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Annie Walsh of CameronTec spoke to FX users to better understand the topical issues and challenges facing the OTC Foreign Exchange market and the central role FIX can play in addressing these challenges.

 Undoubtedly the capital markets in 2011 will be remembered for many history-making moments including some of the largest currency moves the market can remember. We have witnessed the global foreign exchange market — the most liquid financial market in the world with an average daily turnover in the vicinity of USD4 trillion — bear the brunt of one political crisis after another, causing widespread volatility and difficult to pick currency moves.

 
Currency friction in Europe and between the US Administration and China will no doubt remain a prominent feature of the global economy for at least the next 1 – 2 years. On top of this remains uncertainty of government, particularly in Europe, and the implications for continuity of fiscal and monetary policy.
 
Many investment banks too in their search for alpha have been left wondering ”where did the black box get it wrong?” following lack lustre P&L performance, almost industry-wide over recent months.
 
Without a formal open or close, the FX market presents a true ‘follow the sun’ global market, with inherent levels of opportunity and risk.
Against this uncertain backdrop, the FIX Protocol has great potential to centrally feature in what is undoubtedly the single greatest threat (opportunity, if you prefer) facing the global OTC FX market. That is of structural uncertainty compounded by impending regulatory change to be ushered in, courtesy of Dodd Frank, and MIFID II and III.
 
With no unified or centrally cleared market for the majority of trades, and little cross-border regulation, due to the over-thecounter (OTC) nature of currency markets, these are rather a number of interconnected marketplaces, where different currencies’ instruments are traded. Inevitably OTC FX will move, however grudgingly, away from its long-standing (self-serving) model of self-regulation, toward greater levels of transparency, regulatory oversight (either directly or indirectly) and centralised clearing.
 
A Two Speed FX Market
As currently drafted, spot, outrightsand swaps are to be exempt from Dodd Frank’s requirement to be traded via Swap Execution Facilities (SEFs) and be centrally cleared; FX options, Cross Currency (CCY) swaps and Non-deliverable Forwards (ND Fs), however, are not. A perhaps unintended consequence of this two speed approach is the potential for jurisdictional arbitrage, product/financial re-engineering and further fragmentation of execution venues and liquidity.
 
In the short term, it also means that the sell-side needs to fundamentally reconsider strategies for design, development and deployment of Single Dealer Platforms (SDPs). Multi asset class SDPs will now necessarily evolve to become simultaneously both an execution venue as a destination and a gateway to a SEF, depending on the instrument traded.
 

Raymond Russell, of the FIX Inter-Party Latency (FIXIPL) Working Group and Corvil lays out the use cases for the FIX Inter-Party Latency standard and the functionality of Version 1.0.

 Raymond Russell, CorvilGoals for FIXIPL

The principal goal of the Inter-Party Latency Working Group is to ensure interoperability between different latency monitoring vendors. Interoperability is essential because latency monitoring is vital to running a low-latency service, therefore the people building systems need confidence that they can start with one vendor and still migrate to another. What we have seen through the proliferation of latency monitoring systems across the trading world, whether DMA providers, market data providers or trading desks, is that often the problems in managing latency within an environment happen between the cracks. Most firms have a good handle on latency in their own environment because they have engineered it well, but when they connect into a counterparty, it gets tricky.
 
Use Cases
A trader who sees a slowdown in response time will want to understand why they have missed trades or why their fill rates are low, but there are multiple places where that latency could have occurred. One place is in the exchange matching engine, which in some respects is unavoidable. If there is considerable interest and activity in a symbol at the same time, those orders will have to queue in the matching engine, purely as a result of market activity. The latency might also have occurred in the exchange gateway. It is common practice for exchanges to load balance across multiple gateways to accommodate high volumes, and you might have hit a slow gateway. Perhaps the service provider you connect through may have oversubscribed their network and you could be caught in cross traffic unrelated to trading. We have seen all these things happen, so the ability to see where the latency is occurring requires a consistent set of time stamps across the architecture.
 
