Trading through the lens of COVID 19

Published on 28 May 2020

Countermeasures to tackle COVID 19 and the pandemic itself are changing our view of risk at a macro, firm-wide and trading desk level. It has already been a major cause of market volatility, testing the capacity of market makers, investors and market infrastructure to handle extreme price moves and volume.

The longer term effects are likely to challenge existing business structures, best practice expectations and trading models. Already outsourcing and software-as-a-service are seeing increased interest in the front office. In this webinar we discuss how trading may evolve as an outcome of the pandemic and its effects, with guest speakers Gary Paulin, Global Head of Integrated Trading Solutions at Northern Trust Capital Markets, Brett Chappell, Partner at Sherpa Edge and Pontus Eriksson, Strategy Director for Capital Markets, FIS.

Dan Barnes Welcome to Trader TV, I’m Dan Barnes. Today, we’re talking about trading through the lens of COVID-19. Joining me today are Pontus Eriksson, senior strategy director of capital markets at FIS, Gary Paulin, global head of integrated trading solutions at Northern Trust Capital Markets, and Brett Chappell, partner at Sherpa Edge. We’re going to be looking at the way that the understanding of risk has changed as a result of the COVID-19 pandemic, at a firm-wide level, and at trading desk level, and at a macro level. Pontus, can I start with you? How do you see the understanding of risk changing at a macro level?

Pontus Eriksson The repercussions for the COVID-19 pandemic will have profound impacts on the wider economy. Governments have and will continue to issue a financial rescue programs to redeem the situation to the best of their abilities. This obviously has a cost in terms of increased budget deficits and they have to pay for it, so the government has to pay for the deficit. And the top three alternatives, as I see it; they have to either lower interest rates, they have to do interest rate cuts and spin the economy, they can increase inflation to reduce the value of the credit debt, or they can increase the taxation. And this can happen in many ways; one way could be taxation on financial transactions. This has been something that has been in the limelight on and off even before the COVID-19 pandemic, so I wouldn’t be surprised if this emerges again.

Dan Barnes We’ve seen central banks step in to provide liquidity into the market, as we did after the 2008 crisis. Can you tell us how that additional liquidity changes the picture for traders?

Brett Chappell It comes across as to which platform they’re going to use. While you might have certain traders will be coming in, going via Bloomberg or others via Market Access, others via voice, the question is to find out where the central banks are going and where they’re going to be doing their purchases. That is often the real question.

Dan Barnes when we consider the effects of the central bank and the responses from authorities so far, it does appear that volumes are still relatively high, but that the liquidity picture has improved considerably. Pontus, do you have any views on how these government responses have affected your clients so far?

Pontus Eriksson It’s been an unprecedented market turbulence in general with record high trading, extreme volumes. The VIX index, measuring the volatility sentiment in the market has peaked at record numbers and still remain high. Equity markets have gone down, no one has missed that, and that’s pretty brutal. And today it has rebounded to, not former levels, but still good levels. But it’s still a lot of volatility with daily index movements at very high numbers. We’ve seen pressure on credit markets, liquidity and collateral challenges both for lenders and borrowers. Gold markets going down as well. Normally, that’s a safe haven, right? But that has been aborted. We’ve seen the oil futures in total collapse due to changing needs and stranded negotiations within OPEC. Just overwhelmed trading and risk platforms, not being able to cope with volumes and real time risk measurements. In addition to that, we have other players coming in and regulators delaying some of the regulation, because of uncertainties and so on. So that’s a couple of things that happen.

Gary Paulin The regulations that we have now were there in response to the previous crisis, I guess we have to call it now, the GFC, (Global Financial Crisis) and a lot of those were in place to help rebuild the trust that was lost in the GFC, by trying to improve transparency, which is what MiFID was all about. Good governance, which is what the senior managers regime is all about here in the UK, and also the fairness and these structures which have value assessments. And we’re seeing in the US different fund structures like fulcrum fees, trying to address their asymmetry in the market. But I don’t think you’ll see that sort of scale of new regulations for this crisis. What I think you will see is the way that the industry is responding to the regulatory framework we have today may accelerate and may change.

