IIROC, Aviva Investors, Credit Suisse and NASDAQ OMX contribute their insights to our latest discussions on the techniques and technologies of risk management.
Controlling Risk in Today’s Market The Canadian Safety Nets
By Deanna Dobrowsky, Vice President, Market Regulation Policy, IIROC
Canadian regulators, like their counterparts around the globe, have worked to establish a framework to mitigate risk in electronic markets.
We have designed various rules to work as a series of safety nets to protect against events that can lead to unintended outcomes in a high-speed market.
The safety nets are tiered and provide protections, offered by different industry stakeholders, at multiple levels. This layered approach to risk management mitigates risk at different stages in the life cycle of an order, and places the responsibility of protecting the system on various parties.
The four safety nets include:
At the dealer level, automated controls to prevent the entry of orders that can disrupt a fair and orderly market;
At the marketplace level, thresholds that prevent orders from executing at unreasonable prices
Single-stock circuit breakers administered by the Investment Industry Regulatory Organization of Canada that address rapid, significant and unexplained price movement in a particular security; and
Market-wide circuit breakers which halt trading on all equities marketplaces when there are declines in prices that affect the market generally.
Dealers and Automated Pre-Trade Controls The first safety net is maintained by participants – dealers that trade directly on marketplaces and may act on behalf of clients. New requirements (the “Electronic Trading Rules” or “ETR”) have expanded on existing rules to specifically require risk management and supervisory controls related to marketplace access and the use of automated order systems. The ETR require participants to use automated controls to prevent the entry of an order that:
• Exceeds pre-determined credit or capital thresholds, • Exceeds pre-determined value or volume limits, or • Violates market integrity rules or securities regulation.
In particular, a participant that uses an automated order system must have appropriate procedures to detect, prior to entry, an order that is clearly erroneous or unreasonable and which would interfere with fair and orderly markets. The ETR came into force on March 1, 2013.
Marketplace Thresholds The next tier of safety net is at the marketplace level. To date, exchanges and alternative trading systems have not been required to employ volatility controls or trading thresholds. This has resulted in inconsistent, and in some cases non-existent, safeguards on the marketplaces. IIROC has been given the mandate to set marketplace price and volume thresholds, but specific limits have not yet been determined. IIROC has issued a concept paper on this topic and further proposals on marketplace thresholds will be published for comment.
Single-Stock Circuit Breakers Single-stock circuit breakers, which apply to securities included in the S&P/TSX Composite Index as well as to exchange-traded funds, were put in place in February 2012 to address rapid, significant and unexplained price movements in a particular security. A five-minute halt is triggered across all equities marketplaces if the price of the security swings 10% or more within a five-minute period between 9:50am and 3:30pm. Applying a single-stock circuit breaker to securities in a broad-based index reduces extreme volatility in those securities and, by extension, dampens the volatility of the index.
Market-Wide Circuit Breaker The fourth and final safety net is the market-wide circuit breaker which halts trading on all equities marketplaces when there are declines in prices that affect the market generally. Market-wide halts of this nature have historically been, and continue to be, tied to the market-wide circuit breaker in the US. Thus trading halts on all Canadian equities marketplaces generally are triggered based on the decline in the S&P 500 Index from its closing value on the previous day.
Underpinning the Safety Nets As described above, the Canadian safety nets function as part of a multi-tiered system to control short-term, unexplained volatility. Where these measures do not apply or in exceptional circumstances, IIROC will vary or cancel trades that have a negative impact on fair and orderly markets. IIROC’s ability to intervene when required is the final measure strengthening this framework of risk mitigation and management.
Managing Risk in Fixed Income
With Trevor Leydon, Head of Investment Risk for Fixed Income at Aviva Investors.
Like a lot of larger firms, we operate a matrix-style control system for risk management. For things that are electronically-traded, obviously, you can have a little bit more rule-based systematic control, and for OTC and phone-based markets, it’s a little bit more challenging. We try and adopt our controls to reflect a variety of factors, from client appetite to our own risk appetite to market depth. We try and use as many tools as we can to effectively control risk.
