The Financial Services Club's Blog

2012: a banking outlook

Yesterday, we talked about the economic outlook for 2012.  What about the banking outlook?

Well it’s also challenging, with five clear things happening:

• Regulatory change will still be high on the agenda
• Investment banking will get a radical overhaul
• Clearing and settlement will become a much bigger focus
• Reconstructing distribution will be a big challenge
• Contactless mobile will reach a tipping point in retail payments

Regulatory change will still be high on the agenda

It’s pretty obvious that the world’s regulators are continuing to struggle with how to manage the financial system, as most cannot even agree on a definition of what is a commercial versus speculative trade.

They’re getting there … but it’s taking time (three years so far).

Maybe that’s good, as we don’t want to rush into senseless change, but it’s also bad as every regulator has a different idea of how to tackle this crisis.

For example, in the USA Paul Volcker, the wonderfully outspoken former Chair of the Federal Reserve and creator of the Volcker Rule which bans proprietary trading in investment banks, says that working out what is speculative or not is easy: “Bankers know when they're doing a proprietary trade, I assure you. If they don't know, they shouldn't be in the business.  If there are big unhedged positions constantly, then it's proprietary trading.”

That’s the rule: if it's not hedged, it's pure speculation.

But this rule will cost, and cost a lot according to Oliver Wyman , who found that the decrease in market liquidity will deliver a $315 billion paper loss for investors in US corporate bonds.

Certainly, it will reduce trading volumes with the Financial Times quoting Brad Hintz of Sanford C. Bernstein, who reckons the Volcker Rule will see Wall Street’s fixed-income desks experience a 25% decline in revenue and a 33% cut in pre-tax margin. That ain’t good for jobs, and will only pile more misery on top of the 200,000 jobs lost on Wall Street in 2011 (compared to 174,000 in 2009).

London’s going through the same, but the challenges are different as the approach is different.

Here in the UK, we are ring-fencing investment and commercial banks under the Vickers report recommendations, which now have the government’s backing.

The idea is that banks are separated into two – an investment bank and the commercial retail bank.  The idea is that if the investment bank dies, it can be killed without murdering its sibling.

That’s great in principle, but in practice is far more difficult.

For example, the separation will cost anything up to £8 billion a year and it doesn’t even achieve the derisking it seeks.

The Vickers Report is designed to get rid of the results of casino capitalism, if it causes death to the investment bank; whilst the Volcker Rule is designed to get rid of casino capitalism.

The Vickers Report tackles the issue without recognition that it is often poor practices in commercial and retail banking that messed up our biggest banks.  Nothing to do with casino capitalism at all.

HBOS’s commercial lending portfolio, secured through easy access to wholesale funding markets, is the reason why it collapsed.  Same with Northern Rock and Bradford & Bingley with high risk mortgages.

So the idea of keeping the commercial and retail banking system ‘safe’, by ring-fencing it from the investment markets, is not something most people accept or believe.

Paul Volcker doesn’t believe it: “I don’t believe in a firewall or Chinese wall between them, as you need a very high ring fence to stop the deer jumping over.”

Then there’s the human cost of these proposals, with many thousands more losing their jobs in the City, and some estimating it could be up to forty percent of the total workforce in the City.  RBS, for example, has already shed a quarter of their workforce, with another quarter expected to go after Vickers.

Unintentionally, there is a belief that the Vickers reforms will also be a gift for foreign banks. 

Add to this the lurking storm of Europe and the UK’s veto over reforms due to City concerns, and it is no wonder that regulatory matters are still high on the agenda in 2012 … and 2013, 2014, 2015 …

Investment banking will get a radical overhaul

I’ve only put this heading in there as a follow-on to the regulatory piece that preceded this paragraph. 

Personally, I have a vision that investment banking will end up being a facilitative role, with platforms and technologies to enable trading, but no trading in the bank itself.  Instead, all the speculators and traders will be out there in private equity and hedgeland, not in the banking system.

Just a thought.

Clearing and settlement will be the big focus

Due to the changes taking place across the spectrum of investment banking and capital markets, clearing and settlement infrastructures will become a big focus.

This is partly down to the new regulations for OTC Derivatives and more, but also due to increased focus upon liquidity risk and collateral management.

Markets have an extreme between the high risk and high leverage we saw leading up the crisis – when Lehmans collapsed, every $1 of debt was leveraged twenty times across the markets so their $400 billion of losses escalated to near $10 trillion of risk – and minimal risk and leverage you see in markets like Russia.