Most exchanges already employ latency monitoring in their own environment, and inter-party latency and the sharing of time stamps, while less important within the exchange, enables them to work with their members to identify areas of latency. The benefits unlocked through interparty latency are somewhat biased towards the end traders, but they also extend to brokers and market data providers, who receive better quality execution feeds and market data speeds, respectively.
 
For exchanges, the need for latency transparency is becoming a standard requirement as latency has become a competitive differentiator. To the extent that exchanges are comfortable with their own infrastructure and are ready to compete on their latency, they will want to share their latency measurements with members. In my experience, venues and brokers are no longer as reticent to share their latency figures as they were before.
 
Version 1.0 Rollout
Much of the work that we have done with Version 1.0 involved deciding how to produce a standard that on one hand is simple enough to be easily implemented, while ensuring it can still perform in all the basic use cases. Version 1.0, due out in December 2011, is clean and simple and emphasizes the core capability to publish time stamps. We have agreed on the technical scope and it is now going through the formal review procedures required to be standardized by FPL, including a public review. The other important part to be done before it is real is to get two different implementations. There are a number of things that will be ready in a few months’ time, such as distribution through multicast and the ability to automatically group several measurements together across the trade, which we will include in the next version later next year.

BNP Paribas Dealing Services Asia’s Francis So opens up about their new structure, how they use Transaction Cost Analysis (TCA) and their preferences regarding dark pools and High Frequency Trading (HFT) flow. 

New Structure
The Hong Kong dealing desk has been restructured as an externalised/outsourced dealing desk for the buy-side. As a result we are now independent of the asset management group and belong to BNP Paribas Securities Services. Our current name is BNP Paribas Fin’AMS Asia Ltd but this will soon change to BNP Paribas Dealing Services, better reflecting the services we provide. BNP Paribas Securities Services provides middle and back office outsourcing services for buyand sell- side, as well as corporate clients. This new dealing service allows us to provide a full suite of front to back office solutions to meet the needs of the clients. The trend has been for the outsourcing of back office activities and I think it is only a natural progression to consider front office activities. Given the market environment, cost reduction is a key element for asset managers/asset owners.  Outsourcing the dealing activity can help reduce cost but more importantly allows the asset manager to focus on delivering greater value to their clients. Our Paris office has been very successful in attracting external clients and in Asia we plan to ramp up activity in 2012.
 
We treat BNP Paribas Investment Partners (the asset management company of the Group) as one of our most sophisticated clients and as such must ensure that the services provided to them are kept to the highest standard. This will be the same for new clients as one of the keys to attracting and maintaining new client relationships is our ability to provide tailor made solutions and services. Clients can range from new start-ups to existing asset managers that already have a dealing desk. We offer flexibility to asset  managers such that they can choose the asset class and/or geographical region they want to outsource. For example, some asset managers that already have dealing capabilities in their home market may decide to invest in overseas markets or new asset classes. They need to ask themselves whether it makes sense from a cost perspective to create a new dealing desk where initial volume is expected to remain low.
 
We have the knowledge, the expertise and the global reach. We have locations in Europe and Asia to cover all asset classes globally. We also serve fund managers located in different geographical regions.
 
It is important to stress that we are in no way competing against the sell-side. Our clients keep their contractual and daily relationships with brokers. We act as an agency-only trading desk and we do not have any prop flow or take any positions.
 
We work together with the portfolio manager to determine what benchmarks best suit their needs. They are able to send orders to our global Order Management System (OMS) with a specific benchmark. By doing so, we can measure our execution performance using their specified benchmark, be it Implementation Shortfall (IS), VWAP or a specific  measurable benchmark.
Simo Puhakka, Head of Trading for Pohjola Asset Management, shares his experience trading in the Nordic markets, giving his opinions on interacting with HFT, using TCA and knowing whether you can trust your broker.
 
Nordic HFT
The prospects for High Frequency Trading (HFT) are really up to regulators. It will be a free market, but as we all know, regulatory changes affect the whole trading landscape. For example, we can see what is happening in France and the debate that is going on in Sweden, which are quite hostile towards HFT, so those countries.
 