We make it as systematic and with as much pre-trade compliance and pre-trade checks as we can, within reason. From specific things like; can the client mandate handle this type of instrument, this particular stock or bond, or the size of the order, there are a variety of control mechanisms in place and those have to be factored into the broader decision-making process that we as a house will go through. There are human controls via the PM and the individuals concerned, and our investment managers proactively engage with the risk team and compliance to think about size, and to talk through any particular points that are of concern while they are going through the idea generation phase, and then onwards from that we try to implement the controls so they are inherent going forwards but minimise disruption.
Mike Caffi, VP and Manager of Global TCA Services, State Street Global Advisors, and Mike Napper, Director and Head of Global Client Analytics Technology, Credit Suisse and EMEA Client Connectivity Technology, Co-Chairs of the FPL TCA Working Group, examine the motivations for, and the progress of the TCA reference guide.
What is the history of the FPL TCA project? Mike Caffi: The industry has been lacking in any kind of standards for TCA, and that’s not a new problem. I have seen some really good TCA white papers over the last five to 10 years that have tried to address the subject, but eventually these fade on the shelf because there is no follow-up support or interest. What we’ve always needed was some independent group to be able to take ownership of this, but how does one get that started? It never really came about until about a year and a half ago, in September of 2011, with the formation of the OpenTCA group. The group was a collaboration of four sell-side firms in London and EMS and TCA vendor TradingScreen, which was the glue that put them all together.
When I read their white paper I got really excited because I saw a group of individuals who were trying to promote at least what appeared to be an essence of a global standard. They held a conference in London, and then they came to Boston and I contacted the person who was heading the public relations at TradingScreen. They invited me to be on a panel to talk about the benefits of standards, and that was in November of 2011. At this meeting TradingScreen had really tried to move this along, but I saw the need for a larger group to really take on this challenge as well. So that’s where I felt a group like FPL would be perfect.
As a matter of fact, when I was at the conference, I related this back to the early beginnings of the FIX Protocol when I was involved 15 years ago. We needed the collaboration of industry participants within a neutral body such as FPL, to take ownership of TCA standards. I even posed that question to the audience: “who would be willing to form a group, putting up a small amount of money just to get the essence of a working group together?”, but there really wasn’t much reaction at that particular time. Given that the holidays were approaching I decided to let it simmer down until after the New Year.
By early March I contacted John Goeller, FPL Americas Regional Co-Chair, and ran the idea by him to see if FPL would be interested in hosting a TCA Working Group. John liked the idea and soon after he ran it by the organisation’s Global Steering Committee, who also thought it would deliver strong industry benefit and liked the idea. From there, FPL leaders opened discussions with TradingScreen and due to strong FPL member firm interest in addressing some of the key business issues impacting the TCA environment, it was agreed that FPL would create a TCA working group. Representatives from Trading Screen joined this parallel activity.
So it was agreed to put out a call for participation, and on the first pass we had about 70 people sign up. We had our first meeting in June of last year, and that is when we got traction; at that point it was really pretty much driven by consensus, which evolved into a survey that allowed us to prioritise our objectives. That gave us greater focus and direction on what to do and, from that survey, we could see that with 70 or 80 people, we needed to break out into smaller groups.
The number one issue highlighted in the survey was terminology and methodology, and as such it was decided that our first working group should focus on coming up with standardised definitions for TCA in the equity space. This has taken some time as we wanted to take a slightly different approach, not writing a white paper, but more of a working reference guide. That project has been our focus for the last four or five months and right now we’re at a point where individuals are actually finalising the more difficult aspects of that document.
Last September, I said it’d be great if we can have this all done by the end of the year, and that was just a bit presumptuous on my part. Now I realise this is going to take quite a while to produce as there is a lot of work involved, and this is just the equity space. We’re going to look at multi-asset class perspectives of TCA after that.
Mike Napper, would you like to give a brief overview of the reasons behind your involvement? Mike Napper: I’m interested and involved in this initiative from two perspectives. Firstly, I head Credit Suisse’s Global Transaction Cost Analysis Technology, both pre-trade and post-trade. Secondly, I also head FIX Client Connectivity for Credit Suisse in EMEA, for Equities, FX and Listed Derivatives, and thus have exposure to the FIX Protocol and FPL.
