FX trading focus : Opinion shaper : Patrick Fleur

January 31, 2014

THE CHANGING WORLD OF FX .

Patrick Fleur, head of trading and execution at Dutch fund manager PGGM Investments explains why it has a different spin.

How would you describe the trading environment today?

The current market has been dominated by regulatory changes. One of the biggest challenges is that not all the rules are clear and jurisdictions have different timetables for implementation. For example, we are a pension fund administrator and investment manager that invests on behalf of five Dutch pension funds that are exempt for three years before they have to comply with the central clearing obligations under EMIR (the European Market Infrastructure Regulation).

However, that does not mean we should ignore the changes – eventually we will have to implement them. In fact, we’ve already implemented central clearing and are fully operational, but we’ll not use this route unless the upside of using this outweighs the costs.

What has PGGM been doing to prepare?

We have been leading the charge on transaction cost analysis (TCA) with clients and counterparties. It is well established in the equities market but is still evolving in FX. One of the problems is that although we now have a lot of algos, to a large extent benchmarking is missing, which has meant that TCA within FX is currently very limited. This has made it difficult for the industry to conduct TCA and to correctly assess implementation shortfall going forward. Also, whoever is delivering the algo is also doing the TCA, so it’s not independent. There are different opinions in the industry on what to measure, such as whether it should only be commission and fees and not include the bid offer spread. We believe one of our big differentiators is that we calculate these costs and provide greater transparency to our clients.

How are liquidity levels and volumes shaping the market?

What we are seeing is the fragmentation of the FX market. Total volumes are growing but liquidity is decreasing. At the same time it has become cheaper, due to the increased competition, but if you take a closer look you can see it is also mis-priced. It is unclear where this implementation shortfall is going so I am not sure how sustainable this model is. However, I am optimistic that in five years’ time, FX will become more dominant and get the attention it deserves. One reason is the growing importance of FX as an asset class, with UK hedge fund managers being among the most active participants. At the moment the bulk of activity is still down to hedging but you cannot ignore the changes that are going on.

What impact do you think the current investigations into FX will have on the industry?

At the moment we are seeing people getting fired or suspended, and chat rooms being closed. I think these are short-term reactions but not real solutions. People are innovative and chat rooms were part of the development of the industry. They were used as a communication tool with clients and have proven be a good way to share information. However, there needs to be a universal moral or ethical code instilled. For example, traders need to be authorised by the Financial Conduct Authority and this type of code could be part of the wider remit of the qualification. What is happening now is that we are going back to other venues to exchange information where information is not taped, whereas chat rooms are a much quicker way to get information across and contain an audit trail and compliance monitor.

What other changes do you envision?

I think we will also see changes to the methodology of the WM/Reuters*, which is the most popular and transparent, industry-wide standard used. You can change the time window from 60 seconds to 5 minutes, or even longer. The venues used to calculate the fixings could be optimised to reflect the real price during this timeframe.

How do you see the market developing?

Over the long term, I would actually like to see more multi asset class platforms and not have FX treated differently and as a separate asset class. As I mentioned, it is looked upon as a by-product to hedge currency risk and not for the value it can generate. One reason is that clients have under-invested in the expertise needed to understand FX. For example, at PGGM, we’ve invested in the tools, analytics and have people covering FX, 24/5.

Clients are beginning to rethink their existing models and look beyond the traditional uses. However, TCA and smart order routing are the missing links to complete the circle. Companies also need to invest in better order management systems that have proper pre- and post-trade analytics. FX may be developing along the same lines as equities but they are two different asset classes and you can’t simply cut and paste. The tools need to be developed specifically for FX.

In the short term, I expect to see more electronic platforms, which will create fragmentation and make the decision-making process more difficult. However, over the longer term, more tools will be developed and clients will have a greater choice in how to trade, whether it is by agency, phone, using algos or direct market access across all markets. We have already seen a lot of work going into algos with the hiring of small equity algo teams. For example, we started from scratch, but it takes years to build a database. We currently have 63 live algos that we have tested in every market.

*The WM/Reuters service is a joint venture between the WM Company and Thomson Reuters. The WM/Reuters Closing Spot Rate Service was launched in 1994 to provide a better standard for the valuation of global portfolios. This need was a direct consequence of the globalisation of trade and investments which took place in the early 1990’s. Their rates were adopted by major stock market indices, the Financial Times and investment clients.

Biography:

Patrick is head of the trading & execution desk at Dutch fund manager PGGM Investments and a member of the Allocation Committee. His daily responsibility is managing a desk of traders within liquid markets. He is also running the World Overlay Mandate. Fleur joined PGGM in 2007 after spending seven years at ABN Amro and six years running the trading desk at APG (formerly ABP). He studied banking & finance at the business school of Enschede and Mechanical Engineering at the University of Twente in the Netherlands.

©BestExecution 2014

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Opinion shaper : Eric Krueger

Ian Rycott

January 31, 2014

STARTING FROM SCRATCH.

Eric Krueger, head of equities electronic, program and ETF distribution, EMEA, at Barclays, discloses the secrets to successfully building an equity franchise.

What was the driver behind the decision to build a European equity franchise?

The Lehman acquisition in 2008 gave Barclays a top-ranked US equity franchise. But to be truly global we needed to build a presence in both Europe and Asia. Barclays’ strength in the other asset classes proved that it knew how to build successful trading businesses, so it made the decision to build out Equities organically in Europe – a much easier one to make. Also, we could look at our US equity franchise as a template and quickly implement many of the things that made it so successful. Being a start-up has its challenges, but it also gives you the rare ability to build everything properly and to give your business a strong and flexible foundation. We had an advantage here because we did not have to deal with any legacy systems or infrastructure. Also, I think the past few years have been tough for equities in general and we were investing in our trading technology in a period when many others were focusing on cutting costs.

How did you think you could break into such a competitive industry?

Breaking into a very mature and competitive business is never easy, but there was a lot we could leverage from across the franchise when starting out. Barclays was already very strong in the other asset classes and we had a top ranked US equity franchise from day one. This meant that most of our clients were already executing with the bank in some respect as we built out our European capabilities.