Personally, I think that HFT is a good thing for the market, as long as you have the proper tools to deal with it. There are a number of small firms that have been suffering from HFT
since MiFID I because they lack the proper technology and tools to measure and deal with it. We have not suffered in our dealings with HFT, and I would actually say in many cases, it is the opposite. HFT firms seem to add liquidity and when you have the proper tools to deal with it, you can take advantage of it. 
 
Speaking of tools, we started building our own Smart Order Router (SOR ) a year and a half ago. The goal was to create an un-conflicted way to interact with the aggregated liquidity. In this process we went quite deep into the data and turned processes upside-down with the result that we have full control of how we interact with the market. 
 
On the other hand, I welcome technological innovation from the sell-side; for example, brokers now disclose the venues where they execute trades on an annual basis. The surveillance responsibilities that brokers have are beneficial. Many of the small, local brokers and buy-sides, however, are now finding it challenging to upgrade their technology. 
 
Trusting your Broker
Our approach was to take control of our order flow and only use our brokers for sponsored access. We chose full control because, in some to deliver  what I am asking.These questions first arose a few years ago, and we realized we needed to create a transparent, fully-controlled, non-conflicted path to the market. How you interact with different venues – even lit venues, where you have more transparency – will affect your choice of strategy. In most cases, you are better off without brokers making decisions for you. The root of the problem is, when you send an order to the broker, what happens before it goes to the venue? What control do we have over the broker infrastructure, including their proprietary flow, internalization, market making and crossing, not to mention the routing logic?
 
 When we dug into the data, we were quite surprised to see that, although a broker was connected to all the dark liquidity, many of the fills were coming from that particular broker’s dark pool, suggesting there are preferences in the routing logic. Brokers want to internalize flow, which is not a problem, if you are aware of potentially higher opportunity costs. When it comes to dark liquidity, that is an even bigger problem, since our trades were often routed to the broker’s own dark pool or those it has arrangements with. 

Nomura’s Jeremy Bruce summarises the current state of play in terms of European liquidity venue fragmentation, and focuses specifically on venue ownership and geographical concentration of equity execution venues.

Jeremy Bruce, NomuraOwnership and Location of European Equity Trading Venues

In the past few two years we have seen not only increasing liquidity fragmentation in Europe, but a significant change in the pecking order of exchange and venue size. The diagram below lists all venues with a market share of greater than 1% as well as referencing other smaller venues. As can be seen, it shows both the rise of venues, such as Chi-X Europe and BATS, as well as the proliferation of light and dark venues owned by the preexisting exchanges. Chi-X Europe in particular, is now comfortably the largest pan-European venue. There are currently two proposed mergers on the table, firstly between NYSE Euronext and Deutsche Boerse, and the second between Chi-X Europe and BATS.

 

Venues in Europe - by Size

Exchange Locale

The old model of a country having a primary exchange located within its borders (normally in the main financial district), where its companies’ stocks almost exclusively trade is no longer relevant. As corporate ownership of the manifold liquidity venues becomes more complex and blurred, it is perhaps more meaningful to look at the actual location of the exchange. When we say exchange, we are actually referring not to the administrative or corporate headquarters of the exchange firm, but to the location of the IT infrastructure that runs the actual live exchange matching engine. This location is then a physical data centre building, with an additional failover backup site.

Lakeview Capital Market Services’ Peter van Kleef relates the state of high frequency trading (HFT) in Europe including which trades are overcrowded and where the next breakthrough will come from.

Is high frequency order flow in Europe coming from Tier 1 banks or prop desks?

High frequency order flow in Europe comes mainly from proprietary trading firms and hedge funds as well as bank proprietary trading desks.

How is MiFID II changing the mood for HFT? In particular, how will a consolidated order tape affect HFT traders?

High frequency traders were already using a consolidated order tape for their strategies, so the only difference is that MiFID II might make that data cheaper and more readily available. Also, having a consolidated order tape will improve transparency, but that may indirectly cause problems for prime brokers. For example, if a prime broker’s client sees a price in the market data, their execution partner might not be in that market or might not be fast enough to get the price that their client has seen.

