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AFME’s Securities Trading Committee Chairman Stephen McGoldrick unlocks the latest MiFID proposals and looks at the rules for Organized Trading Facilities, algo trading and a consolidated tape.

Organized Trading Facilities (OTFs)
The OTF regime began life as a specific regulatory wrapper to put around broker crossing systems, (which are a new mechanism for delivering an existing service). Crossing, which is almost the definition of a broker, has become highly automated. Whilst most crossing activities have not changed, other aspects of the industry were seen to require regulation – namely increased automation and greater scope of crossing. The initial proposals outlined an umbrella category of systems called OTFs, with one category created to hold broker crossing systems and another to hold the systems for G20 commitments around derivatives trading.

Stephen McGoldrick, AFME Securities Trading CommitteeWhen the MiFID II proposals came out at the end of 2011, the ‘umbrella’ aspect had been simplified into a structure intended to be ‘all things to all people’, which is where it has come undone. MiFID II has created a regulatory receptacle for a practice and the two things differ in shape. The broker crossing system does not fit into the receptacle that has been created for it because much of the trading is against the books of the system’s operators, which is prohibited under the current proposals.

The regulators do not want speculative, proprietary trading within these systems, but unwinding risk created by clients is both useful and risk-reducing. An opt-in mechanism for compliance, allowing traders to decide if they want their orders traded this way may be a solution. Conflict management of this sort is common in the financial sector, as it ensures that any discretion is not exercised against the interests of the client. Certainly, when it comes to measuring the client’s interests against the operator of an OTF, it is absolutely unambiguous that their interests must come first. Therefore, any exercise of discretion that disadvantages the client relative to the operator is already prohibited. A formal, documented process to ensure that segregation stays in place is good, but to effectively prohibit the vast majority of trading on broker crossing systems seems to abandon the regulators’ objectives – to increase transparency and protect clients.

Furthermore, trades allowed into a broker crossing system would be instantly reported, creating post-trade transparency. The current proposals call for OTFs to be treated in the same way as Multilateral Trading Facilities (MTFs), which fosters uncertainty about the waivers for pre-trade transparency. Currently, there are clear criteria for granting a waiver to a platform: one is that orders are large in size, the other is taking reference prices from a third party platform. The Commission will not, however, be making the decisions about waivers; they have been handed to the European Securities Market Authority (ESMA) to determine. There is a danger in specifying too stringent limits for these waivers, which would create a very different landscape from that explicitly envisaged by MiFID I.

Systemic Internalisers (SIs)
Our understanding is that regulators did not want to split activity that was in an OTF into two, but rather to regulate the broker crossing systems and to remove the subjectivity of SIs. The current SI proposal is aimed at regulating automated market making by banks, so that institutions make markets by reference to market conditions, not by reference to their clients. In MiFID I, the SI regime was introduced to protect retail investors, but subsequently this seems to have changed. When the European Commission (EC) was asked by the Committee of European Securities Regulators (CESR) to clarify the rationale for an SI regime, they declined to do so. As a result there is a distinct lack of clarity regarding the intent of the SI rules. If we had a clearer vision of the direction the regulators wished to take the market, then it would be far easier to assess whether the regulations were moving us in the right direction – or not.

 The Capital Markets Cooperative Research Centre (CMCRC)’s Alex Frino talks about his research over the past 18 months and the conclusions as to the truth about high-frequency trading.

 Alex Frino, Capital Markets Cooperative Research CentreWhat inspired you to focus your research on High Frequency Trading (HFT)? 

There is a very poor understanding of the impact of HFTs on the market place. There is a lot of ill-informed opinion in circulation about the impact of HFT on price volatility, and their contribution to liquidity. I wanted to provide some hard data to help markets move forward and inform sensible evidence-based policy decisions.

There was also considerable interest in the idea of conducting HFT research from our regulator partners, including the FSA and ASIC. 

What were your views on HFT at the outset of your research program? 

