Gustaf Hagerud, Deputy CEO and Head of Asset Management, Third National Swedish Pension Fund (AP3).
We have had in-house equity management since the fund started in 2001. But then we primarily had exposure in the Swedish equity market, since we have a large exposure to that market. Internationally, in Europe, which is close to us, we have had both internal and external managers. In 2009, when we really decided to push for a strategy of increasing our index portfolios, we moved more management in-house. In this Alpha-Beta separation strategy all our large exposures in both the domestic and international equity markets were moved into low tracking error portfolios. These Beta-portfolios are either index tracking mandates or index-plus mandates. This is now the case for our holdings in European, North-American and Asian equity markets. European and North American Beta-portfolios are now run both internally and externally. In Asia, however, all exposure is taken within external index mandates. The time difference and the lack of detailed knowledge of Asian markets is the main argument for this decision.
If we have a system to manage the portfolio in-house, we can do it. And then it’s a matter of the performance we can get or expect to get in the portfolio, and our possibilities to actually access the markets. And, of course, we have large challenges in accessing emerging markets. But in Asia since it’s an index exposure, with no active decision-making, we could actually run this internally, but we don’t have to. And, of course, it’s a matter of just looking after the portfolio, understanding what kind of securities to run in the portfolio. So then we would rather use external managers.
The second stage of the Alpha-Beta separation strategy was to move all active portfolio management from traditionally actively managed long-only equity mandates, into internal and external absolute return mandates. The internal active management is now done in long-short portfolios with only risk allocation and no capital allocated. External active management is in the form of hedge funds.
One important reason to implement the Alpha-Beta separation strategy was a more efficient use of fees to external management. We have a certain amount that we can spend on external managers and we’d rather spend this on external managers that can give an absolute return, rather than on those giving us an index return.
Another motivation for the Alpha-Beta separation is that in-house management of Beta-portfolios simplifies quite a lot of what we do in our portfolio, in the sense that we can control exactly what we do with individual securities.
The right tools
It is the proliferation of modern platforms that has given us the possibility to have much more of our asset management in-house. In 2009 we started a public procurement for an order management system that could improve our management of our internal Alpha and Beta portfolios. Our aim was to find an order management system that could be used for multiple asset classes, including fixed income, FX and equities. We also required a system where portfolio trades could be initiated by our internal Alpha-mandates and thereafter be taken care of by our execution desk. When the trades have been executed, they should go directly to our front-office and back-office portfolio systems.
It’s the order management and execution systems that makes this possible. We manage the portfolios electronically. The portfolio managers upload the portfolio every day from our back-office system, and they can execute directly through a broker or through direct market access. We use Bloomberg AIM for this.
It’s extremely easy for us. If it’s our European index portfolio for instance, we have our holdings in the system and we can see the index weights in our benchmark MSCI Europe. From the portfolio view in the system we can automatically create the trades that we want and after execution the trades will go through into our portfolio system. It is an extremely simple solution that we have.
We have only a few people doing the executions, as we don’t have enough resources to have an efficient algo desk. The execution desk managers take part in the management of our large internal index portfolios, and they also execute on behalf of our absolute return managers. The absolute return managers send their trades to the execution desk automatically through Bloomberg AIM.
We have used ETFs and still do, but to a smaller extent. For a large institutional buyer, it’s not efficient to use ETFs, since they are not cost-efficient for us. We do not find ETFs to be an implementation vehicle for any long-term allocation.
The role of external managers
I think we’re moving in the direction of increasingly specialist external managers. But then, if you look at the biggest asset managers in the world, they often have the possibility to track an index better than we have. It’s a matter of resources and research. If we are increasing our internal exposure to the European market, which we have done, then we increase our positions step by step and make sure that we don’t underperform, relative to the index and also relative to external index managers. An internal index mandate in a large liquid market should never be a drag on the return of our total portfolio.
Then you have enhanced or index plus managers and I think there’s still a role for these to be external, and then there are other managers that use sophisticated quant strategies to add some extra return on the portfolio. But, as I said, we try to separate Alpha from Beta.
We don’t have any high tracking error beta portfolios run externally. The large external managers we have are really the ones doing long-short strategies in hedge funds.
We have a similar situation when it comes to fixed income. But, in that case, we’re pushing for more internal management. But you must remember that a fixed income index mandate is very different from an equity index mandate. A fixed income index portfolio is much more complex than an index portfolio on the equity side. This is because on the equity side you can actually hold all the securities in the index, but that’s not the case in the fixed income markets. So you get a larger dispersion from the index and you’re forced to have a slightly larger tracking error. Then there are certain sections of the fixed income markets, such as high yield in the US, which we don’t have the staff to run, and this hasn’t anything to do with whether we have a good execution system or not. It’s a matter of the research on the companies issuing the bonds.
Other pension funds
For us it all depends on our Alpha-Beta separation strategy that makes this possible. Other institutions and pension funds have a very different strategy, with large internally managed active portfolios. And that’s not a road that we have followed. I think, generally, those who have similar portfolios and strategies to us, something like an Alpha-Beta separation strategy, are trying to do what we are doing, because you can implement the strategy without hiring a lot of people.
We are moving slowly and we took a first step in 2009 to implement our strategy; it’s really a steady stretch of processing. And the goal is to have all liquid assets in one system with straight through processing. We’re not there now, but I guess we could be there in five years’ time. I am certain that there will be more sophisticated systems around then that can help across all asset markets.
In-House Asset Management
What’s In A Warning
Brandon DeCoster, Vice President of Product Management at FIXFlyer examines the process of monitoring and alerting, and what might get overlooked.
Alerting is paramount
Mistakes are unavoidable. They can be mitigated, minimised, even anticipated, but the simple truth is that no system, no process, no rigor can wholly prevent human error. A mistyped order, an improperly tuned algorithm, a software race condition: it must be assumed that at some point, despite the best of pre-trade and intraday risk checks, something can and will go wrong. Failure of some kind is an inevitability. Wall Street is littered with large, sophisticated, and respected firms who have experienced high profile failures, sometimes with disastrous market consequences. These failures come in spite of heavy investment in development, testing, and monitoring. Compounding matters are the smaller failures that occur daily, without media attention, but nonetheless with devastating consequences to your operation. The impact of these failures is greatly exacerbated by slow or ineffective responses with timelines measured in hours. Effective alerting and monitoring are the final and most crucial lines of defense. Problems can never be 100% avoided, but a swift and effective response will lead to the best possible outcome. Effective alerting, however, is rarely implemented.
Alerting is not monitoring
It is easy to confuse alerting with monitoring, but in truth these are two different functions. Monitoring provides information on demand. Monitoring tracks state changes and creates audit trails. Monitoring generates reports and provides real time dashboards. Users look to monitoring systems as-needed for information. Monitoring drives alerting, but does not consist of alerting. An alert is a warning bell. Alerts call specific attention to possible problems. Alerts require action. Alerts interrupt. Where monitoring tracks the status of an executing order, alerting tells the trader that this order, one among hundreds of thousands, requires his attention now.
There are six key components to effective alerting:
1. Alerts need to be actionable
If there is nothing for a human to do when an alert is raised, then an alert isn’t the best way to handle whatever situation raised it in the first place. By nature, an alert calls human attention to an emergent situation. If there is no action to immediately be taken, then some other response is warranted.
2. Alerts need to be contextual
An alert in a vacuum is almost worse than no alert at all. Without context, and the tools to support it, the response to even a well-timed alert will be anemic at best. A FIX order rejection means nothing without the order that elicited it. A trade latency alert is useless without insight into historical or baseline latency. Basic research should never be required in responding to an alert: that initial contextual data is crucial to a timely response.