What are the most popular instruments for HFT in Europe? Are there any favorite HFT trades that are becoming potentially too ‘crowded’?

Most people who are new to HFT, trade the most common items such as Eurostoxx, DAX, CAC, AEX, FTSE, Bund, Bobl Schatz Futures, etc. This is counterintuitive, however, as the new traders are entering the most crowded trades and most competitive products. There are crowded trades around Eurostoxx, for example, and as a result, there will always be mini Flash Crashes and disruptions of that kind. The real thing is not to keep people out of these trades but to set up better systems in the exchange to maintain liquidity.

People at buy-sides institutions are often uncomfortable with HFT in markets because they want to trade a large amount, yet they do so in a way that is evident to the market and especially to high frequency traders. If there is an impression that there is a buildup of pressure to sell, then traders will lower their price. Some may complain about this process, but it is not the fault of the high frequency trader. Buy-side institutions need to learn more about interacting with HFT in the market. Institutional investors will find that they enjoy more liquidity when they become more sophisticated in terms of how they interact with high frequency traders.

It is incorrect to view HFT as artificial liquidity. Volume is liquidity. It might not always be liquidity in the direction you want, but it is liquidity. It makes it easier to trade, but people are unfamiliar with how to interact, so they simply need to become more familiar with it.

What are exchanges and MTFs doing to attract HFT order flow?

Many exchanges are supporting volume discounts. Many of the new MTFs want to attract volume, so they offer volume discounts for HFT. If you provide liquidity, you are paid for that liquidity; if you take liquidity, you pay. This model is common in all industries. If you buy more cars, cars become cheaper; if you buy more shirts, they get cheaper. In addition, many new exchanges claim to be faster than their rivals.

On the other hand, the older more traditional exchanges have restrictions for liquidity providers and naked access, which is a  disadvantage for market makers who wish to interact with institutions or directly with exchange members. An unintended consequence of these restrictions is that by banning naked access, they disadvantage those very people they want to protect; i.e. the non members.

ITG’s Clare Rowsell and Rob Boardman outline the best practices for liquidity management across multiple regions, focusing on Asia Pacific, North America and Europe.

In an increasingly global and fragmented trading environment, finding and managing liquidity is the top priority for buy-side traders. The practicalities of doing so are complex, and are underpinned by the tradeoff between the time taken to find liquidity – which can result in delay costs as the price moves away, and the quality of that liquidity – trading against certain counterparties can increase market impact costs. Meanwhile, the global liquidity environment is changing rapidly due to evolving regulation, market structure and the trading tools available. What follows is a short summary of some of the most significant developments affecting liquidity management in different regions around the world.

Asia Pacific

Often cited as having a ‘last mover advantage’ in coming latest to the world of dark pools and alternative trading venues, Asia is now catching up rapidly. Growing awareness of the region’s higher trading costs (approximately one third higher than those of the US and UK) is creating market demand for both new lit and dark liquidity sources. Japan is the only major market that currently allows ‘lit’ or quote-publishing venues to compete directly with the exchanges, and in the past year market share on these venues (including SBI Japannext, Chi-X and Kabu.com) has risen, although they still average around 2-3% of total turnover.

Australia will be next, now that the launch of Chi-X to challenge the ASX exchange’s monopoly has been confirmed for early in Quarter 4 2011. As alternative lit venues develop, the importance of smart order routing grows and in Australia this has been a core component of consultation which will result in changes to regulation affecting brokers and exchanges and mandating Smart Order Routing (SOR) as a mechanism to achieve best price in a multi-market environment. For other Asian markets, buy-side traders have been turning to dark pools as a way of managing trading costs and finding quality liquidity.

Most of the large banks and brokers now offer a dark pool or internalization engine in markets including Hong Kong, Japan and Australia; but given Asia’s already-fragmented market structures, adding more broker liquidity pools threatens to complicate the buy-side trader’s life. This is where liquidity management, and specifically the aggregation of dark pools, is coming to the fore. Increasingly the buy-side are turning to dark pool aggregating algorithms to connect into multiple sources of liquidity through one access point.

