IOSCO Secretary General, David Wright, discusses the major factors influencing global markets, and the future of the global regulatory framework.
IOSCO is the International Organization of Securities Commissions. It brings together securities regulators the world over. We have 200 members representing the vast majority of regulators. Of all the international organisations covering financial regulation at the global level, we are the most inclusive because we have all the emerging market countries with us. This organisation has been running for 30 years and we have become the voice of the global securities regulatory community. For example, we have a series of global standards, what we call the IOSCO standards, which are the benchmarks for any securities market.
These standards form the foundation of all the reviews of financial regulation covered by the FSAP process led by the IMF. Our standards are the global benchmark. We have many interesting pieces of work right now; the multilateral memorandum of understanding, which about 90 of our members have signed, is basically a memorandum whereby all the participants agree to share information for enforcement purposes. The memorandum was used to solicit the exchange of information during the recent LIBOR scandal.
We have a lot of policy positions and we have a critical role in the whole process of global financial repair and reform. A lot of the work that you see referenced in the G20 or working with the Financial Stability Board is of IOSCO origin.
We have worked on high frequency trading, we work on shadow banking, OTC derivatives and credit rating agencies, we work on market structure, we work in accounting and auditing, enforcement and so forth. Of course, as a result of this crisis our work is particularly important. The other thing that we do, which is unlike other organisations, is that we provide technical assistance, and education and training for emerging market countries.
One of the things that we’re going to be working on is to build an IOSCO Foundation in which we seek support from the private sector to develop our members’ markets.
Should regulation be leading or following, who should decide what gets regulated, what gets left up to the market and to what extent do those forces interact?
Historically regulation has been following rather than leading. I think it’s right to say that this crisis shows that a significant number of incentives were wrong in the financial markets. I think the depth and scale of damage in this financial crisis, not in all parts of the world, but in certain parts of the world, show that serious repair is necessary, and that is the focus of the G20 and the Financial Stability Board agenda, which we are major contributors to.
The industry can’t complain, to the extent that they are primarily responsible for what happened, so there is a huge amount of work going on at the global level to try to make the financial system safer and less systematically risky. We are going to work on resolution and frameworks; we’re going to work on OTC derivatives, driving more OTC transactions onto exchanges, and through clearance systems. We are working intensively on the shadow banking system, which I think has surprised everybody with its scale, estimated at $65 trillion or 25% of all global banking assets, making that safer and more understandable; we are looking at money market funds, securitisation, and non-banking organisations, which can build up large amounts of leverage. Those are certainly among the most important areas of work, of course on top of bank capital, which is set by the Basel committee. The world has lost 15% of GDP so far; there are very serious worries of severe damage to certain economies and so we need very strong collective efforts at the
local and global levels to try and put that right, and to try and make the system safer and more sustainable.
Are regulators struggling to keep up in terms of spending, and does this impact their oversight?
Regulators in general around the world always feel they are underresourced. When you look at the resources of one of the better resourced authorities, for example, the FSA, in London the FSA has over 3,000 people. But then you compare that to what used to be the head count of Citibank, which was 300,000 plus and that is just one organisation!
So when you multiply that across all the firms big and small they have to regulate and supervise, regulators in general feel underresourced. I think there are some good things happening though which may help them. For example the project being developed by the FSB called the Legal Entity Identifier which is a numbering system for all participants in financial markets. That I think would greatly simplify tracking market abuse, tracking data in markets, looking for systemic risk building up.
In general IT is helping the regulators detect market abuse, but there are huge markets to regulate and supervise. One of the problems has been particularly in the big complex markets, developed markets because, as has become clear, neither market participants nor the regulators or supervisors of those markets fully understood how they functioned.
We are now in year six of this crisis and we still are struggling our way through on the global regulatory level with the shadow banking system. Shadow banking is of enormous proportions, and we are still working it out. You can’t supervise or regulate a market unless you fully understand it.
I think that the one lesson of this crisis should be that unless you can fully understand not just the product, but how that product interacts, interconnects with other products, how risk can be propagated or, if things start to get difficult, what are the effects on liquidity etc, the effects on credit provision, and the effects on the system, then those products and processes should be held back until we are sure we understand.
Another area is measuring the impact of regulation; looking at the costs and benefits of regulatory change in highly interconnected complex markets, which is extremely difficult. Yet regulators should understand as far as they can the impact before calibrating final regulatory measures.
What do you think the greatest successes and challenges of MiFID were, and how are they being fixed moving into MiFID II?
I no longer work in the European institutions, but I think the biggest successes of MiFID were in crossborder trade of European stocks from one country to another. In other words, if a stock was homebased, let’s say Frankfort or Madrid before MiFID, you couldn’t trade that stock in London and now you can. I think this has been a big market opening move and I think it has largely been beneficial.
It opened up markets and allowed much wider trading and competition for trading, in particular equities and bonds. It’s also allowed new forms of trading to emerge across
all sorts of platforms, as well as competition to the traditional stock exchanges, which has driven down the cost of trading significantly. In theory that should follow through to lowering the costs of capital.
It’s been a disappointment that there’s been no consolidated tape. The industry was sure that the data industry was going to develop this, and gave us strong informal assurances that they would consolidate the tape, but that hasn’t happened. I think perhaps the surprise has been the rapid emergence, and the depth and scale of the unlit part of the market in dark pools. I think it is necessary to shed some more light here.
Most of the trouble in financial markets has been in the opaque markets, which are usually controlled by a few participants. So I think high frequency trading was another area which at the time when MiFID was growing up was probably underestimated. So overall I think MiFID has been a good thing for Europe and I think the market would agree. There has been, some would argue, a worrying fragmentation of order books, but at the same time you have had much more competition, so I would stand by the above assessment.
What principle lessons do you think emerging markets and the bigger Asian exchanges could learn from the US and Europe?
I’ve recently been to an IOSCO regional meeting in Bangkok where all these things were discussed. At the moment there is not a lot of cross-border competition, in the sense of a direct competition in integrated markets. There are pools of liquidity all around Asia, but they are not competing to trade each other’s stocks. Actual cross-border flows of capital are quite small inside the region.
I think the more that you allow competitive forces to open up the better it will be for reducing the cost of capital and recirculation of capital in the region. That said, a lot of emerging market countries have done, in relative terms, extremely well in this crisis. Their markets were simpler, they understood them well, they didn’t have the complexity of western financial markets and probably they feel that having restricted the development of highly sophisticated instruments in their markets has paid off rather well. They feel they have learnt the lessons of the Asian and Latin American debt crises.
More competition at the local level, cross-country competition, and developing common standards across the markets will be a very good thing in Asia and I would encourage them to do that. But at the same time they need to make sure that the regulatory system fully understands all the consequences of growing complexity and interconnectivity.
Some regulators, such as ASIC are looking forward in an impressive way. Likewise we’re also trying to have very regular discussions about emerging market risks in all our major committees. In our board and main meetings, we start with quite in-depth discussions with market participants on, looking at where we feel risks are emerging and what should keep us up at night.
I think that is a good way of bridging public and private interests. Getting ahead of the curve is ideal, though you have to be realistic. I think that markets develop at such a fast pace getting ahead is always going to be a struggle.
So what is it that keeps you awake at night?
People worry very much about the shadow banking system, they worry about securities regulation, they worry about possible impact of algorithmic trading and high frequency, they worry about complex structured products; how those are developing and who they should be sold to.
I think the thing that worries me most, and I think this is the most important policy of all, is resolution. If we can’t move failed financial firms to the corporate graveyard, just like we would a concrete company, and wipe them off the commercial map, have their assets taken over by another firm or restructured without collateral damage and without the public, or governments on behalf of the public, supporting or subsidising or basically backing up failed firms then I think this whole global regulatory reform agenda will be seen to have been a failure.
