By Kevin McPartland
Extending FIX implementations to support OTC trading and clearing
FIX is becoming a viable protocol for the trading and clearing of OTC products, as regulators usher the OTC world toward transparency and standardization. Credit Default Swaps (CDS), FX forwards and FX swaps are the latest set of financial instruments to experience a move toward standardization and are fitting nicely into the model provided by FIX while, the OTC energy market has been leveraging FIX for several years. In response, the industry is starting to see clearing service providers offer new trade confirmation and clearing solutions that allow FIX implementations to be extended from vanilla equity and listed derivatives products to standardized OTC products. CME Group’s Matt Simpson explains that this has the potential to allow significant savings for participants who can likewise extend their existing FIX implementations to support OTC trading and clearing.
Clearing houses make stride
Over the last 18 months regulators have aggressively pushed OTC markets toward standardization in order to achieve price transparency and eliminate bilateral counterparty risk. Clearing is a key component of this plan. Central counterparties such as CME Group, ICE Clear and the London Clearing House (LCH) provide clearing services which can greatly reduce the risk of default and systematic failure across the markets as well as the major players who are the investment banks, asset managers and hedge funds.
Central counterparties run clearing houses which set policies for settling markets and limiting risk. Clearing houses offer a safe harbor from this risk by ensuring that OTC markets are sufficiently collateralized and that in the unlikely event of a default the market impact is minimized. The clearing process involves carefully setting margin rates which are high enough to protect the market but not so high that trading is squashed. Margin is held in the form of collateral which can be called on in case of default. Additionally, clearing members must contribute to a default fund over and above basic margin requirements which also serves as a buffer should a default occur.
Beyond providing a safety net for the OTC high wire act, clearing houses perform other critical day to day functions that are necessary for ensuring stable markets. Valuation (also known as mark to market), cash flow calculations, and settlement price determination are part of an overall clearing service that allows all trades and positions to be fully settled each day. Taking CDS as an example, clearing houses calculate what is referred to as variation margin which is a combination of the change in the market value of a CDS position as well as the coupon accrued on a daily basis. Clearing houses hold variation margin until the CDS position matures or a coupon payment date is reached. Other types of cash flows include the full payment/receipt of a coupon on a quarterly basis and the handling of the upfront amount that is included with trades. All such cash flows are immediately banked rather than being held on a collateralized basis.
Daily settlement price
Determination is a critical process which underlies all functions of the clearing house. Without it, trades and positions could not be valued or margined. For OTC products, this tends to be a democratic process which involve “voting” on the value of a financial instrument by key participants in the form of price submission. Both bids and asks are submitted. The clearing house receives these prices, removes outliers, converges on the settlement price and publishes them to the market.
Another area worth a mention that is specific to CDS clearing is the handling of credit events. A credit event occurs when the issuer of a bond on which a CDS instrument is based fails to make payment. In effect, this is the fundamental purpose of a CDS instrument; to protect the buyer of a bond from exposure to default by the bond issuer. When this happens the clearing house must ensure that the CDS buyer is made whole and receives the unrecoverable portion of the amount held. Likewise, the clearing house must also ensure that the CDS seller delivers on the unrecoverable portion. The recoverable portion is determined by an ISDA auction. Generally, this transaction is cash settled.
Up to this point we have discussed only the back-end aspects of a central clearing service offered via the clearing house. Let’s discuss how trades are actually submitted to the clearing service by market participants. Most participants transact their deals on a third-party trading platform designed to support an affirmation and matching process. Once a deal has been matched it is submitted to the clearing service. This requires that the trading platform know the valid set of instruments, parties, and accounts which are accepted by a clearing service. Taking the CDS market as an example again, trade reports specifying the buyer, the seller, their respective accounts, the contract, price and upfront amount are submitted for clearing. The designated clearing members (DCM) for each party must also be specified. When received by the clearing service the trade is validated and credit limits are checked. If all checks are passed, the clearing service returns a cleared trade confirmation to the trading platform and the trade can be considered “cleared”. In the case of a credit failure the platform will be informed that the deal cannot be cleared.
Now let’s turn to the question of how FIX can be used effectively throughout the OTC trade submission and clearing process as has been described above, keeping in mind that the recent standardization of OTC products makes FIX a relevant player in the OTC arena.
FIX- A relevant player indeed
Firstly, FIX provides an effective mechanism for OTC trade submission. The rich trade reporting workflow allows either single sided or two sided trades to be submitted with all requisite OTC trade attribution. Both models are commonin the OTC market; single sided trades for affirmation and matching, two sided trades if matching has already taken place and immediate submission to the clearing service is desired. CDS, FX, Energy, and other types of OTC commodities such as gold forwards can be fully described using the recently extended FIX Instrument definition. Trade status and report types can be used to concisely convey the trade state at any point in the workflow. CME uses FIX for the purpose of receiving OTC trades submitted for clearing in the aforementioned products from trading platforms. Several of these commercial platforms have been able to leverage existing FIX implementations.
