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Regulation & compliance : Lynn Strongin Dodds

By
Ian Rycott
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REGULATORS TURN UP HEAT ON ASSET MANAGER RISK.

Regulators on both sides of the Atlantic are turning up the heat on asset managers following a new report from the US questioning the risk posed to the stability of the financial system by fund management firms and moves in the UK to increase scrutiny of the sector.

The report from the Office of Financial Research (OFR), a body created by Dodd-Frank to help the Financial Stability Oversight Council (FSOC) spot risks that could de-rail the financial system, concludes that asset management firms are, “vulnerable to shocks” and may need greater oversight of their capital, leverage and liquidity holdings. According to the OFR, asset managers could pose risks to the financial system, for example, when they buy or sell stock in herds, exaggerating market movements, or they increase leverage.

FSOC has already set a precedent for extending its traditional regulatory reach beyond the banks. AIG, the insurance group, and GE Capital, the finance arm of GE, have already been brought under the regulator’s watchful eye, having been declared “Systemically Important Financial Institutions” or SIFIs.  An appeal by insurer, Prudential Financial, against SIFI status recently failed.

Although the OFR report has stopped short of recommending that asset managers become the subject of greater regulation, the body has called for more information from the industry on areas such as on the types of assets, exposures and leverage used in managed funds as well as more data on securities lending and collateral arrangements generally. It also noted that, unlike the UK, US firms are not required to maintain liquidity or capital reserves or appoint chief risk officers.

However, asset managers in the UK have not escaped regulatory scrutiny and they have their own regulatory issues to contend with, as Deborah Prutzman, chief executive of The Regulatory Fundamentals Group, observes. “Systemic risk posed by investment funds is not just a focus in the US,” she says. “UK regulators have recently zeroed in on whether hedge funds are ready to fall as interest rates rise.”

In June a report from the Financial Policy Committee, the Bank of England body monitoring systemic risk in the UK, called for an investigation into the effect of a rise in interest rates on UK financial institutions.  In particular, the FPC argued that financial hedge funds are especially vulnerable to an interest rate rise.  Like its counterparts in the US, the FPC is now gathering more information on which to conduct a risk assessment.

“Precisely where the chips fall on systemic risk oversight is yet to be seen,” says Prutzman. “But what is becoming obvious is that the regulators, on a worldwide basis, are beginning to marshal their arguments that some segments of the asset management industry should be brought into the fold.”

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Measuring My Guys

By
GlobalTrading
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Fabien Orève, Global Head of Trading at Dexia Asset Management
We have tried to clarify how we can manage an easy, productive method to meet our clients’ needs as well as categorise these needs into only a few groups of trading strategies. We have fundamentally identified two groups of trading strategy. The first is market orders, which are widely used from equities to bonds and foreign exchange. Equities market orders are obviously for momentum active funds. They just want to trade immediately and they ask us to use an implementation shortfall strategy. If you take bonds, we use multi-dealer trading platforms where RFQs are widely used. It’s often easy and as it is OTC we execute straight away.Fabien Orève
Foreign exchange is pretty new to this field. We used to trade Forex as a hedging instrument on the 4:00 pm London fixing, especially for equities funds that are benchmarked versus large indices.  So essentially our clients want us to minimise currency risk but recently we’ve seen some clients in the bond side trade Forex markets because Forex can help them generate alpha. Our FX trading platform provides us with an average of bid-ask spread provided by the banks we have gone to.
All of the asset classes are converging in the way we compare our market orders with a benchmark that is more or less current price in all of these markets, regardless of whether it is OTC or regulated. We have a pretty good way to assess this performance.
Behind implementation shortfall there are lots of trading tactics to employ. You have to identify your clients and their levels of urgency. That means for market orders, we split them into two subgroups. One is pure market orders –  trading as fast as possible.
The second subgroup is market care orders. That means we have more flexibility to work an order in the market within a timeframe. We have been able to do this in equities for some time, but now, in other asset classes, technology and market structure allow you to use other ways to manage this order type more efficiently. Whatever the tactic is, you will be measured. I want my guys to be measured from one benchmark, which is arrival price. You have one strategy, you have different tactics, there is only one measurement. Then, we can talk about the impact of market conditions on trading performance.
The second big group of trading strategy is on closing. But closing has many different ways to execute. You have liquid, very easy business. You can get the order done during a closing auction for example in equities. In European bonds, you can get as close as possible to the time trigger that will be around five thirty our time. We try to concentrate easy liquid business around this specific time, but there are other tactics to target closing. In less liquid European equities, you have to start earlier; you have to use other ways to get part of your order done then keep a portion for the closing auction time.