3. Alerts need to be external
Integrated alerting in trading applications has its place, but there is a very real danger here: the proverbial fox is guarding the henhouse. An algorithmic trading platform gone awry may not detect anything wrong with its own behavior. A desynchronised ticker plant cannot see that its quotes are stale. An order management system missing orders is highly unlikely to be able to report that it didn’t receive them! The best and most effective alerts are raised at the boundaries of your trading infrastructure, such as in FIX gateways or middleware.
4. Alerts need to be meaningful
Noisy alert consoles are ignored alert consoles. A single condition should, wherever possible, trigger a single alert. If alerts are repeated or frequent, then rate limiting, throttling, and masking are critical. The ten thousand individual order rejections are countless trees, but there is a forest in a single “Too Many Rejections” alert. Small problems only matter when there aren’t bigger problems: a good alerting platform can distinguish between the two.
5. Alerts need to be real time
The time between an emergent problem and an alert raised needs to be measured in seconds, not hours (or days). The whole point of an alert is to bring an issue to the attention of someone who can take action. Learning at T+1 that a matching engine was trading through for the last four hours of the previous day is, to put it mildly, not helpful. An alert is only effective if it is raised in time to actually do something.
6. Alerts need to be authoritative
The only thing worse than ineffective alerting is incorrect alerting. Faith in an alerting system has to be absolute. The moment a trader isn’t sure whether an over-execution alert is real, the moment a FIX operator isn’t sure that order was actually rejected, all alerts become meaningless. A trader making the call to trade out of a position needs to be able to take the alert at face value without hesitation, and to be able to trust the context of the alert — in this case, the assumed shares.
The Four Deadly Sins of Alerting
Practically, it is difficult to implement pure and perfect alerting. Most of us have existing systems in place, entrenched workflows which are not easily dislodged, heterogeneous systems and competing needs. Developing effective alerting is a process requiring diligence, evolution, evaluation, and re-evaluation at all levels of your operations. Imperfect systems must be deployed, tuned, and made useful over time. If nothing else, one must take care to avoid the most egregious misapplications of alerting.
1. The Flood of Alerts
A single alert for a single problem is the most optimal situation. Commonly, however, a single major problem will manifest in thousands of smaller ones. The last thing any response team needs is a never-ending flood of stale order alerts when the core problem is a failed matching engine. A single order being rejected warrants an alert: ten thousand orders being rejected in the span of a minute warrants a single critical alert. A flood ensures only that alerts will be lost in the sea.
2. The Scheduled Alert
If the same alert is raised every trading day at the same time, then this alert is not serving its purpose. In fact, it is training your response team to ignore the system. Load or volume alerts will often be raised daily at a market’s open. FIX sessions or matching engines will alert that they are down after hours. A ritual the world over in operations teams, is to clear the meaningless alerts which occur every day when the local markets open and close. This is nothing more than noise, and serves only to mask real alerts which may arise.
3. The “Check Engine Light” Alert
There is a class of alerting which hints vaguely that something might be wrong, but provide no further context. This is the “thread-lock” alert which sometimes means that your routing engine is crashing, but usually means only that it is Tuesday. It is the final error handler, the indication that something has gone wrong, but nothing so specific as to be useful.
To be sure, there is a place for the “catchall” alert for strange or unforeseen exceptions, but all too often these become the rule. If one of these vague alerts occurs more than once, spend the time and energy to devise a way to detect the specific problem and raise a specific alert. Otherwise, these types of alerts are ignored at about the same rate as the check engine light in one’s car.
4. The Mechanical Turk Alert
The bane of trade support and operations teams the world over, this is the alert which indicates a possible problem, but which requires a complex procedure to be followed to determine if the alert is legitimate. They give the illusion of complex alerting, while in reality are offloading the actual detection to a human being. This “analyst in a box” is not truly alerting, and does not take advantage of all the powers of calculation computers possess.
For example, imagine an alert indicating that an algorithmic child order may have been orphaned from its parent. Suppose that the only way to determine if this is the case is to run a series of SQL queries against the order database and examine the results. The alert is only doing half of the job. Manual lookups and calculations are the very things alerting is designed to avoid.
Next Steps
Start small. When implementing a new alert, consider for whom it is being raised, and what you expect them to do when they see it. Identify the five most commonly raised alerts in a given month, and evaluate whether they are critical problems requiring immediate responses, or just noise cluttering your console. When you find your users ignoring alerts, ask them why. An excellent example of a well designed alert would be the “unacknowledged order.” This is intended to detect a FIX order which has not received any response (e.g. no acknowledgement or rejection). This represents a discrete problem, an open liability requiring action, and can easily include all of the information necessary for swift human intervention (e.g. trade support calling the venue for a verbal out). Every alert should represent a real problem, imply a clear and direct call to action, and include the necessary supporting information.
The surest way to minimise the damage of inevitable failures is to detect them quickly and respond to them effectively. A comprehensive monitoring and well-designed alerting platform make this possible. A company is judged not by the thousand disasters they prevented, but by the one they did not see in time.
Building A Frontier Market:Mongolia
At the Mongolia Today – Opportunity To Reality event hosted on the 20th March in Hong Kong by professional services firm PwC, the passage of the new Mongolian Securities Law, which has been under consideration for some time, was the focal point of the day.
The law contains a number of key provisions which will enhance the openness and efficiency of the Mongolian Stock Exchange and the ability of foreign investors to dual list, trade, and open up the depository receipt market.
Mongolia is a rapidly growing economy, seeing growth of 17.5% in 2011, and over 12% growth in 2012, on a nominal GDP of $9.9 billion in 2012. With the economy increasingly opening up to foreign investment, reform of the capital markets and the mining and agriculture sectors have been high on the agenda. With commercially viable quantities of more than 80 elements on the periodic table available for mining, Mongolia has taken giant leaps up the international ladder of commodities producers. However, the market is in desperate need of capital.
Saruul Ganbaatar
Deputy CEO, Chief Regulatory Office,
Mongolian Stock Exchange
“I think this roundtable proved to be very useful. It provided the regulators with an opportunity to get together in search for an optimal mechanism of how to collaborate and what essentially needs to be accomplished to expand the market and continue promoting foreign institutional investors participation in Mongolia. Obviously, the amount of work that needs to be done in order to support the new initiatives is immense. Nevertheless, those initiatives certainly must be put in practice in order to be fully successful in reaching our end goals. We’re not reinventing the wheel. We are taking the wheel and applying all necessary adjustments to make it much more “polished” in tune with local standards. We need more liquidity, thus, more inward investment.
As I understand, Mongolia has already come on the radar of a number of global investors, and, provided that we make necessary amendments in our legislation to promote opening of our market to foreign investors and foster investor confidence, and strike the right balance between domestic and foreign investors’ interests, we may truly become the next remarkable story of dynamic growth and development.”
Saruul Bulgan
Director General, Securities Department,
Financial Regulatory Commission of Mongolia
“This is the first time that the regulator, exchange, and foreign and national banks have got together to discuss the new business that is due to enter Mongolia in the second half of 2013. The major takeaways from this session were that all parties involved in this business understand the requirements and needs of international investors because the custodian business is there to invite and drive international investment into Mongolia – investment that is very much needed in Mongolia. This has been an excellent starting point for future collaboration between the parties.”
