The Financial Services Club's Blog

Is it me or has CESR just screwed dark pools? (UPDATED)

Meeting with a mate last night, who happens to be on the inside track of EU regulatory matters as they relate to Capital Markets, he turned to me and said: "have you seen CESR's latest?"

Of course I hadn't, as I've been payments oriented all week and CESR is the European Regulatory body that created MiFID, the Markets in Financial Instruments Directive.  This is the regulation for managing equities trading across Europe.

"What are they saying?" I asked.

"Only that everyone now has to use EBBO!" he chortled.

EBBO is the European Best Bid-Offer pricing system.

What does EBBO mean?

It's basically a price that is dynamically updated with each change in the best price in any of the relevant markets where the instrument is traded.

Therefore, if you're trading in HSBC or Vodafone, EBBO will look across all of the execution venues where those stocks are traded and will tell you the best bid and offer for those stocks in real-time.

So what are CESR saying?

Looking at their website, they've updated MiFID with a new ruling on price waivers for execution venues as from Tuesday of this week (did anyone notice?).

Here's the exact text:

Waivers from Pre-trade Transparency Obligations under the Markets in Financial Instruments Directive (MiFID) - Updated 9th March 2010

...

All orders will be submitted to the system for execution/crossing at the midpoint of the European Best Bid and Offer (EBBO). The European Best Bid price is the highest binding bid (or buy) price available in the central limit order books of the regulated markets and MTFs contributing to the determination of the EBBO. The European Best Offer price is the respective binding lowest offer (or sell) price. Thus the EBBO will always deliver the tightest spread available in the contributing trading platforms.

...

The document says a lot more, but the heart of it seems to be getting at the opaqueness of pricing and lack of a single price feed.

Hence, by enforcing a new rule whereby every participant has to guarantee Best Bid-Offer or - if crossing - the mid-point, they have wiped out much of the motivation for dark pool trading overnight.

Why?

Because dark pools work at giving you a better spread than on the open market based upon a volume order, as well as allowing block trading unseen.

You want a 1,000 HSBC or Vodafone stocks?

Old days: you look at the markets and make a Visible Bid for them.  If someone can trade at that price then they make a Visible Offer.

New days: you place your order into a dark pool and it sits waiting to be filled at the price you specify, a Dark Bid.  This bid is often a price that is better than on the open markets, e.g. not the European Best Bid-Offer but your, discounted Best Bid-Offer which can only be met by other 'dark' players who make a Dark Offer that is also unseen by the markets.

If you want to know more about how dark pools work, the flash illustration on Turquoise's website shows this well.

CESR's new ruling wipes out the new days overnight, as you are now only going to get that order filled by placing visible pricing levels.

Or that's how my friend reads it.

Download the full documentation here (19 page pdf).

Meanwhile the question that arises is that Nomura and UBS have just launched into dark pool territories in the recent weeks ... has this just screwed their efforts big time?

UPDATE #1 13:45 11th March

Ben in France points me to references that the CESR rules allow Primary BBO (PBBO), and is not restricted to EBBO therefore.  PBBO is explained well on Chi-X's website.

Ben says he's asked CESR and they've confirmed that PBBO is OK.  Might have been worth them putting that in the document more clearly in my view, e.g. PBBO isn't mentioned once but EBBO is everywhere.

And it still doesn't answer the basic question: by forcing dark pools to use mid point pricing for all trades undertaken removes the raison d'etre as this gives bank owned dark pools a significant reduction in spread, and therefore P&L, due to the price being a mid price set from an external source.

On the other hand, people like Nomura were fully aware of this.  In fact, it's part of the reason for bringing NX to market (see page 5):

'NX Mid Match (NXMM) operates as a dark mid point crossing venue, with executions made with
reference to the mid point of the Primary Market where the Security is listed.  NXMM operates under a MiFID pre trade transparency waiver with mid-point crossing only as per Example 3 of “Acceptable crossing logics” in the CESR document “Waivers from Pre-trade Transparency obligations under the Markets in Financial Instruments Directive (MiFID)”.

'The NXMM matching logic has been designed to achieve the following characteristics:

• Simple structure;
• Minimal information leakage;
• No gaming;
• No timing advantages; and
• No probing.'

So why would Nomura, Barclays and UBS make announcements and investments in dark pools if it gives them no major P&L advantage?

According to Ben, it's motivated by the need to access the LSE's Turquoise strategic steering committee ... and so the game rolls on.

My City friend agrees that Nomura understand what they need to do in their MTF (Multilateral Trading Facility), but that the real issue is whether banks can still put their trading desk up as a counterparty to a customer order at anything other than a mid price?

This cuts to the heart of being a Systematic Internaliser, which none of them want to be and is the reason for the rush to be a dark MTF.  However, if the rules are interpreted as above and all customer orders go into a dark pool, then the issue of where they are crossed with the prop book arises.

Does the FSA allow the prop book to cross a customer order outside the MTF or is it more likely that crossing with the prop book will need to be done within the MTF at the midpoint, which then cuts the P&L and internaliser gains?

Monthly MiFID MTF Monitor: February 2010

In our second month of monitoring the MTF performances in European Equities trading in partnership with Thomson Reuters Equity Market Share Reporter (EMSR) - for last month's figures and charts, click here - we find that Chi-X continues its success, whilst LSE win this month's battle with Xetra for second place.

Market Share based upon Euro Value:

 

Source: Thomson Reuters Equity Market Share Reporter

Market Share based upon Volume of Trading:

 

Source: Thomson Reuters Equity Market Share Reporter

Market Share based upon Trade Count:

 

Source: Thomson Reuters Equity Market Share Reporter

If you prefer numbers to charts, then here are the numbers:

Source: Thomson Reuters Equity Market Share Reporter 

Source: Thomson Reuters Equity Market Share Reporter

 

Source: Thomson Reuters Equity Market Share Reporter

Source: Thomson Reuters Equity Market Share Reporter

* these figures reflect auction and non-auction transparent order book and dark pool trades, but excludes real-time and post-trade on-exchange reported and off-exchange OTC trades in order to provide a true comparison between the MTFs impact and the traditional exchanges.

SEC to crack down on HFT?

As folks who read this blog regularly know, I often return to the theme of latency and high frequency trading (HFT).  So a friend tipped me to look at the SEC's latest consultation document released in January on trading in American equities markets.  Interesting section at the bottom of page 62:

Latency of Consolidated Data.

The Commission requests comment on all aspects of the latency between consolidated data feeds and individual trading center data feeds.

What have market participants experienced in terms of the degree of latency between trading center and consolidated data?

Is the latency as small as possible given the necessity of the consolidation function, or could plan processor systems be improved to significantly reduce the latency from current levels, while still retaining the high level of reliability required of plan processors?

More broadly, is the existence of any latency, or the disparity in information transmitted, fair to investors or other market participants that rely on the consolidated market data feeds and do not use individual trading center data feeds?

If so, should the unfairness be addressed by a requirement that trading center data be delayed for a sufficient period of time to assure that consolidated data reaches users first?

Would such a mandated delay adequately address unfairness?

Would a mandatory delay seriously detract from the efficiency of trading and harm long-term investors and market quality?

Should the Commission require that additional information be included in the consolidated market data feeds?

I think change is afoot ... and will MiFID Wave 2 do the same?

Why latency is so important (and Goldman wins)

Great article in this month’s Bloomberg Markets Magazine on High Frequency Trading (HFT) which, according to Tabb Group, has increased from almost nothing to account for 61% of US stock market activity and 70% of individual trades since 2005. The SEC announced it is to review this area of trading last month but the focus of the article is what this means in reality from a broker dealer view.

Working with Ancero, Bloomberg has compiled a list of the best brokers using their global trade execution prices between July 2008 and June 2009. This is anannual review, and shows the impact of HFT upon the brokerage community as Goldman Sachs is the clear winner for brokers handling over $25 billion in trades annually.

According to Ancerno, Goldman is the closest at getting orders filled nearest to the price when the order is received whilst JPMorgan, last year’s #1, has fallen to joint fourth with Barclays Capital, behind Bank of America Merrill Lynch and Morgan Stanley.