“All of the asset classes are converging in the way we compare our market orders with a benchmark that is more or less current price in all of these markets, regardless of whether it is OTC or regulated. We have a pretty good way to assess this performance.”

This closing strategy is also benchmarked. When there is a specific price at a specific time we will use it as a benchmark.  For example, we can capture a composite reference price for bonds, and in Forex we will use the 4:00 pm London fixing rate. We know these benchmarks may be subject to controversy but TCA helps us analyse price movements at and around the closing time.

SEF approvals continue whilst US regulator scrutinizes OTC firm. Source : Forex Magnates

By
Ian Rycott
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CFTC_500x250

SEF APPROVALS CONTINUE WHILST US REGULATOR SCRUTINIZES OTC FIRM.

In keeping with the requirement stipulated by the Dodd-Frank Act, institutional trading firms are continuing to apply to the US Commodity Futures Trading Commission (CFTC) for registration as a Swap Execution Facility (SEF).

As yesterday’s business day drew to a close in North America, the CFTC announced that it has approved the applications of two further entities to register as SEFs.

The organizations concerned are DW SEF LLC and TW SEF LLC, both of which are second and third entities for which the CFTC has issued temporary registrations as a SEF.

The applications of the companies, both of which are Delaware limited liability corporations, and are wholly-owned subsidiaries of Tradeweb Global were approved on September 6, by the CFTC’s Division of Market Oversight as part of the Dodd-Frank Act’s provision that firms must provide greater pre-trade and post-trade transparency to the swaps market.

Bloomberg SEF LLC was previously granted temporary registration as a SEF on July 30, 2013, rendering it the first company to obtain such registration.

In order to obtain and maintain permanent registration,

See on forexmagnates.com

Announcement : Truphone and BT partner in US

By
Ian Rycott
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BT_TomRegent
Tom Regent comments on BT partnership with Truphone

TRUPHONE AND BT SIGN PARTNERSHIP AGREEMENT.

Truphone and BT recently announced a partnership where BT will market Truphone Mobile Recording to their US financial customers to help them comply with new regulations called for by the Dodd-Frank Wall Street Reform Act. The Act requires all companies operating or doing business with an organization in the US for certain regulated trading activities have to record all communications from mobile devices that lead to a trade. Truphone Mobile Recording provides such a service and will benefit financial firms by enabling regulatory compliance.

BT_TomRegent

Tom Regent, president, global banking & financial markets, BT, said: “As the Dodd-Frank Act and future regulations come into force, financial services institutions need technology partners who can act as a safe pair of hands to help them navigate successfully through the compliance maze and in a timely manner.  BT’s knowledge and experience of helping financial institutions address their global compliance and regulation obligations, combined with the power of Truphone’s solution, means we are ideally placed to help our customers.”

Read the press release.

It’s Time To Standardise The Electronic Trading Of Energy

By
GlobalTrading
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By Carl Weir, EMEA Head of Cross Asset FIX Connectivity, HSBC and Co-chair of the Global Cross-Asset Committee and Natasha Bonner-Fommes, Head of Product, Marex Spectron and Co-Chair of the Global OTC Energy Subcommittee.
The creation of the FIX Trading Community OTC Energy Subcommittee represents a paradigm shift for the FIX Protocol, unlike any other protocol, FIX is now being engaged by utilities.
The FIX Trading Community OTC Energy Subcommittee (FOTC) was created to define electronic trading standards for OTC energy trading processes. Its mission is to coordinate efforts and identify the common initiatives in pre-trade and trade. FOTC provides its findings to the FIX Trading Community Global Cross Asset Committee (GCAC) for consideration in specifications, best-practices, and educational and promotional efforts.
The creation of FOTC was an evolutionary step in the OTC Energy market as, like other asset classes, regulatory change will require automated workflows for new operational functionality and fiduciary responsibilities. New regulatory reporting will also ensure minimal STP breaks across multiple regulations.
2013 sees the start of an unprecedented slew of regulation for energy traders. Not only will they need to comply with the types of rules traditionally aimed at banks such as the European Markets Infrastructure Regulation (EMIR), but also with additional sets of rules such as the Regulation for the wholesale Energy Markets Integrity and Transparency (REMIT), which broadly comes into force at the same time. On top of these requirements, there are other rule sets in the pipeline such as the second markets in Financial instruments Directive (MiFiD II), which could hit energy traders heavily.
For example, March 18th 2013 saw the first deadline for the new EMIR regulatory compliance come into force, the impact of which is expected to be borne out in an increase in clearing, at least for financial (non-hedging) participants. The drivers for OTC Energy standardisation were borne out of the Financial Crisis in 2008, which was a driver for more financial market regulation both in the EU and US. It was the G20 Summit 2009 in Pittsburgh that set this framework in motion, with the key objectives being to:

  • Increase safety and transparency of OTC derivatives markets
  • Improve market integrity and oversight
  • Reduce failure and credit risks
  • Lower operational risks
  • Ensure alignment on EMIT, MiFID II and REMIT

Other evolutionary reasons for FOTC are that alternative market participants are searching for new opportunities e.g. hedge funds are looking for hedging opportunities that normally would trade electronically. To perform the latter, firms are searching for operational efficiency for real-time processing and require an overview of positions across all assets, a proposition that the FIX Trading Community has borne out repeatedly. In the context of the latter, and FOTC, the standardisation of energy contracts and electronic processes, as well as interoperability and standardisation with exchange based markets, would need to occur. This is not the case in the OTC Energy Markets at present. FOTC will achieve the latter in a phased approach delivering; Business best-practice documentation for Trading, technical standardisation, support for regulations, new fix tags/message types (where necessary), and appropriate Symbology standards to the OTC Energy market.
The appetite for this shift to FIX for OTC Energy has quickly gained the interest of many firms including Marex Spectron, TullettPrebon, ICAP, LEBA (London Energy Brokers’ Association), Tradition, GFI Group, European Federation of Energy Traders (EFET), Total, BP, & NOS Clearing (A NASDAQ OMX Company) to start, with more to follow in the areas of banks, brokers, utilities / producers/consumers, traders/energy traders, (companies), shipping companies, and clearing houses.
The planned focus will be on the Top Energy markets such as:

  1. UK National Balancing Point; the biggest market followed by Title Transfer Facility for natural gas
  2. German power; the biggest power market
  3. Financial coal
  4. Dutch Gas

To put the latter into perspective1 :

  1. The US gas market is 4:1 in favour of OTC to Exchange Traded
  2. In the US 80% is centrally cleared, of which only 20% is Exchange Traded today.

The composition of the market in terms of tradable OTC contracts and products can be seen in the charts below2,3 :
Finally, as mentioned the move to standardise is key as a crossover to the utilities and trading entities mention in the list of participants above. Importantly the support and participation of LEB and EFET is very valuable as they represent over 100 Energy Trading Companies in 27 countries ensuring the improvement of industry regulation and advocacy on wholesale energy market design; promoting legal and market IT standards.
The timing could not be better as the cross asset industry is in a period of dynamic change with some of the most complex changes coming in the form of Dodd Frank, CFTC and EMIR changes. It is important that the OTC Energy Market moves with these changes and does so in a standardised fashion, so that is can react with as little disruption as possible.

