Will Psomadelis, Head of Trading, Schroders Australia and Stuart Baden Powell, RBC Capital Markets discuss the effects of artificial liquidity providers on the trading costs, speed of trading and market structure.
Stuart Baden Powell: We have all read and heard a range of industry opinion about HFT over the previous few quarters, be it from HFT themselves, from investment banks who provide services to HFT or execution venues who are part owned by HFT and happy to create pricing mechanisms such as the ‘maker taker’ or specific order types to attract HFT-type flow. Some banks view the HFT servicing part of their electronic trading desk as a tool for market share gains where commission charges are negligible, yet the payback is the benefit of increased control of liquidity and the boost to corporate business.
Execution venues are frequently judged on market share, but perhaps genuine value-added to the price formation process (not just the spread), reliability and overall liquidity quality should also be factored in. Bringing these points together, a question to pose is what the purchase price for Chi-X Europe would have been if it were itself publicly traded, exposed to full analyst transparency and recommendations, or even not principally owned by investment banks and HFT?
Dropping a level, practice-based publicly available knowledge on HFT is still limited. ESMA has noted the primary techniques being “usually either quasi market making or arbitraging”, some would note that the arbitrage could refer to an evolution of ‘non high frequency statistical arbitrage’, others would add latency and rebate arbitrage to the mix. Either way, these are mere high level descriptives and are not representative of what happens underneath; like algorithms it is not the flyer or website description that is key and like many things in life, it is the details and depth that matter. One of those details discussed in more cutting edge circles is the concept of artificial liquidity.
Will, you run a trading desk for a highly respected institutional fund manager; could you talk us through what artificial liquidity is about and how it impacts on you and the market?
Will Psomadelis: Thanks Stuart. Artificial and natural liquidity, being polar opposites in terms of the quality spectrum, are the result of two different strategies and are generally characterised by differing trade durations (or holding periods). Natural liquidity providers are generally investors that deploy capital in the market to extract a return from an underlying business. These include traditional long-only funds, retail, hedge funds and some fundamentally driven quant funds that invest for periods longer than a few minutes.
Artificial liquidity providers (ALPs) ignore company fundamentals and therefore make their decisions on metrics such as price momentum, correlations or by extracting a return through rebates or commissions to name a few. Market maker liquidity is a prime example of this type of churn that is held up as the Holy Grail by some regulators and the one that I believe doesn’t improve our transaction costs. Whilst arguments have been made that the retail investor can benefit from increased churn courtesy of HFT artificial liquidity primarily through tighter spreads, we should remember that no market-wide benefit can be extracted as spread compression is a zero sum game.
It can be then argued that increased artificial liquidity, which is what we are seeing globally, contributes to the deterioration of price discovery. When market volumes are dominated by trades that have no fundamental basis, stocks can move independently of underlying fundamentals. Empirical evidence shows that stocks now tend to overshoot fundamental news (X.F. Zhang, 2010), ultimately detracting from market efficiency and adding to volatility.
At the institutional order size level, remembering we are really just representing pools of retail investors, we can add to the points discussed above our belief that HFT cannot reduce market impact. The typical institutional order will usually have an order duration of greater than the entire holding duration of a position by a market maker, meaning every trade where we are trading against artificial liquidity, creates a competitor…..
At some point during the duration of the institutional order, the market maker will need to cover their position and therefore compete for stock. This is a real issue when ~70% of volumes are HFT in nature (Tabb Group, 2010 on the US market). Put simply, in the absence of someone willing to withdraw capital from the market at price, it is impossible to inject capital without incurring market impact, even if millions of shares are being churned around you during a game of high frequency ‘pass the parcel’.
The fact that market makers vanish in situations like the Flash Crash and create liquidity vacuums proves that natural investors should not be relying on them for liquidity as liquidity is not really what they provide. Non-predatory artificial liquidity may not necessarily add cost in theory, but it also cannot improve our transaction costs.
Inspecting Artificial Liquidity
Asia Pacific Trading Summit 2011 – Video Recap
By www.fix-events.com
Dark Pools in Asia: The Real Story
By Robert Laible, Lee Porter, Ned Phillips, David Rabinowitz, MIchael Corcoran, Greg Lee
FIXGlobal.com asked leading figures in the trading industry to share their insights into dark pools in Asia. In the first half of 2011, the number of dark pools operating in Asia increased, as did the volume traded on these venues.
Despite these increases, concerns remain about safety and gaming issues are a constant concern for long-only and institutional investors. Nonetheless, dark pool operators profess that their venues still meet the fundamental client demands for reduced market impact and lower trading costs.
What’s the real story with dark pools in Asia?
David Rabinowitz, UBS, Head of Direct Execution, Asian Equities
While Asia Pacific will see an expansion in terms of the types of dark pools in which non-displayed liquidity resides, the continued development of broker-led internal crossing engines will remain the primary dark source for market participants seeking to trade anonymously in an attempt to minimise information leakage and capture some price improvement in the process. The associated smart order-routing capabilities necessary to connect these alternative sources will drive liquidity strategy into 2012.
