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As the regulatory juggernaut gathers pace, Alexander Neil, Head of Equity and Derivatives Trading at EFG Bank examines the issues behind the tape, and what the buy-side wants. 

Many of my buy-side peers have given up hope on a consolidated tape (CT), but the success of a CT is absolutely paramount now, even more so than it was a few years ago. Not just for industry insiders, but for politicians and the outside world to be shown that these can be transparent markets and that we are not penalised by misguided efforts to force volume onto lit markets, abolish dark pools or volume-enhancing factions such as certain HFT activities. In such a low-volume, low-commission environment I feel the stakes are especially high to get this right from the first day, and not let it drag on and into MiFID III . It shouldn’t be this hard to track trades in Europe and it’s funny to think that whilst we’ve seen a real race to zero in pre-trade latency, it feels like the post-trade space is being drawn out over years!

The Holy Grail is a ‘quality’ tape of record at ‘reasonable cost’. But what is a fair price for market data? Is it really something that can be left to market forces, or is it one of those things that should be regulated like electricity prices. After all, there are social responsibility aspects to market data, as ultimately higher costs for the buy-side are implicitly passed on to the broader (investing) public.

There were initially three routes that the European Commission (EC) wanted to take us down. The first route was to employ the same model as they did for execution and let the invisible hand of the market find the best solution and pricing through healthy competition. The second option was for a prescribed non-profit seeking entity to manage the CT, and the third option would be a public tender with just one winner. The EC seems to be leaning towards the fully commercial approach, and it has set the stage for a basic workflow where APAs (approved publication arrangements) collect and pass on the data to Consolidated Tape Provider(s) (CTP). But, if market forces alone could find a compromise between cost and implementation, we would have an affordable and reliable European Consolidated Tape (ECT) in place already, and MiFID II could instead concentrate on new problems.

So my first concern with the purely commercial approach is that so far, it hasn’t worked; incumbent exchanges are still charging pre-MiFID levels for their data (despite, or indeed because of, their diminished market share in execution), and the only real effort to break the stalemate (namely, the MTFs throwing down the gauntlet) will end up just penalising the buy-side more in the short-term. If the regulator doesn’t address data pricing head on, the buy-side may well end up suffering the effects of a scorched-earth move (wasn’t ESMA granted more powers than its predecessor CESR after all?).

Industry Initiatives
However, it’s not all bad. The COBA Project has recently announced a proposal which promises to address these commercial obstacles and has initial support from exchanges and other venues which contribute more than 50% of total turnover. Their solution establishes a new commercial model for Consolidated Tape data which lowers the cost and incorporates the best practices recommendations developed by FPL and other industry working groups. The best practices provide details on how trade condition flags should be normalised thereby enabling consolidation of trade data across exchanges, MTFs, OTC and even BOAT. FPL’s best practices recommendations also bring together wide representation from across the industry, and has been concentrating on data standardisation (including timestamp synchronisation and a clear distinction between execution times stamps and reporting time stamps).

The Coba Project is spearheaded by two former exchange and MTF people, and seems to be the most ambitious in terms of setting a deadline (Q2 ’13). For their sake I would like to see that good work recognised, but the EC has not officially endorsed them and I see this as one of the main failings so far. Without this endorsement or intervention, I worry that the whole effort will run out of steam. And if that happens (if the regulator doesn’t give the industry a nudge) I worry it will ironically signal the failure of the freemarket approach and the regulator will have to make an embarrassing U-turn and go for the prescribed, utility model. Remember the case of BOA T, which had the potential to become an ECT, but it perhaps wasn’t endorsed enough.

So we’re in a position where the exchanges and data vendors are rushing to try and come to a mutually beneficial solution BEFORE the regulator steps in and forces a US-style consolidated tape, and by doing so, potentially remove the commercial benefits for exchanges and vendors.

Being a CTP in itself will be a tough business though, and I wonder if there’s such a thing as a commercially-viable CTP proposition: Not only will they operate in a highly regulated business, but a few years down the line there’s the possibility that Europe goes the same way as the US and starts looking at moving away from a CT and instead getting direct fees from the exchanges (a sort of parallel industry, not quite direct competition). Not only that, but because under current proposals their product will be free after 15 minutes, I expect more investors might just accept a 15 minute lag and get the data for free.

