Smart Japan – Rapid pace of technology speeds adoption of alternative trading venues

March 15, 2009

By Hiroshi Matsubara, Philip Slavin,

According to the World Federation of Exchanges, in December 2008, BATS was the third largest exchange on the planet: larger than Tokyo and London combined. It’s an incredible story for an exchange that no one had heard of three years ago, and which only launched in Europe four months ago.

The rate at which the markets have adopted alternative trading venues, is a vivid illustration of the way the capital markets are changing. The singlemarket environment has disappeared in the US and Europe, with venues like BATS creating a credible alternative to traditional exchanges. As a result, in the US, more than 40 execution venues, including incumbent exchanges as well as the new electronic crossing networks (ECN) and alternative trading Systems (ATS), compete with each other for share of order book trades. The growth of ATSs is such that they now have more than 30 percent of the trading share in US equities.

The story is similar in Europe, following the full implementation of the Markets in Financial Instruments Directive (MiFID) and the abolition of the concentration rules. The combined share of the four multi-lateral trading facilities (MTFs) that are currently operational – Chi-X, Turquoise, Nasdaq OMX and BATS Europe – together account for 16 percent of the trading volume in Europe for large cap stocks.

The state of fragmentation in Japan
Just like algo trading before it, which has moved East from the US to Europe and Asia, market fragmentation will inevitably arrive in Japan. We are already seeing signs of it. Japan’s exchange concentration rule was abolished several years ago, and the move toward diversification of execution venues has started.

As in Europe, fragmentation has to date largely been driven by foreign brokers. Several have already introduced internal crossing services and three block crossing networks are in operation. Whereas those PTSs (an equivalent term in Japan to ECN or MTF), used to be with retail flows only, they are now absorbing institutional prop and agency flows by linking together with leading institutional brokers. Domestic brokers who wish to compete should be prepared to invest now, at least by establishing their own internal markets and smart routing orders between them and the TSE.

However, it is important not to over-state the current levels of development. Although the share of off-the-floor trading taken by alternative execution venues and broker principal bids is gradually increasing and now covers around 7 to 8 percent of total volume, fragmentation is still in its infancy in Japan, as is the adoption of Smart Order Routing.

Indeed, 90 percent of the all transactions of Japanese cash equities take place on the TSE. The Financial Instruments Exchange Act (FIEA), the latest Japanese market regulation which has been in force since September 2007, is mainly focused on retail trading markets and is seen as weak when it comes to defining what is expected from the institutional market participants for achieving best execution. It is perhaps not surprising then that the majority of Tokyo brokers define their best execution policy as “to execute on the Tokyo Stock Exchange. ”Japanese institutional fund sponsors are missing some fund performance with the current status of the Japanese market.

Role of smart order routing
Nonetheless, one result of changes in the market and the role now occupied by PTSs, is that smart order routing(SOR) is beginning to establish a presence in Japan.

The route of a trade is moving, albeit slowly, away from the traditional route from buy-side blotter through a selected brokerage, on to a traditional exchange and then to a clearing house. Where SOR is deployed, the road to execution can be more diverse, as it becomes possible to break up orders, trade them separately on multiple venues and then clear through a variety of competing clearing and settlement regimes. These components then need to be reassembled so as to present a single, unified picture of the original order back to the end customer.

To prepare for this eventuality, some of Tokyo’s leading brokers have already adopted SOR for the Tokyo market, and those that haven’t are investigating their options for introducing it. In fact, the concept of smart order routing is attracting a great deal of interest from buy-sides as well as sell-sides.

In particular, brokers are starting to recognise that they cannot get by without intelligent access to multiple liquidity sources. The ability to probe the most optimal liquidity source dynamically and to route orders intelligently is an added value to their execution services. Differentiation will depend on how smart the router is and where it sits in the value chain.

In doing so, they are following a path that their counterparts in America and Europe have already travelled. Where multiple trading venues are firmly established, SOR is regarded as an essential trading tool for delivering best execution.

Upgrading the system
However, SOR will only truly succeed if the latency within the existing exchanges is improved. Without a low-latency platform a smart order router’s interaction between external exchanges and internal crossing, for example, would not make sense.

The good news is that the incumbent exchanges are in the process of strengthening their trading system infrastructure in order to promote low latency and high data volume. What’s more, forthcoming market milestones such as the launch of Tdex+, TSE’s new trading system for options, in July 2009, as well as Arrowhead, the next-generation trading system for cash equities due in January 2010 should boost the market adoption of SOR. To help matters along, the OSE has also announced it will introduce a next generation trading system, and both the TSE and OSE have announced the introduction of co-location and remote membership schemes.

What is still needed, however, is the right regulatory framework. We believe that the Japanese FSA should try to look again at the adoption and definition of best execution duties, especially for asset managers serving institutional clients. More fundamentally, those institutional fund sponsors, such as pension funds, should raise their awareness of the importance of trading costs among the total fund performance. These will be critical for the creation of more efficient market trading structures and the total uptake of further electronic trading in Japan.

In Europe and the
US, many firms have recognised the absolute need to implement a coherent SOR strategy, and Japanese firms are likely to follow. Whether this is deployed on site or via a third party, the net effect is the same – the computer is now taking a much bigger role in the overall decision-making process of how and where an order gets executed.

Beyond SOR
As we have established, SOR’s role of intelligently breaking up orders and sending them on to different venues is only part of the story. The resulting multiple executions need to be fed all the way through to the back office while still associated with the original order. Each execution will need to reflect the different trading fees and clearing regimes of the venue concerned. Another crucial part of the process is the ability to rewind the tape to see exactly how and why an order was executed. This is central to any best-execution policy, yet is often overlooked by pure-play SOR vendors.

