Excerpts from the 2012 Electronic Trading Report

Transcription

1 Excerpts from the 2012 Electronic Trading Report Compliments of

2 MARCH ELECTRONIC TRADING REPORT Asia Embraces Electronic Innovation Electronic trading in derivatives and structured products in Asia is well established and the region is increasingly becoming a major driver of growth. Daniel O Leary reports. Single-dealer electronic trading platforms have become the new world order. They are tools that aim to reduce costs and increase efficiency for clients. Platforms offering derivatives trading have been operating in Asia for around nine years, with Barclays Capital s BARX, the Royal Bank of Scotland s Marketplace and UBS Equity Investor amongst the platforms currently offered locally. During the last year, firms have been aggressively expanding their e-trading teams and product offerings on these platforms. At the same time, Asian investors have been increasingly flocking to platforms and dealers are increasingly recognizing the growing potential and suitability for such platforms in the region. What makes Asia so prime for the development of electronic trading platforms is that they give greater diversity to an investor base already at home with a fragmented market. Jump in an airplane and fly an hour in any direction from Singapore and you can find yourself in a completely different world with different products and systems of law and governance. By doing this, we automate so much that the issuing cost is quite minimal. Our system has one of the lowest launch sizes on the street. Min Park The fact that a client now is able to have access to various markets and various exchanges and facilitate both inbound and outbound business, in addition to their domestic market, makes it even more compelling, says Leanna Raja, head of South Asia sales for Barclays Capital s BARX platform in Singapore. Yes, [fragmentation] is an obstacle, but it s also an opportunity, she said. Some emerging markets in Asia present a challenge, due to the lack of technological infrastructure, Such as a lack of Internet connectivity, she noted. Yes, it does make it more difficult to get the client base to trade electronically within their own country. But once you overcome the connectivity issues, we ve seen rapid uptake from clients who have a desire to leverage the benefits electronic trading offers them. According to Raja, the uptake in electronic trading has been most pronounced in fx, while fixed-income and commodity derivatives are also rising in popularity in the region. There s definitely more and more recognition in Asia as to what electronic trading platforms actually bring to clients, she said. The drive has been from private banks and hedge funds, but we re also seeing the client base open up to the possibilities to the benefit of electronic trading. They re the real money and increasingly corporate accounts. Credit Suisse and Barclays are examples of two firms that have been expanding in the region to meet the growing demand for electronic trading from clients while also broadening the potential client base. Credit Suisse launched its Asia-focused electronic trading platform Spirit Asia in April The click-and-trade platform was initially only available to Credit Suisse s internal private bank, but has since been rolled out to over 800 private bank subscribers. Min Park and Kenneth Pang championed the development of the e-trade platform when they came over from UBS in 2009 as co-heads of equity derivatives and convertibles for Asia. While Spirit Asia is modeled after Credit Suisse s European equivalent, Spirit, the system is slightly different and uses its own structures and IT. The platform s product suite covers equity-linked structured notes, such as vanilla and variable options, plain vanilla and knockout ELNs, 2 Institutional Investor Intelligence Reproduction requires publisher s prior permission. To receive alerts or online access to Derivatives Intelligence, call (800)

3 ELECTRONIC TRADING REPORT MARCH accumulators and range and fixed-coupon notes. With this system, it basically means everything can be much quicker. Everything will be much more efficient, said Patricia Lau, head of private bank sales, Hong Kong and Singapore at Credit Suisse. Previously, the way that private banks get quotes is the client will call the private banker and the private banker will have to call their products We need to cover as much as possible on the platform, even if client demand is small. We want to cover that. Patricia Lau desk at the private bank and then the private bank s product desk will have to call us. And then we have to get back to the private bank s structured products desk, which then has to get back to the client. Normally it goes back and forth a few times, depending on the client s needs. The turnaround time for the platform s development was swift after Park and Pang arrived, according to Lau. We wanted to bring in an electronic platform to improve the experience of our private bank clients, she said. Lau noted electronic trading platforms empower the private banker. They