When I visited Russia’s exchanges in 2009, here’s what I wrote about SPIMEX and RTS:

“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 client portfolio, 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.”

So we’re now seeing US and European markets grappling with how to implement clearing and settlement systems that enable liquidity, minimise risk, and strikes a balance between unbridled speculation and zero risk.

This is an area that has grown in interest with our clients and sponsors, so much so that on February 29^th the Financial Services Club is launching a Clearing & Settlement Working Group (CAS-WG).

The CAS-WG will hold its first meeting at BT’s offices in Newgate Street, and is organised in association with the Realization Group.

The aim of the CAS-WG is to debate and discuss all aspects of clearing and settlement infrastructures, and the first agenda will have four panels discussing:

• Volker/Vickers/MiFID II and impacts on post-trade operations and IT, particularly with regard to OTC Derivatives and Clearing
• T2S – problems of change and implementation for settlement
• Giovannini Group Recommendations, Innovation & Technology – what progress has been made?
• Standards in Post-trade operations

Panellists from organisations including Euroclear, LCH.Clearnet, EuroCCP and EMCF will be attending.  If you would like to attend, then let us know.

Reconstructing distribution will be a big challenge

Moving away from investment markets, retail and commercial banking is still undergoing big changes.  As discussed all the time here, branches specifically are a problem.

Banks will have to deal with this problem in 2012, as they cannot sustain loss-making operations anymore.

In some regions, six out of ten branches have closed (Iceland); in others three out of ten (Denmark); in the USA, four out of ten branches are loss-making; whilst in the UK, some analysts (me) estimate that as many as four out of five bank branches could close by the end of the decade.

The fact at the core of this change is that banks are electronic businesses distributing through electronic media, and the branch just does not fit that model of business.

As banks need to be the most cost effective they can, why have a branch?

It would be like bookshops fighting to keep their stores open, when it’s obvious they’re dead as they’re all losing money; or travel agents, record shops, video rental stores, etc, etc.

When your business model is dead, admit it and move on.

Contactless mobile will reach a tipping point in retail payments

Speaking of new business models, the one that most retailing banks will move towards is contactless mobile and contactless tablets.

The experience is highlighted well by various firms, but my favourite contactless illustration is from Discover Card and Square:

The reason why I use this one is that everyone assumes contactless = NFC chips.  It doesn’t have to be.  Contactless in my world, is any payment that is simple, automatic and wireless.

That’s what the Discover video shows.

However, NFC is a key part of most contactless plans, so it is also a key part of the process of evolution.

Contactless chips have been around for ages but, on their own, are relatively useless.  We then put chips in cards, but these again are not great.

But put a contactless chip into a mobile and then we’re rocking.

That’s again illustrated well be Google.

The tap-and-go experience is good one, and one that provides major convenience for the customer – whether the customer is a corporate who wants to drive higher sales through their checkout points, or the consumer who wants speed, ease, convenience and value.

It can focus upon not just turning phones into higher volume purchasing points, but into point of sale points too, and all geolocated as contextualised point of focus.

That’s why Movenbank is launching in 2012, as the first cardless and cashless bank.

So, if the major conversation of 2010-11 was mobile, the focus in 2012-13 will be contactless mobile.

Visa Europe endorses this view:

2012 set to be the tipping point for mainstream contactless adoption

77% of contactless owners across all three markets agreed or strongly agreed that contactless technology would ultimately become more commonplace than cash as a payment method (UK: 73%, Poland: 79%, Turkey: 79%)

 87% also agreed that contactless will be instrumental in bringing mobile contactless payments to market in the near future (UK: 84%, Poland: 89%, Turkey: 89%)

And, just in case you want any further detail, checkout this infographic from NFC rumors:

‘Nuff said.

So there you go, the five biggest things that will happen in 2012 in banking:

• Regulatory change will still be high on the agenda
• Investment banking will get a radical overhaul
• Clearing and settlement will become a much bigger focus
• Reconstructing distribution will be a big challenge
• Contactless mobile will reach a tipping point in retail payments

This is not exhaustive of course, as there’s plenty of other things happening, such as Fred Goodwin being brought to trial for breaching company rules (a sure vote winner for the coalition government).

Anyways, a final set of predictions tomorrow about how and which technologies to watch in banking in 2012.

