With James Rae, Advanced Execution Services, Credit Suisse
On the sunny Friday morning of May 7th 2010 I stepped into a large meeting room with the senior management of an ASEAN exchange. We were there to discuss the merits of algorithmic trading in the equities markets. Before the usual pleasantries could be made the President of the exchange had a simple question for me: “was it you?” The post May 6th world had begun.
In our business it’s easy to miss the forest for the trees. Over the past 20 years the accelerating cycle of crisis and new regulations, coupled with an ever changing technological landscape, would lead one to believe that the Holy Grail for the investment industry is to take risk out of every facet of what we do. The irony is that the inherent raison d’etre for what we do, ultimately, is the distribution and accumulation of that very entity – risk. Unless you have a very cynical view of the industry you would have to conclude that risk is not inherently bad, only if managed well. But the task of managing risk for the industry is not so simple. Risk for any activity is the relationship between a potential gain weighed against a related potential loss – or Crisis and Opportunity. The advent of technology into the market has introduced changes and thus new systematic risks into the execution process. The gains of technology in the equities market include the well groomed concepts of improved control, lower latencies, greater transparencies, larger arbitrage opportunities (and greater liquidity), and ultimately a lower cost of execution. And, so goes the argument, as these improvements are introduced and the execution process improves so do the capital markets overall. On the flip side, the potential loss includes unexpected dislocations in the market, which compromise the investment community’s overall faith in the market, lowers participation rates, and introduces the potential of unfettered regulation. So the goal of Risk Management is to mitigate the downside of the risk we’ve undertaken while leveraging its efficiencies. The question that is before us today: between brokers, investors, vendors, regulators and exchanges – how can we mitigate the downside of systematic risk without negatively impacting the markets? And, further, how should this inherent systematic risk be distributed amongst market participants?
One might rely predominantly on the exchanges to provide limits and safety checks to manage systematic risks in the market. But are the exchanges the best equipped to do so? History provides some insight. The most glaring example comes from the US. In reaction to the Flash Crash and the Knight Trading incident, the SEC introduced exchange level single stock circuit breakers and later on replaced them with tighter Limit Up/Down rules enforcing bands around the trailing 5-minute average of each ticker in the S&P 500 and Russell 1000. When a stock price moves outside of the band for more than 15 seconds trading is halted for 5 minutes. Wider bands are offered for other less liquid NMS stocks and are widened at the open and close. How effective are these bands? A Credit Suisse study shows that in the Knight Trading case the limit rules would have failed to stop around 90% of the erroneous orders during the 20-minute sell-off. The immediate response might be to tighten the bands. But the problem with tightening further is that they then begin to disrupt the normal trading activity of the underlying. In fact, to date, 90% of existing trading halts from Limit Up/Down restrictions in the US are the result of poor liquidity, not fat finger errors. So exchanges, while ideally suited to catch very broad limit moves, are not ideally suited to manage price moves across the broader spectrum of stocks.
We would not argue for the elimination of Risk Controls at the exchange level. As noted by Credit Suisse’s head of Advanced Execution Product in Asia, Murat Atamer, “Daily circuit breakers can offer quick solutions to safety concerns, but they can also considerably restrict trading if poorly designed. As such, we prefer temporary trading halts to daily limits and the use of a fixed reference point with exemptions, such as IPOs. Current risk checks put forward by regulators in Asia are mostly static; e.g. price, quantity, average daily volume, and notional based limits, and may fail to stop erroneous orders as they do not reflect real-time market conditions. Clearly, there is a great need for smarter risk management controls that actively engage electronic sales traders (the human touch) and take into account prevailing market conditions. These checks are best suited to be implemented by brokers to preserve market integrity without the cost of excessive trading disruptions.”
Credit Suisse has, since 2010, introduced an array of risk management tools at the order entry point which take into consideration market conditions and the greater intention of the client’s order, something which is not possible at the exchange level while considering each child slice. When implemented, each of these risk management controls is provided with human consideration.
A list of those tools follow:
1. Broker Circuit Breakers
Electronic Sales Traders are execution specialists who provide valuable information on execution strategy and algorithm choices for specific stocks while continuously monitoring buy-side orders. Buy-side orders that experience adverse price movements should be automatically paused. These orders can only be resumed by Electronic Sales Traders, who verify that the price movement was legitimate before allowing an order or algo to continue trading. Broker level circuit breakers are superior to market-wide price restrictions as they can be extremely flexible and successful in separating a legitimate price move from an erroneous trade. These are order specific rather than market or even stock specific measures.
2. Dynamic Limits
Algorithms should have tighter dynamic limits based on short term average prices. These dynamic limits mimic human behavior: they stop algorithms from trading into temporary price spikes and ensure that orders do not fall behind on legitimate price movements and are perfect to minimize impact from a series of DMA orders. Tight dynamic limits are necessary for best execution, just like the US limit Up/Down rules, but will fail to offer protection on prolonged market dislocations as they move with the market. As such, broker level circuit breakers are the best way to provide absolute safety on investor orders.
3. Validating Potentially Impactful Tickets
Any order that has a wide limit price (or no limit price) and a wide volume restriction (or no volume restriction) should be checked against the average trading period volume. If an order is not restricted with price or volume participation limits, the allowed size of the order should be limited. This check not only protects the market before any damage is done, but also encourages prudent trading practices for the buy-side as the only thing needed for the order to be allowed into the market is the entry of a tight limit price or a volume restriction.
4. Direct Market Access Checks
Orders that have a wide enough limit and large enough size to push the price significantly should be rejected before they are sent to the market. For example, brokers have impact checks in place that reject orders that can push the price by the smaller of five ticks and 2%. It’s imperative that these checks are applied before order creation – and thus ideally suited at the broker level.
In conclusion, Risk Management tools need to be considered by all market participants. But each participant is uniquely suited to manage a particular subset of that risk. Exchanges can, and do have, the responsibility to manage systematic risk from the 50,000 level, but brokers have the insight and flexibility to manage risk at the order entry point, where consideration can be given to the intent of the parent ticket and where human intervention can fully consider prevailing market conditions.