Holding The Cost Of Research To Account

By
Yulia Kuksina
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Edward Stockreisser, Chairman of the Asian Independent Research Providers Association.
We’ve been talking about changing the way research is funded and charged for five years. Unbundling is now prevalent, even in Asia, as much as people say it is not. The fundamental thing about Asia that people often misunderstand is that Asia is actually made up of about seven or eight different countries, with their own cultures, regulated bodies etc.
It is true that Commission Sharing Agreements have taken place and customer execution costs are being driven down enormously, but as Chairman of Asia IRP I feel that independent research and the importance of research in an unbundled world (or just a sharing world) isn’t being looked at in enough depth. There’s a huge disconnect between the portfolio manager, the trader, the broker and the research side of every sell-side or independent research provider. Ultimately, no one cares if research is independent or not, they just want good research. The trader wants the orders, the broker wants the flow, the sell-side just want to run effectively as a leader in their research department and the research provider just wants to get paid. But there’s no factor central to this that makes any one care over and above their counterparties. So this is why research has not been looked at.
Development of ‘best research’
The best research is impartial and unconflicting; where the research provider isn’t hampered by a Chinese Wall or a compliance department restricting what can or can’t be said. But, ultimately, best research just means the best ideas. Industry-wide, the average readership of research is about 10-12%. So if you are paying US$100,000 and only gaining 10-12% readership then that means one of two things: Either, the US$100,000 you’re paying is just for that 10%, which means the total value of the research is US$1million — which is obviously an issue. Or it means that money is being wasted and the US$100,000 you’re spending is being thrown away. So how do you re-adjust that readership ratio? At the same time execution costs are being driven down, so let’s drive down what’s being paid to those research firms that aren’t the best in the region.
Changing the culture
It’s got to be about an increase in transparency, for people to ask themselves and their fund managers or money managers “where are you spending this money?” and “who’s given you this idea?”, “why are we not short Apple in September?” — those kind of questions need to be asked, and not just because there might be an IPO going on somewhere else. It’s got to come from bottom up — it’s all about being very ‘macro’.
The services need to be standardised. Research has absolutely zero value until it is being used. I don’t believe that you have to charge the same price for the same level of service. The value-based system is about how much value you have in the investment process which may be about timing, it may be about macro. It’s that return given by each individual. At the moment there is no mechanism to see each individual’s return. The number of research writers has risen in the last ten years from about 15 institution-level people globally to over 500. So if the concept of best research does exist, how do you access those 500 independent researchers, most of whom are the highest-rated people in the surveys and how do you make sure that they all get paid? And how do we ensure that a pension fund or portfolio is getting access to that expertise based as far afield as it might be. How do we access those ideas? We are not using research sufficiently and the research we do have we are not using properly.
People have been talking about soft dollars etc. at conferences for a long time, but what are they actually talking about? You have to remember why CSAs and unbundling came about; because of the level of unacceptable and unnecessary expenditure in the industry that investors shouldn’t have been paying for. We don’t actually talk about that underlying reason, we just talk about the procedure and process that means that brokers now are all scrabbling around for business. Research providers are all trying to get paid.
There needs to be much greater transparency in the system. People must be accountable for the amount of research they’re consuming and commissioning. Research writers need to be able to work without having to spend months travelling to access investors. There also needs to be a mechanism whereby they can get paid efficiently which would allow this conduct of best research to be as applied as ‘best execution’. This is all about transparency but currently there’s doesn’t appear to be any incentive or mechanism to give that greater degree of transparency.
The right tools
