The head of trading at Comgest gives us a detailed insight into the unique challenges (and opportunities) in trading emerging markets.
How do you adapt your trading strategies when operating in emerging markets compared to more established markets?
I would break the differences down over six key categories:
- Liquidity and volatility: Emerging markets tend to be less liquid and more volatile than developed markets. There are very few, if any, MTFs (multilateral trading facilities) in emerging markets, which leads to a more traditional style of order execution. Some sell-side firms have put together block-specific desks in recent years to varying degrees of success.
- Transparency: Market information in emerging markets is certainly not as readily available as in developed markets. We must rely on local brokers to gain insight into market dynamics.
- Regulatory environment: Emerging markets have less developed regulatory frameworks, particularly in frontier markets, which poses risks to market integrity, investor confidence and financial stability.
- Political stability: In emerging markets political stability can be more tenuous. The current situation in Russia is a live example which led to a panic selling of Russian assets and some investors unable to exit positions altogether. We have also seen the US threaten to no longer list Chinese ADRs on their exchanges, which led to many transfers to local lines of securities.
- Currency risk: Currency risk management techniques are very important for emerging markets, in particular for non-deliverable forwards (NDF) trades. Exchange rate fluctuations typically lead to higher currency risk.
- Operational risk: There is an increased risk of settlement delays with less robust systems, and technological disruptions can occur. There can also be cultural differences which must be fully appreciated to trade effectively in these markets.
Could you discuss some of the more operational nuances associated with emerging markets trading?
Some emerging markets require specific foreign institutional investor identification codes such as for example FINI in Taiwan or IRC in Korea to be in place prior to trading. The use of an omnibus account is also common across multi fund structures for ease of trading. Pre-funding is required in markets such as Vietnam where the broker must be in a position to see settled local currency in a dedicated account prior to trading. These distinctions require a heightened interaction with the middle officers, traders and fund managers to ensure a smooth process.
Knowledge of markets specifics is also imperative to ensure effective fund management. A clear illustration of this could be a theoretical transition of Brazilian assets between investment vehicles which if representative of a significant portion of ADV can trigger an auction to which all market participants have access. This could result in potentially different prices for each leg of the transaction.
Despite emerging markets complexity, they have also proven to be quite progressive and nimble in their settlement cycles with China settling on a T+0 basis and India recently moving to T+1. This has led to a more active position management as custodians needed to adjust their operational processes to ensure successful settlement. Trades must be matched as quickly as possible, in some cases shortly after the market has closed. This leaves little room for prices/settlement date mismatches.
Could you touch on trading frontier markets when compared to traditional emerging markets?
Trading in emerging markets that are often referred to as the BRICS, (Brazil, Russia, China, India and South Africa) have more established financial infrastructures and regulatory frameworks. Frontier markets such as Vietnam, Kenya and Nigeria tend to have nascent financial systems and increased levels of risk. Liquidity tends to be higher in emerging markets due to larger market capitalisations and greater investor participation whereas frontier markets tend to have wider bid ask spreads, higher transaction costs (like premiums to foreigners, foreigner ownership limits on investments in certain companies) and increased price volatility.
Can you discuss the importance of building and maintaining relationships with local contacts and institutions when trading in emerging markets?
Relationships with local contacts are fundamental to successfully navigating the emerging markets space. They provide valuable insights into the regulatory and compliance landscape as well as up-to-date market information but may not be readily available to market participants. As with all business relationships it is imperative that the appropriate due diligence is carried out by a legal team prior to commencing a relationship. Due to the particularities of some markets, information must be shared in order to access these markets, such as prefunding, holdings visible in an account, and therefore establishing trust-based relationships can help mitigate counterparty risk.
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