In other words, you simply have to be able to deal with crises in firms clinically, surgically, early and without collateral damage, and that’s a huge challenge, particularly on a cross-border basis, and most of the big problems will be on a cross-border basis, where there are multiple branches and subsidiaries of major firms all over the world. We have to be clear about who is in charge, and how we avoid ring-fencing assets, which will just make their wind up and reallocation much more difficult.
So is that part of the purpose of organisations like IOSCO, to make sure there is cross-border cooperation between regulators?
This is an area which we are going to look much more deeply at in the future: defining what it is and how we recognise each other’s laws and jurisdictions. What are the conditions for establishing equivalence, recognition agreements or substituted compliance agreements? One of the biggest challenges we all face as global regulators,
whether it is IOSCO, Basel or the FSB, is that there are no enforcement tools; there are no legally binding obligations on any jurisdiction in the world to apply these principles and standards that we collectively determine. We don’t have a disputes settlement system like the WTO, we don’t have legally binding enforcement, and we don’t have any sanctions in the sense of a WTO case if a contracting party is found to have abused the rights of another contracting party. We don’t have any of those instruments at the global level and therefore the implementation of this repair agenda is very, very challenging. That’s an issue; whether we should start thinking about a global system where there are legally binding frameworks at the global level. I recently made a speech at the Atlantic Council on these issues. The financial world is evolving quickly and we need to be prepared for that change.
Do you think there is an appetite for a global enforcement framework?
In my speeches I always say that the world is very simple today. There are a few big capital markets and I suppose we can just about muddle through with the few big capital markets and different interpretations of global standards. Now in 15 or 20 years, there’s going to be a lot more big capital markets, and one of the reasons is that securities markets, and capital markets in general are going to have to provide a much bigger share of the global economy in terms of finance, because the banking system is going to be
constrained through the Basel agreements, i.e. with more capital, less leverage and so forth.
So instead of a three by three matrix we’re now going to have a 15 by 15 or 20 by 20 matrix, in which we are going to have many more big capital markets. The danger is that they all start to apply or interpret the global rules in very different ways. Now that is potentially destructive and fragmentary if there is nobody in the centre who says interpretation X or Y is wrong.
My view is that the situation is going to become much more complex in the future as capital markets in emerging market countries grow, and they are bound to grow extremely fast. If these countries realise that they can’t rely anymore long term on the international banking system, they have to develop their own indigenous local market capacity.
So that is why I think it’s incumbent on everybody to think about whether the current institutional structures are fit for purpose for this scenario.
There are solutions out there but these are very difficult things to get at the global level. For example, the WTO was established by an international treaty. If you want to move towards more global institutions with more enforcement authority you are probably going to have to establish that by an international treaty or agreement – no mean task!
IOSCO is facing a rather exciting future because the financing of the global economy is turning more towards securities and capital markets in general, which effectively enhances the importance of securities markets and securities regulators for those markets. So this is a real opportunity for my membership to work together to establish good standards and to ensure that they can implement them. I think this coupled alongside the tremendous growth in emerging market countries that we are beginning to see, makes it a very exciting time for IOSCO.
But the message I want to convey is that the status quo will not suffice for doing theglobal regulatory job before us.
The Global Regulatory Challenge
Capital Risk Management… and the Rising RMB
As the world’s second largest economy, the largest exporter and second biggest importer, there is growing worldwide demand for China’s currency – the renminbi (RMB). The use of its currency will undoubtedly continue to grow, but until recently, the RMB was less accessible from the outside business world, making it difficult for trading partners to manage any risks associated with its currency. By KC Lam, CME Group.
The rapid growth of the RMB only took off in 2010 when the People’s Bank of China (PBOC) and the State Administration of Foreign Exchange (SAFE) started to internationalise it through trade settlement, bilateral currency swaps and the incubation of offshore centers. Since then, the RMB has experienced rapid growth in deposit and trading volume both on- and off-shore. The RMB is now being used for business transactions in multiple off-shore locations which include Hong Kong, Singapore, Korea, Australia and other areas around the world. Accordingly, a need for capital risk management tools for the Chinese currency has emerged.
Offshore RMB in Hong Kong (known as CNH) has been actively traded in the Asian market, but the liquidity and depth of the market quickly dissipates after Asian trading hours. In addition, market access is limited for participants outside of Asia. To move to the next stage of internationalizing RMB, trading in the currency needs to be global and accessible to a diversified client base, across hedge funds, proprietary trading firms, banks, as well as corporate and retail accounts.
In addition, the FX community trades round the clock, and for the RMB to internationalize and globalize, it has to be available not just during Asian hours, but in other time zones as well. In February, CME Group will launch its deliverable offshore CNH futures, offering close to 24 hours of trading, across more than 85 countries, with a T+2 variation margin that would greatly benefit traders outside Asia. This will give customers and clearing members time to fulfil their financial obligation to the exchange to meet variation margin calls.
Increasingly, we are getting end customer queries and requests for clearing NDF (Non-Deliverable Forwards) trades that are traded over the counter. Customers who are trading both futures as well as the over the counter NDF trades can benefit from capital efficiencies through margin offsets.
In this brave new world, one can expect more focus in the areas of clearing, mitigating counter-party risks, hedging, transparency, security and safety of customer transactions. All these will come into play and whether it is a regulatory push or whether it is just inherent risks in the market today, market participants have become more aware of all the various issues that could potentially arise.
The future trend is heading towards full internationalisation of the RMB, where we see the RMB becoming a global payment currency. However, before that can happen, China needs its currency to be fully convertible and it must be perceived to remain strong in value with deep liquidity. In the meantime, the listing and trading of CNH futures plays an important facilitating role in “globalising” the currency and can help China continue the push for greater acceptance of the RMB as an international and trading currency.
In 2010, the offshore RMB business experienced rapid growth in Hong Kong. To give an idea of the size and scope of this expansion, by the end of 2011, CNH deposits in HK totalled over 600 billion Yuan, an increase of approximately 317% versus 2010. Growth had significantly slowed by the end of last year, however, and CNH deposits in Hong Kong had dropped to about 570 billion yuan. By Vivien Deng, Newedge.
What was the reason for this slowdown? The lack of investment instruments for offshore RMB. The total amount of CNH bonds and other instruments is much lower than the CNH deposits in HK, with low liquidity. Therefore, there is an enormous demand for the launch of new RMB denominated products and exchanges have been taking action to address this. Last year, HKEX launched the first exchange-traded USD/CNH currency futures settled in Yuan and CME is soon to launch a deliverable offshore RMB futures product. HKMEX has been preparing to launch RMB denominated gold and copper futures contracts. It is now clear that exchanges are competing to catch the growing offshore RMB pool, as well as position themselves for the advent of RMB internationalisation.
On the other side of this equation, China is preparing to launch USD denominated products. For example, the Shanghai Futures Exchange is preparing to launch a Crude Oil futures contract, which will be denominated in either RMB or USD. The plan is for this to be the first commodity contract open to foreign investors. At present, these efforts are enjoying full Chinese government support, as illustrated by the fact that the CSRC has amended futures trading rules and has taken action to clear obstacles that may halt the launch of this contract. This currently is in a simulation stage to test settlement and clearing processes for both currencies, though concrete plans have not been finalised.
The rapid growth of the RMB only took off in 2010 when the People’s Bank of China (PBOC) and the State Administration of Foreign Exchange (SAFE) started to internationalise it through trade settlement, bilateral currency swaps and the incubation of offshore centers. Since then, the RMB has experienced rapid growth in deposit and trading volume both on- and off-shore. The RMB is now being used for business transactions in multiple off-shore locations which include Hong Kong, Singapore, Korea, Australia and other areas around the world. Accordingly, a need for capital risk management tools for the Chinese currency has emerged.Offshore RMB in Hong Kong (known as CNH) has been actively traded in the Asian market, but the liquidity and depth of the market quickly dissipates after Asian trading hours. In addition, market access is limited for participants outside of Asia. To move to the next stage of internationalizing RMB, trading in the currency needs to be global and accessible to a diversified client base, across hedge funds, proprietary trading firms, banks, as well as corporate and retail accounts.