Crisis and Opportunities
Market Opinion : Jannah Patchay
BACK TO THE DRAWING BOARD.
As the mainstream activities of exchanges continues to stagnate, Jannah Patchay, of Agora Global Consultants argues that now is the time to think out of the box.
Equity markets seem to be the natural solution to a fairly simple supply and demand equation. I have a business – you want to make an investment. My business can issue shares. Voila, we have a match and everyone is happy. What additional embellishment could possibly be required for a transaction as simple as this?
As exchanges have evolved over the centuries, the core components of their business model have changed superficially, but are still clearly recognisable. As matchmakers of investor cash supply to enterprise capital demand, they provide a framework for bringing new IPOs to market, a secondary market and access to liquidity for investors, and market data to facilitate the price formation process. However, in most capitalist economies, exchanges are not actually operated as public utilities at all. Consequently many of the activities in which they engage have so far been revenue generating and profitable to them. That is, until now…
The dramatic decline in IPOs and the stagnation of the primary markets has hit exchanges hard, as news headlines frequently inform us. Falling transaction volumes on secondary markets as a result of increased competition between trading venues, increasingly squeezed margins on secondary market data, and many other pressures are making life a little more challenging for the exchange operator.
Regulation has provided a brief reprieve; increased clearing requirements have led many exchanges to explore vertically integrated trading and clearing businesses, either setting up new clearing houses or investing in existing ones. As regulation strengthens, balance sheet strength and increased margin requirements can drive creation of new products (such as Eris Exchange’s swap futures, or ICE’s swap futurisation programme). But what innovation is taking place in the old fashioned Equities market?
Indeed, can anything be done to salvage the traditional primary and secondary stock markets, in light of the dire picture painted above?
In this aggressive world where the constant mantra is “bigger is better”, what innovations can non “premier league” exchanges bring to the market that not only provide them with new revenue streams, but also enable them to fulfil their core function of helping companies gain access to capital?
One thing is certain; doing more of the same simply isn’t going to work. Market conditions have changed, perhaps permanently, and exchanges must adapt their business models if they are to compete in this new landscape.
However, it isn’t all dismal news. There are examples of successful exchange innovation that fulfil investor and issuer needs, which can be found in some unexpected places. A recent industry conference provided several examples from smaller exchanges attempting to find their own path to success whilst also building the economies and markets in which they operate. Interestingly, their ambitions were often not constrained within their own geographic boundaries.
We often hear government ministers preach to businesspeople that small to medium enterprises (SMEs) are the key to economic growth, particularly in times of global recession such as the one we find ourselves in currently. This is true of not only developed markets such as the EU and the US but also of emerging markets, in which the ability to operate a main market hinges on the creation of an SME market to feed into it. Most SME markets have struggled with the issues of good governance and liquidity. On the one hand, many SMEs do not have the capacity to show compliance with onerous listing requirements. On the other hand, good corporate governance, transparency and accountability to investors are absolutely necessary to build investor confidence and therefore liquidity in the market.
Having examined this problem in detail, one of the Caribbean exchanges has set about implementing an SME market that is built on principles of good governance and investor confidence. Each issuer must have an approved “mentor”, whose role is to ensure that the company complies fully with its listing and governance requirements. The exchange has negotiated with its local government to obtain generous tax incentives for companies remaining listed on the market, without suspension, for a minimum period of 15 years, including a full 5-year tax holiday for these companies. Companies failing to meet their listing requirements for the duration are required to repay any tax benefits accrued. There is therefore a powerful financial motivation for companies to list in the first place, to remain listed, and to ensure that their governance standards are high. As investor confidence in the quality of issuers grows, so too will liquidity in this market.
There has also been much recent discussion of the use of crowd-funding as means for exchanges to build IPO pipelines. For the majority of SMEs, funding requirements are in the order of 10,000 – 250,000. These firms are poorly serviced by the current financial market structure – they are too small for even the SME exchanges (and their business models are not yet developed enough for an IPO), and where they are able to obtain corporate financing through bank lending, interest rates are prohibitively high. The traditional sources of private investment – private equity, venture capital and angel investment are either out of their reach or would require giving up control of the direction of their businesses at a crucial stage in development.
Crowd-funding provides a neat solution; companies can obtain funding at low cost from enthusiastic investors, sometimes in exchange for no more than sample products or free services, but increasingly in exchange for equity. An enterprising exchange, seeing a decline in IPOs on the main market, might look to the future and seek to build up a pipeline of SMEs that will one day IPO on first its junior and then main market. Creation of an exchange-hosted and operated crowd-funding platform would provide an ideal incubator and indeed create a whole ecosystem for funding companies from early-stage capital through to IPO and subsequent debt issues. There is also potential to create a range of new tradable instruments for a crowd-financing model, from debt to future income-related payment streams.
The Equities market may never be the same again, but that is not to say that it will not thrive in the future, in ways which we are only beginning to imagine now.
©BestExecution | 2013
Chris Sims : Ignis Asset Management
COPING WITH COMPLEXITY.
Chris Sims, CTO, Ignis Asset Management speaks to Best Execution about the challenge of coping with multiple channels of regulatory changes while transforming the business and reducing risk.
There are so many pieces of regulation in the market, what are the particular ones that impact your business?
There are a number of regulated areas such as the Alternative Investment Fund Managers Directive (AIFMD), the Fair and Accurate Credit Transactions Act (FACTA), the European Market Infrastructure Regulation (EMIR) and the Retail Distribution Review (RDR). As a result we do not just focus on one thing. We have different projects and it differs depending on the regulation.
What is the impact of the Financial Services Authority’s guidelines on outsourcing?
The FSA is questioning the reasons behind asset managers outsourcing their back office operations. Their main concern is what would happen if the firm suddenly collapses and whether asset managers can take the operations back in-house or instantaneously switch to another provider.
What were the drivers behind your outsourcing arrangement with HSBC?
