China Dealer

FIXGlobal speaks with the buy-side in China about the prospects for China’s equity market, IPOs and how new technology and competition will improve domestic trading.
GDP and Trading Volumes
The property market might continue to cool down in 2012, but it is not reasonable to expect the Chinese economy to shrink significantly this year because the Chinese government will allocate resources to other sectors of the economy. Because of the Lunar New Year effect, it looks as though Chinese Consumer Price Index (CPI) is heading upwards. Based on adjusted CPI, the property asset bubble is a political issue rather than an economic one. The Chinese government has pledged to continue monitoring property prices, and its strong fiscal position gives them various options in terms of how they address this situation. Trading volumes are expected to be much the same as 2011 and inflation should be heading downwards.
Major Driver: IPOs or Economics?
There has been a rapid increase in the number of IPOs in China, but the regulators are questioning the quality of some of the IPO companies. Of those companies newly listed in 2011, valuation declined quite significantly. Investors used to think an IPO was like a lottery – buying new shares virtually guaranteed a profit. Many investors did not consider the actual valuation and quality of the company, and many are now realizing that not all investments are worth their list price.
The Chinese equity markets are in a transition stage; they are moving from being somewhat amateur to being much more economic and investor-driven. There were instances of listed companies in one industry that changed industries after the IPO (often moving into property development) and occasionally changing the name of the company, leaving investors uncertain about their strategy and focus.
Listed companies used to have considerable power, but the market is changing in a positive direction. However, we do not know how quickly the market will become transparent and trustworthy. The regulators, media and institutional investors are now more serious about issues of valuation, transparency, corporate governance, etc. The regulators should consider increasing Qualified Foreign Institutional Investor (QFII) and ways of improving the dissemination of information to investors in order to set a good example in the domestic market.
A primary focus of the Chinese Securities Regulatory Commission (CSRC) this year is insider trading. Addressing this matter will improve the quality of listed companies and give investors greater protection. The regulators are working on improving access to information for investors and institutional funds will benefit significantly from this transparency. Regulators are concerned with addressing both the difficulty of access to information and the quality of information about IPOs, and it is quite likely that they will be able to improve both aspects.
Applying New Technology
The biggest technology upgrade implemented in the past six months has been algorithmic trading. Most Chinese buyside use their brokers’ algos, but in China, domestic mutual funds are not allowed to route orders to brokers. So what many dealing desks have done is to install the brokers’ algo engine on their side, so for every algo they choose, they go through their server and send the order to the exchange. In this way, dealers achieve efficiency in their algo usage because they do not use any brokerage; as a dealer, they are almost like their own broker. Algo trading also provides the buy-side with more precise post-trade analysis; specifically, the ability to analyze how much alpha has been captured and the transaction costs involved.
The primary benchmark used by most Chinese buy-side traders is Implementation Shortfall (IS), which is used to generate information to help the fund manager improve their investment strategies. For example, it might provide data about the delay cost created by an investment decision made an hour after the market opens, showing the fund manager that if the decision had been made earlier they could have saved a certain amount on the investment.
It is important to remember that dealing is not a completely separate process; actually, dealers and traders are a part of the same investment process. There is a general belief in China that dealers provide little value to the process. At many mutual funds, the dealing room does not have a broker’s vote because they do not use brokers. However, with the right tools, the dealing desk can enhance the process and help fund managers by giving them quantifiable feedback.
Many dealers on domestic dealing desks do not really know how much value they provide because they do not have access to the statistics that demonstrate reduced transaction costs. Algos can offer insight into the quality of the trade and the overall investment. Improving the quality of information does not benefit all fund managers, but some absorb it quickly and may change their investment patterns as a result. They might use fewer price limits for their orders, for example and subsequently create orders much earlier than they used to.
Areas for Improvement
Many Chinese fund managers are momentum driven, but in a bear market, trying to catch stocks low and sell high is not easy. From an investment perspective, Portfolio Managers (PMs)should be focused on portfolio construction, rather than simply trading. Portfolio construction can reduce the overall volatility of the net asset value even more than price. The volume traded should then be reduced because many transactions are unusable.
Another area where improvement is necessary is the structure of trading itself. Program trading is still undeveloped because most trading desks at Chinese asset managers do not have the necessary technology, namely, algos. The vast majority of mutual funds use a local provider, Hundsun, whose platform is effective for compliance and risk. From a front office perspective however, they could improve significantly and more competition in this area would be welcome.
China is a huge country – the key to penetrating this market is to commit resources locally and not just provide a service from Hong Kong; this has not been done enough. For the mutual fund industry, in general, the distribution fee is a problem because most of the management fees are paid to distributors at the big banks. The distribution fee is very high, and after the lock up period, the money is withdrawn like a loan to set up the fund. So, smaller mutual fund companies may be fighting to survive in the next few years. Therefore, an increase in competition will assist the growth of the market.
Shuya Kekke of Goldman Sachs discusses the adoption of new technologies and best practices for reducing trading costs.

What technologies are making the most impact on the Chinese trader’s desk? Are they focused on connectivity, TCA, risk, alpha capture/measurement, etc?
For China onshore investors trading onshore products, connectivity and speed are the top priorities. China differs from other markets because of its trading rules: institutions are long only and bound by T+1 trading. Thus, the primary focus of institutional investors in China has been stock picking. However, focus on execution quality is emerging due to an increasing number of private investment trust funds and additional QFII quota. We have seen demand increasing for algorithm trading of both single stock and basket orders.
From a QDII perspective, depending on the experience, sophistication and trading discretion of the trader, requirements vary from vanilla VWAP and POV algos to specialized utility algos, although VWAP is still the main benchmark. Liquidity is also important given the volatility in the markets, so any products that can seek liquidity while minimizing impact are critical.
In terms of TCA, some QDII clients are developing this in-house and have regular TCA reviews with brokers who can provide more sophisticated analysis, including short-term pricing dynamics. Ability to access pre-trade analysis independently and anonymously are also critical as they expand their fund strategies.
From an EMS perspective, most trading desks rely on third-party vendors such as Bloomberg, Hundsun and REDIPlus, but the demand for a slick user interface for quick trading and sophisticated portfolio trading functions has yet to feature. As clients begin to demand better execution quality, the pressure will be on traders to make use of any advances in technology that can give them the edge.
Finally, we are also beginning to see interest in high frequency trading (HFT), with a focus on latency and co-location.
What are the biggest costs of trading in China and what can be done to reduce these?
How can fund managers improve their performance from the trading desk? As total market turnover declines, the market impact cost is getting more and more expensive; many securities have experienced liquidity issues since 2010, partly due to the increase in the number of listed products.
Fund managers may need to extend the order execution period and get used to benchmark orders rather than ‘would if could’ orders, which have been quite popular in China for a long time.
Another way to improve the performance of the trading desk would be to focus on sector portfolio management.