Dan Barnes Gary, one thing I’d like to ask you, do you see, in terms of sentiment amongst your clients, any changes as a result of the stress we’re seeing on markets?

Gary Paulin There’s obviously the market-related stress from what we’re seeing in terms of the volume, but also the volatility. And then there’s the personal stress. How do we deal with the transition to working from home? And I guess just the ongoing uncertainty of events sort of adds a layer of stress to people’s day jobs, but also their lives. By and large, I think most of our clients have managed things incredibly well given the circumstances.

Dan Barnes One of the success stories of this crisis has been the infrastructure has held up and firms have been able to support liquidity throughout the crisis for the most part. That means for end investors, whether they’re trying to get in or out of positions, they found themselves supported by both the buy-side and the sell-side providing that access.

Gary Paulin Absolutely. And I think that’s quite comforting to know that the infrastructure of the market has been put through a highly stressed environment, and I think it’s fair to say that it’s come through with flying colors. I mean, without, as Pontus said, with record levels of volatility, record volumes, whilst that was happening, lots of firms were implementing their social distancing and shelter in place protocols, and it was still business as usual for a lot of firms. So the fact that the industry managed to get through the acute phase of the sell-off in the way it did, I think is really comforting and just shows how robust the industry is.

Dan Barnes After the 2008 crisis, we saw a number of the systemic risks that people recognized being dealt with by a combination of infrastructure, business continuity planning, et cetera. Pontus, following this crisis, how do you see the understanding of risk changing at a firm-wide level?

Pontus Eriksson In general, I think regulators, they have now used the flexibility in the current regulatory frameworks to embed it into the system, to lower the amount of capital banks needs to hold. And this is a relief for banks in these hard times, of course, and good. There’s also been some negative impacts as regulators have increased the buffer for counter cyclical risk. And I think we will see going forward how this will unfold. But it’s clear that banks suffered today and the regulators must balance the need to make sure that the banks are well capitalized, but at the same time giving them enough remedy to survive and be the lifeblood they need to be in in the credit markets.

Gary Paulin Over the longer term I think the pandemic will accelerate some of the big structural changes that were already occurring. One that we were observing coming into this, was firms looking more to outsource non-core functions, which I guess now also includes parts of the front office. So, for me, I think you’ll see an acceleration of some of those trends as opposed to COVID-19 changing things itself.

Dan Barnes Brett, what is your perception of how risk has changed for firms following the market volatility in March?

Brett Chappell One of the main issues has been if you’re a large institution, you might then end up having your back office based in Lithuania. You might then have your settlements based in the Philippines. And when you have to work from home, one of the risk areas that you’ve got is then time to market. And what I mean by this is that, if you have to move quickly and in an agile fashion, it can become very, very difficult for people to move this quickly. So, I think what will be happening perhaps in a few months is that, they are going to start to reevaluate. Yes, we’ve reduced cost, we’ve reduced FTEs, but in contrast to that, we may need to have a more simplified structure than just simply sending a mail and saying, ‘you have to fill this out online and you’ll get a response in 48 hours. The market in this situation can’t deal with it.

Dan Barnes And Gary, would you echo that sentiment?

Gary Paulin I would, and when I use my clients as an example, I think the effects that it had on them, obviously the initial transition from the centralized, more decentralized forms of work and the co-location to the remote location. Of course, that has set up latency, which sort of alludes to what Brett was saying. And just getting to grips with new ways of doing things takes time, e.g. new hardware and connectivity, not to mention the challenges of working at home. I’ve got four kids, a car and a dog and I know what they’re like!

Dan Barnes And of course, we’ve seen automation increase in the finance industry and generally a reduction in headcount. Presumably going forward, we’re going to continue to see electronification of processes, increased use of automation, and that’s from the front to the back office going forwards?

Gary Paulin Without a doubt. One of the two things COVID-19 is going to play on most, in terms of these drivers, I mean, margins are clearly going to be impacted. I think what we’ve seeing over the past 10 years of the whole market is all facets went up. There’s also a lot of cost complacency creeping in, so fixed costs got very high. And that’s all well and good until the tide goes out. When the tide goes out on assets, these costs become magnified and all firms look inward, questions what’s caught, which they double down on, and also what’s non-caught, which they might look to outsource, if a hyperscale provider can perform those functions as good as, if not better and more cheaply than what they could if they were to keep them in-house. It’s that sort of setup we always see at the beginning of big outsourcing waves. And we had it in the back office, and we had it in the middle office, and it’s very much what we see today. So, I would expect that to happen more and more now, and COVID-19 just simply accelerates those trends in my mind.

