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Trading systems : Swap execution facilities

By
Ian Rycott
-

FIRST MOVER ADVANTAGE.

FirstMoverAdvantage_567x750

The rules may still be unclear but Heather McKenzie shows how market participants are carving their stakes.

The non-standard, bilaterally cleared world of OTC derivatives is being dragged into a standardised, electronically traded environment by a series of regulatory initiatives around the world. With detail still to be thrashed out, market participants are jockeying for position in the new derivatives landscape.

In the US, Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 creates swap execution facilities (SEFs), trading systems that enable eligible contract participants to trade on a multilateral basis. In Europe, the review of MiFID has created an equivalent entity – the organised trading facility (OTF) while similar reforms are under way in Singapore, Hong Kong and Tokyo.

In general, the initiatives cover trading, clearing and reporting of swaps transactions. The reporting element is designed to enable regulators to monitor risks that could be building up in the OTC derivatives market as well as to check whether any nefarious practices are taking place. On the clearing front, the general trend is to move away from bilateral processes and towards clearing via central counterparties.

The trading element, which is creating SEFs and OTFs, is where some players are getting excited. Matt Woodhams, head of electronic commerce at wholesale market brokerage GFI, says despite the lack of clarity regarding the rules for SEFs, there is likely to be a “mad rush” before the end of this year of organisations registering to become SEFs. “The industry is not sitting on its hands. People are assuming that swaps trading will be more electronic and they are investing in electronic platforms and connectivity.”

This is a point on which James Rucker, credit and risk officer at MarketAxess, operator of an electronic bond and CDS platform, agrees. “It is not easy to formulate a response, because the rules are not final but firms cannot afford to wait until the rules are in place. There is too much to do and if you wait, there will be only a short time to act.”

MarketAxess has begun by putting trading protocols in place, upgrading and improving existing protocols for its credit trading platform. These moves, says Rucker, will ensure that the firm can be a competitive SEF from the outset. “We want to be market-driven and follow our clients with these changes,” he says. “We are also building in functions around CDS clearing, enabling clients to choose their clearing house, for example.”

On the connectivity front, the company is building links to ICE and CME and will connect to “any clearing house that clears CDS”, he says. Links are also being established to swaps data repositories and futures commission merchants.

The final piece of the puzzle for MarketAxess is compliance and surveillance. “The National Futures Association will provide a number of surveillance services, but firms need to be connected into those and also there are some things that will have to be done internally,” says Rucker.

GFI is taking a similar approach, says Woodhams. The firm is comfortable with some of the requirements it believes will come into play and views the technology that will be required as an evolution of where the company was headed.

The right connections

Connectivity will be a significant task, says Jonathan Morton, vice president at IPC. SEFs will want to connect to as many dealers as possible and there will be a substantial increase in bandwidth and investment to facilitate connectivity between SEFs and dealers, buyside firms and data repositories. “There is a fever pitch of activity as firms bring the required capabilities online because they see a large opportunity and a rapid return on investment in the swaps market.”

Woodhams points up the importance of liquidity, “You can have sophisticated trading protocols and high-performance technology, but an SEF or OTF must have liquidity. No one will look at a system alone; it will all be about liquidity.”

Incumbents in the swaps world will look for ways to move into the electronic trading world while retaining their liquidity, he says. The task will be more difficult for newcomers who will find attracting liquidity a challenge. “Being a first mover in SEFs will be an advantage – if you have liquidity. Being a first mover without liquidity won’t be an advantage and firms may well burn cash.” Woodhams says some firms already have fallen by the wayside because they have launched SEFs too early. “Many people felt SEFs would be well established by 2012; but we are perhaps still one year away from this.”

Tim Dodd, head of product management for the SunGard Front Arena trading system, says first movers will gain a substantial advantage in attracting liquidity. He suggests a “good handful” of the large number of firms that have applied to become SEFs will survive in the long term.

“Swaps are a smaller turnover, bigger ticket area than other parts of the derivatives markets. By making trading electronic there will be some growth, but not a huge amount,” he says.

SEFs will have to support not only an order book style of engagement with liquidity, but will also have to support request for quote (RFQ) type processes. “The market structure will be slightly different so simple exchange-based platforms and ETD platforms that can cope with RFQs will have to be adjusted in order to connect to SEFs.”

Dodd says Europe is likely to develop in the same way as the US, with OTFs looking similar to SEFs in terms of capabilities. “It should be remembered that if you want to deal with US clients or markets that are going electronic, you will need to have the capabilities of participating in electronic markets.”

At present electronic trading in swaps does not mean a push towards zero latency. “It will be good to have the ability to re-quote rapidly and offer safety, but at this stage low latency won’t be pursued as aggressively as in the equities markets,” says Dodd.

Woodhams says reducing latency via methods such as co-location would be “a bit over the top at this stage”. He identifies two dimensions to bandwidth – where price updates can be made many times per second, and where updates have to ripple out across many other prices. “The OTC markets are highly correlated, so latency will be important here.”

Tanuja Randery, chief executive of market data and trading infrastructure services company MarketPrizm, says the company expects the swaps market to follow other asset classes in becoming electronic, starting with connectivity and networks and eventually opening up opportunities for vendors to provide upstream services that market participants would not consider developing or operating in-house.

“We can see a drive to have multi-asset trading systems enabling participants to consider their overall position at every point – clearly having the proper systems and technology to enable this becomes important as more assets are traded electronically. We have also seen firms sharing the know-how among asset classes and trying to capitalise quickly on new opportunities that arise.”

Financial consultancy and research firm Celent believes the future of SEFs and OTFs will be very choppy – a rollout of the platforms over two to three years, with wide block trading limits will require the industry to get comfortable with the idea of SEFs and OTFs “fairly quickly”. In its November 2011 report, Swap Execution Facilities and Organised Trading Facilities, a New Market Structure Emerges, the firm warns that regulatory momentum could fade and whatever market architecture is least disruptive but in the spirit of Dodd-Frank and the European Market Infrastructure Regulation could be adopted by end of 2013.

Celent identifies three key factors that have to be considered; price discovery, trade lifecycle and profitability. Unless these are balanced, the market structure could evolve into a scenario where “nobody wins, as liquidity goes elsewhere, dealer profitability and engagement dry up, and the high cost to trade spurs users to seek risk transfer in other financial products and markets”.

Overall, while Celent believes that SEFs/OTFs will make the swaps market more electronic, transparent and competitive, it says not all transparency is equal. “We especially believe price discovery could be hindered unless careful consideration is made to ensure the rules are adaptable and reflect the reality that the swaps market has far less liquidity than some people imagine.”

©Best Execution

 

 

Market view : Emerging markets

By
Ian Rycott
-

FORMING NEW TIES.

BRIC countries still hold their allure but as Dina Medland reports, investors are looking to connect to a wider group of emerging markets.