 

This is one of three 2012 outlook pieces:

• 2012: an economic outlook
• 2012: a banking outlook
• 2012: a bank technology outlook

 

SPECIAL NOTE

Make your own mind up about my predictions.  Here's what I said would be the big ticket items for 2011 a year ago:

• Trying to gain clarity from the regulatory mess;
• Restructuring to maximise opportunities to arbitrage regulations;
• Reducing cost by moving to variable cost infrastructures;
• Maximising returns through creating high frequency intelligent trading (H-FIT) via algorithmic automation with real-time newsfeeds; and
• Creating differentiation through secure mobile financial services.

 

2010 Review: Capital Markets

Investment banking has had a rocky year all year. Pilloried by politics, public and the media, the investment banker is currently about as popular as a Vampire at a Blood Bank ... not a bad analogy as the refrain all year has been about that giant Vampire Squid that is known as Goldman Sachs.

Goldmans do bring it upon themselves though, as paying $111 million in bonuses this year sits badly with the average Joe. And I must admit that any bank that makes $100 million a day in profit most days, along with an admittance of how they manipulate markets and screw customers, has to be suspect.

The trouble with this is that it brings a whole cloud over the industry, as all banks are now viewed as being casino capitalists, robbing the economies to line their pockets with cash.

Not true.

There are some who might do this, but not every bank is Goldman Sachs.

However, it does mean that most of 2010 has been taken up with regulators and politicians wondering what to do about things like ‘dark pools’ and ‘high frequency trading’.

DARK POOLS

In the case of dark pools, they suspect these of being suspect because of the market manipulating suspicions created by the world’s leading investment bank, Goldman.

It means that regulators have been looking with deep scrutiny at trying to raise the illuminations on dark pools, even though these pools are argued to be good for markets as they increase liquidity by allowing block trading to occur that would otherwise be avoided if such trading was transparent.

Certainly, in Europe, the new revisions to MiFID could damage such trading, as illustrated by this May article from Financial News:

“NYSE Euronext and Deutsche Börse, have argued the regulators should use MiFID II to clamp down on the trading venues, known as dark pools, arguing they lack transparency and are open only to institutional investors, but not retail investors.

“But Rolet, who this week marks his first anniversary as chief executive of the UK exchange, said: ‘The biggest challenge is transparency and the balance between retail and institutional needs. Without institutional crossing networks (the so-called dark pools) some of the latent wholesale liquidity would go unexecuted or be simply more difficult to execute.’

“He said bank dark pools, which enabled customers to trade large orders privately away from the glare of the public exchange order books, served a valuable function in a market where there had been a sharp reduction in average trade size resulting from algorithmic and arbitrage activities.

“He added: ‘Transparency may have diminished in some areas but in formulating a response we should be careful to ensure that the differing needs of wholesale and retail participants are properly recognised.’

“The LSE chief executive and the exchange’s largest investment bank members, believe strict rules on bank dark pools would make it more expensive for institutional customers, such as pension scheme managers and hedge funds, to execute business.”

The result is that the European Parliament took on board a report produced by Kay Swinburne, rapporteur to the Economic and Monetary Affairs committee of the Parliament, during the summer recommending that dark pools be reclassified as multilateral trading facilities (MTFs) or systematic internalisers (SIs), and therefore lit.

The report has now been adopted as part of the MiFID review, and also places limits on order sizes. In other words, it wipes out the very reason for dark pools, as in large block orders placed outside the general exchanges to avoid market movements in advance of the order placement and processing.

HIGH FREQUENCY TRADING (HFT)

Swinburne’s report goes further and recommends a number of other restrictive changes, including:

• Making High Frequency Trading (HFTs) subject to mandatory liquidity provisions;
• An “ongoing regulatory review” of the algorithms used by HFTs;
• Making Multilateral Trading Facilities (MTFs) such as Chi-X Europe, subject to the same level of supervision as Regulated Exchanges.

In particular, there is a focus upon HFT, which has been augmented after the issues in America in May that created the conditions for the ‘flash crash’, something I’ve blogged about too often this year.

Therefore, I won’t do it again, except to say that between targeting dark pools AND HFT, the regulators are doing their utmost to kill any market liquidity and alpha investing strategies that exist.

Is that a good thing?

No, because the regulators are in danger of throwing the baby out with the bathwater.

REGULATORY NIGHTMARES

This was demonstrating by the reactions of the corporates, where they made it clear that the discussions of regulators about ‘systemically important’ and ‘commercial activities’ was purely speculative wording with no practical implementation ability.