Rob Laible, Nomura, Managing Director, Nomura International Hong Kong
The real story is that dark pools fill a void that the exchanges are not equipped to deal with. Also, they save money – whether the buy-side can do a block with no information leakage, or the sell-side algo does not have to cross the spread (which means better performance). TCA has the ability to measure the cost savings and it is resonating with those in Asia that are looking to preserve alpha and increase their performance.
Michael Corcoran, ITG Asia Pacific, Managing Director and Head of Sales and Trading
The Asian dark pool story is still in its early growth phase. ITG is seeing increasing demand from global and Asia-based buy-side for tools that reduce the high costs of trading in the region. Dark liquidity is key, and with dark aggregation addressing some of the issues of Asia’s fragmented liquidity, volumes will continue to rise.
Ned Phillips, Chi-East, CEO
Are dark pools here to stay? Yes. Dark pools in their purest form are the end product of what savvy traders have been doing manually for years on the phone – seeking liquidity and best execution. Is there a danger of gaming? Yes, but it’s way less in dark pools then in manual off-market crossing with the information leakage that occurs there. Dark pool consolidation? We need more pools in Asia first before we can consolidate.
Lee Porter, Liquidnet Asia, Regional Head
All dark pools have a duty to protect and police their communities to ensure the highest standard for members and other stakeholders. The integrity of our platform is key to Liquidnet’s success and that is why we don’t hesitate in asking members to leave if they are not playing by the rules. At the same time, ongoing improvements in technology is aiding the industry and helping ease industry concerns.
Greg Lee, Deutsche Bank, Head of Autobahn Equity Asia
There isn’t a generic answer for the entire region when it comes to dark pools. Different structure and regulations will determine each markets direction. In Japan and Hong Kong we expect that these volumes will continue to rise. Hong Kong regulation doesn’t permit alternative displayed venues, so the market is looking to dark pools for alternative liquidity.
In Japan they have growing PTS volumes, so this could detract from the dark pool growth. In Singapore the minimum crossing size will prevent growth. In Australia they have the on exchange Centerpoint cross, which is growing, but they are also looking at increasing their minimum crossing size for off-exchange dark pools, which would have a negative effect. Outside of these markets, we see little or no dark pool activity or planned growth.
John Greenan : BNP Paribas Investment Partners
WHAT’S IN A NAME?
High Frequency Trading seems to be a catchphrase for all and sundry but John Greenan explains why HFT is so hard to define.
Q. Is high frequency trading good for your business, the market and end investors?
A. To begin with one of the things about high frequency trading is that not many understand what it actually means. It is a not relationship based form of trading but it has become an umbrella term used as a pejorative. However, I think the HFT community has been somewhat remiss in defending itself and has not tried to state the case for HFT. The phenomenon has been around a long time in different ways.
As for whether it is good for business, I do not think the answer is clear. There is a lack of intelligent and rigorous studies about the impact HFT has on the market, end investors and business in general. I think there needs to be more analysis going forward.
Q. How would you define HFT?
A. One of the problems though given our current environment is that there is no nice soundbite to sum up what HFT means. I would not define it as such but categorise HFT in terms of the ratio of cancels that is sent to an execution venue versus the number of orders. In the past, you would place an order on the order book and expect it to be executed. Today, I would look at HFT on a case-by-case basis. Some of the criteria I would look at are the traders’ intentions, trading strategies and the tools being used.
Q. Some market participants will say that liquidity is one of the positives of HFT. Do you agree?
A. HFT focuses on intraday liquidity and attempts to create a two-sided market without market making obligations. It is difficult though to determine whether HFT does actually create liquidity. However, by coming to the market, high frequency traders arbitrage away any price differentials and that does create value in that it makes the market more efficient.
Q. What impact do you think the current regulation will have?
A. In effect policy makers will draw a line in the sand and everyone will have to fit in around that. One of the problems is that the desire to regulate has increased massively since the global financial crisis and this has changed what people view as acceptable. At the high level The Securities and Exchange Commission (SEC) is continuing to discuss which direction new rules on high-frequency trades should take, while in Europe there are regulations such as MiFID II. They have not made any statements but are asking a lot of questions to the various market participants. It does not seem possible in this current climate to have a rigorous and in-depth debate.
The anti-HFT lobby is driving the discussion but the community needs to be more proactive about what it brings to the market. Take the ‘flash crash’, the finger pointing and blaming was enormous but I do not believe that there is enough hard evidence to show who was at fault. Instead, there was an element of control mechanisms not being in place, which is why it is so important that people build and have the right risk management systems in place.
Q. What do you think will be the outcome of all the regulation?
A. As with any human action there will be intended and unintended consequences. It is not clear what the final result will be but there will definitely be more regulation. In terms of the impact, it will cause problems as well as create opportunities. New market participants may benefit while existing ones could feel the pain. We are seeing many firms hiring regulatory affairs liaison officers in order to keep up to date with the latest developments. Their job is to regularly talk to the regulators which will help them identify the potential new and future opportunities.
Q. Against the backdrop do you think we will see a new generation of HFT?
A. There is talk of a new generation of tools being developed but I think it is more of a generational shift. What we are seeing is a technological arms race in the purest sense. One firm builds a state of the art tank and then another firm develops the technology to blow it up. At the end of the day it is the same thing but the technology is better and faster which in turn opens up more opportunities. It’s like what Sean Connery’s character Malone says in the film The Untouchables – you don’t bring a knife to a gunfight. You need bigger guns.