In 2011, we decided to lift out and transfer our back office operations to HSBC. By the end of May 2012, we moved around 150 staff from Ignis to a new HSBC administrative operation in Glasgow. We looked at the resources we had and the gaps we needed to fill and chose this arrangement. There is no one size fits all solution though. In terms of documentation, we did a considerable amount of due diligence and governance. We also put in additional details as to what level of information should stay in-house as well as contingency planning if they go bang in an instant. We have documented everything for the FSA.
What are the benefits?
According to the FSA, the default response from asset managers is they outsource their operations to save money. This was not the case with us. We did not look at the HSBC outsourcing arrangement as a cost effective exercise but as a transformational activity that enables us to cut operational risk. It also allowed us to gain access to technology and infrastructure that we would have had to build ourselves. It gives us a scaleable industrial strength platform that is regularly maintained, upgraded and is able to handle new additional instruments.
What are some of the challenges?
The HSBC outsourcing deal required internal work to get the systems into a fit state so they could be migrated onto their platforms. Part of the challenge is to make sure that you do the in-house development. Another from a technology point of view is the aggregation of data and reporting. One of the problems is that some of the disclosures under the new regulations are straightforward while others such as the EU’s rules on short selling and certain aspects of credit default swaps are more of a curve ball. It requires a level of disclosure unlike anything I have ever seen in the past.
The good thing about the HSBC deal is that it provides us with better quality of data and enables us to dig down to the lower levels to satisfy anything from a regulatory point of view.
Do you think pension funds will stop trading OTC derivatives if it becomes too expensive?
I think it will come down to cost, if you talk to traders and middle managers, the focus is on the infrastructure that will be required to trade derivatives with 30 to 40 separate counterparties and the collateral requirements.
What are you focusing on in the front office?
We are a multi-asset class fund management group and the goal is to improve the systems in the front office for the end user. We have three OMS/EMS systems and we want to ensure that they are better integrated so that the data can flow between them.
Overall what do you see as the biggest challenges from a technological point of view?
It is trying to keep everyone happy at the same time and to keep abreast of the different regulatory requirements and developments. Our in-house IT function has around 60 people which include contractors. It is temporarily higher than usual because of the demands. In many ways it is like being a juggler in that you have to keep all the plates spinning at once.
[Biography] Chris Sims is Chief Technology Officer for Ignis Asset Management. Prior to joining Ignis in July 2011 he spent 13 years at Gartmore Investment Management where he was Head of Investment Operations. He formerly served as development manager at Baring Asset Management and started his financial career as a senior analyst programmer at Nationwide Building Society, having spent a couple of years as a scientific officer at RAF Strike Command. ©BEST EXECUTIONFixed income focus : Dan White
THE AGGREGATE VIEW.
Dan White, founder of leading developer of advanced trading technologies for fixed-income markets, InterDealer spoke to Best Execution about the challenges brought about by regulatory changes and a tough operating environment.
What has been the main impact of a) regulation and b) the prevailing economic conditions?
What we are seeing now is that financial market participants are taking much of their direction from regulation and the need to de-leverage their balance sheets. This has seen a shift of the balance towards just a few firms which are still considered top-tier. Many sellside firms can no longer commit a significant amount of balance sheet to their credit operations, so they are facing increased pressure not to take on significant positions in their trading inventory.
Of the positions that they do take on, they are seeing increased scrutiny from the regulators. So there is greater pressure to offload from their trading positions quickly, within a few hours or a few days. Previously, banks had a greater appetite to take on positions and keep them for 30, or 60, or even 90 days.
This has impacted the market because we’ve seen a concentration of liquidity in large amounts among only a few players. For the sellside players who are able to respond to large amounts, these are the more lucrative trades for them. It allows them to be more selective about where they will respond to inquiries for customers.
The competitive prices in smaller amounts are broadening for a larger group of counterparties. Europe is more electronic trading focused and less dependent on the RFQ than the US, but we are seeing more availability of electronic prices in both regions. We also see more prices on exchanges. Aggregators are also maturing.
As a technology company, what do you see as the main challenges facing the industry?
What we see is a concentration in larger notional amounts only among two or three players, and then an increased number of smaller lots, where in order to get the best price, you have to aggregate from more and more sources. But the prices are out there, and become more relevant, although they are not available using a traditional RFQ trading protocol. It’s not necessarily true that the best price available in the market can be offered by the traditional dealers. From the point of view of a technology company, the challenge that the industry faces is about gaining access to prices from a broad number of counterparties. That puts pressure on connectivity. It is also about ensuring that the best execution protocols take into account all prices regardless of trading protocol.
How do your offerings address these challenges for a) the sellside and b) the buyside?
The key elements are to be able to bring greater connectivity to buyside participants, and to also take into account various trading protocols so you are able to get the best price. From a best execution standpoint, a traditional RFQ will solicit a handful of dealers to come back with the best prices available. However in practice the prices they are coming back with frequently are not as competitive as prices available on exchanges or from other open over- the-counter aggregators. So that RFQ price might not be the best price. The buyside firm needs to be able to obtain the best price in the market regardless of trading protocol, but also manage the workflow using automation.
What our system does for the buyside is that it allows users to access markets from any available RFQ channel and OTC aggregators and exchanges, and displays those prices in one platform, saving on screen real estate. In addition, we provide some algorithms that are designed to optimize trading, using the trading protocols that are accessible by the buyside. We basically give the user the ability to send out an RFQ, but we’ll also aggregate the prices that are available electronically, and we’ll allow the user to decide based upon what prices are available from all sources. We also allow the users to leave liquidity interest with their sellside firms thus enhancing their virtual balance sheet.
On the sellside, there is a situation with sellside firms, where the balance sheet has been compressed. These firms still have an enormous account base and franchise, as well as order flow coming from a diverse set of clients. Our system will allow the sellside firm to act as an agent in riskless principal format or enhanced riskless format, taking small positions through upsizing and simultaneously selling the position.
Could you define best execution in the credit markets and how do your offerings help achieve best execution?
For best execution, it is essential that the buyside is able to defend its position and the trade that it did by showing that it took into consideration all prices from all sources that were available, so if a better price is on an exchange than on an RFQ, for example, they can support their execution on the exchange.
