed to make the firms’ activities more transparent. Again MiFID II maintains these original aims while attempting to strengthen the regime. This means that firms will have to disclose more information to their clients regarding suitability decisions and execution. Key deltas include firms’ new requirements for monetary and non-monetary payments for services, and the disclosure of the costs and risks of instrument bundling is now mandatory.

Pre-trade controls

MiFID II takes the pre-trade controls, established in the original directive, which were designed to improve the tracking of market abuse, and expands them, both in terms of breadth and depth. MiFID II insists on much wider market transparency, and more detailed pricing and order controls will apply to a wider range of instruments for both investment firms and trading venues. This has the potential to be very disruptive to the current operating model. It will likely mean production system changes, new market data sets, reference data revamping and a large programme management effort. There are now much stricter rules on algo testing, broader market making obligations and a new circuit breaker risk regime for HFT trading. Investment firms may find the new rules on algo testing particularly troubling as they have the potential to seriously increase the cost/income ratio. Just as importantly, MiFID II discussions are calling upon operational risk managers to play a much more active role in controls.

Best execution market monitoring

MiFID I introduced a best execution regime designed to get firms to trade in the interest of their clients. This was part of the grand objective to make the EU the most competitive market in the world. The regime consisted of making it compulsory for firms to have an execution policy, and to be transparent with its details. Firms were asked to monitor their own compliance and review arrangements at least annually. MiFID II gets much more specific about the nature of the execution policies and how they are disclosed. To this end a new concept is introduced; total consideration. Firms must ensure they apply this new concept to their execution policy; however, ESMA are yet to make clear exactly what is meant by total consideration. What is clear is that the more specific best execution policies will result in a more complex, expensive and time consuming agreement and reporting processes. An example of a new disclosure requirement is the obligation for firms to publish their top five trading venues by instrument class and to show the quality of execution. Trading venues must also publish data pertaining to the quality of executions.

Your input

This may all sound like a lot of deltas for the industry to get their heads around, but the areas that we have gone into here are just a start. Client handling, pre-trade controls and best execution – together – only make up a small part of the investor protection section of the discussion and consultation papers. There is plenty more to think about. Given both the sheer scale of MiFID II and the fact that its objectives range from fairly broad to downright unclear, the need for all market participants to engage in the ongoing consultation process is high, not least because we are talking about highly complex issues. Those discussed here are linked to several other areas of MiFID II, most notably market data and transparency issues, which form a substantial part of the new regime. Furthermore, the industry is not likely to have a unified voice throughout the consultation process, since what a market data vendor thinks on a lot of these issues is likely to be very different from what those in procurement departments believe. This makes it even more vital for each separate party to get their voice heard. The first, and most important, round of this process is underway now and responses are due 1 August. We look forward to Q&As, guidelines, opinions and reviews of supervisory practices at national level throughout 2015. 2017 is closer than it feels.

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Viewpoint : Intraday liquidity : Darryl Twigg

Ian Rycott

July 3, 2014

THE IMPORTANCE OF INTRADAY LIQUIDITY.

Darryl Twiggs, Head of Product Management at SmartStream, gives his view.

The Bank for International Settlements’ Monitoring Tools for Intraday Liquidity Management, which was published in April 2013, provides national supervisors with the tools for monitoring “large, internationally-active” banks’ intraday liquidity risk, which it defines as: “The risk that a bank is unable to manage its intraday liquidity effectively, leaving it unable to meet its payment obligations at the time expected, which impacts its liquidity position and that of other parties.”

The necessity for intraday liquidity comes from banking activities that involve large value payment and securities settlement systems. The introduction of risk management mechanisms such as Real-Time Gross Settlement (RTGS) payment systems and Delivery Versus-Payment (DVP) settlement in the securities markets, has resulted in the critical need for intraday liquidity.

Without sufficient intraday liquidity these systems could come to a halt or become gridlocked, especially in cases where the settlement bank decides to delay or postpone payments, for example, in order to reduce their intraday liquidity costs, or where certain market scenarios prevent a bank from having sufficient intraday liquidity to meet their settlement obligations.

