Emma Quinn, AllianceBernstein’s Head of Asia Pacific Trading discusses accessing liquidity through dark pools, aggregation and asset allocation.
Trading Volumes, Liquidity and Asset Allocation I think that you’ll see trading volumes rise when you get an asset allocation back into equities, and people have more conviction in the markets. The reason that there’s just no liquidity in the markets is not because people are worried about exchange mechanisms or aspects like that, it’s about the macroeconomic environment and the allocation into equity.
I don’t think that we’re going to see volumes in other asset classes recover faster than allocation into equities as we’ve already seen that allocation change. People are either bullish or bearish, and are set for what they think is going to happen. And so we are in a position that people will just trade around their positions without making any significant move either way until we get some clarity on the macroeconomic environment.
The Rapid Expansion of Dark Pools and Access to Desirable Liquidity We use dark pools to access liquidity for orders we would not normally place in the central limit order book. I think dark pools aid price discovery. There has to be post-trade transparency but once that happens you’ve actually got more transparency on a market than you normally would. In this sort of environment, because you’re not putting out so much into a central limit order book, what used to be 10% of average daily volume is now 30% of average daily volume, you’re obviously leaving more in a dark pool if your order size hasn’t changed. I do think dark pool liquidity aids you, as your expected cost is going to be lower and thanks to post trade transparency in dark pools the market sees a block trade that it would not have seen.
With regard to desirable liquidity, I think the onus is on the buyside to actually put in parameters that can minimize risk. Obviously, you don’t want to go into a dark pool blindly. The same thing could be said of going on to the central limit order book. The same thing can happen to you on a central order book as can in a dark pool, if you’re not smart about the way you trade in a fragmented environment you leave yourself open to be gamed.
Best Execution We have an unbundled commission policy and as such our traders are not limited to paying based on a research vote. We have the discretion to use the broker that will give us the best execution outcome. This discretion is important and enables us to focus purely on the best execution outcomes for our clients.
Impact of Direct and Indirect Costs Imposed on Buy-side Traders by Liquidity Fragmentation We spend a lot of time on quantitative trading strategies and both post and pre-trade cost analysis – we have pre-trade expected costs in our trader management system and we also look at post trade – both daily and weekly as it is not enough just to look at one trade in isolation as so many factors can contribute to whether you have got a trade right or wrong.
Some of the cost of fragmentation has already been borne by the buy-side and sell-side, such as having to have smarter systems and employ quantitative trading. Brokers are now wearing additional costs with some regulators looking to recoup the costs that come with the increase in surveillance costs for a fragmented market. The brokers may have made savings due to the fact that we now have multiple markets and with that came a compression on exchange fees, but they could well and truly be paying that out now to regulators.
Michael Corcoran of ITG sits down with Jason Lapping, Head of Asia Pacific Trading for Dimensional Fund Advisors (DFA), to discuss the practical impact of electronic trading and dark aggregation on his trading process.
Michael Corcoran, ITG: DFA is one of the largest users of electronic trading techniques in Asia Pacific. Why have you chosen this model and what benefits does it bring?
Jason Lapping, DFA: The primary driver for us using electronic trading is to give us full control over the trading outcomes. DFA’s unique process of generating investment returns is highly focused on the overall returns of an investment decision, and that includes the impact of trading. Portfolio managers generate orders for the trading desk but provide some flexibility over what to purchase on a specific day. This means we can be patient, exploiting the opportunities and liquidity available at any given moment. As a result, around 90% of our global trading volume is electronic. In Asia Pacific, that number is even higher, with over 95% of trading managed by our own traders using DMA and algorithms accessing both lit and dark liquidity simultaneously.
Dark and alternative sources of liquidity also form an important part of our strategy. DFA manages in excess of US $240bn, so we are often interested in trading a large percentage of a day’s volume in a stock. We utilize dark pools to try to achieve this in a way that does not signal to the market. Most of our dark pool fills are small, but cumulatively they amount to a significant extra size traded without signaling the extent of our interest to the market.
We generally trade in dark and lit simultaneously as there is an opportunity cost to placing an order only in the dark. So for us dark liquidity is particularly useful as a complementary strategy.
Firms often describe what they do as trading securities, but in fact what we are doing is trading liquidity. And anything that helps us interact with more liquidity is really important. Therefore in the developed Asia Pacific markets, about 10-15% of our total executions are done in dark pools. We believe this helps reduce implementation costs while getting more done. Both of these elements benefit our investors.
