Phenomenal trading growth has generated enough liquidity on the mercantile and futures exchange, BM&F, and stock market, Bovespa, to allow quants to flourish and even the first high frequency trading strategies to sprout. The exchange is investing heavily to encourage electronic trading with more capacity and faster speeds while maintaining its respected, safe platform. High trading and co-location costs, restrictions on market making, and a lack of quant fund expertise will hamper these efforts.
The BM&F Bovespa markets have come a long way in a short time. Volumes have more than quintupled in just six years on Bovespa where daily trading volumes are expected to hit 6.5 billion reais per day this year while volume at the BM&F have more than tripled and should reach 2,543 million contracts per day.
That comes in spite of the 2% tax suddenly imposed on foreigners in October 2009 and the subsequent 1.5% tax slapped on American Depository Receipts (ADRs). The BM&F Bovespa believe that the government is not mulling further tax measures to kill the golden goose of capital markets. After all, it wants investors to pay for the countrys huge infrastructure needs. They include the stadia, airports, local transport and housing associated with the 2014 World Cup and 2016 Olympics as well as the $225 billion in pre-salt capitalization for Petrobras.
More skeptical economists point out that the continued strength of the real, which was cited by the government for the transaction tax in the first place, is continuing to infuriate Brazilian industry. Political pressures to protect vulnerable sectors and keep Brazil competitive may push the government to step up the tax to prevent portfolio investment and hot money if the currency strengthens, they argue.
Stepping on the gas
Whatever the tax outcome, the exchange is working to draw in new investors. One of its stated aims is to entice in five million Brazilian retail investors over the next four years. That will help diversify the investor base and dampen volatility.
At the same time, the exchange wants to build a more international platform. It is working to position São Paulo as a Latin American hub as well as kick-start the Brazilian DR market by getting foreign blue chips listed on Bovespa and encouraging the listing of Exchange Traded Funds (ETFs), says Dr Christian Zimmer, head of quantitative research, Itaú-Unibanco in São Paulo. The seven existing ETFs turn over about R$30 million per day and new funds will have greater specificity, for example, tracking the financial sector, he notes.
The exchange has made significant investments in its electronic trading platforms too with investments worth some R$300 million this year, says André Demarco, Operations Officer and director of operations at BM&FBovespa in São Paulo, the third largest exchange in the world in terms of market value. Until the end of this year, BM&FBovespa aims to be able to process three million trades per day on the equities segment, a doubling in a year. Over the same period, the futures market BM&F will also double its capacity to 400,000 trades per day, he says.
Trade processing is moving out of downtown São Paulo to the suburbs and a tripling of space will enable far greater co-location by brokers and asset managers and reduce latency, adds Demarco.
In two years, the BM&F Bovespa has achieved what it took 10 years to do in the United States, says Daniel Borin, manager at broker Alpes Corretora in São Paulo.
Electronic Trading and HFT
These upgrades are welcomed by the sell- and buy-side and Direct Market Access (DMA) has already captured a 40% market share. That has encouraged an ambitious roll out of choices.
Since 2008, the BM&F has provided four modules. DMA 1 and DMA 2 represent access through a broker infrastructure and authorized access provider, respectively, while DMA 3 offers direct access and DMA 4 co-location, explains Demarco, noting that all four modules must have a broker house as intermediate. The BM&F segment has already generated 10 clients for co-location, he predicts. In September, the four options of DMA will be extended to on the Bovespa segment and clients will soon use co-location there as well.
These upgrades should underpin HFT and enable it to grow substantially, says Demarco, noting that it has already captured a 6% market share. HFT could represent as much as 30% of the market by the end of next year, thinks Borin. He adds that the client base his company sees for HFT is mostly composed of hedge funds, asset managers and proprietary trading desks using basic quant or mixed fundamental and quant strategies and only a small number of true quant funds.
For now, such funds remain thin on the ground in Brazil with perhaps 10 at most. Quant strategies are developed by an individual or small team at a broker running basic algorithms. The most common strategy is pairs trading, followed by trend strategies although not necessarily based on moving averages, according to Zimmer.
Other more elaborate strategies are emerging, however. Itaú-Unibanco, with a team that includes six PhDs, is developing new, more complex sets of rules to generate trade ideas and gain speed, says Zimmer. Many do not require HFT as they are trend following and carried out with low frequency options. One problem is that positions are held to maturity as it is very expensive to get out, he cautions.