Andrew Economides, Head of Market Development, Mongolian Stock Exchange
“It was a well-organised event and it was very interesting to bring together the Mongolian and the international players. At the moment, one of the major things missing from the Mongolian market is the post-trading infrastructure. We are working on bringing that infrastructure to the market. However, as the market is so new and the people involved in the market lack experience, it is very important for the international players involved to be on our side and to help the market moving forward. It’s also important for foreign institutions to consult with local institutions and the regulators in order for the latter to utilise international experience and expertise. I’m very happy to see that the Mongolian stakeholders, the regulators, the facilitators and the banks, are very keen to listen to what the international community has to say. So I think that all these factors will lead to a positive move forward when the right infrastructure is in place.”
The day itself was split into two segments, first a roundtable, attended by key Mongolian stakeholders, including the stock exchange, the regulator, the central bank, major domestic banks, and foreign banks and brokers looking to enter the market. The conversation was a frank exchange of views, covering what the domestic market wants and needs, and what the foreign banks want and need from the Mongolian regulator and exchange.
The one word summary of the roundtable would be liquidity. The creation of liquidity, and the protection of liquidity providers were key concerns for all parties.The second, larger, part of the day focused on custody and the importance of the relationship between local banks and foreign investors in providing custody services. The balance of protecting Mongolian interests and the wish-lists of foreign banks will be an ongoing debate, but the open discussion at the event was at least good natured.
The roundtable, in which senior participants from the Mongolian central bank, stock exchange, and leading national banks, openly discussed the status quo and ongoing future developments of the capital market with selected foreign institutions, was designed to allow for frank but instructive communication between the key domestic market stakeholders and the foreign investors. The new law also opens up Mongolia to the depository receipt market, by which domestic stocks can be issued by a custodian for trading on a foreign exchange. This market is a key provision for the ability of foreign investors to trade large sums on Mongolian stocks and to gain exposure to domestically listed companies without making oversized trades on the exchange. These two provisions make the dual-listing of stocks a much more attractive prospect on the Mongolian exchange, and should go a long way to alleviating the concerns of foreign investors.
The Mongolian Exchange (MSE) has been working closely with the London Stock Exchange (LSE) of late to allow for the expansion of technological offerings on the MSE, and the LSE has been conducting training programs with the exchange in order to enhance knowledge on international standards and expectations of an exchange. Much of the expectations of the foreign attendees of the event rotated on the safety of their assets, and the developing rule of law. While the new securities legislation goes some way to address these concerns, there remain questions around the full impact, and what volumes can be expected on the exchange, and how the custodians will be able to unite their own needs and those of the investors.
Robert Rooks
Consulting Director,
PwC Hong Kong
“PwC was very pleased to host this event at a crucial time in Mongolia’s development phase, which all key stakeholders agree was a valuable opportunity to discuss the issues and regulatory changes that will shape Mongolia’s investment landscape in the decades to come.”
B. Erdenedelger (Degi)
Director of Treasury and Investment Banking, Khan Bank
“Mongolia is growing and there’s much interest from foreign investors; there is lots of interest not just on the custody side,we are also meeting with potential bond investors who are keen to cooperate and invest in Mongolia. One of the topics on the agenda was the new securities law, and stability and the safety of investments. In today’s session we had global custody banks pointing out the safety of the assets. It was good to have the involvement of the FRC, the MSE and the regulators of the commercial banks. The commercial banks are discussing the main foundations that they have to build here in Mongolia in order to address the requirements of the foreign global banks that will come into the market and incorporate with the local banks. That was the most important thing that I took from the roundtable.”
Bruno Campenon
Head of BNP Securities Services
“Beyond the traditional interest around the emergence of a new market, there is the excitement of the complete infrastructure set-up. This goes from the market to the regulation bodies, and the traditional financial actors. The Mongolia conference gave a new 360° view of the potential of the market as well as the hurdles ahead to make it investment ready. Fundamentals are there – from the authorities willingness to proceed, to the multiple ongoing initiatives to create the investment framework. As a custodian, we strongly focus on providing a safe and transparent framework for international investors to enter the market in a transparent and secured manner.”
From the wider conference, many of the panels and discussions were built around sharing information of definitions and processes between the Mongolian and international representatives. Ensuring that each participant has a common working definition of key concepts and practices is a key area for making sure that expectations are reasonable, and that they are flexible over time. Of specific interest to the Mongolian bankers in attendance was exactly what benefit cooperation with the international custodians would give them. The knowledge sharing and efficiencies to be gained between the two are of great initial interest, but what about after a few years when the internationals have local market knowledge and their own established business, will the rate of sharing continue? Of vital importance is the management of expectations between the two parties.
Mongolia is becoming a market of interest to investors around the world, both those looking to increase their exposure to high-growth frontier markets, but also those looking to capitalise on China’s continued commodities imports. Liquidity breeds liquidity, and having world-class securities regulation and solid relationships with international banks should make the initial steps much easier.
Randolph S. Koppa
President, Trade and Development Bank of Mongolia
“As a participant from Mongolia representing a financial institution aiming to provide custody services once the Mongolian regulations are in place, I found the seminar very useful. It was comprehensive in covering all the aspects of custodial services, and had on hand representatives of all the various types of participants, from software vendors to global custodians and major depository receipt players. With the opportunity to understand each bank’s approach to the business and its consequent interest in Mongolia, potential working relationships began coming better into focus. All in all, a worthy event thanks to our host, PwC.”
Outsourced Infrastructure
NYSE Technologies’ Scott Fitzpatrick examines the motivations behind, and the process of, employing FIX as a service.
Little more than a decade ago, inbound FIX connectivity was a major competitive arena for the sell-side. Those who could deliver better, faster and more reliable FIX capabilities were able to capture trading volume from those who couldn’t. As early adopters pressed their advantage, and their competitors played catch up, sell-side firms built out extensive in-house operations to expand, improve and connect clients to their FIX networks.
FIX soon reached the tipping point, evolving into the de facto industry standard. Ten years ago if a sell-side lost their FIX infrastructure, they probably lost 50% of their order flow. Today, if they lose FIX infrastructure, they could lose 90% to 100% of their order flow. Maintaining fast, reliable and flexible FIX connectivity is no longer a point of differentiation. It’s another cost of doing business… another very expensive, time-consuming, distracting cost of doing business.
Flash forward to the post-crisis environment. With the entire industry under increasing cost pressures, sell-side institutions are looking for more ways to focus their resources on the efforts that decrease costs. As a major cost centre (up to $30 million a year for the largest sell-side firms), FIX connectivity has become a logical target for outsourcing initiatives. Until quite recently though, the options for outsourcing FIX connectivity were limited. FIX connectivity requires large, continuous investments in technology and specially trained people. Not many vendors had the ability to keep FIX infrastructure fully up-to-date and working well all the time.
FIX as a Service is a fully outsourced solution for the sell-side’s entire FIX infrastructure. We can host FIX infrastructure, manage it and run it. So, technology investments are no longer required and technical staff can be redeployed. While firms drive down costs, they maintain a stable and state-of-the-art environment that allows their clients to connect with them. They also retain the ability to innovate and take on new workflows and asset classes.
Maintaining interactions with clients
With outsourced FIX connectivity, sell-side firms interact with their customers in the same manner as they do now. When the phone call with the client ends, a work order is submitted or a ticket is opened to create FIX access for this client. Instead of it going to an internal technology group, though, it goes through a service provider. The interaction still takes place between the sell-side and their customers.
Streamlining and consolidating
With ongoing change in the process and products around outsourced connectivity, sell-sides can now have just one FIX infrastructure, not just on the equities desk but operating across asset classes. Instead of connecting four different ways at four different costs, client connectivity is streamlined. Technology providers are also making changes around network consolidation, so it is easier for sell-side firms to reach their client base. When a sell-side is trying to reach one of their client counterparties, there are tolls along each segment of the highway to reach their customers. Outsourcing removes some of those tolls by combining a FIX infrastructure with the client community’s network, essentially wrapping those two components up and providing one service back to the sell-side.
