eq trading: level@regulation across continents

ranked from simpler to more complex/stringent

  1. Australia
  2. UK — MiFID, brexit
  3. Latam
  4. US/Canada
  5. Asia such as Korea, Jap, HK. Each country has strict regulations such as reporting and restrictions.
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fractional shares: quite common]basket trading

https://www.investopedia.com/terms/f/fractionalshare.asp explains that fractional shares can be naturally-occurring, but I want to talk about artificial fractional shares in “normal” stocks.

Custom baskets are traded as equity-swaps. Client specify a weightage profile of the basket like x% IBM + y% AAPL + z% GE where x+y+z ==100. The sell-side dealer (not a broker) would hold the positions on its own book, but on behalf of clients.

Such a basket is not listed on any exchange (unlike ETFs). If client were to go long such a basket directly, due to limited liquidity on some constituent stocks she may not get the desired weightage. In contrast, a sell-side has more liquidity access including smart-order-routers and internal execution.

The weightage means some stocks will have fractional quantities in a given basket. Also such a basket could be too big in dollar amount like $58,476, so the sell-side often use a divisor (like 584) to create a unit price of $100, similar to a share’s price in a mutual fund. Fractional quantities are even more inevitable in one unit or in 391 units.

After a client buys 391 units she could sell partially.

With mutual funds, I often buy fractional units as well, like 391.52 units.

ibank: trade book`against exch and against client

In an ibank equity trading system, every (partial or full) fill seems to be booked twice

  1. as a trade against a client
  2. as a trade against an exchange

I think this is because the ibank, not the client, is a member of the exchange, even though the client is typically a big buy-side like a hedge fund or asset manager.

The booking system must be reconciled with the exchange. The exchange’s booking only shows the ibank as the counterparty (the opposite counterparty is the exchange itself.) Therefore the ibank must record one trade as “ibank vs exchange”

That means the “ibank vs client” trade has to be booked separately.

Q: how about bonds?
A: I believe the ibank is a dealer rather than a broker. Using internal inventory, the ibank can execute a trade against client, without a corresponding trade on ECN.

Q: how about forex?
A: I think there’s less standardization here. No forex ECN “takes the opposite side of every single trade” as exchanges do. Forex is typically a dealer’s market, similar to bonds. However for spot FX, dealers usually maintain low inventory and executes an ECN trade for every client trade. Biggest FX dealers are banks with huge inventory, but still relative small compared to the daily trade volume.

aggregation unit

I now believe there are at least two purposes, not necessarily reflected in any systems I worked on.

  • Purpose: FINRA regulatory reporting on aggregate short positions on a given stock like AAPL. Probably under Regulation SHO
  • Purpose: Self trades (also wash trades) that create a false impression of activity. I believe trading volume for AAPL would be artificially inflated by these trades. “Bona fide” trade reporting is expected. To deal with self-trades, a firm need to exclude them in trade reporting. But what if a self-trade involves two trading accounts or two algorithms? Are the two systems completely unrelated (therefore not self-trade) or both come under a single umbrella (therefore self-trade)? That’s why we assign an “aggregation unit” to each account. If the two accounts share an AggUnit then yes self-trade.

Are equities simpler than FICC@@

I agree that FICC products are more complex, even if we exclude derivatives

  • FI product valuations are sensitive to multiple factors such as yield curve, credit spread
  • FI products all have an expiry date
  • We often calculate a theoretical price since market price is often unavailable or illiquid.
  • I will omit other reasons, because I want to talk more (but not too much) about …

I see some complexities (mostly) specific to equities. Disclaimer — I have only a short few years of experience in this space. Some of the complexities here may not be complex in many systems but may be artificially, unnecessarily complex in one specific system. Your mileage may vary.