Also, we have many competitive advantages thanks to the UK being our home market. We have been able to internalize much of our retail flow, which has helped our dark pool LX, and this gives us a unique liquidity proposition to offer our clients. Last year (2013) we were number one in UK IPOs and number two in UK rights issues. If you look at LSE volumes, we are already number three there. So, in a very short period of time, we’ve been able to show our clients a unique offering in both the US and the UK, which are two of the largest markets in the world.

What are some of the lessons that you have learned over the past few years?

That innovating and bringing new products, or ways of doing things, is crucial. The execution space is extremely competitive and even commoditised in some ways. We felt that the best way to break into a market like this was to continue to innovate and invest in our product offering. We wouldn’t have been as successful if we had just offered the same product as everyone else. We understand that we need to do things differently. An example of this is the automated capital commitment feature that we launched last year. This is on top of our most used strategies allowing our clients to access capital from us in an automated and anonymous manner. This product has helped our clients improve their execution performance and lower order duration.

Also, we are one of the few firms that is fully transparent in our trade reporting. We show if volume in a name has printed off our cash desk or via our electronic strategies. Our clients can use this information when deciding on how they’d like to engage with us to execute.

This is just the start, we will continue to work with our clients and bring new tools out to help their execution process.

What about your dark pool?

2013 was a great year for our dark pool LX. It is now the number one dark pool in the US and it was 2013’s fastest growing pool in Europe according to Rosenblatt’s figures. We learned a lot from our US franchise and were able to emulate many of the things that made them successful. For example, we also rolled out the Liquidity Profiling framework which allows us to monitor all participants in our pool on a real time basis. This allows us to grow our liquidity offering while protecting our clients from aggressive behaviour. Clients have become comfortable with how we police our pool and this has helped us grow.

How have you developed the research group?

The strength of your content offering is important to many clients and we invested a lot in this area. In Europe we took our time and hired many well-known and top-ranked sector analysts. This shows in the fact that we were number one in the year in the Starmine broker rankings. Also, the US research offering was very strong from the Lehman franchise. We can show our clients a strong global and cross asset product that is very unique.

What were some of your biggest worries building a business from scratch?

We hired a lot of people, from many different firms, in a very short period of time. These people all had different ways of doing things and maybe a different perspective on how the business should be built out. At first I thought that this might pose a challenge but I think it turned into one of our biggest strengths. Even though we all came from different firms, we all joined because we wanted to be part of this project. As a result, I think the teamwork we have is really rare. Also, we were able to implement many of the best practices from across the Street and avoid many of the mistakes that we saw in our previous firms. I think this all fed into the business as we built out and will continue to pay dividends in the future.

Biography:
Eric Krueger is head of equities electronic, program and ETF distribution, EMEA, at Barclays. Based in London, he joined Barclays in August 2009. Previously, he was at Bank of America Merrill Lynch for 12 years, where he held a number of management roles in both the US and Europe, most recently as head of equity program sales and trading for EMEA. He holds a degree in Finance and Marketing from Fairfield University, Connecticut.

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Opinion shaper : Alasdair Haynes

Ian Rycott

January 31, 2014

NEW BEGINNINGS.

Alasdair Haynes, founder and chief executive officer of recently launched Aquis Exchange explains why this MTF is different from all the rest.

There are many MTFs on the market so what was the driver behind Aquis Exchange?

When Chi–X Europe was sold to BATs in 2012, I wanted to stay in the industry but had to keep out of the market for a certain period of time. However, in your life you may have a handful of moments where you have an epiphany and mine came when I was buying my son a mobile phone. I looked at the subscription-based pricing model and the impact it has on behaviour. If you are a small or large business or retail customer, there is a price band that suits your needs and I thought why this couldn’t be applied to financial services.

How have you applied this to Aquis Exchange?

If you look at the exchanges in Europe, the fees charged are a percentage of the value of trades, which means their cost base is not linked to revenue streams. They give the biggest discounts to the biggest users. Many of the MTFs are based on a maker-taker pricing model which charges users for orders that remove liquidity from an order book, while offering rebates for orders that add liquidity. What we have tried to do is operate like a telecoms company in that revenues are directly related to the process costs of our business. Clients have their clearing, settlement, execution and data all in one package like you would do for your phone subscription. Users are charged according to the message traffic they generate, rather than a percentage of the value of each stock that they trade. There are different pricing bands to accommodate varying degrees of activity. For example, there is a very low usage band for small firms, which are traditionally disadvantaged by the pricing structure of the incumbent exchanges. At the other end is the top category where usage is unlimited.

We believe our model is fair, inclusive, simple and transparent. I also think this is a more efficient way to run a company because we can predict the number of users and their subscription type for the following year, and from that, allocate and align our costs and revenues accordingly.

What will the charges be?

Starting in the middle of January 2014, we will charge £2,000 per month for trading firms that have a small message requirement per day, and £10,000 ($16,200) per month for unlimited messages (subject to a fair usage policy), which reduce marginal costs to a bare minimum. We do not plan to charge for the data for at least two years. When we do though it will be materially lower than the incumbent exchanges charge.

How did you build the platform when everyone was working remotely?

It was a classic technology story of people working from their garden shed or out of their home to build a business. There are 30 people in the company and over half of us are from Chi–X Europe, so we had a proven team of people who had already worked together on different projects. We met once a week in a Starbucks in London but the rest of the time was spent working separately. One of our main advantages was that we didn’t have to rebuild a platform or use legacy systems but were able to start from scratch and build a new comprehensive integrated multi-dealer platform.

I think that some of the main benefits that our new platform brings are the latency is significantly lower than many of the existing exchanges and the architecture is highly scalable, which allows not only high numbers of simultaneous trading connections but also high transaction capacity.

Do you think the market needs another exchange though?

Currently about 95% of all equity trading is done either on the national exchanges or BATS Chi–X and I think there is space for one or even two more major players. In fact, history has shown that markets don’t like a duopoly and we thought it was the right time for a third player. The European equity market has been through a difficult time and we are finally starting to see growth coming back in this space. Our aim is not just to provide fresh competition to the MTFs and exchanges but to change the pricing mechanisms of the industry and to lower the trading costs maintained by the existing duopoly.