When we first set about doing the research 18 months ago, I began by speaking to the investment management community to gather their views and insights into HFT and its impact on their trading. The feedback I got was overwhelmingly negative. One comment sums it up best – an investment manager said to me that “liquidity provided by the HFT community is like fog – you can see it, but when you reach out to grab it, it is not there.” So I began the program expecting to confirm these dominant views. To my surprise we discovered that the realities about HFT are almost exactly the opposite of that the investment managers were telling me. 

HFT liquidity has been described as ephemeral by many on the buy-side. What does your research suggest about the ability of the buy-side to interact with HFT liquidity? 

We have done research with data from the LSE, ASX, SGX, NASDAQ and NYSE Euronext on exactly this subject. The exchanges furnished us with data that identifies when HFTs are present in the market place. We then looked at the make-take decision. HFTs make liquidity when they put up a quote that gets hit by someone on the other side of the trade. They take liquidity when they hit someone else’s quote. The data clearly showed that HFTs are net makers of liquidity.

Interestingly some of our data also included information about when firms are trading through co-located servers within the exchanges. This data too showed that co-lo HFT activity was also a net provider of liquidity in those markets.

Co-location is described by some as an ‘unfair advantage’. What is your take on that given your research into the area? 

My view is that if the advantage is being put to good use in providing liquidity, then it is not being misused. That pool of co-located flow is providing liquidity that would not be there otherwise, so I cannot see how that is a negative for markets. 

Many market participants – including recent widely-quoted comments by Andrew Haldane of the Bank of England – are critical of the speed and sophistication of markets generally, using HFT as their example. They argue the playing field is not level and that markets should be slowed to take away perceived unfair advantages. What is your view? 

I was frankly amazed by Haldane’s suggestion that markets should be slowed [by introducing speed limits and resting periods]. What he is in effect suggesting is that we should take markets backwards by a decade. That is astonishing to me because I just do not see the arguments. Market participants who do not have the technology to compete with other players can easily access brokers with algorithmic trading engines to help them execute their trades. If you cannot or do not want to build the technology yourself, you can outsource it fairly cheaply and very efficiently.

From an HFT perspective, our research demonstrates emphatically that the liquidity they provide is real and other participants interact with it constantly, so I cannot see a problem there either.

As the fable of the hair and the tortoise taught us, being the fastest away from the blocks does not guarantee the best result. Most in the trading community agree that Japan has lagged behind international standards, despite the importance of its market. However, as Peter Twist of IND-X Securites reports, taking a look-and-wait approach may be Japan’s path to success.

These days, it seems impossible to have a discussion about trading without someone alluding to the concept of a more formalised “best execution” mantra. Fuelled by the ever increasing number of independent execution venues, the obsession with best execution might have become a global fad, but is it anything new? Arguably, the practise has always been at the forefront of all those within the trading community, aided by varying degrees of direct involvement from fund managers. Yet, if this is the case, why is there suddenly so much interest? The fundamental issue surrounding the topic of best execution has to be the underlying meaning. What is best execution?

Everyone has an answer, but there is no single definition that satisfies all parties, and divergent motives allow for significant freedom of interpretation. Even within segments where one might expect a degree of consensus, there is scope for fragmentation. For instance, fund managers who fall into the long term buy and hold category could differ markedly from shorter term momentum investors who could, in turn, be diametrically opposed to the latency play individuals. While the definition of best execution isn’t, in itself, a reason for choosing one execution venue over another, the lack of unanimity only serves to support the self-serving world of best endeavours.

Japan catching up?
Historically, Japan has never been at the cutting edge of new trading landscapes. Rather it has often been slow to move beyond the primary exchanges (including some of the smaller, regional exchanges), and still offers very little in terms of alternative venues. While PTS or similar licenses are now available, and some leading brokers have applied to operate competing venues, there have been varying degrees of success.