MC: Has the move to full control of the trading process been explained to your investors and do you find it’s a differentiator for DFA?
JL: Trading is very much a value-add in DFA’s overall investment process. So our engagement with clients involves explaining that we have an integrated investment process where portfolio managers work closely with the trading desks, giving them a degree of flexibility. When the market is not going our way, this flexibility allows DFA traders to be patient on a specific stock at a given point in time. When the market is going our way, it allows our traders to be opportunistic. We execute at prices where it makes sense to do so, not because we have been told to get the order done today.
What this ultimately means is that trading can start to add value, rather than being a drag on a portfolio’s returns. The cost of implementation can be significant, and our job as traders is to minimize the gap between the theoretical and actual returns of portfolios. I think that many of our clients find this is a differentiator for DFA, and it is potentially a reason to choose us over another investment manager.
Schroders’ Head of Asian Trading, Jacqueline Loh, shares her thoughts on trading in Asia, offering comments on which markets are primed for change, how to find value in dark pools and whether unbundling is as useful as people say it is.
Fragmentation arising from multiple sources of liquidity is a necessary step in the evolution of best execution and in the long term, fragmentation will increase the quality of trade executions in Asia. What it means for the buy-side is investment in infrastructure spending to develop new order routers and the like, so we can electronically seek out and have exposure to multiple liquidity sources. For the sell-side, it means acceptance that there will be more competition for the same block of business in the marketplace. It means different things for different buy-side firms as well.
When I think about the investor ID markets in Asia, I am not sure any model is particularly productive because ID markets make it administratively more difficult to trade. IDs can make best execution very difficult to implement, especially if cash and stock checking is the primary consideration. Some of the ID markets, namely Taiwan and Korea, allow trading through omnibus accounts and that seems to be the way it is evolving. The ID markets are slowly going away, but having said that, the most productive example is probably China because the brokers seem to have a handle on exactly how much cash and stock you have in your account, and therefore how much you can sell and buy. You cannot overspend or oversell, and it is relatively easy to take part in IPOs.
Trade allocation used to be a problem with investor IDs; for example, explaining to compliance and regulators why the prices are not exactly the same between accounts. In these cases the use of omnibus accounts really help. Executing through omnibus ID means you know exactly what is in an account and do not experience many of the issues associated with overselling or settlement. It is a lot cleaner.
With retail-heavy markets, anonymity is the primary consideration for us. We tend to trade more using electronic means and make use of dark pools in retail-heavy markets. In addition to that, the algos we use will be more price-specific, rather than volume-participation models, which are more price impacting.
Best Execution, in the Dark?
You would think that dark pools would have more success in markets where spreads are currently wide and there is a need to be anonymous, which would imply ASEAN markets. In practice, however, it has had more success in Hong Kong, and that is because there are more users of electronic trading there. Perhaps the users are a little more sophisticated as well insofar as they are willing to take accountability for their executions. Which is, in fact, what defines electronic trading.
In our experience, dark pools make a difference in terms of liquidity, however, the question is what creates that difference? Is it the electronic trading system feeding through the dark pool that provides the benefit or is it the dark pool, itself? I would say it is the former, but that may depend on each user. routers. I hope the Securities and Exchange Board of India will consider further change including allowing stock crossings and clarifying the rules regarding P-Notes.
Simo Puhakka, Head of Trading for Pohjola Asset Management, shares his experience trading in the Nordic markets, giving his opinions on interacting with HFT, using TCA and knowing whether you can trust your broker.
The prospects for High Frequency Trading (HFT) are really up to regulators. It will be a free market, but as we all know, regulatory changes affect the whole trading landscape. For example, we can see what is happening in France and the debate that is going on in Sweden, which are quite hostile towards HFT, so those countries.
Personally, I think that HFT is a good thing for the market, as long as you have the proper tools to deal with it. There are a number of small firms that have been suffering from HFT
since MiFID I because they lack the proper technology and tools to measure and deal with it. We have not suffered in our dealings with HFT, and I would actually say in many cases, it is the opposite. HFT firms seem to add liquidity and when you have the proper tools to deal with it, you can take advantage of it.