Canada

Canada has long benefited from trading in an auction market supported by a highly visible electronic book. Even though it was not until the latter half of the decade that ATSs began to spring up in Canada, they quickly gained traction and in 2010 ATSs represented 34% of volume. As these changes have taken place, Canadian regulators have continually reviewed emerging regulation in other regions as Canada continues to parallel more mature markets. With the proliferation of alternative trading venues came an emphasis on the consolidation of data to ensure market integrity. In addressing the need for a consolidated tape, the CSA accepted RFPs and appointed the TMX Group to the role of Information Processor.

Also arising from the multiple-market trading environment is Reg.NMS-style regulations to protect against trade-throughs. February’s Order Protection Rule shifted the best price responsibility to marketplaces and also requires full depth of book protection (unlike the US’s top of book protection). About 3% of Canada’s equity trading is done in dark pools, and although Canada has only two dark pools (Liquidnet Canada and ITG’s MATCH NowSM), Instinet plans to open two this year and Canadian stock exchanges are making moves to offer dark order types.

Put three men and a FIXGlobal’s Edward Mangles around a table; serve them lunch and let the tapes roll. FIXGlobal listened in on a conversation that ranged from regulators to risk and from FX to FIX.

Edward: In defense of the regulator … how should they know what’s going on when neither the sell nor buy-side seem to know?

Vincent: Recent events have shown the divide between the financial market participants and the regulator. For example, the Lehman’s mini bond issue has forced a strong dialogue between the regulator and, in particular, the broker side. But the engagement is slow.

Kent: Retail brokers tend to have a strong voice here in Hong Kong and over the years have developed a strong working relationship with the regulators. Local brokers can at times be pretty outspoken and have proven on many occasions to be an effective lobbying group. From our perspective international brokers tend to be less visible in some of these debates. We see certain common characteristics across Asia where understandably there is a good deal of focus on protecting the retail investor given the high retail investor participation in many of the stock markets in Asia including Taiwan and Korea. The challenge has certainly been in the retail space where there is an overlap of regulatory responsibility in approving and offering products.

Edward: Are we asking the impossible of the regulator to create the same rule book for retail and institutional investors?

Kent: The general principal is that retail investors are less savvy and experienced and regulations need to be explicit. There is a general assumption that as professional investors, institutions can operate with greater flexibility since they can understand the risks in a more sophisticated way. Taking account of this framework then it will not be possible to standardize for both types of investor. The risk is that setting minimum requirements to protect the retail investor may not suit the way business is transacted at an institutional level. Here we advocate consultation and support stronger trade associations.

Vincent: I don’t think you can realistically expect the same regulations for retail traders as for big institutional investors. That’s a utopia that’s never going to exist. These two  groups of investors have different needs. Many regulators – in Europe for example and Luxembourg in particular with their efforts to push through the UCITS 4 protocol – understand that you need different protocols for retail investors.

Kent: But Vincent, every investor has the same goal: making money. It’s only the detailed requirements that are different.

Gerry: There’s certainly a larger burden on the big firms to uphold ethical, legal and fiduciary standards.

Kent: Yes. Retail investors don’t generally have the same constraints on their activities. Institutional investors need a more developed investment process and must ensure fair treatment across all clients regardless of size and fees. Institutional investors will undoubtedly be looking at different investor objectives – for one, they need to be able to implement their strategies in much greater volumes, and in scale, for example.

Edward: How about the role of regulators in curtailing short-selling in many markets? Knee jerk or long-term strategy?

Kent: I’d like to see the ability to short-sell fully resumed as soon as practically possible. We’re now in a situation where some markets have suspended it, and some are allowing it again. This is not ideal. I certainly see the temporary prohibition as a knee-jerk reaction and understandable given the groundswell of public opinion and corporate pressure as the financial crisis took hold – not all of this opinion was entirely rational. In fact, short-selling restrictions can reduce volumes for trading in the markets overall. For one, we have a 130-30 fund. So in this fund, if we’re limited in the number of attractive long-short pair trades we can put on then we’ll just end up trading less. So it’s business that never happens and the unknown would-be client on the other side of our trade – whether they’re institutional or retail – through the exchange, never gets to take advantage of the liquidity. What we need is a greater understanding of how shorting operates. There is a lot of misconception around this issue.

