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Richard Nelson, Head of EMEA Trading for AllianceBernstein, shares his perspectives on navigating volatility, prospects for developing exchanges, new regulation and the balance between transparency and best execution.

FIXGlobal: How much does volatility affect the way that you trade and what are you using to measure volatility on the desk?

Richard Nelson, AllianceBernsteinRichard Nelson, AllianceBernstein:
We use an implementation shortfall benchmark, so the longer we take to execute an order, the wider the range of possible execution outcomes. Volatility, in particular intraday volatility, increases that potential range, so you could see very good or very poor execution outcomes as a result. In reaction to that, we take a more conservative execution strategy or stretch the order out over a longer time period. And, for instance, if we get a hit on a block crossing network, we will not go in with as large a quantity as we would in a less volatile market. In that way we try to dampen down the potential effects that volatility might have on the execution outcome.

FG: How is AllianceBernstein using technology to improve performance and cut costs on the trading desk?

RN: It plays quite an important part and has done so for quite a while. We are pretty lucky in that we have a team of quant trading analysts. Most of them are in New York, but we have one here on the desk in London, and they help us to analyze the changing market environment and recommend the best ways we can adapt to it. Our usage of electronic trading has increased in the last year, we benefit from the quant trading analysts looking at the results we are achieving with our customized algorithms. We are more confident about getting good consistent execution outcomes because they are monitoring the process and making the necessary changes to ensure the results are what we are expecting. This, in turn, increases the productivity of the traders I have on the desk. They can place their suitable orders into these algorithms and let them run which allows us to focus on trying to get better outcomes on our larger, more liquidity-demanding orders.

On top of that, as market liquidity has dropped significantly, we are trying to make sure we reach as much potential liquidity as possible, and ideally we want to do that under our own name rather than go to a broker who then goes to another venue. We believe that going directly into a pool of liquidity is better done under your own name rather than via a broker because we can then access the ‘meaty’ bits of the pool rather than the ‘froth’. We are looking into ways of doing that but one of the problems is that, potentially, you get a lot of executions from a number of different venues, which results in multiple tickets for settlement. Our goal is to access all these potential liquidity pools, yet also control our ticketing costs, which are a drag on performance for clients.

FG: Was it an intentional change to increase electronic trading or was it a byproduct?

RN: It was a little of both. Our quant trader has been with us for two years and when he first arrived he had to sort out the data issues that exist in Europe and to clean things up. Once the data integrity was sorted out, we looked at different ways of employing quantitative analyses. Having somebody here who is constantly monitoring the execution outcomes means we can proceed down this path with real confidence. As a London firm, we were a little behind in our adoption of electronic trading, but now we are in the middle of the pack in terms of usage. It makes sense from a business and productivity perspective that there are many orders that do not need human oversight, which are best done in algorithms.

In this article, Equiduct Trading’s Joint CEO Artur Fischer argues that in times of extreme structural and economic change, there is an even greater requirement for transparency. He believes that in an increasingly fragmented market, there’s an even greater risk that organisations will need even more help if they are to avoid effectively trading in the dark with no clear consolidated view of market pricing. Here he identifies the growing requirement for a new generation of virtual order book that can consolidate all the visible pre-trade information generated from significant relevant markets, effectively delivering transparency and providing firms with access to a single, unbiased source of pan-European equity price data.

The European equity markets have undergone a period of rapid and unprecedented change over the past two years. While some of these shifts have been mainly related to the still-evolving current global economic situation – leading to the disappearance or restructuring of some of the biggest names in finance – others have centred around newlyintroduced regulation, with the arrival of new types of execution venues and cross border clearing venues being among the most obvious and significant.

These changes have created some huge challenges (and it should be said equally huge opportunities) for market participants, whether they be the large broker dealers having to connect to all the new trading venues in search of liquidity, or a pension fund simply trying to understand what the “Best Execution” he has been promised actually means.

Each of the incumbent Exchanges, the new Multilateral Trading Facilities (MTF), and the growing number of Dark Pools or Crossing Networks provides an alternative USP for execution of equity orders, and each operates with a slightly different business model - both pre and post trade. This has understandably stimulated competition for order flow liquidity, introducing alternatives in the post trade space, and leading to a major shake up in fees. Not surprisingly, this has also irreversibly fragmented liquidity. However, this fragmentation is an evolving process; the picture is far from complete or even stable, and can be expected to go through several consolidation and subsequent fragmentation phases before the next “Big Bang”.

Opening up the European equity markets
With new entrants into the execution space, Europe’s equity market is opening up for investors from across the world. FIX-compliant technology is enabling easier connectivity to the new venues and providing an opportunity for a wider range of firms to get access to venues over and above the incumbent. In Vol 2 Issue 8 December 2008 of FIXGlobal, John Palazzo of Cheuvreux stated “FIX affords every broker the ability to get into these markets at an unprecedented pace” – at Equiduct we certainly agree, but there are still some considerable challenges.