Speaking of tools, we started building our own Smart Order Router (SOR ) a year and a half ago. The goal was to create an un-conflicted way to interact with the aggregated liquidity. In this process we went quite deep into the data and turned processes upside-down with the result that we have full control of how we interact with the market.
On the other hand, I welcome technological innovation from the sell-side; for example, brokers now disclose the venues where they execute trades on an annual basis. The surveillance responsibilities that brokers have are beneficial. Many of the small, local brokers and buy-sides, however, are now finding it challenging to upgrade their technology.
Trusting your Broker
Our approach was to take control of our order flow and only use our brokers for sponsored access. We chose full control because, in some to deliver what I am asking.These questions first arose a few years ago, and we realized we needed to create a transparent, fully-controlled, non-conflicted path to the market. How you interact with different venues – even lit venues, where you have more transparency – will affect your choice of strategy. In most cases, you are better off without brokers making decisions for you. The root of the problem is, when you send an order to the broker, what happens before it goes to the venue? What control do we have over the broker infrastructure, including their proprietary flow, internalization, market making and crossing, not to mention the routing logic?
When we dug into the data, we were quite surprised to see that, although a broker was connected to all the dark liquidity, many of the fills were coming from that particular broker’s dark pool, suggesting there are preferences in the routing logic. Brokers want to internalize flow, which is not a problem, if you are aware of potentially higher opportunity costs. When it comes to dark liquidity, that is an even bigger problem, since our trades were often routed to the broker’s own dark pool or those it has arrangements with.
AllianceBernstein’s Global Head of Quantitative Trading, Dmitry Rakhlin, discusses the problem of fragmentation and what makes a good aggregator, along with Ned Phillips of Chi-East, Greg Lee of Deutsche Bank, Steve Grob of Fidessa and Instinet’s Glenn Lesko.
Dmitry Rakhlin, AllianceBernstein
How does aggregation improve trading and best execution? Institutional traders usually demand (remove) liquidity from the markets, which in turn creates market impact. Being able to interact with aggregated liquidity (e.g. all available liquidity) lowers this market impact. Aggregated liquidity also gives a trader the ability to interact with many more liquidity sources randomizing the way the liquidity is taken from the market. This decreases the amount of information leakage and protects the trade from being exploited by predatory strategies.
Does aggregation spell the end of fragmented markets? No. The US equity market is highly fragmented, yet all liquidity centers are interconnected, which allows traders to build various aggregator strategies. No doubt, there is cost and complexity associated with this. Fragmentation also introduces so called latency arbitrage and a potential increase in information leakage (the information leakage can be drastically reduced by using appropriate trading strategies).
The positive aspect of fragmentation is that it creates rich market microstructure (traditional exchanges and exchanges with inverted fee structures, block crossing networks, auctions, conditional order types, aggregators of retail liquidity, etc.). These choices give the buy-side the ability to match their investment strategies to the appropriate liquidity sources and ultimately benefit by being able to trade more nimbly and at lower cost.
From your perspective, is aggregation about greater access to liquidity or reducing trading costs? Both.
Ned Philips, Chi-East
How does aggregation improve trading and best execution?
A good aggregator brings order to fragmented markets by concentrating order flows, and liquidity, from a large number of matching venues. It is a tool that allows all participants to access multiple venues from one easily accessible point, reducing the technology costs and other difficulties involved in monitoring different trading venues.
Does aggregation spell the end of fragmented markets?
No. Even if one good aggregator attracts a majority of trading flows, it would not represent a throw-back to a single exchange monopoly. Aggregators are there to make the process of using multiple markets easier and more efficient and can only exist as long as participants have a choice of matching venues.
What are the risks inherent in aggregation and how can an aggregator ensure improved execution?
Theoretically there is a risk that an aggregator will be so successful that it monopolises the market but competition and risk management would keep things in check.
An aggregator ensures improved execution by concentrating liquidity which reduces spreads and improves execution.
Senrigan’s Head of Trading, John Tompkins, and RBS’ Andrew Freyre-Sanders discuss the way event based funds use liquidity and the effect of ID markets in Asia.
Andrew Freyre-Sanders, RBS: What would you say Senrigan is known for among Asia hedge funds?
John Tompkins, Senrigan: What we are most known for now is being an event-driven fund that is entirely based out of Asia. Nick Taylor founded Senrigan in 2009, and he is known for doing event-driven trading and has been verysuccessful at it. Nick was at Goldman Sachs and Credit Suisse, where he ran Modal Capital Partners for nine years before going to Citadel with his team. Senrigan’s capital raising and first year metrics made the first two years a success.