The World’s Best Brokers                 Loss in basis points*

#1    Goldman Sachs                                     -27.5
#2    BoA Merrill Lynch                                  -32.7
#3    Morgan Stanley                                     -33.6
#4=  JPMorgan Chase                                    -34.2
#4=  Barclays Capital                                    -34.2
#6    Investment Technology Group (ITG)      -35.6
#7    UBS                                                     -36.3
#8    Deutsche Bank                                     -38.8
#9    Citigroup                                             -39.7
#10  Credit Suisse                                        -41.3

A basis point is 0.01%, so Goldman Sachs' 27.5 = 0.275% or just over quarter of one percent. This means that, for a client who placed an order for 50,000 shares at $10 each with Goldman Sachs, they would get the shares for an average price of $10.275 cents; whilst Bank of America would fill the order at an average price of $10.327 cents; Morgan Stanley at $10.342 cents; and so on.

[Figures represent the difference between the executed stock price and the price when the order was placed for brokerage clients in the four quarters ended on June 30th 2009, according to Ancerno]

Why have Goldmans won?

According to Roger Freeman, an analyst covering brokerage houses and exchanges at Barclays plc, because “they have the most developed and advanced electronic systems” and “can get some of the fastest execution times on trades.”

This is why latency is so critical and illustrates the point well.

For example, per day, the US exchanges averaged trading of 10.4 billion shares daily during the year to June 30 2009, with institutional investors globally paying $28.2 billion in trading commissions compared to $30.7 billion in 2008 and $26 billion in 2007.

Interestingly, the basis point difference varies quite widely by region:

Loss in basis points*        USA     Europe     Asia
Goldman Sachs               -25.4     -32.6     -24.0
JPMorgan Chase             -34.1     -35.8     -31.1

This may be a reflection of the early state of low latency in Europe at that time, and demonstrates why Chi-X has succeeded so fast.

LSE's marketing gets desperate

I realise that the LSE has been challenged by the new MTFs like Chi-X, which is why it has recently acquired Turquoise, but surely this sort of advertising is going to new extremes ...

OId boys versus the new boyz

Just been at another fascinating conference on trading and low latency in the capitalmarkets. I’ll write more later on but, for now, thought you might be interested in these stats from Karel Lanoo, CEO of CEPS (not exceptions processing – the Council of European Policy Studies).

He compared the London Stock Exchange (LSE’s) trading and volumes before and after MiFID. Here’s the numbers:

                                                            Trades             Turnover

On order book (Electronic)     2006     78.2 million     €2.2 billion

                                            2009    156.4 million   €1.27 billion

Off order book (OTC)             2006     16.5 million    €3.77 billion

                                            2009     9.63 million   €1.28 billion

And you may think that’s down to the fact that the LSE has been hit by lower volume of trading thanks to the crisis. Yes, in part:

                Trades           Turnover

2008    2.22 million      €24.04 billion

2009    2.17 million      €14.29 billion

Yes, trading turnover was down 40.5% whilst trading volumes remained fairly constant.

So, in other words, something else had an impact.

What could that be I wonder?

Today’s Wall Street Journal

Chi-X Europe, one of the new breed of alternative trading platforms, became the second largest European equities market by value traded in January, leapfrogging incumbent exchanges including the London Stock Exchange (LSE.LN) and Deutsche Boerse (DB1.XE) for the first time. Trading levels for European equities on the electronic order book of the London-based platform, known as a multilateral trading facility, were valued at EUR109 billion ($147 billion) during January, according to figures released today by the Federation of European Securities Exchanges.

 

MiFID Wave 2

I've been meaning to write a few insights into the MiFID review, and will do so in the future.  Meantime, a colleague from Credit Agricole's subsidiary, CA Cheuvreux, sent me a really interesting white paper on the MiFID review and has kindly given me premission to post it here for Finanser readers. 

Issues linked to Crossing Engines (internal order crossing systems) can only be properly understood after a review of the new landscape that emerged following MiFID. We witnessed a destructuring of the market, which has resulted in a war of tick sizes and the emergence of a new category of entrants favoured by the pricing set up by exchanges. During this period, traditional players saw their costs soar, a factor that could lead to the exit of the weakest players without sufficient financial wherewithal to cope with the expenses resulting from MiFID. Pre-transparency, which was one of the major vectors of MiFID, has deteriorated, and liquidity on the lit markets has become an illusion. It is precisely the deterioration of the quality of the lit side that has driven participants to increase their use of dark venues (dark part of MTFs and Crossing Engines) in order to protect the interests of clients wishing to access all liquidity pools. Concerns that subsequently rose regarding price formation mechanisms cannot be lifted by regulating dark pools indiscriminately but rather by restoring the quality of the lit world.

Download the 7-page white paper here: CA Cheuvreux on MiFID

Monthly MiFID MTF Monitor: January 2010

The Financial Services Club is pleased to announce that we have recently agreed a partnership with Thomson Reuters Equity Market Share Reporter (EMSR) to provide a monthly MiFID MTF Monitor.  Our aim is to show how the pan-European investment markets are changing as a result of the MiFID and the entry of the new MTFs. 

EMSR provides extensive, amazing, insightful and very indepth analysis of pan-European trades via electronic and OTC trading, including trade reporting on and off exchange through internalisation reports via Markit BOAT, as well as a pure comparison of trading venues, including dark pools. 

For example, and to begin with, here are the trading stats in euro by trading venue* for January 2009 and January 2010 (doubleclick images to see larger version):

 
Source: Thomson Reuters Equity Market Share Reporter (ENX=Euronext, Xetra = Deutsche Bourse)

As can be seen, Chi-X have now reached the Number 1 spot for all European trading.  Interesting to see how this has changed over two years.  For example, here's the picture back in January 2008:

Meanwhile, if you include on- and off- exchange trades, including all OTC activity, the picture is more like this:

 

Source: Thomson Reuters Equity Market Share Reporter

Hmmmm ... no wonder LSE has been struggling.

Meanwhile, it's also interesting to compare the actual trading by value on the MTFs year-on-year:

 

Source: Thomson Reuters Equity Market Share Reporter

What happened to Turquoise you may ask?  (a) their stakeholders contracts expired; and (b) they got acquired.

Finally, if you really want the detail, then the numbers are interesting (doubleclick to enlarge):

So, there you have our first monthly MiFID monitor.   More to come, and lots of analysis and information we could share.  All in all, thanks to Thomson Reuters for sharing ...

 

* these figures reflect auction and non-auction transparent order book and dark pool trades, but excludes real-time and post-trade on-exchange reported and off-exchange OTC trades in order to provide a true comparison between the MTFs impact and the traditional exchanges.

Is MiFID working?

Just had an enjoyable morning floating around the City and talking with folks about MiFID 2. Now you may think that’s not so enjoyable, but it has been interesting.

For a while now, MiFID has been of concern as it has not achieved what it set out to do, namely to improve trade execution by providing guarantees of processing in terms of the best price, cost, speed of processing. The fact that the Directive celebrates its third year of operation without a single major best execution case or fine shows how effective that has been, particularly as best execution is known to be way off. For example, Equiduct showed a year ago that of the €97 billion trades completed in January 2009 across the most liquid 500 stocks, a third (33.4%) could have achieved a better price on a different venue.

But other things have taken priority over best execution, such as survival and bonuses.

So MiFID has failed in one of its core tenets. It has also failed in another: the transparency of trading.

According to a CFA Institute survey published last month, 68% of respondents felt that market fragmentation has created difficulties in trade reporting obligations.

Although the survey finds no empirical evidence that the fragmentation of trading and pricing has been detrimental to price formation, it does highlight the number one issue for most market constituents, which is the need for a consolidated tape for quote and trade data for European equity markets. You see there are so many trading venues now, each reporting their trades to their own chosen public reporting sites, that users have to increase their connectivity to a much wider range of venues than ever before. With each connection costing around £10,000 per month, that’s a high cost.

This concern has been picked up by Thomson Reuters who have produced an interesting white paper on European data consolidation this month. Their paper provides three key conclusions:

• “The buy side considers the cumulative cost of fees charged by exchanges, and trade reporting services is a significant barrier to adoption of a consolidated tape, and a detriment to overall transparency. We suggest there should be a more modular approach to data pricing that is underpinned by regulatory intervention.

