Where’s my TV remote?

The recently proposed cap on European dark trading has caused quite a stir. It also illustrates how MiFID II policy-making has descended into almost Eurovision song contest levels of farce.

The basic idea is to put a cap (currently proposed at 8%) on the level of trading that occurs away from lit markets. The rationale for this is to protect the regulator’s precious price formation process and so it sensibly excludes large block orders that wouldn’t have traded on an exchange anyway. But, bizarrely, the current proposal is for an absolute limit regardless of whether trading off exchange might actually result in a better outcome for the end investor. A quick look at the FTSE 100 shows that over the past 12 months only 5% of its constituents would have breached this limit and, according to the new rules, would be forced to trade exclusively on lit markets for the next 6 months. But you need to add into this total other MiFID II proposals that will include broker crossing networks and negotiated trades in the dark tally. Taking modest estimates for just negotiated trades, you very quickly get to something like 20% of the FTSE 100 now being sent to the naughty corner. This looks like having a pretty fundamental impact on brokers’ workflow and that they will bear the brunt of the consequences (intended or otherwise).

You would have thought that something as important as this would be approached seriously but, no, this is Europe. So, six years after the original MiFID implementation, we still have three as yet unreconciled versions of the new MiFID II text and face the possibility that the Council of the European Union might even ignore all these and go another way entirely. On top of this, the dark pool dilemma described above is part of a bigger fight going on between the UK and Germany over the future direction of derivatives clearing in Europe. But relax, don’t worry, as next month the Council presidency passes to – wait for it… Lithuania. Well that’s sure to get everything sorted then.

At least I can choose to switch off the Eurovision song contest, just wish I could afford to do the same with MiFID II.

All set for a clear summer

There was an interesting footnote to the FT article on NYSE Euronext’s final shareholders’ approval of the ICE deal yesterday. It talked about how ICE Clear will be taking over clearing for Liffe as of 1st July. This is more than just a bit of corporate housekeeping and may well shape whether we really see competition in European derivatives trading.

Right now Liffe clears through LCH and yes, this is the same clearing house that Nasdaq’s new derivatives market NLX will be using. So there is a big pile of open interest sitting at LCH which will either have to migrate to ICE Clear or stay where it is and provide a great boost to NLX. I know it’s more complicated than this as the Liffe/LCH deal is separate from LCH’s other clearing operations. But, nevertheless, it’s an intriguing possibility as the derivatives industry struggles to aggregate margin and risk post Dodd-Frank. Either way, NLX may just find that their timing is spot on.

Walk the Line: Evolution of the intelligent flow monster

Permanent and profound changes to the trading environment have affected market participants across the board. Steve Grob, Director of Group Strategy at Fidessa, looks at the response of global and super-regional sell-side firms, and how playing the scale game successfully will increasingly depend on a changing and more intelligent relationship with technology.

The growth in market complexity, combined with decreasing trading volumes and an unrelenting churn in global regulation, has had a fundamental effect on traditional sell-side business models. Downward pressures on revenues are accompanied by the soaring costs of servicing client demand. Simply intermediating between clients and sources of liquidity is no longer a guarantee of success.

Just staying in the game requires ever greater investment in technology. But the growth in infrastructure has to be efficient so that revenue increases at a faster rate than the simultaneous rise in costs. This is challenge enough for any firm: but for scale players, with multiple lines of business to support, it is replicated many times over.

One response has been to consolidate technology provision, so that discrete operational silos are collapsed into horizontal layers that support order management, connectivity or risk management. A single platform that can provide both depth of capabilities – managing workflow throughout the front, middle and back office – as well as breadth across an increasingly diverse array of asset classes, reduces the risk of inefficient technology growth.

But the new climate means that firms must go further still and challenge the traditional idea that all technology investment is a source of value. In fact, serious questions are now being asked as to the viability of this approach in today's market conditions.

The role of trading technology is primarily to enable brokers to develop, protect and deliver their IP – the unique features that create true competitive advantage – whether that is highly engineered algos, complex basket trading capabilities, the quality of a firm’s people and relationships, or its international reach and capital base. However, not all technology contributes directly to creating and delivering IP to market. A substantial proportion of technology deployed by sell-sides around the world is largely commoditised. It fulfils a necessary function, but delivers no real differentiating value to the business.