It is essential that firms do not implement SOR systems thinking they will be acquiring a one-stop solution for all the challenges of trading across multiple venues; an SOR system without a complete smart workflow strategy behind it has very limited application. In addition, SOR technology needs to be integrated within the overall workflow, which may combine smart routing, DMA or other forms of sponsored access.

Therefore, SOR must be supported by, and operate in conjunction with, order management, market data, market connectivity, trade management, position keeping and audit trail. Although the marketsthemselves are fragmented, the technology package cannot be: smart trading functions must be tightly integrated into the trading platform.

Eventually, SOR and the other components that are needed for intelligent liquidity access will become embedded as standard features in quality order management systems, in much the same way as advanced trading tools and the ability to handle multiple asset classes have been. This is because SOR is fundamental to the way that trading works in a market place in which multiple venues trade the same stock.

The strong likelihood is that SOR will become the minimum requirement in a package of tools and strategies that are necessary for intelligent liquidity access. Organisations that can successfully combine smart routing across lit and dark liquidity together with real distribution and intelligent workflow will emerge the winners in this new environment.

日本における高度化した市場外電子市場の始動 – 世界的に不安定なマーケット環境の中で本格化した日本の高度な代替執行市場の今後の展望

yoichi_ishikawa

March 15, 2009

By Yoichi Ishikawa
世界の取引所が昨今の金融危機において散々なダメージを受けている中で、東京証券取引所も株価や出来高において低調になっています。一方、ここ数年欧米で見られるような代替市場の拡大傾向が、アジアへ広がり、日本でも急進しています。カブドットコム証券の石川陽一氏は、この騒然とした時期に新しい代替執行市場の存在がより認知され定着することが重要であると述べています。

2009年年初から2月に入る中で、日本の株式市場は、東京証券取引所の1日当りの売買代金が2兆円割れするという売買の低迷が続いており、流動性リスクが懸念される。また、東京証券取引所の売買代金シェアは、日本の全市場の約90%超と一極集中の状況が長年続いており、多数の参加者が一カ所に過度に集中し希望する価格で取引が迅速に行われづらい売買リスクも考えられる。このような情勢の中、2008年より市場外取引に新たに複数の高度な私設取引システム（PTS）が誕生してきており、1つの銘柄の複数の値段の中で、より有利な値段を選び取引を行う高度な電子化された「最良執行（Best Execution）」が定着し始めた。

活性化し始めた市場外電子市場
日本の私設取引システム（PTS）は、1998年に法改正され市場外取引の中で電子的に売買を成立することができるようになった。2001年から2社にて運営が開始されたが、取引所と同様の価格形成を行うことができないことや、参加する投資家が限られたことなどにより十分に普及しなかった。これらの要因により、2001年～2006年までは市場外におけるPTSのシェアは2%に満たなかった。2005年の法改正により、取引所と同じ価格形成ができるオークション方式がPTSでも利用できるようになり、2006年9月、同方式のPTSが、カブドットコム証券にて夜間に始まったことをきっかけに2007年の同シェアは約4%まで伸びた。しかし同取引は、夜間という時間帯や個人投資家であること等により伸び悩んだ。そのような経緯を経て2008年、PTS業界において次のような環境の変化があり、2008年の同シェアは約5.5%、2008年11月の単月では、9%超と過去最高を占めるなど急速に拡大した。

昼間の時間帯に取引所と同様のオークション等の方式にてPTS2社（カブドットコム証券と他1社）で売買が始まり、投資家は、市場外にて取引所同様の取引が本格的に行えるようになった。
同2社では、トムソン・ロイター社のようなグローバル情報ベンダーに複数気配（Depth）を含んだPTSのリアルタイム時価情報を配信し始めた。
これらのPTSで、取引所よりも細かい呼び値での取引が可能となった。
外資系証券を中心とした高度なアルゴリズム取引により、主市場と比較しながらPTS市場にも流動性を供給する新たな取引手法が定着し始めた。
新たに2社にPTS業務が認可され、日本のPTSは計6社となり機関投資家から個人投資家までPTSへの認知が高まった (次ページの図Aを参照) 。但し、新規2社は個人投資家の取引が中心。

複数の価格を比較しながらの売買
右図は、カブドットコム証券が個人投資家向けに提供する複板（”Fukuita PTS（Multi board PTS)”）だ。このツールは、取引所とkabu.comPTSのそれぞれの気配情報を一枚の板画面で参照し、即座に売買できる。同様に複数の取引所やPTSの株価を同時に比較するマルチブック情報ツールは、トムソン・ロイター社などにより提供され始めており、今後投資家が複数の価格や板の状況を一覧で比較しながら売買を行うことが普及し始めてきている。取引所では、多数の参加者が同じ価格を指定するため、時間優先ではあるものの長い待ち行列となることがよくある。PTSでは、取引所とは異なる価格での取引や、取引所と同じ値段でも、より小規模のため待ち行列が短いことなどにより、アービトラージ取引が可能となった。取引所での取引と比べると待ち行列のキューをジャンプする形だ。また、PTSによっては、取引所と比べて1/10となるきめ細かな価格指定（呼び値の刻み）ができるため、アルゴリズム取引にも対応しスライシングした取引ができる。機関投資家は、これらのキュー・ジャンプや細かな呼び値の刻みにより、コスト・セーブができるようになった。これらの取引環境の高度化により、カブドットコム証券の2008年度の第3四半期（2008年10月-12月）では、外資系証券からの高度なアルゴリズム取引等による電子取引が定着し、1日平均の売買代金は、約10億円と前四半期比で約16%増加、2008年10月7日には47億円に達し過去最高を更新した。また、2008年10月後半以降、金融不安の影響でマーケット全体が低調となり注文件数は減少する一方、約定件数は続伸し、約定率は0.6%から1.0%へ上昇した（次ページの図Bを参照）。