• “The coverage and quality controls around MiFID trade publication need to be formalized and enforced to instil market confidence and trust. We make several suggestions to improve trade publication. To be successful, the institutional buy-side, brokers and trade reporting services will need to reach agreement on standards, and these rules will need to be codified through MiFID 2 regulation.

• “Best execution monitoring has been hampered by shortcomings in the provision of the source data contributing to a consolidated tape and by inconsistencies of approach to benchmark calculation between information vendors. In this document, we openly share our TCA (Transaction Cost Analysis) formulas and methodology. We now call upon other vendors to join in defining industry standards for data consolidation and TCA measurement.”

The consolidated tape is the priority for MiFID 2 therefore, along with sorting out the issues of best execution and pricing.

What else might be in there?

Dark pools?

Sure, they are a big issue aren’t they? The CFA survey found that 70% believe dark pools are problematic for price discovery, and the Federation of European Stock Exchanges (FESE) estimates that as much as 40% of trading takes place in the dark.  That means the general investor does not get to see these prices and orders until they are filled in a ‘hidden’ dark world.

FESE says that is wrong.

The banks say it’s just the Exchanges trying to create a smokescreen and that there’s no way the trading in dark pools is at that sort of level. In fact, the FSA has found that it is only about 2.5% of OTC (Over-the-Counter) trades that take place through dark pools whilst, across Europe, CESR estimates it to be more like 1.25%.

Interesting times and I could write a lot more, and will in the future.

Right now though, between the MTF impacts, the increasing use of dark pools, the lack of consistent trade reporting, the increasing use of flash orders and high frequency trading, the need for best execution and price transparency, and more, the regulators have still got a lot on their plate for this MiFID review.

Crisis or no crisis.

How far can investment firms innovate?

I’m continually impressed and amazed by the speed of change in the technology of the investment markets.

For example, last year was all talk about low latency and lit versus dark pools. This year, it’s all about private cloud-based services based upon colocation and proximity services. Next year, it will be all about real-time liquidity and settlement.

Equally, the change from old to new trading venues is quite surprising. I was chatting with one of the MTFs yesterday for example. An MTF is a Multilateral Trading Facility, a new class of exchange introduced by MiFID, the Markets in Financial Instruments Directive.

The conversation reminded me that only two years ago, everyone was saying that liquidity doesn’t move and there would be no threat to traditional exchanges from these new trading venues.

Two years later, Chi-X has more trading and market share than the London Stock Exchange (LSE); BATS is in the Top Ten ...

Source: Chi-X, 19th January 2010, 10:30 GMT

... LSE has acquired Turquoise and completely changed strategy and direction; Euronext has launched a major dark pool; Deutsche Bourse is heavily expanding in ultra low latency connections, targeting latencies under 3.3 milliseconds for Frankfurt-Amsterdam, under 4.5 milliseconds for Frankfurt-Paris, under 40 milliseconds for Frankfurt-New York, and under 49 milliseconds for Frankfurt-Chicago ...

... and so it goes on.

Just two years ago, many exchanges thought that seconds were fine. Today it’s milliseconds. Tomorrow it’s microseconds. And then what?

Is it to achieve the ever elusive cross-asset class trading system? The one where a paired equities trade can be combined with an FX hedge across a global arbitrage?

Nah, we’ve already got that.

Is it to innovate new instruments, even when the last set of instruments – Structured Investment Vehicles, Credit Default Swaps and Collateralised Debt Orders – screwed up the world’s economies?

Nah, we’ve already got that too.

Is it to bring on board new exchanges and focus on emerging markets?

Nah, we’ve already got emerging markets, cross-asset class structure exchange products.

So what is the next wave of major change in trading systems and markets, and how will governments manage to derisk the next wave of innovation?

Well, if the move does become one where real-time execution is combined with real-time settlement and real-time risk management, as I’ve stated before, then the challenge for broker-dealers will be to bring added value to clients through arbitraging across venues and instruments.

But hey, that’s what they do now isn’t it?

Of course.

It’s what broker-dealers and market-markers have done for all time and will be what they do for the future.

You see, the challenge is to keep up with the innovations of a Goldman Sachs and it is the reason why Goldmans made $100 million profits for every day of trading last year.

Now there’s a fine border line between making markets and moving markets, and that’s the line Goldman walk.

It will be interesting to see how Goldman and company make markets in the future, between the Obama tax and the new regulatory regime.

But the key will be to continue to innovate with technology ... and they are and will be.

That is why we are moving towards an almost seamless order flow through execution through settlement system, thanks to smart order routing combined with execution management systems.

That’s one of this year’s big buzzes in trading tech, especially as Asia has followed Europe and America’s approach with Japan clearing the way for new Alternative Trading Systems and venues.

So perhaps the big buzz will really be about arbitraging across venues and instruments using global smart order routing, combined with real-time execution and settlement in microseconds.

Hmmm ... sounds risky to me.

Will governments be up to the job of regulating all of these new innovations?

Source: RJMatson, St Louis Post Despatch

Europe's new regulatory agenda

We had a fascinating and packed meeting at the Financial Services Club this week with David Doyle, EU Policy Advisor, discussing the challenges of the new Barosso European Parliament and their legislative drive in financial services.

David is a regular visitor to the Financial Services Club, and runs our European Financial Regulatory Advisory Group.

In a broad and wide ranging speech, he presented key views around MiFID, the PSD, Solvency II, UCITS IV, Basel III and more, as well as commentary on Jacques de Larosière’s committee and the appointment of Michel Barnier to succeed Charlie McCreevy.

Here’s a summary of the key points David made.

The Commission is taking a 'safety first approach' to regulating capital markets and market actors, and will fill in the gaps where European or national regulation is insufficient or incomplete.

The over-riding principles of their approach are that:

• All that is of systemic importance should be regulated and supervised;
• There is a need for a better well-capitalised finance industry, with less leverage;
• The Commission must leglislate to avoide the perverse incentives in the financial sector that encourage excessive risk taking or over reward;
• Supervision should have the right tools to grasp complex, inter-connected and globalised financial activities; and
• To restore trust, investors and consumers should benefit from clearer, more coherent and effective safeguards.

At this point, audience members asked lots of questions about whether the European approach would be the same as, or coordinated with, the US approach.

David’s feeling is that it is being co-ordinated on the big ticket items – risk, leverage, capital, bonuses and such like – but the rest is still open competition in terms of the way payments, capital markets and specific aspects of the market are operating, such as hedge funds.

There are then the key changes that should be introduced by the new Barosso team in the near term as a result of the Jacques de Larosière. Of these changes, David believes that the new supervisory bodies:

• European Securities and Markets Authority (ESMA)
• European Banking Authority (EBA)
• European Insurance and Occupational Pensions Authority (EIOPA)

Will be the key here.

These new authorities will have teeth, and will be responsible for ensuring that any EU member states who are not following the line of regulatory oversight are brought to order.

This will be in play within two years:

2009-2010 ►national FSAs powers strengthened + focus on harmonising national rules to reduce cross-border differences

2011-2012 ►implement Pan-EU-wide supervision via ESMA/EBA/EIOPA

and will mean that the large states who are proactively interpreting directives will be in a far stronger position than those states resisting such supervision.

In practice, this means the UK, Netherlands are going to be fine; France and Germany will have some wrinkles to iron out; other nations will get a note to say they need to fine tune some stuff; and Spain and Italy will get a large wet fish slapped around their chops.

After all, every Directive I deal with – MiFID and the PSD in particular – it’s Spain and Italy who always seem to be dragging their heels.

David also made an interesting point here, which is that not only will the new regulatory bodies have teeth to drag member states before Brussels to explain why they are dragging their heels, but also resources to assist when assistance is needed. Therefore, in the case of Sweden where their key person for transposition of the PSD left at a critical juncture, this future structure would allow the EBA – the European Banking Authority which is not to be confused with the EBA, the Euro Banking Association, that operates STEP2 and EURO1 – to provide people to fill the gaps. These people may be promoted in from regulatory authorities in other EU member states for example and, in so doing, it will fill the gaps.

David then rifled through all of the areas for legislation and key directives including:

• The Payment Services Directive
• MiFID and Market Abuse updated rules
• Capital requirements Directive III & IV
• Remuneration
• Pan-EU Supervisory Mechanisms
• Hedge Funds & Private Equity
• OTC Derivatives
• Solvency II – Insurance
• Responsible Lending & Borrowing
• Packaged Retail Investment Products
• UCITs IV
• Credit Rating Agencies

It was real insight and incredibly useful stuff.