Instead, this commoditised infrastructure plays a supporting role to the main attraction – the IP layer that sits above it. But because venue proliferation and regulation continue to up the ante, the amount of infrastructure needed to deliver the same IP has increased greatly – the very opposite of the efficient growth that firms need.

To achieve really efficient infrastructure growth, the focus has to be on maximising IP. For everything else, the goal is to ensure that the service is delivered to the right standard and at the right price. This is the underlying argument behind outsourcing, and one that is proving increasingly attractive to the financial services sector.

As long as the right level of cost and competence is maintained to support the IP layer, and the reputation and inherent brand value of the firm is not compromised by external providers, then outsourcing can deliver fairly immediate benefits. The replacement of fixed capital expenditure with variable costs allows large firms to easily and quickly adjust the scale of their business in response to client demand and market conditions. It also gives them the flexibility to experiment with new services or business lines, safe in the knowledge that less successful initiatives can be easily and cheaply exited.

Ensuring this efficiency is dependent on two factors. The first is provider selection. Global and super-regional brokers will need to ensure they work with third-party suppliers who can deliver on the same scale, with a global reach, multi-asset capabilities and crucially, a workflow-centric approach to technology. However, since the commoditised infrastructure is not a source of competition, it can also be provided in partnership with peers or even competitors.

There are a number of areas where such a collaborative approach could be applied in practice. The legally required storage of trade history files is one: a shared, central storage utility could eradicate the duplication that currently plagues data storage, and minimise costs for the industry as a whole. Alternatively, post-trade affirmations and confirmations, where demands for shorter settlement cycles, skyrocketing costs of capital, and a proliferation of buy-side approaches has driven up cost and systemic risk for larger sell-sides, is also a potential candidate for a community-led approach based on a single open standard.

The other critical success factor is making the right decisions about where to innovate and where to commoditise. One firm’s IP is another’s commoditised service and the relationship between the two will eventually become a factor in a firm’s actual IP. For example, the way in which firms interpret the new MiFID II rules that require broker crossing networks to evolve into either MTFs or SIs will have a serious impact on competitive differentiation and hence, IP. How this flow is matched internally could also be a potential candidate for creating IP, as could global program trading or algorithms, the provision of capital and liquidity, and the security of greater risk-checking and compliance capabilities.

In contrast, exchange connectivity is less likely to deliver competitive advantage as the race to zero has reached a point where the effect of a few extra micro-seconds is negligible for those outside the extreme HFT community.

But the critical point here is that the line between the IP layer and the commoditised infrastructure below it is not set in stone. In today’s markets, IP needs to be dynamic and responsive. A unique source of value today may very well be a commodity service tomorrow. Making the distinction between innovation and commoditisation is an iterative process; like blocks falling in a game of Tetris, the arrival and integration of new sources of value can and should push the old differentiating factors into the realms of commoditisation. As the cycle of innovation continues to shrink, the more ruthless a firm must be in managing the line between the two.

Equally, the movement from innovation to commoditisation is not always a one-way street. As markets change, parts of commoditised infrastructure may come back as competitive factors. The Dodd-Frank Act, with its emphasis on central clearing, upfront margining for OTC instruments and introduction of Swap Execution Facilities (SEFs) gives brokers new opportunities to manage risk intelligently on their clients’ behalf. By offsetting margin between net-flat exposures either over different SEFs, or between SEFs and futures exchanges, clearing brokers can help buy-sides manage capital more effectively.

There may also be services that are partially IP and partially commodity: shared storage of historical data may in fact be a source of value with the tools to back-test algos and analyse trading patterns. In this case, the mechanics of a combined database are commoditised, while analysis that powers intelligent trading sits firmly in the IP layer. Whichever way the IP tide is moving, managing its ebb and flow is another way in which firms will be differentiated.

This intelligent approach to scale a business, which is more relevant, more efficient and more focused, clearly resonates in today’s world order where tolerance for inefficiency is fast being dialled down to zero. The greater the trust in suppliers and third parties, and the more capable the management of the two layers of infrastructure, the more responsive a firm can be. Innovative ideas can be sent to market with speed and efficiency and deliver IP rapidly around the globe, giving scale players the agility and flexibility typically seen in much smaller businesses. Circumstances may have forced its adoption, but those firms that fully embrace the intelligent scale model will be the winners in the long term.

A question of life and SEF

There has been a lot of debate around the role of SEFs in the global derivatives market. Some commentators are even claiming that the whole concept is dead and buried before the rules have even been finalised.

