Falling arrows and shifting sands
As we draw into Q4, the top issues in equities are the worrying state of the US small and mid cap market, the impact of unbundling and the dilemma over commission management, falling commissions and buy-side concerns that this will decrease the quality of services from the sell side; shortening broker lists, especially in Asia; the upcoming Shenzhen Stock Connect which is due to go live before the end of the year; the fallout from periods of volatility such as the UK’s Brexit from the European Union; the possibility of Hong Kong becoming an ID market; the rise of ETFs and passive investing.
On the buy side, there is a desire to ensure that the commission rates that are most commonly paid are standardised, but many firms are not meeting their commission targets for certain brokers. The base rate has fallen dramatically over the last 12 months globally, although there is some variation – Asia has fallen more than Europe over the same period.
Responses have been varied; some buy-side firms now actively avoid the use of low-touch services such as DMA if they feel their commission rates are dropping too low; they turn to high-touch services instead. The thinking behind this decision is to ensure the buy side continues to receive useful flows and facilitation services from the sell side; there is a feeling among some on the buy side that increased use of DMA results in a deterioration of these services.
One of the notable issues of the summer has been how to respond to the uncertainty and dislocation caused by geopolitical events. These include the UK referendum in June, in which the UK voted to leave the EU; they also include the upcoming US elections in November, which will decide whether Hillary Clinton or Donald Trump will become President of the world’s biggest economy. There have been concerns on the buy side that the uncertainty causes some market participants to hold back, inadvertently triggering under-performance and thus causing some asset owners to switch to ETFs and passive strategies instead.
Regulatory initiatives around the globe continue to have an impact on trading desks; in equities, some of the more interesting moves from the last few months include the introduction of a volatility control mechanism on the Hong Kong Stock Exchange, which the exchange communicated to investors by uploading a surprisingly funny video on YouTube (watch it – it’s well worth it). The tick size pilot in the US, which is testing a system under which tick sizes would be widened for small and medium cap stocks; and the PRIIPs regulation in Europe, which focuses on packaged retail and investment products. The European Commission adopted a delegated act to supplement the PRIIPs regulation, which introduces content and methodology standards for the key information documents that must be provided to retail investors when they buy certain investment products.
In addition, there is a growing sense of unease about the global shift towards passive investing, which may contribute to periods of volatility and which may also be driving a return to the mean as investment performance increasingly averages out. As sober analysis from Sanford C. Bernstein has shown, there is also the possibility that an excessive shift to passive investing could have a detrimental effect on the economy as a whole, due to a less efficient allocation of global capital.
We look forward to discussing these and other equities challenges in the upcoming debates in 2016 and 2017…
Rising tides and shining lights
In the world of fixed income, one of the more interesting observations of recent months has been the inflow into fixed income funds in July, August and September, following on from the UK referendum result in favour of Brexit in June. Much of this activity has been driven by investors switching from equities into fixed income, as they seek safety in uncertain times. The UK government has still not triggered Article 50 of the EU’s Lisbon treaty, which governs exit from the EU; until it does so, the full impact of Brexit will remain unclear.
On a more general level, fixed income information leakage continues to be a concern for the global buy side. At the more advanced end of the technology spectrum, some market participants have suggested that blockchain, the technology brought to public awareness by Bitcoin but now often used by other firms for a range of purposes, could be used for repo of bonds, providing a surety of settlement that is not currently available.
However, one of the main issues may be transparency. As one participant pointed out in our recent Asia Buy-side Forum debate, given the opacity of the pricing in government bond markets, any pricing no matter how indicative is a starting point for discussion. Meanwhile in terms of global liquidity, one possible improvement could be for the buy side to take on the role of price makers rather than price takers; however, it is unclear as yet to what extent this is feasible in practice. Senior buy-side traders have indicated that there is no prospect of their taking on the role of a market maker in the traditional sense; however, there is some potential for trading on buy-side to buy-side platforms that would enable the buy side to connect liquidity directly.
As in other asset classes, the shift towards passive investing is also a major issue in fixed income markets. Longer execution times, higher execution costs and increasing difficulty sourcing bond securities and completing large trades have driven investors to seek alternatives – including ETFs, according to research published in September by Greenwich Associates. The previous month, BlackRock reported that Australian investors increased their inflows to fixed income ETFs by 41% over the 12 months to August 2016. Meanwhile, Deutsche Bank stated that the Asian corporate bond market represents an opportunity for the development and trading of fixed income ETFs, due to the presence for the first time of “sufficient liquidity” in September 2016.
The impact of central bank policies continues to be a significant factor in fixed income markets. Between 2008 and 2016, the major central banks have increased their combined total assets from $6.4 trillion to 17.6 trillion; some observers have questioned whether this may have a damaging effect on liquidity. Meanwhile, some buy-side firms have noted that they have as many as 16 different work streams to be compliant with the European Commission’s MiFID II regulation. Globally, bond markets are diverse; while in Europe and the US, there is an ongoing drive to push more trading on-exchange, driven by the likes of Dodd-Frank and EMIR and the G20 agenda agreed in Pittsburgh in 2009. In other markets as much as 88% of the market is still traded OTC. Buy-side participants at the recent Asia Buy-side Forum debate in Singapore did not see any likelihood of that changing in the next five years; furthermore, there are significant concerns that the level of transparency surrounding exchange-trading would in any case be a bad idea for liquidity in parts of the Asian bond markets.
Caution: challenges ahead!
There is some frustration on the buy side at the quality of the services being provided by banks in FX. As one buy-side trader noted in our recent roadshow in Asia, it can seem to the buy side as though the banks are not there when needed, and do not provide a good service in certain currency pairs, for example US dollar and Mexican peso.
The Bank of International Settlements is currently working to finalise a code of conduct for currency markets; the goal is to increase transparency and restore public confidence in the integrity of markets. In the UK, the Bank of England is in favour of the code; meanwhile the FCA requires those under its jurisdiction to adhere to industry codes – including the forthcoming BIS code. Among its measures are a prohibition on foreign exchange traders lying and spreading false rumours.
Globally, K&KGC Buy-side research uncovered some interesting findings on FX; these include the buy-side’s top mid-price and fixed fee counterparties globally. Four banks stood out, but there was a clear lead for one bank; the results will be revealed as part of the K&KGC awards in November. In terms of how FX trading desks are organised, the majority of the buy side still use specialist FX traders; however there are a significant minority that use a general multi-asset trader, or even a trader specialised in other asset classes. The most popular performance benchmark in FX trading is arrival mid.
The majority of buy-side traders in FX continue to primarily rely on brokers; however, there are some participants present in the market that began trading electronically in FX as early as 2002. These pioneers are a small minority, but nevertheless there is at least one European asset manager using algos in FX for all trades above 50 million Euros in size. K&KGC Buy-side research indicates that the majority of buy-side firms have not yet adopted FX trading algorithms. Some firms do use electronic venues such as FXall and others.
As with other asset classes, there are those on the buy side who argue that the path to the future involves more buy-side to buy-side trading, with the buy side increasingly becoming price makers instead of price takers.
However, proponents of this view accept that there would need to be a change in mentality on the buy side before the full benefits can be realised.
One of the major challenges for traders in all asset classes in Europe and worldwide is the need to adapt to new regulation, including but not limited to MiFID II, Basel III and EMIR as well as Dodd-Frank in the US and local initiatives in individual countries.
In Europe, much of the European Commission’s efforts in recent years have been focused on improving transparency. Yet despite this push, one of the most critical components of a transparent market – the creation of a consolidated tape – has not been achieved.