By Ned Phillips
Fundamentals rarely change. That’s why they’re called fundamentals. In the trading world this means: buy low, sell high. Aim to beat the benchmark you’re given and trade your positions with the minimum market impact.
So if the fundamentals haven’t changed, what has? Are we throwing ourselves lemming-like off the innovation cliff, without looking at what’s below? Innovation – and by innovation we tend to mean innovation in the way we trade electronically – is only innovative if it raises efficiency and reduces cost.
Hare or tortoise?
One area where we have overachieved in the name of innovation is in speed. Looking back, trading used to involve picking up the handset, dialing the number of your favorite broker, having a chat about what you did on Friday night, relaying the order, waiting for him to yell across the desk to his dealer and waiting for his dealer to yell back when the sale was executed. You then hang up and call your client to let them know that a confirmation will be sent to them sometime later. I’m hoping this sounds familiar. If it doesn’t, then you’re too young, or … I’m too old.
War of the acronyms
How things have changed. Today we have FIX, SOR, DMA, Algos, light pools, dark pools, and many others. The mot du jour is latency. Everything is faster, better, cheaper. These are the new weapons with which traders fight for best execution. Such is the level of technology at your fingertips, you should arguably be able to punch in a few commands first thing in the morning and be good for the rest of the day.
All roads lead to liquidity
However, the reality is very different. More important than speed is liquidity. The ability to source liquidity in today’s multiexchange world is what separates the good traders from the great. All traders in essence want the same thing when looking for liquidity. They want to be able to see everyone else’s liquidity without showing theirs. Of course, that logic doesn’t work. But enough traders are willing to participate in liquidity pools and make use of IOIs – or indications of interest, because they understand the need for a community of traders to work together to make the trading environment better for all.
IOIs and Dark Pools
It is this delicate interplay that created IOIs which are an excellent way to show and source liquidity. As the use of IOIs increased, so too did a more efficient trading culture. Some would argue that IOIs were the forerunner to liquidity pools. Dark pools were developed as the answer to how you advertise a block of stock, without telling everyone else.
When ITG first launched POSIT, it was considered to be ahead of its time. It was, and still is, an excellent concept, but the electronic trading landscape of the 1990s was not ready for the technology. Not until the new millennium did the rest of the market catch up, and together with Liquidnet, these dark pools became forerunners of an explosion of venues in the US market.
Plugging the information leak
Dark pools revolutionized the way people traded in the US. Suddenly you were able to anonymously source blocks of stock without fear of leakage of information. You could show your entire hand in a discrete, yet efficient, manner. For every trade in a dark pool the result was an opportunity cost win. If you had 20 orders at the beginning of the day, and by sourcing liquidity from a dark pool you were able to execute eight immediately, the remaining 12 trades could command much more of your attention. In short, dark pool trading both provided liquidity and freed up traders to focus their attention on the other higher ‘value add’ orders that still needed to be traded in live time on the traditional exchanges.
From better to best execution
Dark pools, however, only help … if you use them. The drive towards increased usage of dark pools has been one of the major changes in the trading landscape. Traders have had to adapt from having two tools on the desk – the phone and the Bloomberg terminal – to having an almost limitless range of play things. Today’s traders must be able to multi-task. Eight screens, multiple alternative venues, an OMS and EMS, a dark pool and a handful of algorithms are now the standard tools of the trade.
I haven’t seen a comparison of the trading quality between a trading desk who embraces all liquidity venues and a desk which doesn’t but I am willing to bet that any desk that uses all the tools at their disposal will be the one that wins. They will be the one who sees every piece of liquidity out there.
Same goal – different tools
These are the tools that allow traders to perform their fundamental role – buy low, sell high, beat the benchmark – more effectively. These are the tools, that when used properly, propel traders above the users of just the telephone and Bloomberg. They can see and access every piece of liquidity.
Traders that don’t use dark pools today, who have a block of stock on their blotter and suddenly see a day’s volume in their stock go through the exchange in one print, may be left wondering “how did that happen?” They are clearly missing out.
The basics of trading haven’t changed, but the tools have. For today’s traders, the message is clear: get on board, or get left behind.
By Ned Phillips