Q. Who are the market participants?
A. The barriers of entry are high in terms of finding people with the right skill set. You may have the cash but there is a steep learning curve and training people is not that easy. If you are a new firm, you may want to poach someone away from their existing firm but that is a slow growing strategy.
Q. What impact do you think the current spate of exchange consolidation will have on the industry?
A. I think it will take time to see any impact because all of these mergers are subject to regulatory approval. All the moves, whether it is London and Toronto or Deutsche Bšrse and NYSE Euronext, are defensive but at the end of the day what matters is whether they can deliver the technology at a lower cost. If they move towards FIX interfaces and traders can connect in a more cost efficient way then I don’t think people will care who the owners are or what the stock exchanges are called. In many ways it is like the development of the electricity industry in that no one cares about the owners as long as they can plug into their own supply.
[Biography]
John Greenan is global multi-asset connectivity manager at BNP Paribas Investment Partners. Prior to this job, Greenan had a number of international consulting roles within investment banks, asset managers, hedge funds and their suppliers. Greenan has a BA Hons, in economics from University of Nottingham.
©BEST EXECUTION
Brian Schwieger : Bank of America Merrill Lynch
CHANGING DIRECTIONS.
Brian Schwieger, head of EMEA algorithmic execution for Bank of America Merrill Lynch explains that trading in these markets is anything but smooth sailing.
Q. How would you summarise the current trading conditions? Is lower volumes the new normal?
A. If you look at volumes over the past couple of months, they have actually been stronger, particularly in relation to the past two years. Admittedly they did fall off in the fourth quarter of last year but usage is back up where it was at this time in 2010. These were the trends before the recent activity around the Japanese situation. One of the main reasons behind those trends was the rebalancing activity we saw from several fund managers, rotating into European equities and out of emerging markets and fixed income.
Q. In general what are the trends in electronic trading for the buyside?
A. It has taken time for the buyside to invest in all the infrastructure required for electronic trading as this is not just about sending the orders over electronically. It also impacts the back and middle office functions in terms of the processing, clearing and settlement of the trades. What is clear is that the number of firms using electronic trading is rapidly increasing with the proliferation of Execution Management Systems among buyside traders.
Q. And the sellside? The financial crisis took its toll on the bulge brackets but they still dominate. Why is that?
A. With the buyside investment in electronic trading, there is the initial investment and then ongoing maintenance. For the sellside, it is a continuing process of developing new trading techniques to improve the performance and efficiency of the electronic trading experience. It is a very competitive market and as a result you have to continue to support and invest in a sophisticated trading infrastructure. However, barriers to entry are high which is why the bulge bracket banks still dominate. These firms are able to capture the required scale to justify this investment because of the breadth of their relationships and services. It’s not just about electronic execution, but services across the board including prime brokerage, investment banking and foreign exchange. It is also down to old-fashioned human relationships and the quality of services and products. The firms that have helped their clients get through the financial crisis have found that their client relationships remain strong.
Q. In terms of the development of products, what algos are being used today?
A. I would say in terms of general usage, people have gone in two directions. They have either opted for lower impact VWAP type algos over a longer period or used more aggressive, shorter duration tactical algos. The next generation of algos are much more sophisticated, intelligent and timely. They are leveraging some of the approaches used in high frequency trading. For example, some are using complex event processing platforms to monitor and create signals which the appropriate algos can react to.
Q. What about developments in the futures industry?
A. Everyone has recognised that equities have led the way in terms of the development and sophistication, but not everything that has been done in the equity space is leverageable, or even desirable, for futures. Futures do not yet require smart order routing, and the liquidity and microstructure patterns are very different. From a trading perspective, there is a much greater emphasis on the granularity of scheduling with futures algos. The most popular approach in futures is TWAP (time-weighted average price). This is because traders are often very sensitive to what their exposure and risk profile is second by second compared to equities, where traders place a higher emphasis on ease of use because of the higher order flow.
Q. What impact do you think that MiFID and other regulation will have on the market?
A. One of the issues is the lack of a consolidated tape although I think MiFID II will provide a framework that will allow the industry to make some progress in creating one. Another area of much discussion is delayed reporting. (CESR proposed shortening permitted delays to ensure that the vast majority of trades are reported no later than the end of the trading day). If approved, this could result in an increase in the cost of capital for many buyside institutions when looking to trade large blocks of stock. The other hot topic is the classification of trading platforms, and what the differences will be between an OTF (Organised Trading Facility) and
an MTF.
Q. What impact do you think that the current spate of exchange mergers will have on the market?
A. I think the impact will be greater on the sellside versus the buyside. In some ways though it opens the door to improved efficiency because there should be fewer platforms to connect to. That could make our job easier as in the past the industry had to undergo a number of technological upgrades and maintenance work for each trading platform that we are connected to. Consolidation of technology is one of the drivers for venue consolidation, but this can take time as the NYSE-Archipelago merger illustrated – it reportedly took 4-5 years to consolidate technology here.
