Citi’s Salvador Rodriguez and Daniel Mathews explain how best execution has evolved alongside MiFID and how the latest proposals are likely to affect buy-side and sell-side trading desks.

How is best execution under MiFID II different from MiFID I and from pre-MiFID? Where have we come?

Daniel Mathews, Citi: Although we are referring to MiFID II, we are at the early stages of the MiFID II legislative drafting process. The European Commission (EC) published its proposals last October,T and there will be a number of amendments proposed by the European Parliament over the coming months. The Council of the European Union (EU) will also table amendments and ensuing agreement between the EC, the European Parliament and the Council of the EU (27 member states) will then be required. It is not yet clear what MiFID II and MiFIR will look like in final form as there are a number of key areas which are acknowledged by both sides to need addressing. What is clear is that there will be significant changes to the drafting that is on the table at present.

Salvador Rodriguez, Citi: With the MiFID II process we have seen closer alignment between buy-side and sell-side interests. There is more cooperation between the buy-side and sell-side with a view to what may or may not come out of MiFID II; and this in itself, is a clear improvement from the earlier iterations, which is encouraging for the business at large.

DM: Certainly, the meetings we have had with the buy-side indicate that they are taking far more interest in what MiFID II will mean for them; they want to participate in the debate and are keen to understand what we are doing from a sell-side perspective.

Tools and strategies that have become accepted best execution for many brokers are now under review (e.g. broker crossing and the Systemic Internaliser (SI) regime). How difficult will it be to provide comparable offerings within the SI framework?

DM: One of the current challenges is understanding how the SI regime will operate under Ferber’s proposals and understanding the unintended (or intended) consequences of the amendments, such as ‘all OTC trades must be conducted under the SI regime’. The scope of the SI only extends to liquid stocks, so what happens to non-liquid stocks? Can we trade them outside an SI? Will all risk trades need to be executed within SI and therefore within published firm quotes, even though a risk trades to client may warrant a price outside firm quotes? At the moment, there are many unanswered questions raised from Ferber’s proposals concerning what the SI regime actually means for us and our clients.

SR: As Dan has alluded to, many of the requirements have fallen into the lap of the sell-side. From a trader’s point of view, the tools, strategies and decisions around how to execute a trade will probably not change significantly. Traders will continue to send VWAP or participate with volume-type orders. Naturally, there are pending questions around how risk is employed and whether firm capital can be used within an OTF environment. As a broader business, how clients and orders interact with risk, and how we internalize house flow, are wide-ranging questions. There is no one clear answer; it is a multi-layered problem and there are still grey areas to be resolved.

From which of the MiFID updates will institutional investors notice the biggest change in execution quality and/or strategy?

SR: The MiFID proposals will clearly affect everyone. Under the Commission’s proposals, a BCN would be an OTF and an SI is not a venue. I think this needs to be unpacked. Legally the classifications are fairly clear – you can trade on either a trading venue (RM, MTF, OTF) or OTC and if the latter then to the extent the trading is systematic and frequent then the firm must be an SI. As Dan says though, Ferber’s amendments have muddied the waters so that it’s not clear how an SI is intended to function. Our job is to figure this out through dialogue with our buy-side clients, and we have been seeing many of them recently on market structure road shows, explaining where the current process is at and the areas still to be resolved.

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.

Brown Brothers Harriman’s Garvin Young explains the decision to adopt a Software as a Service (SaaS) trading system in lieu of traditional on-site architecture.

In its capacity as a global custodian, Brown Brothers Harriman (BBH) takes a holistic view of its trade execution process. This view includes front-end connectivity and execution, all the way through to settlement. The firm continually assesses the current and future needs of its clients to ensure that its products and solutions fully meet their requirements.

Searching for a Cutting- Edge Solution

In late 2010, given the rapidly changing landscape of the brokerage industry related to connectivity, regulation, algorithms and back-office efficiencies, we initiated a RFP process to identify an order management system that could best position its clients for the future.

Specific details of the project included a buy versus build analysis, cost/resource considerations, client retention rates, etc. Given the timeframe that we had set for implementation, it became clear that a build-from-scratch solution would have been both costly and impractical. Such a solution would have required BBH to add staff, incur IT spend, expand occupancy space, and bear significant ongoing maintenance costs.

