Adapting your trading style - How the changing market landscape is driving new skills
Appetite for risk has never been lower and liquidity has never been tougher to identify. The downstream effect is impacting every part of the electronic trading business and culture. Quod Financial's Ali Pichvai examines where he sees the sea change in trading skills and style.
We are at the midst of a structural, and subsequently cultural, change in the capital markets. Firms’ appetite for risk is shifting and counterparty risk is now high on the agenda. This trickles to each function and aspect of investment and execution; from investment decision making, to risk management, and the mechanics of the electronic trading. In addition, liquidity is increasingly fragmented across a multitude of pools and is affecting how electronic markets are evolving. So how does this landscape impact how firms will trade?
Changes on the buy-side and how the future will look are still uncertain. The hedge fund industry, the great innovator investor class, has in large part been discredited and its model will need to drastically change. The quasi-demise of this large segment will leave a void that needs to be filled. It seems that the future lies in more transparent, better risk-managed, low-cost listed products, which respond to the appetite of global multi-asset investment and execution strategy of the investors. Furthermore it is now clear that liquidity and solvency are intimately linked, and evaporating or volatile liquidity creates systemic risk on solvency. This will, without doubt, have a large impact on future capital market structures.
The buy-side transformation will inevitably accelerate the pace of the current secular trends of more electronic trading on centrally cleared liquidity venues and competing global or regional multi-asset liquidity venues. NYSE Euronext, as a global multi-asset liquidity venue, seems to be the role model for all other market participants. The liquidity fragmentation, as observed today, will certainly be greater and more complex going forward. It also seems we have entered a second age of liquidity fragmentation, with three phenomena which have appeared, or been reinforced, in the current turmoil.
Liquidity is becoming ever more dynamic. As competition increases price wars are becoming more frequent, and pricing models are being altered to attract more and more liquidity. For instance, the rebate model for passive orders (i.e. by resting a passive order, you can receive a fee) has often been used as an effective marketing tool for new alternative trading systems. Clients are therefore moving their execution on a realtime basis from venue to venue, as pricing evolves within a competitive landscape, making liquidity ever more dynamic.
Liquidity is decreasing transparency. As new dark pools and brokers internalisation profligate, with the US equities having achieved 17% of execution in these dark venues, the level of transparency is decreasing. This creates a massive trading challenge. Transparent liquidity is important since it creates an efficient price discovery model, which then disappears into a non-transparent execution model.As transparency decreases, in addition to market data sourced from the different displayed prices, there is a need to move to real-time post-trade analysis, to rebuild a more intelligent picture of liquidity.
Volatility increases fragmentation and increases execution risk. The current intraday volatility, and an even lower period volatility, is much greater than at any other time, and bigger than the impact of incurred costs. As seeking liquidity becomes more important, fragmentation will increase. The result is a new type of risk which needs to be mitigated; the execution risk. This means that the investment case can be fully redundant if the execution in a highly volatile market is not properly performed. This risk evolves from the inability to execute down to execution too far away from the investment decision. Another obvious effect is that the widespread algorithmic trading engines, which were built to limit for low volatility markets, have become obsolete. Nowadays, in an averagely volatile day, it is not uncommon to have 300 basis points of volatility, which dwarfs a single digit basis point cost impact. That means that the next cycle of investment in algorithmic trading needs to be redirected towards liquidity seeking algorithmic trading (also called smart order routing - arguably a misnomer, since it is simply routing rather than delivering a real-time decision making process).
