It's a question of Risk!
By Kent Rossiter, Vincent Trouillard-Perrot, Gerry Pablo,
Put three men and a FIXGlobal’s Edward Mangles around a table; serve them lunch and let the tapes roll. FIXGlobal listened in on a conversation that ranged from regulators to risk and from FX to FIX.
Edward: In defense of the regulator … how should they know what’s going on when neither the sell nor buy-side seem to know?
Vincent: Recent events have shown the divide between the financial market participants and the regulator. For example, the Lehman’s mini bond issue has forced a strong dialogue between the regulator and, in particular, the broker side. But the engagement is slow.
Kent: Retail brokers tend to have a strong voice here in Hong Kong and over the years have developed a strong working relationship with the regulators. Local brokers can at times be pretty outspoken and have proven on many occasions to be an effective lobbying group. From our perspective international brokers tend to be less visible in some of these debates. We see certain common characteristics across Asia where understandably there is a good deal of focus on protecting the retail investor given the high retail investor participation in many of the stock markets in Asia including Taiwan and Korea. The challenge has certainly been in the retail space where there is an overlap of regulatory responsibility in approving and offering products.
Edward: Are we asking the impossible of the regulator to create the same rule book for retail and institutional investors?
Kent: The general principal is that retail investors are less savvy and experienced and regulations need to be explicit. There is a general assumption that as professional investors, institutions can operate with greater flexibility since they can understand the risks in a more sophisticated way. Taking account of this framework then it will not be possible to standardize for both types of investor. The risk is that setting minimum requirements to protect the retail investor may not suit the way business is transacted at an institutional level. Here we advocate consultation and support stronger trade associations.
Vincent: I don’t think you can realistically expect the same regulations for retail traders as for big institutional investors. That’s a utopia that’s never going to exist. These two groups of investors have different needs. Many regulators – in Europe for example and Luxembourg in particular with their efforts to push through the UCITS 4 protocol – understand that you need different protocols for retail investors.
Kent: But Vincent, every investor has the same goal: making money. It’s only the detailed requirements that are different.
Gerry: There’s certainly a larger burden on the big firms to uphold ethical, legal and fiduciary standards.
Kent: Yes. Retail investors don’t generally have the same constraints on their activities. Institutional investors need a more developed investment process and must ensure fair treatment across all clients regardless of size and fees. Institutional investors will undoubtedly be looking at different investor objectives – for one, they need to be able to implement their strategies in much greater volumes, and in scale, for example.
Edward: How about the role of regulators in curtailing short-selling in many markets? Knee jerk or long-term strategy?
Kent: I’d like to see the ability to short-sell fully resumed as soon as practically possible. We’re now in a situation where some markets have suspended it, and some are allowing it again. This is not ideal. I certainly see the temporary prohibition as a knee-jerk reaction and understandable given the groundswell of public opinion and corporate pressure as the financial crisis took hold – not all of this opinion was entirely rational. In fact, short-selling restrictions can reduce volumes for trading in the markets overall. For one, we have a 130-30 fund. So in this fund, if we’re limited in the number of attractive long-short pair trades we can put on then we’ll just end up trading less. So it’s business that never happens and the unknown would-be client on the other side of our trade – whether they’re institutional or retail – through the exchange, never gets to take advantage of the liquidity. What we need is a greater understanding of how shorting operates. There is a lot of misconception around this issue.
Gerry: I see the value and merit in allowing short selling in varied markets. In markets that don’t allow it, the regulators need to develop this functionality. It encourages more liquidity and volume. But I do understand that in the current environment the regulators have little choice. We won’t know the full impact until later on.
Vincent: The problem is that there’s no consistency among the regulators. Some only forbid short selling on financials. It’s a disruption to competitiveness between various sectors.
Kent: Yes. And not being able to short, will reduce derivatives trading. The fact is, a lot of the shorting that goes on isn’t just one-way, but a strategy with a ‘long’ component to it as well. And funds that relied on the little performance boost from securities lending fees have also seen their returns diminished. The equity finance desks at the brokers have seen a real drop-off in trade volumes because of this.
Vincent: Now the regulators are trying to encourage investors to buy again in a bear market – and there’s a lot of inconsistency between the messages they’re sending now and what they were telling us six months ago.
Edward: How about Europe – and the role of the regulators?
Gerry: The European market is very different. It’s much larger, all the markets open and close at pretty much the same time and they have a common currency.
Vincent: I think the regulators are more pragmatic. But Europe’s by no means a perfect example. It has, in the past, proved hard to get approval from all the national regulators. But there seems to be a greater push. If you look to all recent efforts to reach a common agreement among the European regulators for the new UCITS 4 directive, which aims to create a common frame for mutual funds in Europe, it sounds like things are going in the right direction. Normally it would take up to five years to get approval from all the countries. But now we’re seeing a political pressure to harmonize – but we’re a long way from this in Asia.
Edward: With market harmonization, is Asia already learning from the experiences in the US and Europe?
Gerry: One of the things that is going to hold Asia back, in most of the markets, is the rule on foreign ownership. This is a limiting factor. I can’t see one country’s stock exchange owning another.
Vincent: It’s already happening in a cross-Pacific context, so why not in Asia. EuroNext is an association between Paris and NYSE. I can certainly see this happening between Singapore and Malaysia, and why not between Singapore and Hong Kong?
Edward: Would this kind of consolidation and partnership enhance competition and ultimately bring costs down?
Kent: This kind of thinking brings us back to the benefits to multiple venues, versus single, national exchanges. You need to think about fragmenting liquidity and whether this brings down costs, or pushes them up. The argument for multiple venues and/or national exchanges has a number of pros and cons.