In 2Q2012, I was invited to help lead this initiative as the sell-side co-chair and I was very happy to contribute. The standardisation will help everyone in the market. It will help clients by providing more clarity on the reports they’re reading. It will help brokers and third party vendors by providing a consolidated reference guide explaining the principles and methodologies to all stakeholders. Firms are doing a lot of creative and original technical analysis, but there isn’t consensus in all cases on some of the basic stuff, and that’s an opportunity.
An area of particular interest, with both my TCA and FIX hats, is the convergence of asset classes onto electronic trading over time, providing greater automation and transparency. We can agree some foundational definitions for what TCA means in a multi-asset-class sense. We have started with a set of Equities definitions, to clarify and standardise what’s already out there and in most cases mature. Then, we’ll expand and mature the definitions across asset classes, where in some cases there is less existing consensus.
Senrigan’s Head of Trading, John Tompkins, and RBS’ Andrew Freyre-Sanders discuss the way event based funds use liquidity and the effect of ID markets in Asia.
Andrew Freyre-Sanders, RBS: What would you say Senrigan is known for among Asia hedge funds?
John Tompkins, Senrigan: What we are most known for now is being an event-driven fund that is entirely based out of Asia. Nick Taylor founded Senrigan in 2009, and he is known for doing event-driven trading and has been verysuccessful at it. Nick was at Goldman Sachs and Credit Suisse, where he ran Modal Capital Partners for nine years before going to Citadel with his team. Senrigan’s capital raising and first year metrics made the first two years a success.
AFS: I know you trade in the US and Europe as well, so is the global fund entirely based out of Asia?
JT: The entire firm is based in Hong Kong, although we have some analysts who spend extended periods of time in the regions of focus. If we do any US and European trading, it always has an Asian bent to it; for example, a UK or European listed company that has a large percentage of their business located in Asia. The few examples are Renault-Nissan, all the Chinese Depository Receipts (DRs) in the US and some Canadian companies doing M&A into Australia.
AFS: Event driven funds require quick access to liquidity. How does the type of deal or event catalyst affect the relative weighting of these items?
JT: The exchanges and companies are smarter, so they generally halt or suspend the names coming into the announcement, and then you have a short window until a given stock starts to trade up towards the terms. Any reasonably-sized fund is not going to be able to get anything done in that time period. After the event, the main concern is your targeted rate of return for the particular deal, which is impacted by the closing timeframe, surrounding risk, regulatory approval, dividend payments, etc, and you set levels where you want to be involved.
Traditionally safe deals with very tight spreads are viewed as the simplest way to risk-reduce, so people take those off and we give liquidity then because we are comfortable with what we are taking on. A lot of people think about the event as just the announcement on the day, but it is actually the time between when you see it and the range gets set. Only if it closes sporadically do you need access to greater liquidity; most of the time, you just need to be in touch with providers rather than have direct access.
AFS: From a trading perspective, once a deal is gone, it is not about that deal. The only speed liquidity advantage is in having systems that can take advantage of the spreads when they may be moving around a certain level. Is that the case for you?
JT: It definitely is. The big differences between Europe and Asia are the number of auctions and the number of times stocks stop trading, which is quite significant. Between three and four distinct times a day, you will have dislocations in spreads for a variety of reasons, and this is an opportunity to improve. Beyond that, a majority of sell-side firms are setting up their own dark pools and there are alternative exchanges in Japan. In those venues, we deal with liquidity providers and market makers who do not care about the individual mechanics of a name; they simply care about the level of spread that they can access.
The most relevant thing is making sure you have the connectivity turned on to access all the forms of liquidity that exist. There is a big differentiation between counterparties in Asia from an executing broker’s standpoint: e.g. what is their default, what do they turn on for you right away, whatcountries do they have their crossing engines in, who do they have in their pool as liquidity providers? You have to know to ask those questions, and it has been very helpful to do that.
Has the industry found its latest villain in the form of dark pools? Not so, argued a group of traditional and alternative trading venue operators over dinner in Singapore last week. Dark pools are nothing new; they’re just finding their feet in Asia’s rugged exchange landscape. FIXGlobal’s Becky Merrett took a look at developments in the industry.