In addition, the FX community trades round the clock, and for the RMB to internationalize and globalize, it has to be available not just during Asian hours, but in other time zones as well. In February, CME Group will launch its deliverable offshore CNH futures, offering close to 24 hours of trading, across more than 85 countries, with a T+2 variation margin that would greatly benefit traders outside Asia. This will give customers and clearing members time to fulfil their financial obligation to the exchange to meet variation margin calls.
Increasingly, we are getting end customer queries and requests for clearing NDF (Non-Deliverable Forwards) trades that are traded over the counter. Customers who are trading both futures as well as the over the counter NDF trades can benefit from capital efficiencies through margin offsets.
In this brave new world, one can expect more focus in the areas of clearing, mitigating counter-party risks, hedging, transparency, security and safety of customer transactions. All these will come into play and whether it is a regulatory push or whether it is just inherent risks in the market today, market participants have become more aware of all the various issues that could potentially arise.
The future trend is heading towards full internationalisation of the RMB, where we see the RMB becoming a global payment currency. However, before that can happen, China needs its currency to be fully convertible and it must be perceived to remain strong in value with deep liquidity. In the meantime, the listing and trading of CNH futures plays an important facilitating role in “globalising” the currency and can help China continue the push for greater acceptance of the RMB as an international and trading currency.
In 2010, the offshore RMB business experienced rapid growth in Hong Kong. To give an idea of the size and scope of this expansion, by the end of 2011, CNH deposits in HK totalled over 600 billion Yuan, an increase of approximately 317% versus 2010. Growth had significantly slowed by the end of last year, however, and CNH deposits in Hong Kong had dropped to about 570 billion yuan. By Vivien Deng, Newedge.
What was the reason for this slowdown? The lack of investment instruments for offshore RMB. The total amount of CNH bonds and other instruments is much lower than the CNH deposits in HK, with low liquidity. Therefore, there is an enormous demand for the launch of new RMB denominated products and exchanges have been taking action to address this. Last year, HKEX launched the first exchange-traded USD/CNH currency futures settled in Yuan and CME is soon to launch a deliverable offshore RMB futures product. HKMEX has been preparing to launch RMB denominated gold and copper futures contracts. It is now clear that exchanges are competing to catch the growing offshore RMB pool, as well as position themselves for the advent of RMB internationalisation.On the other side of this equation, China is preparing to launch USD denominated products. For example, the Shanghai Futures Exchange is preparing to launch a Crude Oil futures contract, which will be denominated in either RMB or USD. The plan is for this to be the first commodity contract open to foreign investors. At present, these efforts are enjoying full Chinese government support, as illustrated by the fact that the CSRC has amended futures trading rules and has taken action to clear obstacles that may halt the launch of this contract. This currently is in a simulation stage to test settlement and clearing processes for both currencies, though concrete plans have not been finalised.
Taking Initiative
Asia’s market structure creates demand for increasingly granular trading information – as Kent Rossiter, Head of Asia Pacific Trading Allianz Global Investors and Michael Corcoran, Managing Director ITG discuss, FIX can help.
Asia Pacific faces different liquidity challenges to other regions, particularly given that spreads are often much wider and are therefore an even more significant contributing factor to overall trading costs (See Chart). As the trading environment evolves in the region and the focus on managing costs grows, the requirements for transparency and feedback on trading increases. This is happening in parallel with the evolution of new trading venues in the region, particularly dark pools. Buy-side traders now want a greater level of detail on their dark pool fills to help them understand the behavior of their orders and manage their execution venues proactively to get the best trading result.
Kent Rossiter heads up the Asia Pacific trading desk of Allianz Global Investors, and is constantly looking for ways to improve the efficiency of their process and minimise the costs of trading. From his perspective, while post-trade TCA is now well-established, a particular growth area is the requirement for more detailed data on a shorter timeframe. He explains “We as buy-side traders are now trading an increasing amount of our orders ourselves using the electronic tools available, and when we do so we want more granularity and data fed back to us: which venues are our orders being executed in, at what price, and how aggressively. We want information that helps us adjust strategies on the fly for better trading outcomes, or quickly review the results so we can manage our future performance.”
One result of this is new demand in the region for analysis of maker/taker indicators on orders so that a trader can identify how often they are crossing the spread to find liquidity. Allianz Global Investors has been working with ITG and other brokers in the region to implement support of maker/taker analysis to help the trading desks improve their insight into market conditions and get more transparency into the behavior of their orders in dark venues.
Understanding Maker/Taker
Understanding whether an order is making or taking liquidity is important, particularly in wide-spread environments such as many of the Asian markets. Michael Corcoran, Managing Director of ITG, says “Traders want to know instantly whether they are providing liquidity or taking it, instead of retrospectively needing to compare fills and timestamps manually against what the market was trading at. This can be very useful information to help them adjust the trading strategy in real-time to the market conditions and the liquidity available. It can also help determine what kind of ‘throttle’ they should put on their strategy or their algo to find the right level of aggressiveness for the orders they are working. In addition to that it can also be a very valuable tool for sell-side firms, helping to refine the development and rules of algorithmic strategies and improve strategic ideas that will work for certain clients or order types.”
This is of growing relevance in a multi-venue environment, for example in Asia where over the past few years a lot more broker dark pools have been developed. Many buy-side firms now choose to use a dark aggregator to help improve their efficiency in accessing multiple venues, and here some kind of maker/taker liquidity analysis can be a helpful data point for assessing the type of outcome a trader is getting in those pools. Corcoran explains “Both ITG as a dark aggregator, and our buy-side clients themselves, want to understand whether orders are consistently making or taking liquidity in a specific dark venue so that the impact can be assessed – for example if our client’s orders always take liquidity in a certain venue we would review that to understand why. If we can pass that data directly back to the clients they can then make a decision about whether they want to be removed from that venue or change the distribution of their order flow across different pools. Likewise, if we see orders taking liquidity then see an unexpected change in the stock’s trading profile, this can be a useful warning indicator about the participants in a specific pool.”
FIX Tag 851 – a Potential Solution
A specific FIX Tag, 851, or Last Liquidity Indicator, has been developed by FIX Protocol Ltd (FPL) as an identifier of maker/taker behavior. The US appears to have the most established support of liquidity-indicating tags with exchanges able to pass the data back to brokers and most of those brokers able to pass that on to clients. In Europe, likewise the large exchanges and brokers can support this, although there is less among the mid and smaller brokers.
However, in Asia the tag is sparsely supported, if it all, by the exchanges, alternative lit trading venues and many of the broker dark pools. Firms therefore have to come up with interpretive solutions and workarounds to give their buy-side clients a higher level of detail and transparency on their trading, particularly in dark pool aggregation.
Rossiter would prefer an industry-wide approach to improving transparency and the availability of maker/taker data which includes vendors, brokers, and most importantly the exchanges “Typically the actual FIX tag for this information is supposed to be generated by the exchange or trading venue, and it is passed to the brokers who need to be able to identify and accept that tag and then pass it into the vendor EMS or OMS platform that the client is using. So there are a number of parties within the workflow who are affected and they need to collaborate to bring in changes. An industry-wide adoption of the relevant FIX tag would definitely be a good solution”.
