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.
Ownership 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.
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.
Otkritie’s Tim Bevan describes the intricacies and idiosyncrasies of the Russian markets, and offers suggestions on how to effectively access the deep liquidity there.
How would you profile the firms that are interested in DMA to Russia?
There is an interest in DMA to Russia from prime brokerage desks because many of the hedge funds that use the global prime brokers have expressed interest in Russia, now that the liquidity has reached the point it has. It is worth pointing out that the liquidity in the local equity market is approximately $2.5 billion a day, and the derivatives market turnover is $10 billion notional a day. These are very significant and deep pools of liquidity. We are certainly seeing client pressure from different areas hitting Tier 1 banks, which in turn is reflected onto us. We are also seeing the big global electronic brokers looking to add Russia to their coverage.
There is sustained sell-side interest, but the other big pocket of interest we are seeing is from the low-latency, high frequency funds that utilize proximity hosting and co-location, who want to place hardware in Moscow and run their strategies in the electronic order books that are available there. There are many more of these types of participants now and they are often in London, New York, Chicago, Amsterdam, Paris and other parts of Europe.
How extensively are algos utilized in Russian DMA?
Obviously for a high frequency fund, the algo is the strategy. This is clearly different from execution algos, like VWAP, which are used to execute orders in a certain manner. Most Russian brokers have the most basic execution algos like VWAP, TWAP, icebergs, etc. It is a relatively new trend (i.e. 6-9 months old) for the big sell-sides to enter Russia, and many have not yet deployed their more sophisticated suites of algos into the Russian market.
Additionally, the Russian market itself, is quite unusual in that there is a lot of programming skill in Russia. The average Russian retail trader is quite often running an algo through an Excel spreadsheet with $10-20,000 worth of capital, so as regards alpha strategies, there is a lot of algo activity in the Russian market. In terms of execution algos, however, I think it has not penetrated this segment yet. As the sell-sides continue to move into the electronic market, the second phase will be to deploy their own execution algos and offer them to their main clients, but we are at the beginning of that part of the process.
With the majority of liquidity isolated in a dozen stocks, how would Russian DMA fit into a firm’s overall trading/investment strategy?
Liquidity is very concentrated in Russia. The top ten names account for the vast majority of liquidity, and even the top two or three probably make up 50% of the market. DMA is possible beyond the top 15 or 20, but it drops off fairly quickly thereafter. Obviously the big blue chip companies are where most of the interest is. Taking Sberbank as an example, there is no liquid Depository Receipt (DR) and there is an unsponsored DR trading of about $2 million a day in Germany. If you want to trade that stock, you have to trade the local market, where it trades between half to a billion dollars a day notional, so there are some very deeply liquid companies that are only available in the local market.
What other asset classes are being attracted or will attract DMA interest?
The biggest interest is in the RTS Index futures, which is an incredibly powerful product. Trading over $5 billion a day notional, more than double of all of Russian equity instruments (both DR and local), sometimes by a factor of two. RTS Index futures trade from 0700 UK time right through to the US close and are among the top ten most liquid equity index futures in the world. This instrument has generated the majority of interest from the quant funds, but interest is increasingly coming from more standard hedge funds and buy-sides where they are allowed to trade futures as it provides an instant hedge or leverage tool with an almost bottomless liquidity pool for any one player.
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.
While MiFID has now been in force for almost a year and a half, the recent market turmoil has given market transparency, best execution – and a whole host of other issues – a new urgency. FPL brought together a roomful of experts from the Exchanges/ECNs, buy and sell-side to discuss the impact to date, of MiFID, and its strengths and limitations addressing the new financial world order. Extracts of the session follow.
Daemon: Let’s dive straight in. How successful has MiFID been in creating an open infrastructure in Europe?
Charlotte: MiFID has had a large impact and has certainly opened up the market. The main challenge is that there’s a fair amount of work to catch up on. We have new MTFs (Multi-lateral Trading Facilities) and more coming through. This brings new competition and means that the market needs to catch up on these developments. We still have a choice of Central Counterparties and we need consolidated data to have an EBBO (European wide Best Bid and Offer). These are the high level issues that are still out there.