Emerging markets are jostling for centre stage. The BRIC moniker has served its purpose as a means of identifying disparate countries with strong growth potential, but different dynamics at play. Amid slowing economic growth in China and Brazil, political uncertainties in Russia and huge infrastructure and political paralysis in India, investors remain keen to hunt for the next story.

The focus is subtly shifting from Russia to Eastern Europe and from Brazil to a wider Latin America – with Asia ex-Japan not far behind – and the ‘exotic connections’ of yesterday are becoming the ‘de rigueur’ ones of today. Linking to these markets though is not always easy as latency, connectivity and market infrastructure in general vary across the different regions.

Philippe Carré, global head of connectivity for SunGard’s capital markets business, responsible for the delivery of hosted services and solutions to trading clients on both the buyside and the sellside, says, “There is a big story on the margins of Europe from the Baltics all the way to Turkey. Russia has highly developed infrastructure and is an emerged market wearing the cloak of an emerging one and might be on the verge of cleaning up its political act. We are seeing stock-picking investors going to Indonesia and the other ASEAN nations in which it is becoming easier to trade. In Latin America both Mexico and Brazil attract strong interest from asset managers and although the overall market is somewhat fragmented, there is talk of co-operation and we could see a grouping of exchanges along the lines of Euronext in Europe.”

Such a grouping may not happen for some time yet, but there are signs of a trend towards vertical integration of market infrastructure. Carré also points out that Colombia, Peru, Chile and Argentina have all come a long way in improving their infrastructures and thus their links – both electronically and culturally – to the global investment community. Challenges remain  – in Peru, for example, the Bolsa de Valores de Lima (BVL) exchange owns 40% of Cavali, a private group responsible for clearing and settlement of securities, but cannot raise its stake any higher because doing so is prohibited under law.

For BT, which supports the largest secure network for the financial community in the world including its Radianz Services available to more than 400 financial institutions in 63 countries, offering economies of scale is the key. Chris Pickles, head of industry initiatives in global banking and financial markets notes, “In countries like Brazil, more brokers want to gain access to other brokers – the ones who are members of the BM&F Bovespa – while the biggest banks will connect directly.”

Beyond connectivity, best execution issues are complicated, but there are signs that change is afoot – Comissão de Valores Mobiliários (CVM), the securities and exchange commission of Brazil, recently instructed the UK economic consultancy Oxera to assess the potential costs and benefits of introducing more competition into the market for trading and post-trading services in Brazil. According to its report, “As Bovespa is the only infrastructure provider of trading and post-trading services for transactions in equities in Brazil and competitive pressure from American Depository Receipts (ADRs) may be limited, the fees charged for trading and post-trading services could be higher than they would be in a competitive market.”

Interest in Brazil is unlikely to diminish.  In fact, former US President Bill Clinton at a conference in São Paulo in late August put his money on the country over China and India. However, companies like MarketPrizm, which offer global trading infrastructure, are focusing its gaze more intently on Russia and Eastern Europe as well as Asia although Brazil is still very much in the picture.

The main drivers are client demand and market fragmentation. As CEO Tanuja Randery says, “Our customers are largely primarily prop funds, and quant driven groups, funds, prime brokers and investment banks. The equities market is very sluggish, so the real activity is in commodities and futures/options and that is why Russian markets are particularly attractive. Warsaw is also coming up a great deal as interesting; people are writing strategies to these markets. In each market we put in a whole co-location slot infrastructure to offer direct market access, and need to provide a focus on low latency data and order routing.”

At BT, Pickles says that the real competitive scramble today is for the derivative markets. “If you’re running an exchange operation you are trying to expand derivatives into other countries. Each of the majors is trying to build out its community and emerging markets are recognising the importance of both derivatives and foreign exchange as the exchange markets become more transparent in the face of regulation.”

TMX Atrium, a provider of infrastructure solutions for the financial community, last month (August) announced new low latency connectivity into Moscow from Stockholm, providing access to key data centres to enable participants to trade the rapidly growing Russian market. The data centres in Moscow and the greater liquidity in London is a combination that is currently providing interesting opportunities for arbitrage.

Emmanuel Carjat, TMX Atrium’s MD, says:  “Our venue-neutral platform is designed to enhance and add supplementary routes as clients demand to provide access to multiple markets, regions and venues to trade the full range of asset classes. We recognise that our client base wish to execute arbitrage strategies between key data centres and in line with our expansion strategy, we will continue to refine our connectivity capabilities to meet these demands.”

Russia does though have its challenges, such as language and the state of technology, according to Carjat. English may be the lingua franca of finance, but it is worth remembering that in emerging markets it can also be short in supply. “In addition at the technical level, some of things we take for granted e.g. voltage levels will be different which requires specialised power adapters for your equipment,” he says. “You might be doing something routine but you can be sure it will not go smoothly.”

Progress though is being made. For example, the Moscow exchange, MICEX-RTS, is expected to launch an initial public offering next year and the Russian government is pushing domestic companies to list at home in order to boost the liquidity of the local market. While market participants welcome the changes, the MICEX-RTS cannot be complacent as the winds of competition are blowing from the CEE, in particular Warsaw.

Opportunities also abound on the latency front especially in Asia as asset managers and brokers trading the region’s equities want faster access to exchanges and market data. In response, the Asia Submarine-cable Express a new underwater cable costing $430m aimed at automated traders opened for business tracing a 7,800km route from Japan to Singapore and Malaysia. Hong Kong will soon be included in the loop which will shave three milliseconds off the speed offered by existing cables and providing the shortest link between the Tokyo and Singapore bourses.

©BestExecution

Market Opinion : Bob McDowall

By
Ian Rycott
-

A BROKEN MODEL.

Against the backdrop of regulation and volatile markets can the “one-stop shop” universal banking model that has defined the industry for the past two decades survive? If so, who will be the main players and if not, what will take its place,? asks Bob McDowall.

Universal banks offered an array of diversified financial services straddling the boundaries between consumer, commercial, and investment banking. The credit crunch in 2007 /8 identified the interdependencies of credit, liquidity, and market risks in national and global financial systems that have had devastating effects when they were incorrectly assessed and inadequately managed for risk.

The credit crunch has exposed the weaknesses of the risk-based pricing models employed by some universal banks. The continuing credit crunch motivated a number of banks to forsake the universal banking models. Moreover the effects of the credit crunch combined and some high level governance and compliance failures have combined with pressures from legislators, regulators and shareholders to force universal banks to review their future business models and organisational structures.

There are a number of significant challenges to the universal banking model:

Political pressures

Politicians are in the driving seat in terms of steering the future agendas of the banking industry because tax payers have bailed out both banks and the banking system. Through support measures such as quantitative easing and increased taxes, savers, investors and taxpayers sense they have been disadvantaged by governments’ support measures to banks. Those measures have not resulted in banks re-engendering financial and economic growth. Politicians have the support of the electorate and the taxpayers in setting the agendas for the banks.

