systematic trading strategies

Third Party Calculation Agents

Third Party Calculation Agents have become more prevalent in the past years. Companies that run the strategy/index calculation as an outsourcing partner for the investment banks. This may not seem of great interest for the end client at first glance; however, there are some benefits to such an approach.

The calculation agent has very broad and discretionary powers. Banks that aim for a sustainable business will not abuse them, but there obviously is a conflict of interest. This excerpt is from the risk factors of an equity structured note.

If the calculation agent is the same entity as the guarantor and the issuer is an affiliate of the guarantor, potential conflicts of interest may exist between the calculation agent and the purchasers.

From a control point of view, it is an improvement to have an impartial third party involved calculating levels. It is true that the banks pay Third Party Calculation Agents, but this is a systematic process that can be verified, unlike CDO ratings for example.

The Third Party Calculation Agent can also provide some help/consulting on best practices for exception handling and some quality control for the rules to less experienced strategy providers.

In big and experienced investment banking operations, these advantages may not count for much, as they normally already follow best practices. Nevertheless, with the proliferation of smaller banks releasing Trading Strategy Indices, the potential for quality control as part of the work of Third Party Calculation Agents could grow.

For most clients, the existence of calculation agents other than the investment bank providing the investment strategy may not be significant enough to influence any investment decisions. Very sophisticated clients sometimes have to set up their own calculation spreadsheets, this could also be an area where Third Party Calculation Agents can leverage their knowledge and offer consulting services.

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trading strategy index exception handlingTrading Strategy Index Exception Handling is an important aspect of the Index rules.  They are purely systematic and do not contain discretionary elements. This allows investment banks and other brokers to offer these products to clients without having to acquire an asset management licence.
This sounds easy enough, however, coming up with rules that cover all possible cases and exceptions is more complex than meets the eye. Unlike rules for a trading strategy applied by a trader for a discretionary portfolio, it is not good enough to cover 80% of the cases and ‘wing it’ if necessary, once the rules no longer cover the situation. Even though this approach simplifies the rules creation process significantly and improves their readability, this can be interpreted as a discretionary element.

 

From a practical point of view, rules that do cover most cases and let the bank act in good faith in all other cases, could be a sensitive alternative. However, this is not how regulation works. Trading Strategy Index Exception Handling is a crucial aspect of best practices and regulatory compliance.

In an investment product that is sold to the public/qualified investors, this discretionary element can mean that a strict regulator (or compliance department) demands immediate action. Either doing an immediate update of the rulebooks or to stop dealing with such products. In the past, a number of banks were not very strict with their documentation, this is causing some headache now.If the nature of these exceptions is not clear, let me give some examples. Trading Strategy Indices and also standard index daily values are usually calculated using the closing price of the underlyings. In the case of a market disruption there may be no closing price, so there is the question how to deal with this.

  • Should a level for that day be published at all?
  • If yes, based on what?
  • Will they be previously published levels changed, once the disruption is over?
  • If the market is no longer disrupted, will there be some sort of backfilling of levels?
  • What if the disruption is for more than 1 day?
Extended market disruption is not common in equity and fixed income markets, but happens more often in the commodity sector. Rules that do in effect cover 100% of the cases need to answer the question of what happens on the fifth day of a market disruption or if a security is discontinued.

It is also worth mentioning that there is some reputational risk involved in dealing "in good faith". Even with the client's best interest at heart, the decisions made may still result in the client losing money. Unlike in the case of a purely algorithmic process, this can result in serious PR issues.

For providers of financial products it is crucial to have impeccable documentation of all offered products. Ambiguities and flaws in such documentation can give clients a free option to litigate in case the investment turns sour. This can cost costs banks a great deal of time, money, reputation and management capacity. Again Trading Strategy Index Exception Handling prevents all this.

In a world of ever more stringent financial regulation, there is little scope for less than complete complete rules on Trading Strategy Indices. Smaller and newer strategy providers may need some outside help on best practices, regulatory requirements and possibly on drafting the rules. This can come from law firms or other specialist providers in this field.
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Index Access WrappersIndex access wrappers are an important consideration in the investment process. Once client want to go for a specific Trading Strategy Index (TSI), they have to decide in which form to access them. Traditionally a lot of institutional clients went for over the counter (OTC) Excess Return Swaps or Total Return Swaps (on excess return and total return underlyings respectively). These are very flexible, but have become a bit less popular because of the involved credit risk and in some cases regulations like Dodd Frank require reporting to the authorities.

Some clients are also worried about credit risk and may not be ready for the operational burden of running a credit support annex (CSA) with reasonably high frequency.