IOSCO Secretary General, David Wright, discusses the major factors influencing global markets, and the future of the global regulatory framework.


IOSCO is the International Organization of Securities Commissions. It brings together securities regulators the world over. We have 200 members representing the vast majority of regulators. Of all the international organisations covering financial regulation at the global level, we are the most inclusive because we have all the emerging market countries with us. This organisation has been running for 30 years and we have become the voice of the global securities regulatory community. For example, we have a series of global standards, what we call the IOSCO standards, which are the benchmarks for any securities market.

These standards form the foundation of all the reviews of financial regulation covered by the FSAP process led by the IMF. Our standards are the global benchmark. We have many interesting pieces of work right now; the multilateral memorandum of understanding, which about 90 of our members have signed, is basically a memorandum whereby all the participants agree to share information for enforcement purposes. The memorandum was used to solicit the exchange of information during the recent LIBOR scandal.

We have a lot of policy positions and we have a critical role in the whole process of global financial repair and reform. A lot of the work that you see referenced in the G20 or working with the Financial Stability Board is of IOSCO origin.

We have worked on high frequency trading, we work on shadow banking, OTC derivatives and credit rating agencies, we work on market structure, we work in accounting and auditing, enforcement and so forth. Of course, as a result of this crisis our work is particularly important. The other thing that we do, which is unlike other organisations, is that we provide technical assistance, and education and training for emerging market countries.

One of the things that we’re going to be working on is to build an IOSCO Foundation in which we seek support from the private sector to develop our members’ markets.

Should regulation be leading or following, who should decide what gets regulated, what gets left up to the market and to what extent do those forces interact?

Historically regulation has been following rather than leading. I think it’s right to say that this crisis shows that a significant number of incentives were wrong in the financial markets. I think the depth and scale of damage in this financial crisis, not in all parts of the world, but in certain parts of the world, show that serious repair is necessary, and that is the focus of the G20 and the Financial Stability Board agenda, which we are major contributors to.

The industry can’t complain, to the extent that they are primarily responsible for what happened, so there is a huge amount of work going on at the global level to try to make the financial system safer and less systematically risky. We are going to work on resolution and frameworks; we’re going to work on OTC derivatives, driving more OTC transactions onto exchanges, and through clearance systems. We are working intensively on the shadow banking system, which I think has surprised everybody with its scale, estimated at $65 trillion or 25% of all global banking assets, making that safer and more understandable; we are looking at money market funds, securitisation, and non-banking organisations, which can build up large amounts of leverage. Those are certainly among the most important areas of work, of course on top of bank capital, which is set by the Basel committee. The world has lost 15% of GDP so far; there are very serious worries of severe damage to certain economies and so we need very strong collective efforts at the
local and global levels to try and put that right, and to try and make the system safer and more sustainable.

Are regulators struggling to keep up in terms of spending, and does this impact their oversight?

Regulators in general around the world always feel they are underresourced. When you look at the resources of one of the better resourced authorities, for example, the FSA, in London the FSA has over 3,000 people. But then you compare that to what used to be the head count of Citibank, which was 300,000 plus and that is just one organisation!

So when you multiply that across all the firms big and small they have to regulate and supervise, regulators in general feel underresourced. I think there are some good things happening though which may help them. For example the project being developed by the FSB called the Legal Entity Identifier which is a numbering system for all participants in financial markets. That I think would greatly simplify tracking market abuse, tracking data in markets, looking for systemic risk building up.

In general IT is helping the regulators detect market abuse, but there are huge markets to regulate and supervise. One of the problems has been particularly in the big complex markets, developed markets because, as has become clear, neither market participants nor the regulators or supervisors of those markets fully understood how they functioned.

We are now in year six of this crisis and we still are struggling our way through on the global regulatory level with the shadow banking system. Shadow banking is of enormous proportions, and we are still working it out. You can’t supervise or regulate a market unless you fully understand it.

I think that the one lesson of this crisis should be that unless you can fully understand not just the product, but how that product interacts, interconnects with other products, how risk can be propagated or, if things start to get difficult, what are the effects on liquidity etc, the effects on credit provision, and the effects on the system, then those products and processes should be held back until we are sure we understand.