  • Many regulatory requirements, not all straightforward
  • Restrictions – Bloomberg publishes many types of restrictions for each stock
  • Short sale — Many rules and processes around short sale
  • Benchmarks, Execution algorithms and alphas. HFT is mostly on equities (+ some FX pairs)
  • Market impact – is a non-trivial topic for quants
  • Closing auctions and opening auctions
  • Market microstructure
  • Order books – are valuable, not easy to replicate, and change by the second
  • Many orders in a published order book get cancelled quickly. I think some highly liquid government bonds may have similar features
  • Many small rules about commission and exchange fees
  • Aggregate exposure — to a single stock… aggregation across accounts is a challenge mostly in equities since there are so many trades. You often lose track of your aggregate exposure.
  • Exchange connectivity
  • Order routing
  • Order management

custom-basket ^ portflio trading

A client can ask a broker to buy “two IBM, one MSFT” either as a AA) custom basket or a BB) portfolio. The broker handles the two differently.

Only the Basket (not the portfolio) is “listed” on Bloomberg (but not on any exchanges). Client can see the pricing details in Bloomberg terminal, with a unique basket identifier.

Booking — the basket trade is recorded as a single indivisible position; whereas the portfolio trade gets booked as individual positions. Client can only sell the entire basket; whereas the portfolio client can sell individual component stocks.

Fees — There is only one brokerage fee for the basket, but 5 for a portfolio of 5 stocks.

The broker or investment advisor often has a “view” and advice on a given basket.

Corporate actions should be handled in the basket automatically.

I feel portfolio is more flexible, more informal than custom basket which is less formalized, less regulated than an index-tracking ETF.

swap on eq futures/options: client motive

Q1: why would anyone want to enter a swap contract on an option/futures (such a complex structure) rather than trading the option/futures directly?

Q2: why would anyone want to use swap on an offshore stock rather than trading it directly?

More fundamentally,

Q3: why would anyone want to use swap on domestic stock?

A1: I believe one important motivation is restrictions/regulation.  A trading shop needs a lot of approvals, licenses, capital, disclosures … to trade on a given futures/options exchange. I guess there might be disclosure and statuary reporting requirements.  If the shop can’t or doesn’t want to bother with the regulations, they can achieve the same exposure via a swap contract.

This is esp. relevant in cross-border trading. Many regulators restrict access by offshore traders, as a way to protect the local market and local investors.

A3: One possible reason is transparency, disclosure and reporting. I guess many shops don’t want to disclose their positions in, say, AAPL. The swap contract can help them conceal their position.

swap^cash equity trade: key differences

I now feel an equity swap is an OTC contract; whereas an IBM cash buy/sell is executed on the exchange.

  • When a swap trade settles, the client has established a contract with a Dealer. It’s a binding bilateral contract having an expiry, and possibly collateral. You can’t easily transfer the contract.
  • When a cash trade settles, the client has ownership of 500 IBM shares. No contract. No counterparty. No expiry. No dealer.

I think a cash trade is like buying a house. Your ownership is registered with the government. You an transfer the ownership easily.

In contrast, if you own a share in coop or a REIT or a real-estate private equity, you have a contract with a company as the counterparty.

Before a dealer accepts you as a swap trading partner, you must be a major company to qualify to be counterparty of a binding contract. A retail investor won’t qualify.

ETF mkt maker #RBC

The market maker (a dealer) does mostly prop trading, with very light client flow.

Q1: creation/redemption of units?
A: yes the ETF market maker participates in those. When the dealer has bought lots of underlier stocks, it would create units; when the dealer has bought a large inventory of units, it would redeem them (convert to underliers)

Q1b: what’s the motivation for dealer to do that?
A: there’s profit to be made

Q3: restrictions on short position held by a dealer?
A: there are restrictions on how long you can hold a short position without a borrow (stock loan). For regular investors it could be a few days or within 0 sec. For a market maker, it is definitely longer, like 5 days

Q3b: how about size of the short position?
A: probably not. However, if a dealer has a huge short position and looking for a borrow, the stock loan could be very expensive.

