Demystifying The Global Equity Markets; An Institutional & Technology Driven Market

For those of us on the outside, the Global Equity Markets can appear to be a myriad of confusing acronyms and technological jargon. Part of the reason is that it is one of the most technologically advanced asset classes, which has given rise to terminology and acronyms that could be considered baffling to say the least to the uninitiated; from "Dark Pool Crossing" to "DMA" and "ECNs". We, at the Banker's Blog, have attempted to demystify the Global Equity Markets, and provide an overview to the market, products, main players and technology involved.

PRODUCTS:
Cash Equities; Traded on regulated exchanges worldwide, such as the London Stock Exchange, New York Stock Exchange and Nikkei 225. In order to trade these equity products (buy or sell), one must be a member of the relevant exchange upon which it is traded or go through a broker. Investment Banks and Stockbrokers pay one off and annual fees to Stock Exchanges for the privilege of placing orders directly with them on behalf of their clients.

Equity Derivatives; Can be split between OTC and Exchange Traded products.
OTC Equity derivatives are always traded directly between two established institutional investors/market counterparties (e.g. a Hedge Fund and an Investment Bank). Each investor in this instance assumes the credit risk that the other counterparty in the trade will fail. OTC derivatives include equity options and swaps. Their characteristics, such as notional amounts, are non-standardised in nature; therefore can be customised to suit the investor's needs in a way Exchange Traded Equity Derivatives cannot.
With Exchange Traded Equity Derivatives, the investors/market participants (e.g. the Hedge Fund and Investment Bank in our example above) would trade the derivative between them via a 3rd party Regulated Exchange. The Exchange acts as an intermediary and assumes the counterparty credit risk between the two investors. In return, each investor (the Hedge Fund and Investment Bank) must pay Initial Margin to enter the trade. Should either or both counterparty default on their obligation to the other, as dictated by the terms of their derivative trade, then the exchange will use the Initial Margin to fulfil the failing counterparty’s obligation to the non-failing counterparty. Exchange Traded Equity Derivatives include futures, options and swaps on single stocks and stock market indices. Contracts are standardised in nature; for example, there will be a standard notional amount for each derivative contract.

CLIENTS:
The global equity markets are characterised by a client set constituted almost exclusively by institutional investors, rather than corporate clients, whom form a large part of the global currency markets, for instance.
Hedge Funds; investment funds that are typically open to only a limited range of professional or wealthy investors, providing exemption from regulations governing short-selling, derivatives, leverage, fee structure and liquidity provision to their investors. Each fund has its own investment strategy. Those funds whose strategies involve taking long or short positions in cash equities or equity derivatives are considered investors in the global equity markets. In turn, the investors in hedge funds themselves expect returns over and above the wider market. They seek these Alpha Returns, returns that exceed the return expected for the risk borne by investments, and pay a premium for it; in the form of an upfront management fee, usually 2% of assets pledged and an ongoing performance fee, anything between 20% and 50% of the returns generated by the fund.
Pension Funds; institutional investors who invest a portion of their funds in the global equity markets in search of long term capital appreciation, in order to grow their assets in line with expected future liabilities. Typically, restricted to taking long only positions in cash equities. In January 2008, the economist estimated that pension funds worldwide hold over US$20 trillion in assets, the largest for any category of investor; ahead of Hedge Funds, Mutual Funds, Insurance Funds, SWFs, Currency Reserves and Private Equity.
Mutual Funds; collective investment schemes, who pools funds from many investors and invests them in bonds, equities, short term money market instruments and potentially other securities too. Mutual Fund investors benefit from the expertise of the fund manager and reduced transaction costs, relative to investing directly in single stock equities themselves. Typically, limited to taking long only positions in cash equities.
Insurance Funds; invests premiums collected from policy holders (the insured entities buying insurance) in a range of asset classes in order to provide an income stream that matches the profile of their continually evolving liabilities. Typically, limited to taking long only positions in cash equities. Sovereign Wealth Fund; a state owned investment fund, which invests in a range of asset classes including bonds, equities, property and commodities. The are two types of SWF; firstly a SWF can be managed by the central bank of a country, who had accumulated the funds through the management of the nation's banking system. These funds are typically of major economic and fiscal importance. Alternatively, SWFs can emerge through state savings, which are invested by various entities solely for the purpose of generating investment returns, similar to a hedge fund. The largest SWF's, at the time of writing, originated from the Middle East (Abhu Dhabi), Far East (China) and Eastern Europe (Russia), mostly due to oil, but in the case of China, due to prosperous growth and a large trade surplus.

PRIME BROKERAGE:
The hedge fund community are typically served by investment banks through a bundled package of services referred to as Prime Brokerage. Financial services within prime broking include Global Custody, Securities Lending, and Financing. Other services include Technology for portfolio reporting and operational support. Added value services include Capital Introduction, office space leasing and servicing, risk management services and consulting services to start up funds.
Historically, Morgan Stanley and Goldman Sachs held the lion’s share of the Prime Brokerage Market, but the 2007-09 financial crisis has led many hedge funds to move away from the traditional sole or dual prime brokerage relationship and diversify their counterparty risk into firms perceived to be most creditworthy, such as JP Morgan, Credit Suisse and Deutsche Bank.

TECHNOLOGY:
Due to the sophistication of hedge funds, each prime broker will typically have their own in-house electronic trading platform that will offer clients market access and trading strategies. These trading platforms offer clients pools of liquidity to open and close trading positions across a range of asset classes and financial instruments.

