WHAT DOES IT MEAN TO MODERNIZE? (Part 1)

In Order to Modernize

Before proceeding any further, let’s pause to consider what core system modernization signifies to a brokerage firm. Celent surveys have found that to brokers modernization means agility in operations and reductions in IT costs.

This prompts the question of how to make modernization a reality. Celent focuses on two jumping off points or angles from which to approach this: One is trading lifecycle optimization (TLO), the second is improving risk management, that is to say, realizing of a dynamic risk-adjusted investment cycle.

Trading Lifecycle Optimization (TLO)

The digital advances in trading environments have spurred the proliferation of algorithmic trading and high-frequency trading (HFT), developments that have reduced the number of traders needed. At the same time, Asia has witnessed increasing fragmentation that is particular to the regional market, spurring the spread of smart order routing (SOR).

Social media and big data are increasingly being used as market data and exerting greater influence on the market at the same time that high touch sales by sell-side firms remains. In addition, increasing diversification is evident with significant variation in the degree of digitization across asset classes and markets, and in terms of liquidity and trade type (bulk, block order, small orders, etc.).

Against this backdrop, a new electronic “hybrid” trading that fuses traditional high-touch trading with HFT and algorithmic trading has emerged in modern capital markets and trading environments. This has extended technology application beyond traditional areas of focus such as trade execution management and portfolio management. Indeed, the role and importance of technology is only growing, particularly in these areas: linking pre-trade compliance in order management, post-trade compliance in the middle office, and the various financial intermediaries (account keepers, transfer agents, administrators, prime brokers) that work across the front, middle, and back offices.

Celent has advocated the concept of trading life cycle optimization (TLO)[1].

TLO has come under scrutiny due to market environment changes that traders face in addition to factors including disparate or unevenly distributed trading technologies as well as trading risks (time, location, asset class, trader).

Hybrid trading environments combining traditional high-touch trading with HFT or algorithmic electronic trading, could clearly serve to benefit from TLO. Spanning the trading process—before, during, and after trading—it is vital to integrate across administration, monitoring, and auditing metrics for governance, risk, and cost (GRC). This makes extremely important to harness market data, which can serve as criteria for TLO.

Trading Lifecycle Optimization (TLO):

Areas targeted for optimization by trading technology block (types of technology used) can be broken down into the following four: infrastructure, operation, trade execution, and allocation.

These technology blocks are very important such as when it comes to audit requirements, sponsor descriptions, trader performance reviews, and identifying automated and discrete ranges. At the same time, these are also seen as crucial functional requirements for the front, middle, and back office systems in next-generation trading.

Celent believes that trading technology modernization should mean for both the sell side and buy side a focus on amending disparity and gaps in this technology.

To be continued – Click to read more

 

Related releases:

Legacy Modernization in the Japanese Securities Industry, Part 1

Legacy Modernization in the Japanese Securities Industry, Part 2


 

Beyond HFT

Last week I attended the Tokyo Financial Information Summit, put on by Interactive Media. The event was interesting from a number of perspectives. This event focuses on the capital markets; attendees are usually domestic sell side and buy side firms and vendors, including global firms active in Japan. This year there was good representation from around Asia ex-Japan as well; possibly attracted by the new volatility in Japan’s stock market. The new activity in the market was set off by the government’s Abenomics policies aimed at reinvigorating the Japanese economy. But I suspect the fact that Japan’s stock market is traded on an increasingly low latency and fragmented market structure gives some extra juice to the engine. Speaking of high frequency trading, Celent’s presentation at the event pointed out that HFT volumes have fallen from their peak (at the time of the financial crisis) and that HFT revenues have fallen drastically from this peak. In response to this trend, as well as the severe cost pressures in the post-GFC period, cutting-edge firms seeking to maintain profitable trading operations are removing themselves from the low latency arms race. Instead, firms are seeking to maximize the potential of their existing low-latency infrastructures by investing in real-time analytics and other new capabilities to support smarter trading. HFT is not dead, but firms are moving beyond pure horsepower to more nuanced strategies. Interestingly, this theme was echoed by the buy and sell side participants in a panel at the event moderated by my colleague, Celent Senior Analyst Eiichiro Yanagawa. Even though HFT levels in Japan, at around 25 – 35% of trading, have probably not reached their peak, firms are already pulling out of the ultra-low latency arms race–or deciding not to enter it in the first place. The message was that for many firms it is not advisable to enter a race where they are already outgunned. Instead they should focus on smarter trading that may leverage the exchanges’ low latency environment, but rely on the specific capabilities and strategies of a firm and its traders. Looking at this discussion in a global context, it seems interesting and not a little ironic that just as regulators are preparing to strike against HFT, the industry has in some sense already started to move beyond it.