市場外電子市場の高度化
2008年に取引所と同等のPTS市場が始動したことにより、外資系証券等によるアルゴリズム取引等の電子取引も益々高度化している。取引所と同方式をとる新しいPTSでは、基本的に取引所と同じ売買方式を取りながらも、取引所より細かな価格指定ができる。そのため、セル・サイドの売買システムでは、最良執行方針のもと、より良い価格がある場（取引所やPTS）を自動的に発見し、注文を回送させる高度な機能が要求され、先行する外資証券では2009年より提供が始まっている。これらの高度な売買システムは、SOR（スマート・オーダー・ルーティング）機能と呼ばれる。SORでは、価格やコストを加味しながらも、有利な場に注文を電子的に自動的に回送することができる。一昨年からのセル・サイドのダークプールの活用に加え、取引所、ダークプール、さらにPTSといった多数の場から最も良い値段を選ぶSORは、機関投資家の売買運用を広範囲に支援するものである。2010年1月には東京証券取引所の新システムが高度かつ高速な取引所として稼働する予定もあり、これらの電子市場の拡大に対し、迅速に注文を執行できる能力がセル・サイド側のSORシステムに要求される。また、これらの最良執行注文の高度化・小口化を背景に、サイズの大きい注文に対しては、PTSでVWAP(売買高加重平均価格)を用い効率的に売買を成立させる取引も、2009年より一般化されるであろう。
まとめ
2008年からの日本における新たな複数の私設取引システム（PTS）の始動の流れは、2009年より有利な値段で取引を行う「最良執行（Best Execution）」が機関投資家およびセル・サイドのSORシステムにより高度に電子化される流れの中で、電子的かつ機能的に取引所を補完する新たな執行市場として定着し、日本の市場全体の売買リスクや流動性リスクを低減させる役割を持つであろう。

Exchanges without borders – Meeting access and latency challenges across the Asia Pacific

john_knuff

March 15, 2009

By John Knuff
Can there possibly be a silver lining in the current financial meltdown? John Knuff of Equinix, argues that now is a time to upgrade your investment, allowing the Asia Pacific region to catch up with its US and European peers.

While the global financial crisis has inevitably had an impact on investment, most commentators seem to agree, that the Asia Pacific market will see on-going development, particularly as it continues to invest in the infrastructure and technologies, that will allow it to match its US and European counterparts, in key areas such as execution speed, easier market access and direct data feeds.
Analysts such as Celent see the current downturn as a significant opportunity for Asia exchanges, even suggesting in a recent report that Asian exchanges have the potential to overtake their US colleagues in the near future. Before this can happen, however, there needs to be sustained investment in the technology, skills and processes that will enable lower latency, easier access and faster data feeds across the region.
One of the key challenges remains the diversity of the region. While the geographical diversity, and vast distances involved, will always make it hard for traders to gain low latency access to multiple market centers, the added complexity of local regulations and last mile access make region-wide performance goals even more difficult to achieve. Nevertheless, factors such as direct market access, the increasing presence of alternative trading systems and the introduction of crossing networks, will have a tremendous impact shortly after local regulations ease.
Investing to close the gap with other global markets
To assume that the different markets in the Asia Pacific region will progress seamlessly together towards a more deregulated and open environment would be unrealistic. The global financial crisis is already leading some Asia Pacific exchanges and regulators to be more defensive in their outlook. However, it also provides an opportunity, for more traditional venues, to develop and implement their own alternative trading strategies to compete, more favourably, with new market entrants as conditions improve.
It is this imperative to remedy the handicap of limited bandwidth and slower trading platforms, that is driving Asia Pacific financial institutions to continue to update their technology infrastructure. As many of the incumbent exchanges re-tool their matching engines and foster technology partnerships, with global leaders like NASDAQ OMX and NYSE Euronext, the broker / dealer communities are quickly positioning themselves to be the partner of choice for many of their US and European counterparts.
Given this background, we believe it’s important for Asian market participants to ensure they are making the right infrastructure and connectivity choices today, to allow them to compete more effectively tomorrow.
A world of more end points and more trading venues
In an Asia Pacific market driven by the continued growth of automated and algorithmic trading, the emergence of new liquidity opportunities and increasing numbers of order destinations and market data sources, we’re increasingly going to see financial firms trading a much wider range of asset classes and instruments across broader geographies.
In those countries, where the incumbent exchanges still handle the majority of trading, these new market developments will have a significant impact as local traders who, limited by their current choices, increasingly send order flows to more accessible and transparent electronic markets. All this translates into more end points and execution venues, and is driving demand among financial services firms for a greater choice of networks with low latency/ high bandwidth capabilities to enable these higher message rates and optimise throughput.
With the landscape of the Asia Pacific market’s different trading centers evolving so quickly, it’s becoming increasingly apparent that a strong element of foresight, and much broader connectivity options, will play as important a role as proximity, when it comes to making location decisions across the Asia Pacific region.

Finding solutions – Now in its 5th year, the FPL conference in Canada tackles the tough issues