Legislative pressures

The political agendas for banks is reflected in a range of legislation covering matters as diverse as corporate governance, remuneration, more extensive financial disclosure and reporting , banking and systemic risk reduction.  The legislative emphasis and priorities may differ in each jurisdiction but the legislation does reflect the Political demands for increased control and oversight of the sector.

Responding to regulation

More expansive legislation translates into additional regulation and increased powers for financial regulators. Increased capital requirements and investment in resources for risk management and financial reporting demand that banks seek additional fixed and working capital. Fixed capital has to come from existing or new investors, Working capital will require a contribution from investors or through review of the operating businesses and their performances.  Business and operating reviews may result in cessation, contraction, consolidation or disposal of some of the lines of business.

Value to investors

Banks represent low returns and high financial and reputational risk in the current operating environment.  National legislative programmes and the Political agendas for banks do not raise the prospects of better times ahead for the sector. As such the sector does is not attractive to investors. The risk premium for investment is higher than it is for other commercial sectors.

Demographic & asset management

The demographic changes in Western Europe are such that the wealth is vested in the over 50’s. Their focus is on preserving or increasing returns on their wealth in a financial environment of artificially low interest rates and increasing inflation. Accordingly the more profitable areas of the banks are likely to be fees generating asset management divisions.

Geographic areas for growth

Until the recent global financial and economic contraction exacerbated by the continuing Euro-zone crisis, the Asian Pacific and selectively South America have been the major areas of growth. Any resumption of growth is likely to start in the Asia Pacific and South American Regions. Although Universal Banks from the Western Hemisphere have been operating in those regions with increasing success, it is by no means certain that they will adopt the Universal Banking model. Concurrently domestic financial institutions are starting to provide competition in core banking services and asset management. 

What will take its place?

Universal banking institutions will remain the key banking constituents for financial growth in mainland Europe supported if necessary by continued Government investment. Universal Banks in mainland Europe have their roots as institutions which funded and directly invested in commercial and industrial enterprises in the economic regeneration of Europe after World War II. However, their scale of ambition is likely to be contained to Europe unless their European customers require servicing in other geographic regions. Banks that continue to employ the universal banking model will pay a premium for capital and funding as rating agencies and investors ascribe a higher risk rating to that business model.

The cost of capital and limitations being placed on proprietary trading have encouraged banks to focus on fee based business such as asset management and corporate advisory businesses. That trend is likely to continue for the remainder of this decade. The banks which are setting this trend will become smaller in terms of people and capital bases through disposal or cessation of more resources and capital intensive businesses.

Smaller, niche or boutique style asset management and corporate advisory businesses are already emerging as a result of teams leaving larger institutions and attracting clients who a more individually serviced approach which focuses on fees for success.

While limited trading facilities will always be required for providing liquidity in financial instruments capital for major transactions is likely to be provided on a transaction by transaction basis from other financial institutions through some broadly based standby facilities.

The Universal bank is unlikely to be the mainstay of investment banking in future. Fragmentation of the industry will lead to more specialisation by smaller institutions. There will be a parade of shops rather than a “one stop shop.’’

Bob McDowall, is consulting associate to commercial think-tank Z/Yen – www.zyen.com
©BestExecution

Post-Trade : Clearing & Settlement

By
Ian Rycott
-

SHAKEN NOT STIRRED.

ShakenNotStirred_610x750

The lines are being redrawn on the clearing and settlement map. Mary Bogan reports. 

The sleepy world of post-trade services is facing a roots and branches shake-up. As new regulations, in the US and Europe, work their way onto the statute books, creating some hugely lucrative opportunities for some players and threatening the very survival of many more, competition in the clearing and settlement space has never looked so intense nor the future so unsure.

“The complexity of the regulations, and the magnitude of potential change that impacts the entire global landscape generally, mean financial institutions are moving into uncharted water. There are few certainties about who will emerge as market winners,” says Saheed Awan, head of global collateral services, Euroclear.

Squeezed in between a regulatory agenda focused on stoking up competition while reducing risk, and a voracious client appetite for products that optimise capital and asset holdings but at no extra cost, the post-trade institutions are having to think fast as the ground shifts beneath their feet.

In the clearing market, the decision by global regulators to drive OTC derivatives trade onto exchanges presents one of the biggest opportunities and threats to incumbent players. “With a new flow worth over $700 trillion, there’s a huge historic business opportunity here for clearers,” says Javier Tordable, CEO of technology provider Cinnober. “Not every incumbent clearer will be able to adapt their business model to cope with OTC complexities and some will stay focused on core business so I’m sure we’ll see new clearing houses enter the OTC business.”  Recent announcements by NYSE Euronext and CME of plans to build new clearing facilities for derivatives in Europe are a sign more newcomers into the clearing space are on the way, says Tordable.

However, growing competition in the clearing space is also being powered by another force. As regulations governing capital and liquidity requirements grow more stringent, so the clamour from banks, demanding interoperability between CCPs, gets louder. Interoperability between CCPs, say advocates, cuts inefficiency and risk by allowing market participants to net and consolidate trades into one single obligation using one pot of margin and one set of procedures in a relationship with just one preferred CCP. It also exerts downward pressure on clearing fees by injecting greater competition between CCPs.

Earlier this year, interoperability seemed to be an unstoppable market force after several trading venues, led by BATS Chi-X, opened the doors to four-way interoperability. In addition, the decision by EC regulators to block a mega-merger between NYSE Euronext and Deutsche Borse seemed to take the steam out of “vertical exchanges”, which restrict choice by forcing customers to drive trades through the exchange’s own CCP.

“I’m not expecting the floodgates to interoperability to open soon”, says Hugh Brown, director of UK markets at EMCF. “EMIR blesses interoperability but it doesn’t make it mandatory.”  According to Tordable at Cinnober though, the pressure from market participants, gunning to consolidate their trade flows into just a handful of large, strong CCPs, will inevitably lead to more competition and consolidation. “We’re already seeing it with deals such as LSE’s recent acquisition of LCH.Clearnet.”

Rising competition though among CCPs has fired up safety concerns in some quarters. “What the advent of OTC derivatives into clearing does is to migrate bilateral risk between market participants to the CCP.  Is that risk going to be managed appropriately and will CCPs create additional systemic risk which could impact on other on-exchange business categories”, asks Ian Cornwall, head of market structure at SIX Swiss Exchange.

Concern also centres around pricing and fair competition. Urs Wieland, CEO, SIX x-clear, has publicly argued that prices are currently as low as they can go. Offers of capped fees at certain trade levels suggest clearing has become a subsidised, loss-making activity for some CCPs, he says, and compromises the notion of a level playing field.

