THE IMPACT OF MIFID II ON YOUR EMIR PROGRAMME.
EMIR may be top of the agenda but MIFID should also be on the priority list. PJ Di Giammarino, CEO of JWG-IT Group explains why.
With the sudden announcement that trade reporting under EMIR will commence for over the counter (OTC) and exchange-traded derivatives in February 2014, few in the industry have their eyes on the longer term. However, MiFID II is, at time of writing, in its final stages of negotiation and, once finalised, threatens to upset all the hard work that firms are doing now.
In a recent JWG poll, 92% of industry respondents said that the impact of MiFID on their EMIR change projects was likely to be ‘medium’ or ‘high’. This response is consistent with our research, which indicates a number of key areas in which MiFID will change the way we trade derivatives (again):
On-exchange trading of derivatives: Derivatives defined as ‘liquid’ by ESMA will be forced to be traded on exchanges, meaning all those foundations laid for OTCs may have to be dug up again;
New types of market venue: The introduction of MTFs, OTFs (organised trading facilities, often known as ‘dark pools’) and SIs (systematic internalisers, such as broker crossing networks) to non-equity instruments will mean significant and discreet changes to the way we trade each class of instruments;
Increased pre-trade transparency requirements: The requirement to publish the volume and depth of orders for all but the biggest orders may see an increase in the size of orders and/or significant adjustments to trade analytics. This will affect not only ETDs but also those derivatives which will still be possible to trade OTC;
Transaction reporting: The extension of transaction reporting to most instruments will also heavily impact the trade reporting systems which firms are building now.
So which of these is giving firms the most cause for concern? At a seminar in November, we asked a number of senior managers from large sellside firms where, if given a notional ten pounds to spend on MiFID, they would put their budget. The results show that, on average, banks will be putting almost 60% of their MiFID budgets into the transparency requirements (see Fig. 1).
There is certainly a lot to be done for transaction reporting: Current reporting mechanisms will have to be rolled out across multiple businesses, each creating its own challenges. Firms will also have to decide whether any of their reporting will be delegated to ARMs (approved reporting mechanisms), which will carry its own legal and procurement costs. There is also the significant data aggregation, validation and cleansing required in order to make sure reports are accurate and achieve compliance.
Furthermore, there are a number of questions about how MiFID reporting will cross over with EMIR reporting: Will transaction reports require unique identifiers such as LEIs (legal entity identifier), UPIs (unique product identifiers) and UTIs (unique trade identifier), which are currently giving firms headaches? MiFID, as currently drafted, also contains an exemption from reporting for trades already reported under EMIR, but how will this work in practice? And, perhaps most of all, will TR reporting infrastructure be able to meet the demands of MiFID reporting?
We also asked the same group which of the requirements they thought would be the hardest to implement, and the results were markedly different. The clear leader, in terms of difficulty, was the requirement to move ‘liquid’ OTC derivatives onto exchanges. Clearly this has huge implications across the whole trade lifecycle including pre- and post-trade analytics, SOR, best execution policy and practice, and could ultimately require a complete change to firms’ derivatives trading strategies.
So when can we expect people to start getting serious about MiFID? At the time of writing, the legislative text was still in the final stages of negotiation. With uncertainty over key issues, such as OTFs and position limits, firms seem to be taking the wait and see approach. Noise from the industry tells us that EMIR is going to run over well into 2014 with the introduction of trade reporting, quickly followed by the move to mandatory clearing between parties trading high values of derivatives.
However, with marathon sessions expected in December to finalise the text before the New Year, this state of wilful blindness cannot continue long. Very soon, firms are going to have to face up to the changes MiFID II is bringing with it, likely before their EMIR change projects have run their course. This means the usual roadwork has to be done – gap analyses, roadmaps, blueprints and test plans – but the firms that get ahead of the game now will enjoy fewer headaches and costs, from having to dig up their infrastructure again, further down the line.
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THE SPOILS OF BATTLE.
Juan Pablo Urrutia, European General Counsel with agency broker ITG is equally scathing. “Several policymakers told me the outcome of MiFID II is a compromise they didn’t vote for. One referred to the proposal on caps as unworkable. According to a TABB Group research note, 86% of investors are seriously concerned about it. There’s a groundswell of opposition in the markets. You then have to ask yourself, what kind of policy making is this? It’s the theatre of the absurd.”
NO PAIN, NO GAIN.
