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.
Economic recovery likely to prove a ‘stuttering’ affair
By Rupert Thompson, Chief Investment Officer at Kingswood
Equity markets continued their upward trend last week, with global equities gaining 1.2% in local currency terms. Beneath the surface, however, the recovery has been a choppy affair of late. China and the technology sector, the big outperformers year-to-date, retreated last week whereas the UK and Europe, the laggards so far this year, led the gains.
As for US equities, they have re-tested, but so far failed to break above, their post-Covid high in early June and their end-2019 level. The recent choppiness of markets is not that surprising given they are being buffeted by a whole series of conflicting forces.
Developments regarding Covid-19 as ever remain absolutely critical and it is a mixture of bad and good news at the moment. There have been reports of encouraging early trial results for a new treatment and potential vaccine but infection rates continue to climb in the US. Reopening has now been halted or reversed in states accounting for 80% of the population.
We are a long way away from a complete lockdown being re-imposed and these moves are not expected to throw the economy back into reverse. But they do emphasise that the economic recovery, not only in the US but also elsewhere, is likely to prove a ‘stuttering’ affair.
Indeed, the May GDP numbers in the UK undid some of the optimism which had been building recently. Rather than bouncing 5% m/m in May as had been expected, GDP rose a more meagre 1.8% and remains a massive 24.5% below its pre-Covid level in February.
Even in China, where the recovery is now well underway, there is room for some caution. GDP rose a larger than expected 11.5% q/q in the second quarter and regained all of its decline the previous quarter. However, the bounce back is being led by manufacturing and public sector investment, and the recovery in retail sales is proving much more hesitant.
China is not just a focus of attention at the moment because its economy is leading the global upturn but because of the increasing tensions with Hong Kong, the US and UK. UK telecoms companies have now been banned from using Huawei’s 5G equipment in the future and the US is talking of imposing restrictions on Tik Tok, the Chinese social media platform. While this escalation is not as yet a major problem, it is a potential source of market volatility and another, albeit as yet relatively small, unwelcome drag on the global economy.
Government support will be critical over coming months and longer if the global recovery is to be sustained. This week will be crucial in this respect for Europe and the US. The EU, at the time of writing, is still engaged in a marathon four-day summit, trying to reach an agreement on an economic recovery fund. As is almost always the case, a messy compromise will probably end up being hammered out.
An agreement will be positive but the difficulty in reaching it does highlight the underlying tensions in the EU which have far from gone away with the departure of the UK. Meanwhile in the US, the Democrats and Republicans will this week be engaged in their own battle over extending the government support schemes which would otherwise come to an end this month.
Most of these tensions and uncertainties are not going away any time soon. Markets face a choppy period over the summer and autumn with equities remaining at risk of a correction.
European trading firms begin coming to terms with the new normal
By Terry Ewin, Vice President EMEA, IPC
In recent weeks, the phrase ‘never let a good crisis go to waste’ has received a large amount of usage. Management consultancies, industry associations and organisations, including the Organisation for Economic Co-operation and Development (OECD) have all used it in order to discuss how the current crisis, caused by the Coronavirus pandemic, presents an opportunity for new and worthwhile change.
The saying is also commonly used to indicate that the destruction and damage that is caused by a crisis gives organisations the chance to rebuild, and to do things that would not have previously been possible. This has the potential to impact financial trading firms, where projects that this time last year would not have made much sense now appearing to be as clear as day. In Europe, banks and brokers alike are beginning to think about what life will look like post-pandemic, and how their technology strategies may need changing.
We can think of three distinct phases when it comes to a crisis. Firstly, there is the emergency phase. This is followed by the transition period before we come to the post-crisis period.
Starting with the emergency phases, this is when firms are in critical crisis management mode. Plans are activated to ensure business continuity, and banks and brokers work to ensure critical functions can still take place so as to continue servicing their clients. With regards to the current crisis period, both large and small European banks and brokers were able to handle this phase relatively well, partly due to the fact that communications technology has reached the point where productive Work From Home (WFH) strategies are in place. For example, cloud-connectivity, in addition to the use of soft turrets for trading, has enabled traders from across the continent to keep working throughout lockdown. From our work with clients, we know that they were able to make a relatively smooth transition to WFH operations.
In relation to the current coronavirus crisis, we are in the second phase – the transition period. This is the stage when financial companies begin figuring out how best to manage the worst effects of the ongoing crisis, whilst planning longer-term changes for a post-crisis world. One thing to note with this phase, is that no one knows how long it will last. There is still so much we don’t know about this virus. As such, this has an impact on when it will be safe for businesses to operate in a similar way to how they were run in a pre-pandemic world. But with restrictions across Europe starting to be eased, there is an expectation that companies will start to slowly work their way towards more on-site trading. For example, banks are starting to look at hybrid operations, whereby traders come in a couple of times a week, and WFH for the rest of the week. This will result in fewer people in the office building, which makes it easier to practise social distancing. It also means that there is a continued reliance on the technology that enables people to WFH effectively.