FIX may also be effectively applied in the reconciliation and cash flow reporting aspects of OTC clearing. The Position Report message allows OTC trades which have been multilaterally netted to be expressed as positions and reported for reconciliation purposes at the end of each day. In the same vein, FIX has recently been extended to represent all the cash flows that are relevant to CDS. Reset to par, Initial Coupon, Daily Accrued Coupon, Quarterly Coupon Payment, and Collateralized Mark to Market are all cash flow amounts that are supported in the FIX lexicon. Additionally, the same FIX workflow used to submit trades to clearing can be used for static trade reporting. In the case of CDS, the FIX Trade Capture Report carries all fields necessary for the DTCC Copper trade reports. CME uses FIX in exactly this capacity in order to provide clearing firms with all details of a clearing cycle.
Reporting of OTC settlement prices on a consistent and timely basis can be accomplished through the use of the FIX Protocol. FIX allows settlement prices to be expressed in a number of terms required by market participants including percent of par, points and spread. This is done using the Market Data Snapshot message. FIX price reporting also provides support for secondary OTC pricing needs, including discount rate which is used to determine the present value of forward style instruments as well as the recovery rate used during a CDS credit event.
Reference data has become another important area with the advent of OTC clearing. Service providers must have a robust model for providing product reference and party reference data. Product reference data represents that set of instruments which are acceptable for submission and can be generically consumed by all market participants. Party reference data is generally unique per market participant and represents the set DCMs and accounts for which each participant is given permission to trade. Many standardized OTC instruments can be neatly defined using FIX. The Security Definition message allows product definitions to be concisely communicated using elements that are common across the FIX model, presenting opportunities for re-use and reduced development effort. The Party Detail List Report message allows a large array of parties to be fully elaborated as well as the relationships that exist between them. Reference information can be delivered either statically in file form or dynamically as real time messages. CME uses FIX to define a broad set of OTC instruments including CDS, FX forward and swaps, commodity forwards, and Energy swaps. CME also uses FIX to report the accounts and the DCMs that can be traded by a given party.
Conclusion
As the OTC world continues to change and regulators develop new requirements for trading, clearing and reporting of OTC products, FIX is emerging as a viable interface. We are starting to see a convergence of two worlds that were formerly separate, as the behavior of OTC markets start to come into alignment with exchange-listed and cleared markets. This provides an opportunity for FIX users to apply a common model to new types of products. Granted, there are areas where FIX will need to be extended and enriched in order to provide the necessary support for OTC users. However, FIX offers a fundamentally sound framework and has already taken strides toward becoming a useful solution in the OTC space.
OTC Clearing ‘FIX’ed Up!
FIX: Streamlining post-trade solutions
By Jean-Remi Lopez
Jean-Remi Lopez of SunGard Global Trading responds to FIXGlobal on how FIX enables post-trade teams to provide more accurate and timely information to decision makers, benefitting their institutions.
How has FIX added value to the world of trading?
There is no doubt that FIX has brought a fundamental change to the way orders are placed and managed in financial markets: a collection of proprietary protocols have yielded to a standardized communication protocol. However some resistance remains especially in the world of post-trade processing.
How can you explain this resistance in the post-trade processing arena?
Every post-trade team is unique in the way it is organized. From a systems perspective, post-trade processing involves a collection of different systems and processes that make up a complex environment. In most organizations, it also includes varying degrees of manual processing. Post-trade workflow often includes a series of batches – epitomized by the “end of day” – rather than immediate processing.
For all its features, FIX remains a real-time messaging system and may not seem, at first glance, an appropriate communication tool for the post-trade environment. However, the sustained drive for Straight-Through-Processing (STP) and the need to reduce transaction risk has driven systems increasingly to interact with each other in a more synchronous fashion: information has to get disseminated immediately post-trade to a large set of systems.
What has been your experience using FIX, especially at the post-trade level?
SunGard has now fully adopted FIX, with a large majority of our clients exchanging FIX data flows in and out of our products. However, this adoption was not completely optimized: too many individual exchange specifics remained in our FIX ‘Rules Of Engagement,’ which were sometimes difficult to comply with for our clients.
SunGard’s approach is now to offer our clients and their FIX counterparts,‘Rules Of Engagement’ that are in line with FIX best practices, whether it is about collecting a plain-vanilla equity order, a derivative order, a client allocation, or broadcasting market data.
At the post-trade level SunGard has experienced a drive towards interconnection at first hand. We found that the first push for using FIX within our solutions came from the derivatives market. With its growing volumes, and the requirement for rapid updating of position and risk keeping systems, timely data flow is crucial. This required our applications to connect directly to clearing houses in order to retrieve trade information immediately upon execution.
Previously we had developed a clearing house gateway which interfaced a set of market-specific communication protocols to our own internal protocol. As our offering evolved, and more modules were integrated into our offering, the proprietary protocol started to show its limitations. In addition, we realized that the same clearing house gateways were developed multiple times, often once per component.
Accordingly, we decided to use a single clearing house gateway for all our products and we made the decision to use the FIX Protocol to exchange the information between our components. This enabled our developers to focus much more on covering clearing house functionalities rather than expanding the scope of the ageing internal protocol.
