By Eddie Thorn, Director of Capital Markets, SQS
A change in the legislation landscape
With recent changes to the Markets in Financial Instruments Directive (MiFID II), tighter regulations are on the horizon. All firms using any form of trading algorithm need to invest in a new way of testing their algorithms or face ceasing trading as MiFID II places stringent algorithm testing requirements on both buy and sell side investment firms. Ultimately, it’s the senior management who will carry explicit responsibility for compliance. Although there is time for change – it needs to happen now for the compliance deadline to be met.
The change has been born out of the regulator becoming increasingly fearful that trading has the potential to cause rapid and significant market distortion. Additionally, hefty financial penalties could be enforced from July 2016 under the Market Abuse Regulation (MAR). This could be up to €5 million on individuals and €15 million, or 15 per cent of turnover, on firms where algorithms cause market disorder or commit market manipulation. Senior managers could even be facing criminal sanctions of up to four-year imprisonment under CSMAD (or its UK equivalent). Whilst MAR does not mandate non-live testing of algorithms, many of the abusive behaviours described in MAR can be detected by implementation of new testing methodologies which will prevent a trading firm falling foul of MAR and its onerous penalties.
A Knight’s tale
The Knight Capital meltdown in 2012 is a sobering example of the ramifications of an out-of-control algorithm. It was widely reported at the time that Knight Capital deployed an insufficiently tested algorithm to the production environment with an obsolete function. When released into production, defective code within the algorithm caused a major disruption in the prices of some 148 companies listed at the New York Stock Exchange. This resulted in four million executions in 154 stocks for more than 397 million shares in approximately 45 minutes. This proved to be a costly 45 minutes for Knight Capital, with an estimated pre-tax loss of some $440 million which led to its ultimate collapse, caused as a result of the single faulty algorithm.
Faulty algorithms are also behind some of the most recent flash crashes. As recent as October 2014, there was one such example in the US Treasury Markets. On the day in question, there was a rapid surge in bond prices across cash and futures markets followed by a similarly rapid retracement in a twelve-minute window lasting from 9:33 to 9:45 ET. Although the size of the move was not unprecedented, it was highly disproportionate to changes in exogenous information. Whilst not implicitly called out, it is widely thought that such unusual movements were due to a faulty algorithm that could have been discovered if more rigorous testing was in place.
This was just a few years after probably the most famous flash crash of all, where in May 2010 stock market trader Navinder Singh Sarao was deemed “significantly responsible” for a flash crash of the US equity and index futures indices. The crash was thought to be caused in part by his sophisticated ‘spoofing’ algorithm.
These may be extremes of the events that MiFID II regulation is seeking to stop being replicated on European exchanges, but lesser events occur with unnerving regularity. It is worth noting that it is not necessarily a major market crash that is the only concern, as much as the need for markets to operate fairly and orderly on a day-to-day basis.
Under MiFID II, investment firms will now be required to test and ensure the stability of their algorithms under stressed market conditions to prevent such disorderly markets and flash crashes as outlined above. Yet, investment firms and exchanges have found it difficult to correctly replicate these real markets in a non-live environment, where the algorithm being tested interacts realistically with other relevant market players.
Requirement for a new test methodology
Trading venues will require members to “certify that the algorithms they deploy have been tested to avoid creating or contributing to disorderly trading conditions” (RTS 7, Article 10, 1). Such tests and certification must be made both prior to initial deployment of algorithms and on any “substantial” update. Additionally, as part of an annual assessment, the investment firms must retest their algorithms to “ensure that they are capable of withstanding increased order flows or market stresses” (RTS 6, Article 10).
The purpose of testing for disorderly trading conditions is to “recreate real market conditions to ensure the well-functioning of algorithms under changing circumstances” (3.2.33) and must include tests that show that the algorithm “can continue to work effectively in stressed market conditions” (3.1.16).
Notably, the “responsible party designated by senior management of the investment firm shall sign off the initial deployment or substantial update” (RTS 6, Article 5, 2). The member must also “explain the means used for that testing” (RTS 7, Article 10, 1). It’s time for senior management and compliance officers at all investment firms to stand up and take notice before they become accountable and penalised for non-compliance. This can be solved in advance by partnering with trusted independent providers such as SQS.
To achieve such rigorous testing requirements requires both a new technology and a new way of testing. Failure to do so will prevent firms being able to continue trading post January 2018.
Cryptocurrencies: the new gold?
By Gerald Moser, Chief Market Strategist, Barclays Private Bank
Time to add to a portfolio?
