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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.

In this article, Nomura’s Ben Springett provides a brief overview of some of the key issues currently impacting European market structure, and shares his own thoughts on some of the changes likely to occur in Europe this year.

Introduction

European market structure, has been, is, and will continue to be, in a state of change for the foreseeable future. Whilst European Commission regulation has been a significant catalyst in this, the industry itself is now looking to progress issues at a faster rate than the expected regulatory change. As such we are seeing increased interest in “self” regulation within the community, particularly in the areas of post trade reporting and efforts to provide a consolidated tape. All market participants are active in this, but it is not unreasonable to assume that it will be down to the broker-dealers to drive any change, as they typically are the ones that have the resources to invest in the process.

Liquidity Fragmentation

Market share amongst trading venues can be measured in many different ways and people can be forgiven from choosing one that paints their own venue in the best light. The accompanying two charts (Charts 1 and 2) show the steady decline of market share amongst the key primary exchanges, to the benefit of the MTF venues, although the total volume levels remain significantly lower than the pre-credit crunch days. When considering primary exchange volumes versus MTFs it is necessary to bear in mind that the primaries are only just starting to compete in each other’s markets, and as such the pan- European MTFs have had more blue chip names with which to capture their market share. This is set to change in 2010; Euronext launched ARCA last year, Xetra have launched their International Market (XIM) and the London Stock Exchange (LSE) have just completed the acquisition of a majority (51%) stake in Turquoise.

Consolidated Tape

MiFID did not mandate a market- wide consolidated tape, as opposed to the NBBO ( National Best Bid and Offer) provided under Reg NMS, and the lack thereof is one of the key concerns raised by the buy-side in a range of forums. There is however, no significant issue with data aggregation offered by a number of key providers such as Bloomberg and Reuters; in addition to some strong fragmentation analysis products available to the market (Fidessa Fragulator, BATS Europe).

In a period of time where cost base is under increasing pressure, attention has now been drawn to the inherent impenetrable conditions that exist in market data (the LSE has sole distribution rights on LSE data, Deutsche Boerse on Deutsche Boerse data etc.), and as the number of venues from which the data is required for increases, so will the interest placed on the associated charges. In an environment with considerable focus on competition, competitive forces cannot work to reduce the fees, leaving regulation as the only option, which was again addressed under Reg NMS in the US.

Tony Whalley, Head of Dealing and Derivatives for Scottish Widows Investment Partnership and Chris Jackson, Head of Execution Sales, EMEA, Citi highlight to FIXGlobal the changing role of the broker, implementing technical solutions and the chances for a consolidated tape in Europe.

 

FIXGlobal: How have electronic trading technologies changed the way you go about your job - for example, a trader’s investment styles or attributes?

Tony Whalley: Previously, brokers just had to find the liquidity; however, nowadays the difference is what brokers need to do in order to find that liquidity. I think if you compare and contrast market conditions today with those 18 months ago, they are dramatically different, and the trader who is unable to adapt to those changing conditions, is not going to do particularly well.

Chris Jackson: The growth of client-driven electronic trading has meant that low touch portions of a clients trading blotter are executed more efficiently and with lower risk. In turn this has allowed the sales trader to operate more efficiently and focus on more valueadded interaction with clients.

 FG: Is sell-side execution performance continuing to improve? What can be done to make that relationship more efficient? How can a broker stand out?

TW: I think it works pretty well. What we have with the vast majority of our counterparties is a symbiotic relationship. I believe that at the end of the day, they need to do business with us in order to have a degree of credibility within the market, and we need to do business with them because, if they’re the other side of our trades, we chose them for best execution purposes. So from that point of view, it works very well.

Occasionally there are spats, misunderstandings, or whatever you want to call it, but I don’t really feel that this is down to developments in the electronic trading market space. I think we’re in a situation where as soon as one broker comes up with a smart-order router, someone else comes up with another, and then another one and another. Once one broker moves into a certain technological space, everyone needs to get there as well; otherwise, one firm is going to find they’ve got an edge over another and, from our point of view, clearly, if that house has a distinct edge, then they’re going to get more business than others. What we’re tending to find, however, is that if a broker does have a competitive advantage, it won’t last particularly long.

FG: Is there a right or wrong answer as to whether firms should outsource technology implementations or develop them in-house?

TW: I think from our point of view, given the size of our operation, it has to be done in-house. I think when you look at some of the smaller niche players, then there is a very good reason why technology could be done outside the firm, but certainly from our point of view, it has to be done internally.

CJ: From a sell-side perspective, the majority of client-facing systems are in-house. Our algorithmic trading platform or our internal order management systems, for instance, have to be designed internally. We’ve found that we need to maintain a level of focus and ‘bespokeness’ to the platform and the product. It needs to be able to adapt quickly to a changing market environment, which you can’t get from out-sourcing. We cannot ask a client to work to a third party’s deadline. That kind of quick turnaround requires that we have control over the resources in-house.