Going for Latency Gold
By Matthew Lempriere
Like a sprinter racing for a gold medal, the traders’ ability to take advantage of latency is influenced not only by their skill as a trader, but also the tools they have at their disposal including hardware and software architecture, network topology and physical distance from execution venues, writes BT Radianz Services’ Matthew Lempriere .
With the 2012 Olympics in sight, all eyes will turn to London (especially those of the BT team, as the official communications partner of the Olympics and Paralympics), where we will watch world class athletes participate in tough and demanding events where a split second can make the difference between winning and losing. But what we should remember is that the competitive edge that an athlete gains over their rivals does not just come down to the individual themselves, but the infrastructure that they have around them; such as kit, training conditions and diet. A combination of these things will ultimately come together and be the key to beating the competition and winning gold.
The same is true in the world of electronic trading. The innovative brains behind the most cutting-edge instruments or complex trade strategies on today’s trading floors would be incapable of making their concepts become a reality without the modern technological infrastructure that is built around them. Where low latency was once an exclusive playground for arbitrage specialists and market makers, it has now become main-stream and is no longer confined to specialist trading systems, but is a requirement for all advanced trading strategies.
As well as coming into the mainstream, increasingly innovative trading strategies and their reliance on the latest, most advanced technology, such as algorithmic and quantitative trading, has pushed the issues of automation, latency and risk management technology further up the agenda. Latency is critical to take advantage of the swings in price and increase in order flow, and is grabbing board-level attention with senior latency-related positions being created within financial institutions to ensure that sustained focus is put on trading desks’ latency capabilities and for taking advantage of low latency to remain competitive. The rise of complex financial instruments has done much to propel reliance on technology further amongst both buy-side and sell-side organisations. This has happened to such an extent that the traditional division between the front and back office, in terms of their relative importance to the trade process, has been almost eradicated. Complex instruments, evolving investment vehicles, regulation and increased investor sophistication have caused the gap between the front and back office functions to narrow considerably. Technology, from the front office through to the back office, must move in tandem to enable the industry to be able to sustain growth and innovation.
In Europe, the trading landscape has undoubtedly changed in recent years with technological innovation and regulatory change – with initiatives such as the Markets in Financial Instruments Directive (MiFID) – providing the catalyst for a rise in alternative trading venues and off-exchange order books. These alternative trading venues have been responsible for growth in the number of trades made as large block orders that may be sliced into smaller bundles of trades to obscure them from the market. In Asia, we have a variety of different markets each with their own set of rules and regulations, so the technology must be able to react and interface with multiple venues. Both network and server technologies have had to provide the capacity for financial institutions to scale and take advantage of these increased volumes.
The New Exchange
By Kevin McPartland
Kevin McPartland, Senior Analyst, TABB group explains the metamorphosis of the Exchange today and how the very definition of an “Exchange” is being transformed.
High frequency traders are not the only ones trying to get faster. The last few years have seen exchanges enter an arms race for speed that rivals the most sophisticated trading shops in the world. The focus on reducing latency and increasing bandwidth is so extreme that we are watching the definition of“Exchange” transform right before our eyes. Not because physical trading floors in city centers have been replaced with massive data centers in out–of-the-way industrial areas, but because the exchange business model has fundamentally changed from one that is transaction-based to one that is technology-driven. The reasons why are quite simple. Execution fees have been driven down by competition largely brought on by field-leveling regulations (read Reg NMS and MiFID) enabling competition and in turn making technology, the real differentiator. The exchanges are desperate to both retain and attract more liquidity, but with execution fees often below zero and market monopolies consigned to history, only a serious investment in technology will ensure life throughout the next decade and certainly investments in technology are being made.
The most serious technology investments have been made by the world’s largest equity exchanges. NYSE Euronext purchased Wombat and NYFIX among others to create the newly branded NYSE Technologies, NASDAQ merged with OMX to create an exchange technology provider with global reach, the London Stock Exchange (LSE) recently purchased MillenniumIT to rebuild its matching engine and be its technology arm, and the Deutsche Boerse has long been a technology provider in its own right. Chi-X, the largest multi-lateral trading facility (MTF), has a separate technology arm in the form of Chi-Tech. Most recently, the Tokyo Stock Exchange (TSE) launched its long awaited Arrowhead platform with hopes of entering the low latency trading world. CME Group, BATS, and numerous others have also invested heavily in ensuring they have the latest and greatest technology. Some are working to maintain their dominant market position and the others are continuing their quest to take liquidity from the incumbents.
Traditional Service Providers : Going Contemporary
By David Goodman
The growth in scale of many large- asset owners, the failure of financial infrastructure during the GFC (Global Financial Crisis), the move of custodians into investment management administration, and cheapening access to trading and portfolio management technology is creating the environment for a substantial change in the financial services industry. David Goodman, Head of Portfolio Solutions, Macquarie Securities (Australia) Limited, explores how this change will have a dramatic effect on the way traditional service providers relate to their largest customers.