re able to get their own pricing quotations, they re able to place orders by themselves, she noted. While the private banker speaks to the client over the phone, they re able to get different pricings and price variations as they speak to the clients. Credit Suisse is planning to broaden the product suit it makes available to investors as the market landscape changes, with structured products such as callable variable reverse convertibles and drifter notes expected to be added to the platform this year. We ll also be adding more underlyings and more features, said Lau. These products don t have as much volume as our other products, but it s important that we have a very broad product suite. We need to cover as much as possible on the platform, even if client demand is in small tickets. We want to cover that. Barclays, like Credit Suisse, has also been developing the capabilities of its platform. One development has been the addition of pricing and execution capabilities for fx and commodities to its Comet equity structured product platform, which sits within BARX Investor Solutions. The broadening of the client base is being driven by the development of the platform, said Raja. What we are offering currently in regards to Asia is more and more complete, Raja noted. In the Singapore market, for instance, not only can clients trade [U.S. dollar/singapore dollar] spot, forwards and futures over the Singapore Exchange, but they can also have access to exceptional liquidity in Singapore bonds, Singapore interest rate swaps and Singapore credit. So the completed product is encouraging more uptake. Barclays is also looking to expand its emerging markets electronic offering after launching CNH spot, forwards and options on the BARX platform in I think with fx options, we ll continue to develop our suite of products and functionality, said James Cowell, head of efx trading at Barclays Capital. A lot of development over the last 12 months has been around Asian currency options and emerging market options and a lot of that is driven by Asian demand. If you take into consideration the challenges currently facing market participants higher costs from impending regulation and increased capital requirements the increase in electronic platform expansions makes economic sense. Also, this front end automation, isn t just efficient execution, Park said. It can also generate documents automatically and automate back office bookings. The automated process means Credit Suisse is able to handle much smaller order sizes than before. And then our end doesn t have to wait to get certain minimum sizes to launch the product. Now we can lower the minimum price to as low as USD25,000. The system also lowers issuing costs. If we don t have the proper size we cannot cover the cost, Park noted. By doing this, we automate so much that the issuing cost is quite minimal. Our system has one of the lowest launch sizes on the street. Lau said investors have been increasingly turning to lower order sizes as a consequence of the financial crisis. But they also don t want to put all their eggs in one basket and they want to diversify, she added. Without this kind of platform, doing trades like this would never be possible from either the investment banking side or the private banking side. It doesn t really make much sense for either side of the trade to handle such small orders. n Institutional Investor Intelligence Reproduction requires publisher s prior permission. To receive alerts or online access to Derivatives Intelligence, call (800)

4 MARCH ELECTRONIC TRADING REPORT U.S. Firms Bulk Up, Focus On Niches The backdrop of the Dodd-Frank Act looms large on the U.S. landscape. Ahead of regulatory deadlines, firms are looking to steal a march on each other. Kevin Dugan reports. The Dodd-Frank regulatory reforms in the U.S. have made electronic trading the way of the future, whether anyone likes it or not. Though firms are not obligated to move some of their derivatives trading to electronic platforms until next year, those who are heading the e-platform businesses are looking to capture the market before end users have a swell of choices. It s a chicken-orthe-egg problem, said Ron Karpovich, managing director in e-commerce Royal Bank of Scotland. Is it now? Is it in the future? As one goes, the rest will follow. Firms racing to beat the market on two fronts, with the bet that the first and most flexible single-dealer cross-asset electronic trading platforms are going to define the way users trade for years to come. As such, firms are looking for ways to lock in a target user base and keep them with a competitive edge. UBS has rolled out a first-of-its-kind platform for buyers and sellers of credit default swaps to make markets on a bilateral basis. RBS will soon launch cross-asset trading for its Agile platform, which targets futures traders by giving them an automated way to hedge gamma. Firms are looking to capture the market before end users have a swell of choices and many are currently formulating platforms and keeping tight lipped about their form. We know we