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.

Shifting Focus of Hedge Funds: From West to East

Hedge funds in the US and UK have come under greater scrutiny from regulators in the aftermath of the financial crisis. New York currently accounts for about 45% of global hedge fund assets, while London accounts for about 15%. But recent proposals regarding hedge fund regulations have not only prompted fund managers to cancel or delay plans to set up new shops in London and New York, many are moving their offices to Asia, mainly to Hong Kong and Singapore. As a result more Asian hedge funds from Hong Kong and Singapore are gaining prominence and market share. The following can be attributed as drivers affecting this shift: • Stable economies, workforce, less stringent regulations favoring financial services, good financial infrastructure in Hong Kong and Singapore. • Tax incentives, licensing exemptions offered by Singapore and Hong Kong governments. • Extensive tax treaty network with other countries which reduces tax liability in treaty countries. • Easy access to Asia’s growing pool of investors whose risk appetite is also on the rise. • Market conditions and high economic growth potential (India and China) – managers who previously invested in Asia from offices in London or America now prefer to be located in the region within same time zone and with easier access to local information. • Investment firms have had to separate their prop desks from other activities – many ex prop traders are setting up their own shops in the region. As a result of these, assets managed by hedge funds in Hong Kong and Singapore has recovered fast post crisis. Though it hasn’t got back to pre crisis levels yet, these two countries have seen significant number of new hedge funds entering the market in the last 12 months. While the two countries look similar in many aspects with respect to the hedge fund industry, there are subtle differences. While Singapore’s policy framework is more relaxed, Hong Kong has stringent regulatory set up. Hong Kong is closer to mainland China and has better access to Chinese markets and investors. This factor coupled with the fact that Hong Kong had a year’s head start over Singapore regarding hedge fund entry has made Hong Kong the biggest centre for hedge funds in Asia – but Singapore is catching up fast. In both countries the industry is concentrated by top few players; in Hong Kong top 20 funds account for 56% of industry AuM while for Singapore top 7 firms account for 20% of total AuM. Singapore attracts a larger proportion of smaller funds (0-50m) while Hong Kong draws a larger proportion of bigger funds (100-500m funds); this is helped by a regulation by Monetary Authority of Singapore (MAS) which proposed managers with less than $183 million and serving less than 30 investors need not be licensed. This competition between the two countries to attract hedge funds is likely to continue in the future and the industry is expected to register high growth in AuM in the next 12 to 18 months.

Alternative Valuation Methods: Gaining Importance

In the highly competitive environment of investment management business, fund managers have been adopting more risk and trading in increasingly complex products. These include many illiquid instruments, OTC derivatives, trade claims, credit swap derivatives and collateralized debt obligations, many of which are not traded heavily and are seldom reported. As a result price discovery of these products becomes problematic giving rise to extreme difficulties in complete portfolio valuations, even though some data are available from brokers, data vendors and others. Therefore valuation has become a key issue in operational risk management for fund houses. Moreover, of late, a number of hedge fund scandals have been uncovered; though this has mostly been observed in the West, it has attracted world wide attention from both investors as well regulators. Hedge funds usually did not necessarily have to adopt standard policy for valuation of portfolios. But the recent market turmoil owing to the financial crisis has given rise to low or negative returns and high volatility; consequently investors are demanding greater transparency and standardization of policies for valuation. Regulators have also woken up and paid particular attention to valuation of complex products. Using counterparty valuations used to be a common phenomenon among fund managers as it was free for them; however, with calls for greater transparency and standardization, independent pricing is gaining importance. A number of technology and market data vendors are providing this service. In addition to raw and real time market data, they also provide analytics services for pricing fixed income, derivatives and other complex securities. This is mostly observed in the west, but many of these players have global presence and therefore this practice is likely to pick up in Asia in the future. Asset managers, who themselves undertake valuation of complex products on an ongoing basis for their own operations, can also provide valuation advisory services to others; however, there are a number of issues with that approach. Asset managers mostly rely on counterparty valuation or develop their own valuation models in house for pricing securities. As a result, pricing of the same product may differ for different fund houses, even though all the methods used may be fair. As trading strategies and pricing algorithms are proprietary intellectual properties of the asset manager, sharing them as part of advisory services may be in conflict with their own investment interests. Positions taken by other investors based on a firm’s valuation recommendation may actually reduce alpha for the firm’s own clients giving rise to conflict of interest. Conflict of interest can arise internally at the firm level as well, as managers, who derive performance and advisory fee from investment returns, often play an active role in the valuation process.