Thoughts on MiFID Best Ex, Bats BMC proposal, & Passive vs Active Rhetoric

Will MiFID Rules Inspire Improvement in Trading ?

Bloomberg reports on an interview with ICE’s CEO where he says that many firms are not ready for MiFID II.   This does not surprise me at all, but I think that this understates the problem.  While I think that the early part of next year will be a mad scramble to comply with the most obvious parts of the rulemaking, it is the aftermath that is likely to be more transformative.   Compliance with technical requirements to build and maintain reference and transactional data, identify legal entities, trade report transactions that have never had such requirements, generate reporting for the public record, and comply with trading rules already consume most of the dialog and effort being expended.  Once that is done, however, other parts of the rule, which specify increased fiduciary duty towards obtaining and documenting best execution will take center stage.  That has the potential to be truly transformative in all products covered by the rule, including equities and most fixed income products, but it will impact each specific product differently.

Equities, for example, is a liquid product where the available market data provides a good baseline for pre-trade transparency, with the potential for investors to estimate what it should cost them to trade.  However, today’s post trade reporting is insufficient for investors to determine best execution of their orders, except for the most technologically adept firms.  This is because most investment managers do not even receive reports on unexecuted orders and firms are not required to contextualize their trade reporting by order type.  Therefore, the MiFID II requirement will almost certainly require investment managers and the brokers & analysis firms that serve them to “up their game.”  Instead of confining TCA to measures like VWAP, that do not actually have much to do with best execution, firms will need to evaluate opportunity costs in addition to comparing their trading to their own, in-context, pre-trade benchmarks.   Since few firms do this today, it is fair to say that change is coming.

Fixed income products, on the other hand, face different issues.  For all but the most liquid sovereign “on the run” bonds, the liquidity profile of most bonds is too low to sustain a limit order book.  As a result, despite the large number of trading platforms attempting to automate the fixed income market, it is unlikely that a solution to pre-trade transparency will be achievable by a “pure” market data solution.   (by that, I mean simple reporting of limit orders resident in displayed liquidity pools)  Thus, solutions for pre-trade transparency are more likely to revolve around bespoke solutions that aggregate requested quotes on bonds being traded as well as reported quotes on bonds with similar characteristics.  Post trade reporting, on the other hand, will be based on metrics of valuation, which is quite different to equity markets.  While most fixed income buy-side traders have well-defined notions of the value of bonds they are buying, the requirements will force them to be able to prove it.   This will require cross asset comparisons and quantitatively derived pricing in order to satisfy the requirement.

Perhaps the most interesting part of this, is that ESMA recognized that not all products are the same, and, for the most part, accommodated those differences in many of the rules.  I am aware that many derivative traders have serious (valid) concerns that pre-trade transparency requirements will hurt available liquidity, but we will see how that plays out.

SEC Should Approve the Bats BMC proposal

Among the many reasons why the SEC should approve Bats’s proposal in my Comment letter are two that are new to the debate:

  1. LESS Fragmentation – Since now that the idea is known and brokers support it, ATSs will almost certainly offer dark matching of MOCs at the closing price if Bats is not allowed to. As a result, it is more rational to compare the proposal to a future world that will exist if it is denied, rather than the current world.
  2. More liquidity at the closing price – The proposal will attract patient investors, who are afraid to “tip their hand” by exposing their size in an auction that publicly disseminates imbalance info. Since the Bats process is 100% dark and only publishes the actual matches trades, investors can put their full trading interest into the process, AND, have enough time to decide what orders to send to the closing auction.

Read the full letter here: https://www.sec.gov/comments/sr-batsbzx-2017-34/batsbzx201734-2169252-157804.pdf

 

More Self-Interested Pronouncements on Passive Investing

Also in Bloomberg, is an article quoting Paul Singer on Passive Investing, where he makes several strange claims.  First, his pronouncement that “Passive Investing Is Devouring Capitalism” may work well with the average person who never took an economics class, but since the foundation of capitalism is “supply and demand” it rings hollow.  The reason passive investing is flourishing is that it is cheap and has delivered average returns better than the active managers it has replaced, which, according to capitalism “101” means it will encourage more demand.   His next claim that shareholder voices are silent with passive investing is, sort of, true, but they are mostly silent with most broad based mutual funds also.  In addition, the recent decisions of the S&P and FTSE Russell index committees, to push back against non-voting shares, shows that the passive managers might not give shareholders a voice, but the index committees do.

Next, he talks about managers having “skin in the game” and I only wish that were always true with active managers.  His funds, as well as other hedge funds often have this as a cornerstone premise, but many active funds, particularly established mutual funds and institutional “long only” managers are not structured that way.  As I wrote previously, many managers running large, diversified portfolios have extremely flawed investment processes, particularly with regard to portfolio construction and trading.  Such managers could learn from the more successful passive managers, who have learned to make their processes extremely efficient.   While active strategies require more expertise to implement, improvement will start with the realization that all diversified managers need to adopt quantitative technology throughout their process.  In reality, the best hope for investors may be another foundational principle of capitalism; “creative destruction,” as the failure of firms who refuse to adapt can usher in a new era.

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