Funds can definitely consider internalising certain aspects of their investment management process. The large funds will not necessarily withdraw externalised functions in certain asset classes in total, they will look to internalise only those functions where it can be done efficiently. Before considering the detail of the impact of these changes it is necessary to understand that the drivers for change at a fund, as well as a fund’s view of efficient production, may differ to that held by other market participants.
The effect of scale in a market where there is a general model of management fees charged on the basis of NAV is well understood. For an index fund, there is an asset size above which the cost of internal production is cheaper than outsourcing. Passive equity fees are very low to reflect this and extremely large scale is needed to consider this move. When one considers the operational risk involved in passive management, outsourcing of this risk also has value to a fund. Funds can often consider internalising this type of activity when it is seen as a step in the direction of internalising other related mandates.
One of the most powerful drivers for change surrounds the experiences of various funds during the GFC. For many funds the greatest disturbance that occurred to them involved the failure of financial infrastructure that drove the structuring of many of the perceived lower risk (but larger value) assets in their portfolio. Redemption issues in index portfolios are still problematic for some funds due to frozen (now slowly thawing) collateral pools backing stock lending aimed at enhancing the returns of the fund. Some enhanced cash portfolios were involved in assets central to the GFC. Investors in long/short extension funds can now understand rehypothecation. For an asset owner these events may initially be a powerful driver to withdraw from these types of activities. Medium term it could be the case that this will cause funds to want to internalise the management of the pipes that froze during the GFC. Internally managing collateral pools and cash assets are related and now supportable by easily accessible technology and services. The GFC has created an incentive for asset owners to want to have more control over where their assets are.
Many large, traditional asset custodians to pension plans around the world have been actively seeking and winning mandates to provide back and middle operations support to large investment managers. These investment managers have adopted varied approaches and this has created the need for the custodians to segment the services they “in source” from some potential clients who are not looking for a full service solution. These services have great scale. An asset owner who has appointed a custodian to hold custody of their assets can now reach in and access the technologies that are provided to their investment to manage such things as collateral pools at a very effective price. This may enable asset owners to continue to enrol in securities lending programs (or ones they directly manage themselves) with a far higher degree of comfort and control over the operational risk they are running.
Broker supplied EMS technology has been abundantly available for a significant period of time. The above trends relating to investment managers outsourcing functions to custodians have provided services such as OMS and Portfolio accounting systems at an efficient price into which the EMS can be plugged.
So after establishing that it is now easier for funds to “in source” parts of their investment process and that they have powerful internal control reasons to do this, what will be “in sourced” and what are the implications for service providers?
As discussed above, aspects of listed equities could be internalised but the counter proposition exists that it maybe more efficient to externalise passive management and to internalise control of the operational risk surrounding any return enhancing activity undertaken. Assembling a team of high quality investment analysts capable of developing processes that can identify and capture sources of alpha in the long term is an expensive process. Using quantitative techniques to identify the betas that potentially drive these returns and internally implementing portfolios to create these returns is more likely. This would mean potentially lower allocations to managers whose returns are correlated to these systemic betas and higher returns to managers who can show uncorrelated alpha generation. Brokers will need to provide quant based product in exchange for implementation flow and structured product solutions that enables portfolio construction.
In addition to the ever cheapening technology required to support internalisation, an investment in human capital is required that would be sourced from traditional buy-side and sell-side firms. Money and geography are factors to be considered. Asset owners are more geographically spread than the large buy-side and sell-side firms and many have strong connections with their local communities and governments. Attracting experienced talent for these funds to internalise could be a significant barrier to entry.
Once an internal funds management team is created it can be employed to re- internalise aspects of other processes that may have been previously out sourced.
The management of trading costs is necessarily an important focus for investment managers as they seek to efficiently implement internally generated investment ideas and manage fund liquidity. Investment managers employed by asset owners see only their part of a client’s total fund. Investment managers are normally not aware of potential internal market liquidity that could exist in other asset pools managed on behalf of their clients fund and excess trading costs could accrue to the asset owner from “missed” internal crossing opportunities. An asset owner would normally have a better view of the cash flow profile of a fund, recognising times when it needs to raise or invest cash. In a fully externalised environment over trading could occur if cash flow moves in a different direction to cash needs. Some asset owners may take the view that they are better placed to manage the after tax performance of their fund centrally, than a number of external managers all trying to be internally tax efficient.
Technology, TCA and Traders: Can the buy-side get the balance right?
By Bill Stephenson, Greg Lee
How do you find that “just right” point between too much technology and not enough; between tracking your traders every move and going with your gut instinct? How do you know when to invest in developing technology in-house, and when to bring in outside expertise? And, importantly, how does the buy-side rate the sell-side?
Bill Stephenson, Franklin Templeton Investments’ Senior Vice-President and Director of Global Trading Strategy, spoke to Greg Lee, Head of Autobahn Equity Asia, Deutsche Bank about the tipping point between sensible and opportunistic.
Greg Lee: While many buy-side firms balk at committing more resource to trading technologies, Franklin Templeton has continued to invest in this area. What has been your rationale behind this approach?
