Anna Pajor, Principal Consultant/Director at GreySpark Partners explains why better transaction cost analysis is the first step in creating better algos for listed derivatives as well as OTC derivatives.
Q. How is the European Market Infrastructure Regulation (EMIR) and the Markets in Financial Instruments Directive (MiFID) II going to change the way buy and sell side trade derivatives from both a listed and OTC perspective?
A. Although the rules may differ slightly depending on the instrument, greater transparency is the main principle applicable to derivatives under both EMIR and MiFID II. This will not only further encourage electronification and standardisation but also increase the costs executing bespoke derivatives. There is also legislation beyond EMIR and MiFID II such as the Fundamental Review of the Trading Book (FRTB) that will also have an impact on trading. The consultation is still ongoing but again it looks like exchange traded derivatives (ETD) will be treated more favourable than OTC.
The result is that derivatives will continue to move onto electronic exchanges because they are easier to monitor in terms of reporting and record keeping. This is especially true for new participants into the market. They may need to implement new solutions for electronic trading but it will be offset by a reduction in the manual work required for reporting. However, there will be added complexity and cost if they want to trade OTC derivatives.
Q. What is the percentage being traded electronically today?
A. In regards to algo trading, electronic trading of ETD is between 95 to 97% globally. Breaking it down into regions, around three quarters of algo trading is done electronically in the US while it accounts for about a half in Europe.
Q. What type of algos are being developed for ETD and OTC? Participants have said you can’t leverage equity like solutions. Is this true and how do they differ?
A. There is not that much development for OTC derivatives. They are much more complex and customised and do not lend themselves to automation. Markets tend to go towards the easier options first which is why most of the focus and development has been in listed derivatives. In this asset class there have been three main drivers – auto hedging and risk management, liquidity sourcing and arbitrage – and that will determine what type of solutions can be applied. Overall, it is a different trading model than equities in terms of how they are traded and accessed. Broadly speaking, it is easier to apply equity like algos for those looking for auto hedging and liquidity sourcing because they can be linked with equity or FX infrastructure. However, arbitrage is much more complicated and similar instruments are traded on different venues. In this case, more bespoke and in-house proprietary algos are used.
Q. Who are the main providers of algos?
A. It is a mixture but for ETDs, they are typically vendors that provide dealing screens. There is not as much demand though as there are for equities but that is slowly changing. I think as the industry develops, the next step will be to add additional functionality as a way to differentiate themselves. Brokers are not that involved because of the nature of the trading of the instruments. For example, in equities, they typically use an order management system and there are opportunities for internalisation within banks. However, with listed derivatives, the majority of dealers pass the flow through.
Q. There has also been talk of the development of real time algos – what progress is being made?
A. With the increased electronic trading and regulation, there is a growing interest but the first step would be to develop intraday real time transaction cost analysis to monitor them. It is not as mature as on the equity side and more work needs to be done on the analytics side.
Q. In general, what are the challenges in developing TCA for derivatives?
A. There are a few challenges in that these instruments are not as fungible as equities. The first step for vendors would be to have a better understanding of the context as well as the underlying data and what they want to measure. Once this has been decided, they can move onto developing pre and intra-trade integration and monitoring. At the moment, vendors range in their solutions and maturity levels with some offering customised interactive dashboards while others provide a more basic service. However, the industry will become more sophisticated as adoption grows for these tools increases. At the moment, around a quarter of market participants use some form of TCA for listed derivatives and I expect this will gain momentum over time.
Q. Who would you identify as the main providers?
A. They are typically vendors who have provided solutions for the equity markets and have moved over to derivatives as well as FX, again to differentiate themselves. They include Bloomberg, Flextrade, Fidessa, SunGard (which was acquired by FIS Global earlier in the year), Ullink, Trading Screens and Inforeach.
Q. Looking ahead, what do you see as the greatest challenges as well as opportunities that participants can leverage?
A. Regulation and data are two of the biggest challenges not just in terms of execution but also in measuring and monitoring. There are also issues around costs and profitability. Listed derivatives are operating on low margins and so participants need to have a better understanding of the impact the new rules and initiatives have on the bottom line. However there are also opportunities around providing better tools for hedging and risk management.