There are some systems that allow you to pay an analyst on the sell-side but there is no impartial system there for the greater good of the industry. PMs don’t care which brokers their traders use. The brokers don’t care what research provider the PM has paid for. There are many examples of researchers who may have worked for six months and not been paid only to find that the relevant trader was paying the wrong research provider in the first place. There is a disconnect, which is not the fault of the trader or the PM – it is just the mechanism that’s at fault. At Asia IRP and Europe IRP and from the investor side, we are trying to regulate and implement these things, but it’s all about pushing the CSAs.
Asia IRP is trying to create the Asia’s first independent research forum.
You can see it happening already with the sell-side talking about reducing their research funds because it is a loss maker. Now it’s not my concern as to whether independents get paid or not but what happens to the minds on the sell-side that are being cut from the banks? In 2008 the most senior experienced minds were hit by the financial crisis. They are either going to become independent or retire. You are then left with research departments run by the more cost effective, junior, less experienced research providers who are not able to offer the concept of ‘best research’. And at some point, with the market shrinking the way it is, the industry is going to have to find a transmission mechanism to bind itself together.
It’s not just about driving cost sharing. But it’s about re-pricing things that we value and things that we don’t, which have been bundled together for so long.

Russian Reform; Glacial But Inevitable

By
GlobalTrading
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By Jesse Sherman, Portfolio Manager, Russian Equities, Renaissance Asset Managers.
In Russia the trading of Global Depositary Receipts (GDRs) at a premium to local shares is a common occurrence despite their equal economic value and voting rights. While most Russian share classes trade within 1% or 2% of each other reflecting often nothing more than conversion costs, there are a handful of local shares trading at discounts of more than 10% to their respective GDR. Trading reforms in 2013 will mark an inflection point in the Russian financial system through broadening access and lowering roadblocks to ownership, and in our view now is the time to use the local market access to leverage returns in attractive stocks.
The modernisation of the Russian financial system has moved at a glacial pace, leaving many international institutional investors constrained from purchasing equities on the local exchange owing to issues including low liquidity, sameday settlement in local currency, the inability to hold shares on record with the custodian, and a lack of fungibility. However, we believe key structural changes this year will mark a major turning point.
With the establishment of the Russian Central Depository (CD), investors will finally be the ultimate beneficiary of record by the end of 2013 (accounts will take time to setup), thus removing this investment barrier. The movement to T+2 (Trade Date + 2 days, from T+0 now) is also expected to be a staged process in 2013 – an initiative that should also reduce transaction barriers as it removes the need for investors to hold funds on account in rubles. Testing T+2 for the Top 15 stocks went live on the 25 March with sole trading on this basis from 1 July. By 1 January 2014, all 1,780 securities are planned to trade on T+2. In our estimation, the combined impact of these two structural changes should lead to higher liquidity locally. Once the market is effectively trading on a T+2 basis, we expect increasing pressure to remove the 25% GDR cap – which limits the value of the GDRs to no more than 25% of a company’s value. We take positively the comments by the Deputy Head of the Russian CD earlier this year that fungibility between Russian GDRs and local shares will only be allowed from 2014. In our view, the caps will be lifted and Russian officials are simply being prudent to help ensure that no material issues arise from the implementation of the changes in 2013.
For those sceptics of Russian reform, we point to the Moscow Exchange (MICEX), which publicly listed last week. MICEX requires ongoing Russian reform to ensure its long-term investment case, in particular the competitive position vs. international exchanges (e.g. LSE) for future listings and trading volumes. Further financial reform is also necessary to enable the Russian privatisation strategy to go ahead and fulfil the Government’s objective to establish Moscow as a global financial centre.
In our portfolios we hold the local shares of companies we find attractive like Magnit, MTS & Novatek since they offer significantly cheaper valuations to the GDRs. As the T+2 implementation progresses, we expect these shares to outperform the GDRs with the discounts reducing to high single digits, enhancing returns for our investors. Removing the GDR caps and allowing full fungibility of the shares will likely be the last push to make the discounts de minimis. While overall, like many other investors, we view Russian reform with healthy scepticism, we do believe that the glacial path of market reform whilst slow is hard to stop.