The core issue for Japan has always been, and – at least for the foreseeable future - looks set to be, the divide between its domestic / onshore and its foreign / offshore trading models. The irony is that new best trading practices are not being forced onto the foreign broker by the local authorities, but rather the high number of foreign brokers operating in Japan are forcing change onto the markets. Given the importance Japan plays within the global economy, this is as surprising as it is expected.

Balancing foreign and domestic interests
Domestically, however, any changes that occur are happening at a much slower rate on the back of the onset of a number of retail focused, i-net based platforms. Retail investors have been a leading force in Japan for some time, and it is only natural that regulators need to balance newer ideas with both foreign and domestic interests in mind. The question is: What has this meant for Japan? The upshot is that, despite new trading landscapes with their high degree of automation, significant advances have been slow to gain traction in Japan. The efforts instigated by the bulge-bracket firms may have been implemented in their local Japan operations, but this only caters for up to a third of the trading population.

While Japan’s domestic economic woes should not be overlooked, the country still needs to recognise the demand and the long-road to travel if it is to open up the established exchanges to greater competition. In short, it has to do more to bring down the costs of participating in its markets, and it has to do more to embrace changes currently being advocated, such as the unbundling of trading and research that has driven trading innovations in other international markets.

That said, Japan has its advantages. Widespread fragmentation, seen in other international markets, has not happened, and this has allowed the procedures of clearing and settling to remain relatively straightforward. So, while it is clear that Japan needs to keep abreast of global changes, its careful hold-back approach is not always a bad thing.

MiFID has undoubtedly made its impact on the industry. FIXGlobal collates opinion from Nomura’s Andrew Bowley and BT Global Service’s Chris Pickles on the success of MiFID and its next manifestation.

Having digested the massive changes MIFID brought to the EU two years ago, what has the financial community learnt from the content of MIFID 1 and the process whereby it was developed and implemented?

Andrew Bowley (Nomura):
First and foremost we must conclude that MiFID has worked. We now have genuine competition and higher transparency across Europe.

Costs are down. MTFs (Multilateral Trading Facilities) have brought in cheaper trading rates and simpler cost structures, and most exchanges have followed with substantial fee cuts of their own. Indeed this pattern is also clearly demonstrated by exception. The one country where MiFID has not been properly introduced is Spain and this is one country where fees have effectively been increased. This teaches us that complete implementation is the key and the European Commission needs to look hard at such exceptions.

We have also seen clearing rates reduced, though the fragmentation itself has caused clearing charges to increase as a proportion of trading fees as typically the clearers charge per execution. Interoperability should help address that, assuming a positive outcome of the current regulatory review.

In terms of lessons learnt from the process we must consider that we have experienced a dramatic change in a short period of time, and should allow more time for the market to adjust before fully concluding or looking to further wholesale change. We are certainly still in a period of transition - new MTFs are still launching; and the commercial models of all of these, mean that we are far from the final equilibrium. To have so many loss-making MTFs means that we cannot be considered to be operating in a stable sustainable environment.

Chris Pickles (BT Global Services):
MiFID is a principles-based directive: it doesn’t aim to give detail, but to establish the principles that should be incorporated in national legislation and that should be followed by investment firms (both buy-side and sell-side). Some market participants may have felt that this approach allowed more flexibility, while others wanted to see specific rules for every possible occasion. The European Commission has perhaps taken the best approach by allowing investment firms and regulators to establish themselves what are the best ways of complying with the MiFID principles, and has perhaps “turned the tables” on the professionals. If the European Commission had tried to tell the professionals how to do their job, the industry would have been up in arms. Instead, MiFID says what has to be achieved – best execution. Leaving the details of how to achieve this to the industry means that the industry has to work out how to achieve that result. This takes time, effort and discussion. FIX Protocol Ltd. helped to drive that discussion by jointly creating the “MiFID Joint Working Group” in 2004. And the discussion is still continuing. A key thing that the industry has learned – and continues to learn – is to ask “why”. Huge assumptions existed before MiFID that are now being questioned or proven to be wrong. On-exchange trading doesn’t always produce the best price. Liquidity does not necessarily stick to existing 100% execution venues. Transparency is not sufficient by just looking at on-exchange prices. And the customer is not necessarily receiving “best execution” from today’s execution policy.