Dan Barnes Do you expect to see a greater concentration of business in fewer firms that will then lead to a greater need for outsourcing?

Pontus Eriksson I think we will see a fair amount of that, but again, it’s going to be a question of, and I’m going to come back on the political situation, it’s a capital markets union. Now, I know you’re saying, ‘why are you bringing that into this conversation?’ Because what is going to be the most fair solution for the clients? And once the dust settles on COVID-19, and the European Commission is going to start to look, they’re going to say we have to make sure that the capital markets are not broken and they’re going to have to be fixed so that we can continue to get capital in, especially after all the contraction we’ve seen in GDP. And one of the ways of doing that, obviously, if you’re going to be in a bank or a large institution, if you’re going to lend, you’re going to have to reduce costs even more. So I think that there is going to be another big shakeout going forward and it will be at the expense of employees in the banking industry, but it’s going to have a political will to try to make sure that the real economy is served. But I hope I’m wrong on that.

Dan Barnes And in fixed income markets where there is a greater fragmentation of both infrastructure and instruments, it might make sense to have a better concentration of market activity?

Pontus Eriksson There is one aspect also with the consolidated tape, which is very much in focus, that will obviously reduce costs going forward, depending on what sort of format the commission is able to do. I think a private, you know, public consortium might work very well on that. But you talked about concentration. I think one important point to point out, as Gary pointed out, he has four children, a cat and dog, and he’s in the house. We go from these very large trading rooms into our own places that are much smaller. And at the same time, we’ve gone from having four, six screens down to two. So the incredible value of real estate space on the screens means that when you have five or six different MTFs and you only have, now two screens to look at it, and most people don’t want to put their nose up to the screen to see what’s going on, you tend to do a little more electronification. And I think that when they do an analysis three months down the road, when people come back, when you have to do a best execution, transaction cost analysis, you’re going to see an increase placement over the MTFs. And they’re going to be saying why? Even though you can have big 10% swings against the generic curve, they’re still going over that because it’s just simply the most efficient way of doing it. But it doesn’t remove the human nature of it. Electronification is fine, but unless you know the material risk taker at the bank or the liquidity provider, you’re not going to get a better price by just going online.

Dan Barnes And Pontus, in terms of the way people manage risk during this crisis, how did you see capital management holding up and how did business continuity planning hold up?

Pontus Eriksson Continuity has definitely become the key word these days; it’s never in my career before have I seen so much focus for businesses just to move on and stay afloat. And some of the areas have been touched here on working from home and the level of, you know, ratio that different firms can operate on. And we have seen examples of really high 98 – 99% of staff can work from home with success rates. And we see examples of where this is simply not possible. And I’ve spoken to some banks and they have to split trading teams into sub teams so as not to blend them. And they have to use different locations and basically build up a complete parallel stream of services to be able to operate. I’ve also seen, you know, outsourced people in India and other places and they have been mandated to go into quarantine and they can’t work from home, and they don’t have the technology because the VPN is not secure enough. So, you have a situation where you have outsourced a large number of people to these places and you can’t have them working normally. So it comes with so many different facets, this work from home and you have the people-aspect of it, of course; the fatigue, the stress and the frustration of it, and there’s a lot that goes into this. I wouldn’t be surprised if banks and other institutions really focus on making sure that they have a nice business continuity plan that, embeds all of the parts of the firm, not just one element of it. You know, it’s got to be holistic.

Dan Barnes Do we actually think that structural changes are possible in the industry? What’s your take on that?