Some of the questions regulators are asking are: Which banks have sufficient intraday liquidity to meet settlement obligations in normal and stressed market conditions? What contingencies should they put in place to react quickly?

For financial institutions and regulators there are obvious lessons to be learnt from the Lehman Brothers catastrophe, and although banks already have some systems in place to manage the risk implications, regulators want to see a more disciplined approach from internationally active banks.

For front office trading?

The front office of every bank produces a summary report at the beginning of each day, which is used as an indicator for trading during the day. As markets move, this summary report remains static – traders will be making decisions on old information and possibly making decisions that could affect the liquidity position of their books. With intraday liquidity they can take advantage of knowing their liquidity positions in real-time and have a holistic view of the current trading environment.

The accuracy of the summary reports at the beginning of the day can be questionable. This is made more complicated by market positions changing in different time zones, especially where money is swept from one country to another. The management of intraday liquidity is therefore becoming a front office tool, whereas traditionally it has been the focus of the back office. Organisations are also looking to make best use of these tools across operations and meet KPIs.

Implications of delayed payments

Failing transactions will bring payment and security settlement systems to a halt, which can result in drastic systemic implications given that all market participants are connected in the transaction chain of activities. The bigger implications of delayed payments and settlement problems can be catastrophic – as was demonstrated during the financial crisis.

The key issue is with correspondent banks who will bear the brunt as very few are able to provide detailed real time reporting.

Most banks’ legacy systems and processes work on an end-of-day or overnight basis and are not geared towards providing real time or intraday information. In addition, trade information is dispersed across different trade and transaction processing solutions which in turn creates IT and data access challenges. There is a need for banks to find a way to aggregate data across these different silos in order to gain a holistic view of their positions, liquidity and exposure.

What banks need to consider

Financial institutions need to act now, they need consider the business benefits of improved visibility of their liquidity and understand the inherent risks associated with having no intraday reporting. The case for implementing intraday liquidity monitoring tools is strong both from an operational and regulatory perspective.

The banks that continue to operate blind without visibility of their exposures are likely to be left behind the curve and will have no control over their risk exposures. One of the biggest challenges for banks will be to capture timely and quality data from their own internal IT and operational silos, and from correspondent banks. Correspondent banks will suffer with the changes as few today are able to provide the level of detailed real time reporting that monitoring tools require.

To manage data challenges banks will need to migrate from cash management solutions focused on settlement to systems that support the new T+0 operational paradigm. These systems will need to be configurable, open and flexible enough to accept cashflow data across the whole lifecycle of a trade so that banks can be more predictive in their approach to cash and liquidity management. As national regulatory supervisors will want to drill down into the details of specific transactions and how it impacts a bank’s intraday liquidity position, doing nothing is not really an option; neither is trying to outsource the problem to a third party, who given the interdependencies of counterparties in the transaction value chain could become a source of risk and stress. Banks need to integrate the monitoring tools within their operations, making them part of their everyday cash and liquidity management processes. After all, what bank wouldn’t want to know its real time liquidity exposure, to know that all trading activity can be funded and that it is maximising its use and investment of funds?

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Viewpoint : Regulation : Silvano Stagni

Ian Rycott

July 3, 2014

It’s fast and furious.

Silvano Stagni, group head of marketing & research at IT consultancy, Hatstand explains that the pace of regulatory change has quickened and you ignore it at your peril.

ESMA’s first consultation on MiFID II/MiFIR has a very short timescale and part of this haste has to do with the choice that the European Commission and the European Supervisory Agencies made a few years ago. The decision to push post-trade derivative regulations to meet political commitments at G20 level left the review of rules concerning the trading of derivatives, transparency and investor protection in need of revision. This is now forcing the pace of the MiFID review.

EMIR is a regulation and it should be implemented in the same way across the Single Market in Financial Services. However, this cannot happen because some of the definitions in EMIR depend on what has been defined in MiFID I (a directive). It therefore has national flavours that are in direct conflict with the idea of applying EMIR in an identical way across the territory.

