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.