Trading for the China Market

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China stock market, mainly the Shanghai Stock Exchange, has two types of shares. The ‘A’ shares are reserved for domestic investor whereas ‘B’ shares (quote in USD) are open to foreign investors. However, due to market liquidity, most foreign investors prefer to participate in the ‘A’ share market.

Shanghai Stock Exchange allows foreign investors that are qualified under the “Qualified Foreign Institutional Investor (QFII)” program to invest in the ‘A’ share market. Each qualified investor was given a quota for investment. All other foreign investors not in the QFII program can only buy ‘B’ shares. Smaller fund managers that could not qualify for QFII can buy P-Notes (Participatory Notes) from QFII approved market maker. Some QFII approved fund manager who are given little quota may participate in the P-Notes and A share market concurrently.

P-Note or participatory notes is an equity derivative product that allows foreign investor to participate in the restricted local stock market. Currently, India and China market is very active in P-Notes due to its restriction in foreign investment. P-Notes track the underlying share closely and allow entitlement of dividends and other corporate action to the P-Notes holders. The cost of acquiring P-Notes is higher since the market maker will transfer all other charges plus an additional premium.

Most market regulator do not like P-Notes market due to its lack of transparency. To counter the P-Notes market, China has recently increased its quota for the QFII program substantially.

The problem when buying P-Notes from these market makers is that the fund manager may buy P-Notes for a single China stock from different market makers. When it is time to sell, fund managers need to keep track of which P-Notes belong to which market makers.

One solution is to create a standard security for a China stock and create several different derivative securities with different references to differentiate between P-Notes from various market makers.  However, these securities must be able to be grouped together for fund managers to perform asset allocation.

Another method is to buy and sell shares using the same China stock quote and on a separate system, individual shares or P-notes are tracked according to the market makers.

To decide which P-Notes or ‘A’ shares to sell, most fund managers adopt the First-In-First-Out (FIFO) inventory accounting method.

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Trading

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Allocation of Brokers

Every investment firm worked with a number of brokers. The management team and in-house traders will decide how many orders to give to each broker. The management can favors one broker more than another broker. The criteria of allocation depend on the transaction cost, execution speed, trading services and investment information supplied by the brokers.

Most investment clients require the fund management company to be transparent on the brokers’ selection and allocation process. The clients would also prefer the fund management company to put in place a "Trading Best Execution Policy".

Trade Blotters

Traders are market and stocks specific. When they received all the orders from the front office system, the information traders required is the aggregated orders of each stocks.

Although funding problem has to be resolved by the front office system, it is imperative that communications between the traders and fund managers are maintained. Traders could provide market information and inform about the market conditions. Traders could advise fund managers in term of the practicality of the price limit orders.

 

Pre-Trade Analysis and Planning

Looking at the trade blotters in the aggregated form, the traders will formulate their trading strategies and plan for the trading day.

Generation of trade blotters is easy. You need to add all ‘Buy’ orders for each stock and add all ‘Sell’ orders for each stock. 

Before the market opens, traders will start calling brokers and distribute orders among the brokers. It is easier for traders to allocate certain stocks such as Stock A to Broker A and Stock B to Broker B. Some investment firm prefers to split up Stock A between Broker A and Broker B. This will complicates allocate later.

The most commonly used platform and messaging system is Bloomberg.

Trading and Management of Brokers

Although traders generally leave the trade orders to the brokers for best execution; traders will still need to monitor the market condition so that they can advise the broker or change the outstanding order when market conditions changes. The traders will use the opportunity to evaluate various brokers’ ability to fill the orders at the best market price.

Allocation

Once the trade is completed, this is the time where traders start considering allocate the shares to each portfolio according to individual orders for each portfolio. Smaller investment firms require their trader to perform such allocation manually. Bigger investment firms rely on trading systems to perform trade allocation. The most common algorithm used in trade allocation is round robin allocation.