Joseph: I agree. We still have a long way to go. The key challenges are the need for smart-order routing, to give us best execution, and bringing more transparency into the market through better consolidation of data.
Daemon: Do you feel we’re going to see a major shift towards the consolidation of data in the short to mid-term?
Charlotte: We haven’t seen it yet, but we are seeing expanding message traffic coming from all firms. A pipeline of six to ten MTFs will be in place by the end of this year, and this increase in traffic will mean that smart-order routers are going to say at some point, ‘enough is enough’. Then we’ll see some consolidation.
Duncan: When you’re talking about openness and Europe, you have to look at the level of openness across all the countries. So until this October, for example, Italy was not open for competition, but now with the Boursa Italia system upgrade, the system now allows for competitive trading.
The other issue is Spain, which definitely does not have an open infrastructure. There needs to be quite a bit of change within the settlement process in Spain so you can have trading on more than one platform, and so people can gain the same efficiencies in Spain as they do for other markets.
From a technical perspective – a lot of the new MTFs have adopted FIX in a big way. What we need is for the other venues to adopt FIX to standardise the way we connect to all the different venues.
Daemon: How about Smart Order Routing (SOR)? What is your assessment on its importance in the current environment?
Duncan: In Europe, if you’re a broker or investment firm, you’ll already have a lot of different places to get order routing capability connecting into exchanges and MTFs. You can use SOR vendors or your own technology. But because brokers have the capability at the level above the exchanges it’s not clear there is a demand from that community for routing between the platforms. If order routing becomes a market place norm and people want or expect it, then we’ll deploy it. But we’ve not yet seen a clear demand.
Kristian: It’s important to remember that it’s not just brokers that are tasked with demonstrating best execution – we have to demonstrate best execution to our clients everyday. To do that, SOR is paramount. When we pick up the phone to deal with a broker, we expect them to have the same capability. The issue we see is the capability of foreign routers. How sophisticated are they? It’s all very well to say trade Royal Dutch on two different exchanges, but have we reached the point where we can trade multi-listings with the same security? There still isn’t that kind of clarity of transparency as to how this will work.
Joseph: SOR is key in Europe. It’s not only a question of getting access to all the venues. It is the ultimate way to make sure you have best execution under MiFID. But a lot of things need to be incorporated. It’s about pricing across multiple venues, its about volume at a specific time, the probability of getting filled at a specific time and looking for hidden liquidity that may be generated on these exchanges.
It’s not enough to be able to trade, for example, 5,000 shares over five different venues. You need to be able to dynamically direct your orders to venues where there is liquidity at this point in time.
Counterparty credit risk theory and practice have been evolving over the past decade, but the recent market crisis has brought it heightened focus. Quantifi’s David Kelly explains how the current best practice is the result of a long evolutionary process.
Over the past decade, banks addressed the problem of counterparty credit from traditional financing experience while the investment banks approached it from a derivatives perspective. As the industry consolidated in the 90’s, culminating with the repeal of Glass-Steagall in 1999, there was substantial cross-pollination of ideas and best practices. Consolidation and the necessity to free up capital as credit risk became increasingly concentrated within the largest financial institutions drove a series of innovations. These innovations involved methodologies, management responsibilities and technology.
The most significant evolution was the transition of the buy and hold mentality to a more marketbased, active risk management model. Simultaneously, substantial responsibility was transferred from credit officers to traders. As various extensions to the reserve and market models have been implemented, a general consensus has emerged that essentially combines portfolio theory and reserves with active management. This combination has placed tremendous emphasis on technology infrastructure.
Banks today tend to be distributed along the evolutionary timeline by size, where global banks have converged to the consensus model while most regional banks are closer to the beginning stages. This paper traces the evolution of counterparty credit risk based on actual experiences within banks that have had considerable influence.