Where did you get your backing?

We did not want to sell a share of the firm to a user because of the conflicts of interest. We also did not want the consortium structure as it is not very efficient. So the employees own 25% of the company while the Warsaw Stock Exchange has a 30% strategic stake. They viewed it is as a way of offering Polish securities to the West and vice versa. The remaining 45% is owned by high-net-worth individuals. Many markets are run with a consortium structure and we are giving ourselves a good 18 months to gain traction. We will know in this time whether the market wants subscription pricing or not. We have about a dozen plus users but are targeting a total of 42 for this year and are hopeful we can get them over the line. We announced our creation in October 2012, launched in November 2013 and have so far been delighted with the results.

What are your future plans?

It is very early days but one of our aims is to sell our technology as a piece of kit or, in effect, an exchange in a box. We can trade any asset class, plus also do the market surveillance and provide the data in a faster and cheaper way. We can also provide a turnkey solution to organised trading facilities that are expected to be launched after MiFiD II is finalised.

In terms of trading, we launched with clients performing test trades in three European markets, – France, Netherlands and the UK. The plan is to widen the number of stocks available to 1,000 plus across 14 markets.

Biography

Alasdair Haynes is the founder and CEO of Aquis Exchange. He is the former CEO of Chi-X Europe and was responsible for growing the business into Europe’s largest equities trading platform and into profitability before its sale in late 2011. Prior to that, Haynes spent 11 years heading up ITG’s international business, pioneering the introduction of electronic trading and crossing into the European and Asian marketplaces. He began his 30 plus-year career in the City with Morgan Grenfell and has held senior positions at a number of investment banks including HSBC and UBS.

©Best Execution 2014

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Viewpoint : Market abuse & TCA : Darren Toulson

Ian Rycott

January 31, 2014

TWO SIDES OF THE SAME COIN.

Two recent hot topics for buy and sellside firms have been monitoring Execution Quality (TCA) and Market Abuse (MAD). Darren Toulson, head of research at Liquidmetrix explains how they are inextricably linked.

TCA and MAD are usually seen as distinct activities, often implemented in different ways using different systems and procedures. But in essence, the consequence of successful market abuse by one participant will often manifest as poor execution performance for their victims. The patterns of behaviour we’re looking for in TCA and MAD are often the same with the TCA ‘victim’ being one side of the trade and the MAD ‘perpetrator’ being the other side. Let us illustrate with an example.

Market manipulation of a reference price to create an instant trading profit?

The diagram shows a pattern of trading activity that, depending on the participants involved, might illustrate market abuse as well as poor execution quality. The example is real and detected in early 2014 using purely public market data – we don’t know who the participants involved are.

To explain what happens (see Fig 1):

At some time before 10:47:15.643 a buy order for a UK stock is placed on a primary mid-point matching Dark Pool.

At 10:47:15.643 the lit order books for this stock are shown. The primary market (LSE) best bid and offer price is 617.0/621.0p (blue squares) and the market wide EBBO is similar at 618.5/621.0p.

At that instant, a liquidity provider with 300 shares resting on LSE at a price of 621.0 cancels their order, causing the LSE bid/offer price to move to a ‘lopsided’ bid offer. The LSE mid-price at this instant lies outside of EBBO so is not really a ‘fair’ market price.

19 ms after the LSE order is cancelled, a trade occurs on the Dark Pool for 300 shares at a lopsided LSE mid price (the order book state is shown in the bottom chart).

Immediately after the Dark Pool trade it’s possible for the seller in the Dark Pool to make an instant profit by buying back immediately on an MTF.

What does this mean from a TCA/MAD perspective?

The buyer with a resting order on the dark pool obtained very poor performance. The intention of using a dark pool is to receive a fair mid-price match with a counterparty; instead the execution occurred at an instant when the LSE mid-price has been distorted by a single market event. No matter what the identities/intentions of the other participants, this trade is problematic for the dark pool buyer from a TCA point of view.

From a MAD point of view, if the trader who cancelled the buy order on the LSE is the same participant who then sent a sell order to the dark pool to trade at the inflated price, then this could be seen as an attempt to profit by causing a reference price to alter. Alternatively, if this was not the intention, or indeed if the participant cancelling the order and the participant selling to the dark pool are different, then this may simply be a ‘fortunate accident’ from the point of view of the dark pool seller. However, the timing of the events and the fact that the same volume cancelled on LSE was then immediately traded at a better price (for the seller) in the dark suggests further investigation may be warranted.

Summary

TCA and MAD really are two sides of the same coin: for any abuse to be successful, someone should have poor execution and someone else should make a profit. To illustrate this, figure 2 shows detectable poor TCA performance as one circle and all cases of suspected market abuse as another circle.

Most poor TCA performance probably has nothing to do with market abuse and is simply down to bad execution strategies.

Likewise, many potential market abuse patterns lead to no obvious systematic trading loss to other participants. In this case, they are more likely to be artefacts of valid trading styles rather than intentional abuse.

There is an overlap (red) where a pattern of potentially abusive behaviour by a participant leads directly to poor trading performance for their counterparty victims.

To reduce false alarms, MAD systems can use TCA style analysis to help concentrate on the relatively small intersection of potentially abusive behaviours that lead to actual trading losses for other participants. TCA systems likewise should try to determine if root causes of poor performances correspond with potentially abusive trading activity by other participants so action might be taken to avoid such scenarios.

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Viewpoint : Post-trade : The challenge of T2S : Fiona Hamilton

Ian Rycott

January 31, 2014

THE DEVIL IS IN THE DETAIL.

Effecting efficient evolution for the European securities markets – a TARGET2-Securities (T2S) viewpoint, by Fiona Hamilton, Vice President EMEA Operations, Volante Technologies Inc.

Change has been on the European securities agenda since the 1990s. But has there been any urgency? Giovannini and Lamfalussy were right though; domestic markets worked fine, cross-border trading was not a big issue and somehow the horrendous costs and complexity from European heterogeneity did not kill the goose that laid the golden egg of profitable operations.