Round Robin Allocation

Assuming we have a BUY order for a particular stock with allocation as shown below:

Portfolio A	1,000,000
Portfolio B	200,000
Portfolio C	50,000
Portfolio D	4,000
	1,254,000

  

There is a total of 1,254,000 shares good-till-cancel market order. The lot size is 1000 shares. Only 50% or 627,000 shares are being executed for the day. The round robin algorithm will allocate 1000 shares for each account and portfolio D’s order will be filled in the 4^thround. This can be a disadvantage to the larger portfolio.

To ensure fairer allocation, a lot size round robin will be allocated for each account in the first round, after which, the algorithm will based on percentage of order filled and the system will favors account with the least percentage of orders filled. The system will ensure that all accounts will reach the same percentage before another round robin allocation is applied.

The following table shows part of the allocation process:

		1st Round	% Allocation	2nd Round	% Allocation	3rd Round	% Allocation	4th Round	% Allocation
Portfolio A	1,000,000	1,000	0.10%	4,000	0.50%	1,000	0.60%	4,000	1.00%
Portfolio B	200,000	1,000	0.50%	-	0.50%	1,000	1.00%	-	1.00%
Portfolio C	50,000	1,000	2.00%	-	2.00%	-	2.00%	-	2.00%
Portfolio D	4,000	1,000	25.00%	-	25.00%	-	25.00%	-	25.00%
	1,254,000

The first round robin, all accounts are given 1000 shares. Subsequently, the system will favor the bigger account until it reached 0.5%. Then, the system will allocate equal shares to portfolio A and Portfolio B. After that, the system will favor portfolio A again until its share reaches 1%. And the system will continue similar way of allocation until all available shares are allocated.

Investment firm can set their policy to raise the marker of 1% to 20%. This means that the system will allocate equal lot size for all portfolios below 20%.

For different brokers with different allotment of a single stock, the system can perform trade allocation for Broker A and use the statistics to continue allocation for Broker B.

Pricing of Traded Stocks

During the course of a trading day, a broker may buy the same stock for different prices depending on the time of the day and market condition. The common practice is to average the price for each trench of stock, so that every portfolio have an equal pricing.

For different brokers transacting for the same stock, each broker will be willing to average the price they transacted however you will have different price for different block of shares transacted by different brokers. This creates additional problem in fair allocation. 

VWAP

VWAP is known as Volume Weight Average Pricing. It is a calculated price use primarily by traders and brokers to measure the execution of trade. It is a measurement preferred because VWAP ignore temporary spike in prices which was transacted on very low volume.

The formula for VWAP =

Where P is price of each trade t, Q is the quantity of each trade t

VWAP for a stock involves adding all the transaction value in the exchange. Only the exchange and larger trading platform such as Bloomberg can compute VWAP since it involves computing all the trade transacted for the day.

If the transacted price of a 'Buy' order is higher than VWAP; this means that the broker who executed this trade is unable to execute at market price and vice versa.

We can also compute VWAP internally by computing the VWAP based on the all the transaction for a stock. Then we can measure the local VWAP against market VWAP.

VWAP is used by traders to measure performance of each broker. Clients in turn use VWAP to measure the performance of the trading desk of the investment firm.

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Cash Management

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Once the trade orders are generated, cash must be provided for buy orders which primarily funded by sell orders. For a single exchange and single currency portfolio, there is not much concern except that you need to ensure that sell orders are filled faster than your buy orders. Therefore, communications between traders and fund managers is important. The traders may need to consult fund managers to delay the buy orders or change the limits of sell orders especially when the sell orders are difficult to fill.