Unfortunately, if you want to know what he said about the above, you’ll have to hire our experts in the European Financial Regulatory Advisory Group or join the Club.

It might be worth you doing that anyway as our next meeting is on SEPA!

Part Three - Real-time risks and opportunities

In the final part of this discussion of risks and opportunities in CEE, I was asked to give a view (see if you can spot me).

 

So here’s my brief summary:

What are the risks for the next year or two?

First, we are still in the middle of what I call the internet, or www, recession. There are still foreign exchange and trade issues between China, Europe and the USA, and doubts over sovereign debt defaults in key countries such as Dubai, Greece and Ireland. In addition, we still have a UK AAA-rating risk of downgrade, as do other countries, and all of this will make 2010’s economic recovery a challenge, although not as hard as this year has been.

Second, we are seeing a major contraction in debt amongst businesses and consumers. This means that those who can pay-off debt are doing so, leaving those who want to borrow or increase debt being those who are increasingly viewed as being higher risk because of their need. This will potentially result in a ‘debt squeeze’.

The debt squeeze is where banks are left with the people who want lending being those they can’t lend to, whilst those they can lend to are the customers who don’t want it and have paid it back.

Third, there are still risks, especially liquidity risks, that will require banks to seek further diversification of risk by either entering new markets or, more likely, pulling out of all markets where risks are less quantified. This could still lead therefore to national protectionism, where a bank actively seeks to focus on known home territories, whilst selling off or shutting down any more recent and therefore less known expansionism.

Fourth, there are issues of corporate governance as mentioned by John McFall.

Fifth, there are the nerves created by the change of leadership of the management of the internal markets of Europe, from the City-friendly Irishman Charlie McCreevy to the unknown but pro-French minister Michael Barnier.

Finally, there is a challenge with technology, in that there is fast cycle change in technologies in the front office areas of retail banking (mobile) and trading rooms (high frequency trading) versus very slow change in back office infrastructures (SEPA is now seven years old and interoperability in Clearing and Settlement is still to happen). This dual carriageway of slow lane back office and fast lane front office technologies is going to crash somewhere in the middle, unless something is done to align the two better.

On the opportunities for the next year or two.

First, things are cheap. If you are a bank with liquidity, then you can pick up a bargain these days. This is no better demonstrated than JPMorgan with Bear Stearns and Washington Mutual, or by Santander with Alliance & Leicester and Bradford & Bingley. If you have capital, then today is a low hanging fruit picking season.

There are also opportunities for those who can innovate. With so many firms focused upon operational excellence and internal management issues, firms that have clearly unblinkered and unfettered capabilities to compete can begin to decimate.

Some of this opportunity is being created by deregulations that have been years in the making. For example, non-bank payments institutions in Europe could sweep up a lot of activity now that they can be registered for processing under the Payments Services Directive. MiFID is still allowing change and competition for the MTFs, with Chi-X and BATS taking a lump or two out of those markets.

Most important of all, of course, are the ability for new banks to enter weak markets. This is why the UK has flurry of new banks, from Virgin and Tesco to Metro and the Post Office.

Therefore, strong, well-capitalised, financial institutions and non-banks can start to cherry pick much of the banking market profitability if they want, leaving the incumbents with the festering gristle.

So, all in all, here’s the message.

For most banks, 2010 will be a return to basics and a focus upon getting the most efficiency and effectiveness out of operations. Operational excellence will still be the key management competency. This was the focus for 2009, but the ‘back to basics’ approach will be even more resonating and loud.

Real-time reporting will be critical from all angles, especially from a risk reporting viewpoint. The FSA has been pushing for real-time liquidity reporting, and it would not surprise me if a move towards real-time clearing and settlement becomes a focus on the table. That’s the focus of trading exchanges, such as Eurex or the Russian exchanges, and real-time is also becoming a focus in the retail world as the march of faster payments progresses. So real-time everything will be key.

Finally, intimate customer knowledge and using the tools for strong customer analysis with data mining tools will be high on the agenda. As bankers, many are looking for more cross-sell opportunities and you only get those if you have customer intimacy. This is a key.

In fact, it is best illustrated by the Tesco example given the other day, where the fact that I know your buying habits means that I can tailor my offer and rates to you on an individualised and personalised basis. If you buy lots of alcohol and cigarettes then your car and life insurances cost more than if you buy muesli and keep-fit supplements. That’s real customer intimacy.

In summary, back-to-basics, real-time everything and customer intimate operations will be the key.

Istvan Lengyel of the CEE Banking Federation didn’t like the idea of real-time trading. In particular, he was concerned that if a bank collapse, such as Lehmans, takes four days today then what happens if it is four nanoseconds tomorrow. What can you do?

I think he missed the fact that I was talking about real-time risk management and real-time liquidity reporting too.

John McFall of the Treasury Select Committee didn’t like the idea of Tesco giving discount on car insurances based on lifestyle. He thinks that two MP’s who find one saves £100 on car insurance because he or she doesn’t smoke would be grounds for a good early day house motion.

I did try to make clear that risk-adjusted pricing is the very heart of finance, and the better you are at this then the safer the markets would be. Equally, risk is at the very heart and nature of insurance. Also, if I give Tesco permissions to mine my lifestyle by being a Clubcard member, then so be it.

 

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Chi-X exploits LSE's weaknesses further

There’s plenty of innovation in banking right now, from investment through commercial to retail banking. And it’s not just amongst the big banks, the thriving banks and the growing banks but amongst the struggling banks, the tarnished banks and the zombie banks too.  For example, Citi is spending a billion dollars on new payments technologies this year, and there's plenty of innovation in their transactions services business.

But some innovators create new business models at the expense of the incumbents - that's the way it's supposed to be, isn't it?

This is no better illustrated than by the announcement of the London Stock Exchange (LSE) which has faced continuing difficulties, as shown by their 37% drop in profits when the FTSE almost doubled in value during the same period.

This is a strong indication of how innovators are disrupting, such as BATS Europe.  But the key innovator with first mover advantage is Chi-X, who launched over two years ago.

Announcing their results for the period between April 1st and September 30th yesterday, the LSE let it be known that the total number of trades in UK shares dealt on the exchange dropped 17% to 78.4 million, with the value of the shares traded falling 46% to £580 billion.

This is during a period when, between March and August, investors have seen the biggest rally in shares in half a century with the value of British shares up from £454 billion to £1.44 trillion.

This is why Xavier Rolet has cut prices and continues to do so (doesn't work), has shrunk the LSE’s workforce by 11% (let's shrink our way out of this), thrown out their TradElect flagship system (which just doesn’t work and broke again today) and is in talks to buy Turquoise (who are also struggling thanks to the Chi-X onslaught).

And how big is that onslaught?

Let’s put it this way, it now has such a large share of trading in most European exchanges that it is now the third largest trading platform for equities tradingl, just behind the Deutsche Bourse and Euronext, and bigger than Spain’s national stock exchange and the Swiss bourse.

It has managed to take a quarter of the trading in the FTSE 100 from the LSE, and this looks likely to increase, especially if LSE’s outages continue.

So what does Chi-X go and do? They only announce the next day that they intend to hire Alasdair Haynes, the hotly tipped contender to have taken the job that Xavier Rolet took earlier this year and also back in 2001.

In other words, the man who should have been CEO of the LSE is now the CEO of its likely slayer and successor, Chi-X.

Funny how the world turns isn’t it?

What would I do if I were heading the LSE, as it is easy to criticise and hard to strategise.

I would change the battleground and create a new market territory for the LSE outside the razor-thin margins of trading the most liquid stocks.

Focus upon creating new markets or generate a new platform offering razor-thin margin trading in other stocks or instruments

The trouble with this strategy is that with 75% of their business tied to the most liquid stocks today, it is too hard to consider as an acceptable approach.  It is too radical.

The thing is that all the radical things the LSE has tried so far have failed, and are likely to continue in this fashion unless they do something radical.

Meanwhile, the 75% liquidity isn't going to disappear overnight so keep that fat margin to fund the next generation of thin margin, and broaden and deepen the platforms.