Brown at EMCF agrees. “I share the concern that some CCPs, who do not have to make a return, are pricing unrealistically to generate new business”, he says. But regulatory moves to create common standards for CCPs, he argues, should curb any risk of competition moving into risk management or CCPs marketing themselves on the basis of reduced margins.

To remove the temptation to compete on margin and to strengthen  risk management, says Robert Barnes, CEO of UBS MTF, what CCPs need is some “skin in the game” and is calling for CCPs to be required to put their own resources into the default waterfall as a curb on reckless behaviour.

For larger CSDs especially, the burgeoning demand from both market participants and CCPs for capital and collateral management and optimisation, is proving welcome news.  Even more than clearers, CSDs are on the cusp of a brave new world. Apart from the EC’s proposal to separate out banking services from the larger CSD’s settlement services, T2S, an initiative driven by the ECB, promises to break down protected national barriers and create open access to Europe’s settlement markets. That has clear implications for pricing. “The natural outcome of T2S is that settlement becomes commoditised so CSDs will need to move up the value chain and offer more value-added services,” says Hersh Tegala, head of business intelligence at Clearsteam. “We want to ensure we still attract a critical mass of securities onto our books and continue to provide best-in-class asset servicing with collateral management – a major industry concern at present, as our differentiator.”

At Euroclear too, collateral management and optimisation is regarded as the space where CSDs, with large pools of collateral, can add value.  “Collateral management is the paramount weapon for risk reduction and regulatory capital efficiency,” says Awan. “It’s the one of the most important responsibilities today in managing your clients’ assets in an optimal way.”

With many institutions facing a tsunami of regulations, Awan says there’ll also be opportunities for CSDs with the scale and resources of Euroclear to collaborate with other CSDs, CCPs and other market participants. Last November, Euroclear France introduced collateral management services with the central bank of France and Euroclear Bank now has cross-border collateral management arrangements with the Hong Kong Monetary Authority.  In July, it launched the “Collateral Highway” which aims to source securities to be used as collateral by providing the infrastructure to move securities where and when needed, no matter where the collateral is held. “It’s a just-in-time approach to collateral management,” says Awan.

BNP Paribas has signed up as the first agent bank to work with Euroclear on the Collateral Highway – another example of how partnership and collaboration between previously competing institutions is likely to characterise the new post-trade space. “We think we will see partnerships that you wouldn’t have believed possible four or five years ago,” says Awan.

For smaller CSDs, with expertise in the legal and tax structures of its local jurisdiction, survival may be probable short-term. Long-term though, they will have to meet the challenges of cross-border competition head-on, following the example of bolder national CSDs such as VP Securities in Denmark.

A small organisation (160 people), which left behind its non-profit status in 2000, it runs a large-scale operation offering highly competitive prices on yearly clearing and settlement volumes of around US$5 trillion. According to CEO, Johannes Luef, over a third of revenues now come from non-traditional CSD activities, such as issuer serving and consulting, and, in 2007, it opened a new CSD in Luxembourg to make it less costly for Danish banks and mortgage companies to finance operations in the Eurozone. To prepare for increased competition and T2S, VP is currently investing in a sizeable overhaul of its systems, backed by its shareholders, Denmark’s major financial institutions.

“I think technology will be key”, says Luef. “One of the basic principles we have agreed with the market is, yes, of course we should join T2S but in such a way that VP takes the load. That’s deep in the architecture of the change and has eliminated customers’ fears.”

It’s a new game in post-trade services and new CCPs and new-look CSDs are on their way. “We’re seeing market participants at different levels looking up and down the value chain for new opportunities,” says Nathan Renyard of BAT Chi-X. “There’ll be a blurring of roles in future and the role of custodians and CSDs will be harder to define.”

©BestExecution
 

 

 

 

 

 

 

FrankTroise : JPMorgan

By
Ian Rycott
-
JPMorgan, FrankTroise
JPMorgan, FrankTroise

BUILDING ON SUCCESS.

JPMorgan, FrankTroise

Frank Troise explains how ECS is expanding its product offering and global reach.

Are you happy with the progress of the group over the past two and half years?

My main focus when joining was to revamp the product offering and strengthen our sales and client service capabilities. I am very pleased with the feedback we have received from clients. We have tracked our progress in terms of client feedback, market share, and financial results. Even in these low turnover market conditions we have grown our market share across the regions by over 25% a year.

Can you explain in greater detail about your product offering and how your client services differ from the past?

Our global product offering is geared toward accessing liquidity for our clients. As a starting point we overhauled our technology infrastructure and strengthened our quant team. Our global products leverage models designed by the quant team at the core. Combining the new infrastructure with the models, we rolled out a new suite of algos, smart order routing and crossing products. Achieving best execution is at the heart of these products. For instance, to simplify usability, we rolled out our Aqua algo. Aqua caters to client trading strategies running the gamut from passive to aggressive. Aqua employs multiple quant models including fair value, dynamic minimum fill, dark order placement and quant posting that are constantly calibrated to current market conditions.

The overhaul of our product offering ties in with our new approach to client service introduced in the fourth quarter of 2010. We added personnel and implemented a proactive approach. We now work much more closely with our clients to best match our capabilities with their trading strategies. We also have what we call a best execution task force which is a team consisting of quants, electronic traders, and product managers who work closely with clients to help optimise their trading strategies. This approach has been rolled out across the US, London, Hong Kong, Australia, Tokyo and Mumbai. A main objective for our products, client sales, and service teams is to have a global approach with local delivery and market expertise.

Staying the global theme can you please expand on your initiatives in Asia?

We have invested significantly in our Asian team and product offering and have seen the results. Our market share in Asia has grown by 50% year over year. We recognised we had a big gap in our product offering in the region and decided to act on this opportunity. We were not pursuing the same strategy as in the West and we have changed that by rolling out the same products and platforms in Europe and the US into Asia. We now have client facing personnel on the ground in Tokyo, Hong Kong, Sydney, and Mumbai and our next generation execution products are already live in Tokyo, Hong Kong, Australia, Taiwan, Singapore, Indonesia, India, and Malaysia with Thailand and the Philippines planned for delivery in the next few months. Lastly, we deployed technology and quant teams locally in this region.

What multi asset class offering do you have?

Multi asset class trading has become increasingly important for clients. We built our infrastructure and product architecture to enable clients to trade equities, options, futures, or any other instrument that trades on a public venue or an electronic bulletin board. We have made a big push with Neovest, our execution management system. Earlier this year we launched 15 new futures markets as part of a drive to build out the global platform. The new futures markets include Brazil, Dubai, Singapore, Sydney and Tokyo, bringing the total number of accessible futures markets on the platform to 29. Our electronic options platform has been up and running in the US for the past couple of years and we’ve recently added options algos to the offering.