For multi-currency and multi-market portfolio, complication increases as different settlement date sets in. Even in the US market, there are different settlement date between stocks, options and money market funds. For stock market, the usual settlement date for US, and most European stocks are T+3, except for German stock market which has a settlement cycle of T+2.  Some other Asia stock exchange has T+2 settlement cycle such as Korea and Hong Kong stock exchange. Shanghai Stock Exchange has settlement cycle of T+1. Although Taiwan market has settlement cycle of T+2, however, there is pre-funding requirement of T or T-1. If you intended to sell certain securities or certain stock market to fund another, you must make sure that you do not sell securities with longer settlement cycle to fund securities with short settlement cycle. The reverse is a better practice. Cash forecast report is an important tool that allows fund managers and traders to execute the trades more effectively.

Please note that the type of orders also impact the trading decisions. Some fund managers prefer to re-balance the portfolio daily with trade order that is good for the day. This allows fund manager to have a better view of the trading conditions.

Cash Management in Details

Listed below is an aggregate of all the Buy and Sell orders of each exchange.

10 Portfolio			Proposed Buy Order (USD)	Proposed Sell Order (USD)	Proposed Net Cash (USD)
NYSE	USD	T+3	(100,000,000.00)	50,000,000.00	(50,000,000.00)
NASDAQ	USD	T+3	(75,000,000.00)	2,000,000.00	(73,000,000.00)
NYSE Euronext	EUR	T+3	(5,000,000.00)	64,000,000.00	59,000,000.00
Deutsche Boerse	EUR	T+2	(3,000,000.00)	22,000,000.00	19,000,000.00
London SE	GBP	T+3	(7,000,000.00)	47,000,000.00	40,000,000.00
Tokyo SE	JPY	T+3	(20,000,000.00)	180,000,000.00	160,000,000.00
Hong Kong SE	KHD	T+2	(32,000,000.00)	3,000,000.00	(29,000,000.00)
Korea	KRW	T+2	(65,000,000.00)	2,000,000.00	(63,000,000.00)
Shanghai SE	RMB	T+1	(35,000,000.00)	3,000,000.00	(32,000,000.00)
Taiwan	TWD	T-1 (T+2)	(35,000,000.00)	4,000,000.00	(31,000,000.00)

Please note that there are some assumptions in the following scenario:

1.    We do not trade foreign exchange actively, instead we instruction the custodian bank to perform foreign exchange transaction on a need to basis.

2.    All unused cash will be converted to portfolio currency.

Listed below is an aggregate of all the Buy and Sell order for a single portfolio (Portfolio A).

Portfolio A			Proposed Buy Order (USD)	Proposed Sell Order (USD)	Proposed Net Cash (USD)
NYSE	USD	T+3	(10,000,000.00)	5,000,000.00	(5,000,000.00)
NASDAQ	USD	T+3	(7,500,000.00)	200,000.00	(7,300,000.00)
NYSE Euronext	EUR	T+3	(500,000.00)	6,400,000.00	5,900,000.00
Deutsche Boerse	EUR	T+2	(300,000.00)	2,200,000.00	1,900,000.00
London SE	GBP	T+3	(700,000.00)	4,700,000.00	4,000,000.00
Tokyo SE	JPY	T+3	(2,000,000.00)	18,000,000.00	16,000,000.00
Hong Kong SE	KHD	T+2	(3,200,000.00)	300,000.00	(2,900,000.00)
Korea	KRW	T+2	(3,500,000.00)	300,000.00	(3,200,000.00)
Shanghai SE	RMB	T+1	(6,500,000.00)	200,000.00	(6,300,000.00)
Taiwan	TWD	T-1 (T+2)	(3,500,000.00)	400,000.00	(3,100,000.00)

Listed below is the aggregate of all Buy and Sell orders for each currency. The table also shows the current cash account and available balance.