How does the growth in the number of electronic trading platforms impact the problem of accessing liquidity?
The larger number of electronic trading platforms creates a greater need for simplified connectivity to all firms, and it’s very difficult for buyside firms or any firms for that matter to connect to all of the different sources out there. So it is helpful to have a single integration point with a firm that’s already connected to all of these platforms so they can access all this liquidity from a single protocol or a single screen.
In terms of the growth of electronic trading how do you see the market evolving over the next five years?
I think there will be a simplified work flow with respect to completing all the connectivity links to all the parties. There will also be this broadening scope of trading protocols, and I think that best execution protocols need to evolve so that buyside firms are taking into account all the prices available from all sources. This can only be done in a fully transparent electronic venue.
©BestExecution | 2013Fixed income focus : Sergey Sinkevich
LOOKING EAST.
Sergey Sinkevich, Otkritie’s Head of DMA (Direct Market Access) outlines the radical changes that are opening up the Russian fixed income market and enabling international investors to trade in confidence.
The Moscow Exchange’s IPO became the symbol of changes sweeping the Russian market and epitomises Russia’s ambition to turn Moscow into a new financial powerhouse. While analysts and the media have principally focused on whether Moscow could successfully compete against other international financial centres such as London and New York for new equity issues, the impact of recent regulatory and infrastructure changes on the fixed income market have gone largely unnoticed. The fixed income market in Russia is being reshaped dramatically, making it more accessible to international investors and enabling more cost-effective execution through direct market access.
Historically, the settlement process made trading Russian securities a cumbersome enterprise. Prior to the merger of RTS and MICEX, Russia’s two exchanges, international investors had to work with two depositories – the National Settlement Depositary and the Depository Clearing Company. They also had to rely on a limited number of local brokers who would help to navigate the intricacies of local regulation, matching and post-trading services.
Russia’s local fixed income instruments always had centralised custody clauses in every prospectus, but the recent changes in regulatory environment and infrastructure finally provided additional comfort to foreign investors apart from the clauses. Last year, after nearly two decades of discussions, the Federal Law on “Central Depository” (the CSD Law) finally came into force, laying the legal foundations for a central securities depository, a fundamental institution that had long been anticipated by international investors.
On 6 November 2012, the National Settlement Depository (NSD) received the Central Securities Depositary licence from Russia’s Federal Service for Financial Markets, fully opening up the locally-issued fixed income market to foreign investors. The same CSD Law permitted Euroclear, Clearstream and other ICSDs to open direct accounts with NSD to process fixed income trades until 1 July 2014 and for cash equities thereafter. These procedures cleared the final hurdles to bringing Russia in line with the standards expected by the international investment community.
In addition to establishing a central depository, on March 25 the Moscow Exchange moved Russian sovereign bonds to T+2 settlement, improving cash management, streamlining business processes, and turning the main Russian fixed income market into a modern European market, with transparent and well-articulated rules. Europe predominantly uses T+3, with Germany and some other countries already operating T+2, and the European Union is aiming to put all 27 member states on a T+2 system, a development that should be completed by 1 January 2014. The U.S., meanwhile, uses T+3, although discussions are developing to reduce this to T+2 to harmonize with other global jurisdictions. All these developments are transforming the Moscow Exchange into a centre for liquidity and price discovery when it comes to trading and investing in Russian instruments.
Even before these ground-breaking changes, Russia’s government bonds were popular with savvy international investors, who were drawn to the country’s attractive returns. Russia’s strong growth fundamentals, low inflation, and low levels of public debt, which in 2012 was at 11% of GDP, make the country’s sovereign bonds an attractive asset for institutional investors. Liberalisation of the matching and post-trading procedures for sovereign debt trading on the Moscow Exchange is going to attract a significant share of the anticipated inflow of international capital into locally traded rouble instruments.
Last year, Russia’s fixed income placements enjoyed an unprecedented growth of nearly 30%, driven by two asset classes; municipal and sub-federal instruments and OEX issued bonds – a Russian version of commercial paper. These new issues offer investors a more diversified range of instruments.
As the Moscow Exchange adds sovereign bonds to its T+2 market, Otkritie Capital offers a more cost-effective execution through Direct Market Access (DMA). Fixed income DMA is a new concept in Russia, but we are already the leader in other markets including on the London Stock Exchange International Order Book.
Founded in 1995 and now one of the largest independent financial groups in Russia, we were among the first to recognise new opportunities offered by electronic trading through DMA. Over the past years, Otkritie and our UK subsidiary, Otkritie Securities Limited (OSL), have invested heavily in cutting-edge technology, developing ultra-low latency connectivity and proximity to LSE and the Moscow Exchange. Today, our speed of execution is one of the fastest available on the market. As an FSA-authorised broker and A1 Prime Brokerage services provider, OSL has become the partner of choice for many of the world’s leading investors.
The new ICSD settlement producers and fixed income DMA are transforming both trading and post-trading of the Russian market, bringing it to the highest international standards. Russia’s sovereign bond yields and credit fundamentals are as attractive as ever, but the days of the “Wild East” settlement practices are over, giving way to a market more familiar to international investors.
Our experienced team, cutting edge technology and unrivalled local knowledge, are ready to help international investors to capture new opportunities in one of the world’s most promising fixed income markets.
©BestExecution | 2013Fixed Income Focus : Robert Hammond
TAPPING LIQUIDITY.
Robert Hammond, Head of Client and Dealer Sales, Europe at MarketAxess, discusses with Best Execution new protocols to meet the liquidity gap in the fixed income market
What is the current state of market liquidity?
In the fixed income and credit markets there are many different types of bonds with very different levels of liquidity. One indicator of market liquidity is the US Federal Reserve numbers for US dealer Inventories. From the peak of liquidity in late 2007, dealer inventories are currently running at around 20%-25% of what they were at the height. Overall dealer liquidity remains pretty static of late.
Of course one has to appreciate that some incoming regulations are inhibiting the market. The Volcker Rule, for example, seeks to limit proprietary trading and the new regulatory environment is bearing down on the OTC (over the counter) rate and OTC credit markets. In addition, the implementation of central clearing is requiring market participants to closely review their trading work-flow.