Caught in the middle of a seasonal Singapore early evening downpour, a group of regional specialists make the dash from their taxis to the warmth of an Italian restaurant. The roll-call reads like the Who’s Who of trade execution – Singapore Exchange (or SGX as it is most commonly known), BlocSec, Liquidnet, Chi-X, ITG, Bank of America Merrill Lynch and Credit Suisse. Have dark pools taken over from hedge funds as the baddie-du-jour in Asia? Should dark pools and exchanges compete, cooperate or co-exist?
Before the first cork was pulled opinions were flying, fuelled by the discussion’s volunteer ‘devil’s advocate’ in the form of Credit Suisse’s James Rae, (also Co-Chair of the FPL Singapore Working Group). “What is the purpose of a dark pool versus a traditional exchange? Why do we need alternative venues in Asia? And how do they interchange?” he asked.
“Dark pools have been around for a number of years,” argued Bank of America Merrill Lynch’s Mark Wheatley, fresh off a plane from Japan. “They’re not new in Asia. It’s mostly an extension of the internal broker systems. The alternative trading systems (ATS) we see now in Asia is the industry responding to the demands of their clients by creating a more formalised system.”
Discussing whether ATS should or not should not exist was pointless it seemed, as I toyed with my antipasti. “These are market and client-driven initiatives. All markets evolve, and financial markets evolve faster than most. To try and back track is both unwanted and unwarranted. Judging from the response from the markets in the US and Europe, ATS are here to stay,” Chi-X’s Rob Rooks stated emphatically.
Competitors or complementary? Before the starters were finished, we’d killed the notion that ATS were going to slip quietly away into the night. Instead the conversation turned to the respective roles of traditional exchanges versus off-exchange platforms.
Liquidnet’s Greg Henry weighed in. “An exchange is about price discovery, it’s about listing and taking companies to market. Our focus is on efficiency, latency, liquidity and best execution.”
Unsurprisingly, it was a common view among the alternative venues around the table. Trading activity on the NYSE, they argued, now accounted for less than 30 percent of revenue. The role of traditional exchanges was increasingly focused on listing and sourcing capital. “The stringent regulations on listing, the information required, it provides a comfort blanket for investors,” Henry argued.
“At the end of the day, we all have to create the structure that works for our clients,” Henry concluded.
The right structure for your client? It was a theme that emerged again and again over the evening. The overriding – although not unanimous – feeling was that dark pools catered for one kind of investor, while exchanges provided security and solace for others.
“We don’t want to list organisations. The compliance involved in the process doesn’t fit with our business model. We’re more interested in a symbiotic relationship between ATS and exchanges. We attract different investors with different strategies. The investors trading through our venue are more likely than not to only hold a position for 10 minutes or less,” explained Rooks.
It was time for our lone exchange operator to pitch in. “We’re comfortable with the competition. Although, if we see a proliferation of venues, such as we’ve seen in the US, this is not going to help the region,” said SGX’s Bob Caisley. “We feel that the best way to move forward is to understand what dark pools offer and to let our clients access this technology,” he added.
It was an understandable position, given the recent announcement of a joint venture between SGX and multilateral-trading facility, Chi-X. The deal, which was inked in August, is aiming to launch its Chi-East non-displayed liquidity pool by June 2010. Clearly the move has raised the stakes as it is the first time in Asia that a dark pool has the backing of a regional exchange.
Stephanie Lawton reports on the latest from the Face2Face Forums in Mumbai and Kuala Lumpur.
Few exchanges have seen such dramatic transformations as those in India. Technology looks set to play a major role in meeting market demands with the BSE announcing its adoption of FIX 5.0 and the NSE using FIX 4.2, with plans to upgrade to 5.0 as needed. Both the NSE and BSE seem determined to not only meet, but exceed their members’ expectations and have aggressive plans to build on existing capabilities and develop new products. Bringing together the Exchanges Three exchanges (NSE, BSE and MCX) came together to debate the role of technology, regulators and, of course, competition.
Jim Shapiro, head of market development for the Bombay Stock Exchange (BSE), stated that the ability of an exchange to innovate and stay ahead of the market, would be the key to its success. Correctly reading how the regulators may react to situations and evolve regulations in India would also be key, he added. Vidhu Shekhar, vice president of new products for the National Stock Exchange of India (NSE), agreed that keeping pace with market growth was essential. “You need to keep your eye on the ball,” he urged. “We need to recognise what’s going on outside India and decide how we, as an exchange, respond to the challenges and opportunities of globalization.”.