Customising solutions
The sell-side has ability and agility to jump in the middle between the order flow that is being sent in by their customer and the order management system that is receiving it. So, firms can then make changes without having to adjust their order management system in-house. Changes within the workflows, and the rules of engagement between each customer, can also be done in a similar manner.
While FIX is a standard protocol, it’s deployed in many ways. Data fields are often populated depending on how one person interprets the protocol versus somebody else. Outsourcing vendors are able to get in the middle and manipulate the messages so that both parties can have the tags in the appropriate fields.
Communication is key
In providing outsourced FIX connectivity the technology vendor becomes an integral part of the clients’ organisation. So, it is essential to establish solid rules of engagement. Our clients can come in and see the status of all their connectivity. If there’s an issue, they can research it and get real time alerts providing feedback on the specific infrastructure issues. Plus, they know exactly who to call and how to rectify the problem. Those pieces really help to streamline the actual implementation and the workflow around the service.
The future of FIX
While it is now essentially for the sell-side to maintain fast, flexible and reliable FIX connectivity, it may no longer be strategically advantageous to do it in house. By outsourcing FIX, the sell-side can redeploy resources to revenue-generating efforts while reducing the cost of operations. As the industry grows increasingly competitive, outsourcing FIX infrastructure may well become standard practice for the better part of the sell-side.
Sophisticated Risk Management Tools Critical for Exchanges and Clearing Houses
By Malcolm Warne Vice President, Product Manager, Risk Management NASDAQ OMX Market Technology
Traditionally, sophisticated enterprise risk management has been the domain of large broker dealers, driven by regulatory capital requirements and optimising return on risk capital. However, the increased systemic importance of exchanges and central counterparties since the 2008 financial crisis has raised the bar on risk management requirements for these institutions.
Clearing houses will have exposure to the same customers across multiple asset classes. OTC-traded financial instruments will have to be cleared through CCPs. While these factors increase the need for sophisticated post-trade risk management, they also provide strategic opportunities to lower costs, reduce potential losses and increase profits. Clearing houses that can provide the best-in-class services enabled by sophisticated risk management will be well positioned to attract and retain business in a centrally cleared environment.
Hallmarks of best-in-class risk management systems include support for the following:
• Cross margining to reduce margin requirements.
The global introduction of OTC Clearing plus the proposed Basel III requirements will increase the overall collateral obligations for clearing members and increase the imperative for them to use scarce available collateral as efficiently as possible. These changes also generate the opportunity to significantly lower margin requirements through cross margining. A sophisticated risk management solution will enable marketplaces to determine margin offsets within and across asset classes by calculating risk offsets across the entire portfolio. The benefits of this can be significant especially across listed and OTC portfolios of the same underlying asset class. According to TABB Group estimates, when all clearable interest rate swaps are eligible for portfolio margining, the additional margin requirements could be lowered by at least 32%, and the industry will see margin savings of at least US$618 billion.
• Real-time risk data.
Access to high quality, real-time risk information is critical for decision-making and is especially important in a stressed volatile market where risk exposure is constantly changing. With up-to-date information, clearing houses can use strategies such as intraday margin calls, member suspensions and hedging defaulting member positions to minimise losses by managing risks as they occur.
• Automated risk policy to reduce costs.
Automating risk policy enables clearing houses to set limits and continually monitor activity to detect and curb breaches. Sophisticated alarm handling ensures enforcement of risk policies by escalating any limit breaches for appropriate action. Clearing houses can lower fixed costs and free risk managers from tedious monitoring and report checking so they can focus on strategic risk management.
• Clearing certainty to maximise potential business and stay within credit limits.
In centrally cleared environments, clearing members generally need to extend credit to create a level of certainty that their trades will clear. To ensure that new deals are within acceptable credit limits and reduce the risk of trade fails, clearing houses will need to establish automated pre-trade credit checking routines. A sophisticated risk management system will offer both Push and Ping methods to support these credit checks. While the Push approach “pushes” credit availability to trading systems, the Ping method performs pre-deal checks in the risk management system prior to accepting deals for clearing. The Ping method is more appropriate for OTC Clearing and should be both fast and also take into account risk offsetting across the entire portfolio to maximise available credit without exceeding limits.
• Calibration of guarantee fund and margin to achieve optimal balance.
It is essential for clearing houses to maintain the proper balance between protecting the clearing house and its members in a default situation without placing too onerous a demand on limiting acceptable collateral. A sophisticated risk management system will provide the stress testing and back testing capability necessary to calibrate both the guarantee fund and initial margin calculations. This ensures the adequacy of these resources in all market conditions and also provides much needed transparency to clearing members.
• Nimble risk technology to quickly take advantage of new opportunities.
An agile, modern risk management solution is the engine that can power new revenue streams. These opportunities can include the clearing of new OTC asset classes brought on by regulatory changes and improved margin calculation. Having an agile risk platform enables exchanges and clearing houses to respond quickly and cost effectively to opportunities when time-to-market is critical.
• Value added SaaS Risk software can generate additional revenue and increase customer stickiness.
The increased market acceptance of hosted software services provides an opportunity for exchanges and clearing houses to offer their risk management functionality as a hosted service to clearing members and clients of clearing members. One potential service is margin optimisation, where clients can analyse their portfolios and perform what-if analysis to determine the most capital efficient way to amend their portfolio. These value added services can help marketplaces differentiate themselves and generate additional revenue via subscription fees.
Investing in a sophisticated risk management solution provides clearing houses with the flexibility to quickly adapt and to provide the necessary tools and transparency to their members. At the same time, this investment can generate additional returns by creating new opportunities to lower costs, reduce potential losses and increase profit while protecting the integrity of the clearing house and its members.
Frontier Hurdles
Leopard Capital Fund Manager, Thomas Hugger of Leopard Asia Frontier Fund and Managing Partner of Leopard Capital LP, goes through some of the major difficulties faced in various frontier markets in Asia.
In the frontier markets, even though you have electronic data services such as the internet, social media, and Bloomberg, it is very difficult to get financial papers or balance sheet papers, and other fundamental papers for some of the companies in these locations. Even if you go to Bloomberg and search on Bangladesh, you don’t have the balance sheet there. If you go into Bloomberg and look at Mongolian stocks, you will often find the price, but the description says, “The company currently has no available information on their current line of business as of 08/2008”. These are often blue-chip companies, and sometimes we have visited them or we have networks there, but there is limited information available.
But this is frequently because business is based on a more personal note, and I would say physical representation gives a big advantage. Our strategy on the private equity side complements this, so everywhere we have firms, we have offices. So we have an office in Cambodia, we have an office in Laos, we have an office in Haiti. When we are successful in fundraising for Myanmar and Bangladesh, we will have offices there too.
For private individuals it is still very difficult to invest in these markets. Go to a private bank in Hong Kong or Singapore, tell them you want to buy stock in Laos or even Vietnam and they will often tell you “Oh we are sorry, we cannot execute”.
Even for the institutional funds, including the bigger ones in some of the smaller markets, many still cannot trade because there are some restrictions, one of the main issues is they have no international custodians. That’s why the big guys often cannot invest in Laos, Cambodia, Mongolia or Papua New Guinea.