Bill Stephenson: Our general philosophy on technology has been to be opportunistic, but sensible. We need to stay ahead of the curve on technology because we realise that, besides our people, technology is the key differentiator on a trading desk. So, maintaining a competitive system with minimal fragmentation and all the requisite functionality was the key.
Certainly, over the past two years we have been very engaged in investing resources into our OMS, EMS, TCA, and internal collaborative technology.
The end result we’re aiming for is best execution. We believe that global integration is achievable and has strong benefits. We’ve adopted an open architecture that allows partners and suppliers from around the world to better understand our platform.
One practical approach we’ve taken is to put our programmers alongside our traders. By doing so, our programmers gain a much clearer understanding of the business, and our traders can rapidly shape our programmes and processes. It’s a collaborative relationship.
Greg Lee: Many firms prefer to buy rather than build, whereas your focus is on developing in-house. What, in your opinion, are the challenges or limitations to outsourcing technology?
Bill Stephenson: We have had a bias towards building our own technology solutions, particularly when it comes to our OMS, but we are not averse to buying as long as we have the ability to work with a vendor to create custom add-ons. We did consider building our EMS into the OMS, but eventually decided to keep it separate, but connectable. To do this, we needed FIX. FIX was the key link.
We now have an EMS that we feel brings together the best off-the-shelf solution with a customisation that took over a year to get right. We had to find a vendor who would work with us to develop customer solutions on a global level. We do believe that a global solution is possible, which is what we have implemented with our OMS and EMS. Granted, there will be nuances for each market that need to be addressed, but generally, one solution can be leveraged globally.
Greg Lee: At Franklin Templeton you see Transaction Cost Analysis (TCA) as being an effective tool. What has been your experience in integrating TCA into the trading process?
Bill Stephenson: Yes, we certainly see TCA as an extremely valuable and value-added tool. Our philosophy is that if you can measure performance – whether its trader performance or algorithm performance –then you can improve it.
Integrating TCA into the process isn’t always easy, but ultimately, it’s part of the best execution process and should be a staple in a trading desk’s daily routine.
What we do encourage is that traders pitch ideas, such as opportunistic algos – and we can bring these online on a probationary basis. It’s all part of the rolling evaluation process, where TCA helps play a part in deciding which execution destinations are adding value to our execution process and which are not.
When we look at TCA each day, we get reports that essentially identify our risks and where we are making our biggest stock specific directional calls. For example, is a trader using a lot of discretion that could theoretically create a $100 million short position (i.e. selling more or buying less than the benchmark target) in the name? This daily reporting helps create a dialogue and allows the trader to better evaluate their strategy and ensure the risks are aligned with the potential rewards.
Greg Lee: You talk about building TCA into the culture of the trading desk. Have you seen much resistance?
Bill Stephenson: Sure, there is some resistance, because the system is not and never will be, perfect. This is especially true with the complexities of our order flow. No rule will work for all scenarios, but we do believe in the law of large numbers. We know that with over billions of dollars and hundreds of thousands of transactions, performance will be statistically significant and trends will emerge.
The process has now been in operation for over ten years within Franklin Templeton, but developing trader buy-in has been a gradual process, and it takes time to embed this workflow into the trading desk culture. We explain the benefits, we work on educating brokers, the end-client and traders, and we also make it clear that this is now part of the trader’s job.
Greg Lee: What about the future of TCA? How do you think the industry can better optimise this process?
Bill Stephenson: We use TCA to evaluate our investment process, our traders and our brokers. It is a constant evolution and we appreciate that it isn’t always easy to isolate the performance of any one contributor to the investment implementation process. Understandably there can be a lot of overlap in performance attribution, but we still believe that we’re close enough to make it a valuable exercise.
And TCA will continue to evolve. I don’t think there’ll ever be a standard benchmark, but that is ok.
Our process of investment management and trading is different than some of our competitors, so we expect our benchmark could be different. But we do believe that our methodology aligns closely to the portfolio manager’s objectives for the client, so therefore our benchmark is appropriate. As for optimisation, the best way to see the true value of TCA is to have a culture of acceptance where it becomes a part of the daily process. Only then can it be used to guide strategy.
Greg Lee: How important is pre-trade analysis?
Bill Stephenson: Pre-trade analysis is a helpful guide, but certainly shouldn’t completely drive decisions. This is especially true if you’re using a model-based trade cost estimate for an order greater than 50 percent of ADV. The risk is that these models do break down and might skew your decision making process.
For smaller orders it can be a more useful guide for traders. Having pre-trade tools built into the EMS or OMS are the most efficient ways of using this process so that the trader’s process is not slowed down.
Greg Lee: What do you consider are the main dilemmas facing buy-side firms today in relation to selecting an OMS or/and EMS?
Bill Stephenson: When selecting an EMS, cost is obviously a factor. Equally you need to look at broker neutrality and the willingness of brokers to join the platform. You also need to look at the vendor firm’s commitment to building custom functionality and their willingness to work with, and invest in the brokers to integrate the most recent destination specs.
The OMS and EMS are two separate and distinct tools, and you need to consider that one vendor may not be able to meet the needs of the manager, especially if they require specific functionality.
