FX has always been a global 24 hour market, and futures are now becoming one, as the number of fungible or correlated products around the world increase," says Sanjeev Lakhanpal, Partner at Beach Horizon, a CTA. "Prime brokers have helped on the operational side with a single line of credit, cross margining and give-up arrangements with local brokers."
"There's been a huge growth in global futures, both as a stand-alone strategy and as a cross asset or cross geography hedge along with other asset classes," says Gray Lorig, chief information officer of Trading Cross Connects (TXC), an incubator of high frequency trading teams.
Of course futures markets have also had to bear their share of the pain in recent years. "Falling participation from leveraged accounts led to a 23% fall in US futures trading last year as more than 2,000 hedge funds and proprietary trading firms exited the markets and banks pulled back on credit, but that looks to be recovering now with growth in rates products and a new focus on futures to hedge longer term risks for many different asset classes," says Andy Nybo, principal, head of derivatives, TABB Group, the strategic advisory and research firm.
Karel Janecek, CEO of RSJ Algorithmic Trading, one of the leading market makers on Liffe, CME and Eurex, tells the story for the short end of the curve. "Before 2007 short term interest rate futures had high turnover and were very stable," says Janecek. "Initially the crisis brought volatility but volumes held until the Lehman crisis. Then volumes fell as volatility soared in 2009. This year volumes have improved as confidence started to return. Our traded volumes are actually 5 to 10 times larger compared to just 3 years ago due mainly to improved, higher activity models and the number of markets traded."
Now the futures markets are characterised by two things: rapid innovation and globalisation. "At TABB, we see tremendous growth in certain asset classes, especially FX and commodities," says Nybo. "There's a lot of speculative appeal to the private investor or small hedge funds particularly, as the technical access costs to foreign pools of liquidity come down. Meanwhile, some exchanges are cross-licensing their products in other time zones to build demand and liquidity, while others have been aggressive in launching new, more exotic products."
"There are some really interesting products like CME's futures on electricity, weather or uranium," comments Lakhanpal at Beech Horizon, "but exchanges don't always launch them sensibly. Unfortunately, some days they hardly trade at all, so there's an unacceptable liquidity risk in trading them." Similarly Lakhanpal sees the problem with copy-cat products launched by different exchanges as fragmentation of liquidity. "With modern telecommunications, there's no issue with traders accessing trading centred in one place," he argues. "But where they collaborate to extend trading hours, it can improve efficiency."
"Preferred instruments depend on the product and costs," says Nybo at TABB Group. "Since Lehman, liquidity has become a critical part of the equation. For energy, some traders prefer ETFs or ETF options to pure futures, for example."
Global access brings with it new challenges besides just liquidity, such as new types of participant. "In Korea 40% of the market are private investors," say Ralph van Put, CEO of All Options Asia, a Hong Kong market maker and adjunct professor in finance at the Chinese University of Hong Kong's business school. "It's unbelievable: housewives, businessmen and day traders all trade futures and options, not just FX, over a drink at the corner shop." By comparison van Put sees the Chinese are still quite cautious. "Before they trade derivatives, retail traders need a brokerage account for at least 18 months and 500,000 yuan," he explains. "The first 10 state owned brokers have started to facilitate margining. Besides investing in the mainland domestic markets, many Chinese are already trading globally out of Hong Kong. The big electronic US brokers see their biggest growth in Asia, especially Hong Kong and China. When the barriers come down it will explode."
"Trading futures in emerging markets raises two issues," says Lorig at TXC. "First, the regulatory environment means you usually need a local partner, which adds complexity and time delay. Then the exchanges themselves are at different stages in the evolution to electronic markets. This often translates into the throttling of quotes and/or trades, or trade workflows which are more appropriate to a voice broking environment, both of which limit algo strategies. Most agree we compress spreads and bring price stability, but when traditional traders can't hit a price they claim it's unfair. It's certainly more competitive, so local participants will have to upgrade their technology. That takes time."
"Emerging markets have been expensive to access due to regulatory barriers, high fees and taxes," adds Nick Nielsen, head of trading at Marshall Wace. "In Brazil you have to pay tax on both margin and capital repatriation. In both Brazil and Korea you have to pre-margin as well, so it's heavy on capital. Then there aren't many liquid instruments so many traders may focus more on currency futures because they're more liquid."
Nevertheless, if traders can cope with these issues there are real benefits. "Futures strategies are not too exchange specific and since quantitative research can also be shared, they're very scalable with falling marginal costs to add another exchange," says Nielsen. "The more markets you trade, the greater the yield, but they have to be transparent and liquid."