There has been a lot of talk about bitcoin, and cryptocurrencies in general, being a “digital” gold. Similar to gold, there is a finite amount, it is not backed by any sovereign and no single-entity controls its production. But for bitcoin to be considered in a portfolio and to become an investable asset, similar to gold, the asset would need to improve the risk/return profile of that portfolio. This seems a tall order.
While it is nigh on impossible to forecast an expected return for bitcoin, its volatility makes the asset almost “uninvestable” from a portfolio perspective. With spikes in volatility that are multiples of that typically experienced by risk assets such as equities or oil, many would probably throw the cryptocurrency out of any portfolio in a typical mean-variance optimisation.
And while bitcoin’s correlation measures are relatively supportive, it seems to falter when diversification is most needed, such as during sharp downturns in financial markets. Looking at weekly return correlations since 2016 shows that bitcoin is not strongly correlated with any assets (see below). It is however only second to US high yield in its correlation with equities. US Treasuries, gold and US investment grade were better diversifiers than bitcoin when it comes to equities.
Furthermore, looking at global equity corrections since 2015 (see below), it is noticeable that bitcoin has performed even worse than equities over the last three corrections. And while gold and fixed income provided some relief during those corrections, bitcoin compounded the loss that investors would have incurred from equities exposure.
The fact that cryptocurrencies also fluctuate alongside equities suggests that investment in bitcoin is more akin to a bubble phenomenon rather than a rational, long-term investment decision. The performance of the cryptocurrency has been mostly driven by retail investors joining a seemingly unsustainable rally rather than institutional money investing on a long-term basis.
Several studies around market structure have shown that emerging markets with high retail/low institutional participation are more unstable and more likely subject to financial bubbles than mature markets with institutional participation. And while more leading financial houses seem to be taking an interest in cryptocurrencies, the market’s behaviour suggests that the level of institutional involvement is still limited. Another issue is around its concentration: about 2% of bitcoin accounts control 95% of all bitcoins.
In summary, difficulty to forecast return, lack of diversification and high volatility makes it hard to consider bitcoin as a standalone asset in a diversified portfolio for long-term investors.
An inflation hedge?
Another point widely quoted in favour of cryptocurrencies is that they provide an inflation hedge. This might be a valid point, if inflation stems from fiat currency debasement. As mentioned above, a currency’s worth comes from the trust economic agents have in it. If unsustainable amounts of debt and large money creation shatter belief in sovereign-backed currencies through spiralling inflation, cryptocurrencies could be seen as an alternative.
Regardless of its price, bitcoin’s production is set on a precise schedule and cannot be changed. If oil or copper prices go up, there is an incentive to produce more. This is not the case for cryptocurrencies. In a very specific and highly hypothetical scenario of all fiat currency collapsing, this could be positive. But other real assets such as precious metals, inflation-linked bonds or real estate usually provide a hedge against inflation.
Bitcoin’s technology should theoretically make it extremely secure. As there is no intermediary, each transaction is reviewed by a large number of participants which can all certify the transaction. However, there have been frauds and thefts from exchanges. Another point to consider is the risk of “losing” bitcoins. According to the cryptocurrency data firm Chainanalysis, around 20% of the existing 18.5m bitcoins are lost or stranded in wallets, with no mean of being recovered. As there is no intermediary, there is no backup for a lost bitcoin.
From a sustainability point of view, adding cryptocurrencies to a portfolio will make it less green. Mining and exchanging them is highly energy intensive. According to estimates published by Alex de Vries, data scientist at the Dutch Central Bank, the bitcoin mining network possibly consumed as much in 2018 as the electricity consumed by a country like Switzerland. This translates to an average carbon footprint per transaction in the range of 230-360kg of CO2. In comparison, the average carbon footprint of a VISA transaction is 0.4g of CO2.
Beyond energy use, the mining process generates a large amount of electronic waste (e-waste). As mining requires a growing amount of computational power, the study estimates that mining equipment becomes obsolete every 18 months. The study suggests that the bitcoin industry generates an annual amount of e-waste similar to a country like Luxembourg.
Cryptocurrencies are here to stay
Innovation in digital assets continues rapidly and will likely drive increased participation, both from retail and institutional investors. The underlying blockchain technology behind bitcoin was meant to disrupt a few different industries. While results have not lived up to the initial hype, more sectors are investigating the use of the technology.
