9.6 Algorithmic trading & high-frequency trading & bond markets

Question 1

What is algorithmic trading?

Answer 1

Algorithmic trading is a form of automated electronic trading performed by institutional investors. It involves creating electronic algorithms that use various metrics, such as price, volume and volatility, and attempts to identify predictable patterns. These will trigger buy and sell signals for the investors, who can then choose to act on the information or not. In more extreme cases, computer systems will automatically execute the trades based on these triggers without the need for a human to place these orders.

Question 2

What has algorithmic trading led to?

Answer 2

Algorithmic trading, where computer systems automatically execute the trades, has led to an evolution in the trading of investments, called high-frequency trading.

Question 3

What is high-frequency trading (HFT)?

Answer 3

High-frequency trading (HFT) involves the automatic execution of trades where holding periods can be as short as a fraction of a second, but the volumes are of such a significant size that large profits can be made on the smallest price movement.

Question 4

What are the advantages of high-frequency trading (HFT)?

Answer 4

The supporters of high-frequency trading (HFT), mainly the market participants using the systems, claim that it increases liquidity and reduces costs and commissions associated with execution. Many automated markets, such as NASDAQ and the LSE have seen volumes increase due to this trading.

Question 5

What are the disadvantages of high-frequency trading (HFT)?

Answer 5

The critics of high-frequency trading (HFT), mainly regulators, claim that it increases the volatility of the markets and can lead to systemic risk. Many have proposed that exchanges should impose speed or frequency restrictions on traders, or position limits on how many positions that traders can hold in a day.

Question 6

What has driven the need for new legislation in MiFID II?

Answer 6

Technological developments in trading, particularly algorithmic trading, have driven the need for new legislation in MiFID II.

Question 7

What does MiFID II state in regards to high-frequency trading?

Answer 7

This legislation will determine the capacity and arrangements needed to manage multi-lateral trading facilities (MTFs) and organised trading facilities (OTFs), that allow or enable algorithmic trading to take place. MiFID II also contains obligations, systems and controls for algorithmic investment firms to mitigate the risks arising from algorithmic trading, including high-frequency trading (HFT).

Question 8

What is fundamental to MiFID II?

Answer 8

Fundamental to MiFID II legislation is that a multi-lateral trading facility (MTF) or organised trading facility (OTF) must have the ability to ensure orderly trading under severe market stress, and must have systems and controls in place that can cope in stressed market conditions. This may include:

1. The ability to slow down the flow of orders
2. Adopt and enforce minimum tick-sizes
3. Provide an environment to test algorithms
4. Participants will also be more heavily regulated, needing to identify:
5. Which orders were generated by algorithms; and
6. Who was responsible for the orders initiated by the algorithm

Question 9

Define a market making high-frequency trading (HFT) strategy.

Answer 9

This is where the algorithm is programmed to place both buy and sell limit orders closely around the current price to create a bid-offer spread. If the market falls slightly, it triggers the buy order. If the market rises slightly, it triggers a sell order. After the order is triggered, the original orders are removed, and a new bid-offer is placed around the new price.

Question 10

Define a ticker tape trading high-frequency trading (HFT) strategy.

Answer 10

This is where the algorithm is programmed to analyse the information being released, at the moment of release, and react immediately. Systems can be programmed, for example, to recognise large orders being placed on the market, through analysis of price movement and volumes, and trade on this information.

Question 11

Define an event arbitrage trading high-frequency trading (HFT) strategy.

Answer 11

Certain recurring events, such as the announcement of a profit warning, generate predictable short-term responses in a selected set of securities. High-frequency traders take advantage of such predictability, before the regular market user has had time to react, generating short-term profits.

Question 12

Define a statistical arbitrage trading high-frequency trading (HFT) strategy.

Answer 12

A more traditional form of arbitrage, where the systems are programmed to identify price discrepancies among assets and trading on this mispricing. Due to the nature of HFT and the computer models used, mispricing can be identified in increasingly complex scenarios and traded on very quickly.

Question 13

What are Gilt-edged market makers (GEMMs)?

Answer 13

Gilt-edged market makers are specialist gilt trading firms, also referred to as primary dealers, who undertake to the Debt Management Office (DMO) to make a market in gilt-edged securities.

Question 14

Who do Gilt-edged market makers register with and who are they supervised by?

Answer 14

Gilt-edged market makers register with the Debt Management Office (DMO) but are supervised by the FCA.

Question 15

How do gilt-edged market makers provide liquidity to the market

Answer 15

Gilt-edged market makers provide liquidity to the market by being obliged to quote two-way prices at which they are committed to deal, in appropriate sizes discussed in advance with the Debt Management Office (DMO). The quotes will be structured to the nearest £0.0001 per £100 nominal value.

Question 16

Who are Gilt-edged market makers obliged and not obliged to quote to?

Answer 16

Gilt-edged market makers are obliged to quote prices to broker-dealers acting for clients and other clients known to them. They are not obliged to quote to other GEMMs or broker-dealers acting in principal.

