Chris Skinner on developments in cross asset trading and the search for liquidity.
At a recent conference, one of the speakers started by saying: "Alpha is what it is all about." He got this look of interest from half the audience and confusion from the other half. After all, much of what goes on in the investment markets is about as understandable as Greek, excluding those of you living in Greece of course. Alpha is all about finding liquid markets to gain higher margins and increased returns. Liquid markets are becoming harder to find as technology opens access for all, and the search for alpha is all about the search for liquidity. What are the major trends in this area?
It is probably worth saying that the chap at the conference who was discussing alpha was me. I had been tasked with presenting the logic for multi-asset class trading, or cross-asset class trading as some refer to it.
I define cross-asset class trading as the ability to trade in equities, fixed income, futures, options and foreign exchange in a single transaction.
Not everyone agrees with that definition as we are currently a long way away from the ability to deal in all markets globally across all instruments today, but this is surely where we are striving to get to.
How this is delivered is also open to question. For example, some people talk about multi-asset trading as being in a single transaction on a single screen using a single platform. Again, that is taking things further than I would push them, as some people do not want a single screen and others think, in today’s world of service oriented architectures, a single platform is not required either. Therefore, I will stick to my definition of trading in as many instruments as I want globally in a single click. That is what cross-asset class trading means to me.
The reason people want this from their technologies is due to the search for alpha – the search for the most liquid markets and the highest returns. In particular, hedge funds have driven this trend.
Hedge funds are becoming the leaders of the pack in terms of setting the buy-side trends. As one asset manager said to me recently, "I used to compete with tracker funds and indices, then with Merrill Lynch Investment Management and now with the merged BlackRock" who, as it happens, recently merged with Merrill Lynch Investment Management.
BlackRock is a mixture of fund management, hedge fund and fund of fund, and is one of the largest asset managers. "As of June 30, 2006, BlackRock’s pro forma assets under management totalled $1.045 trillion across fixed income, liquidity, equity, alternative investment and real estate strategies." In other words, BlackRock is providing cross-asset class fund management.
BlackRock is not alone. For example, one of the largest hedge funds is Citadel whose home page says: "Our team of professionals allocates investment capital across a highly diversified set of proprietary investment strategies in nearly every major asset class."
Question: Why are the hedge funds so focused upon multiple asset classes?
Answer: The search for liquidity.
What is actually happening is that the markets worldwide are automating the easy using cross networking index-tracking technologies. In other words, the traditional fund manager now has the low-cost technology infrastructure in place to provide passive fund management that purely keeps track of the FTSE’s and S&P’s of this world. What the institutional investor wants is therefore humans traders involved in designing asset allocation strategies and portfolio analytics that are far out-stripping the general stock indices. They are challenging traders to really deliver value-add; and the value-add is higher returns with lower risk. That is what they expect, and are getting, from the hedge fund and other alternative investment market players and that is why more and more investment is being pooled through the hedge fund markets.
You only need to look at these two statistics to see what is happening:
- Assets under management of the hedge fund industry totalled $1.225 trillion (Q2, 2006) up 19% on 2005 and twice the total of 2003;
- Hedge funds account for 32% of credit-default swap sellers and 28% of buyers, up from 15% and 16% in 2004.
Hedge funds are driving the markets, the investment pools, the liquidity, because hedge funds are delivering higher returns with lower risk to the institutional investor.
Just look at the volatility of active fund managers dealing primarily in equities versus hedge fund managers dealing in all asset classes. The active equity manager delivers higher returns on some occasions, but lower returns at others. There is also little predictability. Meanwhile, the hedge fund manager buys equity and hedges it with a buy-write, an option that offsets the risk. As they do this, they are delivering higher returns more consistently, more predictability, more reliably.
To illustrate the point, TowerGroup analysed the market movements between 1998 and 2005 in the USA. Equities delivered an average performance of 3.78% with volatility of 18.26%, whilst hedge funds delivered 12.23% performance returns with only 12.06% volatility. Which would you prefer?
That is why the hedge fund markets are soaking up institutional investors’ assets, as the buy-side moves from active equity fund management towards alternative investment strategies using hedge funds to manage the portfolio.
How do the hedge funds deliver such returns with low comparative volatility?
What the hedge fund manager does is finds arbitrage opportunities. For those unfamiliar with the area, arbitrage is a fundamental of derivatives, hedge funds and the capital markets, and is basically finding price differentials between assets so that you can make a quick buck.
Rather than making up my own example of how it works, here’s one from Wikipedia:
"Suppose that the exchange rates in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = £6 = $12. Converting ¥1000 to $12 in Tokyo and converting that $12 into ¥1200 in London, for a profit of ¥200, would be arbitrage."
That is a very basic version of arbitrage. In fact it is so basic, it hardly ever happens as hedge fund managers push these strategies further and further. The first push was through black box algorithmic and program trading strategies where the hedge funds put all of these complex rules into trading engines that look for real-time arbitrage. An example would be:
(i) if Microsoft’s price drifts 2% outside the Volume Weighted Average Price (VWAP) during any fifteen minute period; followed by
(ii) the S&P500 moving by 0.5%; whilst
(iii) dollar:yen spread pricing moves up or down by 0.05%
(iv) all within a two-minute period; then
(v) buy Microsoft with a Dollar spot-forward option
Even that’s nowhere near as complicated as some of the hedge fund multi-asset trading strategies being used today. In fact, the hedge funds are heading towards multi-everything – multi-asset, multi-venue, multi-country, multi-broker … in real-time, 24*7, globally.
This is because hedge funds are increasingly being driven to deliver greater and greater returns to their clients and so it’s all about the search for alpha – the search for liquidity.
The thing is though, that the arbitrage strategies outlined above – where you are trading across multiple assets and markets with multiple data streams involving complex, time-critical event sequences under real-time constraints – would have been impossible a few years ago.