re not the only firm out there selling electronic trading, said Daniel Ciment, head of electronic trading solutions for the Americas at JP Morgan. As a leader in electronic trading, we know that someone out there is trying to take market share. Daniel Ciment Electronic trading has been a part of fx and equities options trading for years, but Dodd-Frank is driving firms to move some of over-the-counter derivatives trading business online. It will change the economics on the trade, change the way we do business and generate revenue, said Jon Butler, head of equities & structured retail technology and change at RBS. But most importantly it will require infrastructure to accommodate all of the changes. To pave the way, banks have been building out their electronic platform teams. We ve grown our team over the last months pretty significantly, said JPMorgan s Ciment. A recruiter in New York who is familiar with the electronic trading market said hiring for some firms has been going on for even longer. CLIENT CALLS Firms design electronic platforms to make trading easier for clients. There are brainstorming sessions, solicitations for client opinions, conference calls. Some platforms are designed to bypass the traditional voice brokers and screen watchers that end users have traditionally relied on. Electronic trading is all about being efficient and doing more with less, Ciment said. The efficiency race has also set firms to focus on specific areas of the market, and finding ways to capture market share. This means developing platforms that are unique to users needs in trading specific financial instruments. In December, UBS launched such a platform, called the Price Improvement Network-Fixed Income. One strategy we decided to pursue, among other things, is to be quite aggressive and forward thinking in developing a meaningful electronic trading platform for customers of CDS, said Paul Hamill, managing director of matched principal trading at UBS. It allows end users to hit or lift prices on about 300 names, see where the most liquidity is in the market, and give users the ability to see where there is activity in the market. Customers know that they can trade with each other, so it s all-to-all and they never have to have [International Swaps and Derivatives Association agreements] with each other, Hamill said. As of mid- February, the platform had approximately 50 users, and about USD1.2 billion has traded over about 200 trades. The platform is also designed to adapt to where the markets have concentrated the most liquidity in the future. Hamill said clients will be able to access PIN-FI through an 4 Institutional Investor Intelligence Reproduction requires publisher s prior permission. To receive alerts or online access to Derivatives Intelligence, call (800)

5 ELECTRONIC TRADING REPORT MARCH application programming interface for algorithmic trading. When traders are required to go through swap execution facilities for off-the-run instruments, like a legacy roll of the Markit investment grade credit default swap index, the platform is designed to consider different clients eligibility for which prices it has available. RBS has also been looking to capture market share by increasing the capabilities of its current platform, FX Agile. UBS is planning on integrating other asset classes on its Agile platform in order to give traders the ability to monitor gamma, or correlation risk. When We know that someone out there is trying to take market share. Daniel Ciment you re doing cross-asset trading, you re looking at correlation risk, Karpovich said. Agile is designed to give futures traders greater ability to set limits on gamma and, he said, hedge more efficiently. It s a speed issue, he said. A futures trader may hedge gamma three or four times a day. Agile allows the trader to set up the parameters for gamma and time and the number of hedges can increase to 70 trades a day. The number increased dramatically because it catches every component. The system looks at every small parameter in price. It is a significantly better hedging strategy by hedging much more minutely. There s a big debate as to how fast it s going to happen in all asset classes. The easy way to look at it is that gamma risk is correlated to price, Karpovich said. So once you give us a gamma number, we can hedge correlation. You can do that with any two assets once you calculate the correlation. It s naturally cross-asset when you start working out correlated prices. Jon Butler But launching novel electronic platforms for assets that have not seen much, or any, electronic trading does not come without its own risk. Some firms may not want to open up a platform when markets might not be ready to embrace electronic platforms just yet. Regulations aside, with equities it took 10 years to get fully electronic, Butler said. There s a big debate as to how fast it s going to happen in all asset classes. n ABOUT INTERACTIVE DATA Interactive Data Corporation is a trusted leader in financial information. Thousands of financial institutions and active traders, as well as hundreds of software and service providers, subscribe to our fixed income evaluations, reference data, real-time market data, trading infrastructure services, fixed income analytics, desktop solutions and web-based solutions. Interactive Data s offerings support clients around the world with mission-critical functions, including portfolio valuation, regulatory compliance, risk management, electronic trading and wealth management. Interactive Data is headquartered in Bedford, Massachusetts and has over 2,500 employees in offices worldwide. For more information, please visit or info@interactivedata.com Institutional Investor Intelligence Reproduction requires publisher s prior permission. To receive alerts or online access to Derivatives Intelligence, call (800)