The market has moved in a direction that requires a review of MiFID anyway. In the past three years, ESMA has issued regulatory guidelines in an attempt to bridge the gap until MiFID II/MiFIR became effective, such as the ESMA regulatory guidelines on automated trading published towards the end of 2011.

Last but not least, financial markets are a global business. Cross-border trades carry a huge regulatory burden unless there is ‘equivalence’ between jurisdictions. For instance, full equivalence with the US can only be established once we have trading rules in place, since Title VII of Dodd-Frank covers both trade and post-trade workflows. The CFTC and SEC have waivers in place that will expire in 2016; failing to have a defined regulatory environment with a set date for implementation by the time those waivers expire may have serious consequences for European institutions that could find themselves in the position of having to implement Dodd-Frank in its entirety for a short time.

The definition of level 1 for MiFID II and MiFIR was a lengthy process and ESMA is therefore trying to catch up by publishing both a consultation paper and discussion paper by the end of May, in tune with the consultation’s end on 1st August. At this stage of the process, ESMA poses many questions and generally listens to people’s opinions, providing they are adequately supported with examples and case studies and that their points are made in a rational way. Don’t say, ‘this is too complicated; it will never happen’, but explain why you believe it will never happen and support your argument with examples. If enough people make your point in an intelligent and unemotional way, they will listen.

So, why do you need to engage in the process? MiFID II/MiFIR will define your trading environment, the way you relate to your clients and your best execution obligations – amongst other things. They will also refine the definition of some of the principles detailed in other directives and regulations, such as the Market Abuse Directive and Regulation (MAD/MAR) and EMIR. You ignore this process at your own risk.

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Market Opinion : The impact of regulation : Jannah Patchay

Ian Rycott

July 3, 2014

Agora_JannahPatchay_770x375 — Agora, Jannah Patchay-770x375

THE WEB WE WEAVE.

Confused? You should be. Jannah Patchay of Agora Global Consultants takes a look at the regulatory quagmire.

It’s tough being a financial markets regulator these days. Not only is the modern regulator faced with a plethora of political drivers and economic challenges; they are also under intense scrutiny from all sides – the industries they regulate, the media, and of course other national regulators, who are looking to them as examples of how, or how not to go about the business of fulfilling their G20 and various other commitments. At times it must feel as though they are under constant fire. As soon as a new piece of legislation is published, or a new deadline set, the barrage of lobbying and requests for clarification begins.

In an effort to avoid another financial markets catastrophe, as in 2007-2008, the G20 made a commitment at their 2009 summit in Pittsburgh to the improvement of market efficiency, risk management, transparency and integrity. In the process of fulfilling this commitment, so much new regulation has been created that some regulators are having trouble just keeping pace.

Take ESMA, for example, and its recent and well-publicised woes arising from the lack of a single definition of what is classified as a derivative across the member states of the European Union. The European Market Infrastructure Regulation (EMIR) refers to the earlier MiFID I for the definition of a derivative. However, in a twist unique to the European Union, MiFID as a directive has been implemented separately by the government of each member state, and therefore the exact definition of a derivative varies from state to state. The UK in particular has a far more lenient definition of spot FX, going out as far as T+7 settlement, whereas other EU member states define spot as T+2.

Difficult questions arose when it became clear that the UK’s Financial Conduct Authority (FCA) would be sticking to its guns on this point, regardless of potentially unworkable inconsistencies this might cause for the new transaction reporting (and possibly clearing) regimes. The solution will likely involve an updated, consistent definition applied, following an EC consultation process, via MiFID II and the accompanying MiFIR, which as a regulation will be directly binding in each member state and supersedes local law, thus resolving the present stand-off.

The EU is not the only regulator to have been caught up in a veritable spider’s web of its own making. In the US, no fewer than five agencies are responsible for supervision of financial markets, with sometimes overlapping jurisdiction. Parts of the Dodd-Frank Act must be implemented by each applicable agency separately, resulting for example, in differing definitions of a “US Person” between the Commodity Futures Trading Commission (CFTC) and Securities Exchange Commission (SEC).

