As the market for retail OTC derivatives in Australia is growing, ASIC has reviewed the financial requirements of issuers of these products. This is to ensure that issuers have adequate financial resources to manage their operating costs and risks and the owners of issuers are committed to the viability of the business.

ASIC Commissioner, Greg Medcraft, said ‘Owners of issuers of complex and risky OTC derivatives such as contracts for difference and margin forex should have enough skin-in-the-game to commit to the success of the business and its compliance with the relevant laws. Increasing numbers of Mum and Dad investors are trading in these complex and risky products and it’s important the interests of all parties are aligned.

‘We want issuers to be required to address operational risks with good cash flow forecasting and by holding sufficient liquid funds against losses and expenses that could arise from these risks,’ Mr Medcraft said.

Consultation Paper 156: Retail OTC derivatives: Financial requirements (CP 156) seeks feedback on:

• requiring issuers to create rolling 12-month cash flow projections,
• removing the current requirements to hold surplus liquid funds (SLF) and adjusted surplus liquid funds (ASLF) and replacing these with a requirement to hold net tangible assets (NTA) of at least the greater of $1 million or 10% of average revenue,
• specifying the net tangible asset (NTA) liquidity requirements for issuers,
• introducing a reporting framework concerning the level of NTA held by issuers, and
• a staged implementation process.

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ASIC is seeking feedback on Consultation Paper 156: Retail OTC derivatives: Financial requirements (CP 156) by 4 July 2011.  Click to view the Consultation Paper.
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ASIC will consider updating regulatory guidance based on the response to the consultation paper. Current guidance for financial risk frameworks for issuers is in Regulatory Guide 166.  Click to view this guide.

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CMC Markets and optionsXpress Australia, a leading online derivatives trading firm, today announced a new partnership for CFDs and share trading that is set to transform the education and broking experience for investors.

The partnership includes the entire optionsXpress Australia family: HUBB Financial, Safety in the Market, optionsXpress and Optionetics.

optionsXpress has chosen to partner with CMC Markets because of the advanced and flexible nature of CMC Market’s Application Programming Interface (API) and wide range of investment tools and products. CMC Markets will provide optionsXpress with the flexibility to offer multiple front ends based on the needs of the individual client.

The partnership means that all optionsXpress Australia clients will automatically have access to trading solutions such as CFDs and shares, and can act on whatever trading signals are generated by optionsXpress’ state of the art Profit Source and Integrated Investor platforms encompassing signals based trading.

“This partnership expands the relationship between the Australian subsidiaries of both firms, which have been delivering unique investment opportunities for traders in Australia for several years now. The agreement we now have in place delivers on optionsXpress’ goal of making it easy for everyday investors to trade derivative products,” said John-Paul Drysdale, Managing Director of optionsXpress Australia.

“We are proud to offer CFDs to optionsXpress Australia’s traders and investors, and to be able to give our clients an important asset class as part of their plans to grow their wealth,” said Mr Drysdale.

“The appeal of working with optionsXpress is that they have a large and loyal client base, both domestically (with HUBB Financial) and overseas. The fact that optionsXpress’ clients were clearly dedicated to the company, across several continents, was a very positive sign to CMC Markets,” said Jamie Clinnick, Head of Partners (Wholesale) Australia and New Zealand at CMC Markets.

“CMC Markets is a strong advocate of trading and investment education and this partnership gives CMC Markets even stronger education options to potentially offer to its own clients, that optionsXpress can support,” said Mr Clinnick.

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Of the global long/short funds, 16 funds were reviewed with five attaining a ‘Highly Recommended’ rating – the Five Oceans World Fund, Platinum International Fund, Platinum Asia Fund, Platinum International Technology Fund and the MLC Platinum Global Fund.

Fund classification

Andrew Scifo, Investment Analyst with Lonsec commented on long/short fund classification.

“Although long/short funds share similar characteristics in terms of being able to hold short positions, the investment strategies implemented by each of the fund managers are diverse,” said Scifo.

“At Lonsec we classify long/short funds into two broad groups – 130/30 style or absolute return funds.”

With a 130/30 style fund, the fund typically maintains a net equity exposure close to 100% – or in other words, a market beta of 1, with the proceeds from short selling reinvested in the fund’s long positions. Short selling is primarily used to enhance overall fund returns and comes with increased market risk.