But debating the viability or otherwise of SEFs is completely missing the point. The right question is how will standardised and custom derivatives contracts trade and clear in a post Dodd-Frank/EMIR world? What these regulations are doing is removing an artificial barrier that has separated futures and OTC workflows for more than 40 years. This has the potential to upset the whole apple cart as proponents defend their turf and vie for control of the piece they don’t own. This struggle is being played out between venues (SEFs v futurisation), clearers (SwapClear v ICE Clear/CME Clearing) and even within the broker dealer and IDB community. On the receiving end is the buy-side which is faced with a rising cost of participating in derivatives markets, just at a time when it is actually looking for efficiencies instead.

The future role of SEFs is an important (but relatively small) question in the total set of changes the derivatives industry is going to go through. Anyone who isn’t prepared for the totality of these changes (and the aftershocks of unintended consequences) might be in for a nasty surprise.

“It’s fragmentation, Jim, but not as we know it” – why Dodd-Frank won’t work

Interesting last week to see that GFI has applied to the CFTC to become a futures exchange. This follows on from ICAP’s purchase of Plus Markets (now ISDX) and so it surely can’t be too long before the other IDBs follow suit and execute their own regulatory hedges too. What they are worried about is that the regulatory regime around swaps seems to favour futurisation rather than SEFs and so will hand the keys to the kingdom over to the likes of the CME, ICE and other derivatives exchanges. This is leading to a headlong rush to set up futures exchanges and so we may see a similar type of market fragmentation that equity markets experienced thanks to RegNMS and MiFID. But, because derivatives contracts are specified (and owned) by their parent venue, they are tied to that venue alone. This lack of fungibility will do nothing for transparency (other than make it worse), and even less for liquidity. Imagine if you could only sell the Microsoft or Vodafone shares you own back at the same venue where you bought them. So, hardly a recipe for best execution either then.

Maybe we can learn a lesson from US equity options markets which operate a multi-market structure (11 at last count, soon to be 12) and yet standardise all contract specifications through one central body, the OCC. This provides the trading community with choice and allows market operators to experiment with different business models too. Even better, there is one standard record of what actually happened in the OPRA time and sales feed. Simple, transparent, competitive – now, what was it again that Dodd-Frank was supposed to be about?

Beware the Ides of March

I read a number of reports this week trying to kill off the idea of the great rotation back into equities. This prompted me to take another look at Fidessa’s spangly new ‘HFT-free’ trading index. At first glance it seems to confirm the view that both institutional and retail volumes fell off badly in Europe.

But, er, hang on a minute. Before we ring the death knell for equities once more, maybe there is another reason. Oh yes, it was something called ‘the Easter break’ that shortened the trading days at the end of the month. So, if you reset the chart and average out the daily volume to get a weekly view, the picture looks very different.

Whilst institutional flow looks to be holding steady, it still seems like the retail market is continuing its shift into equities. Just before you all email me, I know this still doesn’t constitute a trend, but it does seem that there is some momentum behind this phenomenon that we identified a while back.

Maybe Spring really is just around the corner.

Phew! February was a good month too

I got a bit of stick for a recent post where I wrote about the apparent move back into equities trading in January. To be fair, I was only referencing other people’s work but, nevertheless, I was anxiously awaiting the numbers for February. The good news is that volumes in Europe seem to have held up pretty well.

Just as before though, I asked the boffins to strip out the HFT ‘noise’ and just focus on the ‘real’ institutional flow executed by Fidessa’s sell-side clients in Europe. The guys must have had three shredded wheat for breakfast because they went one better and created the chart below which does a great job of showing the change in the value of the flow over the past year.

This chart is based on a value of 1000 for January 2012 and then tracks weekly institutional equity volumes from January through to today. As you can see, executed order flow has risen sharply and the closing value at the end of February was 1484 – a rise of nearly 50% in just 13 months and only 7% away from the high we saw in January. Obviously some of this is explained by general rises in the value of equity assets as broader European indices have risen by about 15%. But, if you’re a European sell-side broker and your volumes aren’t showing the same positive trends, then chances are that someone’s been eating your lunch (or at least eyeing it up anyway).

When we compared this with the picture for retail order flow, the trends were even more dramatic.

You can see that all this talk of the great rotation, higher inflation and negative interest rates has got retail clients thinking about their equity exposures too as the chart shows a 13-month high – a rise of close to 90%. A clear sign that the private investor has got his risk boots firmly strapped on.