"Many traders are bored with traditional markets where they're increasingly seeing pre-arranged deals booked through the exchanges," says Harvey Moses, business development manager at The Kyte Group, a firm offering algorithmic trading and clearing services to day traders, hedge funds, market makers and other professionals. "So they broaden their horizons in the lesser-known BRIC markets. They see the large retail flows as an opportunity for their smarter, faster algos." When one client for example wanted access in Korea, the Kyte Group did a deal with a local Korean broker to provide it complementing their US and European network. Similarly they use local brokers in Russia or Brazil, claiming it is much cheaper than setting up their own infrastructure.
Eurex is one exchange that has moved aggressively to capture these emerging market opportunities. "Our recent initiatives," says Steffen Koehler, head of product development, "include a co-listing agreement with the Bombay Stock Exchange for Sensex futures denominated in US dollars, a cooperative agreement with the Singapore exchange for joint listing of Euro STOXX 50 futures and options also in dollars, and another with the Korean Exchange on the KOSPI index, the most heavily traded index in the world in terms of numbers of contracts. We started at the end of August with the KOSPI 200 Option in Korean off hours. These complement our earlier offerings for a Russian index and Brazilian single stock futures."
Koehler explains the two key challenges of their emerging market offering. "Firstly," he asks, "is there sufficient liquidity in the underlyings? For indices, the existence of liquid ETFs, for example, is important. Are the indices used more widely in trading decisions? Secondly, is there sufficient interest from our members? We're looking for example at index futures and options on ETFs in various markets and finding that more products from emerging markets fulfill these criteria than in advanced economies."
Lakhanpal at Beech Horizon explains how some of the products work. "Traders have been able to trade JGBs for example on Liffe," he explains. "They're not as liquid as Tokyo but the price is settled at the opening price in Tokyo and the position is rolled over to Japan, so it's fungible, and we can view the market as global even if the products are on different exchanges."
Exposures can sometimes be pooled even without fungibility. "Similarly we can trade dollar-based soybean oil futures in Chicago or palm oil in Malaysian Ringgits in Kuala Lumpur," says Lakhanpal. "I have to adjust for the currency but the exposures are highly correlated."
"The new cross-market products from CME and Eurex allow traders to get exposure to emerging markets like India or Korea without having to set up local business relationships," says Moses at Kyte Group "As long as they're sufficiently liquid it works well, but some want the deeper liquidity of the home market and may arb the Western products as well. So we offer both solutions."
Liquidity is always key. Steel at AHL, for example, argues that competing contracts have not always found favour in the market and liquidity has often been quite thin. "We use our operational strengths and trading relationships to access the local markets, where liquidity is better," says Steel. So last year AHL opened an office in Hong Kong with four traders to enable them to efficiently execute around the clock. "Our local presence gives us better access to local liquidity, exchanges and regulators. Having traders working in daylight rather than working nightshifts has resulted in significantly improved performance," says Steel.
High Frequency Strategies
The other key development in the futures markets of course has been high frequency trading but the challenges are growing. "While a couple of years ago it was relatively easy to capture alpha using low latency plays, now it's an arms race," says Steel. "The new game is scale and sustainability. You can't just leave the black boxes to run overnight anymore and come back in the morning."
"Futures are very different to equities because liquidity tends to be concentrated for any given product," says Janecek at RSJ. "That eliminates many gaming scenarios for a start."
With or without fragmentation, some participants will always have a go at high frequency gaming. "Recently we noticed someone trying to manipulate the market," says Janecek, "suddenly showing a large size a tick or so off the market price, followed by a suspicious change of direction. We updated our models to take these gaming strategies into account, treating any sudden outliers with suspicion. Market rules require that all orders should be executable, so just flashing an order is not allowed. In the end we hit the trader hard and he hasn't returned, but you always have to be on your guard."
"High frequency traders may try to game the system," observes Lakhanpal, "but in the old days, so did some locals. You have to be wise to it and with deep liquidity and active market supervision it's difficult to see them having much impact."
Competition is certainly growing, so exchanges are looking to smarter order types. "We currently have about 100 members in our proximity sites who focus on high frequency strategies," says Koehler at Eurex. "Other members have longer term trading horizons and are not so latency sensitive. It's important to keep a balance so we always offer both low latency and low cost or ease-of-use solutions." He suggests that for members with business models that are not so latency sensitive, complex order types, such as one-cancels-the-other, for example, are more important than speed. "Clearly we need to avoid the suspicion that we serve just one part of our trading community well, so consultation is really very important," adds Koehler.
