Can you describe the SFC’s recent regulatory initiative on electronic trading? There’s a huge amount of work and thought being put into the regulatory approach to electronic trading internationally, and this effort has been underway for some time.
In Hong Kong, we published our new rules in March after a public consultation.
The initiatives are intended to provide much needed clarity to intermediaries and traders and, in common with much post-financial crisis regulation, are about safety, soundness and transparency. The rules are broadly in line with regulations across other major international markets and the principles published by the International Organization of Securities Commissions (IOSCO).
In essence, the rules apply to internet trading, Direct Market Access (DMA) and algorithmic trading, and are aimed at ensuring that undue risks are not borne by investors.
What are the comments of the industry on the new SFC regime of electronic trading? Feedback was pretty open and honest. There was no significant resistance to the proposals; it is pretty evident that sensible regulation is necessarily about system safety, testing, internal controls and the risks of DMA.
Of course some comments focused on the ever present tension between the extent of safety measures required to minimise risk to an acceptable level and the costs of those measures to the industry – and to end users.
For example, smaller firms were concerned about the extent they have to employ resources to check out an electronic system that is bought off-the-shelf. The answer is that you absolutely need to check it out – because if you don’t, the risks you are taking on are unknowable; you would be flying blind.
Although the new requirements will inevitably increase operating costs, we believe that the framework will actually facilitate the long-term growth of electronic trading in our market; electronic trading is here to stay and the regime ensures that investors are informed and can be confident. One thing we are very conscious of in Hong Kong is that we deal with a vast range of financial institutions from the very big to the very small. The impact of regulation on them, including electronic trading, can therefore vary, and that’s something we have to be sensitive to. Clearly, large firms may be better able to absorb additional costs than smaller firms.
With that in mind, the new regime will become effective on 1 January 2014 to allow sufficient time for all firms to implement internal control policies and procedures, as well as to make changes to their electronic trading and record keeping systems.
How are you examining dark liquidity? Fundamentally, with dark pools and dark liquidity, we are talking about trading off-exchange on platforms that do not offer pre-trade price transparency. Since the imposition of mandatory flagging of reported dark pool transactions by the Hong Kong stock exchange last year, the reported volume of trades executed in dark pools in Hong Kong has increased steadily, accounting for 2.2% to 2.5% of monthly turnover. This, of course, is very small compared to markets that have actively embraced alternative venues – and are now struggling with how to regulate them and find an optimal balance between the roles of “lit” and “dark” trading platforms.
We have identified a set of key issues concerning dark liquidity – clarity to users as to how a dark pool operates; involvement of retail investors; who within a financial institution can see what’s occurring in a dark pool; what ‘best execution’ means within dark pools; and proprietary orders within dark pools – e.g. the priority of proprietary orders versus genuine client orders.
So, unlike the new electronic trading rules – which are about firms operating between a trading platform and a client, this is a separate topic about the platforms themselves.
We’ve already come across some problems with existing dark pools. They have different configurations and different target clients, and of course they were originally developed to facilitate large trades by large institutions – but have moved on from this to deal with smaller trades. Those banks or brokers who operate their own “internal” dark pools tend to say that they are simply a benign electronic overlay to traditional brokerage operations. Exchanges counter this by saying that all trading needs to have pre-trade price and order book transparency and what the dark pools operators are doing is operating alternative exchanges, free riding on lit market pricing. To address these issues, we have actively discussed the situation with existing dark pool operators with a view to imposing carefully calibrated licensing conditions.
We will also consult the market later this year about codifying our stance to ensure a consistent, level playing field for all operators.
Fabricio Oliveira, Head of Risk Management at Mirae Asset Global Investments Brazil, discusses his approach to pre-trade risk controls and how local market structure influences the occurrence of risk.
Market Open At Mirae we do much of our trading with offshore entities. For example, we have funds that are administered in Hong Kong, Luxembourg, Brazil, US and Korea and this geographical disparity creates operational risk. Differences in settlement price, currency and the timing of financial transfers are all aspects that must be considered when using offshore funds. The ability to settle a US trade in the US and not in another time zone is also important. This is particularly true of Hong Kong as our time difference is a huge barrier to trades in Asia. It is almost impossible to book these trades in Hong Kong even though our traders here see the opportunity to do so.