Greg Lee: How would you visualize the ideal trading platform?
Bill Stephenson: The ideal platform would fully integrate a broad range of pre, during and post-trade processes and content: pre-trade, real time, post trade TCA tools, portfolio attribution, broker voting, external and internal research, collaboration tools and market data. You want it to be modular so that components can generally plug and play, and you want to keep your vendors and partners diversified, which will keep them incentivised to stay cutting edge.
Ideally, a straight-through efficient process, starting from order origination through settlement with all the pertinent decision making tools at your fingertips would be the trading platform we strive to achieve.
However, I’m not sure one platform could offer best-of-breed across all these areas, but ideally these processes should all be inter-operable so that a trader’s workflow can be optimized.
Greg Lee: Relationships are changing rapidly in the trading environment. How do you feel the buy-side is evaluating the sellside in the current climate?
Bill Stephenson: As the saying goes, you’re only as good as your last trade. I think this still holds true when buy-side traders evaluate sell-side performance, but that can be too short-sighted. That’s where TCA can be helpful such that the evaluation encompasses a much broader set of trades over time. However, measurement of actual performance from a TCA perspective isn’t always easy, and there are subjective aspects of the performance to be taken into consideration that are just as important.
We look at aggregated performance and also a series of subjective measures twice a year where our traders evaluate broker performance in eight best execution categories, which are typically standard across all regions, globally.
Under these categories we include questions at the sales trader and firm level that we think are important services that tie into best execution. For example, we will ask our traders to rate a sales trader on the quality of the order flow and trading information, such as market color.
Greg Lee: What do you see as the future for automated trading? Will technology triumph over people?
Bill Stephenson: No, technology will not triumph over people. But the traders who embrace change, who understand market structure and who have solid technology and analytical skills will bring the best value to their clients.
No system can make judgements, so we need real people who understand the markets. The markets are based on individual people’s ideas of value at any given point in time and how they react to changing market prices. Parts of the process can probably be systematised – such as broker or venue selection and opportunistic strategy shifting – but the markets are too dynamic to have one rule set that will always apply. So we do need our traders to be making the decisions, especially around the macro strategy of large orders relative to ADV. We also see sales traders as being resurgent in this low liquidity environment. In low liquidity or higher volatility times, we need high touch order expertise. It’s about finding the right people for the right times and giving them the support and processes to make the right judgement.
OTC Clearing ‘FIX’ed Up!
Extending FIX implementations to support OTC trading and clearing
FIX is becoming a viable protocol for the trading and clearing of OTC products, as regulators usher the OTC world toward transparency and standardization. Credit Default Swaps (CDS), FX forwards and FX swaps are the latest set of financial instruments to experience a move toward standardization and are fitting nicely into the model provided by FIX while, the OTC energy market has been leveraging FIX for several years. In response, the industry is starting to see clearing service providers offer new trade confirmation and clearing solutions that allow FIX implementations to be extended from vanilla equity and listed derivatives products to standardized OTC products. CME Group’s Matt Simpson explains that this has the potential to allow significant savings for participants who can likewise extend their existing FIX implementations to support OTC trading and clearing.
Clearing houses make stride
Over the last 18 months regulators have aggressively pushed OTC markets toward standardization in order to achieve price transparency and eliminate bilateral counterparty risk. Clearing is a key component of this plan. Central counterparties such as CME Group, ICE Clear and the London Clearing House (LCH) provide clearing services which can greatly reduce the risk of default and systematic failure across the markets as well as the major players who are the investment banks, asset managers and hedge funds.
Central counterparties run clearing houses which set policies for settling markets and limiting risk. Clearing houses offer a safe harbor from this risk by ensuring that OTC markets are sufficiently collateralized and that in the unlikely event of a default the market impact is minimized. The clearing process involves carefully setting margin rates which are high enough to protect the market but not so high that trading is squashed. Margin is held in the form of collateral which can be called on in case of default. Additionally, clearing members must contribute to a default fund over and above basic margin requirements which also serves as a buffer should a default occur.
Beyond providing a safety net for the OTC high wire act, clearing houses perform other critical day to day functions that are necessary for ensuring stable markets. Valuation (also known as mark to market), cash flow calculations, and settlement price determination are part of an overall clearing service that allows all trades and positions to be fully settled each day. Taking CDS as an example, clearing houses calculate what is referred to as variation margin which is a combination of the change in the market value of a CDS position as well as the coupon accrued on a daily basis. Clearing houses hold variation margin until the CDS position matures or a coupon payment date is reached. Other types of cash flows include the full payment/receipt of a coupon on a quarterly basis and the handling of the upfront amount that is included with trades. All such cash flows are immediately banked rather than being held on a collateralized basis.
Daily settlement price
Determination is a critical process which underlies all functions of the clearing house. Without it, trades and positions could not be valued or margined. For OTC products, this tends to be a democratic process which involve “voting” on the value of a financial instrument by key participants in the form of price submission. Both bids and asks are submitted. The clearing house receives these prices, removes outliers, converges on the settlement price and publishes them to the market.