6 Sponsored Article Staying in the Game: How Trading Firms Can Advance Market Data Infrastructures By Emmanuel Doe, President, Trading Solutions at Interactive Data Since the birth of electronic trading, financial firms have valued the competitive advantage provided by technologies that quickly access trading venues and deliver key market data feeds. As the industry landscape evolves dramatically, technological advances have radically hastened the speed of trading with transactions being completed in milliseconds. This has raised the market data infrastructure stakes for firms, who now need low-latency data feeds and support for high frequency transactions in order to stay competitive. As they have in the past, firms can rely upon their internal development teams to help them build out their market data environments. Yet the upfront costs and ongoing maintenance and support demands of a low-latency infrastructure are daunting, causing firms to consider an alternative outsourced approach whereby a third-party provider hosts all or key components of a market data infrastructure. There are a multitude of considerations for firms contemplating the market data as a service model. While firms will have to trust an external provider to deliver mission-critical services, they will remove the infrastructure build-out as a gating factor in getting to market faster with new trading strategies. Additionally, hosting offers firms a potentially broader range of data and connectivity services, and it shifts the challenge of infrastructure technology maintenance issues to a trusted third party. It s an understatement to say that the industry landscape has changed radically during the past decade. Ten years ago, the predominant market data distribution model was based on market data feeds flowing from third-party providers to a distribution platform that updated a firm s traders, applications and systems in real-time. The industry has since embraced the emergence of low-latency data feeds, high frequency trading technologies and advanced trading strategies. These developments, coupled with fragmented and highly volatile markets, have changed the market dynamics for trading firms. As a result of low-latency fiber-optic networks and direct exchange feeds proliferating, trades seem to be being transacted at velocities approaching the speed of light. When firms are building or expanding their market data infrastructures, the technology options available to them are far greater than they were 10 years ago. In addition to the traditional consolidated data feeds, many firms are considering direct, low-to-ultralow latency access to futures, options and equity exchanges, foreign exchange venues, and so-called dark pools of liquidity. Wide market access facilitates transactions in multiple asset classes based on a firm s investment and trading strategies. Firms also have more opportunities to expand their reach globally to key financial centers in Chicago, New York, London, Frankfurt and Tokyo, as well as to emerging markets. In fact, firms can establish low-to-ultra-low latency connections to these global markets by placing their trading systems and Emmanuel Doe matching infrastructure in data centers run by exchanges and other liquidity venues. By using proximity and co-location connections, firms can dramatically reduce market data latency to the millisecond level via state-of-theart, fiber-optic telecommunication lines. High-speed market data links are serving the needs of many traders, including electronic market makers and statistical arbitrage desks, and advanced trading platforms such as those running algorithmic-based transactions. Traditional asset managers, hedge funds, firms employing quantitative strategies and mid-market broker/dealers can also benefit greatly from low-latency links. Yet upgrading to a 21 st century infrastructure is presenting a challenge to many firms. While technology has dramatically reduced latency, it has increased the complexity and thus the costs of market data infrastructures. The demands of managing an internal, market data distribution platform feeding traders desktops pale in comparison to those of managing global, low-latency market data feeds, co-location and proximity connections, and the ongoing maintenance and support that are required to stay competitive.