They may well be doing this, with the implementation of MillenniumIT and acquisition of Turquoise, except that both appear to be second choice solutions to compete with Chi-X rather than first choice solutions to create a new battleground.

Roll on the next six months ...

Note: BATS Europe are also doing OK, with Bloomberg reporting that they “'aim to do between 8 percent and 10 percent by the end of the next year, doubling our market share in 2010' according to CEO Mark Hemsley said. 'We have a lot of new firms coming over and we’re benefiting from the increasing sophistication of the trading systems of the big brokers we signed up in the first wave.'

“Over the past five days, Bats Europe accounted for about 8 percent of U.K. FTSE 100 trading, 4 percent of France’s CAC 40 and 3.3 percent of Germany’s DAX on average, according to data from Bats. London-based Chi-X Europe drew about 25 percent, 17 percent and 19 percent, respectively.”

Note: Wall Street Journal headline - MTFs Capture 54% Of Europe's Dark Markets

A trio of alternative trading systems has seized more than half of Europe's "dark" equities market from broker-run rivals in just six months.

Chi-X Europe, Turquoise and Bats Europe together handled 54% of all trades executed by public dark pools in the month to November 19, according to Thomson Reuters. None of the multilateral trading facilities operated a dark pool before May.

Meanwhile, three established dark pools, Liquidnet Europe, ITG Posit and Nyfix Euro Millennium, saw their share of the market shrink to 39% in November from 98% in May, Thomson Reuters said. ITG launched Posit in 1998, while Liquidnet Europe went live in 2002 and Euro Millennium has been operating for 18 months.

Russia's nerves creates massive volatility

After my meetings in Moscow last week, I’m wondering whether there is a Russian model of investing that could work with our Anglo-Saxon world of trading and meeting one of the key guys at MICEX, the Moscow International Currency Exchange (nothing to do with one’s gender), gave me a different view of Russia’s position.

As mentioned last week, real-time settlement is key to Russia’s markets, because no-one trusts each other. This then inhibits leverage because of the need to deposit enough collateral to cover your position.

On MICEX, the Central Bank obviously has an ability to leverage as much as they want because they are guaranteed to pay back. The large banks, such as Sberbank, are allowed a reasonable level of leverage based upon a deposit of a percentage of their trading position, although I had the impression that this is a sizeable percentage. But everyone else has to deposit enough collateral to near enough cover their total trading. This inhibits trading and leverage, but at least it guarantees settlement which some might say is no bad thing.

But there is a bad thing.

Volatility.

As mentioned on Friday, the RTS Index has been bouncing around faster than a Bolshoi Ballet Ballerina this year. This is because no-one invests in Russian stocks or stock markets for the long-term. It’s all short-termism.

A casual trader will play with Russian stocks for six months and then pull out. An e-trader maybe for just a month. When asked “what is long-term in Russia”, my friend at MICEX calmly replied: “less than a year”.

You see you can get your fingers burnt real fast. We talk about short-sellers in Europe and America, but in Russia these guys are not just selling short, they’re selling Bashful, Grumpy, Sleepy, Sneezy, Happy, Doc and Dopey.

These are the ultimate of short sellers, and hence you can buy into Russian stocks in the morning and be a millionaire or a pauper by end of day.

That is why real time settlement is critical, and why positions, margin calls and trading structures are so key.

With MICEX, they claim to be trading around RUB 700 billion (GBP £17 billion / USD $25 billion) per day. Of that, over half is currency trading and the rest is everything from derivatives to equities, corporate bonds to treasury bills.

MICEX’s history is also interesting. The Exchange started just after Gorbachov’s reforms in 1990, as a division of the Central Bank of Russia.

Launched in 1992, it enabled currency trading which, before MICEX, did not exist in Russia.

MICEX were also at the heart of the bubble that led to the 1998 financial crisis in Russia, as GKOs were their stock in trade.  GKO’s - Gosudarstvennoe Kratkosrochnoe Obyazatelstvo’s - are short term state bonds issued by the state of Russia and traded on MICEX. Because people did not understand or know how to deal financial instruments in Russia back then, it meant that debt was generated without any sense of the obligation to pay back.

As a result, GKOs were originally traded for the short term in days and weeks but, as people saw these as state-backed securities, they gradually moved into being traded in months and years. In other words longer term, rather than short term.

The result of over issuing GKOs and trading them long instead of short meant that, by the end of the 1990s, GKOs were worthless and the market imploded, creating a financial crisis with effects still felt today.

MICEX survived because they had diversified beyond trading currencies and GKOs to trading equities.  Today, they trade a few hundred of Russia’s most liquid stocks such as Gazprom.

But the issue remains that, having had fingers burnt by trading long, no-one trades long today. Everyone trades short.

So there’s the rub.

By being short sellers, Russia’s markets are highly volatile and very liquid and, by being risk avoiders, Russia’s markets are totally geared towards zero risk. There is no risk in Russian trading as everything is geared towards real-time settlement. The only risk is technical risk if the systems fail.

A market with risk eradicated is not a market that can trade effectively.

Now I’m back in London and thinking that European and American markets are geared towards high risk arbitrage strategies based upon low latency leverage. We have market risk, credit risk, and operational risk.

But our market encourages risks, and this is also a market that cannot trade effectively, as recognised post the Lehmans collapse.

We are trying to baton down the shutters on liquidity risk and we talk about ‘likelihood of settlement’ as a part of the puzzle, although price and cost are just as important.

In Russia, there is no ‘likelihood of settlement’. Settlement is guaranteed.

But equally, in Russia, there is no long-term investment market.

So there may be a middle ground here, between highly leveraged risk strategies and guaranteed settlement; a middle ground between long-term investing and making a buck through a short selling bet.

Right now, the Anglo-Saxon model is broken, whilst the Russian model is yet to start working effectively to build commerce.

So, will the financial instruments of the Anglo-Saxon model play a part in building leverage and commercial growth in the Russian markets? The Russians certainly think so but if, and only if, the trading model can incorporate the risk management principles of the Russian model.

What has MiFID done for democracy?

Fascinating meetings with the Russian exchanges RTS and SPIMEX. After my reference to military intelligence yesterday, you may wonder whether SPIMEX is something to do with finding out who started the swine flu pandemic but no, it’s the St. Petersburg International Mercantile Exchange.

The two exchanges have very different start points and focal points, with RTS (the Russian Trading System) starting as a privately-owned exchange back in 1995 whilst SPIMEX is an initiative of the government to create a working commodities exchange.

I had been aware of RTS for a while as, during the MiFID investigations, their name came up many times as a working, highly automated exchange. Originally launched using NASDAQ’s trading platform, they soon developed their own products and services, covering algorithmic trading for equities, forex, future and options and more.

Today, the exchange is one of the best performing, with the RTS Index tripling in value during 2009 to an index high of 1,451 at yesterday’s close, compared to a market low back in February of under 500, although this is still well below the high of 2,487 in May 2008.

What is the reason for such volatility?

Oil.

Chris Weafer, Chief Strategist at Uralsib Bank, puts it in context: “We've recovered very strongly this year mainly because of the recovery in the oil price. Plus, the recovery and optimism in the rest of the world has allowed for the Russian ruble to stabilize."

Or is it because RTS is a keen innovator offering analysis across every trader’s portfolio and position in real-time, as the RTS people I spoke with yesterday said.

RTS now offers highly automated trading across 1,400 stocks, with 90% of the trades using automated systems and 10% Over-the-Counter (OTC). It is also one of the top 40 Global derivatives exchanges and trading is getting far more complicated, with around 15 trades per transaction on average today compared with 10 trades per transaction just two years ago.

Similarly talking with the SPIMEX guys, there is a clear vision that they are trying to avoid being another failed commodities exchange (around 60 have been launched since 1990).

Why did the previous exchanges fail?

Because no-one trusted them by the sound of it.

According to a SPIMEX advisor, it was because of a poor understanding of risk, a word rarely used because Russians do not allow risk to occur. This is why most exchange and exchanges are based upon ‘fundamentals’ – "if I can see it, touch it and trade it, then that’s ok. If you are looking for me to pay now for something that might pay back in the future, no way."

This is why most Russian banks do not provide trade finance, and why oil is an issue.

For example, oil producers currently do not co-operate because they do not trust each other, according to one of the guys at SPIMEX.