Gerry: I see the value and merit in allowing short selling in varied markets. In markets that don’t allow it, the regulators need to develop this functionality. It encourages more liquidity and volume. But I do understand that in the current environment the regulators have little choice. We won’t know the full impact until later on.

Vincent: The problem is that there’s no consistency among the regulators. Some only forbid short selling on financials. It’s a disruption to competitiveness between various sectors.

Kent: Yes. And not being able to short, will reduce derivatives trading. The fact is, a lot of the shorting that goes on isn’t just one-way, but a strategy with a ‘long’ component to it as well. And funds that relied on the little performance boost from securities lending fees have also seen their returns diminished. The equity finance desks at the brokers have seen a real drop-off in trade volumes because of this.

Vincent: Now the regulators are trying to encourage investors to buy again in a bear market – and there’s a lot of inconsistency between the messages they’re sending now and what they were telling us six months ago.

“Does your firm use TCA to measure execution performance and if yes, how effective a tool do you find it?”

Ian Firth, Aviva Investors, responds

Aviva Investors both subscribes to and supports the use of Transaction Cost Analysis (TCA). We acknowledge there are limitations, both with available systems and market data. We aim to identify trends and ways to improve our trading strategies, and we have spent a great deal of time and resources to continually improve the process we operate. The key to efficient TCA is accurate data and efficient time stamping. This will demonstrate where within the cycle of the order there are inefficiencies. All of our equity trades are subject to review, although a small number may fall out due to the fact specific markets and benchmarks in those markets are not provided/supported.

Trades are loaded on a daily basis and there is commitment from dealers and our in-house execution analyst to ensure that as much information as possible is attached to clearly identify specific trades. Regular reports with details and exceptions are sent to portfolio teams and management to monitor the ongoing performance of dealers, brokers and execution venues. We compare against various benchmarks, with Implementation Shortfall (IS) being our primary benchmark. There is greater discipline in recording all attributes, whether price limits, volume restrictions or direction from the fund manager, in order to identify exceptions and where appropriate identify these trades.

We have seen, and continue to see, an improving trend to our execution capability. We are able to easily identify outliers and explain the reasons for these. Improving results have helped with our profile and we have been able to distribute the results of our trading capability to end clients. We have received positive feedback from our clients, both direct and end, due to the results and the knowledge applied to explain said processes and results.

Brian Mitchell, Gartmore, responds

Yes; Gartmore’s monitoring and analysis of dealing efficiency is aimed at helping to reduce trading costs, identifying potential deficiencies and helping to ensure that our investment processes are in line with the highest market standards for buy-side best execution.

As part of our effort to ensure cost effective execution, we perform detailed TCA and within that we focus, amongst other things, on both the explicit and implicit costs of trading. Explicit costs include equity commission rates, ticket charges and local taxes. Implicit costs, which can account for more than 85% of overall implementation costs, include: (i) market impact (the cost of the bid/offer spread plus the price movement in excess of the bid/offer spread needed to trade the required volume immediately); and (ii) opportunity cost (the performance impact of not instantaneously completing the execution of an order).

While we use broker-led TCA offerings, (across our cash equities, PT and Algo business flows), we do not solely rely on them, given the potential lack of impartiality. It is also difficult to compare trades transacted by competing brokers, as most will inevitably use differing methodologies. We currently use an independent TCA service to help analyse in detail the true impact of equity trade implementation on client accounts and to analyse Broker / Dealer performance, sending them all trade data from our OMS on a weekly basis.

We participate in an anonymous peer group TCA database, to review our rankings on a wide variety of metrics and, as such, this is an effective tool for comparative work. We can compare our trading costs at the aggregate and/or regional level with others on a more realistic, difficulty adjusted basis.