Jonathan Seddon, Audencia Business School
For hundreds of years there were two players in the financial markets, the broker or low-frequency trader (LFT) working at the exchange and the investor. In 1964 an IBM computer introduced algorithmic trading on the New York Stock Exchange. This was to transform the way the markets would operate in the future.
Financial markets have always moved in cycles from boom to bust, bringing in changes in the way business is done. Perhaps the most significant changes have been witnessed following the 2008 financial crash. Prior to this the U.S. had spent two years rolling out Regulation National Market System (Reg. NMS), whilst in Europe Markets in Financial Instruments Directive (MiFID) had been legislated. The objective was to make the markets transparent by providing a structure to its fragmentation, ensuring the investor would view the market as fair and efficient. However this legislation opened the door for a third player – the high-frequency trader (HFT). The market was then not inherently efficient and the LFTs were able to benefit from price differences (spread) as they provided liquidity in the search of a fair price. Today, HFTs provide most of this liquidity, operating at a much tighter spread and reducing the profits of other providers.
High-frequency trading is a subset of algorithmic trading, and the new legislation opened the door for it to dominate certain sectors of the market, in particular the equity and foreign exchange. Now in competition with other venues, the traditional exchanges looked for ways that they could attract liquidity. Whilst the LFTs had originally provided this, in return for not being charged trading fees, privileged physical position on the trading floor and limiting the number of LFTs offering each stock, this model no longer worked. Instead, exchanges now offered fees to those who could provide (mostly) liquidity to earn fees, but without any contractual obligations. Special order types were developed whose existence or use were not publicised (in 2015 Direct Edge were fined $14m for this). The fragmented market structure meant that those companies who could capture different prices for the same security could profit from arbitrage. Since 2007, HFTs have been engaged in technical battles to reduce latency – for example plans to build 300m tall microwave towers have been submitted in attempt to reduce milliseconds from the time between London and Frankfurt. Exchanges have also seen opportunities to sell co-location to their matching engines and data feeds to those companies who want to capture information as quickly as possible.
High-frequency tranding represents a paradigm shift in the way our markets operate. Unlike other investors, HFTs are not concerned with the profit opportunities in holding a company share, but drive their strategy on volume. Using small order sizes they continuously buy then sell lot sizes of between 100 and 200 shares at fractional price differences.
Liquidity is a by-product of these strategies, which by the law of large numbers, allows them to make profits throughout the day. Using robots, they have removed any emotion out of their strategies, trading as soon as they can rather than waiting to see if a little more can be earned. Statistical control is used to help manage what is bought so that by the end of each day they can close without the risk of holding onto any stock. Artificial intelligence and advanced system development is used to help the mathematical models change into code. Economic trends are not driving decisions, but the analysis of vast data sets and historical patterns to help predict future events. This code is not static but is updated as market conditions change and opportunities are lost.
The traditional activity by fund managers looking to trade at timed intervals is used by HFTs in pattern recognition. HFTs scan billions of records searching for patterns or footprints, which offer statistical opportunity, a process that some have called front-running. Such comments are based on the fact that as HFTs provide liquidity and have no interest in holding any stock, their activity must therefore be questionable. Such comments are driven by fear over robotic behaviour and have little to do with how today’s markets operate. How can you front run a large-order when lot size is hundreds and order details are hidden (MiFID encourage the iceberg order type)? How can you buy up all of the other stock (taking liquidity and paying fees) and then get to the top of the order book on the other side, ahead of all of the other firms who are competing against you? It is far more complex than when broker-dealers were found guilty of such activities.
The financial market is now imposing record fines for nefarious activities. In January this year, the Financial Conduct Authority (FCA) fined Deutsche Bank £163m for money laundering. In January 2016 the US Securities and Exchange Commission (SEC) and New York Attorneys General’s office (NYAG) collectively fined Barclays Capital Inc. and Credit Suisse Securities (USA) LLC more than $150m for dark pool violations. There is clearly market abuse and fraud as individuals such as Navinder Sarao recently admitted to using computers to send false orders to the Chicago Mercantile Exchange (contributing the 2010 flash crash).
Our need for transparency and accountability will be improved when MiFID II takes effect in January 2018, as more trading occurs on a structured, orderly marketplace. Yet record fines only serve to weaken an investor’s confidence that the market is the best place for them to invest their money. This lack of or reduced faith is compounded by stories of how the market is rigged and is no longer fair for the average investor. Questions about the activities of HFTs have been raised ever since Reg. NMS and MiFID were legislated. Does the investor suffer? Is liquidity phantom? How does regulation control a robotic system? The efficient market hypothesis is clearly at odds with the ability of a HFT to walk in a known direction.