Principal difficulties
The hurdles start from very basic things, when last year I made my first trade in Mongolia, I called up the firm I wished to trade with. It was very difficult to reach a person because the fixed line was poor. So I had to call a mobile. I placed the order and I had to confirm it by email. There are some rules in Mongolia that mean that the broker can only place the order in the system if he has it written and signed, and it has to be on an order slip and the client has to sign it. So the broker sent me print-outs of the order sheet, which was in Mongolian. Then I had to sign it and to scan it and email it back and then the order was placed. In some markets people compete for nano-seconds, and this trade took me hours.
An execution in Papua New Guinea takes sometimes two, three days. I often need to call the local broker to chase them up. Sometimes the brokers don’t execute orders and say “Oh no, it was not done today”. So I have to wait for a week or even sometimes a month just to execute small tiny purchases. Of course in Papua New Guinea don’t call them in the afternoon; they are probably not in the office.
Then also in Mongolia, the fee I paid for the first broker was somewhere around 5% in commission and government fees. So I went there found another broker who gave me considerably cheaper executions. In international terms it is still outrageously expensive. Then it took me about four months until I had all the papers process done and when I asked for trade reports I would just get an email saying what I had bought. In this situation there was no contract, nothing, so I requested a contract note. I was probably one of the first foreign institutions for them, so I sent them examples of contract notes and what I expect for my fund, and within 24 hours I had the notes.
Execution pains
In Mongolia, I don’t have live prices on Bloomberg, so I found a website that has a five minute delay. I always check the prices online and I always place limit orders because the spreads can be more than 100%.
The daily turnover in Mongolia is less than US$100,000 and there are maybe one or two liquid stocks and the rest are just super illiquid.
There are also some capital controls, for example in Vietnam, before the broker can execute a trade he calls my custodian and determines a limit. Then the custodian will give the broker his limits and then he can execute. For each broker I have to designate the people, the name and phone number, ID number or fax number of who can ask for the limits in order to get the approval from their custodians.
In Mongolia or Vietnam or in other markets, I cannot sell stock and then buy with the profits, as I am required to wait until the money hits the account again.
One big hurdle is that, for foreign investors it is not easy to access these markets. For me as an emerging fund it is worth it and I went through the pain. It takes months until we have all custodians and brokerage accounts set up.
There is also a problem with ID markets, because if you go to London or New York, you don’t need an ID, you just have an account somewhere and your bank will get a broker and so on. But it is an administrative hurdle and I don’t understand why these exchanges add this pain for foreign investors. Although I think it is also not only the exchange, it is flowing down from the regulator.
Difficulties in opening accounts
In Vietnam it took me seven months to get a trading licence. There is no standardisation of the process between any of these markets. When you have to go back and forth it can take a long time.
For example, to open an account for Pakistan I went to the Pakistani Consulate here in Hong Kong with all the documents and they said they cannot do it because my firm is registered in the Cayman Islands. I went about 10 times to the Pakistan Consulate and finally they made an exception.
Some of the brokers have asked for extensive information to open an account and this can prove very time consuming.
On the other hand, a Pakistani guy with a brokerage, one of the leading companies, came to my office and he asked, “Do you mind opening an account with me?” I said, “Hey listen I’m going through this with such a pain with all the brokers. I don’t want to do this process again I’m nearly at the end of the tunnel”. Then he said, “Okay, listen give me your certificate of incorporation and the MMA of the funds and I promise you it will take two days”. And two days later the brokers account was opened.
In Vietnam, the document has to go to the Cayman Islands, they have to be notarised. Then they have to be sent to the Vietnamese embassy in London to be consularised. It then goes to Singapore to the custodian and the custodian sends it to Vietnam. So the whole process costs $2,000 for two stamps.
Now my fund administrator gives a lot of pain to some of the brokers, because the fund needs a monthly statement of my transactions which is proving to be quite a lot of work. and it is a big learning curve.
Chances of reform
Look at Laos, it’s a communist country. Laos and Cambodia, Cambodia has one stock at the moment and Laos has two. People go to Thailand where it’s a free country. You don’t need an ID, but in Cambodia and Laos, you do. So they are investing a lot of money in technology and people and they don’t make money. Then you consider the ASEAN link and from a commercial point of view, those countries don’t have a stock exchange. It took Cambodia three or four years to get it off the ground. I don’t know how much money they sunk into this project and with the link it could limit trading in this market.
The big stock exchanges are in Thailand and Singapore. But even Thailand today has currency restrictions so you can put money in easily, but if you try to move money out it’s very difficult, especially in large amounts. It also makes it more difficult for people in Laos to trade stocks in Thailand or in Singapore, because they need to buy the local currency.
Lately Emerging and Frontier Markets have underperformed Developed Markets and this provides an excellent entry point since these markets are historically seen as not expensive.
The trading facilities are often inefficient, but when you look at the stock market valuations: some stocks are overpriced but also a lot of stocks are trading below our “fair value model” or even below net cash (most of these companies are growing faster than listed companies in developed markets).
However, while some of the trading facilities are inefficient, in terms of stock market valuations: some stocks are overpriced, but a lot of stocks are trading below our “fair value model” or even below net cash (most of these companies are growing faster than listed companies in developed markets), which is a clear opportunity.
Collaboration with the buy-side
By Jeffrey Alexander and Linda Giordano of Barclays
What are your key concerns with the proliferation of order types and venues?
There is a tremendous amount of technology behind the creation and maintenance of every new venue and every new innovation introduced by these venues. It is difficult to impossible for traders to keep track of the myriad changes that occur, much less assess the potential impact of new order types and system changes. Add in the fact that every broker uses different routing logic, this process is unmanageable without a system of monitoring activity and measuring impact.
What would you like to change in the way trades are reported back to the buy-side?
The buy-side needs to be able to access sub-route level information (including unfilled routes) so that they can begin to understand the impact of using different technologies. Along with these sub-routes, traders also need to construct an accurate picture of what the market looked like at the time of route and execution.
This data resides with each broker as they are making the decisions where, when, and how much to route, as well as having the ability to accurately snap market data that is synced with routes and fills.
Ideally, this information should be available in real-time via FIX. As this is a long-term process, the buy-side should collect data from their brokers and analyse this data.
What metrics could change to increase transparency?
Obviously liquidity taker/provider flags need to be cleaned up, but also knowing the type of contra client would make it much easier to assess the efficacy of certain order types. For example, if a buy-side trader knew that a hide and slide order on DirectEdge typically matches up against HFT players and resulted in a larger footprint, they could work with their brokers to de-prioritise that particular venue.
What is the FPL Americas Buy-side Working Group doing to standardise these efforts?
We at Barclays have been working with a group of 20 large institutions to put together a standard for collection of the required sub-route and market data from every broker. We assign liquidity provide/take flags to every route, use MIC codes to report executing venue, and snap venue-specific and consolidate market data at the time of the route, fill, and several very short intervals post- trade (100 ms out to 1 minute.)
We were asked to collaborate with the FPL Americas Buy-side Execution Venue subgroup to communicate this standard to the members and to discuss the potential for incorporating this information into existing FIX messages and to potentially create new ones.
Are there limits to what can be standardised?
No. Brokers should be transparent with their clients and should work to make data legible. Brokers should expect that their clients have a fiduciary requirement to understand how they are accessing the market and should work to that end. It is the right thing to do.
To what extent is it about transparency and accountability, and to what extent is it about minimising the cost of transactions?
While there is typically a cost event when trading leaves a large footprint and savings will be had by minimising the footprint, the endeavor to understand how your brokers are accessing liquidity is about transparency and accountability. There have been major mistakes made by venue providers, but these errors have been disregarded because the financial impact was small. The point is that although the impact is small, the risk introduced when the market is acting in an anomalous way is increased by these “minor” errors. It isn’t enough for the venues to self-police—traders need to also make sure venues and order types are behaving as expected.