“The rationale behind a 130/30 strategy is that it allows the portfolio manager to fully implement both positive and negative views of stocks. Theoretically, the manager can add alpha by investing additional funds in their highest conviction ideas while also profiting from selling short their least attractive ideas (as opposed to simply not owning the stock),” explained Scifo.

“However, it takes a lot of skill to achieve this on a constant basis and there are additional risks associated with short selling.”

An absolute return fund may utilise a broad range of strategies including short selling, gearing, derivatives and cash to adjust the net equity position in line with the investment manager’s market outlook.

“Because of the different strategies employed, an absolute return fund may have a low correlation with traditional equity benchmarks at different stages of the economic cycle,” observed Scifo.

“The key differentiator of an absolute return style fund from a 130/30 fund is that short selling is used opportunistically and the investment manager is not compelled to maintain a short exposure within the portfolio.”

Key themes to emerge from the Sector Reviews

Level of short exposure

Given the diversity of long/short products within both the Australian and global peer groups, it is not surprising that the level of short exposures held by each fund varies from manager to manager.

“For fundamental 130/30 style funds, the level of short exposure is typically at the discretion of the portfolio manager,” said Scifo.

“With quantitative 130/30 funds, there are generally higher levels of short exposure due to the systemic ranking of stocks by the quantitative model that identifies long and short positions.”

In both the Australian and global long/short peer groups, the majority of managers were holding relatively low levels of short exposure compared to their maximum permitted levels at the time of the sector reviews.

Global quantitative funds disappointed

Quantitative strategies performed poorly over the past few years, largely as a result of extreme market volatility that has led to quantitative processes losing their predictive power.

As a result, in the global peer group, absolute return strategies performed better than their 130/30 counterparts.

High portfolio turnover

Long/short style funds tend to exhibit high portfolio turnover compared to long only funds. In the Australian long/short universe, the sector average portfolio turnover was 224% to the year ended 31 March 2010 – long only funds averaged 76% turnover.

“This impacts the tax effectiveness of Australian long/short funds,” observed Scifo.

“The higher turnover nature of this sector has implications for franking levels and for capital gains tax discount entitlements.”

For enquiries relating to this media release, please contact:

Date: 22 July 2010

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Consequently, the stock exchange, like many other markets, has developed special procedures to allow for Buy and Sell orders to be placed before and after normal trading, and for any of these orders which match or overlap to be settled at prices which are established differently from those applying to orders placed during the normal trading day.

The Pre-opening pricing formula involves 4 steps. If the price is established at any step, then the remaining steps are not needed. This method, used to establish prices in the Pre-open period, also applies in precisely the same way to establish;

• closing prices at the end of the trading day,
• float prices,
• prices following a trading halt or suspension, and
• prices of new listings.

It is often said in all of these circumstances that the market is in “Pre-open”, even though that might seem to be a strange way to describe the state of the market at the close of the day.

This approach enables optimal opening prices to be established, maximises order matching when the regular trading session begins, reduces the load on the exchange’s trading system (ITS) and helps manage price fluctuation and manipulation at the beginning and end of the normal trading session.
Some investors are very suspicious of these arrangements. This quote from a blog on the internet shows a lack of confidence and knowledge that is not uncommon. Advisers who discuss direct shares with their clients should be ready to explain why these sentiments are not accurate, and how the prices of these trades are calculated.

“We all know it goes on: before 10 am, any number of stocks are quoted with sort of reverse quotes, phoney quite obviously. The sellers selling dirt-cheap, the buyers offering prices way above last night’s close, right up to the official start of trading…
I’d like to know, what is the rationale behind all this? Does it serve any practical purpose? if these people are joking, isn’t it time the exchange put a stop to this silly practice?”

Prohibited conduct

Pre-open periods are particularly vulnerable to manipulation, and some practices which are always prohibited but which are particularly relevant to the Pre-opening periods are;

• Order Stacking or Layering of bids (placing Buy orders at various price points below the market to create a false appearance of buying demand).
• Marking the close (trading a stock near the close, with the objective of affecting the closing price).
• Wash trades (both Buy and Sell orders are entered by the same party to artificially inflate turnover, or influence the price of a security).
• Matched Orders (placing an order in the knowledge that an associate intends to make a corresponding offer to buy or sell the same securities on the same terms).
• Placing orders then cancelling them without apparent reason, especially close to the market open or before or during the afternoon Closing Single Price Auction.