Portfolio A & Cash Account		Proposed Buy Order (USD)	Proposed Sell Order (USD)	Proposed Net Cash (USD)	19/2/2013 (USD)
USD	T+3	(17,500,000.00)	5,200,000.00	(12,300,000.00)	5,000,000.00
EUR	T+3	(800,000.00)	8,600,000.00	7,800,000.00	-
GBP	T+3	(700,000.00)	4,700,000.00	4,000,000.00	-
JPY	T+3	(2,000,000.00)	18,000,000.00	16,000,000.00	-
HKD	T+2	(3,200,000.00)	300,000.00	(2,900,000.00)	-
KRW	T+2	(3,500,000.00)	300,000.00	(3,200,000.00)	-
RMB	T+1	(6,500,000.00)	200,000.00	(6,300,000.00)	-
TWD	T-1 (T+2)	(3,500,000.00)	400,000.00	(3,100,000.00)	-

Based on the proposed orders and the existing cash, we can issue some foreign exchange instruction as follows: 

FX	Settlement Cycle		Amount
Buy TWD/ Sell USD	T+2		(3,100,000.00)
Buy RMB/Sell USD	T+2		(1,500,000.00)

Please note that all Forex transaction has the settlement date of T+2.

The traders can now trade with the following cash forecast report. Please note that the traders cannot trade in Taiwan market because of the prefunding requirement. For the Hong Kong, Korea and China market, trader can only buy whatever they could sell.

15-Feb-13
Portfolio A Cash Account			Outstanding Buy Order (USD)	Outstanding Sell Order (USD)	Outstanding Net Cash (USD)	15/2/2013 (USD)	16/2/2013 (USD)	17/2/2013 (USD)
USD	T+3		(17,500,000.00)	5,200,000.00	(12,300,000.00)	5,000,000.00	-	400,000.00
EUR	T+3		(800,000.00)	8,600,000.00	7,800,000.00	-	-	-
GBP	T+3		(700,000.00)	4,700,000.00	4,000,000.00	-	-	-
JPY	T+3		(2,000,000.00)	18,000,000.00	16,000,000.00	-	-	-
HKD	T+2		(3,200,000.00)	300,000.00	(2,900,000.00)	-	-	-
KRW	T+2		(3,500,000.00)	300,000.00	(3,200,000.00)	-	-	-
RMB	T+1		(6,500,000.00)	200,000.00	(6,300,000.00)	-	-	1,500,000.00
TWD	T-1 (T+2)		(3,500,000.00)	400,000.00	(3,100,000.00)	-	-	3,100,000.00

Below is a list of all the trades done on 15 Feb 2013

Traded on 15 Feb 2013		Transacted Buy Order (USD)	Transacted Sell Order (USD)	Net Cash (USD)
USD	T+3	(7,000,000.00)	3,120,000.00	(3,880,000.00)
EUR	T+3	(800,000.00)	5,160,000.00	4,360,000.00
GBP	T+3	(700,000.00)	2,820,000.00	2,120,000.00
JPY	T+3	(2,000,000.00)	10,800,000.00	8,800,000.00
HKD	T+2	(300,000.00)	300,000.00	-
KRW	T+2	(300,000.00)	300,000.00	-
RMB	T+1	(200,000.00)	200,000.00	-
TWD	T-1 (T+2)	-	400,000.00	400,000.00

Base of the trades done, we can deliver a preliminary cash forecast report as follows.

16-Feb-13
Portfolio A Cash Account		Outstanding Buy Order (USD)	Outstanding Sell Order (USD)	Outstanding Net Cash (USD)	16/2/2013 (USD)	17/2/2013 (USD)	18/2/2013 (USD)
USD	T+3	(10,500,000.00)	2,080,000.00	(8,420,000.00)	5,000,000.00	400,000.00	(3,480,000.00)
EUR	T+3	-	3,440,000.00	3,440,000.00	-	-	4,360,000.00
GBP	T+3	-	1,880,000.00	1,880,000.00	-	-	2,120,000.00
JPY	T+3	-	7,200,000.00	7,200,000.00	-	-	8,800,000.00
HKD	T+2	(2,900,000.00)	-	(2,900,000.00)	-	-	-
KRW	T+2	(3,200,000.00)	-	(3,200,000.00)	-	-	-
RMB	T+1	(6,300,000.00)	-	(6,300,000.00)	-	1,500,000.00	-
TWD	T-1 (T+2)	(3,500,000.00)	-	(3,500,000.00)	-	3,500,000.00