Today it’s clearly different. The status quo received its seismic shock in 2008 and, since that time, the agenda has been in continual evolution towards a world of reduced risk (operational and systemic included), transparency, and increased market volume and velocity. Cross-border harmonisation (aka T2S) is not a novelty, but indeed, an integral part of balanced investment strategies.

Left to its own devices, the market can expect various responses to T2S.

The regulatory driven landscape of central entities will see some obvious candidates in these new functions that fail to arrive at the starting line; new names will innovate into leadership positions and others will limp along oblivious to strategy, tactics and the realities of commercial viability.

Visionary commentary on T2S is one thing; for operations and IT however, the devil is in the detail.

Evolutionary path

Looking at the likely evolution, some common denominators are clear. There will be more parties with which to interact electronically, the STP ‘holy grail’ of universal standards and reduced costs will not necessarily be achieved, application vendors will continue to promise future-proofed technology and consultants will abound, allegedly positioned to reduce programme implementation risk. These factors aside, the perpetual lingua franca of financial services will be electronic messages.

With more counterparties across the transaction life cycle, message volumes will increase. As Europe’s 30+ settlement systems manoeuvre into the new regime to offer seamless choice in service, the on-going challenge will be how best to reduce the friction cross-market.

The financial services industry may not change fundamentally but the way we ‘do’ it will. Counterparties, currency, value date, amount, etc, are perennial. Therefore today’s processing engines should still be largely fit for purpose – subject to their handling of risk information, high volumes and IT’s related cost of ownership and latest trends.

A world of message and connectivity-based thinking is arriving where ‘intra’ takes second place to ‘inter’. Welcome to the new regime of message exchange-based processes.

As the June 2015 T2S date looms, connectivity-based thinking needs to take hold and a renewed focus made on the enablement of message-based business processes. The European securities industry is set to have its engines upgraded and to reduce friction successfully the mechanism that we use (i.e. messaging), should be addressed.

Much of the T2S operating landscape has been mapped and it is exhausting reading. Physical connection will be via SWIFT, SIA/Colt, VAN (Value added Networks) or via Direct CoreNet. The 700-page General Functional Specifications maps how the centralised service will operate and will dictate the role of new entities and in all likelihood, impact current processes performed by in-house systems. Formats, timings, functions and destinations of messages will change; adeptness in multilingual messaging and reconciliations will be required.

The increase in message-based connectivity that T2S will stimulate means additions to the vocabulary. New T2S functional messages will be developed into ISO 20022 compliant XML formats, which can be structurally defined in electronically consumable format as XML Schema. The 1575-page T2S ‘User Detailed Functional Specifications’ v1.2.1, published in 2012, defines 130 new messages broken down across 8 categories which reveal the gap between current settlement messages and those required to operate under T2S. Entities must be able to handle new messages in this evolved, ISO 20022 lingua franca.

Predicting reaction

Two responses to T2S messaging look viable. Where equivalent messages, such as ISO 15022 or proprietary, are already being generated, reformatting or transforming into ISO 20022 and vice versa to handle in and outbound T2S messages, can be implemented with appropriate enrichment where necessary. Where messages are completely new, they will have to be created from scratch. Generally speaking, ISO 20022 messages are richer and more verbose than existing ones. Content mapping between formats must be watertight, notably compatibility between current systems and T2S’s enriched XML schema to name but one detail. The devil really is in the detail.

Current middle and back office systems ideally need to be augmented, re-written or replaced to cover the changes which will involve significant costs which most organisations will want to minimise. Lifting the lid on current systems and processes can also be a dangerous pursuit.

In the immediate timeframe, new functions will be in flux and it will be a hard and risky process to integrate into large and complex core systems. It is arguably better therefore, to take this opportunity now, to adopt a messaging architecture which insulates tried and tested from new and emerging. Across the transaction lifecycle the creation of a new messaging domain delivers the flexibility to connect and communicate with new settlement services functions as they emerge and mature. New messaging dashboards will illuminate settlement status and highlight risk across the transaction lifecycle which, after all, is part of the raison d’etre of T2S.

Moving up the food-chain

As the industry moves to more and more cloud and pay-as-you go service approaches, one can see how an evolution in technology investment makes further commercial sense. As new entities emerge, the market needs the agility to respond to choices in service provider, redirect communications and be able to despatch different levels of information to authorities and counterparties in details yet to be defined.

To date, messaging has been seen as a commodity activity – post trade at the end of the settlement cycle. The central theme of this article is that the role of messaging will become its own discipline and its importance as a mechanism to provide flexibility and speed through which to introduce new practices, accelerates it up the hierarchy. Individuals and companies with these skills will assume enhanced status.

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FX trading focus : Electronic trading : Dan Barnes

Ian Rycott

January 31, 2014

GROWING PAINS.

Electronic trading in foreign exchange advances but traders step back from high-frequency trading flow. Dan Barnes reports.

FX trading continued its upward trend, growing on a tri-annual basis, averaging $5.3 trillion per day in April 2013, up substantially from $4 trillion in April 2010 and $3.3 trillion in April 2007, according to the Bank for the International Settlement’s Triennial Survey. Figures from Aite Group shows that high frequency trading accounts for a significant chunk – over 40% of the total spot FX market and 55% of the market that is electronic.

“Electronic trading in FX is maturing at great speed,” says Rob Lane, general manager for EMEA Trading Solutions at market data supplier Interactive Data. “There is a lot more interest around electronic trading in the FX area and the FX products, outside of spot, are starting to gain momentum as more participants come into the market. We are seeing a huge amount of investment within the banks on gaining access to and technology for the FX market, akin to the previous ‘arms race’ in the equities and futures and options sectors. The FX market is maturing as more firms are trading the asset class internationally and there is a growing shrewdness around how to generate alpha.”

Fred Ponzo of capital markets consultancy GreySpark notes that as electronic trading matures, banks are using algorithms to protect liquidity on the interdealer market and increasingly providing algos to clients which are directed at best execution. “This is driven by demand. We see VWAP (volume weighted average price) trades and we are progressively seeing increasing numbers of algos being adapted for the FX market. It is still a few years behind equities. The other reason banks offer algos is that it is the only reason why clients are willing to pay a commission, where FX is largely a non-commission business, it is all about spreads.”

