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Rudolf Siebel, Managing Director of BVI Bundesverband Investment und Asset Management, shares the perspectives of German asset managers and their regulatory

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?

Tim Bevan, OtkritieThere 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.

In this article, Equiduct Trading’s Joint CEO Artur Fischer argues that in times of extreme structural and economic change, there is an even greater requirement for transparency. He believes that in an increasingly fragmented market, there’s an even greater risk that organisations will need even more help if they are to avoid effectively trading in the dark with no clear consolidated view of market pricing. Here he identifies the growing requirement for a new generation of virtual order book that can consolidate all the visible pre-trade information generated from significant relevant markets, effectively delivering transparency and providing firms with access to a single, unbiased source of pan-European equity price data.

The European equity markets have undergone a period of rapid and unprecedented change over the past two years. While some of these shifts have been mainly related to the still-evolving current global economic situation – leading to the disappearance or restructuring of some of the biggest names in finance – others have centred around newlyintroduced regulation, with the arrival of new types of execution venues and cross border clearing venues being among the most obvious and significant.

These changes have created some huge challenges (and it should be said equally huge opportunities) for market participants, whether they be the large broker dealers having to connect to all the new trading venues in search of liquidity, or a pension fund simply trying to understand what the “Best Execution” he has been promised actually means.

Each of the incumbent Exchanges, the new Multilateral Trading Facilities (MTF), and the growing number of Dark Pools or Crossing Networks provides an alternative USP for execution of equity orders, and each operates with a slightly different business model - both pre and post trade. This has understandably stimulated competition for order flow liquidity, introducing alternatives in the post trade space, and leading to a major shake up in fees. Not surprisingly, this has also irreversibly fragmented liquidity. However, this fragmentation is an evolving process; the picture is far from complete or even stable, and can be expected to go through several consolidation and subsequent fragmentation phases before the next “Big Bang”.

Opening up the European equity markets
With new entrants into the execution space, Europe’s equity market is opening up for investors from across the world. FIX-compliant technology is enabling easier connectivity to the new venues and providing an opportunity for a wider range of firms to get access to venues over and above the incumbent. In Vol 2 Issue 8 December 2008 of FIXGlobal, John Palazzo of Cheuvreux stated “FIX affords every broker the ability to get into these markets at an unprecedented pace” – at Equiduct we certainly agree, but there are still some considerable challenges.

How, for example, do “sell-side” firms determine whether they should connect to these new venues? How do they then prioritise which to connect to? How do they choose where to actually send their order? Also, how do “buy-side” investors understand which venues their brokers should be connected to, if they are to ensure them the mythical Best Execution? What price should they be using to markto- market at the end of each day and for intraday position risk purposes?

At Equiduct, we’re hoping to provide some of the answers to these important questions. We hope to be able to shed some light on the situation and show how to achieve best execution on the various available platforms with a range of analytical tools. Uniquely, the toolset includes a Pan-European aggregated feed.

Ensuring execution on the most appropriate platform
Firms across the trading spectrum, whether small or large, are increasingly using sophisticated smart-order-routing solutions and algorithmic trading systems to “slice” orders and to determine where they should distribute the pieces across the Dark Pools, MTF and Exchanges. However, in order for these systems and indeed an individual trader to start to effectively predict the future, it is important to understand the present and the past. Information providers such as Markit or Fidessa with their Fragmentation Index can confirm the common knowledge that liquidity fragmentation is a reality once a trade has been executed. However they do not have the ability to see how the market should have performed by examining the pre-trade order and price information that was available at the time of trade.

At Equiduct we have been collating all visible pre-trade information (Level II data) for the top 700 shares across Belgium, France, Germany, The Netherlands and the UK from the major European venues (BATS, Chi-X, NYSE Euronext, London Stock Exchange, Nasdaq OMX, Turquoise, Xetra) since April 2008. Yes, a significant percentage of order flow has moved away from the incumbent exchanges but what is not such common knowledge is that trades are still not always executed on the most appropriate platform. Indeed our analysis shows that in April 2009 a significant proportion of trades executed on the incumbent exchanges should have been transacted on an alternative venue, and approximately 35% of executed trades are still not transacted on the best price venue. Significant price improvement could have been achieved if this had happened. (See Diagram 1)

George Macdonald, CEO of Macdonald Associates (MACD) looks into the history of German exchange platforms and reveals the future of German exchange connectivity through FIX.