Important information
This material contains the current opinions of the author but not necessarily those of Renaissance Asset Managers and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This document is for marketing purposes only and does not constitute independent investment research. Before entering into any transaction, you should consider the suitability of the transaction to your particular circumstances and independently review (with your professional advisers as necessary) the specific financial risks as well as the legal, regulatory, credit, tax and accounting consequences of entering into such transaction. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
Renaissance Asset Managers is a trading name of Renaissance Asset Managers (Guernsey) Limited and its affiliated companies. This document has been issued by Renaissance Asset Managers (Guernsey) Limited who are licensed to carry on controlled investment business under the Guernsey Financial Services Commission (GFSC); Reference Number 2008335. Renaissance Asset Managers (UK) Limited, an affiliate of Renaissance Asset Managers (Guernsey) Limited, is authorised and regulated by the Financial Conduct Authority (FCA) in the United Kingdom; Firm Reference Number 451343.

FIXing Fixed Income

By
GlobalTrading
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By Sassan Danesh, Co-Chair Global Fixed Income Committee, FIX Trading Community, Managing Partner, Etrading Software


During the past few years, the fixed income markets have moved increasingly towards greater electronic trading, facilitated by the growing acceptance of FIX as the global standard for trading fixed income products.
Working with the industry, the Global Fixed Income Committee (GFIC) extended the FIX Specification and established sets of Best Practices documentation for the use of FIX for the trading of fixed income products that are now being successfully adopted by the global fixed income community.
Looking to the future, work has begun to maximise cross-asset trading efficiencies as well as to automate the administrative messages associated with client enablement on OTC markets.
Further ahead, the challenges of MiFID II are also on the horizon, which will no doubt lead to additional enhancements to support the market’s needs.
Proprietary Past
Fixed income products have traditionally been traded bi-laterally over the phone between counterparties with little by way of electronic trading. Execution venues offering electronic trading for fixed income products have typically done so via a proprietary API.
Furthermore, independent software vendors (ISVs) providing connectivity solutions to the sell-side faced large challenges due to the bespoke connectivity and workflows in fixed income, which reduced competition and stifled innovation compared to other asset classes.
Ripe for Change
The regulatory changes over the past couple of years have been the catalyst behind the fixed income market moving towards a more exchange-like, standardised model as Dodd-Frank in the US and MiFID II in Europe mandate the migration of OTC swaps, Interest Rate Swaps (IRS) & Credit Default Swaps (CDS), onto regulated electronic trading platforms known as Swap Execution Facilities (SEFs) and Organised Trading Facilities (OTFs) respectively. Furthermore, Basel 3 and other capital adequacy requirements have led to the reduced use of sell-side balance sheets to support their fixed income trading businesses, which has reduced bond inventories and led to fragmentation of liquidity and increased costs.
With the industry increasingly focused on cost-reduction, finding ways to unify the trading landscape across asset classes is something that has been welcomed with open arms.
While the initial drive towards standardisation focused on swaps trading, in more recent times there has been a push to standardise electronic trading for cash bond products, such as US Treasuries, European Government Bonds, Gilts, European Credit, Supras, Agencies, US Corporates etc. The adoption of open standards across multiple asset classes is what allows industry participants to leverage and re-use IT infrastructure and realise the cost saving benefits that standardisation brings.
In 2011, a group of leading sell-side banks approached the FIX Trading Community to establish a working group under the governance of GFIC. This working group, comprised of sell-side banks, trading venues and software vendors, was tasked with adapting FIX to the new SEF requirements by creating a set of ‘Best Practices’ for the swaps market.
The technical subcommittee analysed the business workflows specific to the swaps market and discussed how the protocol could be best implemented by venues running either an RFQ (request for quote) or CLOB (central limit order book) trading model. The resulting document was released by GFIC in March 2012. Since then, the majority of soon-to-be SEFs have agreed to migrate their trading protocol to FIX and implement their trading workflows in a ‘Best Practices’ manner.
FIX
 