Creating Digital

March 15, 2009

What a lot can change in a year! Since the last FPL Canada conference, held in May 2008, Canada has been drawn into the liquidity crunch along with the rest of the world. Yet Canada has a risk and regulatory model that is different from many of its established trading partners, most notably the US and the UK. Can the world learn lessons from the Canadian experience?
With only weeks to go until Canada’s leading electronic trading event, it is still hard to pick what the credit crisis and regulatory environment will look like on June 1st, the first day of the conference. What we do know is that there will be increased regulatory involvement, particularly in areas that were previously not subject to scrutiny. In the run up to the event, we asked a range of experts to comment on what they feel will be the hot topics at this year’s event.
Conference Hot Topics
(A) Market Volatility
Market volatility has certainly changed trading patterns. The increasing reliance on electronic trading, leveraged through Direct Market Access/Algorithmic Trading or a portfolio trading desk, is directly connected to the growing need to manage risk, volatility and capital availability. We have seen a dramatic uptake in these services/tools, as there has not only been a focus on how electronic trading is conducted, but also on the expectations of trading costs involved versus benchmarks. The greatest impact has been a higher use of electronic trading strategies relative to more traditional trading and a shift in the types of electronic trading strategies employed.
From a single stock perspective, many traders were loath to execute at single, specific price points due to the potential for adverse percentage swings in the high single to double digits. Algorithms have been employed on a more frequent basis, to help traders participate throughout intervals on an intraday basis, managing risk around the volatility. The violent intraday swings also create significantly more opportunities in the long-short space. Quantitative execution tools have became more of a focus, to take advantage of these opportunities on an automated basis.
What the industry is saying:
“In terms of disruptions relating to market volatility, the Canadian trading infrastructure generally held up admirably. Most dealer, vendor, and marketplace systems handled the massive increases in message traffic and activity with little noticeable impact on performance. This is proof positive that the investment in capacity and competition was well worth it and is now paying dividends.” Matt Trudeau, Chi-X Canada
“Electronic platforms using FIX and algorithmic routers handled significant market fluctuations with no impact to performance. Speed to market for orders made it possible for traders to minimize exposure to huge swings in pricing and to capitalize on opportunity.” Tom Brown, RBC Asset Management
“Many traditional desks were shell-shocked and did not know how to respond to the volatility combined with the lack of capital. Electronic trading tools like algos enabled people to manage extremely volatile situations with great responsiveness. They were able to set the parameters for their trades and let the algo respond as market conditions warranted. Trading of baskets/lists made having electronic execution tools critical. You couldn’t possibly manage complex lists in real-time without very sophisticated electronic front-end trading tools.” Anne-Marie Ryan, AMR Associates
“The recent volatility spike means that risk will likely be scrutinized more in the future than in the past. Post-trade transaction cost measurement systems generally do not consider risk but instead focus on cost. To properly align the interests of the firm and the trader, performance measurement systems will need to reflect both cost and risk considerations.” Chris Sparrow, Liquidnet Canada
Jenny Tsouvalis of Ontario Municipal Employees Retirement System (OMERS)
sees a need for effective integration of investment management and trading processes. “On-line, real-time electronic trading systems provide quick access to liquidity and when coupled with real-time pricing embedded into blotters, identify the effect of market changes on the portfolios and the effect of trading decisions.
“Electronic trading has been successful because of its ability to be adaptive, so it is likely to change in reaction to current issues.” Randee Pavalow, Alpha Trading Systems.
“We’ve seen an increase in the use of algorithms and over the day orders as volatility has increased. The ability to smooth orders over a longer period limits the exposure to price swings during the day. VWAP, TWAP and percentage of volume, seem to be the algos of choice for many these days.” John Christofilos, Canaccord Capital

Masters of Risk – Can regulators and technology be the solution?

By
Creating Digital
-

March 15, 2009

You can’t change the past, but to protect the future, NASDAQ OMX’s Brian O’Malley argues, the financial services industry needs to partner with the regulators to evaluate what went wrong, which market mechanisms worked and which did not. Best practices risk management controls, O’Malley argues, must be put in place, and followed.
The current financial crisis could be described as a disaster waiting to happen. At too many institutions the basic tenets of good long term risk management were being ignored in favour of short term profits. A lack of transparency meant many investment bank boards and executives did not fully understand the risk their firms were assuming with complex new instruments. As a result, they were not able to properly assess the return they were getting for them.
At the same time, trillions of dollars worth of risky OTC contracts were being traded and cleared bilaterally around the globe without proper risk management controls, and the regulators have been accused of being asleep at the wheel.
Opinions vary, but most observers agree on one thing. If regulated exchanges and clearing houses, with proven risk management practices, had a role in the OTC derivatives markets, the crisis would not have been as severe. Therefore, these organizations must be part of the solution.
Exchanges and clearing houses assume and manage counterparty and clearing risk. The members put up capital, and collateral is collected from the counterparties in the form of initial margin. The exchange measures and manages intra-day risk. When market volatility increases, a variation margin call is made. The positions of firms that cannot meet the margin call are liquidated. When the circumstances require it, the exchange can tap into the shared capital and the clearing corporation’s capital.
This system worked extremely well, even during the worst days of 2008. So the question is: should OTC contracts be migrated to exchange trading and central counterparty clearing?
There are precedents for central counterparty clearing in the OTC markets. CLS Bank operates the largest multi-currency cash settlement system, eliminating settlement risk for over half the world’s foreign exchange payment instructions. In the US, fixed-income marketplace, Fixed Income Clearing Corporation, processes more than US$3.7 trillion each day in US Government and mortgage-backed securities transactions.
For the last few years, the London Clearing House has operated a clearing facility for interest rate swaps. The International Derivatives Clearing Group (IDCG) recently started clearing and settling US dollar interest rate swap futures, and Liffe’s Bclear, which already clears OTC equity derivatives, started clearing credit default swaps (CDSs).
Role of risk-mitigating technologies
Creative use of technology can also play a big role in mitigating risk. For example, a large NASDAQ OMX technology client is leveraging technology to minimize pre-trade risk. Its customers wanted a system that could automatically validate a counterparty’s collateral and filter out bids and offers from unacceptable trading firms. In practice, this meant, traders could only see bids and offers from firms with whom they had open credit lines. Considering the number of versions of the order book that need to be sent out, the challenge was to create a system that was robust but not overly expensive or complicated.
The NASDAQ OMX solution was to allow the client to send an order book to all its customers in a single encrypted message. Users have a decryption key that determines which view of the order book they are permitted to see. The client has been using this technology in Europe to help handle pre-trade risk in securities lending.
Despite these examples, some Wall Street firms are resistant to the idea of trading OTC instruments on exchanges and clearing them centrally. They argue that OTC contracts are far more flexible than standardized, exchange-traded contracts. Bilateral trading allows them to retain anonymity. OTCs can be traded electronically or by voice, and typically the larger the deal, the more likely it is to be executed over the phone. Moreover, many OTC instruments are off balance sheet products. If they are centrally cleared, they would have to put up collateral, such as treasury bills, to meet margin calls, and these would be would be an on-balance-sheet item.
An on-balance-sheet item is an asset or liability that a firm formally owns or is legally responsible for. These items also are recorded as a profit or loss on the firm’s income statement. Futures, forwards and derivatives typically are not included on the balance sheet, and therefore they do not affect the firm’s liquidity and capital resources. The issue of off vs. on balance sheet items needs to be included in future risk management discussions.
The OTC market makers also have a vested interest in maintaining the status quo because the lack of transparency and price discovery works in their favor. Migrating these products to exchange trading and central counterparty clearing could reduce their revenue.
Introduced in November 2008, the Derivative Trading Integrity Act amends the Commodity Exchange Act to eliminate the distinction between “excluded” and “exempt” commodities and regulated, exchange-traded commodities, so futures contracts for all commodities would be treated the same. It also eliminates the statutory exclusion of swap transactions, and ends the U.S. Commodity Futures Trading Commission’s authority to exempt these transactions from being traded on a regulated board of trade. In effect, this means that all futures contracts must be traded on a designated contract market or a derivatives transaction execution facility. In addition, all swaps contracts fall under the definition of futures contracts and function basically in the same manner as futures contracts. While it is far from certain that this or a similar bill will pass, clearly the topic will be hotly debated.
At this stage, it is unclear how the OTC market will look in the future, but change is inevitable. The financial crisis highlighted the need for the type of real-time risk management that is an integral part of regulated exchanges and clearinghouses. These organizations can provide transparency where it does not exist today, mitigate counterparty and operational risk and reduce trading costs through the use of efficient technology.
At the same time, the basics of risk management haven’t changed. It is simply the application that has become sloppy. The financial institutions that remained in good shape through the financial crisis were the ones that maintained their risk management discipline and spread their risk around. A back to basics approach, when it comes to risk management, can be just the right medicine for an ailing financial services industry.
Top 10 best practices in risk management
The financial crisis would not have been as severe – or possibly could have been averted – if the best practices in risk management had been followed. Many key tenets were ignored in the interest of short-term gains. Going forward, here are the top 10 practices that, if followed, can help prevent future meltdowns.