"High frequency in Asia is still in the start-up phase, given the relatively high trading costs," notes van Put at All Options. "Many brokers in mainland China cannot allow short trading on futures, for example, but there is so much natural liquidity that the Chinese Financial Futures Exchange doesn't need any liquidity providers. In this early stage, the volume on the Mainland China futures market outpaced the European derivatives markets."
Nielsen at Marshall Wace argues that intense competition is arbitraging high frequency trading margins, so they are less than people think. "If you compare them to the old bank margins for market making, it's much more efficient," says Nielsen. "Execution costs have compressed considerably."
Even in Asia van Put argues that market making in single stock options has become very difficult over the years. "Given the new rules for the banks, funding could become a problem," he notes. "The cost of capital to finance the trading will likely increase. It may be commodity technology but you need co-located servers, you're constantly chasing speed. Besides able to do the trade, speed is crucial from a risk management point of view. Compute power is the limiting factor and so is scalability. Automated market making is still very challenging." Besides the technology van Put also underlines the very large role of traders. "The education of junior traders takes a long time," he says. "Then your traders walk and you've subsidized the competition. Instead people are looking for directional bets, commodities, delta one or something else where analytics can find the alpha and make it scale. In Korea market making is all at the short end of the curve now. A similar trend is seen with the European markets."
"Futures, however, are much easier to understand than options and volume is still growing," adds van Put. "The calculations are much more straightforward and implementing algorithms and automated trading is easier and better scalable!"
Scalability often depends on access so co-location is also growing for big liquidity providers like RSJ. "Each market is traded both individually and in correlation with the others with a total average daily volume of perhaps a million lots or around 20 lots a second," says Janecek. "Our trading engines are co-located in each market centre with a central monitoring function in Prague, but all are exchanging information with each other in real time. In the end it's smart models rather than raw speed that counts. In fact only three years ago we were still trading Liffe from our servers in Prague."
Not everyone of course needs such speed. "High frequency traders, especially traders that are engaged in low latency arbitrage, try to gain an edge by being co-located at the exchange," says Lakhanpal at Beech Horizon. "However, our strategies have a statistical advantage that we have gained through extensive research and don't rely on speed of execution to generate returns. We use systematic strategies that are ultimately driven by ever changing macro and micro fundamentals. When trading liquid futures we use the FIX Protocol for DMA with a number of highly adaptive proprietary algorithms."
In Nielsen's view at Marshall Wace, for short term momentum trading, you can put the computer anywhere as long as it is reasonably close, such as Singapore to access Hong Kong or Tokyo. "The key is always to use your information more efficiently," says Nielsen.
"High frequency futures trading traditionally depended on local or semi-local access," says Lorig at TXC, "so the latencies of the long haul links limit the applicable global strategies. We're now combining regional strategies with global inventory and risk management where collaboration between trading engines is crucial. It's a new set of skills."
Most of AHL's portfolio strategies have medium to long-term alpha horizons. "Our trading infrastructure is located in a state-of-the-art data centre," says Steel, "which is connected to our global offices. We have some co-location as well to cater for higher frequency strategies, but most of our trading engines are global."
As well as infrastructure AHL has invested heavily in people. "We've continued to make a big investment in research and in the Oxford Man Institute in particular," says Steel. "Here we have co-located some of our commercially focused research team alongside the curiosity driven Oxford academics. While each team has its own agenda, the informal contacts are invaluable. This way we get first sight of exciting new academic research. It's a powerful combination."
"Futures are very different to equities because liquidity tends to be concentrated for any given product,"
In their hands
So the future of futures is global, but the next big push could be driven by the regulators. "The Volcker rule has had an immediate effect," says Lorig at TXC, "with banks starting to close their prop desks or considering spinning off their prop desks into hedge funds. How exchange trading of OTC will play out remains to be seen, but it's a new sandbox to play in."
Everyone is monitoring the impact of the Dodd Frank Act. "Position limits are being tightened," says Lakhanpal. "We might see positions monitored across exchanges for example. We'll have to wait and see."
For some regulation could bring competitive advantage. "The increased regulatory focus in some futures markets really plays into our hands," says Steel, "because we have the scale and global footprint to manage the operational aspects of our business efficiently. We trade on 36 venues across multiple timezones and regulatory jurisdictions, so we place a great emphasis on effective management of operational risk."
As global reach and low latency technologies collide in ever tighter competition, operational risk management will probably become the key issue for everyone.