Corcoran adds “in recent years many Asian stock exchanges have been putting investment into infrastructure projects relating to speed and capacity – the quantity of trades through the order book, speed and co-location et cetera. There have been some great improvements, but it has mostly been around these functional requirements. Now we’re seeing a far higher interest in the ‘qualitative’ aspects of exchange data, and as the Asia Pacific trading market becomes more sophisticated and competitive, the exchanges will need to focus more on these kinds of initiatives.”
Rossiter hopes that the workaround he has developed in conjunction with ITG will help to demonstrate results and drive support for these qualitative indicators through the vendor, broker, exchange community. “Changes do need to be made in technical systems to incorporate new FIX tags, and this takes a push from everyone involved to get this fully supported. We’ve had to develop a proxy to get some vision and clarity into this important metric, and then by being able to demonstrate results, generate a wider push for support.”
Through industry-wide groups like FPL and the support of large firms in Asia Pacific like Allianz Global Investors, the industry can continue to evolve and develop solutions to improve trading efficiency on an ongoing basis.
Truth, Lies And H(FT)ysteria – The HFT Conundrum
Fidessa’s Group Strategy Director, Steve Grob, puts some of the major myths around HFT under the microscope.
High frequency trading (HFT) has been the hottest topic in the financial world for at least two years now, and this debate has now reached Australia, which has been busy introducing its own multi-market structure over the past couple of years. Nothing, it seems, raises as many hackles and divides as many opinions as those three words – “high frequency trading” – and this is as true in Australia as anywhere else.
But what is the truth about HFT? Is it the devil, a scourge to markets? Or is it simply the evolution of trading – computer driven trading replacing human trading in the way computers are replacing so many other aspects of our business and personal lives?
Whatever the answer to these questions, there can be little doubt that HFT activity has taken hold and accelerated wherever multi-market trading structures have been introduced. Shrinking average trade size can be seen as a proxy for HFT. Take the FTSE 100, for example. As chart 1 shows, average trade size has reduced significantly since 2008 and a similar trend looks set to impact Australia’s main index too (chart 2).
So, to unpick the problem, let’s look at some commonly held opinions about HFT.
HFTs see market data before other participants, giving them an unfair advantage.
This myth has been making its way around the market in Australia for a while now, but it simply isn’t true. The ASX and Chi-X both have co-location centres where firms can pay to have their computers close to the source of market data. While this does advantage those firms within the co-location environment, or ‘colo’, it’s a level playing field – any firm can enter the colo and all the computer racks are connected to the market data distribution engine such that they all receive it at exactly the same time.
It’s also worth considering what other kinds of firms are in the colo. Many, or most, fund managers (who are aggregators of ‘mum and dad’ retail money) execute their trades through a third-party broker, usually an investment bank or an agency broker like Instinet. It’s these firms that are first in line to buy rack space in colos, and their proximity puts them – and their end investors – on the same playing field as the HFTs. Where the waters become a little murkier is in the US, where it’s claimed that exotic order types such as DAY ISO and “hide and light” orders can be used to almost pre-empt market data and push HFT orders to the front of the queue. Protests from both sides are vociferous and the jury is probably still out as to the truth of the claims.
HFTs don’t follow the rules.
HFTs have to follow the rules just like every other market participant. Those who don’t are breaking the law – pure and simple. Where regulators are struggling is in keeping pace with the rapid-fire trading taking place on their exchanges, and this goes for standard algo trading as well as HFT. ASIC, for example, has been very conscientious in looking at best-practice around the world and is procuring its own fast technology to ensure it can keep pace with its participants. Other regulators would do well to follow their example.
HFT is a completely new phenomenon and markets can’t deal with it.
HFT and algorithmic trading generally are not, in fact, new ways of trading. They’re simply much faster ways of doing the kinds of trading that traders have been doing for decades.
Specific new order types have, however, evolved to tackle the fast and complex environment traders now face. But these are not restricted to HFTs. Each venue publishes the types of orders it allows. The order types are available to all participants, and participants can only trade within these rules. This is true even in the US, where the exotic order types mentioned before are allegedly used to bend the rules in favour of fast-moving participants. If it is found that order types can be used to confer advantage on specific participants, then regulators should act to rectify those situations.
One complaint leveled at HFTs is around ‘quote stuffing’ – sending huge numbers of quotes to a venue to try to determine the trading intentions of other participants.
Quote stuffing is illegal, and any firm participating in this kind of activity should rightly be penalised.
HFTs have superior technology, which gives them an advantage over other investors.
It’s definitely true that HFTs have superior technology. These firms spend millions hiring the brightest minds and build much of their technology in-house, keeping it and the strategies it runs closely guarded secrets.
HFTs argue, however, that none of what they’re doing is outside the law, which is true. It’s also true that they spend their own money on both their technology and their trading. And it’s simply true that great technology in any field is an asset that provides its owners with an advantage.
Another criticism of HFT is that the constant adjustment of thousands of quotes requires huge bandwidth, which puts a strain on market infrastructure. Exchanges have indeed spent millions increasing their capacity and upgrading their technology, and other participants have had to spend in turn to be able to take advantage of the new, faster exchange environments. Constant pressure to upgrade technology is a vicious – or virtuous – circle, depending who you’re talking to. But HFT is more a consequence of this environment than a cause.
HFT is the reason for the volatility and low returns we see in today’s markets.
Since 2008, the whole world has faced extremely challenging market conditions. But to point the finger at one market participant and type of trading is absurd. America and the Eurozone’s ongoing struggles, combined with continuing knock-on effects from the global financial crisis, are first among many obvious macro factors depressing markets around the world. More than four years of bear markets have left investors understandably wary, and volumes are consequentially low. In such an environment, small changes in sentiment create volatility effects that are highly amplified compared to what they would have been pre-2008.
HFT is complex and poorly understood, making it an easy target for firms that are struggling.
The other concern investors raise is around issues like the much talked about ‘flash crash’, and more recent market events. These are serious and legitimate concerns. New regulations that put tools like circuit breakers in place are now being implemented, and tougher requirements are being put on participants to test their strategies before they go into live markets. Such developments can only benefit those who are doing the right thing.
HFTs must be taking money from investors – their profits have to come from somewhere.
This is a far more complex question than it may appear on the surface. But fundamentally, HFTs make money from tightening the spread – the gap between the bid and offer prices for any given stock on an exchange. Nobody is arguing the fact that spreads have shrunk to fractions of what they were before algorithmic trading and HFT came on the scene. HFT profits actually derive from the inefficient trading practices of other market participants and tighter spreads are generally seen as a sign of more efficient markets. On top of this, HFT profits are starting to shrink – evidence perhaps that the industry is reaching a tipping point where spreads have shrunk to the point that profit opportunities are becoming increasingly difficult to find.
The genie is out of the bottle.
The fundamental fact is that HFT is such a huge part of markets that it cannot be ignored. Pandora’s technology box sprang open years ago, and it’s simply not possible to reverse back into the days of floor or telephone trading. Any firms found to be manipulating markets should be disciplined, whether at high or low speed. Clever firms, rather than using HFT as a scapegoat or complaining to each other and the press, should take advantage of the many ways they too can use technology to better navigate markets and deliver better returns for their investors.
The Impact Of European Regulation
Rudolf Siebel, Managing Director of BVI Bundesverband Investment und Asset Management, shares the perspectives of German asset managers and their regulatory requirements for the coming year.
BVI represents the German investment fund and asset management industry, which manages approximately 2 trillion Euros in assets such as bonds, equities and derivatives.
The envisaged and enacted regulations (e.g. MiFID/MiFIR, EMIR, EU Index Consultation) on trading, clearing and settlement of financial instruments and index products as well as derivatives are an important element to strengthen the European securities markets. Our members support well balanced regulatory initiatives in these areas at both the European and national level in order to restore investor confidence, reduce systemic risk and to improve financial stability. BVI is in close cooperation with all relevant stakeholders and regulators in order to improve the regulatory framework in the pre- and post-trade environment.