Germany was slow on the uptake of FIX. In order to understand that statement, it is necessary to take a look at the past. It was not because they were slow at adopting electronic trading, but in fact, precisely the opposite; the Swiss Exchange (then called SOFFEX) and the German Exchange (then called Deutsche Termin Börse) were right at the forefront of electronic trading with their systems going live at the end of the eighties.

Electronic trading took time to gain significant momentum. In 1996 the BUND (a futures contract on German debt) was still traded almost exclusively in London at LIFFE in open outcry. The fully electronic German exchange, despite having been around for six years, had managed to gain only 30% of market share. Indeed, many people at LIFFE believed that derivative trading could never move off the floor and onto an electronic platform. The move to Frankfurt happened in stages, with intense competition at the end of 1997. However, once 50% was reached, the tipping point had occurred and the volumes migrated entirely in just a few months.

The Germans had demonstrated that electronic trading could work. The cash market for equities was also one of the first to move to a fully electronic platform, with the Deutsche Börse order books going live on Xetra in 1997. Since then, electronic trading has swept the globe, with almost no market resisting the inevitable change. There have also been a lot of other changes since then as the trading process continues to evolve. The early success was also the reason for the slow uptake of FIX; the first mover advantage on electronic trading meant that the exchanges and banks built a trading landscape tightly knitted around a small number of proprietary systems.

Ultimately, two main connections to liquidity evolved: Xetra, a proprietary trading platform developed by the Frankfurt exchange, and XONTRO, a system which connected the banks to the regional exchanges (Stuttgart, Düsseldorf, Hamburg, München, Hannover, Berlin and the Frankfurt floor). These two systems ensured that the trading landscape became intertwined and dependent on the existing infrastructure. There was no pressing need for a change. This, in turn, made it very difficult for new entrants such as Equiduct, NASDAQ Europe and Chi-X to gain a foothold. The move to FIX was something inevitable, however, and it was only a question of when, not if, the connectivity changed.

Gradually, some new exchanges did experience success. For example Tradegate, a new startup exchange based in Berlin, has recently been successful in capturing flow, using FIX as their main method of connectivity. Thorsten Commichau of Tradegate said: “FIX is basic technology that makes sure your order stream doesn’t dry up. We at Tradegate have been providing it since 2001 and recently an increasing number of other German exchanges have started to use it too. Tradegate’s FIX interface supports modern order types such as one-cancels-other and trailing-stop limit and has made proprietary access alternatives unnecessary. In 2010, Tradegate Exchange recorded 3.2 million trades, a growth of 33 percent compared with 2009. Nowadays, over 80 percent of all customers send their orders to Tradegate Exchange in the FIX format.”

BT’s Chris Pickles charts the history and structure of German exchange networks.

Wherever you may be from, when you arrive in another country you often find yourself comparing how things are done in the local market, to how they are done at home and in  Germany, there is usually a very good reason for what they do in the financial markets. Germany is probably unlike any other financial market in Europe. As the largest single national economy inside or outside the European Union, it has its own dynamism and momentum that can follow the flow of the rest of the world or take its own direction when it sees that a different approach is needed.

The structure of the market is different for many reasons. Germany is a federation of states, each of which has its own government and economy, and until recently each of the “old states” of western Germany also had its own stock exchange. Those eight exchanges competed headto-head for order flow, and it was only some twenty years ago that the Frankfurt Stock Exchange grew from being the number two stock exchange in Germany to become the largest of the German stock exchanges  and a leading world exchange. But the other German stock exchanges – Dusseldorf, Munich, Hamburg & Hannover, Berlin and Stuttgart – are still actively competing in the market.

Bonds trading has always been a major service area for German stock exchanges. As a result, the concept of integrating trading and trade-related services horizontally across  asset classes and vertically down the STP (Straight-Through Processing) chain to provide more cost-efficient solutions for the local financial community has been an underlying principle behind the development of all financial trading in Germany. That has led to a different market expectation of how technology, connectivity, networks and standards are applied.

Central to the architecture of the German securities and derivatives markets is Deutsche Boerse Group, which operates the Frankfurt Stock Exchange and Eurex, the
German derivatives exchange. This Group also includes Clearstream, which is the domestic Central Securities Depository (CSD) as well as being an international CSD. And the group also includes Eurex Clearing as the Central Counterparty (CCP). Deutsche Boerse Group is not, as the name would imply, the German exchange, but it includes almost all of the central functionality that a domestic market participant would need in order to domestically trade securities and derivatives.