NB: The following list is not exhaustive. Bank of America Merrill Lynch offers a full suite of liquidity seeking, benchmark oriented and schedule driven algorithms for electronic equities execution. Barclays Capital offers BARX, its award winning electronic services platform and leading global provider of electronic transaction solutions, offering electronic execution and a complete set of services across foreign exchange, fixed income, futures, commodities, equities, money markets, emerging markets and structured products. BARX also provides sophisticated algorithmic trading solutions, FIX and DMA connectivity, STP and other leading Barclays Capital services like Prime Brokerage, Research and Analytics. Credit Suisse’s Advanced Execution Services (AES) is a suite of automated, algorithmic trading strategies based on thorough execution research and continuous live experimentation, performed by a team of Credit Suisse quantitative analysts and traders. Over 400Credit Suisse customers leverage these strategies to reduce market impact and improve trading performance vs. benchmarks in North American, European, and Asian markets, allowing traders to focus on the big picture. AES integrates seamlessly within traders’ electronic workflow; no “box” to install, no software to install, no additional front end, just improved trading performance. Nomura’s global equity offering is client focused and includes program and electronic trading platforms that provide clients with access to venues in over 35 countries. Platforms are supported by ModelEx, Nomura’s suite of market-leading algorithmic trading strategies, TradeSpex, Nomura’s portfolio and trading analytics applications, and NX, Nomura’s dark crossing platform. Nomura also provides consultative services and integration assistance.

Further to the banks, broker dealers provide their own proprietary technology. BIDS Trading L.P. is a registered broker-dealer and the operator of the BIDS Alternative Trading System (ATS), which was designed to bring counterparties together to anonymously trade large blocks of shares. Developed by a consortium of leading financial services firms, the BIDS ATS resolves the classic paradox of the block trader – the need to find legitimate trading counterparties without prematurely revealing trading intentions. BIDS Trading is a joint venture of: Bank of America Merrill Lynch, Citi, Credit Suisse Group, Deutsche Bank, Goldman Sachs, JPMorgan, Knight Capital Group, Morgan Stanley, NYSE Euronext, and UBS. BlockCross is an independent (large block) dark pool designed to deliver significant liquidity opportunities while buyside traders remain in an uncommitted posture. Leveraging blotter integration with an open platform, BlockCross strives to provide the broadest spectrum of block liquidity possible. The system includes a unique confirmation process that provides a level playing field for all types of traders looking to maximize print sizes and minimize information leakage. BlockCross has been live for over a year and already represents over 2 billion shares of available block opportunities >5k a day. BlockCross is also referred to as the “Enlightened Dark Pool” because it combines both displayed and non-displayed functionality. Institutional traders now have the ability post actionable indications as an ATS (BLKX). This new concept allows all traders to leverage the industry standard IOI networks and say “Meet me in BlockCross”. Fox River Execution’s suite of execution products was developed to address the unique needs of the institutional trader. Its legacy system, Fox Trader, blends the human logic of a professional trader with the precise mathematical formulas imbedded in Fox River’s proprietary models. For exchange traded funds, Fox Spotlight is a new trading platform that provides a comprehensive system for competitive, real-time price and size discovery in the ETF market. Fox River was ranked #1 execution broker in 2007 and 2008 by Institutional Investor (conducted by independent research firm Elkins/McSherry). Headquartered in suburban Chicago with offices in New York and San Francisco, Fox River Execution is a FINRA registered broker/dealer and a member of the SIPC. For more information, visit http://www.foxriver.com/. Instinet is an electronic trading pioneer, having established the world’s first significant electronic trading venue in 1969, one of the first recognized U.S. ECNs in 1997 and the first pan-European MTF in 2007. Through its subsidiaries and affiliates, Instinet operates two distinct business lines: a global network of agency-only brokers that seek to help institutions lower overall trading costs and improve investment performance through the use of innovative electronic trading products, including smart-routing, algorithms, DMA, dark pools and EMS platforms, and also provide sales trading, commission management services and independent research; and the Chi-X® trading systems, which aim to improve the efficiency of capital markets globally by providing high-performance, low-cost alternative execution venues. Instinet is a wholly-owned subsidiary of Nomura Holdings, Inc. For more information, please visit http://www.instinet.com/. Investment Technology Group, Inc., is a specialized agency brokerage and financial technology firm that partners with asset managers globally to provide innovative solutions spanning the investment continuum. A leader in electronic trading since launching POSIT in 1987, ITG’s integrated approach now includes a range of products from portfolio management and pre-trade analysis to trade execution and post-trade evaluation. Asset managers rely on ITG’s independence, experience, and agility to help mitigate risk, improve performance and navigate increasingly complex markets. The firm is headquartered in New York with offices in North America, Europe and the Asia Pacific region. For more information on ITG, please visit http://www.itg.com/.

ACRONYMS & TERMINOLOGY:
ECN – Electronic Communication Network. A software system that allows members to communicate and trade financial instruments directly with each other. Examples include Bloomberg Tradebook and any of the above listed examples. Orders and quotes are displayed publicly on the network.
Crossing Network – an electronic Alternate Trading System (ATS) that matches buy and sell orders electronically for execution in an anonymous fashion; orders are not first routed to an exchange or other publicly displayed market, like an ECN.
DMA – Direct Market Access refers to an ECN’s ability to place buy and sell orders for equities, from an investor, directly on an order book of a stock exchange, such as the London Stock Exchange. Without DMA, investors must rely on placing orders with their stockbroker who is trusted with the task of best execution with the exchange.
Dark Pools of Liquidity – the liquidity found on crossing networks. These orders are found outside ECN public orders and those orders held on the books of a stock exchange. Orders are anonymous.

SOURCES:
AdvancedTrading
Wikipedia