AFS: I know you trade in the US and Europe as well, so is the global fund entirely based out of Asia?
JT: The entire firm is based in Hong Kong, although we have some analysts who spend extended periods of time in the regions of focus. If we do any US and European trading, it always has an Asian bent to it; for example, a UK or European listed company that has a large percentage of their business located in Asia. The few examples are Renault-Nissan, all the Chinese Depository Receipts (DRs) in the US and some Canadian companies doing M&A into Australia.
AFS: Event driven funds require quick access to liquidity. How does the type of deal or event catalyst affect the relative weighting of these items?
JT: The exchanges and companies are smarter, so they generally halt or suspend the names coming into the announcement, and then you have a short window until a given stock starts to trade up towards the terms. Any reasonably-sized fund is not going to be able to get anything done in that time period. After the event, the main concern is your targeted rate of return for the particular deal, which is impacted by the closing timeframe, surrounding risk, regulatory approval, dividend payments, etc, and you set levels where you want to be involved.
Traditionally safe deals with very tight spreads are viewed as the simplest way to risk-reduce, so people take those off and we give liquidity then because we are comfortable with what we are taking on. A lot of people think about the event as just the announcement on the day, but it is actually the time between when you see it and the range gets set. Only if it closes sporadically do you need access to greater liquidity; most of the time, you just need to be in touch with providers rather than have direct access.
AFS: From a trading perspective, once a deal is gone, it is not about that deal. The only speed liquidity advantage is in having systems that can take advantage of the spreads when they may be moving around a certain level. Is that the case for you?
JT: It definitely is. The big differences between Europe and Asia are the number of auctions and the number of times stocks stop trading, which is quite significant. Between three and four distinct times a day, you will have dislocations in spreads for a variety of reasons, and this is an opportunity to improve. Beyond that, a majority of sell-side firms are setting up their own dark pools and there are alternative exchanges in Japan. In those venues, we deal with liquidity providers and market makers who do not care about the individual mechanics of a name; they simply care about the level of spread that they can access.
The most relevant thing is making sure you have the connectivity turned on to access all the forms of liquidity that exist. There is a big differentiation between counterparties in Asia from an executing broker’s standpoint: e.g. what is their default, what do they turn on for you right away, whatcountries do they have their crossing engines in, who do they have in their pool as liquidity providers? You have to know to ask those questions, and it has been very helpful to do that.
RCM’s Head of Asia Pacific Trading, Kent Rossiter, unmasks the Asian trading scene, sharing insights into how RCM navigates the unlit landscape, identifying the effects of dark liquidity and highlighting ways brokers can facilitate better buy-side decision making.
FIXGlobal: What are the main benefits of dark liquidity in Asia?
Kent Rossiter, RCM: One of the major challenges in Asia has always been accessing liquidity without other parties in the market taking advantage of your position and your need to complete the order. In cases where liquidity is scarce, knowledge that a relatively large order is being worked can expose investors to various risks. In such situations, it is advantageous for knowledge of the deal whilst it is being worked to be discreet until the order is filled. In dark pools run by brokers we can get priority on our orders through queue-jumping.
Dark pools support such an approach as they allow large block orders to be worked without showing size. In this way, trading in dark pools allows a trader to access a broker’s own internal order flow, without being gamed by the market that would otherwise risk non-fulfillment or less efficient pricing. As a result, size trading becomes the norm in dark pools and a trader gets to see blocks that may never have been available otherwise. With no information leakage we are not disadvantaged by the fading you see on lit venue quotes. From a personal perspective, the challenges that arise from dealing across a number of venues and the resulting increased use of technology make the role more exciting and satisfying.
FG: How do you limit information leakage in dark pools?
KR: With the exception of broker internalization engines, the trade sizes found in dark pools are often multiple of what they are on the exchange. So having fewer, but larger prints reduces information leakage, and in many cases we can get done on our size right away. Minimizing the number of times a print hits the tape reduces the chance of this footprint being picked up and working against the balance of your order. That said, broker internalization engines do their part well, keeping any spread savings among the two broker’s clients instead of giving it up to the general market.
FG: If you decide to seek dark liquidity, how do you decide between broker internalizers and block crossing networks?