When deciding on a certain index access wrapper or vehicle, clients have to consider the following aspects:
  • Flexibility
  • Speed of set up
  • (Marginal) Cost of wrapper
  • Complexity of set up
  • Regulatory limitations
  • Necessary documentation
  • Counterparty faced and quality thereof
  • Credit risk exposure to that counterparty
  • Mitigating factors on credit risk, such as CSA
  • Balance sheet costs (on the bank's side) which may affect pricing
  • Liquidity and potential penalty charges for early unwind

 

Possible alternative index access wrappers are medium term notes (MTNs) or certificates, issued either by the investment bank or a third party issuer. They can typically accommodate any underlying that would otherwise be accessed through a swap; however these notes are not very handy in case the client wants to trade in an out of a certain underlying with ease and low transaction costs. Also, unlike doing swaps, MTNs and certificates require the client to put up cash upfront.
Some banks have set up a number of their TSIs as ETFs. This allows investors to access strategies at very low transaction costs, negligible credit risk and balance sheet costs and great flexibility. On the other hand, if an institutional investor wants to make a sizeable allocation in more obscure strategies, the market maker in the ETF may not offer the whole size at the current offer price. Also, the client has to put up the capital upfront.

TSI set up as mutual funds share some of the features of ETF. Again low transaction costs (in the institutional share class), negligible credit risk and balance sheet costs and great flexibility are positive aspects. Bigger trades may lead to an increased tracking error until the fund provider manages to ramp up or unwind his positions to the new levels.

Setting up index access wrappers for highly flexible solutions is a bit more complex. Often a note is set up (typically SPV issued) that has some resemblance to a managed account or a portfolio bond. This note can be collateralised with high quality securities and could even contain a CSA with the swaps provider. With such a set up the client can enter excess or total return swaps with the full flexibility of the OTC set up. None of the credit and potential regulatory issues arise. The obvious downside is the complexity and the set up costs of such a construct and the fact that it will typically only accommodate one swap provider/bank. So either the client has to get these flexible notes in place with a number of banks or face a limited choice and potentially reduced negotiation power in fee discussions.Also, unless a bank has created an easily replicable template for such a setup, this will involve lengthy negotiations and significant upfront costs. Banks will typically only go ahead with such a product if they expect significant repeated business and fees.
Naturally no one size fits all, so investor clients have to weigh their alternatives. One can always change the approach if the current one turns out to be suboptimal.
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Trading Strategy IndicesTrading Strategy Indices or Algorithmic Indices (TSI) or algorithmic indices or algos have become very popular in the past decade. Indices on anything from equities, rates, credit, FX, commodities and even volatility have been offered to qualified investors.

 

Technically, these strategies have a lot of similarities with traditional (beta) indices, such as S&P 500 or DJUBS. But their focus is typically less on representing a certain market, but rather on generating returns. They are segmented in enhanced beta and alpha strategies. The lines can be blurry at times though.

 

Unlike CTAs and managed futures which have trading systems that can be fine tuned and re-calibrated at any point in time, Trading Strategy Index rules are set in stone and cannot be changed once they are published.

 

There are several reasons for the proliferation and success of such strategies: On the supply side there are investment banks, that typically do not have an asset management licence and cannot offer discretionary management to their clients. So Trading Strategy Index based products became a welcome way to tap the asset management market with a new product. The fee structure is also often more akin to Mutual Funds or Hedge Funds and allows banks to generate ongoing revenue streams.

 

Selling products with 3rd party asset managers does happen sometimes, but this is not the normal focus of their sales force and often puts the investment bank into an unwanted competing position with their asset management division.

 

On the demand side sophisticated clients may want to have access to very specific trading strategies, without having to set up extensive execution and monitoring operations. Especially real money investors are often not keen on setting up complex futures trading operations that require a full time trader to watch and roll the positions. Trading Strategy Indices can also allow clients to access markets that they may not be able or willing to directly trade in. Also when clients started to get a better grasp of some of the more simple trading strategies applied by hedge funds, they were seeking for ways to access them at lower costs.

 

In a world where many hedge funds are still charging “2% + 20%” or “1.5% + 15%” there is ongoing demand for products that apparently offer similar risk and returns at a fraction of these costs.

 

The strategies employed cover a wide range. Some incorporate simple strategies, such as momentum, some offer a tweak on standard indices and others run complex optimisation strategies.
Clients looking to get exposure to Trading Strategy Indices, find a large offering of various strategies in different asset classes and different wrappers. This blog aims to provide some clarity in this topic.
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