It will be interesting to see if these trends continue and so we will publish these charts on a regular basis. If you have any suggestions or would like to see more detail – by sector, for example – then please just let us know.

No tax please, we’re British, Italian, French…

The debate about Financial Transaction Taxes (FTTs) seems to roll on and on. Italy’s FTT is due to come into force this Friday and two democrats in the US want to introduce an American FTT. Even EU Tax Commissioner Algirdas Semeta says a global tax on financial transactions eventually should be a reality.

All of this got me thinking about what the real purpose of such a tax is and whether it can ever work in practice. Some regulators have argued that FTTs discourage predatory HFT activity, but the evidence from France (the first country to introduce such a tax) does not seem to confirm this view. The chart below shows volume in CAC 40 stocks and, at first glance, seems to show that volume fell away dramatically after the introduction of the tax on 1st August 2012.

So did this mean that the HFTers slunk away to lick their wounds? Well actually, no, as the second line in the chart shows that volumes across all other European indices fell away too. So what we were really seeing in France in August 2012 was just part of a macro phenomenon and nothing to do with the tax at all.

The second argument put forward by politicians is that such a tax is a way to extract recompense from the financial community as a whole. This doesn’t wash either as any sales tax (think VAT, for example) just gets passed down the line until it reaches the end consumer. So perhaps the real motive is simply a somewhat cynical attempt to introduce a tax that will ride on popular support for ‘bank bashing’. The irony, of course, is that it will be you and me that actually pay this tax in our pensions, insurance premiums and other investments.

As to whether they will work, I have always maintained that in any market participants can move faster than regulators can pass legislation. The introduction of FTTs unilaterally around the globe should prove no exception to this game of regulatory whack-a-mole. Why not see whether Italy’s FTT will fare any better than France’s using the Fragulator live.

Will the derivatives industry follow equities into a world of fragmented liquidity, smaller trade sizes and HFT?

The derivatives industry looks set to undergo a similar set of structural changes to those experienced by the equity markets over the past few years. This had led some to look at the current shape of equity markets as a proxy for what may happen in derivatives. In particular, attention has turned to some of the more controversial outcomes of multi-market trading, such as low-latency, venue-based high-frequency trading (HFT).

The rise of this type of activity was an inevitable, if unintended, consequence of the multi-market structures that emerged in the US and European cash equity markets. This is because when trading is spread over multiple venues, it enables firms to exploit price differences in the same stock over multiple venues or differences in the tariff charged by each venue. Those firms that can do this quickly (or at high-frequency) can rapidly move liquidity between venues just ahead of the pack. The net result is that average trade size tends to get smaller and smaller, as the chart shows.

Whilst smaller average trade sizes aren't necessarily a problem to retail traders, they do provide a significant liquidity challenge for institutions wishing to trade in large block size without undue information leakage.

The structure of the derivatives industry looks set to undergo change in two dimensions. The first is driven by Dodd-Frank Title VII, which seeks to move as much OTC or bilateral derivatives volume as possible onto centrally cleared trading platforms known as Swap Execution Facilities, or SEFs. The second concerns the introduction of more direct competition within the exchange-traded marketplace. Recent moves by NASDAQ OMX in creating its new interest rate derivatives platform NLX, the CME with the new CME Europe exchange and ICE's recent takeover of NYSE Euronext are all testimony to this.

It's also interesting to speculate on which SEFs will emerge successful from the large number of candidates currently stretched across the Dodd-Frank starting line. Some even believe that SEFs will be a temporary phenomenon and that, instead, we will witness the wholesale futurisation of the OTC marketplace.

Whatever happens, we will certainly see a significant growth in the number of venues and the competition between them. Will the derivatives markets inevitably follow their cash equity cousins down a path of HFT, shrinking trade sizes and generally greater complexity?

Differences in the mechanics behind how equities and derivatives trading actually work mean that a like-for-like result is unlikely.

The first difference is that derivatives exchanges either own the intellectual property of their benchmark index products (via exclusive licenses) or control the open interest in their listed products through vertically integrated clearing houses. This means that it is much harder for a competitive venue to siphon liquidity away from an incumbent exchange as traders are reluctant to embrace a new venue unless they are sure it provides sufficient liquidity. This 'Catch-22' has proven a significant obstacle over the years. The DTB's (Eurex's predecessor) success in winning back the benchmark German Bund from Liffe in 1997 provides one notable exception.