There are many banks trying to do the same thing, what do you think are your main differentiators?

Liquidity has been and continues to be one of the most important priorities for our clients. An important factor in achieving best execution is having access to natural liquidity as early as possible in the trading process. We have created an internal pool of differentiated liquidity by consolidating various sources of order flow within J.P. Morgan.  For example, we source house liquidity from the private bank, clearing business, equity derivatives, transition management, as well as third party brokers. This is an ever evolving business and we seek to enhance our client service and product capabilities constantly. We have the scale and commitment to invest in client facing personnel and technology across the globe.

How has the role of the broker changed?

Brokers have always and continue to be in the business of providing research, advice, calendar, and execution services. Clients have investment ideas that need to be implemented and brokers offer all of the full service products as well as multiple execution channels to meet their trading styles. Clients can use the traditional high touch cash program channels in addition to having more control of the execution process at their fingertips via electronic execution products. With respect to electronic execution, brokers are now much more engaged in educating clients about market structure, trading venues, and counterparties. Additionally, brokers are more involved in assisting clients in trade planning and historical and real time execution quality analysis. Clients are looking for much more transparency and analytics tools to understand better the behaviour of electronic execution products. The more we understand clients’ goals and objectives the more effectively we can work with them on developing customised solutions.

Where do you see the greatest challenges?

Combining rapidly advancing technology and regulatory changes results in a set of new execution methods and trading opportunities. Current market structure demands a significant investment in technology and risk management capabilities. We must constantly keep up with the technology arms race and be as nimble as possible while at the same time tightly managing operational and market risk. Although this is not an easy equation to optimise, we feel our scale and commitment to clients’ goals will lead to continued growth in this evolving space.

[Biography]
Frank Troise is global head of equities electronic client solutions (ECS) at J.P. Morgan. He was previously the head of equities electronic trading product at Barclays Capital. Prior to Barclays Capital, Troise worked at Lehman Brothers from 2005 to 2008 and at ITG from 1997 to 2005. He holds a bachelor’s degree in electrical engineering from Boston University, an M.S. in operations research from Columbia University and an M.B.A from MIT Sloan School of Management.
©BestExecution

 

 

Matthew Cousens & James Hilton : Credit Suisse

By
Ian Rycott
-
James Hilton and Matt Cousens
James Hilton and Matt Cousens

KEEPING SCORE. 

James Hilton and Matt Cousens

Best Execution speaks with Matthew Cousens (right) and James Hilton (left) at Credit Suisse, who discuss the different conversations they are having with their buyside clients and how the electronic trading business is changing.

What were the drivers behind the restructuring in Feb?

Hilton: To be honest they were good drivers in that the AES management had done a good job in building a successful business and because of that the management team was seen in a positive light. As a result, some of the team have been deployed to help develop other parts of the business. For example, Rob Maher, (who was previously head of AES sales, Europe at Credit Suisse), has gone to the fixed income division as global head of EFX sales.

Cousens – The other reason is that other asset classes aside from equities are looking to modernise the way they trade and the bank is leveraging our experience.

What if any impact have the cutbacks had on your operations?

Cousens – The restructuring that we underwent in February had nothing to do with costs. AES is in good shape. In fact the number of personnel has not changed over the last five and half years. What has changed is the functionality and our emphasis on trading coverage versus new-sales origination. We have become even more client focused and are out of the office more talking to them about their requirements and how we can help them optimise their trading strategies.

Hilton – The electronic trading business model has matured and as a result our roles have changed. Our coverage desk has more people and on the sales side, we are having different conversations with our buyside clients. We have a significant number of clients on board now and they understand how to use algos and are clued up on best execution but they need new services so that they can trade more effectively. We have also developed new products such as the AES Alpha Scorecard which we launched last year. It analyses the quality of execution-flow across different trading venues on a short-term basis. The programme then steers clients to the most appropriate venue and matches their risk profiles.

What was the reason behind the launch of this product?

Cousens – Let me put it into context. There are huge concerns over the increasing levels of high frequency trading and the Alpha Scorecard enables our clients to better understand who they are interacting with in the dark pool. It builds a profile of the client over time, not just on a trade-by-trade basis. This has given clients a lot more confidence and it is proving very successful at allowing us to monitor participants in the pool. One of the biggest issues in the past was that there was no quantifiable way to measure a profile, until now. We relied on generalized, subjective categorizations.  The AES Alpha Scorecard gives clients transparency in terms of who they are trading with.

Do you think high frequency trading will be regulated?

Hilton – There are many arguments against high frequency trading but the fact is that quant-based strategies account for more of the current market activity and if you were to strip them out then you would see a significant reduction in the availability of liquidity. Spreads would widen and in turn trading would become more expensive. However, there are also different types of high frequency traders and it is important for the regulator and brokers to understand the differences.

What do you see as the impact of regulation in general?

Hilton – Regulation is difficult, costly and time consuming but we recognise as a bank that certain events have to be addressed. It needs though to be implemented with due thought and consideration.  For example, areas such as the proposed regulation of dark pools under MiFID II need to be improved. The general consensus is that the advent of dark pools has been beneficial to the buy-sides ability to trade and they are concerned with the talk of regulating them.

Do you think that best execution has improved under MiFID?

Cousens – MiFID started the process of competition and this has certainly driven down costs and tightened spreads. We have also seen an increase in resources within the buyside to study specific trading details and data, yet the definition of Best Execution is still undefined – it is essentially still just a policy – and clients have different views on how to achieve best execution. 

Best Execution understands that the strategy has been to keep AES as standardised as possible around the world, with algorithms customised for each country by local teams and quant developers. Can you expand on this?

Hilton – Yes that has always been our philosophy – we keep the headline strategies very similar, with relevant tweaks to accommodate the local markets, and then each region will work with local clients to develop custom solutions. Those custom solutions can of course be shared globally. In Europe, we do have a high number of customised strategies but there are also lots of clients who just want tweaks to their trading strategies instead of large-scale customisations.

Overall how have your clients trading patterns changed over the past year?

Liquidity is key in these markets. We have seen an increase in the number of clients using liquidity seeking strategies and using our Crossfinder Plus algorithm that accesses multiple dark pools, including Crossfinder (which is the world’s largest dark pool according to the Rosenblatt Survey May 2012, TABB Group LiquidityMatrix May 2012).

What is the main differentiator from your competitor’s platforms and how do you keep the edge?

Hilton – I think one of the key differentiators is our experience. We have been doing this for the past 12 years and have built a wealth of experience. We also see ourselves as algo specialists. It is difficult business and in today’s environment, the barriers to entry are high. You cannot operate this business on a shoestring and it is important to be able to make significant investments in technology and resources. We are already seeing some firms withdraw from the business or they are sharing the cost with other trading desks.

Do you see volumes returning anytime soon?