KR: The type of dark venues being used for various trades (i.e. between block crossing networks and brokers) are different. As I mentioned, brokers for the most part are matching up little prints that otherwise would have been time-sliced in the general market, and when using these venues the goal is often to save a few basis points along the way while you work an order. You are not often micro-managing each fill, but through the process we are getting spread capture and price improvement. The type of stock you are often trading in these internalization engines are often larger, more liquid stocks; the type of orders often worked by algos.
Block crossing networks on the other hand, while still matching up electronically, are probably more confidential, and take up the function of what brokers still do upstairs - putting blocks together - so size is the real focus here. Both types of dark pools use the primary market for price sourcing since the vast majority of trades get printed at or within the best bid and offer. As the primary markets become too thin, it can cause price formation problems.
While it is not specific to the consideration of dark pools as an extra execution venue, we have to consider potential increased book out costs if we do use dark pools (except via aggregators, since we would only be using one counterparty), just as we have had to for years when deciding whether to execute a block with a single broker versus multiple counterparties. As dark pools proliferate there is an increased chance that we may not have part of our order in that pool at just the right time to take advantage of flow that may be parked there. Dark pool aggregators are aiming to provide the buy-side solutions to this.
ITG’s Clare Rowsell and Rob Boardman outline the best practices for liquidity management across multiple regions, focusing on Asia Pacific, North America and Europe.
In an increasingly global and fragmented trading environment, finding and managing liquidity is the top priority for buy-side traders. The practicalities of doing so are complex, and are underpinned by the tradeoff between the time taken to find liquidity – which can result in delay costs as the price moves away, and the quality of that liquidity – trading against certain counterparties can increase market impact costs. Meanwhile, the global liquidity environment is changing rapidly due to evolving regulation, market structure and the trading tools available. What follows is a short summary of some of the most significant developments affecting liquidity management in different regions around the world.
Often cited as having a ‘last mover advantage’ in coming latest to the world of dark pools and alternative trading venues, Asia is now catching up rapidly. Growing awareness of the region’s higher trading costs (approximately one third higher than those of the US and UK) is creating market demand for both new lit and dark liquidity sources. Japan is the only major market that currently allows ‘lit’ or quote-publishing venues to compete directly with the exchanges, and in the past year market share on these venues (including SBI Japannext, Chi-X and Kabu.com) has risen, although they still average around 2-3% of total turnover.
Australia will be next, now that the launch of Chi-X to challenge the ASX exchange’s monopoly has been confirmed for early in Quarter 4 2011. As alternative lit venues develop, the importance of smart order routing grows and in Australia this has been a core component of consultation which will result in changes to regulation affecting brokers and exchanges and mandating Smart Order Routing (SOR) as a mechanism to achieve best price in a multi-market environment. For other Asian markets, buy-side traders have been turning to dark pools as a way of managing trading costs and finding quality liquidity.
Most of the large banks and brokers now offer a dark pool or internalization engine in markets including Hong Kong, Japan and Australia; but given Asia’s already-fragmented market structures, adding more broker liquidity pools threatens to complicate the buy-side trader’s life. This is where liquidity management, and specifically the aggregation of dark pools, is coming to the fore. Increasingly the buy-side are turning to dark pool aggregating algorithms to connect into multiple sources of liquidity through one access point.
Canada has long benefited from trading in an auction market supported by a highly visible electronic book. Even though it was not until the latter half of the decade that ATSs began to spring up in Canada, they quickly gained traction and in 2010 ATSs represented 34% of volume. As these changes have taken place, Canadian regulators have continually reviewed emerging regulation in other regions as Canada continues to parallel more mature markets. With the proliferation of alternative trading venues came an emphasis on the consolidation of data to ensure market integrity. In addressing the need for a consolidated tape, the CSA accepted RFPs and appointed the TMX Group to the role of Information Processor.
Also arising from the multiple-market trading environment is Reg.NMS-style regulations to protect against trade-throughs. February’s Order Protection Rule shifted the best price responsibility to marketplaces and also requires full depth of book protection (unlike the US’s top of book protection). About 3% of Canada’s equity trading is done in dark pools, and although Canada has only two dark pools (Liquidnet Canada and ITG’s MATCH NowSM), Instinet plans to open two this year and Canadian stock exchanges are making moves to offer dark order types.