Conor Ringland, head of front office at Danish agency-broker Saxo Capital Markets adds, “Saxo’s business is 50% retail and 50% institutional, with the retail segment growing consistently with more sophistication towards FX in that segment. It is a race to produce efficient reliable fast technology and deep liquidity. The algo-based environment has been moderated by unpredictable volatility and liquidity in the market. Faced with those factors system boxes have tended to hiccup over the last few years. There is a bias to having much more manual oversight from our segment.”

The majority of the market is still traded on voice, says Dave Fotheringhame, managing director, head of flow trading eFICC (electronic fixed income, currencies and commodities) at Barclays Capital, with about 15% of the buyside using algos to trade. “For electronic trading, buyside firms may have a single dealer platform (SDP), and there are multi-dealer platforms (MDPs) which are either third party technology vendors aggregating prices across multiple dealers or technology based matching venues like FXAll, 360T, Bloomberg, FX Connect, where clients of all sorts, corporates, asset managers, hedge funds, are able to see prices from multiple dealers to trade against. If they are trading electronically that is how they are doing it.”

Buyside firms are seeing an upside to the increased use of electronic trading. For example, AXA Investment Managers is taking more control over execution using a combination of the latest trading platforms and its own dealing system. It has typically routed FX trades from its order management system into the FXAll platform, using the system to take care of low value items. Year to date it has processed 79% of its FX trades by number of tickets, or 35% by value, while high value tickets are traded by voice.

“This year we started to push FX through to our EMS,” says Paul Squires, head of trading, AXA Investment Managers. “Partly it is to facilitate streaming of prices in a consolidated format but it will also allow us to look at using algos. Finally the EMS provider, Tradingscreen runs TCA of our FX trades which will enhance our capability to benchmark our execution for clients.”

HFT risk

However there are concerns around the effect that trading technologies are having upon market orderliness and stability.

According to Fotheringhame: “One consequence of the high-frequency trading boom is that it has created an informational asymmetry. In most markets there are periods where there is an information asymmetry many times a second, where a few HFT market participants know things that others will know in a few milliseconds time but don’t yet. The economist George Akerlof showed that people trading at an informational disadvantage will choose to leave a market. That is what has happened in FX and the equity market. Volumes are sucked out into other places, either dark pools or other means of trading.”

However, there are advantages to including HFT as part of order flow, argues Ringland.

“From Saxo’s point of view our mandate is to drive price discovery, liquidity and transparency,” he says. “Volume and liquidity is important to us, so while we are not in the business of supporting high-frequency traders, we source liquidity from all of the tier one banks, so the general perception from our perspective would be positive because it adds liquidity and price discovery.”

Nevertheless in the dealer-to-dealer (D2D) market this risk of being exposed to firms that have gained information ahead of other traders has dramatically shifted trading. Historically D2D venues, which allow connections between over-the-counter traders, were dominated by a duopoly of Reuters and EBS, with Reuters holding the trading for certain currency pairs and EBS holding trading in a different set. They allowed voice traders in banks to clear their risk electronically and replaced the voice broker market, however their dominance has waned with the rise of rival markets and HFT.o while we are not in the business of supporting high-frequency traders, we source liquidity from all of the tier one banks, so the general perception from our perspective would be positive because it adds liquidity and price discovery.”

Both EBS and Reuters provide anonymous trading, with deliberately anonymous pre-trade to prevent firms from knowing who they are going to trade with, and opacity around post-trade reports that makes them effectively post-trade anonymous. As a result they were more susceptible than other venues to HFT. Dealer to client (D2C) markets are typically transparent limiting the chances that a trader could become exposed to high-frequency flow.

Reflecting the rise of HFT trading, the average value of spot FX transactions over the last ten years has fallen from US$3.1m in 2004 to US$1.1m in 2013, according to Aite Group (see Fig 1).

The pushback

Reacting against the threat of HFT, interdealer broker Tradition launched a new trading venue in April 2013 call ParFX that would be unusable by firms trading HFT strategies.

“Par FX excludes HFT trading practices by having a specific set of rules that makes it impossible to gain advantage from speed,” says Fotheringhame. “That had a large ripple effect on the existing players in the market. Other major FX venues have now copied or are considering copying one of the most fundamental features of the Par FX market which is the randomised order delay.”

Typically high-frequency trading strategies place huge numbers of orders and then cancel them en masse in microseconds, ostensibly to keep track of price movements, although some traders assert that this merely allows the HFT firm to identify how much liquidity there is at given price points and adjust their strategy to trade against other investors.

“[The delay] is simple to implement, but has a massive impact,” Fotheringhame says. “There is no point in shaving microseconds of time off your trading if you are subject to a random delay which is many times that duration. It creates a level playing field for market participants.”

Despite this pushback against HFT, innovation around faster trading speeds is still adding momentum to the FX markets maturity, according to Lane, suggesting the high-frequency proportion of the market may grow still further.

“There has been a huge amount of activity with firms accessing the liquidity sources including the major players such as EBS, Currenex, FXAll and Hotspot, as well as newer venues that have emerged such as LMAX. Co-location demand within data centres is also growing, as is Direct Market Access, and this is becoming more latency sensitive than ever before, hence the demand for these services, particularly in the Equinix data centres.”

©Best Execution 2014

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Trading : ETFs in Europe : Roger Aitken

Ian Rycott

January 31, 2014

CROWDED HOUSE.

Europe’s exchange-traded fund (ETF) landscape has certainly become more crowded following BATS Chi-X Europe’s launch of a new pan-European platform late last year. Can the market stomach another and what’s the prognosis for 2014? Roger Aitken reports.

Opaque and illiquid. That’s how some have described the European ETF market. However, things are changing and there are high hopes for 2014. The evolution though is likely to differ from the US where it all began in 1993 largely for the retail segment.

Essentially ETFs are a hybrid blending the investment characteristics of an index mutual fund with the trading characteristics of equities. Today one of the most frequently traded in the US is State Street’s SPDR S&P 500, which has seen over 100m shares traded daily. Between 2001 and 2012 the number of ETFs listed in the country increased from 102 to 1,194 with total net assets of more than $1.3trn and 36 product providers as of November 2012.