Most oil producers are local monopolies with no competitive mechanisms. As a result, when oil prices rose in 2007-2008, Russians were paying more for their oil than America and Europe, even though Russia has more oil reserves and production than most.

So SPIMEX was launched in September 2008 to overcome this, with the Russian anti-monopoly committee creating the right environment to trade on exchange by fining several of the oil producers for anti-competitive practices.

But the real common feature of both SPIMEX and RTS is real-time risk management.

Both exchanges proudly talk about their focus upon real-time analysis of traders’ positions.

In the case of SPIMEX, they offer real-time settlement and straight through processing, so there is no risk for trading.

In the case of RTS, they offer real-time positioning of every trader and every trader’s clients portfolios, not just in real-time for their own trades but also for the knock-on effect of their dealings in derivatives down the line.

I asked RTS about their risk management, and they made clear that for each transaction, the risk is calculated for the trader’s portfolio, including all orders to be filled, in real-time. There are then two clearing sessions during the day. One at 14:00, which takes three minutes to process, and the second is at end of day, and takes fifteen minutes.

If a margin call is made, the broker must cover their position within two hours or, if at end of day, before the start of the next day’s trading.

This discussion got interesting, as RTS and SPIMEX appear to be developing systems that ensure no trader can leverage risk to the levels where the market implodes, and they do this in real-time.

It is the nature of new trading systems and operations that they design things to work in the ideal way, as the outline above is what Europe and USA are trying to develop.

For example, the FSA’s £2 billion technology change program for real-time liquidity reporting is pretty much what RTS has today.

No wonder the gentleman from RTS turned to me towards the end of our chat and asked, straight-faced, “what has the Markets in Financial Instruments Directive (MiFID) done for democracy”.

He probed me about best execution and what it means: “is it just all about price, speed and cost (and likelihood of settlement)?”

I then realised what he was getting at.

Where, in all the developments of MiFID and its best execution, transparency and competitiveness objectives, was the mention of risk?

Where is the focus on real-time risk reporting?

Hmmmm ... it’s obvious that RTS, and the Russian aspirations to build the next major Russian-Asian commodities exchange, is something to watch.

Meanwhile, the major thought that struck me in this dialogue, was that we have two opposites.

In Europe and America, we have an over-leveraged, casino capitalism culture of trading that is now being re-engineered to restrain excessive risk without responsibility.

In Russia, we have a risk avoidance trading environment through real time controls, which needs to increase liquidity and leverage in order to fuel the flow of commerce.

If Russia does not achieve this, then its commodities ambitions cannot be achieved.

So maybe there is a happy medium here between the Russian approach to risk controls of trading, and the Anglo-Saxon approach of using financial instruments to create liquidity.

Now there would be a thought ...

*

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What's next for the EU in light of the financial crisis?

Eurofi had their annual conference in Gothenburg, Sweden last month.

The meeting was themed: what priorities for the incoming EU authorities in the light of the financial crisis? and saw a number of common themes recur in discussions by key policymakers, officials and industry figures.

The official report has just been released (download here), and here is their summary of the meeting:

While it is clear that the worst of the crisis is behind us, “we are not out of the woods yet”.

This is in large part because one of the main underlying contributors to the crisis has not gone away: the existence of moral hazard. Indeed, it has probably got worse in the financial system because of the implicit acknowledgement that some institutions are too big or to interconnect to fail has in many cases become explicit.

This is an issue not just for the financial authorities but also for the single market. A total of €3 trillion has been injected into the EU’s financial sector, but it has been distributed unevenly, creating potential distortions of the competitive landscape.

For this reason, as well as the massive burden placed on public finances, it is important to start thinking about an exit strategy that can extricate governments from some of Europe’s largest financial groups.

However, the financial sector faces enormous issues of trust – the public has been appalled by what’s happened. Many market participants have lost faith in each other, partly because the value of so many impaired assets remains so uncertain.

The debate continues over whether banks will be forced to narrow their activities – with influential figures such as Paul Volcker, economic adviser to President Obama, speaking out in favour of restrictions while many in the industry argue that it was not business models that were to blame for the crisis but poor execution.

There is clear consensus that the crisis revealed unsuspected systemic risks and that these must be dealt with. Self-regulation has been thoroughly discredited and new regulation is on the way or has already been introduced in an attempt to harness the momentum for change that much fear is running out as the crisis recedes.

It is agreed that regulation and supervision of individual financial entities is not enough – there must be oversight of macro systemic risks as well and this oversight must be linked to microprudential regulation, not just in the EU but on a global basis.

The industry is clearly unhappy at the weight of new regulation. Jacques de Larosière warns that there are dangers of unintended consequences from the overlapping of the various initiatives. Moreover a system of ratios that would be to some extent disconnected from effective risks would do nothing to address the causes of this crisis. These measures will have a disproportionate impact on Europe where bank intermediation is far more developed than in the US.

However, policymakers have become more confident in their assertions that there are restrictions to the sector’s freedom that are justified for the good of the system as a whole.

Nonetheless, it is recognised that significant challenges remain in implementing the regulation.

An unprecedented level of communication and co-operation will be necessary to ensure that overkill and regulatory arbitrage are avoided.

There must also be a re-examination of the financial system, of its role and size, some participants said. The world faces a range of significant, long term challenges such as climate change, scarcity of natural resources and ageing population. Dealing with these requires a more long term outlook from investors that has been lacking in recent years and to tackle obstacles long term investment has to face up.

The regulatory framework of OTC derivatives and alternative investment funds (AIFs) is also being reviewed with the objective to bring additional safety to the financial system. The industry however points out that constraints that may be unnecessary from a risk mitigation perspective and potentially damaging to customer needs should be avoided and that the specificities of the products concerned should be well taken into account. The risk management processes of management companies should also be revised in light of the financial crisis and the responsibilities and liabilities of the players operating along the fund value chain should also be clarified.

Finally, the on-going actions to improve the efficiency and competitiveness of cash equity infrastructures (MiFID and the Code of Conduct) should not create new risks particularly when implementing interoperability between CCPs.

As Jean-Claude Trichet, President of the European Central Bank, said: “While a lot has been achieved, a lot remains to be done.”

  

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French tractors in Canary Wharf

I’ve become a bit of a fan of Prospect magazine if, for no other reason, than they have useless facts spotted in the media such as “the average weight of new members to WeightWatchers has risen from 12.3 stone (about 77kg) in 1989 to 13.7 stone (85kg) today” (Daily Mail, 24/08/09).

They also have some useful ones, such as “Americans are giving up their landlines at a rate of 700,000 per month. If this continues, the last cord will be cut in 2020” (the Economist, 13/08/09); and “General Electric is the only company remaining from the Dow Jones index of 1896. It had fewer leaders since then (eight) than the Vatican has had Popes” (Fortune, 05/04/04).

All good stuff and useful for presentations.

They also have interesting features such as the interview with Lord Turner, Chairman of the FSA last month, where he caused a furore by saying that some banking activity is “socially useless”. Tsk, tsk.

This month’s magazine continues that debate.

However, hidden on page 27, is this key column by Manneken Pis on EU matters:

“It seems inevitable that the Barroso II (European) Commission will be less committed to the free market than Barroso I. The focus of opposition to Barroso’s renomination as president was the accusation, chiefly emanating from France, that he is an ‘ultra-liberal’.

“One appointment he made five years ago has not served him well in particular. Charlie McCreevy’s term as internal market commissioner has been little short of disastrous for the cause of a deregulated Europe. (ed: how can Manneken say that when we have the PSD and MiFID here now?)

“The former Irish finance minister, a convinced free-marketeer, showed little interest in being in Brussels and even less in regulating financial services where, apparently, the market knew best. (ed: is the author taking the Pis?)

“Then came the crash ... France wants the internal market but there is a complex interplay between who Paris will send and what job Barroso is willing to make available. The main contender is Michel Barnier, a former European commissioner and then foreign and agriculture minister in France.”

Oh Jeez, we’re gonna have flipping French tractor drivers blocking Canary Wharf next.

And it gets worse.

“There’s also talk of its current finance minister, Christine Lagarde.”

Bummer, there goes all of our bonuses too.

But wait, what’s this?

“One possibility is that France is offered internal market but without responsibility for financial regulation, which would be separated off into a specific portfolio. That, said one Eurocrat, would ‘allow the French to say they have got what they wanted, without actually giving it to them.’”