The second difference concerns internalisation. This is a common practice within the equities industry as brokers seek to internalise as much flow as possible before sending it outside for execution. In this way, the trading of stocks is a complex blend of internalisation, OTC activity, dark pools/crossing networks and, of course, execution on public lit markets, Whilst Messrs Dodd and Frank seem determined to converge OTC and exchange-traded derivatives, the exact outcome in terms of market structure across the US and Europe is less clear.

If like-for-like contracts were spread over a bunch of different SEFs, then it's fair to assume that this would provide the same rich picking ground for the HFT firms. SEF operators are aware of this risk but, until the rules concerning their operation are fully clarified, it is difficult for them to take any protective measures one way or the other. In addition, there would appear to be opportunities for firms that can minimise the up-front margin requirements for participants used to operating in old style OTC markets. The dynamics of having multiple clearing houses and the virtual risk/margin offsets available between OTC and exchange-traded products (e.g. a Euro swap and a Bund) are also a factor in all this. It may be that the winners are those firms that can offer their clients the optimum exposure to the combined market rather than just the best prices.

In summary, the derivatives industry is undergoing fundamental change that will introduce multi-market structures resembling those that now exist across many of the world's equity markets. It doesn't follow, however, that the same issues in terms of HFT and dark pools will emerge in their wake. One lesson that can, and should, be learnt from equity markets is that the workflow for market participants will inevitably get more complicated. Expect to see, therefore, more intelligent order routing, growth in algorithms and a new emphasis on TCA, just as exists in equity markets today. On top of this, the greater regulatory scrutiny on the derivatives industry will compel both the buy-side and the sell-side to invest in systems that operate in a more holistic manner and connect front, middle and back office together in a far more intelligent fashion.

And, finally, don’t expect the god of unintended consequences to sit on the sidelines whilst the regulators attempt to straighten out derivatives markets.

In fact, he's probably shaking the dice right now.

The rising tide in equity trading – who will benefit?

Been reading quite a bit lately about how good old-fashioned equities are finding their way back into investors’ favour. And this time it is more than just the indices that are on the move, volume traded is going up too. In many ways, volume or consideration is a more useful indicator of the general health of the trading industry and the US has reported record influxes into managed market funds and ETFs recently. A similar trend is being widely reported across Europe too.

So, if this is the start of a real resurgence, who will the winners be? They say a rising tide lifts all boats and so I guess we can expect all market participants to prosper to some degree. But is this “the right sort” of liquidity? Are the original participants returning to the market or is it just more HFT chasing its own tail?

The charts below might help answer this. The first looks at total European equities traded by consideration and it certainly seems to show the beginnings of a trend.

The second chart is based on data from the Fidessa network. Because it focuses on its core client base of asset managers and sell-side brokers, it effectively strips out HFT and instead represents “traditional” order flow.

The same upward trend is clear and so there are definite grounds for cautious optimism. But the real winners will be those that have been using the downturn to rethink their businesses. Firms that have simply reduced capacity may find that they are ill-equipped to take advantage of this new sea of liquidity. More so, as whatever happens to volumes, the game is different now. The proliferation of venues and order types, combined with on-going regulatory churn, demands a different trading workflow. This needs to be based either on scale or specialisation and the firms that achieve this will get the lion’s share of the new liquidity.

HFT (High-frequency Taxing)

It’s always seemed like the wrangling over regulation in Europe’s capital markets was, in many ways, a proxy for the broader political debate raging across the region. No surprise, then, that on the eve of today’s speech by David Cameron we saw that the European finance ministers have agreed the creation of a vanguard transaction tax bloc that will implement its own Tobin-style financial transaction tax across 11 countries, including France, Germany, Italy and Spain but not the UK. Reading in the FT this morning how the tax is supposed to work, it seems that this approach is full of potential loopholes and get-arounds and will certainly keep the consulting firms and accountants busy as they try to iron out these inconsistencies. More importantly, it illustrates yet again that regulators acting individually or in cosy clubs will never be able to shoot all the regulatory ducks they are aiming at.

It is also unclear exactly why the tax is being introduced (maybe I am just being pedantic). Is it to reduce “speculative” trading as the BBC reports; to purge the industry of HFT; or to retroactively punish naughty bankers that supposedly drove us to the edge of the fiscal cliff? On this last point, no one in the back of the bus that was over-leveraging with cheap houses and holidays seemed to be complaining at the time, but that’s another story.