Question 17

What market can Gilt-edged market makers participate in?

Answer 17

Gilt-edged market makers may make a market in index-linked gilts only, non-index-linked gilts only or all gilts (both index- linked and non-index-linked).

Question 18

What are the 3 things expected of Gilt-edged market makers?

Answer 18

1. Participate in primary gilt issuance
2. Provide the Debt Management Office (DMO) with relevant data about the gilts market
3. Accept the Debt Management Office’s monitoring arrangements. The relevant data to the Debt Management Office is channelled through the Gilt-Edged Market Makers’ Association (GEMMA).

Question 19

What are broker dealers?

Answer 19

Broker dealers are LSE member firms who can trade gilts on behalf of clients (as agents) and/or on their own account (as principal). They have dual capacity. Broker dealers acting in the gilt market act in the same way as broker dealers in the equity market.

Question 20

What is a gilt inter-dealer broker?

Answer 20

A gilt inter-dealer broker, like an equity inter-dealer broker, is an LSE member firm which has registered with the Exchange to provide intermediating services between other LSE member firms.

Question 21

Who are inter-dealer brokers (IDBs) used by primarily ?

Answer 21

Inter-dealer brokers (IDBs) are used primarily by Gilt-edged market makers and equity market makers to facilitate anonymous offset of positions in securities.

Question 22

How do inter-dealer brokers (IDBs) settle?

Answer 22

Inter-dealer brokers (IDBs) settle as principal, i.e. the parties dealing via the inter-dealer broker are unaware of each other’s identity. They cannot take positions in anticipation of finding other parties requiring their services.

Question 23

What role do Stock borrowing and lending intermediaries (SBLIs) perform in debt markets?

Answer 23

Stock borrowing and lending intermediaries (SBLIs) perform the same function in debt markets as they do in equity markets, namely facilitating stock lending.

Question 24

How is the public sector net cash requirement (PSNCR) financed?

Answer 24

The Government’s agent issues gilts, which usually pay coupons semi-annually, to finance the public sector net cash requirement (PSNCR).

Question 25

Who manages the UK Government’s debt?

Answer 25

The Debt Management Office (DMO), manages the UK Government’s debt, it is an agency of the Treasury.

Question 26

What percentage of gilt issues are index-linked gilts (ILGs)?

Answer 26

Approximately 15%

Question 27

How does the Debt Management Office offer gilts?

Answer 27

The Debt Management Office offers gilts in the primary markets via an auction, where it collects bids from interested parties and issues them to the successful bidders.

Question 28

What gilt issuing option is preferred by other countries?

Answer 28

Issuing gilts by auction is also the method preferred in a number of other countries, most notably the US.

Question 29

Explain the tap method.

Answer 29

Although now quite rare, the UK Government has chosen in the past to issue gilts via the ‘tap’ method, where the issue is announced and investors are invited to tender for the issue. If bidders do not offer the price required by the Debt Management Office, that part of the issue not taken up originally can be temporarily withdrawn and released slowly into the market as market conditions become more favourable.

Question 30

How can investors buy gilt-edged securities?

Answer 30

Investors can buy gilt-edged securities either from the Debt Management Office auction (in the primary market), or by trading in gilts on the LSE (the secondary market).

Question 31

How does the LSE provide an orderly marketplace for the trading of gilt-edged and fixed interest securities?

Answer 31

The LSE ensures order through rules and guidance, and the monitoring of trading and market activity.

Question 32

Describe the process of purchasing a gilt?

Answer 32

Gilt-edged market makers will quote prices on their screens and interested parties will contact the Gilt-edged market makers to execute their trades.

Question 33

How can retail clients purchase a gilt?

Answer 33

Gilt-edged market makers do not deal directly with retail clients. If retail clients wish to trade with a gilt-edged market makers, they must do so through a broker.

Question 34

Name the 2 types of prices associated with gilts.

Answer 34

Gilts are quoted at a clean price, but the price paid on settlement is the dirty price.

Question 35

What is the dirty price?

Answer 35

The dirty price is the clean price of the bond plus any interest that has accrued on the bond over time.

Question 36

How is accrued interest over a period calculated?

Answer 36

When calculating accrued interest over a period, it is done on an actual over actual basis. This means the accrued interest is based on the actual number of days since the last coupon and the actual number of days in the coupon period.

Question 37

When do Gilts settle and go ex-dividend?

Answer 37

Gilts settle one business day after the trade (T+1) and normally go ex-dividend seven business days before the coupon date.

Question 38

How is much of the trading in gilts carried out?

Answer 38

Although Gilt-edged market makers offer guaranteed liquidity, much of the trading in gilts is carried out by using e-trading systems between member firms.

Question 39

What does STRIPS stands for?

Answer 39

Separate trading of registered interest and principle securities.

Question 40

What does the STRIPS market allow?