Another area is measuring the impact of regulation; looking at the costs and benefits of regulatory change in highly interconnected complex markets, which is extremely difficult. Yet regulators should understand as far as they can the impact before calibrating final regulatory measures.

Daiwa Capital Markets’ David deGraw catalogs the movements of Japanese markets in 2011 and discusses the various approaches Japan could take with regard to dark pools and High Frequency Trading (HFT).

Volume and Liquidity in Japan
Right now, contagion from Europe and the turmoil from the United States have depressed equity transaction volumes across the globe. Once a recovery starts to gain steam, Asia will be the driver for growth and Japan will be a quality play. Due to the perennial underweighting of Japan, I expect volumes in Japan will quickly surpass pre-crisis levels in such a scenario. With exchange volumes being so low, non-traditional liquidity is playing an increasingly important role. We have seen transaction volumes on our nondisplayed liquidity pool as well as PTS volumes continue to grow relative to exchange volumes. We are trying to bring the benefits of crossing to as many client types as possible and our unique position as a principal domestic investment bank enables us to access semi- to non-professional liquidity sources, such as corporate and religious entities, educational endowments, quasipublic institutions, agricultural cooperatives, and retail investors.

Role of PTSs in Japan
The role of PTSs has increased steadily since the start of this year and has accounted for as high as 7-8% of market share. The success of SBI Japannext and Chi-X Japan PTS shows that the market is rewarding innovation and efficiency that is created as a result of increased openness and competition. Conversely, the closing of Kabu.com shows that a PTS’s revenue model may not be sustainable over an extended period of low trading volume. Therefore it is critical for participants to carefully evaluate the viability of a venue so that the large upfront technology investments are not wasted.

The implementation of centralized clearing through JSCC was critical for the existing PTSs to rapidly and dramatically expand their share in 2011. However, since August, growth has slowed somewhat along with the rest of the market. Having said that, there are still very good reasons to expect future growth in PTS market share. Both PTSs are working aggressively to on-board new participants and Chi-X has recently announced the introduction of liquidity rebates in Japan. Chi-X have a successful record of growing their market share in Europe with liquidity rebates, and such economic incentives are sure to be strong drivers for growth in Japan as well. In fact, it should open the door for a totally new class of venue fee arbitrageurs to trade Japanese equities. Furthermore, domestic institutions are expected to allow smart order routing to PTSs once regulations are amended to exempt PTSs from the 5% TOB rule.

Rudolf Siebel, Managing Director of BVI Bundesverband Investment und Asset Management, shares the perspectives of German asset managers and their needs and goals for the coming year.

Technology and Trading Costs
BVI represents German investment fund and asset managment industry which manages ¤1.7 trillion in assets such as bonds, equities and derivatives. Trading is an issue dear to our hearts. In particular, we welcome the improvements in electronic trading over the past decade especially those based on standards, such as the FIX Protocol, which enable automation based on standardization. That is one of the reasons why we became part of the FIX community in September 2011. Costs of trading have certainly fallen over the past few years, particularly with regard to the costs charged by brokers and venues. Also, trading costs have been implicitly lowered through a reduced market impact. Our members sense that with electronic trading they can be much closer to the market and limit the loss of market value because of the latency in trading. Our members, however, have seen that the cost of support and analytics has not fallen. Some also believe that the buy-side trading volume side had declined and that the sellside volume is on the increase.

Value through Innovation
Having discussed issues of electronic trading within our industry, I think the increased ability to analyze market impact and trading costs has provided value. Over the past few years, our membership has seen value shift very quickly to better market access, especially through smarter routing technology. Based on mutual studies, only about 65% of the turnover of the DA X is now on the Deutsche Boerse, and for the FTSE 100, only 50% is now on the LSE. It is absolutely vital for our members to be able to access different liquidity pools, whether lit or dark. Smart algorithms have become a main issue, but not necessarily in view of improving low latency. Our members are asset managers who base their decisions on the selection of securities and asset classes, not necessarily on squeezing out each latent nanosecond. As a result, low latency trading is a secondary priority for BVI’s members, but smart order routing is obviously important given the large number of venues in the European market. At my latest count, there are about 70+ different types of trading venues, be they exchanges or other trading platforms.