We recognise that the new regulatory framework will put pressure on all market participants (e.g. asset management companies) to streamline and automate even more their operational workflows in the front, middle and back office. Therefore we welcome improvements in automation that are based on standards, such as the FIX Protocol.
Retain the pre-trade transparency waivers
Asset managers need to retain the ability to execute large block orders on behalf of institutional investors without creating a market impact in terms of liquidity or price. Long term investing institutional investors (e.g. pension funds) are vulnerable to the constant risk that other market participants (e.g. High Frequency Traders (HFT)) will identify their block orders and “front run” them.
The German investment fund industry needs pre-trade transparency waivers in order to protect institutional investors.
Besides a large in-scale waiver we also fight for the retention of the reference price waiver. The reference price waiver is necessary to allow the broker working on behalf of the asset manager to split (without creating too much of a market impact) a large order in the course of the trade execution.
If the investment fund industry could not rely on this kind of waiver going forward, asset managers would not be able to place block orders in the market because of the risk of the orders becoming public. Investment managers would need to split each order into very small size transactions to avoid the signalling risk. But the average trade size and the corresponding liquidity for larger orders has already diminished a lot in the lit markets due to excessive high frequency trading.
Proper differentiation between high frequency and algorithmic trading and minimum resting times
The German Ministry of Finance has proposed a national law on high frequency trading prior to the implementation of MiFID /MiFIR .
Asset managers are not HFT and do not use investment funds in order to generate profits through HFT strategies. However, they optimise the performance of their investment fund by also using algorithmic trading strategies, e.g. to automatically rebalance an index-linked portfolio once or twice a day.
Because asset managers, like most banks, are not engaged in HFT, we request that the German regulator differentiates between algorithmic and high frequency trading on the basis of the HFT definition of the European Parliament dd. 26 October 2012. According to the EU Parliament an HFT trading strategy is a trading strategy for dealing on own account in a financial instrument which involves HFT trading and which has at least two of the following characteristics:
(i) it uses co-location facilities, direct market access or proximity hosting;
(ii) it relates to a daily portfolio turnover of at least 50%;
(iii) the proportion of orders cancelled (including partial cancellations) exceeds 20%;
(iv) the majority of positions taken are unwound within the same day.
(v) over 50% of the orders or transactions made on trading venues offering discounts or rebates to orders which provide liquidity are eligible for such rebates.
Usage of Pre-LEIs in the EMIR reporting obligation
The European Market Infrastructure Regulation (EMIR) introduces new regulatory obligations for all participants in the OTC derivative markets. One important pillar of the EMIR regulation is the obligation to report all transactions to trade repositories. The identification of all market participants shall be made through the Legal Entity Identifier (LEI). As the LEI system is not expected to be operational before 2014 we hope that the EU will endorse an interim solution which allows the use of a so-called pre-LEI identifier issued by FSB approved operators such as DTCC/SWIFT (CICI) or WM-Datenservice. If no final LEI or interim LEI is available, the market participants would have to use the BIC Code for the identification of the counterparties. In total we calculate that more than 100,000 entities in the EU need identifiers for EMIR reporting, including 30,000 investment funds/asset managers, 55,000 pension funds, 9,000 companies listed on the European stock exchanges and more than 5,000 insurance companies that are likely users of derivatives but which are currently not part of the BIC universe. These entities would have to register a BIC Code. However, using the BIC means doubling the cost for each company by requiring registration now for the BIC, and at a later stage for the global LEI. It is not fair to require from most of the market participants outside the credit institution sector to go through the time and effort of double self registration. The unnecessary double registration will damage support for the global LEI system in the market place.
LiBOR manipulation – Regulation of index providers
Due to the LiBOR scandal, the EU Commission started a consultation on the possible regulation of index and benchmark providers. We support the initiative of the EU Commission to regulate the production and use of indices in the financial services industry. A new regulatory framework for index providers is essential in order to restore investor confidence in the market and improve financial stability. In particular, full daily transparency of the index, weightings, constituents and contributors would enable all market participants or their service providers to check the correct calculation of an index. This is the best protection against market manipulation attempts going forward.
Many financial indices are based on market capitalisation, but increasingly, market participants use strategy indices which are based on economic fundamentals or on a risk/return profile. That market segment needs to be distinguished from customised/bespoke indices that are created and customised either by the provider of the basic market index or by a third party (e.g. an asset manager) on the request of one or a very limited number of market participants and according to the specification of market participants. Such individually agreed indices should be considered out of scope of the debate at hand and of any regulatory discussion as the implement only a specific risk/return profile of an institutional investor (e.g. an insurance company hedging interest rate risk on the based portfolio). Only market or strategy indices which are created for a large number of users should be in the focus of the potential regulation of index providers.
BVI represents the German investment fund and asset management industry, which manages approximately 2 trillion Euros in assets such as bonds, equities and derivatives.The envisaged and enacted regulations (e.g. MiFID/MiFIR, EMIR, EU Index Consultation) on trading, clearing and settlement of financial instruments and index products as well as derivatives are an important element to strengthen the European securities markets. Our members support well balanced regulatory initiatives in these areas at both the European and national level in order to restore investor confidence, reduce systemic risk and to improve financial stability. BVI is in close cooperation with all relevant stakeholders and regulators in order to improve the regulatory framework in the pre- and post-trade environment.
We recognise that the new regulatory framework will put pressure on all market participants (e.g. asset management companies) to streamline and automate even more their operational workflows in the front, middle and back office. Therefore we welcome improvements in automation that are based on standards, such as the FIX Protocol.
Retain the pre-trade transparency waivers
Asset managers need to retain the ability to execute large block orders on behalf of institutional investors without creating a market impact in terms of liquidity or price. Long term investing institutional investors (e.g. pension funds) are vulnerable to the constant risk that other market participants (e.g. High Frequency Traders (HFT)) will identify their block orders and “front run” them.
The German investment fund industry needs pre-trade transparency waivers in order to protect institutional investors.
Besides a large in-scale waiver we also fight for the retention of the reference price waiver. The reference price waiver is necessary to allow the broker working on behalf of the asset manager to split (without creating too much of a market impact) a large order in the course of the trade execution.
If the investment fund industry could not rely on this kind of waiver going forward, asset managers would not be able to place block orders in the market because of the risk of the orders becoming public. Investment managers would need to split each order into very small size transactions to avoid the signalling risk. But the average trade size and the corresponding liquidity for larger orders has already diminished a lot in the lit markets due to excessive high frequency trading.
Proper differentiation between high frequency and algorithmic trading and minimum resting times
The German Ministry of Finance has proposed a national law on high frequency trading prior to the implementation of MiFID /MiFIR .
Asset managers are not HFT and do not use investment funds in order to generate profits through HFT strategies. However, they optimise the performance of their investment fund by also using algorithmic trading strategies, e.g. to automatically rebalance an index-linked portfolio once or twice a day.
Because asset managers, like most banks, are not engaged in HFT, we request that the German regulator differentiates between algorithmic and high frequency trading on the basis of the HFT definition of the European Parliament dd. 26 October 2012. According to the EU Parliament an HFT trading strategy is a trading strategy for dealing on own account in a financial instrument which involves HFT trading and which has at least two of the following characteristics:
(i) it uses co-location facilities, direct market access or proximity hosting;
(ii) it relates to a daily portfolio turnover of at least 50%;
(iii) the proportion of orders cancelled (including partial cancellations) exceeds 20%;
(iv) the majority of positions taken are unwound within the same day.
(v) over 50% of the orders or transactions made on trading venues offering discounts or rebates to orders which provide liquidity are eligible for such rebates.