Accepting the need for Electronic Trading

In its recent history,the Asian market has been characterized by the adoption of technology in a much more compressed time-frame as compared to its counterparts in the western world. This has been true of the industrial as well as the services sector, where it is also holds true for electronic equity trading. Asia is well poised for a rise in the share of electronic trading in the next few years. Markets such as Japan, Australia, Singapore, Hong Kong and India are seeing a lot of investment happening that is related to Direct Market Access (DMA), Smart Order Routing (SOR) and High Frequency Trading (HFT). The associated infrastructure such as market data services, co-location and so on are also being paid attention to, as is the requirement for helpful regulation. However, in some markets, the regulators are not very confident about and supportive of the needs of greater electronic trading. This is partly because of the financial crisis and rising requirements for risk management, and also due to the flash crashes that have occurred in the NYSE and OSE markets. We expect the regulatory framework to become more flexible in most markets, but there is still an important element that needs to be addressed across the board in the Asia-Pacific. That is the role of smaller brokerages and the buy-side. Unlike larger brokerages, these are still reluctant to adopt electronic trading and to make the investments required to have the same. While attitudes and capabilities do not change overnight, I believe that market investors in Asia need to be made aware of some harsh realities. To start with, the way HFT and algorithmic trading evolved in the US and European markets, there was very little time for market participants to react to and adopt such trading. The change happened so quickly that a number of brokerages and buy-side firms were unable to cope and had to operate in a more constrained fashion or even shut down. The incentive that HFT provides for those trading larger volumes means that the smaller players are at a relative disadvantage. This increases even more if they are slow to react and do not adopt electronic trading. So it is not just the speed of trading that is important to succeed, it is also the speed of thought. Hence, smaller brokerages and buy-side firms in Asia should be more positive and not be afraid of investing in DMA, SOR or HFT. The gains from these might not be apparent immediately, but if the lessons from the western markets teach us anything, it is that the quick and nimble-footed firms were the most successful during the rise of electronic trading. With the trading infrastructure in Asia changing so rapidly, there is little reason to believe things are going to be different here.

Electronic and cross-border trading in Asia

I recently participated as a moderator in two panel discussions on the South East Asian markets in the SunGard City Day held in Singapore on 14th July, the topics being electronic trading and cross-border trading respectively. An important point that came out of the discussions was that Asia-Pacific cannot be seen as one market, unlike the European Union. It comprises of various national markets at different stages of development. Japan, Australia, Singapore and Hong Kong are the leading markets in the region. By comparison, markets such as Indonesia, Malaysia and China are lagging behind. The difference can be seen in terms of infrastructure, e.g., the differences in the latency of the exchanges, as well as the number of products that can be traded on them. In the leading markets, the circumstances are becoming more conducive to high-frequency trading and the operation of alternative trading systems, including dark pools. Co-location services are being provided by the exchanges and the regulators are reducing the barriers on off-exchange transactions, such as the limits on the size of transactions and the time limit within which a transaction has to be reported. A crucial factor in the adoption of greater electronic and algorithmic trading will be the willingness of the buy-side to develop the infrastructure for the same. An interesting example that was quoted in the event was that a buy-side trading desk took three months just to fine-tune the latency of their connectivity to the exchange. What this highlights is the fact that while many in the local sell-side and increasingly the buy-side are convinced of the need to have algorithmic trading, it will take time to put the necessary systems in place. Also, the local players are not sure about whether they can afford the level of investment (and the time taken) required to create the trading infrastructure. Hence, the barriers to adoption of technology are more practical than theoretical, unlike earlier. In fact, most of the panelists stressed that there has been a sea-change in the mindset of the domestic market participants in the last 2-3 years and they are much more open to having algorithmic trading and dark pools now. It is further expected that once ADR/GDRs can be traded in these exchanges, the level of algorithmic trading will go up, with the greater presence of exchange-traded funds also playing a similar role. However, the level of off-exchange trading in the next 3-4 years is expected to go up to 5% at the most, up from the current 1% but much below the 30% levels seen in Europe. Cross-border trading in the ASEAN region has picked up in the last few years. Regulation has also paved the way for this, e.g., in Malaysia, regulation has recently allowed up to 30% of the NAV of a firm to be used in trading assets abroad. Even before the recent ASEAN linkage between six countries was announced, cross-border trading was a prevalent phenomenon. The linkage is expected to increase the level of electronic trading and also make it cheaper and more efficient. The next step should be to develop the post-trading infrastructure and linkages between the central securities depositories.