FIXGlobal speaks with the buy-side in China about the prospects for China’s equity market, IPOs and how new technology and competition will improve domestic trading.
GDP and Trading Volumes The property market might continue to cool down in 2012, but it is not reasonable to expect the Chinese economy to shrink significantly this year because the Chinese government will allocate resources to other sectors of the economy. Because of the Lunar New Year effect, it looks as though Chinese Consumer Price Index (CPI) is heading upwards. Based on adjusted CPI, the property asset bubble is a political issue rather than an economic one. The Chinese government has pledged to continue monitoring property prices, and its strong fiscal position gives them various options in terms of how they address this situation. Trading volumes are expected to be much the same as 2011 and inflation should be heading downwards.
Major Driver: IPOs or Economics? There has been a rapid increase in the number of IPOs in China, but the regulators are questioning the quality of some of the IPO companies. Of those companies newly listed in 2011, valuation declined quite significantly. Investors used to think an IPO was like a lottery – buying new shares virtually guaranteed a profit. Many investors did not consider the actual valuation and quality of the company, and many are now realizing that not all investments are worth their list price.
The Chinese equity markets are in a transition stage; they are moving from being somewhat amateur to being much more economic and investor-driven. There were instances of listed companies in one industry that changed industries after the IPO (often moving into property development) and occasionally changing the name of the company, leaving investors uncertain about their strategy and focus.
Listed companies used to have considerable power, but the market is changing in a positive direction. However, we do not know how quickly the market will become transparent and trustworthy. The regulators, media and institutional investors are now more serious about issues of valuation, transparency, corporate governance, etc. The regulators should consider increasing Qualified Foreign Institutional Investor (QFII) and ways of improving the dissemination of information to investors in order to set a good example in the domestic market.
A primary focus of the Chinese Securities Regulatory Commission (CSRC) this year is insider trading. Addressing this matter will improve the quality of listed companies and give investors greater protection. The regulators are working on improving access to information for investors and institutional funds will benefit significantly from this transparency. Regulators are concerned with addressing both the difficulty of access to information and the quality of information about IPOs, and it is quite likely that they will be able to improve both aspects.
Applying New Technology The biggest technology upgrade implemented in the past six months has been algorithmic trading. Most Chinese buyside use their brokers’ algos, but in China, domestic mutual funds are not allowed to route orders to brokers. So what many dealing desks have done is to install the brokers’ algo engine on their side, so for every algo they choose, they go through their server and send the order to the exchange. In this way, dealers achieve efficiency in their algo usage because they do not use any brokerage; as a dealer, they are almost like their own broker. Algo trading also provides the buy-side with more precise post-trade analysis; specifically, the ability to analyze how much alpha has been captured and the transaction costs involved.
The primary benchmark used by most Chinese buy-side traders is Implementation Shortfall (IS), which is used to generate information to help the fund manager improve their investment strategies. For example, it might provide data about the delay cost created by an investment decision made an hour after the market opens, showing the fund manager that if the decision had been made earlier they could have saved a certain amount on the investment.
CIBC’s Thomas Kalafatis maps out the new CSA rules regarding direct electronic access and suggests its potential effects on brokers and institutional traders.
Are the updated Direct Electronic Access (DEA) requirements a response to patterns endemic to Canada or are they a response to patterns observed elsewhere? Given the existing Investment Industry Regulatory Organization of Canada (IIRO C) rules and the timing of the Canadian Securities Administrator (CSA)’s DEA rule proposal, it is fair to say that the rules proposed by our regulators are intended to maintain consistency with changes in other jurisdictions and prevent regulatory arbitrage. We do not believe that the rules are the result of a specific effort to solve a localized Canadian problem, but rather a preventative measure to ensure structural issues that have arisen elsewhere will not take root in Canada.
The issues around direct electronic access raised in the United States (who is accessing marketplaces directly, and how they are ensuring automated systems will not malfunction) are less of a concern in Canada. TMX rule 2-501 limits who is eligible to receive DEA access, restricting DEA to wellcapitalized firms, or firms that are registered and regulated in certain other jurisdictions.