Highly fragmented market

Europe has some way to go before it catches up. It is far more fragmented, with some 24 stock exchanges listing ETF products versus three for the US. Between them the London Stock Exchange Group, Deutsche Börse and NYSE Euronext account for over 80% of on-exchange ETF trading, and one might rightly ask if any more entrants can be absorbed.

This is particularly so if one considers that around 70% of ETF trading in the region is transacted over-the-counter (OTC) according to industry estimates and confirmed by data from Deutsche Börse’s Cascade OTC platform operated by Clearstream.

Wallace Wormley, managing director, OSPARA Ltd, a wealth management advisory firm, says: “With so much fragmentation already in the European exchanges space and platforms that handle ETFs, it is difficult to expect this type of growth to continue. More likely to happen is consolidation, with M&A activity occurring amongst existing players as well as new entrants from Asia and the Americas looking to muscle into the business.”

On the ETF provider front, Europe had 41 players as at the end of November 2013 according to a Deutsche Bank ETF market review published at the end of the year. The trend is up over 2012, with five new entrants. However, FinEx Fund Plc, the highest ranked of the new crop had assets under management (AUM) of E34m and is dwarfed by BlackRock, the top ranked ETF provider in Europe, with 263 ETF products and E145,538m AUM. This represents a 22% increase since the end of 2012 and it accounts for 48% of the entire European market, totalling E303,061m which is up 8% from end 2012. The firm’s acquisition of Credit Suisse’s ETF business has helped i-Shares (BlackRock owned) capture more market share and it accounts for about 75% of all physical ETF-only assets.

Deutsche Bank ranked second with E37,632m (12.41% share) followed by Lyxor Asset Management with E31,905m (10.52%). Of other notable players, Vanguard, a leader in the US, has put extra efforts into Europe. Ranked fifteenth and offering nine ETFs, it has seen a stellar 1133% AUM rise to E2,594m from E210m a year earlier. UBS in seventh place saw a 16% rise in AUM to E10,758m across 114 ETFs. State Street Global Advisers, another top US provider, ranked ninth in Europe, saw a 93% jump in AUM to E6,140m inside one year.

Physical versus synthetic

Deborah Fuhr, managing partner at ETFGI, an independent research and consultancy to the global ETF and exchange traded product (ETP) industry, notes in terms of the European landscape there has been an increasing preference for physical replication of late.

“Ever since the bankruptcy of Lehman Brothers we have seen clients display a preference for ETFs that hold underlying securities as opposed to those that use synthetic replication. This is not related to concerns over counterparty issuer risk, but quite often due to the fact that it is easier and simpler to understand. Some players also do not like derivatives.” An example could be a FTSE 100 ETF that buys stocks in the index rather than something synthetic that might hold Eurozone securities and a swap.

Fuhr adds, “Over the past year Lyxor and Deutsche Bank moved their [ETF] business from being in their investment bank to being in their asset management arms. They also started to offer physical products. In Lyxor’s case they converted some products and launched a few new physicals. Deutsche Bank were initially launching some physical products based on the same benchmarks as their synthetic, but more recently have been converting some synthetic products to physical.”

Highlighting the trend BlackRock has almost 100% of its European ETF product (254 ETFs) in physical replication and five in synthetic form as at the end of November 2013, while the split for UBS was 75% physical / 25% synthetic and Vanguard’s nine products were entirely physical.

“We have also seen generally that firms are putting a greater focus on Europe and additionally dedicating resources to the region,” notes Fuhr. UBS, for example, has expanded significantly and adjusted fees downwards to their offering. “Previously it [UBS] had an institutional share class that was lower in price than their retail offering, but now the fee has been aligned such that they are all at the lower fee.” The bank has also expanded its market team and has a consortia model whereby they are partnering with firms like Legal & General, PIMCO and Nomura to bring products to the market.

Adriano Pace, Tradeweb’s director of equity derivatives and product manager for the firm’s multi-dealer European-listed ETF platform, commenting on OTC versus on-exchange ETF trading says: “The nature of the European market means that there is clearly a role for both on-exchange and OTC trading. The OTC market allows market participants to execute very large and significant orders – without any market impact or slippage – however, there were some limitations trading larger orders via voice or chat.”

To address the issue of facilitating larger-size ETF trades, Tradeweb launched a multi-dealer European-listed ETF platform in October 2012. Pace explains: “We built the platform directly in response to some of our biggest asset manager clients in Europe telling us that there was a fundamental gap in the market for trading ETFs.”

He adds: “Smaller trades were happening on exchange while many of the bigger trades had to be executed OTC. There was no structured way to ask for prices or indeed to get multiple dealers to compete with each other for pricing. And there was no easy way to record that auction process in a way that would be compliant with what the regulators want to see, and which would provide a fuller picture of the depth of the market.”

Starting out with eleven dealers, Tradeweb today has eighteen dealers signed up – including some of the biggest global investment banks – who benefit from the platform’s functionality and heightened efficiencies. This includes aspects such as integrated trade processing, direction locking and identifier matching to reduce the risk of trading errors.

Stephan Kraus, responsible for the development of the XTF-segment at Deutsche Börse, comments: “Although bilateral trading certainly has its value when trading large blocks of shares, most investors will find the continuously growing on-exchange liquidity in ETFs nowadays ample enough to conveniently execute even larger-sized orders with next to zero market impact.”

He argues: “Taking the on-exchange path is therefore not only more transparent, but often proves to be more efficient when considering all costs involved in the decision making and order execution process. This is particularly true when counterparty risk is of concern to investors, given that on-exchange ETF trades are cleared by a central counterparty, thus effectively mitigating counterparty risk.”

Fuhr contends that a lot of “positive winds” are pushing the ETF market along and Europe should prosper going forward – barring a major disaster. She believes too that the introduction in the UK of the Retail Distribution Review (RDR), new rules introduced in January 2013 by the UK’s Financial Conduct Authority, should help boost ETF interest among retail investors as independent financial advisers have to review the whole market for products. Equally an upcoming version of RDR in the Netherlands should do no harm either.