Latika Kundu, head of market operations for the MCX-SX, focused on the role of technology. “It’s about awareness of products on the market and how we ensure maximum accessibility to these new products,” she argued.
Looking at the progress of DMA and automated trading, the BSE felt the process was still in its infancy, with DMA still showing market constraints. However, algorithms were attracting a lot of interest from most market participants. New players, in particular, were ramping up this aspect of their technology and product offerings, with the BSE keen to attract these new market entrants.
On the subject of regulatory changes, all the exchanges agreed that the regulators had come a long way in engaging with the market and the exchanges. The main concern centered on systematic risk and in better understanding their clients’ requirement. On the idea of a MiFIDstyle system, the exchanges said that though the issue of best execution was being actively discussed, it still remained a complex issue. According to Shapiro, dark pools wasn’t high on the regulators’ priority list and block trading provoked more interest.
The Keynote – High Frequency Trading
High Frequency Trading as the New Market Makers was addressed by Ronald Gould, Chief Executive Officer, Asia- Pacific, Chi-X Global.
To start his presentation, Ron questioned whether High Frequency Trading is ‘bad’ or just ‘badly understood’. He gradually unfolded the story by looking at the development of HFT in the US and Europe in terms of regulatory evolution and the technology arms race. He also illustrated that an Alternative Trading System (ATS) has a positive impact on trading volume, which was reflected by the explosion of trading activity in Europe and in the U.S. He predicted that Asia-Pacific markets will undergo many of the same changes as the U.S. and Europe with HFT will playing a critical role in many existing Asia-Pacific markets with relatively low liquidity.
What are the major issues for electronic trading in India?
The major drivers were still the foreign institutional investors that were showing a strong appetite for algorithms, explained Murat Atamer, vice president equities, at Credit Suisse AES. “FIXatdl would be attractive to our clients,” said Atamer, adding that India was not a market that should be traded without algos.
Credit Suisse’s Murat Atamer explains the rise of high frequency trading and alternative venues in Asia Pacific and what it means for algo traders.
For investors using electronic trading tools, it is now more important than ever that algorithms have minimal signaling risk and prudent controls in place. Traders with sophisticated and safe execution tools at their disposal will be able to increasingly differentiate themselves from the competition. Those who do not could underperform, and that is why it is clear that High Frequency Trading (HFT) is here to stay in Asia Pacific.
As seen in the US ‘Flash Crash’ of May 6, changes to the equity trading landscape bring with them new responsibilities for brokers, and it is up to the broker community to meet them. By using algorithms designed to stop executing trades if prices start to behave abnormally, brokers can look out for temporary price spikes, which do not serve investors’ interests or which could be caused by ‘fat finger’ errors, and so on. All DMA orders and algorithm slices orders should be vetted against the order book to gauge any potential market impact before they ever reach the market.
Investors’ relentless search for alpha in increasingly crowded markets means that HFT and liquidity fragmentation have taken a permanent place in the daily trading activities of many Asian investors. Of course, there are critics, but it is becoming increasingly clear that they will change the way investors trade Asian equities over the next decade.
India has recently offered a great example of this. Earlier this month, the first completed trades in India, using Smart Order Routing (SOR) in that highly fragmented market have so far achieved an average price enhancement of 6bp, more than the bid/offer spread for the names traded on the day. That is good news for investors.
Consider HFT, first. Credit Suisse estimates that some 10% of market trading activity in Asia Pacific is now driven by HFT, although this is closer to 40% in Tokyo. This remains a small proportion by comparison to Europe, where it is estimated that HFT accounts for 35% of total trading activity, or the US, where estimate the figure to be 60% (Exhibit 1).
The rise of HFT in Asia outside Japan is due to a number of factors converging and feeding off each other to create ideal conditions for the exponential growth of this trading style.
Firstly, Asian trading volumes have increased markedly, led by global investor demand for exposure to the regional growth story and the strong performance of regional markets. Since January 2010 alone, the number of shares traded in Asia ex-Japan each day has increased by around 60%. Secondly, Asian exchanges have been competing ferociously with each other to increase trade volumes and are now engaged in a technology arms race as they strive to capture more business (Exhibit 2).