IIRO C Notice 09-0081 addresses how automated systems should be managed to mitigate the risk of malfunctions. It requires brokers to manage the risk of electronic trading by clients in the same way that they manage the risk of their own electronic trading. This includes ensuring that automated risk filters are in place, that order flow from an automated system can be interrupted/switched off by the broker, and that strategies are tested prior to being deployed to market. These basic, principlesbased protections have been effective at mitigating risk in Canada since well before the wave of automation hit our markets in 2008.
The proposed DEA rules are a movement away from the IOSCO principles-based approach that has traditionally been taken in Canada, towards a more prescriptive regime more like the 15C-3-5 rules introduced by the SEC in the United States this year. This builds consistency between the Canadian and American jurisdictions that are so closely intertwined.
Automated pre-trade risk filters are in place for many brokerdealers. How difficult will this regulation be to implement? Broker-dealers will need to monitor the proposed rules closely, particularly with regard to their Sponsored Direct Market Access (SDMA) clients. These clients have their own sophisticated automated risk management systems in place – as required by UMIR rules and, more importantly, as a result of their own risk aversion. They connect directly to exchanges to minimize latency. The DEA rule proposes to change this, in parallel to 15C-3-5 in the US, in that brokers will need to have “direct and exclusive control” over the risk filters on client flow; this means that a duplicative set of filters operated by the broker will have to be put in place.
In this case, Canadian brokers benefit from the earlier adoption of 15C-3-5 in the United States where various technologies have been developed to meet SEC rules that went into effect in the summer of 2011. Depending on the needs of its client base, a Canadian broker can choose between several types of risk filter offerings operating in a latency range from the low milliseconds to the low microseconds. The only differentiator is cost, with a significant premium on the single-digit microsecond lowest latency offerings.
Generally, it is not economic for a Canadian broker to develop the ultra-low latency solutions in-house, and the Canadian broker community benefits from the availability of third party technologies developed to meet the US rules that came in to effect earlier this year.
John Bates of Progress explains how complex event processing works and how it can simplify the use of algorithms for finding and capturing trading opportunities.
A brief summary of Complex Event Processing
Complex Event Processing (CEP) is about treating actions that happen all the time as specific events, which describe the action, and then being able to analyze those events as they are streaming through a system, while looking through them for patterns that create opportunities or threats. In the trading world, this means things like trading opportunities, such as monitoring a set of instruments across multiple trading venues and looking for particular patterns. Those patterns might be high frequency trading (HFT), statistical arbitrage, correlation relationship between two items, or even execution algorithms that are slicing orders based on some predefined metric.
The threats often focus around pre-trade risk. For example, will placing the trade exceed predefined risk levels, or run into potentially abusive trades, like a wash trade. CEP is about being able to monitor business in real-time to analyze what is happening now and, based on that, to try to predict what is about to happen and act on it immediately.
The value of Complex Event Processing
The world of trading is so fast moving. Research done by the AITE Group suggests that the average lifespan of a trading algorithm can be as short as three months. This is because new trading patterns are constantly coming to light and ones that might have been very successful might no longer be available as the markets become more efficient. In the old days, trading algorithms were like a cottage industry, in much the same way as the making of muskets used to be. Highly paid and highly skilled craftsmen would handcraft the algorithm. It was the domain of the very rich and not very many could be involved in the game.
With the advent of CEP technologies in the last ten years, now anyone can find patterns in fast-flowing data feeds, but more importantly, CEP provides the tools for business people to describe new algorithms quickly. This means that traders can keep up with a trading world that is moving ever faster, and which the handmade craftsmen struggle to keep up with. Suddenly, it has become easier for smaller firms to create algorithms to compete with the larger ones. There has been a revolution in software for the trading space, in that firms of all sizes now have access to the technology that was previously available only to Tier 1 banks.
Peeking under the bonnet
In a CEP platform, there is an engine which has the tools that allow you to model and visualize new strategies as they are running, as well as see any opportunities or threats. On top of this is an adaptive layer, with connectors to convey different formats of events in and out of the processing engine, taking in market data and sending out trades. CEP platforms can work off a simple consolidated feed, but organizations find that it is better to connect to trading venues directly because it reduces the latency and things can be seen as they happen.