7 Sponsored Article Market Data as a Service The technologies that have enabled the internal development of low-latency market data delivery have also given rise to an alternative. Firms can now have a third-party service provider host all or part of their market data infrastructure. The main benefit of this approach is economic. An independent company can offer more cost-effective hosted data, networking and IT support services because the associated costs can be amortized across their entire customer base. In addition, by working with a third party, trading firms can keep pace with technology upgrades and new products from exchanges and other data suppliers. This service offering generally referred to as market data as a service can also enable a firm to incrementally implement changes. Firms can start with a proximity or co-location solution to quickly capitalize on economies of scale. As a next step, firms might add more venue connections and data feeds that allow them to advance their trading strategies without having to substantially increase their market data infrastructure costs. A managed services approach to low-latency market data delivery can mitigate the need for firms to build and maintain direct links between data centers and transaction venues. They can also delegate the ongoing maintenance of software and hardware, including networking protocols, operating systems, switches and routers that support stateof-the-art deployments. Another option for firms is shifting the ongoing testing and quality control for telecommunication links, port-to-port speeds, line speeds, and hardware and software systems to a third party. Hosting providers can also take over the management of expensive upgrades to increasingly faster lines, and datacenter services and disaster recovery commitments become their responsibility. In terms of secondary benefits, third-party hosting of state-of-the-art market data flows can allow firms to take advantage of the consolidated feeds that can be delivered along with the low and ultra-low latency offerings. The consolidated products can cost-effectively feed analysis systems that generate cross-market pricing comparisons. They can also support financial modeling of arbitrage opportunities and bolster strategy back-testing and portfolio analysis. Weighing the Options Before firms embrace market data as a service, they have to address the considerations that can frequently complicate the decision to overhaul market data infrastructures. An important step in this process is conducting an inventory of the existing infrastructure. Complicated, state-of-the-art market data infrastructures can require project management, research and design, trading system reviews, network capacity and utilization reports, network performance assessment and tuning, and network risk analysis. Specifically, firms need to understand their requirements for reliability, lowlatency support and scalability. Once these levels are clear, firms will have to establish how much they need to spend to achieve and maintain their goals. They will also need to determine their proximity and co-location requirements, which could include connectivity to exchanges, other trading venues and dark pools of liquidity. They will also have to assess their hardware procurement needs, software configuration and installation costs, and maintenance. At a higher level, firms will need to monitor end-to-end latency levels across their infrastructures, as well as review networking and server performance. They will also have to anticipate upgrades and updates of key applications and operating systems. Firms will also need controls in place to guarantee acceptable levels of service and support. Once a firm has measured and quantified the full scope of requirements, it will be able to decide whether its market data infrastructure is better managed internally or externally with a third-party provider that offers design, procurement, installation and network hosting services for low-latency trading environments. Complexity has yielded a range of alternatives, and firms have the flexibility to devise solutions that best support their market data strategy. If done correctly, firms can lower both the complexity and TCO of their missioncritical infrastructures. The Benefits The market data as a service approach allows for choice of services and great flexibility in deployment. Firms are not limited to outsourcing their market data infrastructures on a wholesale basis. They can have a mix of onsite market data implementations, hosted market data feeds, and co-located applications and systems. Hosted feeds and co-location/ proximity services can be utilized for algorithmic and quantitative trading. This range of delivery options can help firms meet the performance demands of their trading constituents and advanced strategies. By leveraging the state-of-theart offerings of a third-party provider, a trading firm can optimize its market data infrastructure and be prepared to exploit new delivery options as they emerge. In summary, embracing market data as a service enables firms to fully focus on seeking out new trading opportunities. They can redouble their efforts to devise new trading strategies and test them across multiple global locations while avoiding the upfront technology costs and ongoing maintenance.