Making financial markets work safely, efficiently and for the greater good is a serious matter. But, whilst European regulators seek to tackle these problems with unilateral or “vanguard group” legislation, the market will simply get more distorted and complex – hardly an ideal outcome. The other observation is that carrots tend to work better than sticks when it comes to shaping behaviour.

Anyway, the key questions about this initiative are why, will it work and how long will it take before it is actually implemented? Just like with the broader political agenda on closer European union, the answers are, respectively, ill-defined, probably not, and don’t hold your breath.

Dark matter

In cosmology, dark matter is a type of matter that the boffins reckon accounts for a large part of the total mass of the universe. It cannot be seen and neither emits nor absorbs light. And yet it is estimated to account for over 80% of the total universe – so, pretty important then.

In European equities trading the rise of dark pools has created a similar enigma. Everybody knows that dark pool trading is important and makes up a significant proportion of the total trading universe, but no one really knows just how much (or how little). So, rather than let the folks at Fidessa Labs enjoy their usual Christmas jamboree of Twister and mince pie eating competitions, I asked them to produce the attached report. Just as with dark matter it relies on estimates, but it does provide a neutral and (hopefully) comprehensive view of the what, where and how much of dark trading in Europe. Please let us know what you think and what else you would like to see included.

In the meantime Happy Christmas and see you next year.

Caught up in consolidated tape (again)

Just when I was hoping to start thinking about the Christmas holidays (beginning with the first of the season’s parties this week) we’ve seen a bunch of announcements on the European consolidated tape, including those from FPL and The COBA Project.

Everyone acknowledges that the lack of an agreed tape of record makes any concept of true best execution pretty meaningless and yet, five years on from the introduction of MiFID, there still seems little sign of progress. The two announcements this week claim to be industry-led solutions, but neither has the complete backing of the market and neither solves the fundamental problem that continually seems to get kicked down the road. For a more detailed analysis you can visit the Regulation Matters website, but basically the issue centres on who the data belongs to anyway. Is it the investment managers that make the buy/sell decisions, the brokers who execute and, in some cases, match orders, or the venues that list the stocks in question and match order flow too? This has a crucial bearing on who should actually pay for this data and then how much. The Eurocrats seem vague on all this and yet they state that if commercial providers don’t step in to provide such a consolidated tape at “reasonable cost” then they will take matters into their own hands. Worse still, they seem to mix up the post-trade requirements (that are required for proving best execution) with the real-time situation which firms have solved already to reflect the venues they wish to spread their orders across.

It’s a shame because the industry has done a lot of the hard work in agreeing the rules by which such a tape should be compiled through the MMT. This is the standard that both FPL and COBA hail as their Eureka contribution to the problem. Without real alignment on who pays who for what, though, I imagine we will still be warming our hands on this one for years to come…

I’m a mid-sized broker – get me out of here!

On the train this morning, I was browsing through London’s Metro newspaper to see who the latest ‘victims’ in The X Factor, Strictly, I’m a Celebrity etc, were (incidentally, it’s probably the people that actually watch these programs, but that’s another story). I was a bit shocked, therefore, to come across a double page spread examining dark pool trading. I was even more surprised to see that it was, in fact, a pretty well-balanced article with only one small factual inaccuracy (Turquoise operates both a lit and a dark market). Other dark pool stories have cropped up recently too and so it prompted me to have a look at the latest stakes in Europe.

The chart below shows the official dark pool tally and the relative shares of the total reported dark market in Europe. What’s interesting is that you can see a steady rise in dark pool trading and that probably the biggest success story is UBS MTF. The reasons for its success are pretty simple – it has the widest stock coverage, it’s cheap and, right from the beginning, it has supported interoperable clearing.

What’s more interesting, though, is what the chart doesn’t show you. Broker Crossing Networks (or BCNs) are not obliged to report in the same way and so, whilst they still match orders away from lit markets, it’s very hard to get any accurate figures for their real volumes (either here or in the US). BCNs are absolutely in the sights of European regulators, however, and will be forced, under MiFID II, to become either full MTFs or Systematic Internalisers (a classic bit of clumsy Euro-fudging). Obviously this has got the big firms thinking hard, but I wonder what this means for the smaller firms for whom crossing client trades is one of their last truly profitable activities. The new rules will make automatic crossing a much more regulated activity, but the problem comes in exactly what activities these new regulations extend to. Obviously, the matching engines of the big boys get caught up in this definition, but what about using a spreadsheet to track different incoming client orders, or if I email a colleague on the desk next to me with a potential matching opportunity?

