With Regulators across the region on the march, investors clamouring for best practice, and new fintech firms bringing technology to attack inefficiency, Gaye Anable and Jake Tantleff of ITG’s RFQ-Hub urge that simple steps to automate now can help take the pain out of the inevitable future.
21st October, 2015 was ‘Back to the Future’ day. The film, made in 1989, painted a picture of what life would be like in 2015 with some surprisingly accurate predictions, as well as plenty of more amusing ones. It prompted an interesting bout of reflection on all that has – and hasn’t – changed in the last 30 years.
What would a trader from the 1980s make of our 2015? If they were an equities trader, they would likely be astonished at the very different world they now inhabit: an electronic world of automation, in which trades are routed through platforms where computers make complex, split-second decisions and human error is significantly reduced. A heavily scrutinised world characterised by efficiency, transparency and advanced risk management, where all information needs to be tracked and traceable.
An equity derivatives trader, however, would arrive in a world not all that different from the one they left. Sure, we have things like instant messaging and email now. But trading is often still done in a relatively informal fashion, across multiple disparate lines of communication, with many deals still struck via voice calls. Most of this is not tracked in detail, and what does get recorded is often not easily retrievable. ‘Electronification’ of the market has been slow, and partial. Inefficiency and lack of formal process are common.
There are good historical reasons for this lack of progress in the equity derivatives space. By its very nature, the instruments that comprise it are far more diverse and idiosyncratic – and therefore withstand standardisation far more – than those in the cash equity space. In many cases traders are dealing with unique products each time they trade. Historically, technology has struggled to cope with this complexity and diversity, which poses natural barriers to automation. In turn, this has made the asset class much harder to regulate.
This situation is particularly marked in Asia given its fragmented regulatory landscape, which makes consistent derivatives regulation a challenge. Despite this, change is on the way fast, and regulators across the region are on the march to shine a light on OTC products, particularly given the high proportion of Asian retail and high net worth individuals who invest in derivatives, compared to other regions.
While longer term global regulations are advocating a path through transaction reporting and mandatory clearing to an end goal of electronic trading, the immediate focus in Asia is on trade reporting. Japan has already legislated electronic trading, though at present only for interest rate derivatives. Australia’s ASIC Derivative Transaction reporting regulations will expand in December 2015 to include equity and commodity derivatives. Singapore’s MAS is also phasing in additional asset classes and has a consultation underway on mandatory clearing of OTC derivatives. Hong Kong’s SFC is currently awaiting ratification of pending legislation and has stated it will move aggressively to match global timelines and keep up with other authorities for derivatives reporting.
Regardless of the precise detail of the new regulatory landscape, the main contours are clear and inevitable. It will be an environment that mandates transparency and auditability. All trades will need to be recorded, and information concerning them easily retrievable. Reporting will be paramount. The new landscape won’t necessarily make a difference to your business model, or what you trade – but it will mean that everything you do has to be visible and recordable.
It’s not just about regulation of course – the regulators are themselves catching up with a changing world. Trading within most other asset classes is already much further down the path of automation, both in Asia and elsewhere. And the current wave of fintech disruption clearly signals that ad-hoc, manual trading processes are destined for the dustbin of history. Investors are also increasingly looking for signs of best practice as a signal of credibility and assurance: while performance will always be the most important factor in attracting capital, good operational practices are becoming more and more important to even be considered for managing investor money.
There are direct benefits for fund management and hedge fund firms themselves, too. Newer, automated systems are able to deliver significant efficiencies at every stage of the chain, from the trading itself through to analytics. The industry is ripe for a ‘Moneyball’ revolution when it comes to the latter. The 2011 film tells the story of the adoption of ‘sabremetrics’ within US baseball. Assembling teams used to be an instinctive, qualitative affair, based around the expert-yet-human judgment of scouts watching player candidates. The ‘sabremetrics’ approach – based on hard, quantitative data covering a player’s performance in every area of the game over an entire season – has since come to dominate, given its demonstrable superiority at producing results.
Similarly, when it comes to selecting brokers for any given OTC trade, many firms rely on historic relationships, fallible memory or favoured providers. Modern systems, by contrast, come with functionality that can easily show who in the market has typically provided you with the best quote for that product, or who may offer liquidity. It isn’t about removing the human element – far from it. Rather, it is about the humans involved being able to use modern technology to its full potential in the course of doing their job. And as with the Moneyball example, firms that switch their approach before it becomes the norm will have the opportunity to reap the biggest immediate benefits.
The combination of regulatory focus, investor interest, and new technologies has brought this to a head. Fund managers and hedge funds need the tools and capability to find liquidity as well as track and report all equity derivatives trading activity – which in practical terms means ensuring all such activity goes through a system that automates the process to some degree. This will form the backbone of any response to the new regulatory landscape, while also allowing the buy-side to demonstrate operational efficiency to investors, and use technology to get the best results from their traders and liquidity providers. Firms needing to upgrade would do well to move now, rather than waiting and being forced to react. After all, the final destination will be the same.
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