Q: how is the bid or ask price decided in the market maker system? Is it similar to the citi muni system? In a competitive, highly liquid market, demand is sensitive to price.
A: fairly simple because the underliers’ bid/ask are well-known and tight. For a bond ETF, the spread is bigger.
A: inventory level in the dealer’s account is another factor
A: pressure in the market micro-structure is another factor. If you see heavy bidding and few offers, then you may predict price rise

share buy-back #basics

  • shares outstanding — reduced, since the repurchased shares (say 100M out of 500M total outstanding) is no longer available for trading.
  • Who pays cash to who? Company pays existing public shareholders (buying on the open market), so company need to pay out hard cash! Will reduce company’s cash position.
  • EPS — benefits, leading to immediate price appreciation
  • Total assets — reduces, improving ROA/ROE
  • Demonstrates comfortable cash position
  • Initiated by — Management when they think it is undervalued
  • Perhaps requested by — Existing share holder hoping to make a profit
  • company has excess capital and
  • A.k.a “share repurchase”

trade bust by exchange^swap-dealer

Trade bust is rare on real exchanges, usually for some extreme scenarios.

It’s more common in a equity swap dealer system. (Assuming a buy) there are two transactions:

  1. client leg: contract between dealer and client, client buying IBM from dealer
  2. exchange leg: regular buy on nyse.

After a swap trade is executed i.e. after the hedge order has been executed on nyse, the dealer can bust the client leg. So for the time being there’s only the hedge position on the dealer’s book — risky. Now dealer will execute another client leg transaction at a new price.

dark pools – a few observations

Most common Alt Trading Service is the dark pool, often operated by a sell-side bank (GS, Normura etc).

A “transparent” exchange (my own lingo) provides the important task of _price_discovery_. A dark pool doesn’t. It receives the price from the exchanges and executes trades at the mid-quote.

Market order can’t specify a price. You can think of a market buy order as a marketable limit order with price = infinity. Therefore, when a market order hits a limit order, they execute at the limit price. When 2 limit orders cross, they execute at the “earlier” limit price.

Therefore, on the exchange, I believe all trades execute either on the best bid price or best ask. I guess all the mid-quote executions happen on the ATS’s.

Dark pool is required to report trades to the regulator, but often with a few sec longer delay than an exchange.

Dark pool may define special order types beside the standard types like limit orders or market orders.

Forex is quote driven, not order driven. Forex has no exchange. The dominant market is the interbank market. Only limit orders [1] are used. However, within a private market operated by a single dealer, a “market order” type can be defined. I feel the rules are defined by the operator, rather than some exchange regulator.

[1] A Forex limit order is kind of fake – unlike the exchange’s guarantee, when you hit a fake limit order that dealer may withdraw it! I believe this is frowned upon by the market operator (often a club of FX banks), so dealers are pressured to avoid this practice. But I guess a dealer may need this “protection” in a fast market.

order internalization

I guess internalization is not automatic. Special logic needed.

https://www.fool.com/investing/2018/03/19/how-does-robinhood-make-money.aspx explains

Brokers can also match up buyers and sellers on their own in a process known as “internalization.” If one client wants to buy 100 shares of Advanced Micro Devices and another wants to sell 100 shares, the two orders could be matched up internally, and Robinhood could collect the very small difference between what the buyer pays and the seller receives.

———- a veteran’s answer ———-
“I don’t think we have logic locally to cross against firm automatically. The trader would have to send an explicit order to cross against firm. There is a Smart Order Router layer that intercepts order and they may have some logic there to automatically cross against firm.”

On 6/20/2012 3:10 AM, Bin TAN (Victor) wrote:

See job spec below about “internalization”. Is there non-trivial business logic about that in your system? I guess if a client places a limit buy order and the internal best offer is better than the exchange best offer then do it internally.  Is it that simple or there are hidden complications.

Not sure about market orders but I guess if the internal best offer is better than the exchange best offer then obvious…

IV – HFT trading operation support

Q: What’s a busted trade. How can it be busted?

Q: If I send a IOC sell of 12.05 but the best bid is $12, how could this be filled?

I believe IOC / FOK are all limit orders. Market orders are implicitly IOC — if orderbook is (almost) empty on this side, the market order is (partially) cancelled.

Q: what’s a resting order?

Q: if a sell limit order is $27 and a new buy limit order comes in at $28, what would be trade price?
A: $27. new comer is given the best price available. Note the buyer doesn’t know what the best offer would become when his order hits the book, so he uses limit order not a market order.

Q: what’s away order?

Q: whats intermarket sweep order