Yet again, then, it looks like the law of unintended consequences is going to come into play. Let’s just hope that this time the smaller firms don’t get voted off before they have a chance to have their say.

What can we learn from Apple, Microsoft and London taxis?

Three stories in the FT today showed how different firms are positioning themselves to meet the changing competitive landscape. First, Apple announced that it was shaking up its senior ranks after the maps fiasco on its latest iPhone.  Is this the first sign of unrest at Apple since the demise of the inspirational Steve Jobs? And, more to the point, would he really have condoned the launch of the iPad mini?  For the first time this looks like Apple is playing catch up with the competition rather than striking out and being truly innovative.  On the other hand, if Apple is facing competition from manufacturers of smaller devices, then maybe it’s better that it gets to do the cannibalising itself. 

Microsoft, on the other hand, has pretty much bet the farm on Windows 8 – its new touch screen OS will be almost totally unfamiliar to its one billion plus existing users but, if it is successful, this will reshape perception of the company entirely.  Last of all is Manganese Bronze the makers of the “iconic” London taxi which announced it will probably go into administration this week.  Its famous black cabs had regulatory protection because they were the only vehicle that could turn in a tight enough circle to cope with London’s narrow streets.  This monopoly was squandered as it failed to innovate, failed to reach outside its core market and didn’t adapt to new technologies and processes.

What does this have to do with my industry – capital markets? Well, plenty.  Global financial markets are undergoing fundamental and accelerated competitive change. Regulation and technology continue to melt away the distinction between asset classes, trading styles, venues, brokers and the buy-side. So, be Apple and out do the competition, be Microsoft and try to change the game but, if you do nothing, you might just end up like Manganese Bronze.

In defence of derivatives

FragVision Episode 7 looks at the common misconceptions about the derivatives industry and the likely impact of some of the new regulations that it is having to get to grips with.

Is the time up for HFT?

Few can have missed the fact that Germany is set to go it alone on curbing HFT, although it looks like the rest of Europe won’t be too far behind. The proposed European legislation will insist upon a minimum resting time for orders before they can be amended or cancelled.

This has sparked a fair amount of discussion here at Fidessa Towers on how it will (or probably won’t) work. Presumably the stop watch will be in the hands of the venues themselves, but trading firms won’t necessarily know when an exchange has hit the start button and so they won’t know when they can send an amendment or cancellation. This is because the way trading platforms work means that the messages they send back are often out of step with each other. Acknowledgment that an order has been received often arrives after it has actually entered the system (sometimes it is even after the order has been filled). The boffins call this asynchronous communication and it looks like being a rather nasty fly in the ointment that regulators are trying to rub into the HFT “problem”. One approach is that the venue simply queues all order amends and applies them once the 500 milliseconds is up – but in which order? And how do they protect themselves from claims that they didn’t quite get it right for a particular trader’s order?

On top of this the processing overhead of making all these measurements may create anomalies in how the trading platforms behave. And, finally, European venues do not run on one standard universal clock, and yet many trade the same stocks, so problems may arise here for market participants too.

Whatever happens, it looks like this piece of legislation will cause yet another slew of unintended consequences which will doubtless be followed by more regulation. The real problem in all this, though, is that the current cycle we are in simply drives up complexity and costs for the market as a whole and this inefficiency means everyone suffers.

Social media and the return of high touch trading

The past decade has witnessed the wholesale electronification of global trading. The term “low touch” was coined to describe exactly this and the electronic routing of client orders to markets with the minimum of intervention from their broker. This meant that the value add of the sales trader was increasingly denuded and the key differentiators became simply cost and market coverage. Interesting, then, that at the International Trader Forum in Madrid last week a number of high profile buy-sides were talking about a return to full service, high touch brokerage. This is because a combination of persistent low volumes and increased venue complexity are making it harder and harder to get orders filled. On top of this, the desire to avoid predatory HFT activity has meant that firms want to know exactly who they are dealing with and the likely outcome of showing their hand at any given venue. This has always been the preserve of the high touch world, where managing the relationship was the key to success – liking and disliking different counterparties and having different circles of contacts to interact with depending upon any given trading objective. This is what traditional brokers were able to provide to their clients and, in some cases, still do. But now there’s a new game in town. In parallel with the electronification of markets, the rise of social media has shown how relationships are now forged, maintained and evaluated electronically.