There are many stories of institutional firms who have lost out because they have inadvertently caused an adverse market move. There are cases of companies who have split business between traders only to find that they are actually competing against each other in an otherwise quiet market. Or of companies who have simply been given unfavourable executions because they did not know at what rate best execution could be achieved. The good news is that with new technology and a better understanding of the process best execution can be achieved. One of the first issues to address when placing a big-ticket order with a bank or a broker is the simple fact that the trader might be front-running the execution. This can be very costly and is very difficult to prove in an OTC (Over the Counter) market. The smallest hint that a large transaction is going through means that some traders will buy or sell for their own advantage. This behaviour is unethical and most market participants will do their very best to avoid such patterns among their traders, but it can be very difficult to detect. ‘Front-running’ on a broader base could in theory happen for non-malicious reasons. It could be that the individual trading desk might have to cover pre-existing orders. If this does happen it becomes very difficult to say which average rate should apply for which client, or whether it should be the average of all trades which should be used. Either way, it is likely to have a negative impact on the overall result. The second issue faced by institutions is whether they deal with one specific market maker or several market participants, which then allows prices to be compared. Both options present different risks. If a number of market participants are used it is likely that the trade will be leaked. Traders will interact with the market and the required rate will be lost. However, if the institution talks to just one bank their hedging requirement may not fit into the current position of the bank’s trading desk. If they already have large positions on their book the bank’s trader will have no other choice than to show a price further away from the market, as they take into account what is already being processed internally. This generally results in the average rate of the fill becoming less favourable. Additionally, it is possible that it will become more difficult for the trader to quietly place the order in the market, therefore the trader may have to be more aggressive in his or her trading style, which may lead to an overreaction from the market, which will result in a less favourable execution for the client. In both these cases it can be advantageous to clear business via a Prime Broker or Central Counterparty to ensure that anonymity is given and no-one, except the Prime Broker knows about the flow before – and after – it has been executed. The perfect solution is to have as many market participants’ liquidity as possible, keep the trade confidential and avoid human error. There are a number of new market participants who are developing this solution and who allow the aggregated spread to become narrower than the spread any given liquidity provider will be able to provide. They can offer the most aggressive bid in the market as well as the most aggressive offer available. This approach also has the advantage that the full depth of liquidity is visible, including the corresponding spreads (often referred to as ‘liquidity smile’: the full display of liquidity available at different bid/offer spreads), which reflects current market conditions and helps to enhance the overall liquidity. By having access to the full market with a high number of liquidity providers behind it, the client can easily judge where the ‘real’ market is at any given moment. This includes the natural buying interest on one side versus natural selling on the other side, which provides a positive benefit by narrowing the spread, rather than having the market trading away. If this solution is adopted the most important question is deciding who to clear through, or more exactly, which Prime Broker to use. Most providers will offer a number of options from which the best-fit partner can be chosen, based on what settlement limits and which trading lines exist for the corporation. The other option is to allocate a certain amount of business directly to selected partners and dedicated liquidity providers, but at the same time use the service of specialised brokers to conduct business that exceeds the day-to-day business and requires special care for the best execution. This guarantees favourable execution and helps to provide anonymity and protect the client’s name. Another problem in placing large trades is the potential inefficiency of the human trader. Traders have been known to overreact in certain situations or conversely not react quickly enough. To avoid this, a significant number of corporations and institutional clients have started to use algorithmic trading solutions, which can provide improvements in execution without the risk of human error. The underlying concept is to make the execution more reliable and, over a period of time, produce more effective results. The biggest advantage of algorithmic trading is however also its biggest disadvantage in that all executions will average. This means it is not very likely that any execution will be at the peak, but at the same time it is very likely that the execution will be on a sound middle basis of where the markets were at the time. Another advantage of algorithmic trading is that it can be bespoke. It can be programmed to execute exactly how the user wants, in terms of timing and volumes. The most commonly used execution style is the time slicer, also known as ‘time weighted average price’, which will allow the user to define a period of time during which the machine will execute parts of the order, often in random time intervals and in random sizes, to ensure that no other market participant can detect a trading pattern. This obviously works best in combination with anonymous trading, where the order will blend in with other business going through the same broker. This combination will make the order ‘invisible’ for all other market participants and ensure total discretion. The trend in the market is clearly going towards automated or algorithmic execution. At the same time, it has become clear that aggregation of liquidity is mandatory for execution of big orders. A number of providers have stepped into this new environment and are delivering tailor made solutions for institutional clients. These providers have the resources to invest in the latest technology required to give the best execution. So, putting big-ticket trades into the market is no longer the headache it used to be. With 2014 looking like a year when there will be increased volatility the ability to hedge quickly and efficiently will be a great advantage. 
Average daily volumes were $18.8bn in November 2013 versus $14.7bn in the same month a year previously. While traditional FX platforms are seeing volumes decline, the Russian FX market registered a growth of 28% year on year mainly in the United States Dollar/Russian Ruble (USD/ RUB) pair.
Bloomberg’s recently launched service is called First Word Foreign Exchange (FX), what does it aim to do?
Outsourcing
While investors have been using social media sites for years as part of their decision-making process, the huge volumes of data from services such as Twitter prompted Tabb Group to investigate whether such data can be analysed effectively and accurately. “Many advances have been made in this field and we are beginning to see some of the companies developing analytics tools that can find signals for trading, but it requires a significant effort to do this,” says Bogard. “The key to success lies in having platforms that can limit the data to what you want to receive.”
Hugh Cumberland, business development manager at Colt, says data historically used in the trading world has been kept in relational databases, is highly structured, formatted and cross-referenced, which gives it great integrity. Analysing such data via query languages such as SQL also delivers clear, understandable results. “The explosion of social media data has led to some firms wanting to mine that information for their trading activities,” he says. “But this data is unstructured, is not validated and is in a free format.”
Still a burgeoning field, improvements need to be addressed, says Bogard. Despite significant progress in analysing English language social media, analysis of other languages, including internet slang associated with social sites, is under-developed, severely limiting applicability. But according to Bogard’s co-author Sussman, social media is already changing the way news, data and opinions are generated, disseminated and consumed. “For better or worse, financial markets need to adjust accordingly,” he says.