What trends are we seeing in terms of trade size?
It’s very difficult to generalize about the market, since there is very little public data available in Europe but we do think there is a trend towards smaller trade sizes. We obviously see the volumes going through our own platform, though we cannot see what goes through other platforms, or the size of telephone trades, for example. What we do know is that fund managers often break larger orders into smaller sizes in order to transact electronically.
Typically in the US credit market, where data is available, close to 20% of trade volume is executed electronically versus around 80% via the telephone. While dealers enjoy using electronic trading, they still have a preference for doing the large ticket sizes by telephone. We handle the vast majority of those electronic trades in the US and expect the percentage to continue growing.
How is electronic trading filling the liquidity gap?
There are a couple of key ways in which electronic trading can help drive liquidity. First, as far as MarketAxess is concerned, we’ve expanded the dealer participation on the platform by adding a broader group of regional and specialist dealers, providing investors with a much larger pool of counterparties to trade with.
The second thing we’ve done is to bring buy-side counterparties together, when there is no suitable dealer price available, through MarketAxess’ Open Trading. In addition to the normal client-to-dealer RFQ (Request For Quote) transaction model, Open Trading allows our investor clients to trade directly with other investors. This is helping to increasing liquidity by further broadening the number of potential trading counterparties.
Our dealer pool in Europe comprises 26 banks who are both quoting live, streaming prices on the platform through our click-to-trade (CTT) protocol, and are prepared to respond to client RFQs. In the US, our dealer pool comprises around 80 banks. Our Open Trading protocol works in the following way: if a clients send an RFQ to a bank but cannot find an offer, they can then choose to send their request, anonymously, into the Market Lists order book where other investors can see and respond to that order. This may result in a transaction with another client.
Currently we offer the Market Lists protocol for all of our US and emerging market products, and we are finalizing the development of the same system in Europe. In Q1 2012, when we started offering clients the option to make their order requests visible to other clients, some 15% of the orders were being placed into the Market Lists order book. By the end of 2012 this had reached around 65%, and this year, on average, over 70% of client orders are being opened up to other investors on the platform.
Is the traditional trading model working in fixed income trading?
In order to demonstrate best execution, market participants must call at least three dealers. However, most clients typically want to call more than three, as one cannot guarantee that those three dealers will be able to quote on the bond issue sought. Clients will probably make four or five phone calls, but realistically, this process will not be as fast and efficient as the electronic route.
Therefore one might say the traditional model is lagging the electronic model. Transacting over the phone also requires a significant amount of physical workload in terms of manually confirming the details of a trade – including the executed price and which dealers were canvassed for their initial quotes. In fairly rapid market conditions, price slippage could be experienced between a quote being received from a dealer at the outset and finally executed upon. Ultimately that might turn out to be a much worse execution. Contrast that with getting an order executed so much faster electronically, and with a full audit trail.
Are there any new protocols being developed to meet new market demands?
The European fixed income market exhibits a different market convention to the US where trading is undertaken on a spread trading basis, as opposed to a predominantly price-based protocol in Europe. (Emerging markets also trade on a price protocol). Consequently, we are working on adapting the Market Lists work-flow to allow for these differences in trading conventions between the US and European markets.
©BestExecution | 2013
Fixed income focus : Gherardo Lenti Capoduri
MADE IN ITALY.
Gherardo Lenti Capoduri, Head of Market HUB, Banca IMI explains why Italy is ahead of the game when it comes to best execution.
Gherardo Lenti Capoduri, Head of Market HUB, Banca IMI explains why Italy is ahead of the game when it comes to best execution.Back in 2007 in Italy, MiFID I came into effect for fixed income trading. As a result each Italian fixed income market began to compete against one another. The choice available included two regulated markets (Borsa Italiana-MOT segment and MTS BondVision), four fixed income MTFs (ExtraMOT, Hi-MTF, EuroTLX and MTS BondVision Corporate) and 17 Systematic Internalisers (SIs). It is perhaps illuminating to see how our fixed income markets have developed in the period following this regulatory change (see Fig. 1-2)
These markets target either institutional size orders or retail size orders and within their respective spaces they compete against each other by offering members:
• Different microstructures (all to all, quote driven, quote and order driven, auction, RFQ etc.)
• Different products (government bonds, corporate bonds, emerging market bonds, high yield, sovereign bonds, multi or single currency)
• Additional compliance related services (fact sheets on each instrument)
• Price
Following this change in market structure, brokers started to offer best execution in fixed income by adding smart order routing (SOR) to their execution policy, and their market-making desks started to access and capture available flow on several different markets. It is worth noting that brokers have striven to offer clients access to both market traded and OTC liquidity through creative solutions which aim at aggregating and normalizing, as much as possible, these two very different sources of liquidity. In short, the core components of this fixed income model include:
• A Systematic Internaliser
• Market memberships
• OTC – liquidity
• Sales support: Pre trade and post trade transparency – all blended and made unique with their own choice of technology.
On the market-making side, investments were made in order to compete in a more transparent environment. Both the Hi-MTF and EuroTLX successes show that there is an appetite by market-makers to provide liquidity on these markets. What is key is that in a structurally illiquid market such as fixed income, both cater to the specific needs of the market-maker by building their market microstructure around the presence of a market-maker.
Hi-MTF is only quote driven – the orders hit the market maker’s bids and offers, whereas EuroTLX is a hybrid, quote and order driven microstructure where market-makers have an obligation to be present on the book all day of a minimum size but enjoy a certain level of protection through the presence of anti-gaming rules.
Banca IMI launched Market HUB, its multi-asset electronic trading platform, in 2007. The asset classes available from the start were equities, fixed income and listed derivatives. FX was added in 2012. In fixed income, in addition to Banca IMI’s high touch service, it offers best execution and access to over 20,000 bonds by connecting to trading venues, OTC liquidity providers and offering additional liquidity on Banca IMI’s systematic internaliser Ret Lots Exchange.