When I focus on the risks for open trading, the settlement movement is an important concern. Whether you are focused on market risk or liquidity risk, all risks need to be monitored, so you can have a clear view of what potential risks lie ahead.
High Frequency Trading There is much discussion in the industry and at conferences about high frequency trading (HFT) in Brazil, but we are not yet ready for high frequency strategies. The industry is starting to see how HFT works, but liquidity in Brazil across asset classes is insufficient to support these strategies. There are approximately 300 listed companies in equities and about half that number in derivatives, whether in bonds or yield curves or currency. The local players who run HFT strategies focus on the few stocks and derivatives with liquidity, which does not give them many options to find alpha over short periods. It will be interesting to see how it works in North America and Europe and for us to consider what might be possible in Brazil. For now, I do not see many players in HFT and I can count on one hand the number of funds using HFT.
Our pre-trade risk controls have not had to account for HFT volumes and speeds yet, so we have focused more on core control mechanisms. We have some vendors who can produce risk controls for the current liquidity. If we have liquid stocks, derivatives or OTC products, then we can define our own risk controls. Fund houses with hundreds of funds will have difficulty in applying those controls to the trading systems, but as Mirae mainly focuses on equities, our implementation burden is much lower. Today, all our pre-trade risk controls are done in real-time, including automatic limits. Beyond this, we still have a layer of control in the trader on the desk.
Working with Brokers When discussing risk controls, it is important to mention that in Brazil all brokers employ significant risk controls on their side, to prevent them from taking on more risk than they can carry. When the brokers start to trade with the exchange, the exchange provides them with risk guidelines and limits. As clients of the sell-side, buy-side desks cannot exceed their assigned broker limits and their orders will be automatically paused if the broker’s limits are reached. The broker’s risk controls are complete; they will not take on risk. As a result, their clients do not have much help in implementing their own controls. This is exacerbated because a fund house may trade with many brokers – in our case we deal with 35. It is impossible to implement one solution per broker, so we rely on our OMS provider to connect with the brokers and to match up risk controls.
Schroders’ Head of Asian Trading, Jacqueline Loh, shares her thoughts on trading in Asia, offering comments on which markets are primed for change, how to find value in dark pools and whether unbundling is as useful as people say it is.
Fragmentation arising from multiple sources of liquidity is a necessary step in the evolution of best execution and in the long term, fragmentation will increase the quality of trade executions in Asia. What it means for the buy-side is investment in infrastructure spending to develop new order routers and the like, so we can electronically seek out and have exposure to multiple liquidity sources. For the sell-side, it means acceptance that there will be more competition for the same block of business in the marketplace. It means different things for different buy-side firms as well.
When I think about the investor ID markets in Asia, I am not sure any model is particularly productive because ID markets make it administratively more difficult to trade. IDs can make best execution very difficult to implement, especially if cash and stock checking is the primary consideration. Some of the ID markets, namely Taiwan and Korea, allow trading through omnibus accounts and that seems to be the way it is evolving. The ID markets are slowly going away, but having said that, the most productive example is probably China because the brokers seem to have a handle on exactly how much cash and stock you have in your account, and therefore how much you can sell and buy. You cannot overspend or oversell, and it is relatively easy to take part in IPOs.
Trade allocation used to be a problem with investor IDs; for example, explaining to compliance and regulators why the prices are not exactly the same between accounts. In these cases the use of omnibus accounts really help. Executing through omnibus ID means you know exactly what is in an account and do not experience many of the issues associated with overselling or settlement. It is a lot cleaner.
With retail-heavy markets, anonymity is the primary consideration for us. We tend to trade more using electronic means and make use of dark pools in retail-heavy markets. In addition to that, the algos we use will be more price-specific, rather than volume-participation models, which are more price impacting.
Best Execution, in the Dark?