8 MARCH ELECTRONIC TRADING REPORT Potting The Path To Real Time TCA The focus on transaction cost analysis in equity trading is gathering pace as buyside firms and their institutional clients pay greater attention to trading costs and execution. Buysiders have been focused on developing TCA on a next-day basis, but some are now moving towards having TCA real time to further improve efficiency. Rob McGlinchey reports. Transaction cost analysis is a tool that provides the buyside with data outlining performance, costs and trading behavior. It is increasingly becoming a focus for buyside firms not only to better understand the costs incurred during the trade life cycle, but also as a way of measuring the efficiency of trade execution and the performance of brokers. It has previously been used by firms as a monitoring tool for compliance. In an environment where a few basis points may be the difference of whether a trade is successful or not, TCA can be used by firms to identify lower transaction costs that lead to higher portfolio returns. Buyside firms can then use the data from TCA to measure the performance of trades and their transaction costs, while also estimating future transaction costs. The reason we believe TCA is so important is because we have to measure ourselves to be accountable to our clients. Skilled traders can and do help create positive investment alpha they enhance outperformance within a portfolio, said Anton Aitken, a director and head trader for European equity trading at Franklin Templeton Investments. To show this we think it s critical to use utilize a relevant and well constructed benchmark. Transparency is clearly very important, because with it brings a high level of oversight into the execution process. So TCA assesses the quality of a trader s decision process through the life of a trade. It creates direct accountability within the execution process. In the past, TCA data has been provided on a longer term TCA Reporting Time Periods Preferred By Buy-Side Users Source: AITE Group TCA EVOLVING AT FIRMS According to a recent report from Aite Group, buyside firms see a greater need for TCA, particularly in algorithmic strategy and venue analysis. The report, which surveyed 20 buyside firms, highlights that although TCA is more prominent in equities, it is expanding into other asset classes and instruments such as fixed income and futures. Domestic equities (100%) and international equities (84%) made up the majority of asset classes and instruments where TCA was utilized, followed by fx (50%), exchange-traded futures (20%) and fixed income (20%). basis to asset managers, either monthly, quarterly or annually. According to officials, some asset managers still utilize TCA on this basis, while others are also focused on a next-day basis. With firms using TCA increasingly in the trading process, however, real-time TCA is increasingly being developed by buyside firms. Franklin Templeton Investments is one firm that is developing real-time TCA. The firm has been working with ITG, an independent vendor, to revise its TCA process and achieve real-time TCA. Real-time TCA would be more transparent and would allow a trader to adjust an execution strategy dynamically while giving the firm immediate feedback on the effectiveness of this change in strategy. TCA real-time is the next frontier for those that are willing to spend the time and effort getting there, said Aitken. It can carry with it a hefty cost, but we believe if you are looking to improve your trading process, then you must understand the level of execution risk you are taking during the day, how that will impact your performance and then measure yourself accordingly. The next stage might be introducing TCA on a +1 basis for some, but for us, the next level is definitely real time. Robeco Investment Management is another firm that is developing real-time TCA. The firm is one month away from implementing real-time TCA. We have been working 8 Institutional Investor Intelligence Reproduction requires publisher s prior permission. To receive alerts or online access to Derivatives Intelligence, call (800)

9 ELECTRONIC TRADING REPORT MARCH with a third party transaction services provider that has specified all hardware, software, and tick data requirements for our project. Additionally, they will handle all of the overnight processing outside of our infrastructure, said Mark Kuzminskas, director of equity trading at Robeco Investment Management. We have set up the environment in a way that a dashboard will reside on each trader s desktop enabling them to monitor and adjust the order flow parameters in real time. Challenges exist to establish real-time TCA, with one significant factor being cost. A firm will need to invest in its network to get the required trade data to flow back. A robust system must also be implemented to analyse and make sense of the data in order to display the information in an effective and a user-friendly format for the trader. Many buyside officials argue that the benefit, or as they call it, the Holy Grail of real time TCA outweighs the short-term cost implications. Since real time TCA develops a profile for each portfolio manager on every trading day in different market conditions, it allows a firm to understand how the portfolio manager would act and react in a specific market. What excites me about real time TCA is that we are able to KEY FACTS Regulatory developments in the U.S. and Europe have been a major driver in TCA being adopted by firms. In the U.S., firms are required to prove best execution, while in Europe, under the Markets in Financial Instruments Directive, a best execution policy was drawn up for broker dealers and asset managers. Proposals from the European Commission for an updated MiFID set out further requirements in the area of best execution. Under the proposals, trading venues will have to publish data on execution quality, while firms will have to release the names of their top five execution venues on an annual basis. link it with historical portfolio manager preferences in a way that, based on back tested results, will enable us to achieve more robust trading results for our clients, said Kuzminskas. Aitken added that establishing an audit trail will be the focus for many firms going forward. An audit trail would internally scrutinize