That said, stopping European investors buying ETFs in the US where larger volumes can be sourced may be more challenging. As will addressing post-trade issues in Europe and resulting higher costs associated from investors buying the same ETFs on the same exchange but choosing to settle in different venues.

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Viewpoint : ETFs : Guy Simpkin

Ian Rycott

January 31, 2014

TRADING ETFs ON EXCHANGE – WHAT NEXT FOR EUROPE?

European equities market structure has undergone a transformation that has opened up barriers to cross-border equities trading. Guy Simpkin, Head of Business Development at BATS Chi-X Europe asks whether the European ETF market may be on the cusp of a similar evolution?

Since the introduction of the US SPDR® S&P500® ETF (SPY) in 1993, SPY has become the largest ETF in the world, on some days trading more than the value of the entire European stock market. But while participants are frustrated that European ETF volumes remain a pale shadow of the US, there is a common view that the European market has considerable potential for higher volumes, lower costs and reduced risks. This potential can be met if we collectively work to increase transparency and liquidity in the ETF primary and secondary markets.

Step by step

If we are to increase the universe of end-investors in ETFs and grow assets under management a first critical step will be to significantly improve on-exchange liquidity. To do this we have to incentivise price formation and encourage end-investors to engage. Effective market making will tighten spreads and add depth so attracting investors and more market makers. This creates the requisite liquidity cycle.

The larger challenge is to attract investor interest when competing products are vying for the same, limited amount of available capital. Education, increased distribution and competition will gradually attract more participants to the benefits of using ETFs, but to achieve their full potential some evolutionary steps also need to be taken.

Increasing transparency

In the US, any ETF trade entered into away from an exchange has to be reported within three minutes. In Europe participants are not required under MiFID to report their off-exchange ETF trades. Until MiFID II addresses this issue (slated for 2016/17), or transparency is addressed voluntarily by market participants, the predominantly institutional use of ETFs will continue, with 70% to 80% of European ETF volume pre-negotiated and traded bilaterally, away from the central market.

To address the lack of transparency around pre-negotiated trades, we introduced a suite of trade reporting services in November 2013 with the support of six leading global banks. The service, called BXTR, allows market participants, regardless of size, to meet regulatory reporting requirements. These pan-European services provide a solution to the reporting of pre-negotiated ETF trades and the option to bring them on-exchange and into central clearing.

Pooling liquidity

Issuers have historically cross-listed their ETFs on a number of exchanges to enfranchise domestic participants and regional distribution teams. However, these multiple listings add cost to the product and fragments trading and settlement. By trading the same security on a pan-European venue like BATS, investors could avoid this problem and still settle and hold the fund locally, as if traded on the national exchange.

Multiple listings across trading venues also forces market makers to split their risk capital. This fragmentation makes it difficult for customers to determine whether they’re trading at the best price available. Similarly, whilst trading the same instrument on different venues, often in different currencies (e.g. €, £, $ and CHF), can generate arbitrage driven trading activity, the resulting fragmented settlement can necessitate a re-alignment of assets across CSDs. Adding complexity and increasing settlement risk adds costs and deters firms from participating as actively as they might wish and hinders the market in performing its key price formation role.

Mitigating risk

The settlement problem could be addressed if, like a normal equity shares, each ETF was issued in and settled in a single location. This could be achieved in a national central securities depository (CSD) or an International CSD like Euroclear Bank. The latter already performs this role for other pan-European instruments such as depository receipts and Euro bonds and will be used by BlackRock iShares for a selection of forthcoming listings. The benefit of this solution is that national CSDs can act as settlement participants inside the likes of Euroclear Bank, providing their own customers and their clients with the same settlement services they would receive when operating domestically. In the US, all equity trades are settled in one CSD, the DTCC.

Appealing to investors and issuers alike

Like mutual funds, ETFs are designed to perform in line with a specified index or asset. Unlike mutual funds, ETFs can be traded during the trading day at their prevailing market price. Whilst the ETF’s pricing relationship with its underlying index and constituents enables investors to value it intra-day, its precise value is influenced by the fund’s tracking error, level of cash held in the fund and market sentiment. Many investors have historically invested only mutual funds, the market size of which dwarfs European ETF assets under management, and only ever traded at the fund’s Net Asset Value (NAV). To attract these customers, ETF issuers need to meet this need whilst still supporting the ability of market makers and end-investors to trade in size. Current demand is satisfied through the interaction of Authorised Participants (APs) and issuers in the create/redeem process. By meeting these needs through an on-exchange service, costs could be reduced significantly, while transparency would increase, opening up the market to a wider audience.

By working with market participants to address issues concerning transparency, liquidity, and risk, we believe we can build a European ETF market that is more efficient at growing volume and assets under management.

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Fixed income trading : Sourcing liquidity

Ian Rycott

January 31, 2014

THE ISSUE OF LIQUIDITY.

On 3rd December 2013, the FIX Trading Community hosted their UK Regional Meeting, at the London offices of Markit. The agenda for the event was ‘Sourcing Liquidity in the Credit Markets: How to Improve Secondary Market Liquidity’. Sassan Danesh, co-chair global fixed Income subcommittee, FIX Trading Community, managing partner, Etrading Software, moderated the panel.

In order to give a very balanced view of the market the panel was evenly split between the buyside and sellside, and included Dominic Holland, global head of credit eSales, Deutsche Bank; Stephane Malrait, managing Director, global head of credit, rates, FX and emerging market eCommerce, Société Générale Corporate & Investment Banking; Lee Sanders, head off foreign exchange and money market execution, trading and securities Financing division, AXA Investment Managers and Carl Sells, European head of trading, AllianceBernstein Ltd.

Danesh kicked off the discussion with a look at the current structure of the Fixed Income marketplace and how, compared to other asset classes, the move to a more electronic market is still in its infancy. He referred to a McKinsey & Greenwich report, which states that in 2012 less than 30% of EU corporate bond trading was done electronically. Given there is no centralised marketplace, the ‘Request for Quote’ model has been the standard method of trading, with voice still dominating the picture. The relative illiquidity of the majority of the bond market and the average ticket size (seventy times larger than equity tickets), voice based trading has in the past made more sense.