The practical implication for financial market participants subject to these rules is that they must be extra vigilant in ensuring that the correct definition is used in the right context at all times, resulting in greater expense incurred in rolling out changes to systems and processes for compliance.

Extraterritoriality is the one word guaranteed to strike terror into the heart of any compliance or regulatory change professional. It is the weapon of the regulator intent on extending their jurisdiction as far as possible. The CFTC has expanded the scope of Dodd-Frank’s Transaction Level Requirements (including trade reporting, risk mitigation and clearing) to include US branches or affiliates of non-US banking entities, and even, in some cases, US individuals employed by non-US entities. A fund, organised and marketed outside the US, may come into scope based purely on the potential that it might be sold to a US investor.

A more cautious non-US banking entity, or one with less deep pockets, might choose to exit its US business entirely rather than attempting to comply or restructure their businesses at great expense. In the EU, ESMA is still pondering what might constitute a “direct, substantial and foreseeable impact” on European markets, as contracts having these characteristics will be brought into their jurisdiction, even if they are executed between two third-country (i.e. non-EU) counterparties.

However, what happens when a market participant is subject to two (potentially conflicting) regulatory requirements? What happens when a trade is deemed by the CFTC to be mandatorily executed on a swap execution facilities (SEF), cleared by a CFTC-authorised CCP and reported to a CFTC-registered trade repository, and that same trade, due to the involvement of an eligible counterparty, is simultaneously required by ESMA to be cleared by an EU-registered CCP and reported to a European trade repository? What happens if there is no mutual recognition of these entities, for example, where a trade repository registered with ESMA is not recognised by the CFTC? These situations are the absurdities of extraterritoriality, posing genuine and simultaneously meaningless obstacles to trades that, under a single jurisdiction, would be considered perfectly legitimate.

Fortunately for market participants, some progress has been made in harmonising regulatory requirements across various regimes. In July 2013, the European Commission and the CFTC agreed to a “Path Forward” in implementing new derivatives market regulation. This included provisions for recognition of “substituted compliance” where one regulator deemed another’s provisions to be equivalent to its own, on a case-by-case basis.

The CFTC has already granted targeted no-action relief for risk mitigation rules (portfolio reconciliations, dispute resolution, timely confirmations) where these requirements are met through compliance with their EMIR equivalents. In addition, the CFTC is nearing completion of a proposal to recognise foreign Designated Clearing Organisations (DCOs) where these are subject to comparable regulation and supervision in their home jurisdictions.

No-action relief has also been granted for derivatives trades executed on an MTF which would otherwise be subject to the SEF execution mandate (the fact that SEFs and MTFs are conceptually and substantively very different in their trading models and rules for participation is another story, for another time).

However, there is still some way to go. Many of the other G20 members have not yet published or implemented their own rules honouring the commitment, and bilateral negotiations with every other regulator imposing extraterritorial requirements may not be feasible for them. Perhaps the time has come for more international standards, aimed at a more consistent and harmonised international market. Might such a thing be possible, or even desirable?

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Fixed income trading focus : Sourcing liquidity : Sassan Danesh & Tim Healy

Ian Rycott

July 3, 2014

Be25_FIX_Danesh-Healy_582x375 — Sassan Danesh & Tim Healy, FIX

THE QUEST FOR LIQUIDITY.

Sassan Danesh (below left), Co-Chair of Global Fixed Income Subcommittee, and Tim Healy (below right), Global Marketing and Communications Manager for the FIX Trading Community, report on the challenge of finding liquidity in fixed income markets.

The markets have always hated uncertainty, whether it’s a macro event, a micro event, cyclical changes or something more systemic. The structure of the fixed income market is certainly undergoing some dramatic changes brought on by regulations such as Dodd-Frank, MiFID II, Basel III and uncertainty surrounding the future has highlighted liquidity constraints. Couple those concerns with the prospect of rising interest rates and an aversion to risk by the banks and you have the almost ‘perfect storm’ for an illiquid market.