According to the World Federation of Exchanges, in December 2008, BATS was the third largest exchange on the planet: large

Yoichi Ishikawa of kabu.com Securities navigates the developments of PTSs in Japan and their effects on markets, traders and regulators.

(1) Could you tell us about the history of PTS in Japan and its growth over the past 3 years?

The history of Proprietary Trading Systems (PTS) in Japan began with the launch of PTS trading in September 2000 as the country’s first alternative stock trading platform. Initially, two brokerages developed and launched PTS operations geared primarily toward after-hours trading for retail investors, using the closing price at exchanges and VWAP for certain institutional investors. As a result, until April 2007, PTS trading never accounted for more than 0.2% of overall market volume (monthly basis). PTS trading volume, however, gradually began to expand starting in the second half of 2007 owing to the added liquidity provided by new link-ups between PTS operators and brokerage houses. In 2008, PTS midday trading was launched, offering smaller minimum price movements than the exchanges. PTS operators expanded to six firms, and a small number of international brokers began smart-order routing (SOR) operations.

2009 brought even smaller minimum price movements - less than 1 yen - and the launch of PTS stock price streaming through major information vendors such as Thomson Reuters, Bloomberg and QUICK. As a result of these advances, PTS trading exceeded 1% of overall market volume (monthly basis) for the first time in October 2009. Although the launch of the Tokyo Stock Exchange’s (TSE) advanced trading platform, Arrowhead, at the start of 2010 resulted in reduced latency and reduction of tick size, overall market trading value, including the Tokyo bourse, has not witnessed a significant increase. While PTS trading value, too, has not seen much in the way of growth, PTS trading is now primarily used by brokerage houses for algorithmic and electronic trading to capitalize on arbitrage trading opportunities to leverage the price discrepancy between the Arrowhead System and the smaller PTS price ticks. Arbitrage trading will likely grow to represent over half of all trading on the kabu.com PTS platform.

(2) What are the implications of the growth of alternative platforms/PTS - On clients?

Since 2009, Japan Consolidated Tape, which displays the best price from multiple markets (traditional exchanges and PTSs) using streams from major information vendors, has become the focus of attention regarding the trend toward a reduction of tick size, including less than 1 yen. While institutional investors are considering using SOR to efficiently execute trades at this best price, the challenges faced include: developing systems (OMS, back office administration, etc.) to link with PTSs, which have not been used until now; the formulation of internal rules and regulations; and dealing with environmental changes arising from greater liquidity in the Japanese equities markets, including PTSs.

- On sell-side firms?

Brokerage houses have focused attention on organizing internal policy governing PTS usage, the pursuit of reduced latency using collocation and the review of whether PTSs represent a viable alternative market trading platform and the capabilities of SOR, such as whether orders can be routed efficiently to multiple markets. From a policy perspective, after the start of 2010 several brokerage houses in Japan have revised their best execution policy to clarify SOR connections to PTSs.

As for settlement cost and counterparty risk, a growing number of firms, including those who previously avoided connecting to PTSs, are now considering using PTSs more intently because the Japan Securities Clearing Corporation (JSCC) will offer clearing services to alleviate these risks from July 2010. On the other hand, in terms of technology, the ability to develop advanced and sophisticated IT systems, including reduced latency networks and direct feeds from the markets, represents a pressing need in the battle for best execution, especially considering prices can fluctuate by the millisecond in SOR.

“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.

In this article, Nomura’s Ben Springett provides a brief overview of some of the key issues currently impacting European market structure, and shares his own thoughts on some of the changes likely to occur in Europe this year.