Thank goodness for political machinations and machinery, ay?

The future vision for trading

At the Deutsche Bourse Open Day for IT, I chaired a panel comprising senior figures from Eurex, the International Securities Exchange and IBM.

The focus of the panel was the future of trading technologies, and was a wide ranging discussion covering everything from dark pools to high frequency trading (HFT).

Questions were abounding, such as:

Question:

Is HFT good or bad for liquidity as it gives large players an unfair advantage over small to mid size players and allows market abuses such as flash orders and front running?

Answer:

As long as everyone has equal access to the markets, then it is no issue. The fact that some traders cannot afford the technologies to deal in flash orders is not an unequal market perspective; it’s just that some are better at doing this and can afford the systems to do it. There is no barrier to entry however.

(BTW, I totally disagree with that view)

Question:

At these speeds, is it technically impossible to do compliance? For example, Barclays Capital are just one illustration of the markets becoming more difficult to manage when they are fined for not even being able to get the timing right on a trade execution.

Answer:

Yes, this is more difficult but time stamping trades is an essential core competence of any trading house. The issue lies with low latency and how a broker deals with order flow. If you cannot time stamp effectively when an order is received, filled and executed throughout the trade flow then you are not delivering on that core competence.

This happened recently with TD Securities who were accused of front running trades, and yet how do you prove you weren’t front running when everything takes place in a microsecond? TD Securities fought off a recent investigation to prove they were not front running by being able to demonstrate timings through their order flow, and so yes, keeping time is a basic requirement today.

Question:

What about the whole aspect of the changing regulatory regime with the new rules being developed by the G20, the de Larosiere report, the confirmation that there will be a MiFID II, etc. In fact, MiFID II, according to a speech by Charlie McCreevy in Dublin recently*, will incorporate OTC Derivatives in its next iteration. What does all of this mean for trade execution and technologies?

Answer:

The markets are ready for more regulation although it is interesting that most regulation creates unintended consequences. For example, the law of intended consequences is demonstrated by MiFID where the aim of the regulation was to have more transparency and openness and what did we get? More opaqueness, price fragmentation and a growing off-exchange trading environment using technology to create dark pools. This is the key to the technology used in the trading environment- to create arbitrage, risk and profitability for the client.

Meanwhile, everything will move towards real-time reporting. For example, Eurex is already able to provide real-time clearing at trade execution.  Firms will move towards this model for real-time trade reporting and real-time risk and liquidity management.

Question:

What about Social media & Twitter? Don’t these tools support insider trading? Do we end up with all traders being searched for personal communication devices before they enter the trade floor?

Answer:

No, you don’t need to go to that extent. Facebook and Twitter are electronic communication tools however, so they need to be brought under the controls and disciplines of compliance regulations or be blocked and, if a trader is found in contravention of such in-house policies, then it’s a disciplinary dressing down and possibly termination of employment. But you can do things about these areas. For example, research into this area (download report) clearly shows that the US regulatory rules apply just as much to tweets as they do to email. And there are tools you can implement to monitor such activities and store and forward such information, which is the right approach to take.

Question:

How do you see the development of Cloud Computing in the trading markets?

Answer:

In the US, we have seven major exchanges and I can see the world developing into one where those seven exchanges all place their servers in a massive server farm, co-located with market makers and brokers, so that the systems can deal in real-time. That’s where we are almost at today and certainly will be moving in that direction more and more over time.

The answers above were my own take on the discussions by the way, and not quotes from the panellists, but you get the idea of the flow.

We finished with a vision of the future of trading which I will sum up as being a world where each continent has a massive data centre of co-located servers representing the main trading venues of each economy.

The European data centres will naturally locate in London, Paris and Frankfurt; America’s will be in New York, Chicago and possibly San Francisco; Latin America’s in San Paolo and Buenos Aires; Asia’s in Mumbai, Tokyo, Shanghai, Hong Kong and Australia; and Africa and the Middle East will be based in Johannesburg and Dubai (or Bahrain or Qatar dependent upon how the region’s financial centres compete for dominance).

Fourteen massive data centres with mirroring and backup for each other.

Effectively a massive cloud of trade execution.

And yes, that’s where we move towards – a secure global cloud computing environment, all linked by dark fibre between fourteen massive data centres.

The data centres house the world’s exchanges and their broker dealers.

They can transact in microseconds within exchange and, thanks to terabit lines, can send a trade execution around the world in under a millisecond.

Lightning dealings in order flows through smart order systems that allow billions of offers and bids to be matched in a millisecond.

All of this liquidity flow being watched under a traffic light system of liquidity risk and market monitoring, such that market abuses are visualised and captured during the trade flow in real-time.

The G20 agreements on co-located data centre environments dealt with that one after the financial crisis of 2013, when the dark fibre smart order routers allowed Goldman Sachs to front run ...

Aw shucks, now I’m just getting cynical again aren’t I?

* In his speech to the EU Public Affairs Ireland Conference on 18th September 2009, Charlie McCreevy, European Commissioner for Internal Market and Services, stated:

“There appears to have been a significant migration of share trading transactions from the more regulated MIFID venues to the unregulated over the counter broker dealer venues where substantial unregulated dark pools of liquidity have built up. This gives rise to questions as to whether there are unfair commercial advantages for the operators of these venues and whether the trend undermines price discovery, market integrity and efficiency for the market as a whole. The MIFID review will address this issue.”

*

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Innovations in Payments, Part Three

In the securities settlement markets, we’ve spent years trying to break down barriers to clearing and settlement ... and most of those barriers are still there.

We wonder what to do about it?

And regulation seems the only answer.

Or is it?

As we look at innovations in payments (retail, commercial covered in last two posts), this week is the final thoughts on this as we study payments in the trading room and investment markets.

There are clearly some things afoot which will change things.

The first is that everything is real-time or supra real-time.

Sure, we talk about fast and scalable systems, but in the trading arena we’re talking not just fast but super fast.

What’s super fast?

Well, a human blink of an eye takes about 200 milliseconds or a fifth of one second.

Today’s trading systems trade in under 200 microseconds.

There are 1,000 microseconds in a millisecond, so we can trade 1,000 times faster than the blink of an eye.

That's super fast.

This is the world of latency, which I’ve blogged about often.

But latency really does bring in a new focus on real-time.

For example, I spent last week at a fascinating open day for Deutsche Bourse’s IT and intend to write a detailed update through this week on what came out of that day.

To start with, here’s a chart (double click to enlarge):

This was presented by Colt Telecom and shows linkages between London, Frankfurt and Chicago, with latency of 50 milliseconds or thereabouts. In other words, four messages can move between Frankfurt and Chicago in the time it took you to blink.

Here’s another picture:

This shows how all the exchanges are linked via high speed dark fibre 1 gigabit per second (1G) and up to 10G.  The view is that, by 2011, these lines will be moving data at 6.4 terrabits per second (t/s).

6.4 t/s!

This means we will be moving from a world where it takes about 0.5 seconds to send a message right around the world once (two blinks), to one where that global transaction of data could move around the world in a complete cycle in under one millisecond (blink and you miss it).

This is the real-time world.

Now think about liquidity, risk, clearing and settlement and imagine a world where, as you trade.

Your complete picture of liquidity positions are transparent to all traders internally.

Your liquidity risk exposures, market and credit risk exposures and more are visible to all counterparties in real-time.

Your trade reporting and pricing is visible to all regulatory and supervisory authorities in real-time.

And real-time clearing takes place as part of trade execution.

This world is not a future vision but a reality.

Eurex, for example, thanks to being tightly coupled with a clearing system (Eurex Clearing), are already offering real-time clearing.

Meanwhile, we have regulators moving further and further towards information reporting duties that go far beyond today’s methods.

That is why real-time trade and risk reporting will be a reality in the near-term.

End of day just doesn’t cut it.

Intra-day doesn’t manage it.

Real-time everything.

That’s the future of investment markets.

Real-time visibility and transparency for all counterparties to manage risk.

Mmmm ... now it gets interesting.

MiFID's progress: slow, but sure

It's been a while since I wrote about MiFID and so, when I was asked to provide an update recently, here's what my take on the world of European trading is like two years on.