Another area worth a mention that is specific to CDS clearing is the handling of credit events. A credit event occurs when the issuer of a bond on which a CDS instrument is based fails to make payment. In effect, this is the fundamental purpose of a CDS instrument; to protect the buyer of a bond from exposure to default by the bond issuer. When this happens the clearing house must ensure that the CDS buyer is made whole and receives the unrecoverable portion of the amount held. Likewise, the clearing house must also ensure that the CDS seller delivers on the unrecoverable portion. The recoverable portion is determined by an ISDA auction. Generally, this transaction is cash settled.
Up to this point we have discussed only the back-end aspects of a central clearing service offered via the clearing house. Let’s discuss how trades are actually submitted to the clearing service by market participants. Most participants transact their deals on a third-party trading platform designed to support an affirmation and matching process. Once a deal has been matched it is submitted to the clearing service. This requires that the trading platform know the valid set of instruments, parties, and accounts which are accepted by a clearing service. Taking the CDS market as an example again, trade reports specifying the buyer, the seller, their respective accounts, the contract, price and upfront amount are submitted for clearing. The designated clearing members (DCM) for each party must also be specified. When received by the clearing service the trade is validated and credit limits are checked. If all checks are passed, the clearing service returns a cleared trade confirmation to the trading platform and the trade can be considered “cleared”. In the case of a credit failure the platform will be informed that the deal cannot be cleared.
Now let’s turn to the question of how FIX can be used effectively throughout the OTC trade submission and clearing process as has been described above, keeping in mind that the recent standardization of OTC products makes FIX a relevant player in the OTC arena.
FIX- A relevant player indeed
Firstly, FIX provides an effective mechanism for OTC trade submission. The rich trade reporting workflow allows either single sided or two sided trades to be submitted with all requisite OTC trade attribution. Both models are commonin the OTC market; single sided trades for affirmation and matching, two sided trades if matching has already taken place and immediate submission to the clearing service is desired. CDS, FX, Energy, and other types of OTC commodities such as gold forwards can be fully described using the recently extended FIX Instrument definition. Trade status and report types can be used to concisely convey the trade state at any point in the workflow. CME uses FIX for the purpose of receiving OTC trades submitted for clearing in the aforementioned products from trading platforms. Several of these commercial platforms have been able to leverage existing FIX implementations.
FIX may also be effectively applied in the reconciliation and cash flow reporting aspects of OTC clearing. The Position Report message allows OTC trades which have been multilaterally netted to be expressed as positions and reported for reconciliation purposes at the end of each day. In the same vein, FIX has recently been extended to represent all the cash flows that are relevant to CDS. Reset to par, Initial Coupon, Daily Accrued Coupon, Quarterly Coupon Payment, and Collateralized Mark to Market are all cash flow amounts that are supported in the FIX lexicon. Additionally, the same FIX workflow used to submit trades to clearing can be used for static trade reporting. In the case of CDS, the FIX Trade Capture Report carries all fields necessary for the DTCC Copper trade reports. CME uses FIX in exactly this capacity in order to provide clearing firms with all details of a clearing cycle.
Reporting of OTC settlement prices on a consistent and timely basis can be accomplished through the use of the FIX Protocol. FIX allows settlement prices to be expressed in a number of terms required by market participants including percent of par, points and spread. This is done using the Market Data Snapshot message. FIX price reporting also provides support for secondary OTC pricing needs, including discount rate which is used to determine the present value of forward style instruments as well as the recovery rate used during a CDS credit event.
Reference data has become another important area with the advent of OTC clearing. Service providers must have a robust model for providing product reference and party reference data. Product reference data represents that set of instruments which are acceptable for submission and can be generically consumed by all market participants. Party reference data is generally unique per market participant and represents the set DCMs and accounts for which each participant is given permission to trade. Many standardized OTC instruments can be neatly defined using FIX. The Security Definition message allows product definitions to be concisely communicated using elements that are common across the FIX model, presenting opportunities for re-use and reduced development effort. The Party Detail List Report message allows a large array of parties to be fully elaborated as well as the relationships that exist between them. Reference information can be delivered either statically in file form or dynamically as real time messages. CME uses FIX to define a broad set of OTC instruments including CDS, FX forward and swaps, commodity forwards, and Energy swaps. CME also uses FIX to report the accounts and the DCMs that can be traded by a given party.
Conclusion
As the OTC world continues to change and regulators develop new requirements for trading, clearing and reporting of OTC products, FIX is emerging as a viable interface. We are starting to see a convergence of two worlds that were formerly separate, as the behavior of OTC markets start to come into alignment with exchange-listed and cleared markets. This provides an opportunity for FIX users to apply a common model to new types of products. Granted, there are areas where FIX will need to be extended and enriched in order to provide the necessary support for OTC users. However, FIX offers a fundamentally sound framework and has already taken strides toward becoming a useful solution in the OTC space.
Clive Pedder : SunGard
A FIRM OF MANY MOVING PARTS.
It has been a busy year as SunGard further expands its reach into equity trading. Clive Pedder, Chief Executive Officer of SunGard’s global trading business for London and Northern Europe discusses the seamless integration of recent acquisition, GL Trade.