The new SEF world

Mandatory SEF trading began on 15^th February and currently there are about 20 Swap Execution Facilities (SEFs) registered with the US Commodity Futures Trading Commission (CFTC) through which participants can trade. Even at this early stage, there has been some consolidation in the market and a number of key players have emerged in the rates and credit space.

Almost 95% of all Interest Rate Swaps (IRS) volume executed on SEFs since the start of the year has been
attributed to ICAP, Tullett Prebon, BGC Partners or Tradition. Bloomberg, Tradeweb and GFI have also seen some decent volume. For credit default swaps, Bloomberg has emerged as the clear winner capturing more than 70% of the total volume since the start of the year; GFI and Tradeweb have also gained some traction.
However, brokers are faced with a decision; do they connect to all SEFs or just the popular venues and take the risk of being unable to access certain pools of liquidity?
The problem of liquidity fragmentation in the swaps market has been further exacerbated by the lagging implementation of European regulations; MiFID II is unlikely to come into force until 2016, two years behind the Dodd-Frank regulations in the US. As such, if a European participant wishes to trade with a so-called “US Person”, then this trade must be executed on a SEF and in accordance with the Dodd-Frank rules. This has resulted in a 30% drop in notional terms of Euro denominated interest rate swaps traded on SEFs since the start of mandatory trading back in February. Also, a clear split has emerged with separate pools of liquidity forming for “US Persons” and “Non-US Persons”.

The challenge going forward will be how best to access this fragmented liquidity and the key will be the ability for banks to easily integrate with all of these venues, whether it be a SEF, MTF or Exchange, offering an economically equivalent swap future product, in a standardised, low-cost manner. What the market agrees on at this stage is that a collaborative approach to solving the fragmentation issue makes sense. The good news is that the vast majority of the SEFs have adopted the FIX Protocol, which means more efficient and cost-effective connectivity for all concerned.

A Low Inventory Environment

The feeling in the market place seems to be that fixed income may well take a similar path to the equity markets. The huge block trades that were once the norm in the credit markets will be replaced by smaller and smaller average order sizes over a period of time as the fragmentation of liquidity continues.

The Basel III capital requirements have forced banks to drastically reduce the amount of inventory they can keep on their books. This has led to the buyside stockpiling the vast majority of corporate bond inventory without an efficient and practical way to trade in and out of these large positions.

Will the role of the buyside morph into one of a price maker as well as a price taker, as the traditional dealer’s model of committing capital gradually disappears? For the less liquid issues, this is a possibility. The financial market participants are frantically looking for a solution with dozens of existing or proposed initiatives out there aiming to solve the liquidity problem. But how will the buyside connect to each of these platforms? The use of standardised connectivity solutions based on FIX is likely to be a critical factor in ensuring a successful transition to the new market structure.

*Sassan Danesh is Co-Chair FIX Trading Community Global Fixed Income Subcommittee, and Managing Partner, Etrading Software. Tim Healy is Global Marketing and Communications Manager for the FIX Trading Community.

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Fixed income trading focus : TCA : Alex Clode

Ian Rycott

July 3, 2014

USING TCA IN FIXED INCOME TRADING.

Bloomberg’s business manager, Alex Clode, explains how the challenges of designing an effective TCA tool for fixed income have finally been overcome and outlines the benefits to be gained from using TCA practices in other asset classes.

When Bloomberg surveyed the market early last year, 47% of traders, compliance and investment managers practiced TCA for equities, as opposed to a mere 5% for fixed income. Why has demand been slow to take off and what is driving growing interest?

The main problem has not been so much a lack of demand as a lack of supply. In fact the same poll showed over 38% were interested in Fixed Income TCA (as the next asset class other than equities, more than twice the amount of people interested in FX TCA (14%)). The lack of supply has been down to fact that it’s difficult to pull together all of the necessary pieces but a significant further acceleration in demand over the past year has meant that suppliers have had to respond. That growing interest has been driven mainly by an increase in regulatory scrutiny, opportunity and awareness of TCA.