Two years after the Market in Financial Instruments Directive (MiFID) came into force in Europe and not a great deal has changed ... or has it? There are certainly new exchanges and new clearing systems, but the general landscape of Europe dominated by the three largest exchanges – Deutsche Bourse, NYSE Euronext and the London Stock Exchange – remains unfazed ... or are they? Certainly there are many pretenders to these giants’ thrones, but are any of them really up to the job?

In November 2007, MiFID’s rules on transparency of trading came into force. The idea was that we would have a pan–European investment market that would be as open and seamless as the US markets. Various players threw their hat into the ring to shake things up and, two years later, only one is making any major inroads: the Instinet subsidiary, Chi–X. Meanwhile, the other pillar of MiFID’s intent lies untested and unchallenged, namely the focus upon best execution. However, for anyone to believe that MiFID is a damp squib would be wrong. It has shaken the foundations of the European investment industry by bringing in new technologies, new focus and new pricing systems that, over time, will demonstrate a radical restructuring of the European markets.

Before we delve deep into this territory, let’s look at the new competition first.

The first mover to leverage MiFID’s opportunities was Chi–X, the pan–European equities exchange geared towards algorithmic trading. The fact that Chi–X was first mover, opening for business in April 2007, meant that by the time the second movers came into the market – Turquoise and NASDAQ OMX started trading effectively in September 2008 – there had been an 18 month cycle of gaining liquidity which has proven hard to break.

Under MiFID’s rules, there is meant to be a requirement for best execution based upon the price, speed and cost of processing, but this rule has never been tested and, more often than not, trades flow to where the market knows. Therefore, Deutsche Bourse, NYSE Euronext and the LSE are still thriving, and the only new entrant to make any headway has been Chi–X.

Chi–X do claim that this is based upon more than just being first mover, as they do offer very low latency (high speed) capabilities for high frequency traders. For example, the cycle time to process an order through Chi–X is around two milliseconds, compared to around six for Turquoise and significantly slower cycles through the traditional exchanges.

This low latency capability has been critical for the main market makers, who see speed of trading as a key factor for exploiting market opportunities and leveraging their algorithmic trading systems.

In addition, the second movers launch in September 2008 was just bad timing as this coincided with the market crash caused by Lehman Brothers collapse. Launching new equities exchanges just as all market trading volumes declined significantly was just poor timing.

It does not mean that the new entrants and market restructuring has finished though, as other trading facilities have launched since September 2008 including Equiduct, BATS and Quote MTF. In fact, according to the Council of European Securities Regulators (CESR, soon to become the European Securities Authority), there are 125 Multilateral Trading Facilities (MTF) that have registered for licence with them since MiFID came into force.

And most of these facilities have one thing in common: low latency technologies at low cost.

For example, the average order cycle, including clearing, is 10 basis points on the new exchanges, compared with 70 or more on the old exchanges. They also have a model based upon a higher fee for those who take liquidity versus those who bring liquidity. Finally, they are highly geared towards dark pool trading activities and electronic liquidity providers through advanced technology services.

This last point is a key one as, alongside new equities exchanges, the other major change in European trading has been the rise of dark pools, where orders can sit waiting to be filled unseen. Turquoise was the first aggressive play in this space, backed as it is by the major market makers. Since Turquoise launched, we have seen several others rise including Smartpool from NYSE Euronext and Baikal from the LSE.

Nevertheless, these dark pools may encounter a few issues in the future as the USA is the model they are based upon, and Wall Street traders have recently found themselves in hot water over the use of dark pools and low latency to potentially manipulate the markets using flash trades, also known as ‘gaming’. The way this works is that, through the automated systems for trading, dealers can see a large order entering an exchange a half a second before it is filled. That half a second allows them to rapidly process hundreds of orders for the shares about to be traded using algorithmic low latency processing. The result is that by the time the buyers’ order is filled, the pirce has risen by a cent. Perform such trading regularly through the day, and those cents soon add up to a tidy profit for the brokers and dealers using such trading facilities.

These practices are about to be banned by the SEC, although NASDAQ has already said it will not allow them. Just as NASDAQ makes this announcement, NYSE Euronext's new data centre to support high frequency trading facilities is soon to open in the USA. Therefore, the market will move to support liquidity, and if the liquidity is legitimate then there will always be at least one exchange who will support it.

This is concerning the European Commission, even more so with the fact that pricing has become fragmented across so many pools of liquidity, many of which are dark. This is potentially the rule of unintended consequences and the rumours of a MiFID II to resolve these issues abound.

Meanwhile, all of this fragmentation and dark trading is having a major impact on the traditional exchanges.

The traditional exchanges spent many years protected by concentration rules that forced traders in each country to process orders through their national exchange. These rules were removed on November 1st 2007, when MiFID came into force, and has opened the exchanges to major new competitive forces unseen before.

Although these new competitors have struggled to take liquidity, the fact is that some are. Chi–X for example, is processing an average 20% of FTSE 100, DAX 30 and CAC40 shares these days, and Turquoise claims a further 5%, even nearing 10% of the FTSE 100.

A quarter or more of the most liquid shares trading on the traditional exchanges moving to the new exchanges in a couple of years is a concern, and each exchange has taken a different route to meet these concerns.

Deutsche Bourse saw a 7% drop in Xetra and 14% decline on Eurex trading in Q2 2009 compared with Q2 2008, with only Clearstream’s custodial services delivering a bright spot. NYSE Euronext made a $182 million loss in Q2, mainly due to severance costs with LCH.Clearnet over their acquisition of LIFFE, the London–based derivatives exchange. And the LSE is in a right muddle, with former leader Dame Clara Furse leaving in a cloud of issues over their strategy and new CEO Xavier Role announcing a radical departure in approach.

The last point was the most shocking in fact, as ex–Lehman banker Xavier Role intimated that he was going to dump their flagship system, TradElect. TradElect was developed by Accenture and Microsoft as a next generation trading system that went live in the summer of 2007 at a cost of £40 million. The system was developed before the impact of dark pool and low latency trading however, and has never been able to compete with the order speeds of Chi–X and their clan.

Therefore, after only two years, the system looks to have had time called in order to create a real next generation trading service that processes at lightspeed.

Even so, one fact about the system has proven how difficult it is to take liquidity away from a trusted venue. Just before Lehman Brothers collapse, the LSE had a software failure for several hours on September 8th 2008. During this period, it should have led to major moves to the new exchanges as trading was stymied on the LSE for almost a day. It didn’t happen however, because most of the pricing feeds at that time were tied to pricing on the LSE and, with no price feed from the LSE, there were no pricing deals to be done on the alternative exchanges.

This will change in due course, as the new players find their niche, but today it is still the case that most traditional exchanges own their markets, or a large part of their markets. Yes, it is being eroded, but only slowly.

Which brings me to a final point. The erosion of tradition exchanges dominance of their country’s investments and trading is tied heavily to the openness and access to clearing and settlement in each constituency. Without easy securities settlement at the post–trade end of the process, the new exchanges are effectively frozen out of the markets.

The new exchanges have achieved a fair amount in resolving this issue, with new Central Counterparty (CCP) clearing systems from the USA, in the form of the EuroCCP a subsidiary of the DTCC, and in Europe with Fortis’s European Multilateral Clearing Facility (EMCF). But there are still many issues in interoperability and access to clearing and settlement in many countries, as evidenced possibly by the strong results of Clearstream in the Deutsche Bourse’s reporting this year.

Until the European Commission eradicates the Giovannini barriers – the barriers to cross–border securities settlement identified way back in 2003 and still unresolved today – and create a truly open and transparent post–trade system for Europe, the pre–trade equities exchanges can make inroads, but they will only be narrow roads rather than expressways.

In conclusion, two years after MiFID, Europe has a buoyant and lively marketplace for trading and investment that is gradually moving towards the European Commission’s vision of an open and transparent pan–European trading regime. The new MTFs have managed to gain a quarter of the most liquid stocks trading activity, and this will grow even further over time. Meanwhile, the traditional exchanges are rethinking and redeploying new technologies to compete.

The result at this stage is that the liquidity pools of Europe are running deep ... and dark.

A useful chart (doubleclick to enlarge):

For those interested, the book on MiFID gives a comprehensive review of the Directive with chapters written by many of the market experts.  This article is also a useful backdrop to compare the state of the MiFID markets in April 2009.

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