You would think that dark pools would have more success in markets where spreads are currently wide and there is a need to be anonymous, which would imply ASEAN markets. In practice, however, it has had more success in Hong Kong, and that is because there are more users of electronic trading there. Perhaps the users are a little more sophisticated as well insofar as they are willing to take accountability for their executions. Which is, in fact, what defines electronic trading.
In our experience, dark pools make a difference in terms of liquidity, however, the question is what creates that difference? Is it the electronic trading system feeding through the dark pool that provides the benefit or is it the dark pool, itself? I would say it is the former, but that may depend on each user. routers. I hope the Securities and Exchange Board of India will consider further change including allowing stock crossings and clarifying the rules regarding P-Notes.
Guosen Securities’ Shen Tao reveals the latest trends in algo usage by Chinese asset managers, domestic mutual funds and Qualified Foreign Institutional Investors (QFIIs).
Who are the primary customers for algorithmic products in China? Algorithmic trading started in the Chinese A share market some time in 2007. In 2005, the first commercial FIX engine went live to accommodate the execution needs of the Chinese A share market of Qualified Foreign Institutional Investors, or QFIIs, as part of the plan by the Chinese government to allow regulated capital market investment by foreign investors. After an initial experimental phase of FIX connectivity with global trading networks, the local FIX trading platform became solid enough to interface with a real algo engine. In 2007, some leading global investment banks (predominantly, QFIIs from the sell-side) began to offer algorithmic trading facilities for their clients and their own proprietary trading desks. Most of these facilities were located offshore (e.g. Hong Kong) and connected to the Chinese brokers’ FIX gateway via a financial trading network such as Bloomberg.
The earliest providers and users of algo trading in the Chinese market were solely QFIIs and their clients. In 2008, although the global market was in turmoil and many infrastructure budgets were cut across the international financial community, there were still some firms seeking expansion opportunities for the future. Among them, some global banks with local brokerage joint venture subsidiaries began to build their onshore algo facilities. At about the same time, some leading purely local brokers also started their efforts in algo development, Guosen among them. We started in March 2008 and also targeted QFII investors for algorithmic trading, however, we understood the future of algorithmic trading in the Chinese market would rest on the domestic mutual fund industry. In late 2009, the Guosen algo platform was almost ready and the aforementioned onshore algo facilities run by the sell-side joint ventures of global banks also went live. The day of the algo had finally arrived for China.
In 2010, with support from a leading buy-side OMS vendor Hundsun; Guosen and UBS began their efforts by offering an algo solution for local mutual fund companies. In November 2010, UBS won its first success with two Beijing-based mutual fund companies, with Guosen securing a third six months later. Since that time, more than a dozen mutual fund companies have started using algorithms from UBS and Guosen. 2010 was the first year of the algo, from a local perspective. Currently, the momentum of mutual fund companies adopting algo platforms continues. We estimate that by the end of 2011, in terms of assets under management, over 40% of the local mutual fund industry could be covered by broker-provided algo services.
In retrospect, QFII investors were the founders of the market, but soon, the local mutual fund industry will become the primary user of algos. In addition, we foresee insurance companies adopting algo trading soon.
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.
RCM’s Head of Asia Pacific Trading, Kent Rossiter, unmasks the Asian trading scene, sharing insights into how RCM navigates the unlit landscape, identifying the effects of dark liquidity and highlighting ways brokers can facilitate better buy-side decision making.
FIXGlobal: What are the main benefits of dark liquidity in Asia?
Kent Rossiter, RCM: One of the major challenges in Asia has always been accessing liquidity without other parties in the market taking advantage of your position and your need to complete the order. In cases where liquidity is scarce, knowledge that a relatively large order is being worked can expose investors to various risks. In such situations, it is advantageous for knowledge of the deal whilst it is being worked to be discreet until the order is filled. In dark pools run by brokers we can get priority on our orders through queue-jumping.