which venues your orders are routed to once they leave your trading desk as well as the performance of those venues. Such venues would include the cash desks of investments banks, traditional sales traders, discretionary and nondiscretionary dark pools or other liquidity captured through the use of a broker s smart order router. We are going to control all elements of the routing process including destination, size, limit parameters, and timing. Moreover, all order and execution details will be captured in our audit trail and incorporated into our real time analysis, added Kuzminskas. One other area where TCA is being used more is to evaluate the performance of traders and to also provide data for the traders so that they can improve their future performance. The majority of respondents, 75%, said understanding transaction costs to improve trading opportunities in the future was the main reason for utilizing TCA. n Futures On The Rise U.S. futures usage is tipped to rise among hedge funds and mutual fund players. Market conditions and the regulatory drive to create open markets, such as with swaps, are key factors behind the prediction. Matt Simon, a senior analyst at TABB Group, outlines what is in store. As interest rates begin their ascent from zero, Dodd- Frank is implemented and market conditions improve, futures trading will become a more important portfolio tool for institutions. Many of the largest and most sophisticated investment managers, including top mutual fund companies and hedge funds, are expecting to either start trading futures or increase their futures trading levels. Likewise, U.S. futures exchanges announced record volumes in 2011 and TABB Group expects this momentum to carry forward into 2012 (see Exhibit 1). Of the 12 million futures contracts traded per day in 2011, nearly 50% were executed by buy side traders. From just a few years ago until today, the percentage of trading by the buy-side continues to increase. Rising volumes in the U.S. futures market is a clear indication of hedge fund speculators that are once again on the rebound, post-credit crisis. In addition, traditional Institutional Investor Intelligence Reproduction requires publisher s prior permission. To receive alerts or online access to Derivatives Intelligence, call (800)

10 MARCH ELECTRONIC TRADING REPORT investment managers facing increased competition from hedge funds and passive investment strategies are running more-complex portfolios. And pension funds are increasing their allocations to commodity trading advisors, as investing in futures has the potential to provide better alpha returns as well as capital preservation. EVOLVING PORTFOLIO DEMANDS Exhibit 1 U.S. Futures US Futures Trading Trading Volume Volume ( e) ( e) Millions of contracts traded on US exchanges Going forward, the regulatory push for centrally cleared and exchange-traded instruments will add to volumes, as will provisions within the Dodd-Frank Act that are transitioning OTC swaps trading to more transparent swap execution facilities (SEFs). As swaps trading becomes more automated, the ability of traders to use interest rate futures and other related instruments as part of overall strategies becomes attractive, especially for correlation and relative value strategies that look to profit from price changes in other asset classes. Another factor behind the increased adoption of futures is the need by portfolio managers to generate and retain alpha. With a rise in ETFs and beta-replicating strategies, there is significant pressure on asset managers to increase returns as investors choose between active and passive management. Futures provide leverage and exposure to asset classes and markets that historically have not been in the active management sweet spot. The ease and flexibility of using futures to access these markets provide an efficient way for firms to expand their strategies (see Exhibit 2). An additional incentive for the buyside is to better manage capital. Dodd-Frank opens up a world of opportunity for investment managers, especially for firms already trading OTC interest rate swaps. Interest rate futures will become both a complement and an enabler for strategies that have traditionally relied on OTC swaps for returns. Similarly, equity managers continue to struggle with putting cash inflows to work in today s fragmented equity markets, and futures are an effective way to achieve this objective. Futures are also gaining greater prominence among traditional asset managers as an effective hedging vehicle, and are becoming more important to managers looking to protect against unanticipated movements in asset prices. As CAGR 24% 1,043 1,324 1,653 2,044 volatility and market uncertainty become the new market norm, traders are gravitating toward a new crop of volatility products that can help manage -18% 2,850 2,645 2, e +10% 3,354 3,056 2,765 this market environment. And as investment portfolios become global, fluctuations in foreign exchange rates can be hedged with fx futures, rather than having to bear the risk of exposure to wildly fluctuating exchange rates. ELECTRONIC TRADING IMPACT Trading U.S. futures has traditionally required little execution expertise or special tools. Traders simply could pick up the phone to place an order with a notional value of millions of dollars and get executed instantaneously with minimal market impact. However, as trading increases, volatility fluctuates, and products evolve, the emphasis on having the right set of trading tools is becoming essential. Total Other/Metals FX Commodities Energy Equity Source: Futures Industry Association, TABB Group Today, buyside traders are exploring the potential benefits of electronic trading tools designed for the intricacies of the futures marketplace. The buyside will first look to existing brokers for these tools, but