Is there a balance between broker freedom to seek rebates and buy-side need to minimise trading cost?
All things being equal, it makes sense for brokers to access the least costly venue. The question is, however, what is the definition of “all things being equal.” Using metrics to assess footprint need to be incorporated into the model that defines equality. Execution quality should never be sacrificed to achieve rebates.
What work is there to be done on where you didn’t execute as well, and is this real-time or sometime later?
The buy-side needs to have a better understanding of what is hurting and what is helping. The broker controls the technology that directly accesses the market and buy-siders need to be armed with data so they can have more informed conversations about routing technology.
Real-time analysis will help to allow traders to change course to mitigate implementations gone wrong, but there is a bit of a learning curve to get to that point which will be facilitated by starting with longer-term analysis.
Is there a danger all this will just be for the largest firms alone, due to data management issues?
This is why a standard is so important. If every buy-side firm requests different flavors of sub-route data, the development burden on the sell-side will be unmanageable and the focus will be on satisfying larger clients. However, if the brokers only have to develop to one file specification for every client, it becomes much more scalable.
In addition, the cost of market data redistribution fees needs to be borne by the sell-side as attempts to match market data to route and fill timestamps is highly inaccurate, especially at micro-second intervals. We propose to include key market prices.
This will also make it more tenable for the buy-side to implement an analysis program.
Via our Execution Consulting team, Barclays has developed technology to help the buy-side analyse venue footprint for both trades that occur via Barclays, as well as those that are traded elsewhere. We have created a research team that has built a multi-broker analysis system to help the buy-side analyse venues, as well as all phases of implementation. This team sits behind a Chinese wall that ensures data is secure and not accessible by sales/trading and the solutions developed can be housed at Barclays or can be implemented using local databases.
What is the time horizon for these reforms – how long should/will it take to standardise this data?
The sooner, the better, but adoption will be an organic process that stems from demand. We have a core group of firms who will use the standard we collectively put together when they finally do take the plunge to adopt a program to capture sub-route data from their brokers. The more firms that go out with the same file spec, the faster the standard will take hold. There are already a handful of firms that have sent the standard around to other brokers, so adoption is already in progress. I do think, however, that firms are moving slowly with this because a) they are waiting to see what FIX will offer and when it will be available and/or b) they are trying to find resources to dedicate to doing the required legwork.
Controlling Risk in Today’s Market The Canadian Safety Nets
By Deanna Dobrowsky, Vice President, Market Regulation Policy, IIROC
Canadian regulators, like their counterparts around the globe, have worked to establish a framework to mitigate risk in electronic markets.
We have designed various rules to work as a series of safety nets to protect against events that can lead to unintended outcomes in a high-speed market.
The safety nets are tiered and provide protections, offered by different industry stakeholders, at multiple levels. This layered approach to risk management mitigates risk at different stages in the life cycle of an order, and places the responsibility of protecting the system on various parties.
The four safety nets include:
- At the dealer level, automated controls to prevent the entry of orders that can disrupt a fair and orderly market;
- At the marketplace level, thresholds that prevent orders from executing at unreasonable prices
- Single-stock circuit breakers administered by the Investment Industry Regulatory Organization of Canada that address rapid, significant and unexplained price movement in a particular security; and
- Market-wide circuit breakers which halt trading on all equities marketplaces when there are declines in prices that affect the market generally.
Dealers and Automated Pre-Trade Controls
The first safety net is maintained by participants – dealers that trade directly on marketplaces and may act on behalf of clients. New requirements (the “Electronic Trading Rules” or “ETR”) have expanded on existing rules to specifically require risk management and supervisory controls related to marketplace access and the use of automated order systems. The ETR require participants to use automated controls to prevent the entry of an order that:
- Exceeds pre-determined credit or capital thresholds,
- Exceeds pre-determined value or volume limits, or
- Violates market integrity rules or securities regulation.
In particular, a participant that uses an automated order system must have appropriate procedures to detect, prior to entry, an order that is clearly erroneous or unreasonable and which would interfere with fair and orderly markets. The ETR came into force on March 1, 2013.
Marketplace Thresholds
The next tier of safety net is at the marketplace level. To date, exchanges and alternative trading systems have not been required to employ volatility controls or trading thresholds. This has resulted in inconsistent, and in some cases non-existent, safeguards on the marketplaces. IIROC has been given the mandate to set marketplace price and volume thresholds, but specific limits have not yet been determined. IIROC has issued a concept paper on this topic and further proposals on marketplace thresholds will be published for comment.
Single-Stock Circuit Breakers
Single-stock circuit breakers, which apply to securities included in the S&P/TSX Composite Index as well as to exchange-traded funds, were put in place in February 2012 to address rapid, significant and unexplained price movements in a particular security. A five-minute halt is triggered across all equities marketplaces if the price of the security swings 10% or more within a five-minute period between 9:50am and 3:30pm. Applying a single-stock circuit breaker to securities in a broad-based index reduces extreme volatility in those securities and, by extension, dampens the volatility of the index.
Market-Wide Circuit Breaker
The fourth and final safety net is the market-wide circuit breaker which halts trading on all equities marketplaces when there are declines in prices that affect the market generally. Market-wide halts of this nature have historically been, and continue to be, tied to the market-wide circuit breaker in the US. Thus trading halts on all Canadian equities marketplaces generally are triggered based on the decline in the S&P 500 Index from its closing value on the previous day.
Underpinning the Safety Nets
As described above, the Canadian safety nets function as part of a multi-tiered system to control short-term, unexplained volatility. Where these measures do not apply or in exceptional circumstances, IIROC will vary or cancel trades that have a negative impact on fair and orderly markets. IIROC’s ability to intervene when required is the final measure strengthening this framework of risk mitigation and management.
What To Expect From The SFC
With Ashley Alder, CEO, Securities and Futures Commission of Hong Kong.
Can you describe the SFC’s recent regulatory initiative on electronic trading?
There’s a huge amount of work and thought being put into the regulatory approach to electronic trading internationally, and this effort has been underway for some time.
In Hong Kong, we published our new rules in March after a public consultation.
The initiatives are intended to provide much needed clarity to intermediaries and traders and, in common with much post-financial crisis regulation, are about safety, soundness and transparency. The rules are broadly in line with regulations across other major international markets and the principles published by the International Organization of Securities Commissions (IOSCO).
In essence, the rules apply to internet trading, Direct Market Access (DMA) and algorithmic trading, and are aimed at ensuring that undue risks are not borne by investors.
What are the comments of the industry on the new SFC regime of electronic trading?
Feedback was pretty open and honest. There was no significant resistance to the proposals; it is pretty evident that sensible regulation is necessarily about system safety, testing, internal controls and the risks of DMA.
Of course some comments focused on the ever present tension between the extent of safety measures required to minimise risk to an acceptable level and the costs of those measures to the industry – and to end users.
For example, smaller firms were concerned about the extent they have to employ resources to check out an electronic system that is bought off-the-shelf. The answer is that you absolutely need to check it out – because if you don’t, the risks you are taking on are unknowable; you would be flying blind.
Although the new requirements will inevitably increase operating costs, we believe that the framework will actually facilitate the long-term growth of electronic trading in our market; electronic trading is here to stay and the regime ensures that investors are informed and can be confident. One thing we are very conscious of in Hong Kong is that we deal with a vast range of financial institutions from the very big to the very small. The impact of regulation on them, including electronic trading, can therefore vary, and that’s something we have to be sensitive to. Clearly, large firms may be better able to absorb additional costs than smaller firms.