Finally, we have the post-crisis period. In terms of the current crisis, this stage is very unlikely to occur until a vaccine has been developed and distributed to the masses. Although COVID-19 has caused mass economic disruption, many analysts are predicting a strong rebound once the medical pieces of the puzzles are put into place. It may not be entirely V-shaped, but the resiliency displayed by the financial markets thus far suggests that it will be healthy.
Currently, many European trading firms are taking what could be described as a two-pronged approach.
The first part of this consists of planning for the possibility of an extension to phase two. Medical experts have suggested that there could be some seasonality to the virus, with the threat of a second wave of COVID-19 cases in the Autumn meaning that the risk of new restrictions remains. If this comes to fruition, there would be a need for organisations to fine-tune their current WFH strategies and measures, and for them to take greater advantage of the cloud so as to power communications apps.
The second component consists of firms starting to think about the long-term needs of their trading systems. Simply put, they are preparing themselves for the third phase.
It is in this last sense, that the idea of never letting ‘a good crisis go to waste’ resonates most clearly.
Currency movements and more: How Covid-19 has affected the financial markets
The COVID-19 pandemic has been more than a health crisis. With people forced to stay indoors and all but the most essential services stopped for multiple weeks, economies have suffered and financial markets have crashed. Perhaps the most public and spectacular fall from grace during the early stages of the pandemic was oil. With travel bans in place around the world and no one filling up at the pumps, the price of oil plummeted.
Prior to global lockdowns, US oil prices were trading at $18 per barrel. By mid-April, the value had dropped to -$38. The crash was not only a shocking demonstrating of COVID-19’s impact but the first time crude oil’s price had fallen below zero. A rebound was inevitable, and many traders were quick to take long positions, which meant futures prices remained high. However, with stocks piling up and demand sinking, trading prices suffered. Unsurprisingly, it’s not the only market that’s taken a knock since COVID-19 struck.
Financial Markets Fluctuate During Pandemic
Shares in major companies have dipped. The Institute for Fiscal Studies compiled a round-up of price movements for industries listed by the London Stock Exchange. Tourism and Leisure have seen share prices drop by more than 20%. Major airlines, including BA, EasyJet and Ryanair have all been forced to make redundancies in the wake of falling share prices. The automotive industry has also taken a knock, as have retailers, mining and the media. However, in among the dark, there have been some patches of light.
The forex market has been a mixed bag. As it always is, the US dollar has remained a strong investment option. With emerging markets feeling the strain, traders have poured their money into traditionally strong currency pairs like EUR/USD. Looking at the data, IG’s EUR/USD price charts show a sharp drop in mid-March from 1.14 to 1.07. However, after the initial shock of COVID-19 lockdowns, the currency pair has steadily increased in value back up to 1.12 (June 25, 2020). The dominance of the dollar has been seen as a cause for concern among some financial experts. In essence, the crisis has highlighted the world’s reliance on it.
Currency Movements Divide Economies
In any walk of life, a single point of authority is dangerous. Indeed, if reliance turns into overreliance, it can cause a supply issue (not enough dollars to go around. More significantly, it could cause a power shift that gives the US too much control over economic policies in other countries. Fortunately, other currencies have performed well during the pandemic. Alongside USD and EUR, the GBP has also shown a degree of strength throughout the crisis. However, these positive movements haven’t been shared by all currencies.
The South African rand took a 32% hit during the early stages of the pandemic, while the Mexican peso and Brazilian real dropped 24% and 23%, respectively. Like the forex market, other sectors have experienced contrasting fortunes. Yes, shares in airlines and automotive manufacturers have fallen, but food and drug retailers have seen stocks rise. In fact, at one point, orange juice was the top performer across multiple indices. With the health benefits of vitamin C a hot topic, futures prices for orange juice jump up by 30%. The sudden surge had analysts predicting 60% gains as we move into a post-COVID-19 world.
Looking Towards the Future through Financial Markets
The future is always unknown and, due to COVID-19, it’s more uncertain than ever. However, the financial markets do provide an indication of how things may change. The performance of USD and EUR in the forex markets suggest there could be a lot more trade deals negotiated between the US and Europe. The surge in orange juice futures suggest that health and wellness will become a much more important part of our lives. Even though it was already a multi-billion-dollar industry, the realisation that a virus can alter the face of humanity has given more people pause for thought.
Then, of course, there’s the move towards remote working and socially distance entertainment. From Zoom to Slack, more people will be working and playing from home in the coming years. The world is always changing, but recent have events have made us appreciate this fact more than ever. The financial markets aren’t a crystal ball, but they can offer a glimpse into what we can expect in a post-COVID-19 world.
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