Reserve model Reserve models are essentially insurance policies against losses due to counterparty defaults. For each transaction, the trading desk pays a premium into a pool from which credit losses are reimbursed. The premium amount is based on the creditworthiness of the counterparty and the overall level of portfolio diversification. Premiums are comprised of two components – the expected loss or credit value adjustment (CVA) and the potential unexpected loss within a chosen confidence level, also referred to as economic capital. Traditional banks like pre-merger Chase and Citibank and their eventual investment banking partners J.P. Morgan and Salomon Smith Barney all used reserve models but the underlying methodologies were very different.
Banks converted exposures to loan equivalents and then priced the incremental credit risk as if it were a loan. In practice, traders simply added the number of basis points prescribed by a table for that counterparty’s risk rating, the transaction type and tenor. In contrast, the more derivatives oriented investment banks calculated reserves by simulating potential future positive exposures of the actual positions. The simulation models persevered because they more precisely valued each unique position and directly incorporated credit risk mitigants, such as collateral and netting agreements.
By 2000, the simulation based CVA and economic capital reserve model was state of the art. Institutions had expanded portfolio coverage in order to maximize netting and diversification benefits. However, trading desks were complaining that credit charges were too high while reserves seemed insufficient to cover mounting credit losses instigated by the Enron and WorldCom failures. The down credit cycle, following the wave of consolidation and increased concentration of risk, forced the large banks to think about new ways to manage credit risk. While banks had used Credit Default Swap (CDS) as a blunt instrument to reduce large exposures, there had been limited effort in actively hedging counterparty credit risk. The need to either free capital or increase capacity spawned two significant and mostly independent solutions. The first solution, driven by the front office, involved pricing and hedging counterparty credit risk like other market risks. This had the effect of replacing economic capital reserves with significantly lower VaR. The second solution, basically in response to the first, introduced active management into the simulation model. Active management or hedging reduced potential future exposure levels and corresponding economic capital reserves. The next two sections review these solutions in more detail.
Front-office market model An innovation that emerged in the mid to late 90’s was the idea of incorporating the credit variable in pricing models in order to hedge counterparty credit risk like other market risks at the position level. There were two ways to implement this ‘market model’. The first involved valuing the counterparty’s unilateral option to default. The second used the bilateral right of setoff, which simplified the model to risky discounting due to the offsetting option to ‘put’ the counterparty’s debt struck at face value against the exposure. Using the unilateral or bilateral model at the position level was appealing since it collapsed credit risk management into the more mature and better understood market risk practice.
Paul Squires, Head of Trading, AXA Investment Managers opens up about the relationship between the buy-side and exchanges, and the perceived effects of recent consolidation among exchanges.
From Trading Desk to Trading Floor
We trade on an exchange in the name of a broker, which means there is a buffer between the exchange and the buy-side. The interaction we have with the exchanges and MTF’s works much better now. The MTF’s have done a good job engaging with the buy-side over the past few years, which makes a lot of sense when you think of the evolving landscape of market structure. Historically, buy-side firms and exchanges were never quite sure if they needed to pay much attention to each other; however, there is a much more collaborative dialogue now. Most buy-side desks have mixed feelings about some of the bigger exchanges, in much the same way that some of the brokers have mixed feelings about the positioning of exchanges. On the up-side, there is a sort of national, utility element to the exchanges. For things like index funds, primary exchanges own the end of day official pricing.
Before MiFID, the primary exchanges were responsible for more of the trade and transaction reporting and it was easier to interpret that data compared with the fragmentation of trade reporting following the first MiFID installment. On the buy-side, we have this simplistic view that it is positive for reporting to be centralised through the primary exchanges because having liquidity in a single venue is something we see as beneficial. Also, the level of monitoring around the primary exchanges is higher than around the MTF’s, and therefore, things like governance and robustness tend to be greater. Generally speaking, we see the primary exchange as a kind of trustworthy elder statesmen in the world of market structure. Where I think the challenges around the exchanges lie are that innovation can be bogged down by their hierarchy and organizational structure, and therefore, cannot compete quite as dynamically as some of the MTF’s, which clearly have much lighter infrastructure considerations. It is no surprise that some of the primary exchanges have lost market share to the MTF’s, who have been nimble, technology focused and reactive in the face of a changing environment.