With that in mind, the new regime will become effective on 1 January 2014 to allow sufficient time for all firms to implement internal control policies and procedures, as well as to make changes to their electronic trading and record keeping systems.
How are you examining dark liquidity?
Fundamentally, with dark pools and dark liquidity, we are talking about trading off-exchange on platforms that do not offer pre-trade price transparency. Since the imposition of mandatory flagging of reported dark pool transactions by the Hong Kong stock exchange last year, the reported volume of trades executed in dark pools in Hong Kong has increased steadily, accounting for 2.2% to 2.5% of monthly turnover. This, of course, is very small compared to markets that have actively embraced alternative venues – and are now struggling with how to regulate them and find an optimal balance between the roles of “lit” and “dark” trading platforms.
We have identified a set of key issues concerning dark liquidity – clarity to users as to how a dark pool operates; involvement of retail investors; who within a financial institution can see what’s occurring in a dark pool; what ‘best execution’ means within dark pools; and proprietary orders within dark pools – e.g. the priority of proprietary orders versus genuine client orders.
So, unlike the new electronic trading rules – which are about firms operating between a trading platform and a client, this is a separate topic about the platforms themselves.
We’ve already come across some problems with existing dark pools. They have different configurations and different target clients, and of course they were originally developed to facilitate large trades by large institutions – but have moved on from this to deal with smaller trades. Those banks or brokers who operate their own “internal” dark pools tend to say that they are simply a benign electronic overlay to traditional brokerage operations. Exchanges counter this by saying that all trading needs to have pre-trade price and order book transparency and what the dark pools operators are doing is operating alternative exchanges, free riding on lit market pricing. To address these issues, we have actively discussed the situation with existing dark pool operators with a view to imposing carefully calibrated licensing conditions.
We will also consult the market later this year about codifying our stance to ensure a consistent, level playing field for all operators.
What is the thinking of the SFC on High Frequency Trading (HFT)?
The impression that we get is that, although much has been discussed ever since the US flash crash in 2010, the jury is still out as to a) what is HFT, b) what is good HFT and c) what is bad HFT.
And you can break this down into a number of components about the “bad” side. Is HFT too unstable? Does it provide false liquidity? Does it disadvantage other investors? HFT firms tend to point to reduced spread and informal “market making” functions as the positive side of HFT.
HFT in terms of system stability and fairness is one angle. The other is the extent to which HFT can be used to commit market abuse. There are a whole list of new terms around this which mostly describe activities that are similar to market abuse in “slow” markets – spoofing, layering and so on – which often means misleading the other side of the book into believing you’re trading in one direction when in fact you’re doing the opposite. This could be manipulative. However, it is interesting that ASIC in Australia has recently concluded that HFT cannot be singled out as an unusual locus for market abuse.
We do not have any firm data on HFT activity in Hong Kong. However, according to the industry, it remains subdued. This seems largely due to the frictional cost of trading equities. Stamp duty of 0.1% of payable by the buyer and the seller can easily exceed the wafer-thin profit-per-trade that constitutes much HFT business. HKEx is in the process of upgrading its market infrastructure (including trading, the data centre and market data services) to offer enhanced services like co-location and a central gateway, so it remains to be seen whether financial costs do remain an impediment in cash markets.
Regulators in the US, Europe and Australia are taking steps to establish whether HFT-specific regulations are required. We will continue to monitor the situation closely and if HFT raises any regulatory concerns in our market, we will actively consider how to address the issues.
Under the IOSCO umbrella and individually, how do you reconcile what other regulators are doing with the trading environment in Hong Kong?
The biggest discussion at the moment regarding cross-border regulation centres on trading in OTC derivatives.
Against this background, there is every reason to support international standard setting by the IOSCO to operate as a benchmark for cross border activity and to ensure that those standards are sufficiently detailed as to be credible.
The debate about cross-border activity focuses on how to deal with the extent to which regions such as the EU or the US apply their own laws extraterritorially and the extent they should instead refer to international standards and use other techniques to operate in a cooperative manner. The current debate is pretty central to the IOSCO because, when push comes to shove, a lot of work is being done to produce international standards, but if they’re not used at the sharp end of cross-border activity, then this begs a question as to the utility or authority of these standards.
Together with many other countries, the SFC holds a strong view that further energy should be put into the development of a common understanding amongst global regulators, as to how they will assess different jurisdictions when applying rules across borders in order to promote consistency, but without derogating from investor protection. In this connection, credible international standards should be the first port of call. The IOSCO has now set up a task force, with which the SFC is closely involved, with a mandate to identify cross border regulatory techniques and develop principles about how these techniques should be used by IOSCO members. Essentially, it’s about developing a toolbox for regulators to determine, among other things, whether or not rules of overseas jurisdictions are acceptable substitutes for their own when dealing with cross border activity. The aim of the exercise is to help achieve greater consistency of regulation globally and to avoid the possibility of fragmentation impacting on liquidity and, ultimately, reduced financing available in growth regions such as Asia.
Principles versus rules based regulation, where do you sit?
Hong Kong’s regulatory regime is a principles- or outcomes-based system, but by principles we do not mean light touch. It’s rather unfortunate that at some point there seems to have been confusion between those two phrases.
A properly regulated principles-based regime does not mean enforcement is weak – there’s no correlation between the two. The SFC’s enforcement track record over the past few years has certainly demonstrated that this is not the case.
One perceived advantage of a rules-based approach is that because a rule looks like a bright line test it’s easier to regulate and is more effective. But the problem with this is that the more detailed you get, the larger and more complex the rulebook becomes and, the easier it is to inadvertently build gaps into the system.
If you have an outcomes-based or a principles-based approach, gaps should be minimised but there is of course a large responsibility on the part of the regulator to do a good job because it’s not simply a box ticking exercise. This implies that the regulator has to exercise sensible judgements about regulatory outcomes, but also that market participants have to do the same thing. Firms sometimes come to us asking for check-lists to give them certainty. Our normal response is that this type of certainty is illusory, absent careful judgments about outcomes, and in any event check-lists are a recipe for an abdication of thought as well as loopholes.
What comes next from regulation in Hong Kong, Asia, and the rest of the world?
At the high-level, there are three areas of focus.
First, from a Hong Kong perspective, local regulations will continue to be developed to address local market characteristics; we have to be sensitive to the way that our local market is different from other markets.
For instance, while the dark pool project has an international context, it’s fundamentally a local project. Our proposal to enhance regulation of electronic trading also has an international dimension (and makes references to the IOSCO standards), but again, it’s a local project.
The second area relates to Hong Kong as a gateway with China. And that’s mainly about two things. The first is cross-border activity around listed companies and secondary market trading. The second aspect has to do with strengthening Hong Kong as an asset management centre. This means harnessing the growing pool of off-shore RMB to invest into China and encouraging Mainland investors to invest overseas via Hong Kong. This is reflected in plans to introduce a regulatory framework for the mutual recognition of Mainland and Hong Kong funds as well as encouraging the domicile of funds in Hong Kong.
Third, in the international arena, our main focus is on the IOSCO and the part we play in developing international solutions to the regulation of cross border financial activity. We are pleased to see that the IOSCO is growing in stature and is also putting plans together to develop its research, training and collaborative function for all regulators – whether for growth markets or developed economies.
Where Do Your Orders Go Before They’re Executed?
Capital Group’s Brian Lees is driving efforts to ask more questions of brokers, and for more data on where an order is shown before it executes, but can the buy-side handle the resulting deluge?