Usage of Pre-LEIs in the EMIR reporting obligation
The European Market Infrastructure Regulation (EMIR) introduces new regulatory obligations for all participants in the OTC derivative markets. One important pillar of the EMIR regulation is the obligation to report all transactions to trade repositories. The identification of all market participants shall be made through the Legal Entity Identifier (LEI). As the LEI system is not expected to be operational before 2014 we hope that the EU will endorse an interim solution which allows the use of a so-called pre-LEI identifier issued by FSB approved operators such as DTCC/SWIFT (CICI) or WM-Datenservice. If no final LEI or interim LEI is available, the market participants would have to use the BIC Code for the identification of the counterparties. In total we calculate that more than 100,000 entities in the EU need identifiers for EMIR reporting, including 30,000 investment funds/asset managers, 55,000 pension funds, 9,000 companies listed on the European stock exchanges and more than 5,000 insurance companies that are likely users of derivatives but which are currently not part of the BIC universe. These entities would have to register a BIC Code. However, using the BIC means doubling the cost for each company by requiring registration now for the BIC, and at a later stage for the global LEI. It is not fair to require from most of the market participants outside the credit institution sector to go through the time and effort of double self registration. The unnecessary double registration will damage support for the global LEI system in the market place.
LiBOR manipulation – Regulation of index providers
Due to the LiBOR scandal, the EU Commission started a consultation on the possible regulation of index and benchmark providers. We support the initiative of the EU Commission to regulate the production and use of indices in the financial services industry. A new regulatory framework for index providers is essential in order to restore investor confidence in the market and improve financial stability. In particular, full daily transparency of the index, weightings, constituents and contributors would enable all market participants or their service providers to check the correct calculation of an index. This is the best protection against market manipulation attempts going forward.
Many financial indices are based on market capitalisation, but increasingly, market participants use strategy indices which are based on economic fundamentals or on a risk/return profile. That market segment needs to be distinguished from customised/bespoke indices that are created and customised either by the provider of the basic market index or by a third party (e.g. an asset manager) on the request of one or a very limited number of market participants and according to the specification of market participants. Such individually agreed indices should be considered out of scope of the debate at hand and of any regulatory discussion as the implement only a specific risk/return profile of an institutional investor (e.g. an insurance company hedging interest rate risk on the based portfolio). Only market or strategy indices which are created for a large number of users should be in the focus of the potential regulation of index providers.
EMS Consolidation On The Desktop
Bud Daleiden, Global Head of Business Development, ConvergEx RealTick examines the changing nature of EMS services.
The year 2012 was a challenging one in the trading world. Trading volumes were down as economic concerns permeated the financial world. Financial firms were under enormous pressure as commission revenue contracted. Combined, these factors caused the sell-side to reduce their technology expenditures on marginally profitable relationships and led the buy-side to re-evaluate their own spending for technology and market access. That same pressure flowed upstream to the execution management system (EMS) vendors leaving them to compete fiercely for new desktop connections. Some struggled to survive or even perished. Other EMS options will likely disappear in 2013 as well. Well-positioned technology firms, however, have been able to thrive and grow market share in tough times by listening to customers and understanding their challenges, and by leading the industry with solutions that respond to and anticipate trends in the marketplace, including:
• Lowering the total cost of ownership
• Consolidating the desktop through multi-asset, multi-broker trading
• Providing powerful execution capabilities
Lowering the Total Cost of Ownership
Both the buy-side and sell-side were looking to trim costs in 2012. That trend is likely to continue into 2013, especially if trading volumes remain low. Technology vendors can help manage down buy-side costs in a number of ways. Delivering the EMS in a SaaS (Software as a Service) model helps traders to avoid more expensive and complex hardware models that require an on-site, server-based installation and IT staff to monitor and support multiple systems. Under the SaaS model, only the user interface is installed locally on the trader desktop while trading and market data services reside remotely in the cloud and are accessed on demand.
Additionally, market data alternatives should be offered that provide cost saving opportunities. An EMS should give the trader the ability to draw their exchange data from a number of sources while maintaining high data quality. Most EMS solutions give the customer the option to source live exchange market data from either their own ticker plants or directly from third party providers. This, however, can be expensive when adding exchange fees and data infrastructure surcharges. Some options, such as drawing data from a Bloomberg terminal residing on the same computer, help the customer avoid duplicate exchange fees altogether.
Finally, vendors need to provide an inexpensive and flexible API that offers users the ability to route orders programmatically using the EMS provider’s broker network, and allows them to access market data seamlessly using a single codebase. Incorporating all of these functions together in a single API reduces the client’s time to implementation, simplifies integration, and reduces support costs by minimising reliance on multiple technologies. Combining order routing and market data capabilities in a single API also provides customers with the flexibility to build custom solutions, ranging from simple order entry to very complex home-grown trading algorithms.
Consolidating the Desktop Through Multi-Asset, Multi-Broker Trading
A few years ago, the typical buy-side trader had multiple trading platforms on their desktop. Separate front ends were needed for trading with different brokers. Even more were required for trading across asset classes. Besides driving up end-user cost due to multiple computers, this segregated approach dictated complex desktop trading interactions which required the trader to toggle between disparate platforms. Task-switching between software applications in an effort to find the right broker or asset class was commonplace and slowed workflow processes considerably, while also creating a barrier to straight-through processing.
In the industry today, high-performing EMS solutions allow the trader to do most, if not all, of their trading on a single, highly configurable desktop application. These platforms provide a uniform workflow across trading desks easing the pressure to meet various regulatory, compliance, and risk requirements. Traders can place orders in any asset class with any number of brokers through a single, consolidated platform. Still, the trader must pick wisely. Many vendors claim to be multi-broker but have limited broker connectivity, while others purport to be multi-asset yet have a strong bias to single-asset trading.
Providing Powerful Execution Capabilities
As the search for alpha intensifies in a difficult trading environment, financial technology vendors can do many things to assist the trader. The most obvious of these is to provide access to a broad suite of broker algorithms. Traders often want access to the newest algorithms that give them the perception of an edge in trading and the most robust trading platforms offer users the ability to define their own algorithmic trading strategies within the standard interface or through a flexible, open architecture API.
Certain advanced EMS solutions also give the trader options to manage large lists of orders from a single blotter. Parts of the orders can then be parsed out to a variety of brokers following pre-defined distribution settings.
Even though 2013 will likely see extremely high competition in the electronic trading space, well-positioned providers will continue to grow at the expense of the weaker players. In order to succeed, solutions providers like RealTick need to be highly responsive to market trends and customer needs. This means offering cost-effective solutions while meeting the demand for global, cross-asset, broker neutral consolidated trading solutions.
Broadening The Base
SkyBridge Capital Founder and Managing Partner Anthony Scaramucci examines the role of hedge funds, and efforts to bring more individuals into the fold.
What do you feel are the most important technological and regulatory changes to have taken place on the marketplace in your career?
High speed trading, quant trading and the open access to information that the internet has provided are the most important technological changes in the marketplace I have seen during my career. The Jumpstart Our Business Startups (JOBS) Act has the potential to be the most important regulatory change as it has the ability to create a level playing field for investors.
What is the importance of hedge funds to the health of the marketplace?
Price discovery is what ultimately makes capital markets one of the healthiest examples of capitalism. Price discovery is central to what hedge funds do. They make the market more efficient and they add some creativity too.
What is the importance of hedge funds for participants in the marketplace – investors, both retail and institutional, and the fund managers themselves?
There are a number of different hedge fund strategies available to investors; some are risk enhancing, while others help to mitigate risk in an investor’s portfolio. If used appropriately, a diversified hedge fund portfolio may reduce overall portfolio volatility, offer lower correlation to traditional equity and bond portfolios and provide investors with access to a wider range of strategies than they might typically have. Mortgage investing, distressed debt investing and commodity/futures strategies are just some examples. A hedge fund portfolio has the potential to help investors smooth out their returns and compound capital at a higher rate over time.