Through the RFP process, we looked for a provider with a reputation for stability. In an environment of microsecond execution, an OMS must be reliable, stable and flexible. The ability to  customize the solution was also important. The solution had to include a robust front-end while also keeping with BBH’s requirements of high-quality middle- and back-office processing. Our integrated execution and settlement product required a solution provider with strong expertise around maintaining high straight-through processing levels and real-time client reporting.

As a privately held organization, BBH maintains a high focus on risk management, which meant that a strong track record of regulatory reporting and risk management tools was also critical. The firm’s global and sophisticated client base has complex connectivity requirements, such as Reuters, Bloomberg, ULLINK, SWIFT and virtual private networks (VPNs), to name a few. Further, its clients have specific FIX tag requirements and run multiple versions of the FIX Protocol. We required a solution that was able to meet all these demands.

Identifying the Right Provider

BBH narrowed the search to six top providers of equity execution platforms and went on to select Fidessa. BBH’s Investor Services clients recognize us as a leader in technology solutions, with the capability of offering them a sustainable, long-term and flexible solution that allows them to access new markets to grow their business. We determined that their platform aligned well with these needs, and offered an ideal complement to its existing proprietary solutions. 

Gen Utsumi, a longtime member of the Japanese electronic trading community, talks about how the events of 11 March 2011 may indicate the future direction of electronic trading in Japan.

When I was a teenager, I loved computers. Back then it was really exciting to wait for the release of a new personal computer every year. My first PC was the NEC PC-6001MK2 which was the first Japanese PC with synthetic voice speaking ability – it had 64KB of memory and a cassette tape player. For more than 20 years, the world of computers was a very exciting place. There were always new technologies evolving in the industry and so many talented people shared that excitement.

Now, computers are even more advanced, but people are not as excited as before. The computer industry seems to have matured. Could we say the same for electronic trading?

Nine years ago, when I started to sell FIX engines in Tokyo, ‘STP’, ‘Electronic Trading’ and ‘FIX’ were the buzzwords. Having a FIX interface was an exciting thing and sometimes when an exchange introduced their FIX interface based on real needs, they also used it as a marketing tool. Electronic trading was a frontier of the financial industry and I met a lot of people with ‘frontier spirit’. Once an electronic  trading link was established via FIX or other means, new services and strategies started to emerge, such as Proprietary Trading Systems, algorithms, Smart Order Routers (SORs) and dark pools.

These, along with technological advancement, brought a wave of colocation and low-latency products and the race is still going on. Now it seems that having ‘microsecond’ latencies is not surprising anymore. Would latency be exciting again if it were in nanoseconds? My guess is, probably not. While there are still ways to make money in electronic trading, the industry seems to have matured.

Allow me to make another analogy: Japan. Japan has also matured socially and economically. Infrastructure is well established yet Japan’s boom period has long since passed. General sentiment is gloomy due to government resignations, a low birth rate, low economic growth, huge government debt, and reduced trade profits because of global competition.

Then the earthquake hit on 11 March 2011. Surprisingly, people were relatively calm in Tokyo, considering the magnitude of the event. There were many rumors circulating regarding the Fukushima Nuclear Power Plant, but people continued doing business as normally as possible. I will not repeat the grave details here, but I would like to point out that many people are starting to say that this event was a sign of change.

Now three months later, there are signs of recovery here and there. With disaster of this scale, it is obvious that help from the government is not sufficient to respond to the needs of all those people affected. Refugees are being supported by volunteers, families, neighbors and friends. There are over 2,000 refugee camps and some camps are better equipped than others.

One particular refugee camp I know is getting considerable support including food, trucks, bicycles and other living needs as well as comics for the kids – all of which are brought in by supporters. People visit the camp every weekend from Tokyo and the people in the camp welcome those supporters whole-heartedly. There was a strong mutual ‘trust’ established between the people in the camp and their supporters. The camp next to it is not doing so well; they accept donations and goods at the gate, but they do not welcome volunteers and supporters to visit their camp. There was no ‘trust’ here.