Hilton and Cousens – Quantitative easing and other measures will create short-term volume spikes but there will be more bumps in the long term. No one is yet convinced that sustainable volumes will come back any time soon nor do they expect to see a sudden sizeable seismic shift in volumes in Europe. The other issue is that the mix of traders is different. There is a much higher percentage of quant business and much less of the real fundamental trader and that also has had an impact.

[Biography]
Matthew Cousens and James Hilton , are directors and co-heads of sales EMEA for the Advanced Execution Services Group (AES) of Credit Suisse. Prior to joining Credit Suisse in 2006, Hilton spent six years helping to build the direct execution business at UBS. Cousens joined Credit Suisse in March 2007 after being head of DMA Sales at AKJ Ltd, prior to which he was a director and general manager at EBI Ltd.
©BestExecution

Brendan McCarthy : Knight Direct

By
Ian Rycott
-
Brendan McCarthy-Knight
Brendan McCarthy-Knight

KNIGHT VISION.

Brendan McCarthy, Knight

Brendan McCarthy, Knight Direct’s head of sales and relationship management talks to Best Execution about recovery from the nearly disastrous glitch of August 1st, and the lessons learned as well as the impact of impending regulations in the US and Europe.

What has been the impact of the technology problems that cost the firm to suffer a $440m loss in August?

The truth is nothing is perfect and there are errors. If you look at the stock market crash in the 1930s, it was a fully manual market that was responsible. In today’s electronic markets, humans still make mistakes. Following that mistake, we received

very strong support from both clients and our competitors. Three investors (Fred Tomczyk, CEO of TD Ameritrade, Martin Brand, managing director of Blackstone and Matthew Nimetz, advisory director of General Atlantic), have joined the board in the past month. At Knight Direct, our technology and business of providing agency algorithms is separate from the affected unit, so we were able to bounce back quickly once it was clear there was no impact on us. Across the entire firm, Knight initially lost market share, but the flow has returned and we have regained our leading position.

What accounts for the support?

I think it is a combination of culture, products, research and client services. It is also down to the way we handled ourselves. We have good relationships and have always put the client first. However, we also were transparent about the error and have learnt our lessons. We recently hired IBM to look into the trading glitch and are currently conducting an internal and external review. We are also putting in place better policies, practices and procedures to avoid this from happening again.

Looking at the market as whole, what impact do you think the impending regulation will have?

I think the competition that has been created by regulation such as MiFID in Europe and RegNMS has led to innovation. We have seen a plethora of alternative trading platforms and new solutions such as smart order routing and sophisticated algos to source that liquidity. In turn, the primary exchanges have lost market share to off- exchange venues. This is not the case in Europe although we are seeing an increase in terms of the concentration of flow to these off-exchange platforms.

Do you think the rules have made it easier to achieve best execution?

The execution experience has materially improved and the average execution speed has dropped significantly to less than one second compared to north of three to four seconds in the past. Innovation has also meant that the costs of trading have been dramatically reduced for the end investor.

Where are we today?

The European framework is more nascent than in the US and is guided by a different structural framework. It is not as efficient or cost effective as the US because of the clearing and settlement costs. Central clearinghouses (CCPs) need to interoperate in order for the European market to develop further. What is happening is that many are trading American Depositary Receipts (ADRs) instead of directly on the platforms because it is less expensive.

Do you see interoperability happening?

It depends on where MiFID goes. If the regulation can achieve interoperability then the implicit as well as explicit costs will decrease and it will create a much better bid/offer spread. It is not clear though that this will be the case with the current form of MiFID II. At the moment, everything is being proposed, but nothing is being enacted. If it does not happen then it will be difficult for the European market to get to the next level. This does not mean that interoperability will go into reverse but that it will not reach US levels.

In terms of tools, what are clients looking for?

In the US, there is clear need for intelligent sourcing algos. The development of effective algorithms requires heavy investment in technology, market data and strategies to extract alpha as well as connectivity. We believe the value of a broker like Knight is to help clients efficiently navigate the market through sophisticated trading tools that lower the market impact as well as explicit and implicit costs. We can offer customisation in that we can take a standard algo and configure it to better meet a client’s particular trading strategy. But more than that, we design and improve our algorithms on in-depth research, that’s our differentiator.

There are concerns about high frequency trading. Do you think it is warranted?

There are four different types of high frequency traders – passive, stat arb, directional and structural. The majority are passive and provide some kind of liquidity but there are those that act very aggressively and there needs to be some kind of regulation around that particular activity. They should not though all be lumped together.

What are your plans for the future?

We plan to continue to invest heavily in our algo research and development of new, more intelligent tools for our buyside clients. We want to optimise their trading strategies and level the playing field for all market participants.

[Biography]
Brendan McCarthy was recently promoted to Head of Sales & Relationship Management at Knight Capital’s algorithmic trading unit Knight Direct. Previously McCarthy had been business manager for Knight Direct and prior to that Knight’s market making business, and fixed income business. He started his investment banking career at UBS after graduating from Boston College in 2005.
© Best Execution

FIX goes semantics!

By
Yulia Kuksina
-


Martin Sexton of London Market Systems Limited examines the benefits of the SKOS network for product classifications.


Being top of the game is the aim of any trade association and FIX members are not scared of putting their heads above the trenches when it comes to identifying a clean and simple solution to an industry issue. Not only has a proposal been put forward that meets the OTC derivative products reporting requirements associated with Dodd-Frank, but it is also working with others such as ISITC and X9 to create a viable solution to meet the need for a globally acceptable classification scheme under the ISO banner. There is an overlap between these two initiatives in that financial products need to be appropriately classified; and this is where semantics has a role to play.
As soon as ontology is mentioned a concern is always raised as to the potential impact on a project due to the risk of adding latency into the deliverable time line. There is the impression that any semantic analysis is complex and yields little in tangible benefits. So what is the missing link? Could it as simple as identifying a framework capable of linking a semantic model onto a physical model?


Simple Knowledge Organisation System (SKOS) is just that framework; it allows the user to provide meaning and understanding to financial product classifications and, where appropriate, a visual representation can be used to help convey its intended use and ensure the industry exploits its capabilities and achieve maximum potential.

If we take the recent FIX Protocol regulatory reporting proposal, SKOS allows us to link the FIX terms with those outlined in the final rule (17 CFR Part 43 – Real-Time Public Reporting of Swap Transaction Data). ISDA for their part has developed a set of taxonomies. Based on four key terms the strict hierarchy under each asset class comprises three related terms, namely Base product, sub-Product and Transaction type. A further extension to this scheme is provided for commodities to support the Settlement type (this can have the value “cash” or “physical delivery”). The FIX proposal covers all asset classes and base products whilst the ISDA proposal only focuses on OTC derivative products.