On the other hand, there are some potential competitive concerns which venue consolidation raises, and we’ll have to wait and see how this pans out with both the regulators and then in practice.
Q. Looking ahead, what are the challenges and opportunities ahead?
A. The major challenge is to keep making the investments that will enable us to remain competitive. The opportunities are taking what we have learnt in terms of efficient execution in the equity space and applying that across all asset classes. l
[Biography]
Brian Schwieger is a managing director in charge of EMEA Algorithmic Trading for Bank of America Merrill Lynch. Schwieger joined Merrill Lynch in 2005 with the responsibility to build their sales trading desk for Algorithmic Trading. With over 15 years of trading experience, he helps traders and clients understand and identify the algorithmic strategies and tactics, which best suit their objectives. His previous trading experience spans equity portfolio, equity cash and commodities (Oil & Gas). Schwieger holds a Masters in Finance from London Business School and a BSc (Econ) from the London School of Economics.
©BEST EXECUTION
Christian Bower : QuoteMTF
AIMING HIGH.
Competition may be intense but Christian Bower, commercial director, Quote MTF believes there is definitely room for one more execution platform.
Q. Is Quote MTF still on target for the April 4th launch?
A. Yes we are. We have publicly confirmed a minimum of eight liquidity providers committed to the platform via our equity participation programme. In many ways it feels like we have been an F1 racing team with an optimised car that has been raring to go, and finally we have secured our crew of drivers.
The trading companies who have become our liquidity partners are drawn from the UK, France, the Netherlands and Ireland, some having US parentage. We have had to bide our time but support has rallied behind Quote MTF and I think one of the main catalysts for this has been the current wave of consolidation, such as the proposed mergers between Chi-X and BATS, the London and Toronto Stock Exchanges, and Deutsche Börse and NYSE Euronext. These mergers are unleashing further pressure for a sustained number of lit platforms to keep user costs competitive and optimise trading opportunity.
Q. What market share are you aiming for?
A. Our immediate target is €1bn in average daily traded volume and we hope to achieve this as quickly as possible, but certainly by year end. We are aiming for a 5-6% market share in pan-European equities over the next 18 months but there is no doubt that the business environment is much tougher today than four years’ ago when Chi-X launched. While we have the advantage of more liquidity providers signed up from the outset – other platforms I understand had three or four passive participants and quickly gained market share – today’s participants are pressed on technological resources and are cautious where they spend tighter budgets.
Equally, having seen several venues fail, participants are much more focused on whether you have a sustainable business model and the trading / business case of why they should be using your platform. That said, because the pioneering companies have explained the MTF concept, we’re not having to start from scratch as they had to. Indeed, the brokers have already invested heavily into the technology required to cope with fragmentation, so the cost of adding new venues to smart order routers, for example, is much lower.
Q. There are many MTFs in the marketplace and consolidation is taking place. What are your differentiators?
A. To me one of the biggest differentiators is that we have an efficient business model. We run at a fraction of the cost of the existing MTFs and our breakeven point is considerably less than what is required by other alternative venues. While our operations are hosted at the Interxion data centre in the City of London, and we will be clearing all trades through the EMCF (European Multilateral Clearing Facility), we achieve our cost efficiency by leveraging technology and operational capacity across platforms, and gravitating to lower cost centres of business. This latter point has been particularly important as we build out our regulatory and supervisory divisions in the wake of pressure from the European Regulators.
This economic longevity argument means that we present a truly viable solution for sustained market competition and that the intellectual and technological investment made in dealing with fragmentation will continue to serve a purpose. It also reduces price pressure on us and allows us to be competitive while delivering the highest quality of service.
Our exchange fees sit at a floor-breaking 0.14bps for taking liquidity and we will continue to cap our fees at €14,000 until 2012. This will ensure that we can pass these savings straight on to the end users.
Q. Why did you decide on equity participation and not giving rebates?
A. From the outset it was our intention to develop the business organically with the brokers attracting the passive providers. Most recently we have been strongly led by market participants who advised us to maintain the differentiator in our fee structure. We are offering our participants a 40% stake in exchange for liquidity. This effectively creates an alternative mechanism of inducing passive flow but, we feel, aligns the interests of the trading firm more closely with the business. By offering liquidity providers ownership in the company they are more incentivised to contribute to the platform’s long-term success, which also helps to remove some of the criticisms surrounding high-frequency strategies.
Q. Who do you view as your major competition?
A. Some people would say that any venue in the lit market is a competitor, but look it at from a retail sector point of view. Take Philip Green [Sir Philip Green, boss of UK retail group, Arcadia – Ed.]. He opens several shops on a high street, which to some extent compete but together make the high street a more attractive market place to visit, increasing choice, competition and expanding the hinterland. Equally, it has not stopped him expanding his portfolio of stores, or stopped other shops from opening. The combined force of these shops has attracted people to this area and this creates volume and trading in its own right. I think the same thing applies to the trading venues. Rather than the various lit venues viewing each other as competitors, I think we all value each other’s existence. In fact, I have had good advice and guidance from heads of other MTFs. I think a fragmented market is a positive thing in that it gives people choice and ensures accurate pricing. I also believe that Quote MTF could benefit from the merger between Chi-X and BATS’ MTFs in Europe in that they have similar users, some of which could look to diversify and utilise additional platforms.