In 2012, this same group of banks asked for an equivalent set of ‘Best Practices’ for cash bonds. The result was extension to the FIX specification to support North American credit trading (to support two-step negotiation for spread trading) as well as US Treasury trading in the wholesale markets (to support auctions and workups). All other markets were found to be supported by FIX already and simply needed to be documented in a cash bonds ‘Best Practices’ documentation. The specification and Best Practices were released in February 2013.
The Future
This year, GFIC has been working to extend the coverage of the cash bonds ‘Best Practices’ to the following areas:

  • Enhanced post-trade workflows (e.g. modification of allocation instructions)
  • Support for multi-leg strategies such as bond v/s future
  • Tiered price contribution
  • Extending swap guidelines

Additionally, the group  has launched an initiative to automate the process of enabling clients onto fixed income OTC electronic trading platforms. This is currently highly proprietary to each individual OTC market. It is often ad-hoc and manual, leading to unnecessarily high enablement costs and error rates. With the entitlement workflow likely to grow significantly with an increase in the number of electronic trading venues, these factors suggest the time is right to provide an automated and standardised approach to client enablement.
The TESI (Trading Enablement Standardisation Initiative) was launched this February, with the remit of defining an open industry standard for the permissioning of buy-side traders to trade with sell-side banks on OTC electronic venues. Once complete, these guidelines will explain how trading relationships can be established on an automated basis, thereby reducing operational risk and increasing the efficiency of trading enablement on SEFs as well as bond electronic trading venues.


Change is the new normal

By
GlobalTrading
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By Ben Jefferys, Head of Trading Solutions, IRESS
Constant change is the new normal these days for sell side brokers not only in Australia but also across the rest of the world. Regulation is the main driver of this constant change, followed by competitiveness and an overall quest to reduce costs and introduce efficiencies where possible. In 2013 trading volumes still remain subdued even though there have been noticeably good volume for days even weeks seen earlier in the year. The positive in this is that the sell-side is focussing on the order flow that they have, making sure it gets the best possible result for their clients and are keen to do so in the most efficient manner. Thankfully the barrage of change due to the competitiveness between the exchanges has become less intense. The regulator, ASIC, has helped to control some of this by trying to have exchanges release innovation based changes on a biannual basis. This almost routine release of innovation by exchanges has had to be balanced carefully so that sell-side brokers have the ability to test, release and ultimately incorporate it into their day-to-day operations. Brokers can become saturated with change and the cost to deploy new software into production can be high. This teamed with scarce or limited test resources means that decent innovation can unfortunately go by the wayside. The priority for brokers is always meeting regulatory requirements, anything else comes second.
Some of the recent regulatory changes have had a significant impact on trading in Australia. Perhaps not strictly in terms of the amounts traded, but certainly when it comes to how and where. One of the objectives that saw changes to the Market Integrity Rules (MIRs) was to limit small orders at either the bid or offer price being crossed off the market by dark pools and crossing systems. Crossings within the spread or rather the National Best Bid Offer (NBBO) are still permitted as long as they offer a meaningful price improvement. This has in effect removed the far majority of these types of NBBO crossings and instead the orders must route through to the exchange to trade with the existing lit liquidity on either the ASX TradeMatch or Chi-X order books. It would seem that the ASX, where the bulk of passive orders sit, would be the main beneficiary for now as prior to the rule change operators of dark pools and crossing systems could execute both orders via an NBBO crossing at a cheaper combined rate. Orders are now trading separately on the market where brokers must pay the full buy and sell transaction fees instead of a slightly cheaper combined fee for a crossing.
Another of the changes that has been more positively accepted by sell-side brokers is where ASIC have relaxed the requirements for reporting large block sized special crossings by introducing a tiered structure where smaller stocks have a smaller minimum block size requirement. As these crossings don’t share the restrictions of their NBBO siblings we are seeing dark pools being adapted to cater for the change. Overall the changes bring Australia more in line with its overseas peers which is especially positive when attracting order flow from offshore. Regulation aside there has been little time left for brokers to innovate by way of introducing new technology. The exchanges have new products available for faster trading that use ITCH and OUCH protocols, but for the most part brokers still rely on the older and slower products because the new versions are not quite rich enough in terms of the available data to be fully replaced.
For those that do or rather can take such products, their focus is likely being as fast as possible to react to market movements and subsequently trade whilst for others it will be about minimising the disruption to their existing order flow from latency arbitrage or rather the dreaded High Frequency Trading (HFT) strategies. Whatever you want to call it, HFT, gaming or information leakage, there has been a noticeable rise in this type of activity over recent months. Some brokers are able to combat the issue by taking the newer products as mentioned above from the exchanges. Others look to fine tune their smart order routers by normalising the arrival times when spraying an order across exchanges. This reduces the window of opportunity to be beaten by an HFT strategy and for the most part is rather effective.
The last area of change that we see is where brokers are reviewing their infrastructure for a number of reasons. First of all is cost, all brokers are under pressure to cut costs in this environment. Add to this the geographical issues associated with using a smart order router and gaming, and brokers have compelling reasons to look at how and where they host their trading systems. Centralising infrastructure to save money, deliver better trading performance whilst at the same time offering a more complete disaster recovery setup seems to be a good result all round.
Looking towards the future we expect to see more of the same. Globally, regulators are still working out how best to deal with dark liquidity and HFT. Thankfully the approach in Australia has been well balanced and measured ensuring that brokers have enough time to react and adapt. The pressure to drive down costs and increase efficiency will continue. At least by ensuring that brokers are compliant with regulatory changes also means that from a technology point they are up-to-date and aren’t left behind giving everyone the best possible chance at survival in a tough and changing market.