What is the benefit of broadening out the base of hedge fund clients?
It is something that needs to be done. Why should alternative investments be the province of the ultra-wealthy or the large institution? There is more than $2 trillion in the space for good reason: smart money and competitive returns. Let’s give a broader set of investors a shot too.
Volumes are low, equities are struggling, what steps do you take in your portfolios to spread out and mitigate these challenges?
In the current environment we expect the risk on/risk off market behavior to continue and correlations across asset classes to remain high. For this reason, we have avoided strategies like long/short equity and global macro/CTA strategies that are challenged in this type of climate and have found attractive risk reward opportunities in mortgage and credit related strategies.
What is the top thing on your wish list – be it regulatory, technological, or something else?
We want to continue to expand our alternative product offering to a broader base of investors. We want to democratise the hedge fund industry. Access to the top managers should not be the exclusive domain of the privileged and wealthy. Assuming the JOBS Act is signed into law, we believe the industry will be able to communicate with and educate investors of all levels in a meaningful way.
What do you feel are the most important technological and regulatory changes to have taken place on the marketplace in your career?High speed trading, quant trading and the open access to information that the internet has provided are the most important technological changes in the marketplace I have seen during my career. The Jumpstart Our Business Startups (JOBS) Act has the potential to be the most important regulatory change as it has the ability to create a level playing field for investors.
What is the importance of hedge funds to the health of the marketplace?
Price discovery is what ultimately makes capital markets one of the healthiest examples of capitalism. Price discovery is central to what hedge funds do. They make the market more efficient and they add some creativity too.
What is the importance of hedge funds for participants in the marketplace – investors, both retail and institutional, and the fund managers themselves?
There are a number of different hedge fund strategies available to investors; some are risk enhancing, while others help to mitigate risk in an investor’s portfolio. If used appropriately, a diversified hedge fund portfolio may reduce overall portfolio volatility, offer lower correlation to traditional equity and bond portfolios and provide investors with access to a wider range of strategies than they might typically have. Mortgage investing, distressed debt investing and commodity/futures strategies are just some examples. A hedge fund portfolio has the potential to help investors smooth out their returns and compound capital at a higher rate over time.
What is the benefit of broadening out the base of hedge fund clients?
It is something that needs to be done. Why should alternative investments be the province of the ultra-wealthy or the large institution? There is more than $2 trillion in the space for good reason: smart money and competitive returns. Let’s give a broader set of investors a shot too.
Volumes are low, equities are struggling, what steps do you take in your portfolios to spread out and mitigate these challenges?
In the current environment we expect the risk on/risk off market behavior to continue and correlations across asset classes to remain high. For this reason, we have avoided strategies like long/short equity and global macro/CTA strategies that are challenged in this type of climate and have found attractive risk reward opportunities in mortgage and credit related strategies.
What is the top thing on your wish list – be it regulatory, technological, or something else?We want to continue to expand our alternative product offering to a broader base of investors. We want to democratise the hedge fund industry. Access to the top managers should not be the exclusive domain of the privileged and wealthy. Assuming the JOBS Act is signed into law, we believe the industry will be able to communicate with and educate investors of all levels in a meaningful way.
Analysing TCA
Carlos Oliveira, Electronic Trading Solutions at Brandes Investment Partners examines the process of choosing a TCA provider, and the role of FPL.
We use Markit’s Execution Quality Manager (formerly known as QSG) for equity trading TCA. Our decision to switch providers was based on increased algorithm usage, a desire for more functionality, greater execution transparency and most importantly, the availability of more granular data for analysis via FIX.
We FTP our data daily and the results are available to us no later than US market open the next day. Trades are reviewed against traditional and custom benchmarks. We grant access to every trader and risk member, so that they can construct their own views as desired. Typically on a quarterly basis, we conduct our own and adapt broker studies to better understand the impact of our orders.
The implementation process
We evaluated four providers before making our final decision. We wanted a flexible platform that would accommodate maximum self-serving, custom reporting needs; minimal ongoing maintenance or upgrades requiring internal resources; and flexibility on custom solutions, such as the proper measurement of our ADR creation activity.
One vendor offered a very rich solution that was beyond our needs. For two others, we were not comfortable with the process for submitting data and how much work we would need to do internally. A key determinant was the overall level of commitment to the implementation, which we concluded Markit’s Managing Director Tim Sargent clearly demonstrated. It took us roughly two months to solidify the extract process and we went live on January 1, 2011.
TCA has become a key component of our trading process and we continue to realise value, primarily for post-trade at the moment. The value comes from the constant learning about our orders, what has worked well or not, and the adapting and improving of trading.
The large amount of data to analyse can be overwhelming at first and easily misinterpreted if not careful.
Frequent and honest dialog with the vendor, the traders, as well as tapping other sources of knowledge (i.e. broker TCA contacts and industry publications) is key to a successful implementation. Many reports went through several iterations, sometimes a quarter or two apart, before we got it to a meaningful and actionable state.
To avoid having too much of a one-side perspective, we compare broker-provided TCA reports with our vendor often. This helps the dialogue with both the brokers and the vendor – keeps both parties engaged and attentive.
The role of FPL
Our interaction with FPL began with the TCA implementation.
In late 2010, in conferences as well as in industry press, many parties were encouraging the buy-side to gain a better understanding of broker SOR practices and where the orders were getting executed, but with no actionable recommendations outside a specific platform. Being broker-neutral, the FIX execution venue reporting best practices proposed in early 2011 by the FPL Americas Buy-side Working Group helped us to move forward with this goal in the TCA platform. FPL Membership has enabled further contact with other buy-side firms and knowledge sharing not available otherwise to a smaller firm.
We started by asking for Tag 30, LastMarket. Broker responses to the data request varied greatly across brokers and regions. Correspondence spanned many months and contacts, particularly when we asked for MIC codes as opposed to proprietary values. We understand the queue priorities of brokers’ systems and demands of larger clients, and are very appreciative for what they have done thus far.
Some of our broker relationships have been exceptionally supportive in this effort, leading to enhanced dialogue on routing practices and more meaningful, targeted market structure content calls. Though not perfect, it is a significant improvement from just a year ago.
Ideally we would like to move forward and obtain data for Tag 851, but we are very much aware of the mapping challenges from exchanges to the brokers and to the OMS/EMS systems. We tabled this for 2012, but plan on revisiting it again in 2013.
What is next?
We are currently upgrading our OMS and exploring new functionality. Ultimately we hope for a richer dataset to enhance our capabilities, with some of the current TCA analytics embedded directly in the OMS and as close as possible to a real-time basis.
TCA for FX is also in the works, with a combination of in-house and broker solutions. This is now possible given timestamp collection improvements earlier in the year, but there are challenges still for obtaining data for benchmarking at a reasonable cost.
With greater attention to market structure and its impact to long term investors, the need for further transparency into the execution of orders by brokers, so as to understand our impact and performance will only continue to grow. For example, it would be great to know the sub-routing/destinations visited prior to getting a fill. The dialogue already in place between brokers, vendors and FPL working groups is a great step towards leveraging FIX for some level of data standardisation in the TCA arena that we hope will gain further traction in 2013.
Getting To The Pool
CLSA’s Global Head of Trading and Execution, Andrew Maynard, and COO of Trading and Execution, Joakim Axelsson, delve into the nuts and bolts of setting up and running Commission Sharing Agreements.
Commission Sharing Agreements (CSAs) between the buy- and sell-side are, in concept, an invaluable tool as they facilitate the unbundling process thereby freeing client’s trading desks to seek best execution.