German securities exchanges have continued to offer floor trading right up until today, and many TV stations around the world that want an image of “real people trading” tend to use a picture of the Frankfurt exchange floor – no matter what market they may be talking about. Order matching has remained a fundamental of German securities trading. While the USA went to quotedriven markets, and the UK used “Big Bang” to move to a single quote-driven exchange, Germany continued to use competing order-driven markets to deliver cost-efficient trading to investors. That may sound conservative, but as a counter-argument, the London Stock Exchange has re-introduced order matching and this now processes greater trading volumes than its quote-driven system.

When the German exchange systems were being developed, ISO industry standards for securities messaging and market data were in their very early days, and  were not truly “fit for purpose”, so that any exchange system that wanted to use ISO message standards had to apply work-arounds, typically using free-text fields to try to make up for the inadequacies of the standard formats. As an example of how cooperation can sometimes be better for markets than pure competition alone, the German exchanges jointly created BrainTrade, which operates the Xontro national order routing/matching system, which offered the FIX Protocol as the interface standard for use by the German trading community. FIX was first introduced by Deutsche Boerse as a commercial product running at the customer site on top of the legacy interface VALUES, although take-up was  limited.

The FIX Protocol is also now being applied by Deutsche Boerse for users of its Xetra securities trading systems and its Eurex derivatives trading system, initially as a front-end to its high-speed proprietary protocol ETS. This will allow member firms to apply their existing use of the FIX Protocol to both Xetra and Eurex, but only where latency is not considered to be critical. The next stage will be to offer a native interface supporting FIX semantics over a high-speed transport in the context of new platforms for trading and clearing. This will provide performance as well as simplicity of access, starting with Eurex and followed by the Xetra trading system.

As recent history shows, China has a vast and diverse economic system, which contains a number of economic sub-systems, many of which have experienced growth in the last 36 months. In the media, headlines portray China to be an economic powerhouse, with expansion plans that have far reaching implications for these domains, including electronic trading in Financial Services.

One area that has seen much attention from western companies in the financial sector over the last two years is that of the Qualified Domestic Institutional Investors (QDIIs). More and more of the QDIIs, are gradually being granted authorisation by the Chinese government to trade global offshore securities in the stock, bonds and other securities. QDII programs are used in places where the capital markets are not yet completely open to all investors. For example, any institutional investor in China that obtains approval to be a QDII may invest up to 50% of net assets into allowable foreign securities, so long as not more than 5% is invested in any one security.

Background on some recent changes to the QDII programme

According to DeaconsLaw.com, the China Securities Regulatory Commission (CSRC) has confirmed it had signed Memorandum of Understandings (MOUs) with four jurisdictions, namely Australia, Germany, Korea and Luxembourg, in addition to Hong Kong, United Kingdom, Singapore, Japan and USA over the past year. This means for commercial banks, QDII investment products issued by commercial banks may invest in listed stocks and mutual funds supervised by the relevant regulatory bodies in these jurisdictions. Also, in the case of Chinese fund management companies (FMCs); in 2009 the FMCs were permitted to extend their asset management services to multiple-client accounts, following single client segregated account services, which were launched during 2008. Whereas now, FMCs may expand their managed account asset management services to include investments in offshore markets and mutual funds as well as offering QDII funds.

To be able to invest offshore, FMCs need to apply for a new QDII investment quota or use any balance of their existing QDII investment quota (originally granted for the launch of QDII funds), provided an approval is obtained from State Administration of Foreign Exchange (SAFE).

Trading offshore – Global Markets

Global Markets may be a new experience that some of these Chinese Funds’ find they have insufficient understanding or experience to adequately deal with.

This perceived shortfall of global markets trading experience manifests itself in both an opportunity and a threat, each with their own risks, neither of which can, nor should be ignored. Prudence and patience should be employed when prioritising the financial services opportunities in China; with their exceptionally high savings rate and positive trade balance providing an abundance of capital, some of which is targeted at foreign investment – Qualified Domestic Institutional Investors (QDIIs), this is a fledgling sector and is transitioning very slowly.

What is important for western companies to consider is that a lot of leg work will be necessary, whilst it may feel like a fruitless exercise, it is important to stick at it and be sure that your value proposition is appropriately reviewed in the right forum.

The financial services arena in China, is no stranger to electronic trading, this can be seen with their domestic solutions, which demonstrate a good deal more Straight Through Processing (STP) than most western organisations.