How, for example, do “sell-side” firms determine whether they should connect to these new venues? How do they then prioritise which to connect to? How do they choose where to actually send their order? Also, how do “buy-side” investors understand which venues their brokers should be connected to, if they are to ensure them the mythical Best Execution? What price should they be using to markto- market at the end of each day and for intraday position risk purposes?

At Equiduct, we’re hoping to provide some of the answers to these important questions. We hope to be able to shed some light on the situation and show how to achieve best execution on the various available platforms with a range of analytical tools. Uniquely, the toolset includes a Pan-European aggregated feed.

Ensuring execution on the most appropriate platform
Firms across the trading spectrum, whether small or large, are increasingly using sophisticated smart-order-routing solutions and algorithmic trading systems to “slice” orders and to determine where they should distribute the pieces across the Dark Pools, MTF and Exchanges. However, in order for these systems and indeed an individual trader to start to effectively predict the future, it is important to understand the present and the past. Information providers such as Markit or Fidessa with their Fragmentation Index can confirm the common knowledge that liquidity fragmentation is a reality once a trade has been executed. However they do not have the ability to see how the market should have performed by examining the pre-trade order and price information that was available at the time of trade.

At Equiduct we have been collating all visible pre-trade information (Level II data) for the top 700 shares across Belgium, France, Germany, The Netherlands and the UK from the major European venues (BATS, Chi-X, NYSE Euronext, London Stock Exchange, Nasdaq OMX, Turquoise, Xetra) since April 2008. Yes, a significant percentage of order flow has moved away from the incumbent exchanges but what is not such common knowledge is that trades are still not always executed on the most appropriate platform. Indeed our analysis shows that in April 2009 a significant proportion of trades executed on the incumbent exchanges should have been transacted on an alternative venue, and approximately 35% of executed trades are still not transacted on the best price venue. Significant price improvement could have been achieved if this had happened. (See Diagram 1)

MiFID has undoubtedly made its impact on the industry. FIXGlobal collates opinion from Nomura’s Andrew Bowley and BT Global Service’s Chris Pickles on the success of MiFID and its next manifestation.

Having digested the massive changes MIFID brought to the EU two years ago, what has the financial community learnt from the content of MIFID 1 and the process whereby it was developed and implemented?

Andrew Bowley (Nomura):
First and foremost we must conclude that MiFID has worked. We now have genuine competition and higher transparency across Europe.

Costs are down. MTFs (Multilateral Trading Facilities) have brought in cheaper trading rates and simpler cost structures, and most exchanges have followed with substantial fee cuts of their own. Indeed this pattern is also clearly demonstrated by exception. The one country where MiFID has not been properly introduced is Spain and this is one country where fees have effectively been increased. This teaches us that complete implementation is the key and the European Commission needs to look hard at such exceptions.

We have also seen clearing rates reduced, though the fragmentation itself has caused clearing charges to increase as a proportion of trading fees as typically the clearers charge per execution. Interoperability should help address that, assuming a positive outcome of the current regulatory review.

In terms of lessons learnt from the process we must consider that we have experienced a dramatic change in a short period of time, and should allow more time for the market to adjust before fully concluding or looking to further wholesale change. We are certainly still in a period of transition - new MTFs are still launching; and the commercial models of all of these, mean that we are far from the final equilibrium. To have so many loss-making MTFs means that we cannot be considered to be operating in a stable sustainable environment.

Chris Pickles (BT Global Services):
MiFID is a principles-based directive: it doesn’t aim to give detail, but to establish the principles that should be incorporated in national legislation and that should be followed by investment firms (both buy-side and sell-side). Some market participants may have felt that this approach allowed more flexibility, while others wanted to see specific rules for every possible occasion. The European Commission has perhaps taken the best approach by allowing investment firms and regulators to establish themselves what are the best ways of complying with the MiFID principles, and has perhaps “turned the tables” on the professionals. If the European Commission had tried to tell the professionals how to do their job, the industry would have been up in arms. Instead, MiFID says what has to be achieved – best execution. Leaving the details of how to achieve this to the industry means that the industry has to work out how to achieve that result. This takes time, effort and discussion. FIX Protocol Ltd. helped to drive that discussion by jointly creating the “MiFID Joint Working Group” in 2004. And the discussion is still continuing. A key thing that the industry has learned – and continues to learn – is to ask “why”. Huge assumptions existed before MiFID that are now being questioned or proven to be wrong. On-exchange trading doesn’t always produce the best price. Liquidity does not necessarily stick to existing 100% execution venues. Transparency is not sufficient by just looking at on-exchange prices. And the customer is not necessarily receiving “best execution” from today’s execution policy.