Volatility and Connectivity
We are now in a market where there are no longer any safe havens among asset classes, and in times of high market volatility it is absolutely necessary to link your internal systems to outside trading platforms in order to be flexible and quick to market. German asset managers have yet to establish connections across asset classes, and the FIX Protocol is very important as a basis for discussing the connectivity issue. Going forward with Dodd-Frank and new regulation on the European side, the the connectivity with Central Counter Parties (CCPs), will also be a big issue for 2013 and 2014. As far as it is possible, connecting to all markets and asset classes in an electronic way, and connecting to more CCPs will be the challenge for next few years.

Annie Walsh of CameronTec spoke to FX users to better understand the topical issues and challenges facing the OTC Foreign Exchange market and the central role FIX can play in addressing these challenges.

 Undoubtedly the capital markets in 2011 will be remembered for many history-making moments including some of the largest currency moves the market can remember. We have witnessed the global foreign exchange market — the most liquid financial market in the world with an average daily turnover in the vicinity of USD4 trillion — bear the brunt of one political crisis after another, causing widespread volatility and difficult to pick currency moves.

 
Currency friction in Europe and between the US Administration and China will no doubt remain a prominent feature of the global economy for at least the next 1 – 2 years. On top of this remains uncertainty of government, particularly in Europe, and the implications for continuity of fiscal and monetary policy.
 
Many investment banks too in their search for alpha have been left wondering ”where did the black box get it wrong?” following lack lustre P&L performance, almost industry-wide over recent months.
 
Without a formal open or close, the FX market presents a true ‘follow the sun’ global market, with inherent levels of opportunity and risk.
Against this uncertain backdrop, the FIX Protocol has great potential to centrally feature in what is undoubtedly the single greatest threat (opportunity, if you prefer) facing the global OTC FX market. That is of structural uncertainty compounded by impending regulatory change to be ushered in, courtesy of Dodd Frank, and MIFID II and III.
 
With no unified or centrally cleared market for the majority of trades, and little cross-border regulation, due to the over-thecounter (OTC) nature of currency markets, these are rather a number of interconnected marketplaces, where different currencies’ instruments are traded. Inevitably OTC FX will move, however grudgingly, away from its long-standing (self-serving) model of self-regulation, toward greater levels of transparency, regulatory oversight (either directly or indirectly) and centralised clearing.
 
A Two Speed FX Market
As currently drafted, spot, outrightsand swaps are to be exempt from Dodd Frank’s requirement to be traded via Swap Execution Facilities (SEFs) and be centrally cleared; FX options, Cross Currency (CCY) swaps and Non-deliverable Forwards (ND Fs), however, are not. A perhaps unintended consequence of this two speed approach is the potential for jurisdictional arbitrage, product/financial re-engineering and further fragmentation of execution venues and liquidity.
 
In the short term, it also means that the sell-side needs to fundamentally reconsider strategies for design, development and deployment of Single Dealer Platforms (SDPs). Multi asset class SDPs will now necessarily evolve to become simultaneously both an execution venue as a destination and a gateway to a SEF, depending on the instrument traded.
 
Simo Puhakka, Head of Trading for Pohjola Asset Management, shares his experience trading in the Nordic markets, giving his opinions on interacting with HFT, using TCA and knowing whether you can trust your broker.
 
Nordic HFT
The prospects for High Frequency Trading (HFT) are really up to regulators. It will be a free market, but as we all know, regulatory changes affect the whole trading landscape. For example, we can see what is happening in France and the debate that is going on in Sweden, which are quite hostile towards HFT, so those countries.
 
Personally, I think that HFT is a good thing for the market, as long as you have the proper tools to deal with it. There are a number of small firms that have been suffering from HFT
since MiFID I because they lack the proper technology and tools to measure and deal with it. We have not suffered in our dealings with HFT, and I would actually say in many cases, it is the opposite. HFT firms seem to add liquidity and when you have the proper tools to deal with it, you can take advantage of it. 
 
Speaking of tools, we started building our own Smart Order Router (SOR ) a year and a half ago. The goal was to create an un-conflicted way to interact with the aggregated liquidity. In this process we went quite deep into the data and turned processes upside-down with the result that we have full control of how we interact with the market. 
 