Dark pools support such an approach as they allow large block orders to be worked without showing size. In this way, trading in dark pools allows a trader to access a broker’s own internal order flow, without being gamed by the market that would otherwise risk non-fulfillment or less efficient pricing. As a result, size trading becomes the norm in dark pools and a trader gets to see blocks that may never have been available otherwise. With no information leakage we are not disadvantaged by the fading you see on lit venue quotes. From a personal perspective, the challenges that arise from dealing across a number of venues and the resulting increased use of technology make the role more exciting and satisfying.
FG: How do you limit information leakage in dark pools?
KR: With the exception of broker internalization engines, the trade sizes found in dark pools are often multiple of what they are on the exchange. So having fewer, but larger prints reduces information leakage, and in many cases we can get done on our size right away. Minimizing the number of times a print hits the tape reduces the chance of this footprint being picked up and working against the balance of your order. That said, broker internalization engines do their part well, keeping any spread savings among the two broker’s clients instead of giving it up to the general market.
FG: If you decide to seek dark liquidity, how do you decide between broker internalizers and block crossing networks?
KR: The type of dark venues being used for various trades (i.e. between block crossing networks and brokers) are different. As I mentioned, brokers for the most part are matching up little prints that otherwise would have been time-sliced in the general market, and when using these venues the goal is often to save a few basis points along the way while you work an order. You are not often micro-managing each fill, but through the process we are getting spread capture and price improvement. The type of stock you are often trading in these internalization engines are often larger, more liquid stocks; the type of orders often worked by algos.
Block crossing networks on the other hand, while still matching up electronically, are probably more confidential, and take up the function of what brokers still do upstairs - putting blocks together - so size is the real focus here. Both types of dark pools use the primary market for price sourcing since the vast majority of trades get printed at or within the best bid and offer. As the primary markets become too thin, it can cause price formation problems.
While it is not specific to the consideration of dark pools as an extra execution venue, we have to consider potential increased book out costs if we do use dark pools (except via aggregators, since we would only be using one counterparty), just as we have had to for years when deciding whether to execute a block with a single broker versus multiple counterparties. As dark pools proliferate there is an increased chance that we may not have part of our order in that pool at just the right time to take advantage of flow that may be parked there. Dark pool aggregators are aiming to provide the buy-side solutions to this.
RCM’s Head of Asia Pacific Trading, Kent Rossiter, points out some of the good and bad of Indian SOR and reflects on Hong Kong market structure.
Are Smart Order Routers (SORs) in India working well?
SORs sure are working in India. I am not sure what is more of a raging success in the Asian equity SOR world, India or Japan, but the cost savings estimate numbers we are hearing are evidence enough to suggest that Indian SOR development is a big plus.
For ages, there have been two meaningfully big markets; the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Up until a year ago, when Securities and Exchange Board of India (SEBI) opened the playing field up, investors who wanted the liquidity of both had to do so by manually monitoring their screens. This was painfully labor intensive and with the thin displayed liquidity of bids and offers, difficult to actually execute. You would often find fills from one exchange or another being executed at inferior prices to the other as a dealer had their eyes off the ball. Those executions were inevitably followed by a conversation with a dozen excuses. I would be told what I was seeing on my screen was not the real situation, but a latency delayed picture.
For the most part we are only using brokers with SOR for our Indian executions, and these brokers co-locate servers so latency is no longer a concern. We are getting fills at the best prices available and from two pools of liquidity where we may have only had one in the past. Only if the order is really small would we limit ourselves to one exchange in an effort to save on ticketing charges.
SOR is just the most recent visible step in the broader trend of the evolution of markets. Accordingly, the buy-side and sell-side traders have to educate themselves and keep up.
What are the issues with Indian SOR?
It is the lack of interoperability at the post-trade clearing level that has limited the true savings many investors would have benefited from otherwise. This is a challenge that SEBI continues to address. The lack a central clearing counterparty for the NSE and the BSE causes settlement costs to be about twice what they would be if only one exchange were used, and this is a consideration for most institutions when deciding whether or not to use two exchanges. If the exchanges and SEBI could reach a solution in terms of interoperability arrangements for SORs, the cost savings and benefits of SOR usage could be passed to the end users. Until then, its true potential remains yet to be uncovered.