Osaka Securities Exchange’s Matthias Rietig reports on the most recent developments in order routing and algorithmic trading in Japanese equities and derivatives.

Upgrades to Japanese Exchanges

Although the Japanese markets have been fully electronic since 1999, last year’s upgrade to arrowhead by the Tokyo Stock Exchange (TSE), as well as Osaka Securities Exchange (OSE)’s move to J-Gate, are quantum leaps in terms of performance. In OSE’s case, the move to faster technology - internal round trip times have been reduced from 60 milliseconds (ms) to below 1-2ms across all derivatives products - also paved the way for a broad revision of trading rules. All Japan-specific rules have been abolished, making way for global standard price/time First-In-First-Out based trading. This will make OSE more transparent and efficient, and hence, a fairer market.

Since Japan is one of the three largest equity markets in the world, the move towards a more globalized market structure, coupled with technology upgrades, will transform Japan into a new hot spot for High Frequency Trading (HFT). That being said, it is important for the exchanges to navigate through this paradigm shift wisely so as to not alienate the domestic user base and very active domestic retail participants. Although TSE volumes jumped about 10% after their move to arrowhead and spreads narrowed, the domestic proprietary trading houses that could not manage the very expensive transition as well as a huge decrease in profitability were driven out of the market, which resulted in a  decrease of around 40% in the Japanese cash equity dealer population.

Although we see a proliferation of Multilateral Trading Facilities (MTFs / so called PTS’s in Japan), dark pools and crossing networks and the like entering the market, the liquidity from the domestic layers is still pretty sticky and has an exchange bias. That being said, even in Japan the times are changing and I expect the share of MTFs to increase steadily over time.

With the arrival of Chi-X Japan, all of the existing Proprietary Trading Systems (PTSs) reviewed their business models and it can be assumed that, due to the successful launch of arrowhead and a speed competitive main market, inter market arbitrage activity will rise. Since the Japanese exchanges are already very competitive with their pricing, the battle will be fought over value added services and features, like speed, tick sizes and access options. Overall, a decrease in trading fees can still be anticipated, which should benefit the end users.

While we do see the first signs of new growth of the PTS’s, overall volumes are still relatively small, with TSE capturing roughly 94%  of the overall volumes on exchange equity cash trading, OSE about 5%, and the remaining PTS’s command a combined share of roughly 1%. It will be interesting to watch how market structure will evolve with the opening up of the JSCC, which for the first time started to serve PTS’s as a clearing house in July 2010.

Competition will increase, and although Japan is often labeled as overprotective, many domestic market participants believe it is a good development, as competition clearly cultivates services. The government, itself, is committed to induce more competition among markets to gain competitiveness in an international context and re-establish Tokyo as the financial focal point in Asia.

As the equity cash market is increasingly fragmented, the situation in the equity derivatives space is less so. OSE occupies the major chunk of Japanese equity index futures trading, the most prominent being the Japanese benchmark index Nikkei 225, through the Nikkei Mini Futures, which is one of the ten most actively traded index futures contracts, globally． Furthermore, OSE occupies a 100% share in Japanese Equity Index Options.

Although overall volumes went south for most of the other Japanese derivatives exchanges for the last couple of years, trading volume increased for five consecutive years. The newly launched J-Gate derivatives platform in Tokyo aims to make the overall market proposition of Japan more cost efficient and attractive. Located in the same data center as TSE as well as some PTS’s, J-Gate will hopefully benefit from cross connectivity, analogous  to the US and European markets.

Smart order routing and algorithmic trading

Smart order routing (SOR) has been gaining traction in the last few years, and the launch of more sophisticated trading platforms, as well as the overall increase of sophistication of the buy-side, should further facilitate this trend. Although adoption by the international buy-side is already relatively widely implemented, the domestic layer has been more prudent to adopt SOR. In any case, it can be expected that the domestic players will catch up quickly, as they are currently screening the market to be ready once the overall liquidity on the PTS’s increases.

Steve Grob of Fidessa explains how brokers, traders and exchanges can adapt to life under MiFID II.

If MiFID II increases regulation on broker crossing networks, what other options do brokers have to trade with minimal market impact?

It depends upon the shape any such regulation takes. It looks likely that MiFID II will introduce a new category of ‘venue’ called an OTF - or Organized Trading Facility - that will be used to describe Broker Crossing Networks (BCNs). This will help the market as a whole as it differentiates the client crossing activity of brokers from their other, discretionary, activities. In this latter case the broker is fulfilling its fiduciary duty to its client in other ways such as by risking its own capital in order to complete a client order. This is a completely different activity from the quasi ‘venue-like’ matching of two different client orders electronically.