What has happened?
The technology drive is delivering cheapness of processing, networking and connectivity, combined with increasingly powerful application solutions and services. And many of these solutions can be dropped in anywhere through SOA.
This means that the hedge funds are pushing the boundaries of what technology can do more and more each day. They have to, in order to find liquidity. That is why it is no longer good enough just to have a black box algorithmic trading strategy. Hedge fund managers want rocket science, not black boxes (for more on this see Tools of the trade
That is also why the markets are moving towards multi-asset dealing … because they can. The fact is that the markets are no longer bounded by execution venue, exchanges, geographies, brokers and dealers. There are no boundaries in today’s markets. The markets are liquid and trading moves to where liquidity is highest.
That is why the sell-side is responding by extending their services to cover all the bases required for liquidity. That is why many of them have acquired Execution Management Systems (EMS) in the last year or so, such as Goldman Sachs' purchase of RediPlus, Citigroup's buyout of Lava Trading, Lehman Brothers' absorbing RealTick and Nomura’s recent swallowing of Instinet and Chi-x.
In fact, Order Management Systems (OMS) and EMS is all becoming blurred as we move into Advanced Execution Systems (AES). AES tries to deliver a truly integrated buy and sell side through technology. That is why trading, dealing and execution are all becoming seamless, as brokers place execution engines into exchanges through co-location services across integrated OMS and EMS. The result is that the dealers who can provide liquidity by placing business the fastest in real-time will be the winners.
The thing is though, that the sell-side may be placing a nice veneer over their systems by acquiring, combining and front-ending but, behind the scenes, many are desperately trying to keep up with the demands of today’s markets.
As hedge fund managers demand high-speed, low latency connections across all execution venues of choice, sell-side players are struggling.
The trouble is that a lot of these broker-dealers are sitting with old structures and processes still in place. So, we talk about multi-asset trading and you look under the roof of most brokerage houses and find they have an integrated multi-asset dealing desk … but underneath the desk are all the old cables, pipes, silo’s and functions. In other words, an integrated dealing desk backed up by a multi-platform, multi-function middle and back office.
This will not deliver on the promise that the hedge fund folks are after. They want truly integrated globalised markets, not some fudged together sticking plaster with a patchwork quilt of technology behind it. Added to which, the more that systems are front-ended and non-integrated, the more latency in the systems. And latency is what it’s all about. Those who shave off the nanoseconds are winners.
That is why the winners will be the Tier 1 broker-dealers, who are now leveraging their technology budget to build truly integrated capabilities across all execution venues, including their internal “dark pools”. Dark pools are financial markets not available or visible to the general public, such as orders on a broker’s internalisation engine made available through an electronic cross network (ECN), with a great example being the recent dark pool launched by Instinet and Credit Suisse.
This means that the heavyweight players – UBS, Citigroup, JPMC, Goldman Sachs, HSBC, Merrill Lynch and so on – will all be able to leverage their multibillion dollar technology budgets whilst the rest will be struggling. After all, if you cannot provide liquidity with low latency across global markets and instruments, what can you provide? That is the question being asked of the exchanges.
The stock exchanges were fine as liquidity pools for trading in the equities of their national markets a decade ago, but today – in this globalised cross-networking cross-asset class, multi-everything world – what is the role of an exchange?
That is the question and challenge being raised from all angles. By regulators through MiFID and RegNMS. By markets, through multi-everything hedge strategies and sell-side pressures to deliver anytime, anywhere execution. And by technology providers as they develop new algorithmic, all-singing all-dancing order management and execution management systems. No wonder we are seeing the bloody battles amongst exchanges to increase their critical mass for liquidity.
The most aggressive player appears to be the NYSE who not only has expanded their geographic footprint through the purchase of Euronext, alongside investments in the India’s National Stock Exchange (NSE) and possible deals with Japan, but has also expanded its offer from pure equities trading through to multiple products and trading platforms covering cash equities, exchange traded funds (ETFs), options, bonds and other new businesses.
This is the nature of the new world of multi-everything.
Exchanges are competing with sell-side for liquidity and execution, whilst the buy-side are being led by complex globalised hedge fund strategies as investors seek the funds that deliver the highest returns with the least volatility. All of this being driven and supported by low latency, low cost, highly networked and globalised technologies, applications and systems which interconnect and deal continuously in real-time,
In some ways, I cannot believe that I wrote that last paragraph because, ten years ago, the fund management world was being rattled by low-cost automated tracker funds that followed the market indices. That was nothing compared to what we see today, with hedge fund globalised arbitrage trading across all asset classes, brokers, markets, venues, exchanges, networks.
The technology deployed ten years ago was the leading-edge at the time, but was nothing compared with the grid, blade, IP networked, real-time world we deal with today. Almost like comparing the first space rockets with the space shuttle, the tracker fund computing of 1997 is antiquated when compared with hedge fund algorithmic computing of 2007.
Ten years from now, will this force for complexity continue?
The longer-term will see more specialisation of boutique brokers around technology plays which allow direct connectivity for rocket scientist fund managers to create the most automated, globalised, macro-trading arbitrage strategies around micro-market, micro-volume block executions.
The day of the multi-everything fund is already here. The day of the multi-everything at a micro-level fund is the next game. The game of trading in fractions of markets using pieces of instruments in faster and faster volumes. The game of using nanosecond arbitrage to deliver alpha returns. The game of searching for alpha: the game of searching for liquidity...
...either that or someone will pull the plug on all the systems and we will all return to open outcry.Chris Skinner is CEO of Balatro, chairman of the Financial Services Club, and a director of TowerGroup.
Web links: www.towergroup.com
, and www.balatroltd.com
Author's email: Chris Skinner