The current work you are doing on venue reporting analysis
Our first push was simply to try to collect information about ‘where’ we were executing and a little bit about ‘how’ we were executing, namely, did we post or did we take liquidity. So having done that, the question was where do we go from there? And as such, the topic of requesting more data on where we didn’t execute and what order types were used started to be raised by some representatives on the FPL Americas Buy-Side Working Group. Some participants had already started down this road with brokers, asking for information relating to post-trade about where their orders were sprayed out to by the algorithms and what types of orders were placed on exchanges and also which exchanges they were on, etc. So that’s where the conversation began and that’s where we reached out to Jeff Alexander and Linda Giordano, because Barclays had already spearheaded this conversation.
What we are looking to achieve either in real time or post-trade, is whether we can standardise a format for brokers to tell us how our order interacted with the market, including when the order was placed, what order types were used, where it was placed in the markets and whether or not we got hits. The concern with this is not so much can we get it, because if we sign enough non-disclosure agreements we can get the information from the brokers. Some brokers have concerns about that information getting out and somebody reverse-engineering their algorithms, but from the buy-side perspective, I think the biggest concern is whether we can manage the volume of data that we would get.
The resources to store and analyse data and make some sort of good use of it
With the original data that we were getting, on where the execution took place, we talked a lot about this with smaller firms who were using TCA vendors to help them analyse this information. With this type of information, if we went a step further, the brokers would not want us sending that out to TCA firms, because it shows their methodology for how their algorithms behave. I was in New York several weeks ago and took the opportunity to meet up with Jeff and Linda while we were there. We invited Jeff to join one of our conference calls for the buy-side committee, which he did, and he talked about what they’ve been proposing. He showed proposals for both the real-time collection of data, via FIX messages, actually proposing a whole new FIX message to be created for this purpose, which could then be sent in real time. Or, alternatively we could standardise a format for collecting the information post-trade which, as a spreadsheet, would then tell us what we want to see. We’re trying to standardise how you ask for the data and what format it is going to be in, by creating best practices for how to get the data from the brokers. That way the brokers don’t have to keep coming up with a different format for every client that asks for it. The best practices do specify that the ISO MIC codes would be the standard for identifying the exchange that you executed on, but we said nothing about what you should do with the data once you get it.
Exchange involvement in the conversation
We did talk to some exchanges when we were first trying to standardise how to identify the exchanges, because when we first standardised the MIC codes, they did not cover all the exchanges, this was due to the fact that they hadn’t all registered with the ISO organisation and we wanted them to.
We had a little bit of trouble in differentiating the dark order books from the lit order books and some of the exchanges that have both. These exchanges consider themselves a hybrid book, and they didn’t want to be known as two different things. We didn’t have a way to differentiate the dark and the lit flow without introducing yet another FIX tag. That back and forth added to the conversation as part of the registration authority’s decision to come out with the new market segment concept, which says you can have an exchange defined and have child MIC codes that differentiate different segments of the market. We’re beginning to start conversations with exchanges about this topic, but that’s the extent to which we’ve had any discussion with them.
Broker willingness to participate in the process
The first half of this, just getting the information about where you executed, the brokers didn’t have any problem, because it’s public record once it executes. When we started talking about the more detailed reporting, they did raise a concern about the information being sent out and NDAs so that, you, as a client, are not going to send the data out to a third party. But because other firms had already started down this road we talked about the purpose of this, which was just to have someone looking over their shoulder to make sure that they are acting in the best interest of the client and not potentially favouring rebates over best execution; they can’t really argue with that logic. Somebody should have some oversight as to whether or not the right decisions are being made.
We haven’t talked to a large number of the sell-side yet, however this will be done prior to publishing the best practices, as they will be shared globally with the FPL membership for review. It’s certainly possible we can meet more resistance on this. However, because it is our order and our data being generated, and because of our activities, we shouldn’t face too many challenges, as long as we can come to an agreement about how it is disclosed and how it will be used internally.
Critical mass when enough brokers are on board
If we get some firms saying, “Yes, we’ll show you this data,” and some that say, “No, we won’t,” the ones who won’t are likely to get phone calls from heads of trading saying, “Well, if you won’t share the data, then we may not be able to trade with you, because we need to be able to monitor the quality of what you’re doing.”
In this situation, if there are some holdouts and the rest of the industry is going forward with it, I would not imagine that the holdouts would be able to continue to do so. There’s always going to be a balance between the proprietary data and the need for transparency about how trades are executing.
Touching base with European counterparts
We released an updated version of the guidelines last summer and worked closely with the EMEA Business Practices Subcommittee. We have also spoken with the EMEA Investment Managers Working Group and we have had phone calls to bring them up to speed on what we’re doing, and there’s definitely interest on their side to support this. A lot of the firms that are part of the US Buy-Side Working Group are global firms, so we have a vested interested in getting Europe, and Asia as well at some point, involved in helping us carry this forward.
The burden of extra data on smaller buy-sides
It will be up to each firm to come up with the resources to do something with the data. The challenge will emerge if it turns out that the information can’t be disclosed to a third party to analyse as there are a lot of buy-sides that simply won’t have the resources to do this themselves.
We are already seeing vendors incorporate information about where you execute into their EMS systems. A few weeks ago I attended a conference and I saw firms that had taken that information and shown a real-time pie chart about where an order was executing, and it was using MIC codes; pretty much the standard that we had set up with FIX, and it was reading them through the FIX messages. So, you can get a certain degree of information about how you’re executing already, but taking this extra step to see where you didn’t execute and what that means, such as ‘is a broker trying to get rebates at my expense?’ You’re going to deploy a certain amount of resources to do that, if you’re not allowed to send received data out to a vendor.
Extra burden on the brokers
Some of the smaller brokers might have resource issues in trying to produce the data. We’re starting out focusing on the larger firms. But of the ones that we have talked to, it’s not a matter of, “Do I have the data?” Their biggest concern is, “Am I going to be asked for this in 50 different formats for 50 different clients?” And that’s the problem we’re trying to address. Let’s get this standardised in a uniform way to minimise the work involved, and then you can set up whatever processes on the sell-side you need in order to generate in that format.
A lot of the smaller-sized firms do rely on vendor EMS’s as well and they may be able to ask their vendors to give them a way to generate the data. Again, having a standard format would help in this regard too. We want to try with the bigger brokers initially and see how useful we’re finding the data before we try to push it further. We’re still just at the discussion phase about how much data we are going to generate. We are trying to get our arms around just how much data we’re talking about here; we’re not quite sure.
We don’t currently know whether the broker is sending 20 quotes per second to one exchange and doing that with 14 exchanges all the once, or if it is less. We’re going to do some case studies just to get an idea. If we were to do this real time, here is the spreadsheet showing how many FIX messages that would have generated. Then we can go back and say whether or not we’d be able to handle that volume. There are a lot of questions that we have to answer.
Timeframes
This initiative has taken time, as we have sought to collect the data about where we were executing and the make or take flag, in addition to the principle and agency information. Achieving just those three items in addition to composing the standard for gathering this information and then popularising it, has taken time. We have also had a lot meetings with the brokerages, and saying to each firm, “now we have the standard, we expect you to adopt it.” We have then been monitoring the data that they sent, which has been an integrative process because we got some poor quality data at first. It’s been a constant feedback loop.
This next phase is likely to be similar as well. We haven’t set a deadline specifically for this. We’re taking it one meeting at a time and coming up with some action items and then following up. I would imagine it’s another year or two before we start to see adoption being carried forward.
This is very new territory for everybody. It has always been about actual transactions taking place, and now we’re talking about generating data for the transactions that ‘didn’t’ take place. That’s a whole new arena and whether or not, we, as the buy-side, can actually handle what we’re requesting, is a big question mark.