BCNs are part of the non-lit trading category that also includes buy-side crossing networks such as Liquidnet, dark Multilateral Trading Facilities (MTFs), such as Chi-Delta or  SmartPool, and bilateral Over-the Counter trading. Unfortunately, all of these very different activities are sometimes lumped together as ‘dark’ trading. The lack of clarity around non-lit trading is the cause of much confusion amongst the regulators, some of whom seem to think that all ‘dark’ trading is somehow bad, however, trading away from an exchange is often the only way that many investment firms can achieve their objectives without undue information leakage or price slippage.

What is really needed is a clear description of each of these non-lit categories so that traders know what they are getting into, how deep the water is and who else they might be  swimming with. In this way, the investment community is free to choose the best way of completing its orders.

Where is the biggest opportunity for banks in this new round of regulation? How can European banks come out ahead from this, or is it a question of losing the least?

The banks have suffered as much as any other market participants. In particular, the lack of a clear consolidated record of post-trade information has made it harder for them to prove the efficacy of the millions of pounds they have invested in technology to help their clients navigate the new post-MiFID liquidity. Clearer reporting rules will also make it  easier for them to rebuff the politically motivated criticism they have faced.

What role will technology have in ameliorating the effects of MiFID II? What solutions should firms consider in order to better cope with the shift toward lit venues and transparency?

Technology has and will continue to play a huge part in all this. One of the trends we are seeing is a convergence between algorithmic trading and Smart Order Routing (SOR) so that the process of deciding how to trade gets combined with where to trade. On top of this we are also seeing a greater propensity for the buy-side to fly these hybrid algos  remotely.

How can European high frequency proprietary traders remain competitive if they are required to undergo public scrutiny regarding their algos and strategies?

The High Frequency Trading (HFT) community would certainly find life difficult if its algos and strategies were open to public scrutiny, although this would seem to be an unlikely outcome. Given that HFT represents such a significant proportion of European (and US) volumes it would be an incredibly brave move if the regulators sought to censor them in such a heavy-handed manner. In many cases, the HFT community is simply acting as electronic market makers and actually are increasing liquidity and reducing risk in markets. This is because they act as sellers when there are no natural buyers and vice versa. On the other hand, there is a perceived concern over what can happen to markets if their algos go wrong or misfire. The first people to suffer in any such eventuality, though, are the HFT firms themselves, so it is not in their interest to be careless in this area.

Nevertheless, mistakes can happen and most HFT firms would accept the idea ofcircuit breakers being introduced at the exchange level. This is where the ‘fuse box’ needs to be and it is right that the exchanges bear the cost of this as they are the ones making money selling space to the HFT players in their co-location centres. Ultimately, the responsibility for maintaining an orderly market must rest with the venue rather than the participants. If they build faster and faster racing tracks, then they surely have a responsibility to erect and maintain suitable crash barriers.

The European equity trading landscape has undergone a period of rapid change, since the implementation of MiFID (Markets in Financial Instruments Directive) in November 2007. The new regulation shook up the financial industry in an unprecedented way mainly by the abolition of the concentration rule and the determination to make Best Execution the ultimate guarantee of protection for the investor. Although MiFID has not been successful in every aspect, it certainly succeeded in bringing a competitive edge to European equity trading, resulting in a drop in trading cost for brokers. On the flipside: the market has become more fragmented, and the complexity and cost of providing best execution are emerging as important factors.

Breaking barriers to entry

As new trading venues have started, the main challenge faced by market participants has been to facilitate the connection to new platforms. The use of FIX Protocol standards, making it easier and cheaper to connect to an exchange, was one of the key elements of the success of the Multilateral Trading Facilities (MTFs). And now the reality is that stocks can be and are actually traded on several different venues: traditional exchanges, MTFs, Systematic Internalisers and dark pools. The main European indexes are now traded, on average, on more than 5 visible venues. Furthermore, to attract liquidity, new players offer an innovative and simpler fee structure: no membership fees, no market data fees and attractive trading fees: posting liquidity is now rebated while in the meantime, removing liquidity from MTFs is still less expensive than on traditional exchanges.

With reduced costs, new liquidity available and frequent tighter spreads, MTFs have all the assets to attract the brokers. And it works. On the main European indexes, traditional exchanges have lost up to 44 % of market share.

Of course, traditional exchanges launched their own MTFs and dark pools and lowered their fees to compete with alternative platforms, but by and large these have not enjoyed as much success as the new entrants.

Despite the drop in costs of connection and membership, trading on alternative platforms generates new costs: costs of physical connectivity of course, but also unexpected costs due to the increasing complexity of trading.

Increasing complexity of Trading

To have a full picture of the market, brokers now need to connect to more venues. Of course, the connectivity costs involved are one of the barriers to entry. Not to mention that the sustainability of those models are still to be demonstrated. Brokers are reluctant to invest money in those solutions without knowing if they would reach any return on investment. In addition, even if connected to several venues, brokers have to set up efficient Smart Order Routing (SOR) systems to make the best of the opportunities brought by the fragmentation.