In fact, it is concerning that the regulations being developed will more likely kill the markets:

• By clamping down on bonuses, investment bankers will all move out into hedge funds and private equity;
• By eradicating risky activity, regulators are also eradicating worthwhile investment activity;
• By locking down trading pools and practices that create liquidity, markets will seize up and cough and die;
• By demanding collateral placement to cover trading exposures, markets will be more restricted to just the largest players with deep pockets; and
• By banning prop trading, market makers will no longer make markets and trade and investment flows that fuel economies will disappear.

And none of the above really addresses the issue anyway, which was how the risk models created by the markets enabled massive risk exposures to be allowable when they were clearly, in hindsight, untenable and unworkable.

Where’s the regulation that addresses this area?

Which part of the regulatory structures of Dodd-Frank in the USA and MiFID II in Europe is addressing the fundamental question: how to eradicate products in banking that fuel risk, if the risk model has not been proven, tested and is comprehensible and comprehensive.

Meanwhile, we have had a few other key areas of regulatory focus, such as how to unravel a major global bank in 48 hours so that we can allow the too big to fail banks ... to fail.

CLEARING AND SETTLEMENT

Finally, there has to be a nod towards clearing and settlement. The whole clearing and settlement field is still a mess, with most of Giovannini’s barriers still unaddressed. That’s because of national market interests and focus.

During SIBOS, this all became clear as we spent so much time discussing interoperability that it became a buzzword, and we all know what you do with buzzwords don’t you?

Yep so, to finish the year, here’s a nice little buzzword bingo card for y’all to play with when you get back to the office in January (doubleclick to enlarge) ...

Oh yes, and if you're a real MiFID freak then Dechert produced a nice four-page PDF detailing the revised regulatory regime they anticipate this month.

The similarity between OTC derivatives and cheese

I recently chaired a conference focused upon FXMM, or foreign exchange money markets for those unfamiliar.

It’s a strange territory full of hedging and algo’s, but the bit of the day that really caught my attention was when Heather Pilley from the OTC Derivatives and Post-Trade Policy Division of the FSA, presented the plans for new regulations in this area.

She began by saying that the G20 has made it clear that by the end of 2012 there needs to be global regulations in place to ensure that OTC derivatives are traded on regulated exchanges.

This agreement is a drop dead date that the FSA, the EU and the USA are all working to such that, by 31st December 2012 or before, global markets will have fully regulated OTC derivatives markets.

On the 15th September, the European Commission released their proposed European Market Infrastructure Regulations (EMIR), and Heather made it is clear that these are similar, but not the same as, those proposed in the USA.

For example, EMIR includes FX exotics and forwards if they are being used for investment rather than commercial purposes. The US excludes FX forwards, so it’s different.

America restricts bank ownership of CCPs but Europe does not; EMIR instead strengthens the governance and surveillance requirements of CCPs but does not stop banks having ownership.

Similarly, smaller financial counterparties who are ‘not systemically important’ are excluded in American rules, but Europe bases ‘systemically important’ on a clearing threshold rather than the size of the counterparty.

This creates the shadiest area: the actual definition of what is ‘systemically important’.

Equally, a large OTC derivative contract for hedging based upon ‘commercial activity’ is excluded, whilst the same derivative if it is for investment purposes is included. Question: how do you separate and define these activities?

When a contract is made by an airline to hedge against oil price rises, is that commercial activity or investment activity?

This has not been defined in EMIR and are ‘still being worked upon’, hopefully in time for an agreement before the end of 2012.

Other areas that may confuse are that clearing obligations for these contracts are in two forms.

First, from a bottom-up view, the Central Counterparty (CCP) in Europe must be named and authorised by the national regulator, which will be identified through registration with the European Securities and Markets Authority (ESMA). This also determines the competent authority responsible for the contract, based upon the country of the CCP’s location.

Second, from a top-down view, ESMA determines which contracts must be cleared centrally and once a contract is in, it’s in 100%.

This begged the question as to whether that means every contract is reviewed on a contract-by-contract basis, or whether it is by definition of the type of OTC contract being made. According to Helen, it is based upon the class of contract, not every contract one by one.

Bearing in mind the confusion of the above, Helen then said that the legislation is likely to be ready by April 2011, the technical standards by Spring 2012.

With all of these things still to be defined, such as thresholds, this seriously worried the corporates in the room, especially the definition of ‘commercial activity’. For example, Malcolm Cooper, Global Tax & Treasury Director for the National Grid, asked a range of questions including: can we ensure that commercial activity includes cross-currency swaps where there is no trade involved, but it is a valid hedge of commercial activity? Has anyone looked at the cost implications, as few treasury departments will have the resources to cover intraday margin calls if that’s the direction such regulations take?

