The trader's checklist for emerging markets

February 22, 2016 09:00 AM

The opening week of trading in 2016 demonstrated just how volatile markets are at the moment. The Shanghai Composite Index fell by 7% on two occasions, prompting a double suspension in trading and a continued dismal outlook for one of the world’s most powerful economies. Other markets followed this downward trend, opening to considerable losses with some of the worst first-day performances seen in recent years.

With China unlikely to stabilize considerably in the near future, does this example represent a wider trend? Are international investors, and the United States in particular, growing weary of the pitfalls that accompany high-growth economies?

Despite the country’s slowdown, which is possibly more due to macro-economic government transparency and unreliable growth figures, there is still an appetite from North American investors for emerging markets in the region. Judging by the demand we have seen in recent months for connectivity to Dubai, Turkey, Shanghai, Mumbai, Tokyo and other Asian exchanges, the answer is clear: These markets definitely are still in fashion.

This is likely because the majority of trading firms love nothing more than a success story. High-growth exchanges always have offered this promise despite their high-risk, high-reward characteristics. They are a more attractive, lucrative option compared to the weak growth seen in some established markets. For example, India’s most recent annual GDP figures (Q3 2015) showed growth of 7.4% in contrast to Germany’s 1.8% (see “Room for growth,” below). 

However, in reality, emerging markets represent different things to different traders: Impressive financial returns lying in wait to be discovered, lucrative trading opportunities unseen domestically, the best and worst sides of High-Frequency Trading, spectacular losses when a trading strategy overcommits to a region and, if managed ineffectively, numerous technological headaches. 

Regions such as North and Southeast Asia, the Middle East and Latin America are dramatically changing how many traders approach global strategies, portfolio diversification and investment technologies. On the other side of the sector, trading platform and market data providers also are re-evaluating how they deliver investment capabilities to customers. When you add the unpredictability of an emerging market to the equation, it is apparent how challenging emerging markets can be to navigate.

All that glitters

Not surprisingly, connecting to these locations reliably is a completely different matter. The most lucrative new exchanges often lie within difficult-to-access regions under-served by traditional telecommunications operators. For High-Frequency Trading firms, legacy transatlantic or transpacific connectivity is especially unsuitable – too sluggish, costly and unreliable. 

If emerging markets are to deliver the desired positive returns, traders need to know with complete certainty that their trading model will not be brought down by an underperforming network connection into say, Mumbai or Singapore. 

Obviously this is easier said than done. Picking an exchange is one thing, selecting an appropriate technology provider is another, especially if the financial marketplace is on the other side of the world. 

Then comes the matter of regulation. Emerging markets are unique in this respect and most are still evolving on a monthly basis from a technical infrastructure and governance point of view. Economies also can change rapidly, so it is crucial that traders possess the necessary flexibility to adapt immediately to pricing signals being displayed locally, and those further afield. 

Waiting six months for a local telecommunications operator to deploy direct connectivity to a specific exchange is too long in the first place, let alone when alterations have to be made in tight time periods.

Shifting perceptions

Furthermore, by their very nature, heavily unregulated and deregulated regions mean there are added risks. Sentiment for certain trading subsets can shift swiftly. Evidence of this can be seen with the sudden negativity associated with High-Frequency Trading by China’s market operators. 

Concerns with market spoofing – the generation of mock orders to unfairly influence a share price – has led authorities to consider a number of initiatives. Suggestions include implementing a timed delay on high-frequency trades, ensuring traders provide a detailed description of their strategy’s intentions and transactional penalties if a firm cancels high volumes of trades in a short period of time. Any of these actions would likely heavily penalize the sub-market. It also poses questions about firms that locate their trading infrastructure in the data centers of exchanges. 

What happens when regulatory attitudes suddenly change? Emerging markets are as much about preparation as they are about leveraging new opportunities before anyone else. Traders need dedicated technology, connectivity and market data partners to be well positioned to solve these challenges the moment they arise. 

It is important to state that different regulatory landscapes do not necessarily equate to negative outcomes by default. Sometimes under-regulated regions are actually an opportunity within themselves – they can offer greater flexibility and present fewer legal hurdles. After all, too much regulation can stifle progress and growth.

West meets east

The marketplace in question could welcome new models and systems. This can be seen with many emerging exchanges in the Middle East and Asia that are adopting advanced technologies to increase their attractiveness to the American and European financial community. They are blurring the lines between technology provider and traditional marketplace. 

One case in point is Borsa Istanbul. Its welcoming attitude toward High-Frequency Trading is well documented. In recent months the exchange has taken significant steps to improve its global network connectivity and data center colocation portfolio. There have been new products for international, more established markets – September 2015’s launch of Borsa Istanbul’s BIST 30 in London, for example. In December 2015, Borsa Istanbul announced the deployment of its Nasdaq technology – another step intended to ease the technical processes for international traders wishing to invest in the region. For trading firms already using a telecommunications operator that connects directly into the exchange, access is even easier. 

The strategy appears to be having a positive effect. The Turkish market has performed well over the last four years – an increase of 24,000 points, albeit with significant volatility — and despite Russian sanctions in 2015 and ongoing political uncertainty, policy measures and Borsa Istanbul’s focus on the international financial community could likely lead to improved investor demand this year. 
DGCX (Dubai Gold and Commodities Exchange) has implemented a similar strategy and despite the global commodity sector’s poor performance in 2015, the exchange has seen trading volumes increase 41% in 2015, in particular its Hydrocarbons segment volumes grew by 72% over 2014. 

Relationships first profits second

There is one important aspect left to discuss. A consideration some U.S. traders commonly overlook is that emerging markets are in their very essence culturally different. Finance may be global, but countries certainly are not. Rushing into a location can result in aggravations such as language barrier issues, unresponsive technical staff, prohibitively long time- scales, poorer engineering standards, less protection from regulatory bodies and quality of service concerns. 

Smaller investors using brokerage and market data platforms generally are protected from these headaches, but the technical departments within larger trading firms and institutional investment houses know first-hand how counterproductive ineffectual technology partnerships can be. These teams serve as the conduit between a trader’s emerging market strategy and the actual exchanges. They need to be able to build a global network that matches the firm’s investment objectives quickly. 

There are many providers that specialize in this area, though few focus heavily on emerging markets in Asia and the Middle East. This is because of the aforementioned cultural differences – they can be difficult to overcome – however, when a trader (and their technical department) is supported through the process, new routes become less of a technical or commercial choice, and more a strategic initiative that promises the desired returns for the firm. 

Yet, for all the promises that exchanges, data providers and technology companies make, how can traders ensure they receive what they expect? Due diligence is essential (see “Keys to assessing EMs,” below).

From a market data and technology provider point of view, attention should be focused on several key questions (see “Answer these questions before jumping overseas,” below).

This highlights some of the rewards and negatives associated with intra-region trading and what can be achieved when moving beyond the confines of the U.S and Europe’s established economies. Traders always should ensure an appropriate level of due diligence before moving their firm to invest in dedicated trading systems and connectivity to an emerging exchange. However, when the decision has been made, there are options available that ease the process and open up lucrative routes that were otherwise blocked by geographical and technical limitations.

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