While MiFID II hasn’t changed best execution requirements per se, regulators have expressed disappointment with what they see as substandard execution policies and review processes so greater scrutiny is almost certain. Regulators are also demanding greater post-trade transparency in non-Equity markets which should increase the supply and reliability of good pricing data on which TCA so crucially depends. Regulation and higher banking capital reserves are also driving more fixed income trading onto more formal electronic or other exchange-type platforms.

This fragmentation of fixed income trading across multiple trading methods and venues makes trading more complex. Suddenly the potential for trading expertise and process to raise or lower performance and rewards in fixed income, particularly given the size and volume of some of these deals, is looking immense.

But the big push for TCA for fixed income isn’t just coming from regulation. As trading desks and trading strategies become more integrated, practitioners, and especially equity traders who have already witnessed the impact of TCA on processes and cost, want those same analytical tools for examining other asset classes.

So how could TCA improve trading expertise and process in fixed income businesses?

What traders have learnt is that regardless of asset class by evaluating not single or specific trades but the entire trading process, you can identify trends or persistent behaviours that explain where and why performance is strong or weak and therefore where it might be able to be improved. By grouping trades together rigorously on an apples-for-apples basis at the right aggregate level, you can quantify and evaluate trades, and see, for example, which classes of security, region or order difficulty have been traded well or badly and the particular points on the curve where performance rises or dips. You can also spot the trades with dealers that cost more or when orders from particular portfolio managers present specific challenges.

It’s only by profiling all orders and grouping them together coherently that TCA helps you pinpoint where problems lie and then allows you to dig into the process to facilitate improvements.

What are the common mistakes people make when they introduce TCA?

The biggest pitfall is that data is aggregated at the wrong, usually too high a level. Say, for example, I want to compare the dealers I use. If I send all my easy-to-execute orders to one broker and the difficult ones to another then it doesn’t really help me to know that the performance and costs of the first one are more competitive than the second. I’m not comparing those brokers on an apples-to-apples basis. The vectors of how we group securities together and how we combine brokers, security type, currencies, maturity ratings and other proxies for ease or difficulty and liquidity, are important ways we break down and group orders to allow for meaningful comparisons. It is critical that data is normalised before use.

What advice would you give about selecting a good TCA tool for fixed income?

As well as being able to group trades using a variety of key vectors as discussed earlier, the quality of pricing sources used in TCA is critical in fixed income, especially since there are few volume-based analytics or benchmarks to rely on yet. The fixed income market is reliant on dealer-contributed pricing, but this is very diffuse with different brokers covering different fixed income classes and providing prices of different quality. As a result a credible Fixed Income TCA process needs to include a combination of contributor pricing, observed pricing and evaluated pricing.

The way we solve for contributor pricing is by using our Composite Bloomberg Bond Trader (CBBT) a composite price drawn from hundreds of different dealers. It provides the weighted average bid-and-ask price of contributions submitted by Bloomberg dealers, weighted heavily towards executable prices and actual trade data where available. The algorithm removes stale pricing and provides a comprehensive, credible and timely pricing source. For observed prices we use the client’s own RFQ data to identify, for example, the price and the broker with whom a trader executed a particular deal. As we also capture and store the quotes received from other brokers at the time, the data can show how closely those quotes matched the final execution price and provides a basis for calculating best and worst hit ratios. Finally, for evaluated prices, we use our proprietary BVAL price source. This uses three different methodologies to help evaluate pricing in cases where either the dealer-contributed pricing is very thin or securities trading is less active or liquid.

Apart from a set of defensible, accurate and relevant pricing sources, it helps if a TCA tool allow users to conduct analyses of different asset classes on the same platform and the user has absolute control of the data and a toolbox for answering the particular questions they want to answer.

What is the future for TCA beyond fixed income?

One of the main trends we have noticed is that there is an increasing interest from compliance in TCA tools for transaction surveillance. Compliance professionals are having to understand and improve the transaction process to become more alert to suspicious trading and can probe whether a spike in trading activity, for example, is indicative of, say, wash trades. This adds to the complexity of TCA, as we are introducing tools to not only benchmark trades, but also start to observe and quantify behavioural patterns. Regulators are also insisting institutions have more tools for spotting and reporting abuses and can demonstrate clearly that trading processes are properly monitored. Undoubtedly, there will also be a clamour for TCA for derivatives in the future, but that is some way down the track!