Heather reassured by saying that most legitimate trading would be allowed and that it is only the systemically important areas that are the focus of the regulation.

This led to Mike Hazell, Group Treasurer with Debenhams, asking whether a $500 million currency swap is systemically important, as that’s a pretty regular and common deal for his firm.

Heather responded that they would be looking at net exposures, and that this still needs further definition.

Another audience member asked why OTC regulations will apply to FX forward contracts for investment purposes which operate on a three-day cycle, but do not apply to FX spot trading which operates on a two-day cycle. Is it fair to exempt one and not the other, just for one day’s difference?

All in all, the whole conversation left me with the sense that those who are developing the regulations really do not know what they’re doing.

There are massive inconsistencies between the European Commission’s papers and views, and those of member states. Equally, there are big incongruence’s between the US view and the EU view.

Finally, the fact that the G20 has laid this down as drop dead by end of 2012, there’s a big danger of creating something so full of holes, that Emmental Cheese will look positively robust by comparison.

MiFID II: the post-trade agenda

One of the big topics in capital markets is intra-day liquidity and post-trade transparency.

Such discussions are far more noticeable now because the whole reason for this crisis, according to some, was the loss of trust between counterparties. That loss of trust was based upon counterparties not having enough liquidity to cover their positions. After all, if Lehmans could collapse with billions of dollars of debt – and they were AAA rated – then anyone could collapse.

We then had this dialogue around the right levels of counterparty cover and collateral required in the markets at start of day, end of day and intraday to enable effective trading.

There were discussions of whether it should be like the Russian markets, where collateral has to be pre-posted every morning to cover the day’s trading.

Or whether there was a way to just put circuit breakers on the markets, like the Eurex Clearing model discussed last week, although that liquidity control is based upon self-management.

There have been other discussions about regulatory controls of liquidity risk, such as those provided by the UK’s FSA that requested real-time reporting of liquidity positions, at an estimated cost of £2 billion in new technology spending.

Meantime, Europe announced the de Larosière reforms a year ago, and these reforms are now coming into play as the three new regulatory authorities- the European Banking Authority, the European Insurance Authority and the European Securities Authority - come into play.

And, of course, America is trying their darndest to sort out the mess of OTC Derivatives and fragmeneted trade reporting.

So, in summary, we have global, regional and national regulations working together and apart to try and lock down this space, as illustrated by this slide (doubleclick image to enlarge):

Stolen from Harald Keller’s (Senior Manager, Payments Markets, SWIFT) presentation – for more click here

Overall, the focus of all these regulatory changes is around liquidity risk, which brings in several other key elements including collateral management, clearing and settlement and post-trade reporting.

For example, at last week’s meeting in Germany, Robert Barnes of UBS kept using the line: “post-trade reporting is the next pre-trade”.

What he meant by this is that if you have real-time trade reporting, then that helps the markets with transparency of investment strategies and where the next trades will come from. Therefore, if you can immediately see who traded those two million Apple shares on the dark pool, then you can immediately alter your algo strategies to suit.

Bring in the algo news feeds et al and he’s right.

The trouble with this is that post-trade reporting is good if people do it, but a lot of trading operations ignore trade reporting. In fact, the only post-trade reporting market that seems efficient is London thanks to Boat. In some other markets, T+3 is the order of the day ... or even worse.

So one thing that MiFID II is likely to do is to bring in some mandatory trade reporting requirements that strengthen the moves where the first version of MiFID failed.

Another facet to MiFID II will be some form of mandatory real-time reporting of trades, and a clearing and settlement directive incorporated as part of this.

Now that’s a leap of imagination –real-time trade reporting, real-time liquidity positioning and real-time clearing and settlement.

I’ve blogged about real-time opportunities before, and do NOT think that the European Securities Authority, the European Commission or the ECB would be silly enough to mandate real-time everything, but I do think they will want to see true interoperability across all clearing systems.

The LinkUp Alliance and Code of Conduct has gone some way down this route, but the situation is still pretty fragmented as can be seen from this chart, courtesy of Robert Barnes at UBS:

Sure, this is slightly out-of-date, but things haven’t changed that much and so transparency of trades, simple and straight through clearing and real-time liquidity management are definitely order of the day for the regulatory agenda.

This is Part Four in a Series of Posts on the Regulatory Agenda for Capital Markets:

• Part One: SEC to crackdown on HFT?
• Part Two: What was the cause of the 'flash crash'
• Part Three: Exactly what is and how big are 'dark pools'?
• Part Four: MiFID II - the post-trade agenda
• Part Five: Best Execution and Global Trading

These items also build upon a series of posts about the Deutsche Börse:

• If you can't afford the tech, get out of the market
• Circuit breakers on the Deutsche Börse
• Forget Frankfurt, I'm moving to Basildon

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

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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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.