European Regulation
MiFID II is expected to introduce many of the changes to the fixed income market structure already experienced in Italy. Of course, it won’t be exactly the same, and the market will not react in exactly the same way, but the main “ingredients” are there. Looking at the financial services industry in London, what we have observed in Banca IMI in the last two years is a shift from an initial resistance to the regulatory changes proposed, to, more recently, some innovative solutions being thought of and, in some cases, rolled out. What is currently being rolled out is only the beginning – solutions range from brokers setting up their own marketplaces to brokers who clearly state the need to provide clients with aggregated rather than fragmented liquidity. In our view, the second approach is more interesting for clients, especially if combined with the additional liquidity offered by the broker on its systematic internaliser.
The SI allows the broker to provide liquidity to its clients, and flow that is not captured is routed to market venues through a SOR. Dealer-to-client (D2C) venues tend to target either retail size orders or institutional size orders. In Europe the venues that Banca IMI monitors are the following:
• Retail size: BME, Stuttgart, Deutsche Börse, NYSE Euronext, NasdaqOMX/Nordics, SIX Swiss Exchange, Hi-MTF, Borsa Italiana/MOT, EuroTLX.
• Institutional size: Bloomberg, Tradeweb, MTS Bondvision, MarketAxess, Reuters TRFIT, NYSEBondMatch.
Regulatory impact
We believe that the industry, once the resistance to regulatory change has been overcome, will find innovative ways to adapt. The fact that this change takes place in a business environment in which flow is not expected to increase and margins are expected to decrease will add an edge to the creativity required in order to balance these elements.
The shift from a mainly OTC trading environment to a mainly regulated market trading environment can be compared to a “Copernican Revolution”. Overall it will introduce greater transparency and major changes such as CCPs. However, we believe that just as the planets continued to exist, so will the key components of fixed income flow within investments banks which comprise: sales/information and traders/risk. What will change is the flow generation process. Regulation will force standardization and this lends itself to industrialization and automation of processes which up until today have been labour intensive.
In this scenario, we believe Banca IMI’s Market HUB Fixed Income solution is innovative and has the opportunity to compete at the European level by offering clients a MiFID II trading environment, today.
©BestExecution | 2013 [divider_to_top]Fixed income focus : FIX Connectivity : Sassan Danesh
SETTING STANDARDS.
Sassan Danesh, FPL Co-Chair, Global Fixed Income Committee, and Managing Partner, Etrading Software explains how and why the adoption of the FIX connectivity protocol in fixed income trading came about.
Historically, a large percentage of fixed income trades have been bilateral OTC deals arranged via a sell-side broker. Executing these deals required the broker to field a large sales force to handle calls from the buy-side and facilitate the transaction with the broker’s market-makers. Needless to say, this model involved extensive costs, which led to the emergence of early fixed income electronic trading platforms at the turn of the millennium, seeking to provide a low-touch and streamlined execution service for bond trading.
However, the market share of these venues was small due to a number of challenges. One of the hurdles faced by market participants attempting to use these platforms was that connectivity to them was difficult and often rather expensive. This was because the fixed income trading workflows were much more complex than for equities. This meant that using a standard such as FIX presented many challenges, as sometimes the messaging language did not offer the functionality needed to manage these workflows and as a consequence the early platforms each developed their own individual proprietary protocols. The financial implications of this were huge, with some firms estimating it was costing multiple times more to connect to fixed income venues via a proprietary protocol, versus equity trading platforms offering standardised FIX connectivity.
For a while, the financial benefits of moving to electronic trading allowed firms to absorb these large connectivity costs. However, the impact of the financial crisis and the resulting wave of new regulation led to reduced profitability, increased obligations on the industry to enhance transparency and a more fragmented marketplace emerged. This accelerated the need for a more efficient electronic trading environment.
The role of FIX
In mid-2011, representatives from the broker-dealer community, approached the non-profit FPL (FIX Protocol Ltd.) organisation in order to work towards establishing FIX as the open standard for connectivity to both existing and new venues, so that the industry could benefit from the greater transaction efficiencies and the lower cost connectivity enjoyed by equities, and also increasingly by the FX and derivative markets.
In response to this request, FPL formed a group to address the challenges emerging in this environment. Through the work of this group, in 2012 FPL produced recommended guidelines for how FIX could be used by emerging Swap Execution Facilities (SEFs) to trade interest rate swaps (IRS) and credit default swaps (CDS). These guidelines are now being used to support FIX implementations by a number of SEFs. The urgency to prioritise these products was dictated by the imminent regulatory need for SEFs to be operational.
Once the swaps guidelines were complete, the group then turned its attention to the use of FIX in the cash bond markets and resulting FIX guidelines were released in February of this year.
Key challenges
The process of creating the recommended FIX guidelines involved successfully overcoming a series of issues:
Collaboration – Given the prevalence of proprietary connectivity protocols in fixed income, many trading venues were not used to the idea of collaborating with their competitors to establish a global standard for the benefit of the community. FPL is structured as an independent and neutral industry-driven organisation, bringing together market participants to address the business challenges impacting the trading community through the use of standards. These factors were critical in reassuring stakeholders that a suitable forum existed for discussing the technical challenges and arriving at a set of guidelines that would deliver industry-wide benefit, independent of any given venue or broker.
Scope – The fixed income markets comprise a multitude of individual product types, from government bonds to high yield instruments and also include derivatives such as IRS and CDS. Trading is global in nature, with regional differences. The FIX guidelines were able to address this large scope due to FPL’s global presence and diverse membership, which includes buy and sell-side firms, trading venues, vendors, regulators and industry associations. This broad membership base of firms from across the world enabled the guidelines to benefit from the participation of experts with a strong knowledge of each of these markets.
Relevance – Given that trading venues already had existing proprietary connectivity implementations, a key objective of the initiative was to ensure that the FIX guidelines would capture the existing established market practices. To achieve this goal, FPL listed over 80 different business workflows currently used in the industry and provided recommendations for each workflow individually, showing how FIX could support that specific practice (where necessary this also led to the development of additional FIX functionality). Taking this approach ensured that all dominant market models were accommodated in the FIX guidelines.