Edward: How do your think technology will cope with the growth of multiple venues in Asia? Do we simply inherit what’s being rolled out in the US and Europe?
Vincent: Are the tech needs that different? I think we have similar needs worldwide.
Gerry: Technology in the US has had to be robust enough to accommodate the estimated 60 dark pools and exchanges that are currently operating.
Kent: The technology is already available. But it’s a big task to bring it all to Asia, where we’re still at a much earlier developmental stage than the US. But we’re seeing some investment being made here by the brokers, so that they can connect to multiple execution venues. But in a number of Asian markets the exchanges still have ironclad grasp on all trading and there’s no competition. These are the same exchanges which tend to have more restrictions on trading.
Gerry: Yes. While the various networks may have different functionalities, everyone’s game plan is pretty much the same: to provide liquidity and best price. This is the baseline forum for all the new venues.
Edward: I’d like to turn to another hot topic. Counter-party risk. From the buyside perspective, who’s calling the shots in allocating trades to brokers?
Kent: From our perspective, there’s basically two parts to that question. Firstly, our investment team conducts an extensive semi-annual vote to assess the services we use from the Street. So we get input from traders, research analysts, and fund managers on which firms are providing the best services. We then aim to pay more of our commissions to these ‘voted brokers’, but a prerequisite is that these brokers must be on our ‘approved broker counterparty list’. There are a lot fewer brokers on the ‘voted list’ than the broader ‘could trade with’ counterparty list. This counterparty list is reviewed and maintained by our risk department, and coordinated on a global basis. The actual placement of trades is not decided by management – and I suspect that’s the way it is at other firms as well. An added level of complexity comes into play with unbundling, which is growing in popularity and seeing some real take-up in Asia, probably accelerated by the recent financial crisis.
Furthermore, there are a number of smaller, specialist firms whose financial situation may be tenuous – and we won’t trade with them. We’re assisted by the technology of our systems, so our EMS even prevents us from routing or processing trades with a broker code unless that broker has been approved. And when an approved broker goes ‘on watch’, then their codes are deactivated on the system.
Vincent: Counterparty risk is not exclusively on the broker side. In the fund industry, more and more attention is focused on the custodian firms. Regulation insists on a separation between who manages the fund and who holds custody of the fund. This is relatively new and it’s the responsibility of the fund manager. Our clients are asking us now: who is your custodian and how do you review your brokers.
Kent: Often the client already has a custodian, and we’re just taking over an existing mandate from another manager. However, in many cases where a mandate is new, the clients may well have chosen the custodians without our input.
Edward: How has the recent turmoil affected the internal relationships? Clearly, the risk management and trading teams will have different priorities. How do firms marry the need for tight control and regulation with the need for risk taking that is inherent in making money for clients?
Kent: In our industry, you do need the risk takers. This is how you beat your peers. Nevertheless, you need monitoring on the risk side to make sure you’re capturing the full picture. Reviewing the credit worthiness of trading counterparties isn’t a task that rests with the trading dept. That’s better kept with an independent department who’s tasked with looking into their financials.
Vincent: On one hand we’re seeing a flight to quality and a search for simple products, together with a strong pressure on disclosure and transparency. But this does risk standardizing your products. You need to be able to deliver a little bit of alpha to prove to your investors that they’re right to entrust you with their money. As a fund manager, you need better products to justify your fees. If you simply replicate an index, where is your added- value? It’s a balance between the monitoring system and the judgment aspects of the investment process. We need to differentiate, but we have tremendous pressure to stay within our guidelines. Our head office and also the customers require this.
Edward: A recent buy-side survey highlighted that the buy-side is going to spend as much on technology this year, as last. Do you think this is an indication that the buy-side is taking ownership of the technology, rather than relying on the spending by the sell-side?
Kent: Maybe the sell-side feel that they’ve already spent enough on technology, but I’m not sure they’re anywhere near where they need to be, for example with regards to accessing dark pools in Asia. For that matter, most aren’t even using their internal flow in an effective manner. And when it comes to popular usage of smart order router’s (SOR’s) in Asia, it’s an investment that’s been mostly overlooked up till now. Asia’s had dual exchanges like Osaka/Tokyo, or India’s Mumbai/National exchanges competing with each other for flow for years, but very few brokers can effectively trade between them in an electronic and automated manner. Most are still using dealers to do this trading manually. So a lot of the spending the sell side’s done was on technology to help themselves be able to handle high capacity periods, i.e. with the use of DMA and Algo’s, either for their own staff internally, or direct usage by their clients.
Gerry: We certainly need to keep on top of our IT requirements as there is always the desire for larger budgets in this space. We always need greater advancement in this dynamic environment, and we need to ensure that we capture every part of the technology advantage to create speed, precision and cost reduction. Technology is a continually evolving arena, so taking the lead, rather than ownership, may be more appropriate, but it is a consultative process.
Edward: What is the role of FIX? Is this the way forward for a more efficient trading platform in Asia?
Kent: Certainly the kind of standardization of messaging that FIX creates makes things much easier. We are all real lucky that every major Asian market has adopted FIX as the de-facto standard.
Vincent: I’m sure we’ll see the regulators pushing for much greater standardization and FIX has a key role to play in this.
Gerry: I think despite the difficulties we’ll have bringing markets such as China under a universal protocol, it is still what we should aim for. We need an agreed set of parameters to create this one homogenous, efficient electronic platform for routing orders, trading and settlement. This is where I see FIX advantages. It’s a neutral platform which already has broad consensus between the buy and sell-side.