$450 trillion in a single place

It’s great being in another timezone as, after my 11-hour flight, I felt really tired so an early dinner and then bed by 10 o’clock ...

... waking up at 1:30 a.m.for a nice five hours of watching movies whilst trying to get back to sleep.

I get to my first meeting and say, “y’know, I’ve been awake since half-one and need coffee”. I then find that everyone else from Europe and America is the same way and up since one or two this morning.

This may be a bleary-eyed SIBOS therefore and I get to my first session, which focuses upon clearing and settlement, to find the audience asks no questions ... yep, they need coffee.

The session opens with a statement from the SWIFT hosts that this is a record-breaking SIBOS with over 5,300 people registered which is more than SIBOS in Sydney three years ago.

So much for a market that has meant to have imploded.

In fact, as I go around the exhibit hall, I see that many of the booths are bigger, brighter and better than ever ... including those of Citi (“we’ve spent a billion dollars on infrastructure in 2009”) and Royal Bank of Scotland (“making it happen”).

Anyways, back to the first session which was a keynote from Michael Bodson, Executive Managing Director of the DTCC.

The DTCC is the large US Central Counterparty Clearing systems (CCP) with the aim of moving into being the largest clearing system globally, as demonstrated by their OTC Derivatives information warehouse which, according to Michael, now tracks $450 trillion worth of credit derivatives in 35 countries.

He emphasised that this is key: a single data repository, a single warehouse, a single hub. The idea of multiple hubs for each region, which is being mooted by the EU as they do not want to rely on a single US-based hub, is clearly wrong in his view.

This is because right now, it is clear to all parties how to register a risk because it is on a single database. If there were multiple hubs, then which risk gets registered on which hub for which counterparty becomes confused.

Or that’s the DTCC’s view.

On a wider note, he did say that post-trade has suddenly become a hot topic because we stared into the abyss last year and survived thanks to collective resilience of the infrastructures.

“A year ago, nothing worked. Stocks failed, bonds failed, everything failed ... except market infrastructures. Infrastructures worked.”

He outlined that the DTCC handled $500 billion in open Lehman Brothers trades during the six weeks after their collapse on September 15th 2008. In fact, during one day, they liquidated $300 billion in open positions.

These are shocking numbers and the fact that the infrastructures worked and were resilient was the key.

This is why the clearing and settlement plumbing of the world’s financial markets has gone from being “about as exciting as goat’s cheese” to being sexy.

Clearing and settlement has moved from being post-trade back office boredom to being critical to everyone’s management of risk and exposure in these global markets of liquidity.

Interestingly, the DTCC had actually run a simulation of a major top ten investment bank failure based upon Lehman Brothers as the case in point, as a training exercise just weeks before their collapse.

A prescient moment.

Michael also referenced that regulators should have three areas of concern in the markets – an asset bubble, liquidity risk or major fraud. The fact that you had Lehman Brothers and Bernie Madoff within months of each other shows what a good job the regulators are doing.

Yeah, baby, yeah.

This presentation made for a good grounding for the panel that followed which was all about competition and value-add between global custodians, central securities depositories (CSDs) and central counterparty clearing systems (CCPs).

To be honest, there’s a challenge there in that you don’t really want competition between these groups if you are trying to manage risk effectively. The ideal risk manager you see, is a risk management of one, where all risk is centralised. That is the point of a CCP or CSD, to have it centralised.

As a result, you really have a natural monopoly when it comes to clearing and settlement. This was the grounding of the panel which comprised:

• Philippe Metoudi of Clearstream representing Asia;
• Monica Singer of Strate representing Africa;
• Ted Rothschild pf JP Morgan representing America; and
• Alan Cameron of BNP Paribas representing Europe;

chaired by yours truly.

It turned out to be a really good panel, debating the nature of ‘value-add’ and ‘competition’ in the post trade clearing markets.

As I chaired it, I didn't take many notes or quotes but am sure it will get a write-up somewhere and will link to this later.  The one comment I did note was the one comment from the floor from a not-for-profit clearing infrastructure:

“CSDs get accused of being fat, dumb, lazy and bureaucratic as state-run enterprises and are then told that it is not right if they try to innovate, compete and reduce prices and costs. We can’t win.”

Yeah, baby, yeah.

*

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