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)

The Investment Roadmap, a guide created through a collaboration between the world’s leading messaging standards, to provide consistent and clear direction on messaging standards usage was released in May 2008. A year later, FPL’s Operations Director, Courtney Doyle asked the authors of the roadmap for their assessment of its impact on the industry and how they saw its future evolution.

Courtney Doyle: What was the motivation and purpose behind this Investment Roadmap collaboration?

Genevy Dimitrion (ISITC Chair): Today, Market Practice and Standards are inextricably linked and yet for all our efforts, Market Practice exists as a mere documented recommendation. However, we see convergence between the two areas to the point where market practice can be encapsulated directly into the standards themselves. The roadmap has a role to play in this evolution, and we see it as critical for the next generation of standards. It also helps to provide future users direction on which messaging standards should be used throughout the trade lifecycle.

Jamie Shay (Head of SWIFT Standards): Our involvement was driven by clear market demand from our customers. They needed clarity about which syntax to use in which space and, more importantly, they wanted a way to make these standards interoperable. SWIFT and FIX have been working together for a number of years towards a single business model in ISO 20022. The decision to work together on an Investment Roadmap was a natural progression. It provides clear direction with regard to messaging standards usage as it visually “maps” industry standards protocols, FIX, ISO and FpML, to the appropriate asset class and underlying business processes.

Karel Engelen (Director and Global Head Technology Solutions, ISDA): Similar to SWIFT, ISDA felt it was important to map out the coverage of each of the different standards so people could get a complete view of the industry standards at a glance. We also thought it would be a useful tool for determining where we had duplication of effort or functional gaps to complete.

Scott Atwell (FPL Global Steering Committee Co-Chair): As the others have pointed out, we needed to provide greater clarity as to how the various standards ‘fit together’. We sought an approach that recognizes, leverages, and includes the financial industry standards without reinventing and creating redundant messages that generate cost and confusion for the industry. The effort was named ‘Investment Roadmap’ as its founding purpose was to aid industry firms’ technology investment decision making.

Courtney Doyle: The roadmap was released over a year ago. Is the community referring to it and using it as a guide on how to invest in standards? How should firms use it and what does it mean for them?

Scott Atwell: FPL has found the roadmap useful as a tool for standards investment. However, the roadmap benefits are multifaceted. It has driven an even greater level of collaboration and cooperation amongst our standards organizations. Discussing it often serves as a ‘conversation starter’ that leads to healthy discussion and debate. It has also served to facilitate key changes to the ISO 20022 process such as the ability for FIX to feed the ISO 20022 business model and to be the recognized syntax for the Pre-Trade/Trade model.

Genevy Dimitrion: ISITC consistently refers to the roadmap when presenting to our members as the guidelines on message standards to be used within the trade lifecycle. It has become an extremely helpful tool for our members in understanding the key standards available and how and when they should be used.

The FPL Americas Electronic Trading Conference, for those in electronic trading, is always a year-end highlight and this year was no exception. Sara Brady, Program Manager, FPL Americas Conference, Jordan & Jordan thanks all the sponsors, exhibitors and speakers who made this year’s conference a huge success.

The 6th Annual FPL Americas Electronic Trading Conference took place at the New York Marriott Marquis in Times Square on November 4th and 5th, 2009. John Goeller, Co-Chair of the FPL Americas Regional Committee, aptly set the tone for the event in his opening remarks: “We’ve lived through a number of challenging times… and we still have quite a bit of change in front of us.” After a difficult year marked by economic turmoil, the remarkable turnout at the event was proof that the industry is back on its feet and ready to move forward with the changes to the electronic trading space set forth in 2009.

Market Structure and Liquidity
Two topics clearly stood out as key issues that colored many of the discussions at the conference – regulatory impact on the industry and market structure as influenced by liquidity, and high frequency trading. An overview of industry trends demonstrated that the current challenges facing the marketplace are dominated by these two elements. Market players are still trying to digest the events of 2008 and early 2009, adjusting to the new landscape and assessing the changing pockets of liquidity amidst constrained resources and regulatory scrutiny. The consistent prescription for dealing with this confluence of events is to take things slow and understand any proposed changes holistically before acting on these changes and encountering unintended consequences.

The need for a prudent approach towards change and reform was expressed by many panelists, including Owain Self of UBS. According to Self, “Everyone talks about reform. I think ‘reform’ may be the wrong word. Reform would imply that everything is now bad, but I think that we’re looking at a marketplace which has worked extremely efficiently over this period.”

What the industry needs is not an overhaul but perhaps more of a fine-tuning. Liquidity is one such area that needs carefully considered finetuning. Any impulsive regulatory changes to a pool of liquidity could negatively impact the industry. The problem is not necessarily with how liquidity is accessed, but the lack of liquidity that results in the downward price movements that marked a nightmarish 2008. Regulations against dark liquidity and the threshold for display sizes are important issues requiring serious discussion.

Rather than moving forward with regulatory measures that may sound politically correct, there needs be a better understanding of why this liquidity is trading dark. While there is encouraging dialogue occurring between industry players and regulatory bodies, two things are for sure. We can be certain that the evolution of new liquidity venues is evidence that the old market was not working and that participants are actively seeking new venues. We can also be assured that the market as a messaging mechanism will continue to be as compelling a force as it has been over the last two decades.