We find it quite fascinating to see what will happen. Given the rate of market expansion, globalization and regulatory changes - all of which lends itself to consolidation - it was an inevitability. Exchanges have to be forward thinking about what their long term roles will be and although there are different aspects to this, what we tend to focus on is cash equities only. When people think of the Toronto or London exchanges merging, they think it is kind of interesting. Deutsche Boerse and NYSE Euronext, on the other hand, is fairly mind-blowing. In a wider context, the really interesting developments for us, the market participants, are for exchanges to look into other asset classes and areas of activity to secure a revenue stream for the future. The real impetus is not from cash equities; it is very much about clearing, OTC, potentially, fixed income markets and looking at what they can do in more commercial areas.
Net Gain/Loss from Exchange Mergers
We would hope to see technical enhancements at the exchanges. By applying a rule of best practices, the things that work well for the Toronto Stock Exchange or the London Stock Exchange could be transported to the other exchange, as with Deutsche Boerse and NYSE Euronext. The technical platforms and order book layout are quite relevant, so we would hope to see some enhancement in that area. Nonetheless, I would not necessarily promote a uniform market layout or order book structure, as I do not think we need that in every single exchange we trade on. To some extent, the more that order books’ structures align, the more it helps traders who are trading multiple markets. We can pre-constrain a lot of unique exchange rules in our systems, but there are segments where human intelligence and manual control of the various elements are vital. In this respect, we would see any alignment of market practices as a fairly positive development.
The obvious potential negative outcome of the mergers is in returning to situations where the exchanges have too much of a monopolistic position and can potentially raise costs without the market having any ability to challenge it. If the MTF’s or exchanges raise their costs, we do not necessarily see that on the buy-side because of the buffer that the broker provides. There is a fairly high margin in the commission rates we pay our brokers and they cover their costs of trading our orders on the venues, and those venue transaction prices would have to increase exponentially for it to become a direct factor for us. Of course, it does eat away at margins for the brokers, and it may come to a point where they need to pass those costs on. The buy-side is somewhat safeguarded from rising venue costs, but not completely.
Robert Rooks, Independent Market Consultant, questions the current Asian equities market infrastructure and statesthe case for greater competition.
As listed companies, many of Asia’s bourses, like the companies they list, are under constant pressure to reduce costs and return an ever increasing value to their shareholders. This pressure is driving exchanges to invest in or consolidate with other exchanges to continue to offer value to the investors. Market participants, themselves, are questioning whether these so-called ‘global alliances’ will increase market access, reduce costs and return real profits to investors. Consolidation is often a consequence of economic circumstance with any perceived benefits eventually trickling through to the end customer, or in the case of exchanges, the market participants and finally, to the investment community.
Change needs to be spread wider than just the exchange level, to include clearing houses. In Asia, the exchange often owns and operates its own clearing houses, leaving one to wonder whether any savings made on the exchange are clawed back through the clearing and settlement process, given the vertical silo monopolies that they operate. Arguably, this is why the region’s exchanges have the largest market cap and remain some of the most profitable in the world. With continued advances in technology and the advent of new venues it is realistic to assume that this would lead to a reduction in the cost of trading through uniformity and efficiencies? If this is the case, why is the transactional cost of clearing and settlement still far higher in Asia than in other regions?
It would appear from the US and European markets that competition, not consolidation, is what drives costs down. In Europe and the US, the emergence of new trading venues and market operators has led to increases in market efficiency, as well as a substantial reduction in costs. New venues have necessitated new clearing solutions, such as the European Multilateral Clearing Facility (EMCF), further reducing the costs of clearing and settlement. Along with new entrants reducing execution fees, the EMCF has contributed substantially to the increases in liquidity and improved transaction cost transparency.