Overall, I reckon the optimal size for the market is about six to ten liquidity pools. In many ways it will be like the development of the ATMs in the banking industry. People needed to see enough coverage, and continuity of coverage, for the concept to exist, but then are impartial about who the operators are as long as they get the right service, efficiencies, price and technology.
Q. What impact do you think the regulation will have on the company?
Ironically, in many ways Quote MTF is symbolic of the current regulatory ideology. We are a lit pool and have no intention to launch a dark offering or smart order routing services. This fits into the current environment where regulators are placing a great deal of emphasis on transparency. There are several discussions over how to classify dark pools and broker crossing networks. I think the regulation that is being proposed will drive some flow back to the lit market and may force some of the firms to change their model.
Q. Looking ahead, what do you see as the industry’s biggest challenges?
The traditional exchanges are going to find it increasingly tough to remain viable in equities trading but they have an important role to play and the MTFs are there to take up the slack for equities as they refocus on other business areas and product types. From MiFID II and ESMA specifically, we anticipate heightened regulation and surveillance and to that end we are spending serious money on personnel and technology to comply with future rules. Some of this endeavour will focus on cross-venue surveillance and working with the regulators to provide the attributed audit trail or large trader ID data they require. And of course we are all in the hands of fate when it comes to investors’ appetite for equities. Another downturn in volumes could wipe out additional trading venues, so keeping operational costs low is crucial.
[Biography]
Christian Bower is commercial director at Quote MTF. Previously he worked as a consultant to the investment management, trading and capital markets. The focus has been creating technology businesses and managing business generation for financial institutions and business-critical software companies. He was also office manager EMEA for Portware UK.
©BEST EXECUTION
IIROC and FIX Protocol
By Eric Whaley
The Investment Industry Regulatory Organization of Canada (IIROC) will adopt a FIX-based protocol as the standard regulatory feed specification for all equity exchanges and marketplaces operating in Canada. IIROC regulates Canada’s investment dealers and all equity and debt marketplaces in the country. The organization was formed in 2008 through the merger of the Investment Dealers Association of Canada and Market Regulation Services Inc. IIROC’s adoption of FIX means IIROC joins a global list of institutions that already leverage FIX for their electronic exchange of information.
IIROC has selected FIX for all its regulatory data feeds to ensure that the protocol it mandates for Canadian regulatory market data is in-line with global practices and is a cost-effective and flexible standard that can be adopted by market participants.
The adoption of FIX for all regulatory market data feeds is a necessary part of IIROC’s Surveillance Technology Enhancement Platform, or “STEP”, initiative. Launched in 2008, STEP is the implementation of a new cross-market surveillance platform to monitor trading on all equity marketplaces and exchanges operating in Canada. IIROC’s STEP program’s key objective reflects the complex realities of today’s trading environment. Once implemented, the program will provide an efficient, cost-effective system for realtime market surveillance across multiple marketplaces. As the markets continue evolving, the platform will allow for flexibility and speed-to-market enhancements in response to shifting market structures and trading volumes. IIROC expects full implementation of the STEP platform in Q1 2010.
IIROC’s standardization of the regulatory feed in the FIX format includes nearly six months of consultation with FPL. The two organizations worked together to design a FIX standard specification that would meet IIROC’s need for timely and accurate trade information from the equity marketplaces it monitors.
The collaboration between IIROC and FPL became a successful partnership. Together the two organizations conducted a gap analysis to identify current data needs and reviewed data specifications to determine how the FIX Protocol could best be leveraged. IIROC concluded that the FIX message standard provided the most costeffective and flexible solution for trading data in a multi-market environment.
Since FIX is an open standard used around the world, this will also contribute to keeping Canada’s capital markets efficient and competitive by allowing existing exchanges and future entrants to interface with a standard industry messaging protocol.
For regulators such as IIROC, rapidly changing market conditions present an ongoing challenge to maintaining effective compliance oversight and market surveillance. IIROC is confident that FIX will assist the needs of both regulators and marketplaces by providing the standardization and flexibility required to keep pace with the evolution of Canada’s capital markets.
Keeping Risk at Bay: A Systemic Approach
Timothy Furey, Goldman Sachs, Neal Goldstein, Nomura and John Goeller, Bank of America Merrill Lynch, shed light on the process of managing risk in electronic trading.
At the start of this year, FPL announced the completion of an initial set of guidelines, which recommends risk management best practices in electronic trading for institutional market participants. In the third quarter of 2010, FPL launched a group to raise awareness regarding the implications of electronic trading on risk management and to develop standardized best practices for industry consideration. Over the last few months, the group, which consists of a number of senior leaders in electronic trading from the major sell-side firms, has been working on developing this set of guidelines to encourage broker-dealers to incorporate a baseline set of standardized risk controls.