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Fixed income trading focus : MiFID II : Gherardo Lenti Capoduri & Umberto Menconi

Ian Rycott

July 3, 2014

MiFID II: from OTC to regulated markets

Gherardo Lenti Capoduri, Head of Market Hub, Banca IMI and Umberto Menconi, Market Hub, E-commerce Distribution, Banca IMI look at the ramifications and solutions.

MiFID II is quickly approaching, putting the concept of best execution firmly in the spotlight. The difference with the revised directive is that it is casting its net much farther beyond equities to reach a wider set of asset classes including fixed income and over the counter derivatives as part of Europe’s efforts to fulfil the G20 commitment to reform those markets. Be25_04.UMenconi.BancaIMI The European Securities and Markets Authority (ESMA) has put out its 800 page tome for consultation but the most contentious areas are dark pools and open access. The former includes placing two limits on dark pools – 4% in a single dark pool and 8% across all dark pools while the latter will allow users to process trades through a clearing house of their choice, irrespective of where they traded. When we attempt to define MiFID’s concept of Best Execution, we need to keep in mind that the best execution obligation under MiFID is not purely the outcome of minimizing the transaction cost. MiFID really concerns the full, process-based set of requirements that might be implemented by investment firms and intermediaries to fulfil the new obligation of establishing all reasonable steps for achieving the best possible net results for the client, when executing orders. The jury is out as to how this will play out, but if the implementation of the original MiFID is anything to go by, countries will have their own interpretation. For example, since the introduction of MiFID in 2007, not every client has taken advantage of the implementation of the reform as announced and not every European country adopted MiFID in the same way. This is because it is a Directive, which allows investment firms to have some flexibility in determining and establishing the main characteristics of the relative weighting of the three key “ingredients”, namely total consideration (price, net of costs), speed of execution and likelihood of execution and settlement. As we mentioned in a previous article in Best Execution, Italy implemented MiFID reforms in a strict way, particularly in regard to retail market structure. It anticipated the inclusion of non-equity instruments, which is now of course part of MiFID II. For example, in 2007, Italy’s Banca IMI launched Market HUB, its multi-asset electronic trading platform. Equities, fixed income and listed derivatives were available at the start and FX was added in 2012. In the fixed income space, the bank offers a high-touch service as well as best execution, and access to over 20,000 bonds by connecting to trading venues, OTC liquidity providers and offering additional liquidity on Banca IMI’s Systematic Internaliser, RetLots Exchange.

Breaking concentration

The other challenge has been the abolition of concentration rules, which has led to a lesser role for Regulated Markets and growing fragmentation in order execution. This combined with a deterioration of the market environment following the 2008 financial crisis has increased the risk of illiquidity for some financial instruments/markets and lower levels of order execution. More efficient intermediaries have tried to mitigate the issues by offering customers an integrated book with one or more levels of prices, according to the relevant trading venue, during the pre-trade phase as well as smart order management systems that can dynamically direct the order to the best venue according to MiFID criteria, properly weighted in the post-trade stage. One of the main problems though is that market data sources throughout the trading cycle have become increasingly expensive and would benefit from a consolidated pan-European tape for post-trade.