Answer 40

The STRIPS market allows the cash flows on a gilt (coupons and redemption value) to be traded as separate instruments. This allows investors to trade the STRIPS as if they were zero-coupon bonds.
 

Question 41

What happens when corporate bonds are issued?

Answer 41

They may be sold as an open offer for sale or directly to a small number of professional investors (a private placing).

Question 42

What does an open offer for sale involve?

Answer 42

An open offer for sale involves a syndicate of banks with one as lead manager buying the bonds and then reselling them to investors. The sale of these bonds is typically underwritten by the banks (who naturally charge for this service). Underwriting offers the issuer a guarantee that a specified level of capital will be raised in the issue – even if this means that the underwriter has to buy some or all of the bonds themselves.

Question 43

What is a bought deal in regards to an offer for sale?

Answer 43

If the lead bank buys all the bonds and sells them to a collection of issuing bonds (the syndicate), this is called a bought deal. The syndicate members could then sell the bonds on at varying prices.

Question 44

What is a fixed price re-offering in regards to an offer for sale?

Answer 44

More usually, the lead manager and the syndicate buy the bonds together and offer them at a fixed price for a certain period (a fixed price re-offering).

Question 45

How is the corporate bond market different to the gilt market?

Answer 45

The corporate bond market is similar in many respects to the gilt market, except that the Debt Management Office is not involved. Market makers register with the LSE and are obliged to quote prices to other member firms, excluding other market makers, inter-dealer brokers and stock borrowing and lending intermediaries.

Question 46

Explain the difference between market makers in the corporate debt market and Gilt-edged market?

Answer 46

Market makers in the corporate debt market are essentially the same as Gilt-edged market makers; however, unlike Gilt-edged market makers, they make use of SEAQ, a quote driven system in the LSE. Both firm and indicative prices may be available on the SEAQ screen during the mandatory quote period. Note, although corporate debt securities may be quoted on SEAQ, there is no obligation for market makers to use the system in the same way as there is for the trading of equities. In fact, the majority of corporate bonds trade over-the-counter.

Question 47

What are the rules for market makers reporting prices for various trade sizes?

Answer 47

Market makers may display different prices for different sizes of trade.

Question 48

How are corporate bond trades reported on the LSE?

Answer 48

Trades on the LSE are reported in the same way as equity trades to fulfil post-trade transparency requirements.

Question 49

What has the LSE introduced for corporate bonds and why did they introduce this?

Answer 49

The LSE has introduced order book trading for corporate bonds on the order book for retail bonds (ORB). Corporate bonds have not generally been an asset class available to the small investor and the introduction of this system is hoped to improve this access.

Question 50

What happens in the decentralised dealer market?

Answer 50

Dealers make a market amongst themselves, creating pools of liquidity rather than having a centralised exchange. This creates an extra liquidity risk to the price of these bonds.

Question 51

What is the difference in maturity dates of corporate bonds and gilts?

Answer 51

Corporate bonds can have a maturity date much longer than is found in gilts, i.e. bonds with maturities of up to 100 years.

Question 52

What is an international bond (Eurobond)?

Answer 52

An international bond (Eurobond) is a security where the denomination of the bond and the country of issue are all different. For example, a company issuing dollar bonds in Paris and Tokyo, or a company issuing yen bonds in Frankfurt and Dublin.

Question 53

What is the common feature of the currency of eurobonds?

Answer 53

Commonly, eurobonds are issued in the currency and country where the issuer finds it cheapest to raise the finance, and then swapped into the currency the issuer wants.

Question 54

What type of bonds are Eurobonds?

Answer 54

Eurobonds are bearer bonds i.e. anonymous, freely-transferable securities.

Question 55

Explain immobilisation.

Answer 55

Due to the risks of holding bearer documents, many eurobonds are kept in international central securities depositaries (ICSDs) such as Euroclear or Clearstream. This is referred to as immobilisation.

Question 56

How is interest paid on Eurobonds?

Answer 56

Interest is usually paid on eurobond issues (fixed or floating) once per year. Interest is also paid gross of withholding tax. This feature makes eurobonds very attractive to international investors.

Question 57

How are most Eurobonds issued?

Answer 57

Most Eurobonds are issued like corporate bonds, using either a bought deal, where the underwriter buys up the full issue and sells them to interested parties, or a fixed price re-offer, where a syndicate issues the bond.

Question 58

How is most trading in the eurobond market is conducted?

Answer 58

Most trading in the eurobond market is conducted OTC via the telephone rather than on domestic exchanges, although exchange-traded eurobonds are becoming increasingly common.

Question 59

How are Eurobonds settled?

Answer 59

Once a deal is struck, it is reported to ICMA (the International Capital Market Association) before it is processed for settlement. Reporting to ICMA takes place T+1, ready for settlement of the Eurobond trade T+2.

Question 60

Name the organisations which settle Eurobond transactions.

Answer 60

Euroclear and Clearstream settle Eurobond transactions.

Question 61

Who regulates the international bond market?

Answer 61

ICMA (the International Capital Market Association)