Pontus Eriksson The way I look at it, there are other risks now becoming increasingly important. You know, people were very preoccupied with financial risks, but we see a lot of other types of risk coming in and our customers tell us about them; everything from cyber risk, because people are more digitalized, we see a lot of fraud, money laundering, and outsourcing risk. We also see people who wants to outsource more and use software as a service, but that also comes with aspects of this. The business continuity risk due to this pandemic is probably the most interesting one right now. We also see other types of risks that normally are suppressed a bit, and risk where you have correlations factor like; cross gamma risk or wrong-way risk, those kinds of risk types. And I think the current teams and their associated work from home mandates, come with its own sets of risk. The new normal that will be developed going forward would definitely have a blend of people working more from remote locations and from home.

Dan Barnes Brett, do you think a greater flexibility around the systems available and the skill sets available from traders might be necessary in the future?

Brett Chappell I believe that’s correct. However, things are going to be done on a really individual level, because it comes down to the needs. If you are an insurance company and you have the pure beta funds and you just spit out what your order says and then you just have to go out and execute by end of day, you know, it’s a very different way of trading than if you have a bottom up approach to building up a credit portfolio fx, where you’re trying to generate alpha, where maybe you can take 2-3 months to buy a certain instrument or to sell a large size. But these have to be taken into account, and it’s a behavioral aspect so that, yes, the technology will make for increased deficiencies, and that is fantastic and that will continue unabated. I think it’s going to continue accelerated even in the next few months, but we cannot underestimate the importance of behavioral understanding and empathy when going out and dealing with this, because that will have a difference for each client depending on their investment strategy.

Dan Barnes That’s very true. Gary, how do you think that understanding of risk might have now changed on the trading desk?

Gary Paulin What the industry is having to solve for now, I think becomes the base case for disaster-planning in the future. Whereas once work from home was a auxiliary function, it’s now a primary importance. When you think about these challenges that they’ll need to solve, fx; how will we deal with prolonged staff absences and say a critical function like dealing, without compromising, as Brett mentioned, best execution, or operational performance or control? That was already a worry for many senior managers taught by the regime who are considering whether, fx, the junior trader was appropriate to discharge all these new obligations and if not, weigh those costs of retraining or rehiring them against solutions like outsourcing. So, there’ll be people-problems, but would also be control-problems. And so far, how do you supervise remote offices or telework arrangements? How do you perform due diligence on your current vendors and how do you select new ones? And then there’s just the practicalities of carrying like-for-like equipment that’s required to replicate business as usual, which for a trading desk, you need that equipment, and you need the three screens. You need the turrets, you need that. I think a lot of firms will discover that they have a robust and resilient disaster plan to meet the requirements, that I think the pandemic is forcing on us. It’s going to add a lot of cost and complexity at a time when a lot of firms are trying to cut costs and simplify operations.

Dan Barnes Pontus, do you think market risk has changed at all?

Pontus Eriksson Market risk has definitely changed. There’s been increased turbulence that we talked about, and I think the real-time aspect of risk has become more important. We’ve seen a number of cases where, because of the turbulence in the market and the volume, we’re seeing higher margin requirements, more margin calls, and simply it’s not good enough to intraday or end-of-day support for that, so you need to have much more robust risk services. Ideally you want to have them as a service, because you don’t want to rely on people who may not be in office, you need to have a service provider.

Dan Barnes What operational changes would you expect to see on the trading desk level?

Brett Chappell I would probably see a lot of counseling, because I think some people are very much stressed out and tired and forced to work. I would see that there’s going to be an overlay of perhaps that having an equity solution for fixed income is not a panacea. I think what you’re going to see is, obviously, further consolidation among some services, and it’s going to be a very difficult transitional phase. Because if you have a team of five traders, you know, let’s say they cost a 1.5 – 2 million to run, we’re talking euros, and you find, ‘OK, I’ll send them over to an outsourced, you know, to Gary or to Brett or whomever. We can do that.’ It’s going to further increase the stress. So even though it might sound funny, I think you’re going to have to come with the operational efficiencies, reduce operational risk. That’s very clear, and try to move as much as possible online, but be aware there’s going to be human cost.

Gary Paulin With the implementation of the senior managers regime last year, a lot of senior managers who discovered that they were responsible or accountable to the activity of dealing, were often uneasy about some of the ways that the functions were playing out. Fx, duplicity of roles where the PM was also the dealer, and we know these roles become very different and distinct, and the level of expertise needed to be a portfolio manager and to be a good dealer in a world that’s becoming more electronic, are very different. And so I think we will see those roles splitting. And of course, if you don’t have the dealer, but you’ve got the role, then you need to consider how best to solve that.