The CFTC Rule identifies two key facets, namely asset class and contract type, each of which can be broken down further by sub-asset class and contract sub-type respectively. SKOS provides the ability to manage the relationship between all the terms and most important link them to the associated FIX equivalent tags.

At a high level the relationships between the CFTC’s final rule, the FIX and the ISDA proposals can be represented in a diagrammatic form.


There is also an awareness that the product taxonomies capabilities has limited capability of classifying risk, therefore the FIX proposal also includes a taxonomy specifically design to quantify the risk associated with the position.


In addition to capturing the relationship between terms, it is also possible to render details about each term (or Concept in SKOS). The figure that follows is a snippet of the FIX taxonomy used as part of trade lifecycle, principally for order routing. The taxonomy comprises the FIX tag 460 Product which can be further broken down by SecurityType (Tag 167). The example includes the associated labels for each tag, supplementary information such as a definition of the term and any external references:


Other industry standards lend themselves to being represented in a SKOS framework, the most obvious of these that would benefit from this framework is ISO 10383 the Market Identification Code (or MIC). Apart from the concept of a market itself, it also includes information about the locale of the market (country and city), its market status (eg Active), the live date and the industry acronym for the market. The tabular nature of the ISO MIC means that it can be easily transposed into SKOS.


Some users of SKOS have indicated how easy it is to construct a classification, though it somehow doesn’t feel right. This makes sense, if one does not apply some form of management framework around the data. For example, if one examines the ISO MIC, the market itself is normally governed by the laws of the jurisdiction in which it resides. That relationship needs to be captured and appropriately documented. It may also reside in a city where other markets exist. Thus the exchange has both a relationship to the city as well as the city to all the markets. SKOS provides sufficient documentation constructs to allow one to define context and provide examples.

So what are the advantages of SKOS? Apart from the reduced time to market, given the ease at which one can construct a classification, the main advantage is that it allows one to identify explicit relationships between terms within a scheme, in a human readable form. Once “skosified” and with the help of an appropriate engine, the user can then undertake complex searches that can allow one to identify similarities, refine the searches and ultimately improve the design of the classification itself.


Efforts continue to be put into managing the deluge of regulations and FIX protocol continues to respond to the industry’s requirements in a prompt and adaptive nature. The introduction of semantics can provide FIX members with the latest weaponry to remain at the top of the game.
[1] TopBraid Composer Graphical Screenshot

Viewpoint : Luigi Campa

By
Ian Rycott
-

LEVERAGING HISTORICAL KNOW-HOW.

EuroTLX_LuigiCampa_786x375

The e-trading of bonds in Italy has more than a 10 year history, but is quite new to the rest of Europe. Best Execution speaks to Luigi Campa, head of business strategy and development at EuroTLX, a leading European MTF for the e-trading of fixed income securities, to see what lessons can be learnt in light of the upcoming MiFID Review?

Blackrock’s Aladdin Trading Networks and Goldman Sach’s GSessions are only two of the latest trading venues that are incoming in the growing space of bond electronic trading. Since MiFID II will extend also to non-equity financial instruments requirements of liquidity and transparency, the fixed income world has started to reshape.

There is, however, one country in Europe where already the effects of MiFID’s first release in 2007 translated into an increase of competition amongst all kinds of bond trading venues (regulated exchanges, multilateral trading facilities, systematic internalisers). “Best Execution rules did not affect that much the Italian equity space, but they surely did for fixed income asset classes”, says Luigi Campa, head of business strategy and development at EuroTLX. “Of course, there are historical reasons behind Italy being so evolved in the e-trading of bonds, the main one represented by the strong public debt”.

In fact, when the first stock exchange was set up by the Chamber of Commerce of Milan in 1808, this was done not for permitting the industry to have access to a different financing channel, but for ensuring a secondary market to public debt issues, so that until 1863 only government bonds were tradable. “It is during these years that the roots of our public debt can be traced back: when Italy was reunited in 1861, the decision to recognize all government bonds of those states that came together in the Italian Kingdom was taken in order to assure foreign investors about the credibility of the newborn state”, explains Campa. “Since then, the country has always relied upon borrowing, with public debt multiplying by 1,885 times within one century”.

Thus, Italian investors have historically been used to handling with debt securities, and not only with the ones issued by the government: the whole banking system relies on issuing fixed income instruments as a main funding mean. “Italian banks have the highest bonds / total collection ratio in Europe, around 40%, and these bonds are mainly sold to private investors, representing 32% of their total financial assets”, says Campa.

The result of this is a highly competitive fixed income scenario: when MiFID came into force in 2007, Italy’s decision to extend pre- and post-trade transparency requirements to bond securities came not as a surprise. At that time, there were already two regulated exchanges, four MTFs, 330 alternative trading systems (which shrank to 18 systematic internalisers right after November 1, with the rest declaring to be non systematic) and four different Smart Order Routers awarding those venues with the best conditions.

“The Italian retail-size market is very similar to the equity model”, says Campa. “Trades on venues such as EuroTLX all run on a central limit order book, with full pre-trade transparency on a five-level depth, with price and time priority, anonymous and continuous, and with complete post-trade transparency”, Luigi Campa says. “Of course, in a world made up by hundreds of thousands of bonds, most instruments are structurally illiquid and thus are not suitable to be traded on an exchange, but on a subset of fixed income securities, such as govies, supranational, corporate and banking bonds, it is possible to have a very liquid market.”

The efficiency of the whole system depends also from how the post-trading works. “This is entirely straight-through processing, with settlement instructions automatically sent in real time to the CSD, ICSDs or CCPs, and with a daily reconciliation report provided to each market member.”

The CCP feature, in particular, is being more and more appreciated by market participants, since it guarantees also anonymity in trading and lowers the tied-up capital required by regulators. “With the Capital Requirement Directive (CRD IV) and Basel III imposing capital constraints to European banks, holding inventories of corporate bonds on their books will become extremely expensive: the development of electronic order books enables these bond stocks to move more freely from investor to investor, without banks to have to act as risk absorbers. Flow and electronic bond-trading business are clearly the future.”

Campa expands, concerning the highly debated issue of transparency versus liquidity, “what we at EuroTLX have learnt in more than ten years of running fixed income e-trading venues is that an increase in transparency actually increases trades number and volumes”. Besides, even the US can be taken as an example, with most academic papers arguing that liquidity was not hindered by TRACE, the corporate bond market post-trade reporting system that was introduced in 2002.

“The electronification of cash fixed income in Europe has, however, still a long way to go: if about 60% of government bonds are traded electronically in the dealer-to-client market, on non-govies this percentage goes down to 20%”, says Campa. “And there is lot that has to be done on the entire value chain. For example, interoperability for all financial instruments on the CCP side, and a consolidated tape on the post-trading side. But we are quite optimistic, and by leveraging on the experience gained on our home market we want to play an important role in the current reshaping of the European fixed income scenario”.