Research on HFTs is difficult because of the highly secretive nature of their operations as they compete with other HFTs for micro-price differences on market inefficiency. They are proprietary and have no need to attract external investors (in the way an investment company presents its portfolios). There is a clear conflict in the business models used by HFTs and LFTs. No longer able to provide liquidity on all markets at decimal prices, the LFT has seen its profits squeezed as the spread has tightened. The HFT, not having the same overhead structure as the LFT, is able to profit because of the high-frequency strategies used. Some argue that HFTs are parasitic because their actions do not add new information, instead they simply extract profit by unnecessary trading, whilst other argue that a reduced spread means that the long-term investor has a better deal when they buy or sell. Having no formal contract to supply liquidity has caused some to comment that HFTs only trade when they are able to profit and stop when informed trades are sent. Others have said that in the past, when markets turned, the brokers chose to have a long coffee break and not pick up the phone. Other research has shown high activity by HFTs when volatility spikes.
How we can ensure that are market are fair and transparent? All regulation should facilitate price discovery and the long-term investors must be able to execute in a liquid and efficient market. For those who present arguments that spreads have tightened, volatility has reduced and efficiency increased, there are others who can point to contradictory research. People cite phantom liquidity, shares which are available and then disappear when you try to trade, as clear evidence that HFTs are gaming the market. Yet other research 1 that has looked at cancellations on the S&P500 argued that the most common event following a cancellation is for another quote to replace it. There is no clear evidence on how the market actually works and more detailed research is needed if we are able to present any conclusive argument. What is clear is that the market contains three players: the investor, LFT and HFT. The conflict is between the LFT and the HFT, both looking to earn profits from their trading activities which are driven with the sole intention of creating liquidity for the long-term investor. High-speed trading is not without problems. However slowing the market down because it is unfair that some companies are just too quick is a backward step. The speed at which an investor is able to identify a stock, trade and settle is a reflection of the increased market efficiency. Those activities, which are illegal, need to be punished. Those activities, which strengthen the market, need to be monitored but encouraged. If HFTs cause problems for LFTs because they cannot compete, the question is whether the LFTs are now becoming redundant.
Barclays announces new trade finance platform for corporate clients
Barclays Corporate Banking has today announced that it is working with CGI to implement the CGI Trade360 platform. This new platform will provide an industry leading end-to-end global trade finance solution for Barclays clients in the UK and around the world.
With the CGI Trade360 platform, Barclays will provide clients with greater connectivity and visibility into their supply chains, allowing them to optimise working capital efficiency, funding and risk mitigation. By utilising cloud based functionality for corporate banking clients, Barclays will also be able to offer a leading client user experience through easy access and real-time integration to essential information, combined with the latest trade solutions as the industry-wide shift to digitisation continues to accelerate.
This move underpins Barclays commitment to supporting the trade and working capital needs of their clients and reinforces a commitment to innovation that has been central to the bank for more than 300 years.
James Binns, Global Head of Trade & Working Capital at Barclays, said: “We are delighted to announce our move to the CGI Trade360 platform and to have started the implementation process. We have a longstanding partnership with CGI, and the CGI Trade360 platform will mean we can continue delivering the best possible trade solutions and service to our clients for many years to come.”
Neil Sadler, Senior Vice President, UK Financial Services, at CGI, said: “Having worked closely with Barclays for the last 30 years, we knew we were in an excellent position to enhance their systems. Not only do we have a history with them and understand how they work, but part of the CGI Trade360 solution includes a proof of concept phase, which is essentially seven weeks of meetings and workshops with employees across the globe to guarantee the product’s efficiency and answer all queries. We’re delighted that Barclays chose to continue working with us and look forward to supporting them over the coming years.”
What’s the current deal with commodities trading?
By Sylvain Thieullent, CEO of Horizon Software
The London Metal Exchange (LME) trading ring has been the noisy home of metals traders buying and selling for over a hundred years. It’s the world’s oldest and largest metals market and is home to the last open outcry trading floor. Recently however, the age-old trading ring, though has been closed during the pandemic and, just a few weeks ago, the LME announced that it will remain so for another six months and that it is taking steps to improve its electronic trading. This news fits in with a growing narrative in commodities about a shift to electronic trading that has been bubbling away under the surface.
Something certainly is stirring in commodities. The crisis has affected different raw materials differently: a weakening dollar and rising inflation risks bode well for some commodities with precious metals being very attractive, as seen by gold reaching all-time highs. Oil on the other hand has had a tough year and experienced record lows from the Saudi-Russia pricing war. It has been a turbulent year, and now prices look set to soar. While a recent analyst report from Goldman Sachs predicts a bullish market in commodities for the year ahead, with the firm forecasting that it’s commodities index will surge 28%, led by energy (43%) and precious metals (18%).