Danesh posed four questions to the panellists about both the causes and potential solutions to the current liquidity crisis. Their responses are below. Both the buy and sellside were equally as frustrated by the current lack of liquidity. Their responses are below.

1. Why has liquidity dried up in the credit markets?

Whilst panellists acknowledged the reduction of sellside balance sheets as a major cause of the lack of risk appetite, there was also a discussion on how the low interest rate environment has also changed investment behaviour as it favours passive tracking over active trading strategies. Some panellists suggested that this shift in trading patterns has caused a reduction in the recycling of inventories across market participants and an increase in buy and hold strategies, which further hampers liquidity.

Additionally, whilst the European buyside has access to a large amount of pre-trade data, there was a consensus that this is not of a sufficiently high quality to allow informed trading to take place. The result is spikes in prices when a buyside attempts to trade at an indicative price, which can then frustrate them even more, leading to less liquidity and creating a vicious circle.

2. What is the market doing to bring back liquidity?

There was some concern that multiple initiatives could cause market fragmentation and the panel agreed that this could be mitigated by ensuring connectivity across the individual market places and initiatives to ensure liquidity could be sourced from the most appropriate location.

Additionally, the panel agreed that the quality of market data needs to improve, and discussed the tension between high quality pre and post trade data, acknowledging that too much post-trade transparency could also damage liquidity through information leakage on trades.

Finally on this question, the panel discussed how a market architecture could be created. There was agreement between the buyside and sellside that it would be beneficial to achieve such a shift in the market rather than relying on pure buyside or pure sellside initiatives alone.

3. What role should the buyside play in changing the market structure?

All the panellists acknowledged that it is extremely important for the buyside to have their voice heard with any initiative, since the vast majority of inventory resides with them (one statistic shows that 97% of fixed income inventory resides with the buyside). Posing the question as to whether or not this can be tapped into caused some disagreement with the realisation that lines between buy and sellside could soon blur. However, there was also general agreement that the buyside was now starting to become more proactive in discussing initiatives and solutions with their sellside counter-parts and all panellists agreed this was a helpful step in the evolution of the market.

4. How can we source liquidity in a fragmented market?

Panellists then discussed the question of how to source liquidity if things remain fragmented. They agreed that comparing fixed income to equities, a move towards aggregated access to liquidity pools would seem to be logical, if not necessarily easy to achieve, and that any proposal to aggregate liquidity should be agnostic of, and complementary to existing market initiatives whether sponsored by banks, brokers or vendors. Focus should be on creating a market architecture that enables such aggregation to be performed through technical standardisation. This approach would allow diversity of business models within the market place, whilst removing the risk of market fragmentation.

The conclusion was that there is a real appetite from the market to work together – information is now being shared and will continue to be in the future. With the buyside now fully engaged in the market initiatives, the move towards further adoption of electronic trading coupled with an increased flow of better information should lead to greater liquidity. All parties would like that as we head into 2014.

This article was written by Sassan Danesh, Co-Chair Global Fixed Income Subcommittee, FIX Trading Community, Managing Partner, Etrading Software, and Tim Healy, Marketing Manager, FIX Trading Community

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DO YOU KNOW WHAT YOU’RE MEASURING (AND WHY)?

THE CHANGING WORLD OF FX .

Patrick Fleur, head of trading and execution at Dutch fund manager PGGM Investments explains why it has a different spin.

How would you describe the trading environment today?

What has PGGM been doing to prepare?

How are liquidity levels and volumes shaping the market?

What impact do you think the current investigations into FX will have on the industry?

What other changes do you envision?

How do you see the market developing?

STARTING FROM SCRATCH.

Eric Krueger, head of equities electronic, program and ETF distribution, EMEA, at Barclays, discloses the secrets to successfully building an equity franchise.

What was the driver behind the decision to build a European equity franchise?

How did you think you could break into such a competitive industry?

What are some of the lessons that you have learned over the past few years?

What about your dark pool?

How have you developed the research group?

What were some of your biggest worries building a business from scratch?

NEW BEGINNINGS.

Alasdair Haynes, founder and chief executive officer of recently launched Aquis Exchange explains why this MTF is different from all the rest.

There are many MTFs on the market so what was the driver behind Aquis Exchange?

How have you applied this to Aquis Exchange?

What will the charges be?

How did you build the platform when everyone was working remotely?

Do you think the market needs another exchange though?

Where did you get your backing?

What are your future plans?

TWO SIDES OF THE SAME COIN.

Two recent hot topics for buy and sellside firms have been monitoring Execution Quality (TCA) and Market Abuse (MAD). Darren Toulson, head of research at Liquidmetrix explains how they are inextricably linked.

Market manipulation of a reference price to create an instant trading profit?

What does this mean from a TCA/MAD perspective?

Summary

THE DEVIL IS IN THE DETAIL.

Effecting efficient evolution for the European securities markets – a TARGET2-Securities (T2S) viewpoint, by Fiona Hamilton, Vice President EMEA Operations, Volante Technologies Inc.

Evolutionary path

Predicting reaction

Moving up the food-chain

GROWING PAINS.

Electronic trading in foreign exchange advances but traders step back from high-frequency trading flow. Dan Barnes reports.

HFT risk

The pushback

CROWDED HOUSE.

Europe’s exchange-traded fund (ETF) landscape has certainly become more crowded following BATS Chi-X Europe’s launch of a new pan-European platform late last year. Can the market stomach another and what’s the prognosis for 2014? Roger Aitken reports.

Highly fragmented market

Physical versus synthetic

TRADING ETFs ON EXCHANGE – WHAT NEXT FOR EUROPE?

European equities market structure has undergone a transformation that has opened up barriers to cross-border equities trading. Guy Simpkin, Head of Business Development at BATS Chi-X Europe asks whether the European ETF market may be on the cusp of a similar evolution?

Step by step

Increasing transparency

Pooling liquidity

Mitigating risk

Appealing to investors and issuers alike

THE ISSUE OF LIQUIDITY.

1. Why has liquidity dried up in the credit markets?

2. What is the market doing to bring back liquidity?

3. What role should the buyside play in changing the market structure?

4. How can we source liquidity in a fragmented market?

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