While the regulatory frameworks across Asia have not developed to the same extent with respect to unbundling and CSAs as they have in Europe and the USA, as a tool CSAs are becoming increasingly common in the Asia-Pacific markets including Australia and Japan. Asian funds seeking to attract international money for management in Asia need to demonstrate to their clients that they are implementing best practices and both CSAs and unbundling integral to the process. So what we are now seeing is a broad acceptance of CSAs in markets which do not necessarily regulate unbundling and best execution. With money becoming more mobile globally, the growth of CSAs in Asia is inevitable as they are a mainstay of the global investment process. The necessary regulatory frameworks will follow – and the challenges to both the buy- and sell-side of administering CSAs will continue.
In Asia, we have observed first-hand the evolution of the CSA business, and over time as the penetration has grown, both the benefits and the challenges of implementing and managing CSAs have become more apparent.
The trading processes within the industry are evolving rapidly. There is far more focus on execution quality from both the buy-side and sell-side traders. Combining this increased focus on execution quality with the technology advances happening in parallel allow far greater transparency about the quality of the trade in real time. This results in a very different level of engagement between the buy- and sell-side traders about the trades, which is very healthy. In this respect, CSAs have achieved the objective of ensuring that the ultimate end investor is receiving an enhanced quality of trading, i.e., best execution.
Clients have implemented their best execution process quite differently. At one extreme are those clients who do not use CSAs and have completely detached their trading desks from their investment management teams to the point where the client’s trading desks are not allowed to know how the various fund manager ranks each brokerage research. To these clients, having best execution is all that matters. While this model certainly ensures the traders have freedom to seek best execution, it can have unintended consequences as brokers who do not receive payment for their research and advisory services over a period of time will naturally have to reduce their service levels to these types of clients. To take this to the extreme, an argument can be made that brokers should not provide any research and advisory services to these types of client.
More common are those clients who implement systems and processes to value each of the services they receive from their brokers. These clients manage their payment process very carefully to ensure that they pay the correct amount for services received and any commission left over is ‘jump ball’ based upon pure execution quality at a lower commission rate.
Finally there are those clients who have yet to formalise their broker ranking, valuation, or execution processes. These clients, while more informal, can be equally demanding from a best execution process, it is another way to achieve a similar best execution result.
From a broker’s perspective each of these client processes has to be catered for and of course that means greater administration, more operational complexity and therefore more costs for brokers. While global commissions are falling, brokerage expenses are indirectly being increased by greater regulation. In some instances another party is being introduced to the chain as CSA aggregators have spotted an opportunity to inject themselves into the process flow – again at a cost.
One of the issues facing the sell-side is that in receiving a CSA cheque, the broker is not actually doing the trading. No broker likes to receive CSA payments over the client trading flow. The sell-side wants to be involved in the trade, as not only does it deepen the relationship with clients; the natural liquidity provides opportunity for further flow and crossing. When an account pays a CSA cheque in lieu of commission, we question the reason. Does it mean that the buy-side trader doesn’t think we offer best execution in that country or in that sector? Either way it can be read as a signal that we need to improve our execution capabilities. It also ensures that brokers offer all the various avenues of execution, every different pool of liquidity, every different connectivity vendor, etc.
Brokers that are not in the top tier of execution, those that cannot afford the regional infrastructure and technology platform necessary to compete, or those brokers that are relying on CSA cheques alone, are operating in a very dangerous space – particularly in these times of lower liquidity.
The buy-side trader has to focus more on the implementation and metrics of the trade than the research payment and therefore allocates trades accordingly to ensure best execution. This is why brokerages which have historically been known for their research product are now forced to make a decision. Do they become a ‘research only’ house receiving cheques? Or do they compete in the execution space?
Major brokerages on the sell-side with both execution and research offerings have had to make a range of necessary investments over recent years to remain at the top of the execution brokerage list. On the other side of the equation, being a CSA broker administering regular payments for clients requires a significant infrastructure spend to maintain a professional service; however these costs are somewhat offset by the additional flow.
Another problem faced by brokers is that analysing client profitability has become far more complex. Clients who pay commissions through trading for further pay-away via CSA often vary the instruction dates and the payment amounts. As a result it is becoming increasingly difficult to project net profitability per client, which of course results in it being more difficult to gauge the level of service to provide to clients. To add further difficulty, if you are receiving CSA payments on a quarterly or semi-annually basis, this lumpy revenue flow can also impact resource allocation.
It is important that both parties understand what the CSA is trying to achieve and the metric the client is trying to develop so that you can resource the client properly. So from the sell-side perspective you now need to look at how to allocate internal resources when your income stream is no longer as clear cut.
Interestingly there is no sell-side consistency as to who manages the CSA process internally. In Asia the process has developed somewhat organically and we see it as an area which needs to be managed by the front office.
While the sell-side has many challenges to consider, the buy-side has it no easier. The buy-side has to find answers to some very difficult questions, what each broker’s research is worth to us, what is execution worth to us? In addition, after the recent FSA consultations, much of the buy-side has to look into what is corporate access worth, what defines corporate access and how do they pay for corporate access going forward. These are structural changes that need evaluation and global implementation across many regulatory frameworks.
For all the challenges and issues however, we don’t believe the system is broken. CSAs remain an incredibly valuable tool allowing the buy-side to manage their commission pool, rewarding those brokers who provide value and allowing their trading desks to achieve best execution.
CSAs are not new, but perhaps only now that they have been widely adopted and implemented are some of the complexities and implications coming to the forefront, and as always the industry is changing to adapt to them.
Peter Randall : Equiduct
MUDDY WATERS.
Peter Randall, CEO, Equiduct
The uncertainty over the economy and the prolonged eurozone crisis may be blamed for the parlous state of the equity markets but it is not the only reason. The continued lack of clarity on how to achieve best execution has also shaken investor confidence. Despite MiFID and the reams of White Papers and articles trying to explain the concept, it remains elusive.
Harking back to 2007, the original rules were supposed to provide the backbone. However, the definition was all encompassing and the terminology was difficult to decipher. For example, what was meant by the need to “take all reasonable steps to obtain the best possible result for clients taking into account the execution factors such as price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of an order.” How could participants prove that their brokers had also established and implemented effective ‘execution arrangements’ for complying with the best execution obligation?
There was also no framework for monitoring whether firms were pursuing the best execution course of action plus as a directive and not a regulation, implementation has been slow and uneven across the national boundaries. It is no surprise then that many firms adopted a generic best execution policy. There was hope that MiFID II, which is currently being negotiated between the European Parliament and the Council of Ministers, and expected to take effect in 2015 and 2016, would have addressed some of these shortcomings.
This does not look likely. It will continue not to be mandatory to prove best execution plus the fate of the linchpin – the much needed consolidated tape which shows where the best execution is – has been left unclear. There is currently no single universally accepted post-trade picture that market participants can look at to assess which trades went where and why. The only way to achieve best execution is to include prices of every platform in Europe. Although the European Commission has thrown its weight behind a tape, it has been left open to a public tender process, rather than setting a specific provider.
These developments may not have as great an impact on the large institutional investor or fund management house which have the resources to navigate the markets and the clout to hold their brokers to account. This is often not the case though with the smaller retail investor. In fact, the UK’s Financial Services Authority has raised doubts over whether retail investors were getting the best deals when it published a paper highlighting the practice of brokers choosing venues that offer them financial incentives. The regulator noted that some brokers were sending client trades to venues that were offering less competitive deals for the brokers’ clients in return for secret commissions pocketed by the broker itself.
A movement is growing among retail investors to embrace competition and look farther afield than the mainstream stock markets for the best prices. They are increasingly becoming a more important member of the trading community and are looking to have their voices heard.
©BestExecution