Intra-day trading is hard as it has to support the costs from both the broker and exchange. You cant afford to make too many mistakes, says Zimmer. Only some strategies require an HFT platform and include more obvious arb opportunities, such as that between standard and mini contracts, designed to encourage retail investors, which are fully fungible on a ratio of 5:1 and where trading to capture price discrepancies requires great speed, he says. Other common trades are long-short pairs between ordinary and voting shares and between ADRs and local stocks, he adds.
The efficacy of simple strategies is being erased by new entrants and DMA. When Kosmos Asset Management started in 2003, arbitrage spreads were wide even on basic trades such as between Bovespa-listed stocks and American DRs, says Alberto Araújo, chief operating officer in São Paulo. New players came in and chipped away at spreads. Its difficult to find pure arbitrage plays at all today and: managers are both fighting for a place in the queue for instant opportunities so profits are just pennies or fractions of pennies, says Araújo. That makes co-location, which enables asset managers to come to the head of the queue, indispensable for immediate arb opportunities, he notes. The company has $50 million under management.
Kosmos too is increasing the sophistication of strategies to stay ahead of the game, looking at correlations between countries, for example. That includes trading Exchange Traded Funds (ETFs) in the US versus components in other countries and could include an ETF based on the MSCI Brazil against local market futures. We had to diversify. Every day, its getting harder to cash in on opportunities. Its a new era for everyone, he says.
The most oft heard complaint of quant investors is the cost of transacting. The BM&FBovespa exchange has a monopoly position, which is allowing it to gouge on prices, say investors. When you speak to Bovespa, they says that the stock price of NYSE fell when they introduced price discounting for HFT and so they are not going to do it in the same way, says one source.
Co-location costs are exorbitant compared to the United States, says Zimmer. The CME charges $1,500 per month while in Brazil the cost for full access is R$15,000 ($8,696) for the same period. On certain exchanges some brokers even allow co-location for free if volumes are high enough, adds Araújo. Overall, Zimmer predicts little demand for DMA 4 as so few companies will be able to make money thanks to these high costs.
Moreover, planned discounts for HFT based on trading volumes and to be introduced in November are set too high, complain investors. Only the largest financial institutions will be eligible for the discounts. For any other investor, it will be really hard to reach this, says Araújo.
On Bovespa, a company will need to trade over 500 million reais per day to be eligible for the maximum discount. That is about 7% of the total trading on the market, points out Zimmer. And even then the full discount is parsimonious compared to other markets: The cost of HFT on Bovespa after discounting is about 10 times more than the post-discount price on the NYSE, he points out.
The BM&FBovespa defends its pricing policy on co-location and discounting. Trading platforms have proven to be stable and the exchange offers a full service, including central counterparty clearing, notes Demarco. I would not say that our co-location is expensive. We carried out a survey of global exchanges and we feel our pricing is in line with global norms. We include electricity, security, air conditioning and space for offer a discount of R$5,000 to R$15,000 for those using co-location for both segments, BM&F and Bovespa, he notes.
Other obstacles to the development of the Brazilian HFT market include the lack of a market making capability as naked trading is not allowed. Anonymous dark and grey pools are also discouraged although theoretically possible. In international markets, some 40% of HFT strategies are driven by market making, notes Zimmer.
Investors expect to see alternative trading platforms emerge to challenge BM&FBovespa and expect that their introduction will have a substantial impact on pricing. The regulator, the Comissão de Valores Mobiliários, is seen to be keen to encourage the proliferation of new platforms and Brazilian legislation allows them.
Partnership between an exchange and a local bank is considered to be the most likely route and discussions between such parties are said to have taken place. One difficulty will be adapting the trading platform for the Brazilian market. Any foreign newcomer will need to set up a central counterpary clearing system and involve brokers.
Restrictions may seem onerous and keep trading prices high while limiting liquidity creation, but may have played a key part in preventing a Brazilian version of the dramatic events of May 6 when the Dow Jones Industrial Average plunged by 9%. The Ibovespa fell only 4% that day, points out Demarco.
The BM&F Bovespa exchanges impose price control mechanisms that compare prices to recent trades and will not accept those that are outside a range, says Demarco. It imposes a five-minute restriction on trades when the Ibovespa has dropped by 3%, he adds.
There is of course a price to be paid for such safety and it remains to be seen how high HFT flies given these restrictions.