On the other hand, I welcome technological innovation from the sell-side; for example, brokers now disclose the venues where they execute trades on an annual basis. The surveillance responsibilities that brokers have are beneficial. Many of the small, local brokers and buy-sides, however, are now finding it challenging to upgrade their technology. 
 
Trusting your Broker
Our approach was to take control of our order flow and only use our brokers for sponsored access. We chose full control because, in some to deliver  what I am asking.These questions first arose a few years ago, and we realized we needed to create a transparent, fully-controlled, non-conflicted path to the market. How you interact with different venues – even lit venues, where you have more transparency – will affect your choice of strategy. In most cases, you are better off without brokers making decisions for you. The root of the problem is, when you send an order to the broker, what happens before it goes to the venue? What control do we have over the broker infrastructure, including their proprietary flow, internalization, market making and crossing, not to mention the routing logic?
 
 When we dug into the data, we were quite surprised to see that, although a broker was connected to all the dark liquidity, many of the fills were coming from that particular broker’s dark pool, suggesting there are preferences in the routing logic. Brokers want to internalize flow, which is not a problem, if you are aware of potentially higher opportunity costs. When it comes to dark liquidity, that is an even bigger problem, since our trades were often routed to the broker’s own dark pool or those it has arrangements with. 

ITG’s Clare Rowsell and Rob Boardman outline the best practices for liquidity management across multiple regions, focusing on Asia Pacific, North America and Europe.

In an increasingly global and fragmented trading environment, finding and managing liquidity is the top priority for buy-side traders. The practicalities of doing so are complex, and are underpinned by the tradeoff between the time taken to find liquidity – which can result in delay costs as the price moves away, and the quality of that liquidity – trading against certain counterparties can increase market impact costs. Meanwhile, the global liquidity environment is changing rapidly due to evolving regulation, market structure and the trading tools available. What follows is a short summary of some of the most significant developments affecting liquidity management in different regions around the world.

Asia Pacific

Often cited as having a ‘last mover advantage’ in coming latest to the world of dark pools and alternative trading venues, Asia is now catching up rapidly. Growing awareness of the region’s higher trading costs (approximately one third higher than those of the US and UK) is creating market demand for both new lit and dark liquidity sources. Japan is the only major market that currently allows ‘lit’ or quote-publishing venues to compete directly with the exchanges, and in the past year market share on these venues (including SBI Japannext, Chi-X and Kabu.com) has risen, although they still average around 2-3% of total turnover.

Australia will be next, now that the launch of Chi-X to challenge the ASX exchange’s monopoly has been confirmed for early in Quarter 4 2011. As alternative lit venues develop, the importance of smart order routing grows and in Australia this has been a core component of consultation which will result in changes to regulation affecting brokers and exchanges and mandating Smart Order Routing (SOR) as a mechanism to achieve best price in a multi-market environment. For other Asian markets, buy-side traders have been turning to dark pools as a way of managing trading costs and finding quality liquidity.

Most of the large banks and brokers now offer a dark pool or internalization engine in markets including Hong Kong, Japan and Australia; but given Asia’s already-fragmented market structures, adding more broker liquidity pools threatens to complicate the buy-side trader’s life. This is where liquidity management, and specifically the aggregation of dark pools, is coming to the fore. Increasingly the buy-side are turning to dark pool aggregating algorithms to connect into multiple sources of liquidity through one access point.

Canada

Canada has long benefited from trading in an auction market supported by a highly visible electronic book. Even though it was not until the latter half of the decade that ATSs began to spring up in Canada, they quickly gained traction and in 2010 ATSs represented 34% of volume. As these changes have taken place, Canadian regulators have continually reviewed emerging regulation in other regions as Canada continues to parallel more mature markets. With the proliferation of alternative trading venues came an emphasis on the consolidation of data to ensure market integrity. In addressing the need for a consolidated tape, the CSA accepted RFPs and appointed the TMX Group to the role of Information Processor.

Also arising from the multiple-market trading environment is Reg.NMS-style regulations to protect against trade-throughs. February’s Order Protection Rule shifted the best price responsibility to marketplaces and also requires full depth of book protection (unlike the US’s top of book protection). About 3% of Canada’s equity trading is done in dark pools, and although Canada has only two dark pools (Liquidnet Canada and ITG’s MATCH NowSM), Instinet plans to open two this year and Canadian stock exchanges are making moves to offer dark order types.