Brett Chappell You have to have a separation of the investment decision taker and the executer. They have different tags when they come down. You know, RTS 27, 28, you want to make sure that you’ve got that documented. And even though they’ve given perhaps a 2 year leeway on MiFID II, to try to see what best execution is, they’re going to start focusing on this because in Q2, when you’ve seen an incredible amount of loss, they’re going to be very unhappy funds, you know, let’s say a treasury or a city treasury can no longer meet their pension obligations because they’ve lost 20%. So they’re going to go see the portfolio manager who they’ve given money to invest and they’re going to demand, ‘why did you do this? Can you document that you did the best trade for me?’ And you’re gonna have, ‘well, someone did a screen dump of a Bloomberg ALLQ and you traded there?’ It’s going to be very delicate for a lot of these people. So you’re going to have to try to come up going forward in six months, nine months’ time, people are going to have to really evaluate what is the definition of best execution? And TCA is going to become even more of a topic, whether it’s in-house or outsourced.

Pontus Eriksson 100 percent agree. 100 percent agree.

Gary Paulin I agree.

Pontus Eriksson Pontus, at the moment, there are a number of ongoing regulatory initiatives, including the transition from LIBOR, the development of consolidated tape for both equity and non-equity markets in Europe. How do you see trading desks engaging with those given how distracted they might be by market activity at the moment?

Pontus Eriksson The IBOR transition is unlike any regulatory reform, right? It underpins all the IBORS in the world. It underpins debt and derivative contracts at an estimated value of 300 trillion dollars, so it’s massive. And the idea is to move the IBORS to the alternative rates, and I think the question you’re asking is, it’s like a double edged sword, because on one hand you have the banks who have already started these programs to do the transition. And the argument for continuing to do that is that you kind of have started already or you’re halfway through and, it kind of makes sense to develop the liquidity in the newer alternative rates. The counterargument is this is one of the most massive transformation journeys ever. So why would you do that at the same time as you have this pandemic crisis, which is one in 100 years?

Dan Barnes Gary and Brett, do you see the potential for regulatory change to be accelerated as a result of this crisis?

Brett Chappell Who’s going to have a big seat at the table? That is going to be the local government. So, the question is, will this be a continued promotion of nationalism like you see in certain countries with America First under the current regime. Or are you going to see in Europe a perhaps tighter European hegemony? That is going to be the big thing that’s being debated and according to how press and people’s wealth and cases are going to come against it, they’re going to have a much bigger seat at the table and that’s going to be the nation’s.

Pontus Eriksson There’s so many trends that we had before the COVID-19 that will be accentuated or exacerbated by the fact that we have this pandemic right now. One such element is electronification in general. I mean, you can talk about the electronification in the fixed income space or in even all asset classes. And I think that’s just going to continue to be a trend over the foreseeable future. And as the world goes towards more digitalization in all layers of the economy, we will see this need. And if you join this with business continuity planning, it’s going to be something that is very, very important. And then on top of this, you might see more outsourcing, more software as a service embedded into this and much more due diligence on these providers that will provide the service, because you need to rest assured that they can service the firms in hard times so all their salary agreements needs to be in place and validated.

Gary Paulin When you think of some of the big trends that are coming out of the previous crisis, transparency is one of them. And the need for greater disclosure to enable decision makers to make the more informed decision is also sort of a megatrend, I guess, towards the way we all make decisions now by using data and not relying on, you know, the ways of the past, which was more to do with perhaps belief. And you’ve known someone for 50 years or whatever it is, you know, that way of making decisions is no longer, I think, acceptable in the modern world. And it’s critical now to be able to base decisions on the evidence. And so this whole trend that Pontus alluded to, is part and parcel of this bigger megatrend to provide more evidence in our decision making.

Dan Barnes I’d like to thank Pontus, Gary and Brett, for their insights today, and of course you for watching. To catch up on our other shows, got to TraderTV.NET or ETFTV.NET.