Recognize and manage the natural tension between P&L and risk mitigation; ensure there is a vibrant dialogue and balance.

Be prepared to walk away from a deal or a product.

Start at the top; ensure oversight and engagement of independent directors.

Make individuals accountable, not committees; every risk has an owner.

Look around the corner and anticipate risk even if the light is bad.

If it is too good to be true from a margin perspective, it is, and doesn’t include the risk cost.

Empower the internal audit department; ensure that the staff is capable and can think like business people.

Engineer smart controls that are automated and woven into the systems and operations; challenge the control status quo as often as you do the business delivery.

Leverage the experts in assessing risk and controls, know what you don’t know.

Maintain transparency for the risk inventory, risk appetite and monitoring of the risk appetite.

Going Off-Market: Can Alternative Venues Give Solace in a Skittish Market?

By
yoichi_ishikawa
-

March 15, 2009

By Yoichi Ishikawa
National exchanges worldwide have been pummeled by the recent economic turmoil and Japan’s Tokyo Stock Exchange (TSE) has been among the hard hit, both in terms of value and volume. The trend towards alternative trading venues, seen in the US and Europe over recent years, has spread to Asia, with Japan being among the first adopters. kabu.com’s Yoichi Ishikawa asks whether these new venues may prove a popular option in tumultuous times.
In the first two months of 2009, the stock market in Japan saw continuous low levels of trading and ongoing fears that liquidity would dry up permanently. Daily trading volumes on the TSE dipped below Y2 trillion. Adding to trading fears, the volume share traded on the exchange exceeded 90 percent of Japan’s entire domestic market. This concentration of trading on one exchange has, in fact, been the norm for many years in Japan, but concerns are growing a single exchange environment is curbing market efficiency, with transactions often not achieving best execution. Under these circumstances, several new and sophisticated proprietary trading systems (PTS’) have emerged for offmarket transactions in 2008. The goal, for these PTS’, has been to create an electronic trading method that allows the selection of the best price among multiple prices for a single issue.
Japan’s financial system has allowed for such off-market online transactions since 1998, and in 2001 two companies set up operations. However, investor interest was slow to materialise, as a lack of sophistication in early versions meant that prices could not be formed in the same manner as on the exchange. These system weaknesses kept the share of PTS transactions below two percent on offmarket trading between 2001 and 2006. A revision of the law in 2005 prompted a major shift allowing for price formation in the same manner as on the exchange. In response to this change and a perceived demand for extended hour trading, kabu.com was launched in 2006 offering night time trading.
By 2007, the share of PTS trading had reached about 4 percent. While growth was still slow, the stage had been set for the increasing popularity of PTS’. The following year, market share expanded to 5.5 percent, with a single-month record high of over 9 percent in November 2008.
Driving factors for growth
Soon after, two companies (including kabu.com) began daytime PTS trading using the same auction format as the exchange, enabling investors to do full-scale ‘offmarket’ trading in the same way as ‘on exchange’ trading. These companies also began transmitting market data to global information providers (such as Thomson Reuters), which allowed for real-time PTS market price information, including multiple quotations (depth).
The new PTS’ also allowed transactions at nominal prices, at smaller units than the exchange. Adding to the sophistication, transactions using advanced algorithms – mainly by foreign securities firms – opened up a new trading method that brought new liquidity to the PTS market. New players to the PTS market, (bringing the total number of operators to six, with the two new companies licensed focusing on individual investors), helped raise awareness of PTS’ among institutional and individual investors alike. Together the companies offered off-market trading to individual and/ or institutional investors. (See diagram A on next page.)
Trade by comparing multiple prices
Diagram B shows a typical kabu.com interface, tailored for individual investors. It allows users to see information on both kabu.com and the TSE. Market information tools, allow for share price comparison across multiple PTS’ and exchanges. With a number of traders offering identical prices on the Exchange, long queues to execute trades can occur. PTS’, on the other hand, has fewer traders, meaning shorter queues. They also allow for arbitrage trading at prices different from the Exchange, or even at the same time as the Exchange.
Equally, as PTS’ allow for smaller price units – one-tenth of those on the Exchange – it makes for easier algorithmic trading and breaking orders up into smaller trades. Together these advantages allow institutional investors to save on costs.
This sophisticated trading environment has allowed PTS’ to accommodate electronic trading by foreign securities firms, using advanced algorithms and other trading formats. This resulted, in our case, of an average trading volume per day of approx. Y1 billion between October 31 and December 31, 2008, representing an approx. 16 percent increase compared to the previous quarter, with a record high of Y4.7 billion set on October 7, 2008. Although, since October 2008, financial uncertainty resulted in a sluggish overall market, pushing down the number of orders, the number of contracts increased, making the contract rate jump from 0.6 percent to 1.0 percent (see figures following).
Sophistication of the offmarket e-marketplace
Looking back, it was the ability of PTS’ to trade at par with the exchange that drove technological advances and investor interest in the off-market trading format. The sellside enjoyed the advanced functionality that automatically sought out the right market and best price, allowing for best execution and forward orders. From 2009, these systems are available to foreign securities firms, many of whom are already familiar with alternative trading venues elsewhere in the world and Smart Order Routing (SOR) systems.
These SOR applications not only take into account price and cost considerations, but also allow for orders to be electronically and automatically forwarded to the most advantageous market, including exchanges, dark pools or PTS’.
Scheduled for launch in January 2010, the TSE is developing a new highspeed exchange system that takes into account the proliferation of PTS’ and the widespread adoption of electronic markets.
To be compatible, sell-side SOR systems will be expected to provide high-speed order execution capabilities. Also, with the sophistication and unit minimisation of best execution orders, transactions that allow for the trading of large orders using VWAP (volume weighted average price) by PTS’ look set to become commonplace in 2009.