MiFID II

Just as MiFID I gave rise to new business models the same will be true for the new, revised directive. Buyside firms are concerned over the progressive weakening of their sellside counterparts, especially in the fixed income market. The classic and central market trading model characterised by customer-sales-trader workflow is going to be reshaped. It will still play a central role but more weight will be placed on flow generation and third-party order execution. There will also be new structures in the OTC markets. The correct fine-tuning of the transparency of the central limit order book (CLOB) model of the traditional markets and the liquidity inside the OTCs is the key point for any attempt to redefine the new model of execution and to add value to customers. There also need to be execution venues called organized trading facilities (OTFs) for fixed income and derivatives. The finer details have yet to be divulged. Solutions though are already in the works. Some intermediaries are developing smart order execution tools to collect – in the same execution policy – traditional markets and OTC and to compare different execution models (e.g. CLOB, RFQ, Voice). Concepts such as large-in-scale orders and products such as “order sweeping” from one execution venue to another are also being developed. Consistent with the idea that there will not be an execution model winner (RFQ or CLOB, order driven or quote driven), Banca IMI has developed its RetLots Pit non-systematic internaliser solution that is already active and is moving forward in the direction of integrating OTCs versus traditional markets. We believe that a virtual book, composed of the bids and offers, coming from different venues and market makers, would be the best instrument to consider. The correct integration and control of the criteria described above, the respect of the relevant new “ingredients” introduced by MiFID and developed in MiFID II, the flexibility to manage and compare the different types of orders, market models, settlement instructions and client classifications, together with a strong control over the entire execution chain represents the real added value for customers. It enables intermediaries to set up the proper execution policy for the best execution of clients’ orders and the potential to capture greater market share. ©BestExecution 2014 [divider_to_top]

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SWITCHING CHANNELS.

Lee Sanders, head of execution FX & MM and UK & Asia Fixed Income Trading at AXA Investment Managers explains the move to a new dealing system.

How has the market changed over the past year?

What have been the drivers behind the changes made to the dealing system and move to TradingScreen for FX, and what will be the impact of this on fixed income?

Has it helped improve the TCA process?

Overall, TCA has been increasingly gaining traction in FX, do you think it will become as popular as for equities?

How has the relationship between the buy and sellside changed over the last few years?

What opportunities do you see for AXA IM?

THE SINGLE TRACK.

There may be a lot of talk about multi asset class trading but Lynn Strongin Dodds finds the industry still trades in silos.

VOLUME & FRAGMENTATION.

Continuing the series from last issue, Ben Calev, Chief Technology Officer at Transaction Auditing Group, Inc., (TAG), provides an analysis of the European derivatives markets.

Market share – Covered series

Market share – AEX-based options

THE NEED TO ENGAGE.

PJ Di Giammarino, founder and CEO of JWG-IT Group assesses MiFID II’s new conduct requirements.

Client handling

Pre-trade controls

Best execution market monitoring

Your input

THE IMPORTANCE OF INTRADAY LIQUIDITY.

Darryl Twiggs, Head of Product Management at SmartStream, gives his view.

For front office trading?

Implications of delayed payments

What banks need to consider

It’s fast and furious.

Silvano Stagni, group head of marketing & research at IT consultancy, Hatstand explains that the pace of regulatory change has quickened and you ignore it at your peril.

THE WEB WE WEAVE.

Confused? You should be. Jannah Patchay of Agora Global Consultants takes a look at the regulatory quagmire.

THE QUEST FOR LIQUIDITY.

Sassan Danesh (below left), Co-Chair of Global Fixed Income Subcommittee, and Tim Healy (below right), Global Marketing and Communications Manager for the FIX Trading Community, report on the challenge of finding liquidity in fixed income markets.

The new SEF world

A Low Inventory Environment

USING TCA IN FIXED INCOME TRADING.

Bloomberg’s business manager, Alex Clode, explains how the challenges of designing an effective TCA tool for fixed income have finally been overcome and outlines the benefits to be gained from using TCA practices in other asset classes.

When Bloomberg surveyed the market early last year, 47% of traders, compliance and investment managers practiced TCA for equities, as opposed to a mere 5% for fixed income. Why has demand been slow to take off and what is driving growing interest?

So how could TCA improve trading expertise and process in fixed income businesses?

What are the common mistakes people make when they introduce TCA?

What advice would you give about selecting a good TCA tool for fixed income?

What is the future for TCA beyond fixed income?

MiFID II: from OTC to regulated markets

Gherardo Lenti Capoduri, Head of Market Hub, Banca IMI and Umberto Menconi, Market Hub, E-commerce Distribution, Banca IMI look at the ramifications and solutions.

Breaking concentration

MiFID II

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