Based on the cash forecast reports, the fund management team can issue additional Forex instructions as follows:

FX
BuyRMB/SellJPY	T+2	(4,800,000.00)
BuyKRW/SellJPY	T+2	(3,200,000.00)
BuyHKD/SellJPY	T+2	(800,000.00)
BuyHKD/SellGBP	T+2	(2,100,000.00)
BuyUSD/SellEUR	T+2	(4,360,000.00)
BuyUSD/SellGBP	T+2	(20,000.00)

The updated cash forecast report will be shown on 16 Feb 2013

16-Feb-13
Portfolio A Cash Account			Outstanding Buy Order (USD)	Outstanding Sell Order (USD)	Outstanding Net Cash (USD)	16/2/2013 (USD)	17/2/2013 (USD)	18/2/2013 (USD)
USD	T+3		(10,500,000.00)	2,080,000.00	(8,420,000.00)	5,000,000.00	400,000.00	900,000.00
EUR	T+3		-	3,440,000.00	3,440,000.00	-	-	-
GBP	T+3		-	1,880,000.00	1,880,000.00	-	-	-
JPY	T+3		-	7,200,000.00	7,200,000.00	-	-	-
HKD	T+2		(2,900,000.00)	-	(2,900,000.00)	-	-	2,900,000.00
KRW	T+2		(3,200,000.00)	-	(3,200,000.00)	-	-	3,200,000.00
RMB	T+1		(6,300,000.00)	-	(6,300,000.00)	-	1,500,000.00	6,300,000.00
TWD	T-1 (T+2)		(3,500,000.00)	-	(3,500,000.00)	-	3,500,000.00	-

The red mark indicates that we could trade China and Korea market which we previously could not. There are no restrictions in trading markets with T+3 settlement cycle.

Below is a list of all the trades done on 16 Feb 2013:

Traded on 16 Feb 2013		Transacted Buy Order (USD)	transacted Sell Order (USD)	Net Cash (USD)
USD	T+3	(10,500,000.00)	2,080,000.00	(8,420,000.00)
EUR	T+3	-	3,440,000.00	3,440,000.00
GBP	T+3	-	1,880,000.00	1,880,000.00
JPY	T+3	-	7,200,000.00	7,200,000.00
HKD	T+2	(2,900,000.00)	-	(2,900,000.00)
KRW	T+2	(3,200,000.00)	-	(3,200,000.00)
RMB	T+1	(1,500,000.00)	-	(1,500,000.00)
TWD	T-1 (T+2)	-	-	-

Based on the trades done on 16 Feb 2013, our preliminary cash forecast report is shown below:

17-Feb-13
Portfolio A Cash Account		Outstanding Buy Order (USD)	Outstanding Sell Order (USD)	Outstanding Net Cash (USD)	17/2/2013 (USD)	18/2/2013 (USD)	19/2/2013 (USD)
USD	T+3	-	-	-	400,000.00	900,000.00	(7,520,000.00)
EUR	T+3	-	-	-	-	-	3,440,000.00
GBP	T+3	-	-	-	-	-	1,880,000.00
JPY	T+3	-	-	-	-	-	7,200,000.00
HKD	T+2	-	-	-	-	-	-
KRW	T+2	-	-	-	-	-	-
RMB	T+1	(4,800,000.00)	-	(4,800,000.00)	-	4,800,000.00	-
TWD	T-1 (T+2)	(3,500,000.00)	-	(3,500,000.00)	3,500,000.00	-	-

Based on the preliminary report, we need to convert most currencies into USD to fund the purchase. The Forex instructions are as follows:

Buy USD / Sell EUR	T+2	(3,440,000.00)
Buy USD / Sell GBP	T+2	(1,880,000.00)
Buy USD / Sell GBP	T+2	(7,200,000.00)

The final cash forecast report taking into consideration of Forex instructions is as follows:

17-Feb-13
Portfolio A Cash Account		Outstanding Buy Order (USD)	Outstanding Sell Order (USD)	Outstanding Net Cash (USD)	17/2/2013 (USD)	18/2/2013 (USD)	19/2/2013 (USD)
USD	T+3	-	-	-	400,000.00	900,000.00	5,000,000.00
EUR	T+3	-	-	-	-	-	-
GBP	T+3	-	-	-	-	-	-
JPY	T+3	-	-	-	-	-	-
HKD	T+2	-	-	-	-	-	-
KRW	T+2	-	-	-	-	-	-
RMB	T+1	(4,800,000.00)	-	(4,800,000.00)	-	4,800,000.00	-
TWD	T-1 (T+2)	(3,500,000.00)	-	(3,500,000.00)	3,500,000.00	3,500,000.00	3,500,000.00

We can complete all the China trades today; however, we can only start trading Taiwan stock starting tomorrow.

Trades done on 17 Feb 2013 will be:

Traded on 17 Feb 2013		Transacted Buy Order (USD)	transacted Sell Order (USD)	Net Cash (USD)
RMB	T+1	(4,800,000.00)	-	(4,800,000.00)
TWD	T-1 (T+2)	-	-	-

The final cash forecast on 18 Feb 2013, there is no need for Forex instructions:

18-Feb-13
Portfolio A Cash Account		Outstanding Buy Order (USD)	Outstanding Sell Order (USD)	Outstanding Net Cash (USD)	18/2/2013 (USD)	19/2/2013 (USD)
USD	T+3	-	-	-	900,000.00	5,000,000.00
RMB	T+1	-	-	-	-	-
TWD	T-1 (T+2)	(3,500,000.00)	-	(3,500,000.00)	3,500,000.00	3,500,000.00

We can buy all the Taiwan stocks today.

Trades done on 18 Feb 2013 will be:

Traded on 17 Feb 2013		Transacted Buy Order (USD)	transacted Sell Order (USD)	Net Cash (USD)
TWD	T-1 (T+2)	(3,500,000.00)	-	(3,500,000.00)

The final cash forecast will be:

19-Feb-13
Portfolio A Cash Account		Outstanding Buy Order (USD)	Outstanding Sell Order (USD)	Outstanding Net Cash (USD)	19/2/2013 (USD)	20/2/2013 (USD)	21/2/2013 (USD)
USD	T+3	-	-	-	5,000,000.00	5,000,000.00	5,000,000.00
TWD	T-1 (T+2)	(3,500,000.00)	-	(3,500,000.00)	3,500,000.00	-	-

As you can see, cash management is a complex task especially with multiple currencies. Cash management usually are done by the fund management support team under the supervision of the fund managers. Cash forecast report are generate daily for the fund management team.

One common practice is for the fund managers to hold the buy orders until the sell orders are done. This is to ensure that Buy order for individual portfolio are not delayed or left out due to funding problem.

Please note that the whole operation will get more complicated if we are managing 20 different portfolios. Every portfolio must be managed separately and their cash holding may be different from other portfolios.

As far as traders are concern, they will aggregate all the buy orders and sell orders for a particular exchange and for a particular stock. Therefore, it is the fund manager team’s responsibility to instruct traders to hold the buy orders due to funding problem.

If the investment firm has the policy of foreign exchange hedging then the fund management team will work with Forex traders. Traders will negotiate with the custodian for a better price and at the same time buying some futures to perform hedging and eliminate foreign exchange risk.

For some portfolio, especially fixed income portfolio or balanced portfolio, the client requires that excess cash should be place with the money market fund. This will greatly increase the complexity of cash management.

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