The objective of the guidelines is to provide information around risk management and encourage firms to incorporate best practices in support of their electronic trading platforms. In today’s volatile marketplace, the automation of complex electronic trading strategies increasingly demands a rational set of pre-trade, intra-day and pattern risk controls to protect the interests of the buy-side client, the sell-side broker and the integrity of the market. The objective of applying electronic order risk controls is to prevent situations where a client, the broker and/or the market can be adversely impacted by flawed electronic orders.
The scope of the particular set of risk controls included in the guidelines is for electronic orders delivered directly to an algorithmic trading product or to a Direct Market Access (DMA) trading destination. The recommended risk controls included provide the financial services community with a set of suggested guidelines that will systemically minimize the inherent risk of executing electronic algorithmic and DMA orders.
In what area are sell-side and buy-side firms’ risk controls most in need of improvement?
Timothy Furey, Managing Director, Goldman Sachs and FPL Risk Management Committee Co-Chair:
One of the observations coming from the FPL risk sessions was that the buy-side and sell-side had really given considerable thought to their own individual firm’s risk controls. That said, both the sell-side and the buy-side should continue to focus on pulling together a standard, consistent base set of controls that their respective firms can reasonably implement. Therefore, it is more a question of standardization than a need for specific improvement.
John Goeller, FPL Americas Regional Committee Co-Chair and Managing Director, Global Execution Services, Bank of America Merrill Lynch:
This effort was not necessarily to address an apparent deficiency in how the buy-side or the sell-side handles risk management, but to codify a set of best practices for all firms to use. It was generally accepted when we started this process that all firms implement some level of risk controls around their business. Our goal was to identify the most common ones and ensure that we have a base set of controls that all firms can implement.
Neal Goldstein, Managing Director, Nomura Securities International and FPL Risk Management Committee Co-Chair:
It is important for the buy-side community to recognize that their efforts to implement risk management controls for electronic trading will be more effective when a collaborative effort is made with their sell-side executing brokers. For algorithmic and conventional (low frequency) DMA orders, the first line of defense should be the risk controls incorporated within the buy-side OMS/EMS. The most effective risk control is to prevent a questionable order from leaving the buy-side OMS/EMS.
A specific factor that the buy-side should be looking at more closely is the impact a given order has on available liquidity. While the order validation employed by many buy-side clients accounts for notional value and order quantity, another factor that needs more consideration is the Average Daily Volume (ADV) during the trading interval. Creating an order to trade, where the volume participation rate may exceed ADV for a given interval, can have significant adverse impact on execution price and algorithmic performance, particularly for illiquid names.
What role, if any, should the exchanges play in implementing risk controls?
John Goeller: Most exchanges have technology solutions (in certain situations it is mandatory) around risk management. In some cases, these tools are optional and only work when accessing a particular exchange. Regardless, if a firm is utilizing exchange provided tools, home-grown, or vendor-supplied, they can still leverage our efforts to understand whether their tools are implementing industry best practices.
Neal Goldstein: The exchanges have already been playing a keyrole by implementing protection mechanisms, such as circuit breakerson individual securities, in response to excessive price moves. Having effective risk controls applied upstream by the client and the broker trading systems should effectively address a high percentage of risk management scenarios related to order entry. There are some obvious ules related to FIX connectivity, such as canceling all open orders on disconnect and the detection of questionable order entry patterns, that make a lot of sense to have.
Timothy Furey: The most important aspect of the work done thus far by the FPL Risk Committee is to point out that regardless of where risk controls sit, it is critical that we all work together to determine the most appropriate and most efficient ways to protect the marketplace.
How often do you think the ‘Pause’ option will be applied by brokers: hourly, daily, weekly? Also, how would a firm whose primary trading strategy is high frequency/low touch incorporate this guideline?
Neal Goldstein: For algorithmic order flow, I would expect that sell-side brokers will pause questionable orders a couple of times per day, particularly around ADV thresholds for illiquid names. Orders that exceed ADV thresholds are far more common than the conventional “fat finger” error, where an extra zero is inadvertently applied on the order quantity. The concept of pausing is more relevant to algorithmic trading, where orders tend to be larger and trade over longer horizons. For high frequency trading clients, where orders have typically smaller size and are highly sensitive to latency, any order that exceeds a broker’s risk threshold should be rejected immediately, rather than paused.
Timothy Furey: The notion of a “Pause” is not new in the world of algorithmic trading, where intelligently and effectively working an order may be part of a particular strategy. Similarly, with orders that go directly to the market, if an agreed upon control is triggered based on prevailing conditions, there may be instances where rejecting or pausing the order may be the appropriate strategy.
John Goeller: Pausing orders versus outright rejecting them really depends on the business flow and the arrangement with the client. An electronic order that pauses after exceeding a threshold is typically an algorithmic order that is expected to be worked over a certain time horizon in an algorithmic trading engine. When an algorithmic order is paused, a sales trader at the broker dealer will assess the risk and either send the order on or call the client for further clarification. This is in contrast to a DMA order (low-touch, high frequency), which requires an immediate response, so most trading systems will reject the order when it exceeds a risk threshold.
Buy-side on Execution Venue Reporting: Untangling Trade Reports
Wellington Management’s Lee Saba and Capital Group’s Brian Lees and Bill Rosner discuss the FPL Americas Buy-side Working Group and its recent work on execution venue reporting.