©BestExecution |2012

 

 

Viewpoint : José Arnulfo Rodríguez San Martín

By
Ian Rycott
-

MEXICO: THE SMART INVESTMENT ALTERNATIVE.

ACCIVAL A.Rodriguez

José Arnulfo Rodríguez San Martín, Deputy Director of Investment Analysis at brokerage house Acciones y Valores Banamex reviews the economic fundamentals and market forecasts to make his case*.

In this Summer’s Olympic Games, the Mexican Olympic team won the football gold medal in a decisive match against favourites Brazil at Wembley Stadium. This event raised a question – is possible for the Mexican financial markets to emulate the success of its soccer team and become the best asset allocation alternative for international capital markets for the remainder of 2012, 2013 and even the years to follow? I would suggest that the economic fundamentals and market prospects make that a real possibility. My key arguments leading to this conclusion are:

1. The healthy state of public finances, favourable external accounts and improved growth prospects.

2. The political possibility that long-awaited structural reforms in the field of public finances, labour and energy could be implemented and executed, which could in turn lead to an improvement in Mexico’s sovereign debt rating – presently rated one notch above investment grade – and steer the country onto a path of stable growth.

3. The prospect of high returns in both equity and bond markets. The first sustained by strong local market performance and the second due to the high yields offered by local government bonds that could represent a clear credit arbitrage opportunity for international investors, especially when the solid Mexican public finances are considered.

Market performance

In spite of the adverse international financial and economic environment, the Mexican Stock market will probably be one of the most profitable markets in 2012 and certainly has been the most resilient one over the last few difficult years. Looking ahead, higher economic growth expectations for Mexico linked to higher expectations for economic recovery in the US, lead to a positive forecast for Mexican stock markets. This perspective, while being good in itself, could be greatly improved by the approval of important structural reforms and the upgrade of Mexico’s sovereign debt rating before mid-2013.

 

 

 

 

1) Mexican Stock Market Performance (USD)

 

 

International Stock Market Performance (USD)

 

2011 2012

 

Colombia -19.2 18.3

Mexico -13.4 18.0

S&P 500 0.0 11.8

India -36.5 9.3

DJIA 5.5 7.8

UK -6.0 5.7

Peru -13.3 5.1

Europe -11.4 2.7

Japan -14.5 -0.1

China -18.0 -4.7

Brazil -27.1 -5.6

 

Source: Accival with Reuters data

 

 

Economic growth and public finances

In the next couple of years the two main concerns that investors around the world will face are the following: poor economic growth and huge fiscal imbalances in several of the developed countries, which might lead to sovereign debt downgrades, reductions in bond prices and episodes of foreign exchange volatility. In light of these indicators one is led to the conclusion that Mexico presents a privileged position for investors in a world filled with uncertainty:

• Mexico’s 2012 forecasts for real economic growth fluctuate between 3.5% and 4.0%. This is a pretty good growth rate, especially when growth forecasts for USA – Mexico´s main commercial partner – are under 3.0%. This gained greater significance after the Presidential and congressional elections held in July, which suggest that Mexico is on track track to approve structural economic reforms that might be able to strengthen the internal market and contribute an additional source of economic growth.

• With a 40% public debt to GDP ratio and a 2.5% fiscal imbalance for 2012, Mexico presents a solid public finance scheme. Despite these figures international ratings agency Standard & Poor’s has kept Mexico’s sovereign rating at BBB, one notch above investment grade but seven notches below France and eight below Germany. However, the Credit Default Swap market has recognized Mexico’s superior credit quality by assigning risk premiums – measured as the spread over Treasury bonds – as only a bit higher than Germany’s and even lower than those for France. This evidence suggests that the markets could be discounting an improvement in Mexico’s sovereign debt rating in the near future.

• The yield to maturity for the 10-year local currency Mexican Bond began 2012 at 7.0%, but by mid-August had fallen to 5.4%, with an increasing effect on the bond’s secondary market prices and therefore producing important capital gains for tenors. This movement could be interpreted as another market reaction anticipating an improvement in the Mexican sovereign debt rating. However, even after this significant adjustment, yield rates offered by Mexican bonds still represent a very attractive investment opportunity, especially for international investors whose opportunity cost, judged against the US 10-year Treasury Note yield, fluctuates below 2.0%.

 

 

 

 

 

 

 

 

 

2) S&P: Credit Rating vs. 5Yr CDS

 

Source: Accival with Reuters data.

 

Friendly rate policy

Mexico’s foreign exchange rate policy is friendly to foreign investors since it is characterized by absolutely free currency convertibility at market rates, perfect capital mobility without restrictions or taxes, and a highly liquid market with many international participants. As a consequence the Mexican peso has become a good hedge currency against international volatility episodes, such as the US financial system crisis in 2008 and the Greek financial struggles in 2011. On the other hand, in the last twelve years Mexico’s manageable current account deficit – less than 2% of GDP – has been surpassed by a capital account surplus leading to an international reserve accumulation of approximately US$160 billion; a historical record for the country.

 

 

 

 

 

 

 

 

 

3) Local Currency Performance

 

Source: Accival with Reuters Data.

 

Structural reforms

In the last decade Mexico has developed an outstanding record of economic stability and adequate fiscal and monetary policies. However, rating agencies have been reluctant to improve Mexico’s sovereign debt grade for the following two arguments: first, Mexico’s slow rate of economic growth – a questionable argument this year – and second, its dependency on oil exports that represent about 35% of total Government income. In order to solve these structural problems and provide Mexico with a renewed economic framework capable of improving productivity, boosting economic growth and isolating public finances from oil price fluctuations, three structural reforms have been proposed:

1) Fiscal reform aimed at increasing the taxable base, rationalizing public expenditure and the introduction of universal consumption taxes linked to a universal social security system.

2) A labour law reform that will provide flexibility to the labour market by reducing the fixed costs of hiring and the approval of flexible hiring procedures.

3) An energy reform that will allow private investment in the energy sector. At the outset it will only allow investment in electric energy generation, and eventually oil extraction, which remains a delicate issue that will require a constitutional amendment.

In the last fifteen years these reforms have been proposed by different Presidential administrations but haven’t been approved due to a lack of consensus amongst the different political parties in Congress. The general election for President, Senate and House of Representatives held last July, resulted in a change of the ruling party in the Presidency, although it failed to obtain a majority in the Congress. Nevertheless, the main political parties have declared their intention to discuss these reforms in order to provide the structural changes required by the country. The achievement of a general consensus amongst the main political parties would make it feasible to see some of these reforms approved before mid-2013, in which case Mexico will definitely be the smart investment alternative.

*With special recognition to the Debt Analysis and Research Team in Mexico
 
©BestExecution | 2012

 

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