Introduction

European market structure, has been, is, and will continue to be, in a state of change for the foreseeable future. Whilst European Commission regulation has been a significant catalyst in this, the industry itself is now looking to progress issues at a faster rate than the expected regulatory change. As such we are seeing increased interest in “self” regulation within the community, particularly in the areas of post trade reporting and efforts to provide a consolidated tape. All market participants are active in this, but it is not unreasonable to assume that it will be down to the broker-dealers to drive any change, as they typically are the ones that have the resources to invest in the process.

Liquidity Fragmentation

Market share amongst trading venues can be measured in many different ways and people can be forgiven from choosing one that paints their own venue in the best light. The accompanying two charts (Charts 1 and 2) show the steady decline of market share amongst the key primary exchanges, to the benefit of the MTF venues, although the total volume levels remain significantly lower than the pre-credit crunch days. When considering primary exchange volumes versus MTFs it is necessary to bear in mind that the primaries are only just starting to compete in each other’s markets, and as such the pan- European MTFs have had more blue chip names with which to capture their market share. This is set to change in 2010; Euronext launched ARCA last year, Xetra have launched their International Market (XIM) and the London Stock Exchange (LSE) have just completed the acquisition of a majority (51%) stake in Turquoise.

Consolidated Tape

MiFID did not mandate a market- wide consolidated tape, as opposed to the NBBO ( National Best Bid and Offer) provided under Reg NMS, and the lack thereof is one of the key concerns raised by the buy-side in a range of forums. There is however, no significant issue with data aggregation offered by a number of key providers such as Bloomberg and Reuters; in addition to some strong fragmentation analysis products available to the market (Fidessa Fragulator, BATS Europe).

In a period of time where cost base is under increasing pressure, attention has now been drawn to the inherent impenetrable conditions that exist in market data (the LSE has sole distribution rights on LSE data, Deutsche Boerse on Deutsche Boerse data etc.), and as the number of venues from which the data is required for increases, so will the interest placed on the associated charges. In an environment with considerable focus on competition, competitive forces cannot work to reduce the fees, leaving regulation as the only option, which was again addressed under Reg NMS in the US.

George Kledaras of FIX Flyer discusses how FIX enables buy-side firms to get better value for their research using
commission sharing agreements.

There was overwhelming interest from the buy-side member community at the FPL Americas Electronic Trading Conference to discuss Commission Sharing Agreements  (CSAs), also known as Client Commission Agreements (CCAs) depending on your buyside or sell-side perspective. CSAs allow asset managers to separate the fees paid for trade execution from the fees paid for research and other services such as FIX connections and market data.

A survey of the buy-side conducted by Integrity Research Associates reports that in the US, “CSAs have gained in popularity over the last five years, and now account for 30% of research commission payments on average. Respondents [to the survey] typically use 5 CSA providers, although some large investment firms use 12 or more.” In the UK, this number is 70% of research commission payments on average.

CSAs allow asset managers to “unbundle” the sell-side trade commission into separate execution and research spending, so that the manager may pay for the execution service with a portion of  the commission fee, and use the rest to pay for research or research related services to one or more places. Often this is because the research provider is not necessarily the broker that executed the trade.

The Securities and Exchange Commission (SEC) in the US and the Financial Services Authority (FSA) in the UK both encourage the use of CSAs in order to allow the manager to optimize the services that they receive, and at the same time, increase the transparency of these fees to the end investor.

The most critical element to understand is how commission breakdowns could be reported to the buy-side with FIX, in order to comply with CSA regulations and describe the workflow from the buy-side that tells the sell-side what research and other services that the sell-side pays for. The significance of CSAs to electronic trading is evidenced by the recent FPL Americas Electronic Trading Conference panel on CSAs.

How FIX facilitates CSAs

Commissions generated by the buyside are reported using back office systems that feed into settlement. After settlement, the broker keeps a breakdown of what portion of the commission is going to be used for execution versus research using rate tables agreed upon with their asset manager clients. While CSA systems right now are based on T+1, delivering commission breakdowns in FIX will allow OMS vendors to provide commission systems in real-time, leading to increased service for the buy-side and further growth in the CSA market.