Market Phases

Before we look at the pricing calculations, the following is a reminder of the various phases of the Integrated Trading System (ITS) throughout a normal trading day.

From 7 am to 10 am, no trading takes place. Brokers and investors enter orders which are ranked in order of price then time. This is the morning Pre-open.

At a time randomly chosen by a computer to be within 15 seconds of 10 am, share codes beginning with A or B commence trading. Existing orders that can be matched are traded at the Match Price (see below) established in the Pre-open.

The remaining stocks open progressively in tranches every two and a quarter minutes (+/- 15 secs) until the 5th and last block of stocks (S to Z) starts trading at 10:09 (+/- 15 secs).

Up to 4 pm the market trades normally.

For 10 minutes after 4 pm brokers enter, change or cancel orders ahead of the close. Trades do not take place, but Match Prices are calculated, updated and displayed. This period is known (oddly) as the Pre-open prior to closing.

For just 2 minutes from 4:10 pm (+/- 15 secs) a Closing Single Price Auction (CSPA) takes place. The auction takes place with all trades in any particular stock taking place at the Match Price which was determined in the Pre-open according to the rules discussed in this article.

The system is then available for adjusting then purging orders, and finally for system maintenance, before closing for 12 hours from 7 pm.

Match Prices in the Pre-Open

Because orders can be entered during Pre-open but trades do not take place, orders may ‘overlap’. This means that highest Buy orders may be at a higher price than the lowest Sell orders. Special rules are required to resolve the difficulty this creates.

For example, a stock in Pre-open has a Buy order at $10 and a Sell order for the same quantity at $8. ITS will not trade these ‘overlapping’ orders. When normal trading (or the CSPA) resumes, these ‘overlapping’ orders will trade at a price known as the Match Price or Single Price Auction. The Match Price is continually updated as new orders enter the system.

But what should that price be? If the system set the price in our simple example at, say, $9.00, then both parties would be satisfied. The buyer would be buying more cheaply than her order specified, and the seller would get more than he was prepared to accept. However, this will be the case at any price between $8 and $10. While it may appear to be fair to “split the difference”, that may not be the fairest solution in the real world, when many orders at various prices and volumes will often exist.

Note that the method described only has effect if there are overlapping orders. If the highest Buy order for a stock in Pre-open is lower than the lowest Sell order, then no trades take place and those orders will remain in the queue established by price and time in the system until cancelled, amended, purged or traded in the normal way in the open market.

Calculating the Match Price 

To calculate the single Match Price, four principles are applied in order. Each stage provides a filter for the next, so that only those possible prices that survive from the first stage are considered in the second. If only one price is possible after applying the rules at any stage, then that becomes the Match Price and it will not be necessary to go to a further stage.

Consequently, if a price can be established under the first of the principles, then that will be the Matched price. The fourth principle always establishes a single price.

The principles applied are these.

1. The price should be the one that provides the maximum volume of executed trades.
   For example, if there are 70,000 buy orders at a price of $10 or less, and 30,000 sell orders at $10 or more, then clearly 30,000 shares would trade if the price were $10. If there were a price at which a higher number of trades would take place, then that would become the Match Price under this first principle.
If the exactly the same volume of trades would be executed at more than one price, then a choice among them will be made by applying the second principle
2. The price should be the one that leaves the least quantity of shares in unfilled orders.
   For example, in the example used in principle 1, 30,000 shares would trade if the price were $10, and 40,000 buy orders would remain unfulfilled. If any other price that was still a possibility after principle 1 resulted in fewer unfulfilled orders, then it would become the Match Price.
If the same quantity of shares in unfilled orders would arise at more than one price, then a choice among them will be made by applying the third principle
3. The highest potential price should be used if market pressure is on the buy side, the lowest if the pressure comes from sellers.
   For example, using the same example again, if two prices remained from principle 2, then the higher of them would become the Match Price, because the unfilled orders are on the buy side. If pressure comes from both sides, the final principle will be applied.
4. The price should be set with reference to the last traded price.
   If the last traded price is within the range of potential prices that are still possible after applying Principle 3, then that will be the Match Price. Otherwise, the Match Price will be the potential price that is closest to the last traded price. For example, assume two prices, $10.90 and $11, are still possibilities after principle 3 is applied. If the last traded price was between these prices, for example $10.95, then that would be the Match Price. If the last price had been $11.05, however, that would lie outside the range, so the closest of the possible prices, in this case $11.00, would be the Match Price.

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