In summary, the rapid development of PTS’ in Japan over the past year is driving the establishment of a new execution market that supplements the exchange both electronically and functionally, and looks set to reduce trading and liquidity risks across the broader market. In parallel, Japan will see the advanced automation of best execution for institutional investors, and continued adoption of SOR systems by the sell-side to allow for best execution.

Adapting your trading style – How the changing market landscape is driving new skills

By
Creating Digital
-

March 15, 2009

Appetite for risk has never been lower and liquidity has never been tougher to identify. The downstream effect is impacting every part of the electronic trading business and culture. Quod Financial’s Ali Pichvai examines where he sees the sea change in trading skills and style.
We are at the midst of a structural, and subsequently cultural, change in the capital markets. Firms’ appetite for risk is shifting and counterparty risk is now high on the agenda. This trickles to each function and aspect of investment and execution; from investment decision making, to risk management, and the mechanics of the electronic trading. In addition, liquidity is increasingly fragmented across a multitude of pools and is affecting how electronic markets are evolving. So how does this landscape impact how firms will trade?
Changes on the buy-side and how the future will look are still uncertain. The hedge fund industry, the great innovator investor class, has in large part been discredited and its model will need to drastically change. The quasi-demise of this large segment will leave a void that needs to be filled. It seems that the future lies in more transparent, better risk-managed, low-cost listed products, which respond to the appetite of global multi-asset investment and execution strategy of the investors. Furthermore it is now clear that liquidity and solvency are intimately linked, and evaporating or volatile liquidity creates systemic risk on solvency. This will, without doubt, have a large impact on future capital market structures.
The buy-side transformation will inevitably accelerate the pace of the current secular trends of more electronic trading on centrally cleared liquidity venues and competing global or regional multi-asset liquidity venues. NYSE Euronext, as a global multi-asset liquidity venue, seems to be the role model for all other market participants. The liquidity fragmentation, as observed today, will certainly be greater and more complex going forward. It also seems we have entered a second age of liquidity fragmentation, with three phenomena which have appeared, or been reinforced, in the current turmoil.
Liquidity is becoming ever more dynamic. As competition increases price wars are becoming more frequent, and pricing models are being altered to attract more and more liquidity. For instance, the rebate model for passive orders (i.e. by resting a passive order, you can receive a fee) has often been used as an effective marketing tool for new alternative trading systems. Clients are therefore moving their execution on a real-time basis from venue to venue, as pricing evolves within a competitive landscape, making liquidity ever more dynamic.
Liquidity is decreasing transparency. As new dark pools and brokers internalisation profligate, with the US equities having achieved 17% of execution in these dark venues, the level of transparency is decreasing. This creates a massive trading challenge. Transparent liquidity is important since it creates an efficient price discovery model, which then disappears into a non-transparent execution model.As transparency decreases, in addition to market data sourced from the different displayed prices, there is a need to move to real-time post-trade analysis, to rebuild a more intelligent picture of liquidity.
Volatility increases fragmentation and increases execution risk. The current intraday volatility, and an even lower period volatility, is much greater than at any other time, and bigger than the impact of incurred costs. As seeking liquidity becomes more important, fragmentation will increase. The result is a new type of risk which needs to be mitigated; the execution risk. This means that the investment case can be fully redundant if the execution in a highly volatile market is not properly performed. This risk evolves from the inability to execute down to execution too far away from the investment decision. Another obvious effect is that the widespread algorithmic trading engines, which were built to limit for low volatility markets, have become obsolete. Nowadays, in an averagely volatile day, it is not uncommon to have 300 basis points of volatility, which dwarfs a single digit basis point cost impact. That means that the next cycle of investment in algorithmic trading needs to be redirected towards liquidity seeking algorithmic trading (also called smart order routing – arguably a misnomer, since it is simply routing rather than delivering a real-time decision making process).
It is therefore reasonable to hope that the shift will mean that, at last, fully supported multi-asset trading becomes a reality. The change is more than overdue. The vast majority of current investment strategies are already multi-asset or even cross-asset, but are not properly supported by the trading and execution vendor, broker-based or even exchange-class systems. The pressure to respond to this unfulfilled investor demand, to need to holistically manage risk (for any given client across different asset classes, without being too lax or too restrictive), and to reduce the cost of overall trading systems and infrastructure, are potent drivers to make this conscious shift happen.
The mainstream sentiment, driven by the backlash to the financial meltdown, is that capital markets and trading are beyond control and need to revert to a simpler model. This is a simplistic response. In reality while the level of financial innovation increased, technology investment did not keep pace, and this was particularly true post the mild recession of 2001. It is unrealistic to have expected increasingly complex concepts, such as liquidity fragmentation, risk associated with execution and multi-asset / cross-asset trading to be handled competently with the same old technology. If history is any guide, the future will likely be even more complex. So those investing intelligently in technology will be tomorrow’s winners.
Looking specifically at the execution world, there is a dire need to apply new technology which can manage the current degree of complexity and the need to repatriate execution making within the firm, instead of fully outsourcing it to liquidity venues or the sell-side players. The good news is that adaptive trading technologies are becoming both available and affordable to most market participants.
Adaptive trading technologies deliver real-time decision making mechanisms which rely on real-time market data and post-trade data. They direct and seek liquidity whilst fulfilling the original execution objective (or best execution policy). This allows it to handle complex scenarios, with multiple execution policies and numerous liquidity venues, on a multi-asset basis. Realistically, these technologies need to leverage the current trading investment in terms of infrastructure, upstream and downstream systems, such as risk management, or connectivity, and be as non-disruptive as possible.
There are, however, potentially major failure points. These include:

Speed against complexity: There is a trade-off between the complexity of the decision making process (also called algorithm), and the effectiveness and speed of the algorithm. The right balance is usually empirically found on a case-by-case basis.

Testing the machine requires a new approach: The classical quality assurance and testing approach does not apply to these very complex decision making processes. The testing combinatory permutations for just three to four liquidity venues and some real life client trading behaviour exceeds 100,000s of cases. The cost and length of such extensive testing is both excessive and impossible. The only way is therefore is to take a new approach which is based on statistical sampling of the test cases (and the art of sampling is itself difficult) to simulate as closely as possible a real production environment.

One key application of adaptive trading technologies is the ability to address decreasing transparency. That means real-time post-trade analysis of non-transparent liquidity. This information can be then complemented by market data (assuming that dark pools are usually trading at mid-price) and used as a basis on whether to directly execute on a given dark pool or not.
In conclusion, the changing market landscape demands a shift to adaptive trading technologies and that shift needs to happen now. Firms are still investing in technology, albeit strategically, and in order to keep ahead of their competitors in tough market conditions, firms need intelligent trading systems that can adapt to a constantly shifting environment.

Future of FIX down-under

By
Creating Digital
-

March 15, 2009

FIX is here to stay. This was the message that emerged loud and clear at the FPL Australia FIX Conference held in Sydney on 11 March. In a standing-room only arena, approximately 300 attendees, (one third of whom were from the buy-side), met to discuss the benefits and drivers of FIX within the Australian financial community.
None of the expert speakers and panelists at the FPL event pulled their punches in a day that focused on both the business and technical issues of electronic trading in Australia. Against a backdrop of a tough six months for the Aussie markets, the need to catch up with global trends on FIX, compliance, transparency, liquidity and alternative trading venues was front and centre.
Elegantly moderated by Sky News Australia’s Bridie Barry, the day started with an interview with Michael Block. The General Manager of Investments for FuturePlus Financial Services, spoke about the importance of diversifying globally, and the kinds of systems that would allow this expansion. Block said transparency – in particular with regard to accountability and tracking – was essential with superannuation funds. The issue of cost was also going to take increasing prominence, with transactions costs being only the tip of the iceberg.
He argued that the financial services would shrink and the winners would be the managers that embraced the need for change. “Re-invent or die. Be an early adopter. Think globally and diversity your investment,” Block concluded.
Hot on Block’s heels, Prudential’s Richard Coulstock spoke about the revolution in the buy-side. He spoke about the need to test the liquidity as it slowly moves away from the traditional exchanges. Coulstock said that while trends from the US and Europe would expand into Asia, there was a need to appreciate this regions complexities. “This is a multi-market, multiregulation region,” he added.
The dealing landscape has changed, he argued, and with it greater responsibility was shifting to the buy-side. Both the client and regulator were forcing the buy-side to up its game, he said.
On the role of FIX, Coulstock was adamant. “FIX is vital to your business. It’s a global standard that makes our job more efficient and reduces the error side. We couldn’t do without it.”
A familiar face to most of the delegates, Greg Yanco, ASIC’s regional commissioner offered the perspective from the regulatory side.
Yanco started with an assessment of the fundamental strength of the Australian economy and how the local corporate culture had a strong focus on sound business models, appropriate controls and adequate reporting and disclosure.
He said ASIC as an active participant in the International Organisation of Securities Commissions (IOSCO), whose membership covers 95 percent of global markets, Australia was well positioned to shape the future role of regulators worldwide, and how this would affect the domestic market.
Finally, Yanco touched on the hot topic of short selling. He said the ban wouldremain in place, given the current market conditions, but that a decision was expected by 31 May.
With interactive voting technology, the delegates were asked: What should the priority be for the regulation of Australian trading? 44 percent pointed to the licensing of alternative venues, while 40 percent said the focus should be on the global financial crisis.