Increasingly, therefore, it seems that 2020 is turning out to be a watershed moment for commodities, and it’s likely that the years ahead will bring about significant transformation. And whilst this evolution might have been forced in part by coronavirus, these changes have been building up for some time. Commodities are one of the last assets to embrace electronic trading; FX was the first to take the plunge in the 90s, and since then equities and bonds have integrated technology into their infrastructure, which has steadily become more advanced.
The slow uptake in commodities can be explained by several truths: the volumes are smaller and there is less liquidity, and the instruments are generally less exotic, essentially meaning it has not been essential for them to develop such technology – at least not until now. This means that, for the most part, the technology in commodities trading is a bit outdated. But that is changing. Commodities trading is on the cusp of taking steps towards the levels of sophistication in trading as we see in other asset classes, with automated and algo trading becoming ever prominent.
Yet, as commodities trading institutions are upgrading their systems, they will be beginning to discover the extent of the job at hand. It’s no easy task to upgrade how an entire trading community operates so there’s lots to be done across these massive organisations. It requires a massive technology overhaul, and exchanges and trading firms alike must be cautious in the way they proceed, carefully establishing a holistic, step-by-step implementation strategy, preferably with an agile, V-model approach.
The workflow needs to be upgraded at every stage to ensure a smooth end-to-end trading experience. So, in replacement of the infamous ring, these players will be looking to transform key elements of their trading infrastructure, including re-engineering of matching engines and improving communications with clearing houses.
However, these changes extend beyond technology. For commodities players to make a success of the transformation in their community, exchanges need to have highly skilled technology and change the very culture of trading. All of which is currently being done against a backdrop of lockdown, which makes things much more difficult and can slow down implementation.
What is clear is that coronavirus has definitely acted as a catalyst for a reformation in commodities. It is a foreshadowing of what lies ahead for commodities trading infrastructure because, a few years down the line, commodities trading could well be very different to how it is now, and the trading ring consigned to history.
Afreximbank’s African Commodity Index declines moderately in Q3-2020
African Export-Import Bank (Afreximbank) has released the Afreximbank African Commodity Index (AACI) for Q3-2020. The AACI is a trade-weighted index designed to track the price performance of 13 different commodities of interest to Africa and the Bank on a quarterly basis. In its Q3-2020 reading, the composite index fell marginally by 1% quarter-on-quarter (q/q), mainly on account of a pull-back in the energy sub-index. In comparison, the agricultural commodities sub-index rose to become the top performer in the quarter, outstripping gains in base and precious metals.
The recurrence of adverse commodity terms of trade shocks has been the bane of African economies, and in tracking the movements in commodity prices the AACI highlights areas requiring pre-emptive measures by the Bank, its key stakeholders and policymakers in its member countries, as well as global institutions interested in the African market, to effectively mitigate risks associated with commodity price volatility.
An overview of the AACI for Q3-2020 indicates that on a quarterly basis
- The energy sub-index fell by 8% due largely to a sharp drop in oil prices as Chinese demand waned and Saudi Arabia cut its pricing;
- The agricultural commodities sub-index rose 13% due in part to suboptimal weather conditions in major producing countries. But within that index
- Sugar prices gained on expectations of firm import demand from China and fears that Thailand’s crop could shrink in 2021 following a drought;
- Cocoa futures enjoyed a pre-election premium in Ghana and Côte d’Ivoire, despite the looming risk of bumper harvests in the 2020/21 season and the decline in the price of cocoa butter;
- Cotton rose to its highest level since February 2020 due to the threat of storm Sally on the US cotton harvest, coupled with poor field conditions in the US;
- Coffee rose 10% as La Nina weather conditions in Vietnam, the world’s largest producer of Robusta coffee, raised the possibility of a shortage in exports.
- Base metals sub-index rose 9% due to several factors including ongoing supply concerns for copper in Chile and Peru and strong demand in China, especially as the State Grid boosted spending to improve the power network;
- Precious metals sub-index, the best performer year-to-date, rose 7% in the quarter as the demand for haven bullion continued in the face of persistent economic challenges triggered by COVID-19 and heightening geopolitical tensions. In addition, Gold enjoyed record inflows into gold-backed exchange traded funds (ETFs) which offset major weaknesses in jewellery demand.
Regarding the outlook for commodity prices, the AACI highlights the generally conservative market sentiment with consensus forecasts predicting prices to stay within a tight range in the near term with the exception of Crude oil, Coffee, Crude Palm Oil, Cobalt and Sugar.
Dr Hippolyte Fofack, Chief Economist at Afreximbank, said:
“Commodity prices in Q3-2020 have largely been impacted by COVID-19. The pandemic has exposed global demand shifts that have seen the oil industry incur backlogs and agricultural commodity prices dwindle in the first half of the year. The outlook for 2021 is positive however conservative the markets still are. We hope to see an increase in global demand within Q1 and Q2 – 2021 buoyed by the relaxation of most COVID-19 disruptions and restrictions.’’
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