And with Facebook announcing a stablecoin, or a cryptocurrency pegged to a basket of different fiat currencies, central banks have accelerated the movement towards central bank digital currencies. Those could improve payment systems resilience and facilitate cross-border payments.
Energy stocks drag down FTSE 100, IG Group slides
By Shivani Kumaresan
(Reuters) – London’s FTSE 100 slipped on Thursday, weighed down by falls in energy stocks as oil prices slid after a surprise increase in U.S. crude inventories, while IG Group tumbled on plans to buy U.S. trading platform tastytrade for $1 billion.
The blue-chip FTSE 100 index lost 0.4%, while the domestically focussed mid-cap FTSE 250 index also slid 0.4%.
Energy majors BP and Royal Dutch Shell fell 3.2% and 2.5%, respectively, and were the biggest drags on the FTSE-100 index. [O/R]
“What is holding back the UK is a lack of tech stocks to capture the ‘rotation’ back into tech seen since Netflix results,” said Chris Beauchamp, chief market analyst at IG.
“Stock markets overall are much quieter today, looking so far in vain for a new catalyst for further upside.”
The FTSE 100 shed 14.3% in value last year, its worst performance since a 31% plunge in 2008 and underperforming its European peers by a wide margin, as pandemic-driven lockdowns battered the economy and led to mass layoffs.
British Prime Minister Boris Johnson said it was too early to say when the national coronavirus lockdown in England would end, as daily deaths from COVID-19 reach new highs and hospitals become increasingly stretched.
IG Group tumbled 8.5% after announcing plans to buy tastytrade, venturing into North America after a stellar year for the new breed of retail investment brokerages.
Ibstock jumped 7.3% to the top of the FTSE 250 after the company said fourth-quarter activity benefited from better-than-expected demand for new houses and repairs.
Pets at Home Group Plc rose 2.2% after reporting an 18% jump in third-quarter revenue, boosted by higher demand for its accessories and veterinary services as more people adopted pets during lockdowns.
(Reporting by Shivani Kumaresan in Bengaluru; editing by Uttaresh.V and Mark Potter)
Wall Street bounce, upbeat earnings lift European stocks
By Amal S and Sruthi Shankar
(Reuters) – European stocks rose on Wednesday after Dutch chip equipment maker ASML and Swiss luxury group Richemont gave encouraging earnings updates, while investors hoped for a large U.S. stimulus plan as Joe Biden was sworn in as president.
The pan-European STOXX 600 index closed 0.7% higher, getting an extra boost as Wall Street marked record highs.
All eyes were on Biden’s inauguration as the 46th U.S. President, with traders betting on a bigger pandemic relief plan and higher infrastructure spending under the new administration to boost the pandemic-stricken economy.
Tech stocks rallied to a two-decade peak in Europe after ASML Holding NV rose 3.0% to all-time highs on better-than-expected quarterly sales and a strong order intake for 2021.
Meanwhile, Richemont rose 2.8%, after posting a 5% increase in quarterly sales as Chinese splashed out on Cartier, its flagship jewellery brand.
Britain’s Burberry jumped 3.9% after it stuck to its full-year goals, saying higher full-price sales would boost annual margins, while Asian demand remained strong.
The pair boosted European luxury goods makers that are heavily reliant on China, with LVMH and Kering gaining between 1% and 3%.
“Any sign that retail spending is picking up in China is going to be a boost to the Western markets and those heavily exposed to it,” said Connor Campbell, financial analyst at SpreadEx.
The European Central Bank is set to meet on Thursday. While no policy changes are expected, the bank could face more questions about an increasingly challenging outlook only a month after it unleashed fresh stimulus to bolster the euro zone economy.
“With the new round of easing measures fully in place and no new forecasts to be presented tomorrow, it should be a fairly uneventful day for the euro,” ING analysts said in a note.
Italy’s FTSE MIB gained 0.9% and lenders rose 1.6% after Prime Minister Giuseppe Conte won a confidence vote in the upper house Senate and averted a government collapse.
Conte narrowly secured the vote on Tuesday, allowing him to remain in office after a junior partner quit his coalition last week in the midst of the COVID-19 pandemic.
Daimler AG jumped 4.2% after its Mercedes-Benz brand unveiled a new electric compact SUV, the EQA, as part of plans to take on rival Tesla Inc.
Germany’s Hugo Boss added 4.4% after Mike Ashley-led Frasers said it boosted its stake in the company.
(Reporting by Sruthi Shankar and Amal S in Bengaluru; Editing by Shailesh Kuber and Arun Koyyur and Kirsten Donovan)
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