Due diligence in an uncertain new market
It’s no surprise that MiFID II was the top concern highlighted by senior buy-side traders at the recent 5th annual ATF Global Summit in London on 2 February 2017.
Among other notable changes, MiFID II marks the final end of the road for the broker crossing network (BCN) – a service which has long been used by the buy side to minimise market impact. From 3 January 2018, all former BCNs will have to either reclassify as an MTF or an SI, or cease operations immediately. At the same time, the much-debated MiFID II volume caps for dark trading will be introduced, changing the way the buy-side interacts with dark liquidity in the EU forever.
In addition, national exchanges are seeking to regain the trust of long-only buy-side traders by championing a number of new block trading services, all of which essentially promise larger trade sizes than the traditional vanilla lit markets, which have seen order sizes consistently decline over the last decade.
Either way, there seems little doubt that a shift away from dark trading to the lit markets will not occur, regardless of the intentions of regulators. At a recent 14th ATF Equities debate in London, one senior buy-side trader commented an opinion on the relative appeal of different parts of the market: “The lit market will be one of the last places I would look for liquidity,” he said.
The role of TCA continues to be a delicate topic for the European buy side in 2017, as traders have stated that trading teams can be reluctant to trade a block if it is going to look worser in the TCA – despite the fact that doing a block might actually be in the best interests of the PM. This is a cause for frustration among heads of trading, yet with the increasingly onerous regulatory environment under MiFID II, there is more pressure than ever before on traders to evidence their trading decisions with data, not least including TCA. Whether this is ultimately in the interests of the end-investor remains to be seen.
Several other challenges stand out. Among these, the continuing shift towards passive trading strategies is one. Meanwhile, intra-day liquidity continues to thin out as participants increasingly concentrate on the market close. One senior buy-side trader based in London recently estimated that 90% of the day’s volume is to be found at the close.
As MiFID II is approaching, the buy side need to firm up their best execution policies and processes, their broker selection process and how to manage their dealing commissions. Establishing a more robust framework for pre-trade analysis is needed.
On the buy side, the key issues for fixed income as we go into 2017 include the difficulty of understanding and comparing incompatible data from different brokers in various different formats, as well as the estimated cost of implementing MiFID II in Europe. In addition, under the new rules, OTC sellers will be required to have an APA (Approved Publication Arrangement) in place so the majority of the buy side, who made their decision, are already planning to establish direct relationships with APAs to satisfy regulatory requirements.
One further question is how to define a liquid bond under MiFID II – an issue that was highlighted by the French buy side in the most recent ATF in Paris in November. Beyond this, the buy side are also working to understand how to report their top five trading venues in MiFID II under best execution requirements. Within best execution, TCA has come to be seen as increasingly important, but several questions remain unanswered, not least of which whether to use a third party for TCA analysis and how to obtain the relevant data. Speaking of data, there is also demand for more predictive analysis that would estimate the market impact for block trades.
As 2017 unfolds, K&KGC will host buy-side focused roundtable debates to discuss the future of fixed income in Frankfurt on 9 March and in London on 15 June. The key themes on the agenda include electronic bond liquidity initiatives, which are gaining volume, as well as the challenges around the optimal use, or choice, of the EMS/OMS. There will also be an opportunity to discuss best execution under MiFID II, OTC best execution policy documentation, and MiFID trade and transaction reporting obligations.
Countdown to collateralisation
One of the top concerns reflected by the buy side at the recent 5th annual ATF Global Summit on 2 February in London was that the industry has been caught off guard by the deadline of 1 March for collateralisation of NDFs and other non-spot FX instruments. At the same time, trading desks felt that there has been a lack of support from banks. Worst-case scenario, some firms are seriously worried that the CSAs under which they interact with their brokers do not allow for variation margin, effectively meaning that the trader cannot hedge their FX trades.
Even if such obstacles can be overcome, the approaching deadline will still be a challenge for many. Some traders have speculated that there could be a delay to implementation to allow the industry more time; however, at the time of going to press there was still no confirmation of this from the regulatory authorities. Furthermore, quite apart from the timeline, there is also concern that FX market volatility could spike in March as a large portion of the market concentrates around a handful of large brokers that are seen as safest during the transition. A related point is that there could be a liquidity squeeze at times of market volatility if the buy side hoards cash FX.
Relationships with brokers continue to be a primary concern for the foreign exchange trading desk in 2017; however, one of the top concerns now is the increasing “juniorisation” of sell-side sales traders. Several traders on the buy-side are worried that experienced sell-side sales traders have left the industry in recent years; these have been replaced by much more junior staff, who lack the experience to provide the same level of support to the buy side. This was consistently mentioned by several participants at the 5th ATF Global Summit in February 2017, and all participants were agreed on the issue.
On the technology side, automation is becoming increasingly significant for traders in foreign exchange.Buy-side traders are looking to simplify the trading process, with some trading desks choosing to automate everything below a threshold size, such as £100,000. Some firms are already automating one in three of their tickets, and that number is expected to rise in the near future.