The combination of the two creates some intriguing opportunities that might finally prove how social media and financial markets are supposed to work together. Market pioneers are starting to make this connection – such as Tony Mackay (founding CEO of Chi-X Europe) with MarketBourse – but you wonder if an exchange is even needed at all. Historically exchanges provided a physical meeting place for interested parties to engage in price discovery, but increasingly these same parties can now find each other in cyberspace. So maybe the return to high touch trading is achieved by overlaying social media concepts on top of the low touch networks that now proliferate the industry. This would enable different counterparties to not only find each other but also build and extend their relationships based upon shared interests or capabilities.

However all this pans out, the current difficulty in finding suitable liquidity means that a return to more relationship-based trading looks a distinct possibility. The use of social media in this way could provide high touch service but without the high cost.

Beanz Meanz MiFID

Imagine I ask you to go to the shops and buy me something simple – let’s say 5 tins of beans. You go to the local shops, return with the goods and I pay you for them, together with a tip to compensate you for your efforts. If you do a good job in terms of price and getting all 5 tins quickly, then I might well ask you to do my shopping on a regular basis. But if I discover that you did a poor job and paid over the odds, I won’t ask you again and I’ll suggest to my friends that they don’t either.

Now let’s assume that a law is passed obliging you to drive to every available store and, before you buy a single tin, check all the prices to ensure you are getting me the best price. To make it harder, some of these stores (which only operate in dark alleyways) won’t actually tell you the price or even if they have any beans; all you can do is write down the price you’re prepared to pay on my behalf, leave a note on the counter and come back later to see if you were successful. To make it trickier still, a newcomer arrives in town and starts buying and selling tins of beans between the different stores hoping to exploit tiny differences in their prices. Because he has a faster car than you (and knows about your legal obligation to me) he waits until you are about to visit a particular store, zooms past you and stocks the shelf with tins he bought cheaper elsewhere. So you buy a faster car, but then so does he, and now the roads are full of people driving like maniacs. Accidents start to happen as wrong prices get put on tins and people crash off the roads in the hunt for the elusive beans.

To complete the nightmare, let’s finally assume the lawmakers forgot to include any mechanism that combines all the different prices that were available so that – despite all your efforts – I simply can’t tell whether you have met your obligation to me or not.

The moral in all this is that regulators seem keen to stress that with technology comes responsibility, and yet no one seems prepared to take them to task on whether they are actually making markets any better. Let’s just hope that derivatives markets fare a little better as they run the same gauntlet.

Whilst my breath is still warm

Good to see that the HFT community is finally starting to educate the regulators and policymakers. As we all know, the debate hinges on whether these firms are really acting as electronic versions of traditional market makers and, if they are, whether they should be subject to some of the same formal market making obligations. In particular, regulators have been gnashing their teeth over the fact that such firms are free to replace their quotes as often, or as “frequently”, as they like. The regulators argue that all this activity creates substantial noise that clogs up data pipes and distorts the true picture of the real price of a stock. In their defence, the HFTers argue that they have the right to re-price their “product” just as often as market conditions dictate and that, anyway, they aren’t breaking any laws.

This prompted me to ask a friend about how all this worked in the good old days of manual markets and traditional market makers. In response to this question, he paused for thought and then replied that, in those days, your quote was valid “whilst your breath was still warm.” Basically, this was just a poetic way of saying that it all depended upon a bunch of factors – how fast markets were moving, the instrument in question, the client, and even the different nature of individual trading floors and exchanges. Seems like the regulators might struggle, then, to impose an absolute time frame for quote validity in today’s world as any level is destined to be wrong in most cases, most of the time. If they are determined to impose absolute limits, then why not do it the other way round, i.e. say that HFTers can pull their quotes just as often as they like but there is a certain minimum time period before they can resubmit a quote? This idea was put to me the other day and, whilst it sounds like a subtle change, it would seem to provide a fair and equitable solution to the problems of both the HFTers (namely having to trade on a bad or stale quote) and the trading community at large (noise and clogged data pipes).

Irrespective of the merits of this approach, solutions that are fair and equitable on all market participants should be the mantra of the regulators. This means divorcing themselves from the politicians and accepting that perhaps the best they can ever hope to achieve is a solution that leaves everyone equally unhappy.