Back to basics
The mid-morning session took the delegates back to basics with Martin Koopman giving his FIX101 overview. It was the opportunity for people familiar with FIX to refresh their knowledge, and for newcomers to the protocol to enjoy a 10 minute crash course. The points he covered included:

FIX is the language of Electronic Trading globally, with over 10,000 users globally

FIX is a specification of what and how to communicate – it is not a software, network or service

FIX allows greater connectivity with the rest of the world

FIX is relatively new to Australia, but there is already a good knowledge of the protocol here.

The rise in international order flow over the past two years has driven FIX usage in Australia

It is not a competitor to IRESS. IRESS uses FIX

Two panel sessions followed: one buyside and the other sell-side. The clear message from the buy-side to the audience was that FIX was coming, and that we all need to be able to access it.
From the sell-side panelists, there was a consensus that FIX adds efficiency to the trading process. The role of FIX in driving the agenda of the sell-side connecting to exchanges was also discussed. Finally, an appeal was made to the vendors for a more cost-effective FIX solution for smaller brokers.
Meet the exchanges
In a lively session, representatives from three exchanges, NZX, Chi-X and Liquidnet, directed their questions at ASIC, asking when their application to operate in Australia as a competitor to ASX would be granted. The audience was then asked: Does Australia need alternative execution venues? An overwhelming 89 percent said yes. However when asked how may trading venues would make for market efficiency, 70 percent opted for fewer than five. While it gave panel moderator ASIC’s Greg Yanco lots to consider, he countered with a challenge for the exchanges to bring greater liquidity to Australia.
The day continued with the view from local buy-side firm, Prepetual’s Mark deCourcey during a panel session. DeCourcey had strong views on the benefits of FIX to the buy-side community. He argued that as a buy-side firm he wanted multiple solutions, and the FIX had changed the way they traded. ORC’s John Cameron explained that FIX should be considered as “simple plumbing” that should work seamlessly and, most importantly, that vendors should play a key role in making the roll out of FIX easy for clients. IRESS’ Peter Dunai said he was open to FIX and that they did not consider the protocol to be a competitor. “We already use it in our business and we’re seeing a greater demand for FIX connectivity,” said Dunai.
Delegates were then asked to vote on: What is the biggest driver for FIX adoption in Australia? 46 percent answered, offshore and international trading, and 38%, improved efficiency and risk.
Following a series of concurrently held sessions focusing on either the business or technical side of FIX, the final two presentations focused on some firsthand experiences using FIX in Australia and the future capabilities of the protocol. As Martin Koopman summarized, “The major benefit of FIX is the pragmatic way in which it can be used to solve real business problems.”
Concluding what was an exceptional event in terms of participation and content, Andrew Fraser of Challenger offered the delegates a simple perspective: “FIX is here to stay. There is no alternative.”

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Profile : John Barker : Liquidnet

STRIKING THE MATCH.

Liquidity is a scarce commodity these days but Liquidnet believes there are more opportunities than closed doors. John Barker tells Best Execution why.

Can you tell me the background to Liquidnet

What has been the impact of the financial crisis?

Which new markets are you looking at?

What new products and services do you expect to introduce?

There have been dramatic changes thanks to MiFID and the financial crisis. Where do you see your place in the landscape?

What do you see as the biggest challenges this year?

Profile : Stephane Loiseau : Société Générale

FINDING THE RIGHT PATH.

As liquidity fragments and markets stay volatile, it is not always easy to find the right pools. We ask Stephane Loiseau of Société Générale how the bank is helping clients navigate through these difficult times.

Can you please give provide some background to the execution services group?

Who are your main clients?

What has been the impact of the financial crisis on SG and the industry?

What do you think the impact of MiFID has been? Do you think we will see more MTFs given the current volatile market conditions?

Do you think dark pools have been good for the market?

What are your plans for the future?

What do you see as the main challenges for the industry?

Smart Japan – Rapid pace of technology speeds adoption of alternative trading venues

日本における高度化した市場外電子市場の始動 – 世界的に不安定なマーケット環境の中で本格化した日本の高度な代替執行市場の今後の展望

Exchanges without borders – Meeting access and latency challenges across the Asia Pacific

Finding solutions – Now in its 5th year, the FPL conference in Canada tackles the tough issues

Masters of Risk – Can regulators and technology be the solution?

Going Off-Market: Can Alternative Venues Give Solace in a Skittish Market?

Adapting your trading style – How the changing market landscape is driving new skills

Future of FIX down-under

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STRIKING THE MATCH.

Liquidity is a scarce commodity these days but Liquidnet believes there are more opportunities than closed doors. John Barker tells Best Execution why.

Can you tell me the background to Liquidnet

What has been the impact of the financial crisis?

Which new markets are you looking at?

What new products and services do you expect to introduce?

There have been dramatic changes thanks to MiFID and the financial crisis. Where do you see your place in the landscape?

What do you see as the biggest challenges this year?

FINDING THE RIGHT PATH.

As liquidity fragments and markets stay volatile, it is not always easy to find the right pools. We ask Stephane Loiseau of Société Générale how the bank is helping clients navigate through these difficult times.

Can you please give provide some background to the execution services group?

Who are your main clients?

What has been the impact of the financial crisis on SG and the industry?

What do you think the impact of MiFID has been? Do you think we will see more MTFs given the current volatile market conditions?

Do you think dark pools have been good for the market?

What are your plans for the future?

What do you see as the main challenges for the industry?

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