Adoption – One of the success factors for the initiative was ensuring that the FIX guidelines could be adopted easily and to minimise the cost implications of transitioning to FIX. Many of the bond electronic market places also offered derivatives trading. Therefore, FPL ensured that wherever possible the bond guidelines were consistent with those published the previous year for swaps, so the venues could benefit from the resulting cross-asset synergies. The guidelines also benefited from the use of FIX in the listed derivatives space, which allowed market participants to leverage their existing investments in FIX infrastructure from these other asset classes. As a result, many venues have started to adopt these guidelines and more are expected to announce their support in coming months.
Benefits
This work is now yielding large benefits to the industry, by helping to meet the implementation challenges of new regulations. To name a few:
– The Dodd-Frank Act in the USA will result in the establishment of new swaps trading venues called Swap Execution Facilities (SEFs); this is likely to generate a high demand for new fixed income connectivity. Already, many brokers and multiple SEFs have announced that they will be adopting the new FIX guidelines, successfully overcoming the original implementation and connectively challenges feared.
– Basel III is resulting in brokers holding less bond inventories, which in turn is causing increased fragmentation in the industry. The result is a proliferation of new electronic bond markets attempting to usurp the traditional role of the broker. These new venues require new connectivity from industry participants to ensure efficient price discovery and sourcing of liquidity across the market – a requirement that is best met through electronic trading practices supported by standards such as FIX.
– MiFID II in Europe is looking to achieve additional pre-trade transparency in the fixed income markets (both bonds and swaps), with results that are expected to be similar to the Dodd-Frank Act in the USA.
The future
The work of FPL won’t stop here. FPL is continuing to update the FIX guidelines in-line with the evolving regulatory environment, ensuring that market participants can use FIX to meet their business needs. Additionally, the guidelines themselves are being extended to cover some of the less common workflows such as different permutations of cross-asset trades within fixed income. For example, common strategies such as basis trades and butterflies are now being incorporated into the guidelines.
Finally, FPL has just launched a new initiative which has come about due to the trading element of fixed income becoming more electronic and market participants expressing a desire to automate additional elements of the trading process. A prime example of this is the administration that currently takes place to grant permission for a trading relationship to occur on an electronic trading venue. As each trading relationship will need to be validated on ‘day one’ of the new SEFs going live, this is an initiative that could present significant efficiency savings for these markets.
©BestExecution | 2013
Fixed Income Focus : Michael Krogmann
INTEGRITY COUNTS.
In a market of proliferating electronic trading venues, Michael Krogmann, EVP at Deutsche Börse AG, explains why they may have a platform in Xetra Bonds that will stay the course.
Why do you think bond trading has to shift from OTC to regulated markets?
Bonds as an asset class have become much more popular with investors and they have significantly gained importance on a macro-economical level. As a result of the financial crisis, governments and companies alike were forced to look for re-financing alternatives. This continuously growing prominence has not been reflected by the traditional bond trading places. Telephone- or “request for quote”-based trading simply lacks the transparency and the efficiency an asset class this important requires. After all, investors are confronted with unclear prices and high risks. Thus, transparency and market integrity in bond trading are absolutely necessary. In two years’ time, it will be mandatory anyway, due to the transparency requirements which will come into effect with the implementation of MiFID II. In addition, CRD IV (Basel III) increases capital requirements for dealers. Hence inventory based liquidity provision becomes more expensive – another reason for a shift to organized electronic markets.
How would you try to convince market participants to change their traditionally OTC-bound bond trading activity?
The same way you always convince ration people: by showing them a superior alternative, by making them a better offer. Deutsche Börse has done exactly this by introducing Xetra Bonds. This new product segment on Xetra aims to provide investors with exactly the market quality and standard for bond trading they expect – and rightfully demand – from equity markets. In OTC trading, market participants have to request quotes from several banks to assess whether they get competitive pricing. In bonds, they have no access to continuous real-time pricing. Xetra Bonds, however, offers real-time price discovery via an open order book with a depth of no less than 5, meaning the five best bid respective ask prices will be depicted. Therefore, investors are able to enjoy best execution of their bond trades exactly as they do when trading equities or ETFs. This way, they can be sure they are getting a competitive price, especially since they trade under the same conditions as every other market participant. Xetra Bonds provides every market participant with a fair, identical and anonymous access, as required for regulated markets.
In a nutshell, this is our USP – we offer more transparent and fair pricing than any OTC trading facility, thus promoting a market integrity bond trading has not experienced before.
A better offer usually means a better price. In this respect, why is your new offering superior to other recently established platforms?
There are several factors which set our new offering apart from those of our competitors. Let us talk transaction costs first. Explicit transaction costs in bonds trading on Xetra are very low due to a highly attractive pricing model and the efficiency only straight-through processing on a fully electronic and sophisticated trading platform can offer. However, explicit transaction costs account for not more than 20% of the overall transaction cost. In the end, it is implicit transaction costs that determine the price of a transaction, which fully depends on the liquidity in the respective bond. The Xetra Bonds market model ensures the highest possible liquidity and, therefore, the tightest spreads and considerably lower trading costs. The trading model – comparable to the trading of blue chip equities – is supported by designated sponsors who provide continuously binding quotes for the 60 German government bonds in this product segment. We are talking bid-ask-spreads which today can be as tight as three basis points.
In addition to our offering of German government bonds the Xetra Bonds segment includes 2,000 of the most traded European government, supranational and corporate bonds. The trading of less liquid bonds is based on a continuous auction model supervised by so-called Specialists. These Specialists provide indicative quotes and additional liquidity where and when needed. This way, they are able to make less liquid bonds as tradable as liquid ones, making sure the majority of the orders will be executed at competitive prices and the tightest spreads.
Another important factor is the elimination of counterparty risk. German government bonds are settled by a Central Counterparty (CCP) in Germany, bringing more safety and efficiency to settlement in Europe.
What else does the Xetra Bonds segment bring to the table?
