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EMEA Exchange Buy-side Regulation

Adapting To Constant Change

By Neil Bond, Partner, Equity Dealer, Ardevora Asset Management

neil-bondIn an evolving trading landscape, the buy-side needs to embrace technologies to extract liquidity wherever they find it.

Exchanges have been around for a great many years and will likely be around for many more. They play a crucial role in the listing of securities, but are also secure trading places, and data vendors. They have not remained unchallenged even if the politicians seem to be aligned with their interests, and they have had to evolve. Recently we have seen IEX enter the trading, listing and data arena.

Spotify has also come to market avoiding the traditional channels.  So the primary exchanges need to keep on their toes which they have been doing by way of conditional order type venues for large-in-scale (LIS) orders and periodic auctions for smaller orders.

The MiFID changes this year have been the most dramatic to the UK market since “Big Bang” in the 1980s when trading left the floor and went screen based. So, what do traders need to keep up in this constantly changing trading landscape?

I believe that new technologies and trading styles and venues need to be embraced. One thing that does seem to remain constant is a trader’s need to source liquidity. The trend toward passive investing has had a somewhat detrimental effect on liquidity, with stocks being bought and sent to the index trackers’ vaults, unlikely to see the order book again for years.

In the past, you could ask a market maker and be quoted a reasonable size (maybe “a penny out in a hundred”), but that was when balance sheets were healthy and accessible, spreads were wide and commissions were high. Market makers cannot operate like that anymore and instead of making thousands of pounds in a large trade, have to make the same amount but over thousands of trades. We need to understand what the costs are when accessing the liquidity and the price of urgency.

The resurgence of quant fund managers could also create a vein of liquidity that has been absent since the quant crisis of 2007, when some of the smartest fund managers suffered unprecedented losses. The use of artificial intelligence in stock selection is increasingly popular, but caution is needed in the form of human supervision and intervention to avoid a crash. The data available now has increased immensely and processing power has also accelerated greatly. Many of the tools that traders dreamt of are now a reality and help us not only make informed decisions but also demonstrate how we arrived at those decisions.

Where trading commissions are fully segregated from research payments, traders can freely trade where they find best execution and use sophisticated tools to aid them in their broker/venue selection analysis. At a glance now I can see a host of visuals together on a dashboard that explain the factors that determine whether or not putting a block together at current levels is the right price.

Two-tier market
We seem to be transitioning to a two-tier market place where one set of trading strategies is needed for larger orders and a completely different set for sub-LIS orders. The options for block trading are well catered for by high touch sales traders, conditional venues and the traditional block crossing venues POSIT & Liquidnet. For sub-LIS trades things get a little more complicated. It is a world frequented by high frequency traders and electronic liquidity providers who tend to have extremely short holding periods, but they are trying to convince the world that they want to trade larger sizes and hold positions for longer.

Understanding the toxicity (normally measured by market impact and reversion) has become a core requirement for traders who now have to decide between the lit market, dark pools (assuming double volume caps are not in effect), periodic auctions and systematic internalisers (SIs) for their smaller orders.

Increased transparency was one of the aims of MiFID II, and one area where this has succeeded is giving buy-side traders more granularity into the counterparties they are trading against. Some larger money managers have trading volumes big enough to gather the data in order to make educated decisions.

However, most of us do not have a large enough data set to do this and still rely on data collection and analysis from our brokers. The selection of trading venues, particularly non-bank SIs needs to be approached quantitatively – some may have strengths in small- and mid-cap stocks, others may have strengths in particular regions or sectors.

Now that all trading data has to be reported, it would be nice to think we could end up with a consolidated tape that would be beneficial to all market participants, but for that to happen data costs would need to be addressed and these revenue streams are proving to be an insurmountable hurdle.

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