Risk
One of the messages that the market seems to be sending is that sponsored access, particularly naked access, is an undesirable practice. Presenting the broker dealer perspective on the issue, Rishi Nangalia of Goldman Sachs noted that while many agree that naked sponsored access is not a desirable practice, it still occurs within the industry. A panel on systemic risk and sponsored access identified four types of the latter: naked access, exchange sponsored access, sponsored access of brokermanaged risk systems (also referred to as SDMA or enhanced DMA) and broker-to-broker sponsored access.

According to the U.S. and Securities Exchange Commission (SEC), the commission’s agenda includes a look specifically into the practice of naked access. David Shillman of the SEC weighed in on the commission’s concern over naked access by noting, “The concern is, are there appropriate controls being imposed by the broker or anyone else with respect to the customer’s activity, both to protect against financial risk to the sponsored broker and regulatory risk, compliance with various rules?” Panelists agreed that the “appropriate” controls will necessarily adapt existing rules to catch up with the progress made by technology.

On October 23, NASDAQ filed what they believe to be the final amendment to the sponsored access proposal they submitted last year. The proposal addresses the unacceptable risks of naked access, and the questions of obligations with respect to DMA and sponsored access. The common element of both of these approaches is that both systems have to meet the same standards of providing financial and regulatory controls. . . Jeffrey Davis of NASDAQ commented on his suggested approach: “There are rules on the books now; we think that they leave the firms free to make a risk assessment. The NEW rules are designed to impose minimum standards to substitute for these risk assessments. This is a very good start for addressing the systemic risk identified.”

These steps may be headed in the right direction, but are they moving fast enough? Shillman added that since sponsored access has grown in usage there are increasing concerns and a growing sense of urgency to ensure a commission level rule for the future, hopefully by early next year. This commission proposal would address two key issues – should controls be pre-trade (as opposed to post-trade) and an answer to the very important question, “Who controls the controls?”

Timothy Furey, Goldman Sachs, Neal Goldstein, Nomura and John Goeller, Bank of America Merrill Lynch, shed light on the process of managing risk in electronic trading.

At the start of this year, FPL announced the completion of an initial set of guidelines, which recommends risk management best practices in electronic trading for institutional market participants. In the third quarter of 2010, FPL launched a group to raise awareness regarding the implications of electronic trading on risk management and to develop  standardized best practices for industry consideration. Over the last few months, the group, which consists of a number of senior leaders in electronic trading from the major sell-side firms, has been working on developing this set of guidelines to encourage broker-dealers to incorporate a baseline set of standardized risk controls.

The objective of the guidelines is to provide information around risk management and encourage firms to incorporate best practices in support of their electronic trading platforms. In today’s volatile marketplace, the automation of complex electronic trading strategies increasingly demands a rational set of pre-trade, intra-day and pattern risk controls to protect the interests of the buy-side client, the sell-side broker and the integrity of the market. The objective of applying electronic order risk controls is to prevent situations where a client, the broker and/or the market can be adversely impacted by flawed electronic orders.

The scope of the particular set of risk controls included in the guidelines is for electronic orders delivered directly to an algorithmic trading product or to a Direct Market Access (DMA) trading destination. The recommended risk controls included provide the financial services community with a set of suggested guidelines that will systemically minimize the inherent risk of executing electronic algorithmic and DMA orders.

In what area are sell-side and buy-side firms’ risk controls most in need of improvement?

Timothy Furey, Managing Director, Goldman Sachs and FPL Risk Management Committee Co-Chair: One of the observations coming from the FPL risk sessions was that the  buy-side and sell-side had really given considerable thought to their own individual firm’s risk controls. That said, both the sell-side and the buy-side should continue to focus on  pulling together a standard, consistent base set of controls that their respective firms can reasonably implement. Therefore, it is more a question of standardization than a need for specific improvement.

John Goeller, FPL Americas Regional Committee Co-Chair and Managing Director, Global Execution Services, Bank of America Merrill Lynch: This effort was not necessarily to
address an apparent deficiency in how the buy-side or the sell-side handles risk management, but to codify a set of best practices for all firms to use. It was generally accepted when we started this process that all firms implement some level of risk controls around their business. Our goal was to identify the most common ones and ensure that we have a base set of controls that all firms can implement.

Neal Goldstein, Managing Director, Nomura Securities International and FPL Risk Management Committee Co-Chair: It is important for the buy-side community to recognize that their efforts to implement risk management controls for electronic trading will be more effective when a collaborative effort is made with their sell-side executing brokers. For  algorithmic and conventional (low frequency) DMA orders, the first line of defense should be the risk controls incorporated within the buy-side OMS/EMS. The most effective risk control is to prevent a questionable order from leaving the buy-side OMS/EMS. A specific factor that the buy-side should be looking at more closely is the impact a given order has on available liquidity. While the order validation employed by many buy-side clients accounts for notional value and order quantity, another factor that needs more consideration is the Average Daily Volume (ADV) during the trading interval. Creating an order to trade, where the volume participation rate may exceed ADV for a given interval, can have significant adverse impact on execution price and algorithmic performance, particularly for illiquid names.

What role, if any, should the exchanges play in implementing risk controls?

John Goeller: Most exchanges have technology solutions (in certain situations it is mandatory) around risk management. In some cases, these tools are optional and only work when accessing a particular exchange. Regardless, if a firm is utilizing exchange provided tools, home-grown, or vendor-supplied, they can still leverage our efforts to understand whether their tools are implementing industry best practices.