Something that cannot be quantified like transaction cost but nevertheless is very important: Xetra Bonds is future-proof, especially in the light of increasing regulatory requirements regarding pre- and post-trade transparency. Bond trading on Xetra not only complies with current regulations but already today reflects the transparency requirements by the revised European MiFID directive that is expected to become mandatory within the next two or three years.
Let us talk about a different aspect of bonds – the issuing side. What can your exchange offer to companies wishing to list their bonds?
For that very purpose, we have introduced an exchange segment for bonds with a variety of transparency standards for companies. Thus, companies wishing to raise their profile and to increase their visibility among potential investors can list their bonds in the newly created Prime Standard. Fulfilling the highest transparency requirements, they will be able to address institutional investors all over the world and gain access to a broader and more direct distribution channel to private investors for the first time. This new segment appeals to larger companies – listed or not – that wish to place bonds from a value of EUR 100 million. After the successful introduction of the Entry Standard for bonds for mid-sized companies in 2011 the Prime Standard was only a logical extension.
How do you expect Xetra Bonds to perform in the long run?
Realistically, it will take some time but I am confident Xetra Bonds will attract – and hold – a significant share in overall bond trading over the next few years. After all, Xetra is a leading pan-European market place and the trading platform of choice for 250 European banks and broker firms in 18 countries. I am sure many of them will appreciate our new bond offering tailored for investors’ and issuers needs. A major boost in interest for Xetra Bonds will be the forthcoming regulatory changes by MiFID II in 2015.
©BestExecution | 2013Fixed Income Focus : Bob McDowall
THE FUTURE DIRECTION OF FIXED INCOME.
Although electronic trading in fixed income has gained traction, the road ahead is not smooth. Bob MacDowall explains.
This century, at an operating and operational level, fixed income markets in North America and Europe have made considerable advances at the technical level, but they have been overshadowed by the after-effects of the financial crisis and the general macro-economic outlook. By contrast most of Asia is enjoying economic growth and is well positioned to capitalize on the structural and operational improvements developed in North American and European bond markets.
The articles in this special feature section reflect the current level and scale of electronic trading, examples of innovation and product development in fixed income trading as well as the best practices that have been developed.
Institutional traders no longer call two or three broker-dealers, who are likely to hold inventory in the selected bond to see which firm can offer the best price and then execute. The credit crisis, resultant regulation and advances in technology have lead to the development of an increasingly electronic marketplace. The technology substantially reduced start-up costs for new systems as well as operating costs plus it adapts to changing marketplace dynamics. As a result the distinction between broker-dealers and exchanges has blurred.
A complicated picture
However, the processes for trading cash bonds have proved much more complex than for equities. The standard functionality was not available. As a result, a small number of venues developed proprietary protocols but the financial implications meant that the costs of connecting to fixed income venues versus equity trading platforms offering standardised FIX connectivity is expensive.
The fixed income sector cannot ignore other factors which have and will continue to influence this market. For example, trading has been exacerbated by the eurozone reducing the quality of sovereign bonds in comparison with many corporate bonds, which historically had higher yields. Investors have perceived that corporates have higher credit and default risks and an underlying lack of liquidity. In response to the shortage of available capital and increasing regulatory capital requirements traders have reduced inventory levels.
Capital charges under Basel III have encouraged some brokers to leave the fixed income business but electronic trading should enable banks to trade with less capital. They can access a larger number of clients and move positions from their trading books more efficiently. Furthermore, capital constraints are serving to reduce transaction sizes.
A large portion of the fixed-income market remains OTC, which is in defensive mode by dramatically widening bid/offer spreads. There is currently disagreement among the buyside as to the longer-term effectiveness of the Request for Quote (RFQ) model in the current economic environment. Some believe that this model has already ceased to function in stressed markets, while others feel that there is currently no credible alternative. The key issue is that there is no consensus on the best business model for the future. Lack of secondary market liquidity has a direct impact on yields and the flow of debt issuance. As liquidity evaporates and capital providers are constrained, fewer market participants will be able to operate efficiently, leading to reduced competition. It will then fall to the buyside to provide that liquidity and they will require a greater incentive.
Retrenchment by investment banks and brokers in the fixed income sector is posing problems for asset managers seeking liquidity in secondary bond markets. They have significant liquidity risk challenges in managing their fixed income portfolios on an active basis. In that environment electronic platforms, including single dealer platforms and multi-dealer venues run by independent operators, should benefit with managers looking for alternative ways to trade, but it is not providing the full solution.
A growing divide
The current eccentric monetary policies being pursued by central banks in much of the western hemisphere continue to bring price/valuation as well as supply/demand distortions. The sector is witnessing highly visible divergence in economic growth prospects by geographic region. They pose critical investment implications in the years ahead for the US and Europe in particular.
The US Federal Reserve has been trying to strike a policy balance that both mitigates the deflationary impact of a variety of successive crises while at the same time containing the possibility of higher inflation. It has expanded its balance sheet by the policy of quantitative easing, as well as the maintenance of extremely low policy rate levels. In addition, the central bank’s bond purchasing in 2013 is likely to absorb most net US fixed income supply, further distorting markets and exacerbating supply/demand imbalances.
In the eurozone lending has declined. It is particularly weak in the corporate sector in Italy, Spain, and Portugal, where banks have instead rapidly increased sovereign debt holdings rather than lend. The region is continuing to deleverage despite rising unemployment and fragile consumer spending. This is not auspicious for a rapid return to growth. Temporarily at least, the European Central Bank has improved sovereign financing rates, which was critical to alleviating the crisis.
The situation is different in the Asia-Pacific region. Japan is still trying to address structural difficulties, while the rest of developing Asia has strong growth prospects leading to an expansionary bond market. Initiatives are required to develop a pan-Asian bond market. This includes lifting the obstacles to cross-border capital flows and harmonising the regulations, withholding tax provisions, accounting practices, rating conventions and clearing and settlement systems that pose challenges for foreign participation in regional bond markets.
Most of Asia’s challenges within the fixed income market lie within its own grasp to resolve. By contrast the US and Western Europe are dependent on resolution of their economic and deficit problems.
©BestExecution | 2013