What is the history of SunGard global trading?
About 14 months ago, SunGard acquired GL Trade, a global financial software solutions company. The rationale was to give European buyside firms better access to SunGard’s trading product suite and allow SunGard’s US buyside clients to tap brokers in Europe and Asia. This is because the users of SunGard’s existing trading tools were predominantly US buyside firms, while GL Trade’s client base was more heavily weighted to the sellside in Europe and Asia. GL Trade itself was also a product of several acquisitions over a long period of time but the company had reached the point where in order to move to the next level, it had to either go through a leveraged buyout, private equity type of transaction or be sold to a trade buyer. We all agreed that SunGard was the best option because of the entrepreneurial spirit and mindset.
How has the acquisition progressed?
I can honestly say, and I have been through several acquisitions, that this has been one of the smoothest integrations. We did have some overlap but we decided to combine the best of breed wherever we could and develop a common sales and distribution team for the products. The result has been a combined global trading business that delivers a consolidated offering across equity trading, market data, exchange traded derivatives, trading and risk management. We offer multi-asset, front-to-back trading solutions, including order management, advanced execution, smart order routing, clearing and settlement, as well as market connectivity and information services.
What has been the impact of the financial crisis on the business?
Broadly speaking if you look at the current environment, the financial crisis is still occurring to a large extent and the result has been a greater focus on integration, cost efficiency, innovation, risk management and better internal controls. There is no doubt that it is a much tougher business environment, but the group is extremely resilient and we have held our own. In terms of trends, what we have seen in an increased focus on exchange traded products and a shift away from OTC derivatives and more exotic instruments.
What do you think about the debate about high frequency traders?
There is nothing new about high frequency trading and I do not think that the practice is wrong. I cannot think of any market failure or regulatory transgression that these traders have caused by being in the market. They exploit inefficiencies and have injected liquidity into the markets to the benefit of the end investor. It is understandable though that regulators are cautious and wish to better understand the model and the impact it could have on the markets.
There is also a great deal of discussion around sponsored access and DMA in the EU and the UK. I do not see a great deal of difference and in fact sponsored access can be seen as an extension of DMA. Although one or two exchanges have raised objections, I think again there needs to be a better understanding about what sponsored access is and who is using it. It is up to the brokers to undertake the due diligence around the firms they are sponsoring. If they do not and there is a problem then it will be their reputation on the line.
What do you think about the discussions around dark pools?
Again, dark pools are not a new phenomenon. Brokers and banks that are a significant size have been internalising as much flow as possible for a long time. They would be foolish not to as it benefits the end investor. Regulators in Europe, the UK and US are concerned about the risks they pose to market transparency and integrity, but I think we will see more venues coming onto the market.
Do you then think there is room for the new venues coming onto the market?
The MTFs that have been launched under MiFID have created price and liquidity competition to the established exchanges. However, I do not think such a high level of fragmentation is sustainable. It is not viable to break liquidity into so many pieces and this presents a challenge for brokers seeking “best execution,” as defined by MiFID. Today there are five main market participants – LSE, Chi-X, Turquoise, BATS and NASDAQ OMX – but there are new venues coming onto the marketplace. The future success, though, depends on their ability to attract sufficient flows. Chi-X has the advantage of being an early mover and a lot of liquidity has stuck, but it may not be that easy for the newer players.
What are some of the challenges you see for the banking and broking community?
I think the market will split even further between the top tier players and the boutiques, with the mid-tier firms facing the greatest challenges. This is because in order to fulfil MiFID obligations and to ensure best execution, brokers have to be able to connect to as many multiple markets as possible. The larger firms have the depth and breadth of resources and technology to access all the liquidity pools while the niche firms are able to focus on a narrow slice of the market. Those in the middle may not be able to afford to do this, which means they might have to give up their flow to other brokers.
What is SunGard global trading’s plans for the future?
In Europe, the biggest challenge is keeping up with the uncertainty in terms of markets and merger and acquisition activity in the industry.
The other issue is not to let the focus on cost stifle innovation and development. It is important to continue to launch new products and sharpen your competitive advantage. For example, this past summer we launched Assent ATS, an alternative trading system in the US that aggregates US equity trade flow from users of SunGard’s Assent, Brass and GL Stream trading solutions. This was a natural extension of our Assent product that offers brokers DMA as well as liquidity-seeking algorithms to help access fragmented liquidity across asset classes and major markets.
We are also aiming to harmonise and consolidate our complementary offerings around market data delivery, which includes MarketMap – which grew out of a company called Infotech that was acquired by GL Trade in 2007 – as well as FAME. MarketMap offers real-time and delayed data from multiple global exchanges and OTC sources while FAME provides a variety of real-time market data feeds and end-of-day data.
[Biography]Clive Pedder, chief executive, London Northern Europe, SunGard Global Trading, joined SunGard through the acquisition of GL Trade. Prior to GL Trade, he was CEO of a number of global businesses within Misys Banking Systems. His earlier career spans several general management positions within the financial technology sector.
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