FIX Protocol Ltd. (FPL) launched Buy-Side Working Groups in the Americas, EMEA and Asia Pacific regions in order to provide a platform for buy-side representatives to discuss how their needs can be efficiently met by the automated trading community. As an initial task the group prioritized their main concerns which resulted in a focus on the following areas:
- Post-Trade – generating best practices for different allocation methods and creating a central repository for ‘best practices’ that users could leverage to standardize messaging in the post-trade space.
- Test Symbology – providing the financial community with risk averse tools for production validation of complex trading and portfolio management systems.
- Execution Venue – standardizing the reporting of the executing venue and creating a rules of engagement/best practices document.
The primary focus of the Execution Venue Initiative, listed above, has been to seek a more consistent response from the broker-dealer community with regards to broker reporting of the execution venue on each fill. As a result, the group has sought to standardize and expand the information received in trade reports from brokers by creating a best practices document to help resolve these challenges. The buy-side participants would like to encourage the sell-side community at large to implement these guidelines after consulting with their clients on the readiness of their systems.
Although some of the information being requested is not new and brokers have been supplying this data in their trade reports for some time, the type, amount and how information is sent from distinct brokers to the buy-side varies. Therefore, the information that is being requested as part of the guidelines will enable the buy-side traders to:
- Increase awareness of where their orders are being filled as the market continues to fragment into dozens of dark and lit trading venues.
- Better understand if the venues receiving their orders are the most desirable.
- Enable money managers to determine whether or not the routing decisions of the brokers were made to the benefit of the broker or the client.
It is important to note that this initiative is not focused on any major changes to the FIX Protocol specification itself but the establishment of a set of best practices with a goal to lead to greater consistency and standardization among broker practices.
FIXGlobal: What was the genesis of this idea?
Bill Rosner, Manager of Application Development, The Capital Group Companies and FPL Execution Venue Working Group Co-Chair:
The idea to do this particular effort stemmed from a survey that FPL held in early 2010. Buy-side firms were asked to rank the importance of various streams of work that we were preparing to undertake and the Execution Venue topic received a great deal of interest.
Lee Saba, Vice President, Wellington Management and FPL Buy Side Working Group Chairman:
The execution venue concept is not a new idea but one the FPL Buy-Side Working Group felt could satisfy our trading desks’ demand for more transparency in the equity marketplace. As the Buy-Side Working Group was forming, we quickly realized we had many similar initiatives and decided to pursue them together. As a collection of buy-side firms we felt if we agreed in principal to an execution venue standard the dealers would have more reason to adopt the request.
Brian Lees, AVP, Manager of Application Development, The Capital Group Companies and FPL Execution Venue Working Group Co-chair:
As the Buy-Side Working Group was discussing where to focus its initial efforts, this topic clearly struck a chord. As the equity market has become increasingly fragmented through the proliferation of electronic venues in recent years, it feels natural to begin asking for information about where and how our order flow is being executed.
FIXGlobal: How will this additional information improve traders’ decision making capabilities and will the offset in broker workload be commensurate?
Bill Rosner: In general, the buy-side traders are going to have better visibility into how and where their orders trade. With that comes the ability to make better decisions about when, where and how they place orders. A large percentage of the flow that we send through brokers today should contain this information; the working group surveyed many brokers and each said that the information is largely available. So it seems the buy-side hasn’t done a good job of communicating its wishes to the brokers and requesting this information in a readily consumable format. In the end, that was the goal of this group. We want to be sensitive to the capabilities of the sell-side while working with them to develop a consistent approach toward meeting our goals.
Lee Saba: I believe there are two major improvements by standardizing the execution reporting. The first is real time analytics per FIX placement provided to our traders. The more information we can provide real-time to our traders, the better the execution quality for our clients. Secondly, we can provide a more detailed historical experience for our execution quality analysts from last market, liquidity indicators and capacity standardization. In regard to your workload question, the feedback from the broker community has been very positive for the Execution Venue Initiative and the creation of the Buy-Side Working Group. The dealers can hopefully realize cost savings by no longer needing to build custom interfaces for each client if the buy-side agrees on the basic framework. It works both ways – we get our initiatives completed and the sell-side saves by building it once.
Brian Lees: The transparency provided by this information allows the buy-side to keep its finger on the pulse of its orders in real time and enriches trade data. This should also create opportunities for additional post-trade analysis. For the broker, the ability to deliver this information in a consistent manner should reduce the proliferation of client-specific data translation requests that are costly to maintain. We therefore see this as a win-win situation.
FIXGlobal: Where do you anticipate hurdles in achieving adoption for the Execution Venue best practices?
Bill Rosner: We believe the biggest hurdle will be making sure each execution venue, without exception, is represented by an ISO Market Identifier Code (MIC). This is particularly important where dark pools, especially those run by the sell-sides, come into play. That’s where visibility gets murky. The Execution Venue Working Group is committed to reducing these gaps in visibility by consistently screening the data we receive and providing feedback to the sell-side community.