over time they will explore moresophisticated tools provided by brokers and vendors building out their electronic offerings. Leveraging their experience, trading firms running futuresspecific portfolios, including CTAs and hedge funds, will look to compete with more-diversified institutions by refining their execution strategies to include automated trading tools that make execution practices more efficient. One area seeing considerable uptake is algorithmic trading, with order flow executed through algorithms increasing from singledigit percentages to 10% of ADV expected by the end of Meanwhile, direct market access (DMA) trading will decline by a nearly equal amount (see Exhibit 3). FCM BUSINESS FACES SCRUTINY Facilitation of electronic trading will be a key gateway to a critical part of the futures business: clearing and settlement services. As transaction volumes grow, revenue earned from these services will see corresponding increases. With clearing revenues representing an even greater pool of revenue for futures commission merchants, the battle will be to attract 10 Institutional Investor Intelligence Reproduction requires publisher s prior permission. To receive alerts or online access to Derivatives Intelligence, call (800)

11 ELECTRONIC TRADING REPORT MARCH Long-Only Hedge Fund clients with higher trading volumes. However, the recent collapse of MF Global continues to resonate with the buy side, and they will continue to increase their focus on the solvency of their FCMs. This creates opportunities for FCMs able to sustain strong balance sheets and also for firms with the financial wherewithal to Exhibit 2 How do the following factors influence your futures How do the following factors influence tradng activities? your futures trading activities? CTA 4% 29% 55% 19% 90% 62% 8% 18% Cash Flows Risk Mgmt/Hedging Alpha Exposure to Asset Class 9% 6% support increasingly risk-averse clients. Even as trading volume continues to grow, needed investments resulting from new regulatory initiatives will raise the cost of doing business. Thus, the short-term outlook for FCMs is not all rosy. Specifically, FCMs are facing an evolving regulatory environment that places more onerous compliance burdens on their operations. Going forward, FCMs will not be able to increase revenues without a differentiated value proposition. Lower costs may initially help sway selections, but over time are not long-term differentiators. FCMs will need to bring a broad range of services to a relationship, including both execution and clearing services expertise. Fast and efficient execution capabilities are critical, but unless they are paired with trouble-free back office processing and clearing, the relationship will quickly dissolve. SEEKING LIQUIDITY IN THE U.S. AND GLOBALLY The domestic futures exchange landscape will expand as venues that either do not have futures trading decide to enter the marketplace, or for those that currently do have capabilities to trade futures, expand more of their functionality and product offerings. The dominance of the CME in both trading and clearing has resulted in a marketplace with concentrated liquidity and greater simplicity. However, there is room for competition. A number of U.S. exchanges have expanded their futures product offerings in recent years and although these exchanges have seen varied degrees of success they face challenges in growing their franchises. The biggest challenge they face is simple; they need to overcome the liquidity position of the CME in the U.S. futures market. Product innovation remains one of the key ways that exchanges can compete. In order to gain trader attention, especially as investment trends evolve, exchanges need to introduce products that capture the interest. Recently, the growth of sector-based futures, CBOE VIX futures, and Russell/MSCI index products illustrate how investor demand contributes to product adoption. International markets also figure prominently for U.S. investors in Half the traders we interviewed said they either planned to start trading internationally in 2012 or were considering doing so, with the focus clearly on emerging markets. Participants identified a wide range of markets they are interested in accessing, including those in Europe and Asia, as well as emerging markets like Brazil, Russia, India, and China. WHAT THIS ALL MEANS As buyside institutions become more involved with futures, rising demand will prompt more innovation, greater competition and ultimately a better environment for the brokerage industry. The combination of less restrictive investment mandates and a more sophisticated investor base provides the gateway to increased revenue for FCMs over time. However, both FCMs and buy side traders are not blind to marketplace developments. As interest rates begin their ascent from zero, Dodd-Frank is implemented, and market conditions improve, futures trading will become Exhibit 3 Buyside Side Order Order Flow Flow Allocation Allocation by by Channel, Channel, Algo; 4% DMA; 83% Phone; 7% FIX; 6% Source: TABB Group US Futures Trading 2012 a more important portfolio tool for institutions with greater emphasis on trading more efficiently. Meanwhile, as institutional volumes increase, traders will look to automate processes and self-directed trading will become the norm. FCMs with robust electronic offerings will see substantial opportunities, especially if they can find the right mix of services that appeal to the growing population of investment managers using futures in their investment strategies. Matt Simon is a New York-based senior analyst at TABB Group, a strategic advisory and research firm focused on capital markets. n Institutional Investor Intelligence Reproduction requires publisher s prior permission. To receive alerts or online access to Derivatives Intelligence, call (800)