A Shift In Mindset

By
Yulia Kuksina
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The traditional sell-side execution model is being re-examined, resulting in the consideration of scenarios that were at one time unthinkable. Instinet’s Managing Director Glenn Lesko and Celent’s Research Director Securities and Investments Group David Easthope discuss.
There’s been a lot of talk lately about the expected increase in the outsourcing of equity trading technologies. Why do you think that is?
Glenn: It’s no secret that there are significant economic pressures on equities groups these days. Volumes have stagnated globally, regulatory compliance costs are increasing, commission rates continue to be compressed, revenue drivers that were once able to subsidise banks’ equities business have shrunk and the cost of maintaining trading infrastructures grows.
That has caused many on the sell-side to very critically examine legacy business models in an effort to right-size their cost bases in light of this new reality. Businesses lines that have historically been loss leaders but at the same time considered untouchable, like capital commitment or wide research coverage, are now being reconsidered in favour of scaled back offerings that are profitable in their own right.
As part of this process, one of the biggest cost centres, technology — is also being examined. From hardware and software costs to data centre charges, connectivity and trading platform development, technology-related costs comprise a substantial portion of overall equities budgets and this number is only getting higher as markets continue to grow more complex. And while only a few years ago the prospect of outsourcing parts of this infrastructure was unthinkable, the secular shift we find ourselves in has caused firms to consider ideas that were once anathema.
What are the economics driving this shift?
David: As Glenn noted, persistently low revenues, stubbornly high costs and capacity challenges are currently confronting sell-side equities businesses. On top of that, the derivatives and prime services businesses that once subsidised equities units are no longer capable of doing so. As a result, most banks’ management groups are no longer tolerant of expensive IT supporting a business with sub-par returns. Furthermore, because revenues are going to be hard to find amidst low volatility, we believe radical expense reduction programs have become necessary among not only mid-tier broker dealers, but also the largest broker dealers as well. In short, we believe brokerage firms must start to think the unthinkable – it is far better to assume that any and all IT can be outsourced than to assume none can.
With the increasing commoditisation of technology, how can banks and brokers differentiate themselves?
Glenn: Consider for instance the execution management system (EMS) that a trading desk uses to access the markets. Four or five years ago, most of the major banks offered their own proprietary platforms, which were viewed as a way to make client business “sticky” and also serve as a true differentiation point. Since then, however, we’ve seen the number of trading venues globally increase dramatically as dark pools have gone from a US-only phenomenon to globally prevalent; message traffic that must be processed has grown exponentially as HFT has become such a considerable part of the overall market; and multi-asset trading functionality has become a must. All of which has created a scenario in which it’s hugely expensive to develop and maintain an EMS, meaning that the true upper echelon EMS platforms are all offered by technology vendors; Goldman, Barclays and Citi – all of whom until relatively recently had proprietary EMS systems – have exited the space at least directly. To me this is a reflection of the increasingly prevalent attitude on Wall Street where firms say “we’re not going to try to be all things to all people – instead we’re going to focus on our strengths and make sure we’re profitable where we operate.”
Is the overall trend towards cloud computing services playing a role?
David: Cloud computing is definitely part of the solution here, particularly when we are referencing infrastructure as a service (IaaS). IaaS can include proximity services, co-location, hosting, storage and network services from players like NYSE Technologies, Savvis and OptionsIT, among others. In addition, managed services from a player like Thomson Reuters or Interactive Data, who can provide real-time content and data management, makes a lot of sense in this environment. Moreover, if we think even more radically, the outsourcing of certain compliance functions through offerings such as NASDAQ’s FinQloud can be attractive. That said, some trading applications and other front-office activities may never be cloud appropriate.
What other aspects of the execution value chain are currently being evaluated?
Glenn: There’s definitely a range, from small and mid-size firm’s looking to offload their execution offering in its entirety to bigger banks seeking to outsource what they view as non-differentiating aspects of their platform. For the latter, EMS/OMS has probably been the most obvious example thus far but we’re starting to see other aspects examined as well. For instance, several years ago, certain trading algorithms were distinctive and consequently real unique selling points for the firms that offered them. But as they’ve become not only more commoditised but more expensive to operate as well, brokers are beginning to “white label” all or parts of their algo offerings.
Another area is market connectivity. Developing and maintaining connectivity infrastructure is not a trivial undertaking and consequently something that many firms are looking to outsource.
Still another is the provision of multi-asset functionality. Offerings such as futures and options trading capabilities are extremely challenging given the tremendous amount of market data that must be processed and the separate registrations and licenses that are necessary.
Then there’s the other end of the spectrum where the whole offering is white labelled. For these firms, the ability to provide value through research, management access or even ownership structure while ensuring that clients get the best possible trade execution via partnership is a scenario that all stakeholders – clients, outsourcer and outsourcee – find compelling.
How much of the execution services process could you foresee being outsourced in five years?
David: Ideally, any portion of the infrastructure that’s non-differentiating will ultimately end up being outsourced. However, brokerage firms may lag and differ in how they interpret non-differentiating. Using an environmental analogy, we think brokerage houses should look for radical ways to lower costs throughout the equities franchise, by the mantra of reduce, re-use and recycle. Let me give you some examples. Equities franchises must reduce the number of trading applications supported and also reduce not only operations staff but also the number of sales traders supporting more mundane types of execution. There are also opportunities to invest in further development of client portals to replace some equities sales/traders with cross-asset regulatory/execution consultants, which is what the market is increasingly asking for these days.
Continuing the environmentalist analogy, re-use is a more difficult concept than reduce since much of the technology supporting equities execution is actually being repurposed to support trading in other asset classes, including fixed income. In fact, many top tier brokers have actually moved equities trading executives over to fixed income. In this context, re-use may be more about applying execution methodologies and algorithms to other asset classes to earn returns from scale.
If we can torture the analogy further, we believe the greatest appeal is in recycling. By recycling, we mean outsourcing not only infrastructure, but also adopting a managed services mentality for high performance trading applications. A managed service is a service offering in which operational functions are taken over by an external provider who can use its scale to lower the cost of ownership of those functions. Let us not forget that the mentality is key because the technology options have been available for mid-tier brokerages for some time now.
Was the recent decision by Nomura to make Instinet its execution services arm related to this trend?
Glenn: Yes, by all means. Nomura took a good long look at the current environment and determined that we’re in the midst of a true secular shift rather than a cyclical bump in the road, necessitating a fundamental change to their business model. As a result, we’ve spent the last 10 months or so working to migrate the Group’s entire equities execution services offering outside of Japan to Instinet. At the end of the day, Nomura made the decision to focus on its strengths: execution services (cash, program and electronic) on an agency-only basis through Instinet, and focused research coverage and focused research coverage and capital intensive products via the Nomura branded broker-dealers.
The other significant portion of this migration that’s worth noting is Instinet’s new role as the defacto trading technology services division of the Group by providing EMS and other execution technology solutions through the organisation. In this way, Nomura is very much “outsourcing” critical components of its technology infrastructure to its Instinet subsidiary.

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