Lee Saba: One major hurdle is having all execution venues listed with the ISO MIC standard. Through our analysis we found active execution venues that have yet to register a MIC. Some venues have lit and dark books and we would like to know exactly where we printed. At a later date we may define FIX workflows for all non-ISO executions but we’ll save that for the future. One last thought, before receiving the new execution data, I highly recommend testing with your counterparty as there will be some work to calibrate their systems to handle the new FIX tags.
Brian Lees: The biggest hurdle is likely to be achieving a high percentage of ISO MIC registration among the venues that are out there, and doing so in a way that distinguishes between dark and lit books. In general we anticipate that once this information starts to be collected in earnest, some adjustments will be necessary to iron out any wrinkles that develop. One area of uncertainty is whether this information will be consistently provided in situations where one venue routes out to another. The working group briefly discussed this but decided to defer the topic to a later time.
FIXGlobal: What are the mechanisms for adapting these best practices after implementation?
Bill Rosner: Constant feedback and communication among the buy-side and sell-side communities. We’ve been very encouraged by the desire that the sell-side community has shown to work with us to get this information flowing. In addition, the other FPL regional buy-side committees (EMEA and Asia Pac) and FPL Global Technical Committee have been great in providing feedback and support for this effort. We’re looking to leverage those relationships as we push toward complete adoption of the execution venue best practices.
Lee Saba: As a buy-side firm you’ll want a quick and easy way to capture the data in real time as well as historically. Also, as execution venues come and go you’ll need to track these changes. Essentially rendering, tracking and storing the execution data will be very important.
Brian Lees: We see this as an iterative process. Once this information begins to flow from the sell-side, validation of the data on the buy-side will be necessary to ensure completeness so that some follow up can occur to address inaccuracies and omissions. Brokers in turn may need to follow up with some of the venues to encourage them to provide the necessary data. Diligence in creating this analysis/feedback loop will be an important ingredient for success.
From High-Frequency Trading to High-Touch Trading
IPC’s Jonathan Morton discusses the role of voice communication systems an the world of high frequency trading.
It seems like everyone defines “high frequency trading” slightly differently. Ask ten industry veterans and you will get ten variations on a similar concept. While it may be difficult to pin down an exact definition of high frequency trading, there are definite characteristics that help define the trading strategy. High frequency trading depends on speed of execution and ultralow latency.
High frequency trading involves the large-scale turnover of numerous positions, making a small return on each turnover. Traders use intricate algorithms that are based on good models run on fast computational technology to calculate and run the models, executed on a high speed basis.
Although even as high frequency trading continues to grow in popularity, there are still calls for high-touch trading activities that utilize voice communication systems. In trading derivatives, for example, voice communications is a key component. It has been hypothesized that the move to electronic execution systems could lead to a sharp decline in voice trading on many trading floors.
On the contrary, the role of voice communications continues to play a significant part in the trade lifecycle. High-monetary value trades demand a certain amount of voice interaction from multiple parties in order to formulate a decision on an execution process. If the trading of OTC derivatives is moved to new swap execution facilities, traders will still need to rely on voice solutions for sharing information and collaboration between traders and other experts within their organizations.
To truly understand the importance of collaboration across the various entities on a trading floor, it is first necessary to note the environment in which a trader operates. Traders communicate constantly with sales traders, clients, research analysts, portfolio managers and financial advisors, constantly working to meet the needs of the firm, stay in sync with the strategy of their desk and make money for their clients.
A trading floor communication system is a critical component in enabling this communication and collaboration. There is an extensive array of required capabilities, ranging from voice facilities, such as intercom and archival systems, to integration with the PC applications traders use, such as CRM, OMS and market data applications.
Integration with other systems and applications using industry and open standards is becoming increasingly critical in allowing traders to work efficiently and maximize their productivity. When a volatile market environment is layered with real-time electronic information feeds and multiple, complex financial instruments, it becomes challenging for traders to facilitate all of the steps needed to execute a trade. Numerous members of the trading community, be they product experts, analysts, risk managers or brokers, are continuously involved in negotiating for the best price to ensure that the final transaction is viable for both the customer and the trading institution.
As each trade moves across the trade lifecycle from the front to back office, it touches multiple members. The result is an increasing demand for transparency from compliance teams, for more efficient and direct communication across both, the trading floor and the enterprise, as they establish and execute strategies. Systems that provide the middle and back office staff with access to the same private lines used by traders, help enhance voice communication with the front office.
Using industry standards, line sharing across the trading floor enables traders to instantly access the appropriate team members on a call. This, in turn, provides greater transparency for compliance team members as they can easily be kept “in the loop” on each trade by connecting more efficiently to traders within their firm. In the high stakes world of trading, optimized voice communications technology and streamlined workflows enhance efficiency and collaboration within organizations.
Prior to executing a high-monetary multilateral trade, a significant percentage of traders use a combination of electronic and voice trading systems to gather information and market color from other market participants and to collaborate with other members in their company’s network. Newer trading platforms seamlessly integrate Voice over Internet Protocol (VoIP) for direct market access, spanning multiple asset classes to execute high-frequency trades swiftly.
The combination of low-touch and high-touch trading systems for financial services firms creates numerous opportunities with significant advantages for all trading participants. The future trading floor will look to leverage both strategies for success and ultimately, improve a firm’s operations.
