Nordic Trading: Buy-side Takes Control


Simo Puhakka, Head of Trading for Pohjola Asset Management, shares his experience trading in the Nordic markets, giving his opinions on interacting with HFT, using TCA and knowing whether you can trust your broker.
Nordic HFT
The prospects for High Frequency Trading (HFT) are really up to regulators. It will be a free market, but as we all know, regulatory changes affect the whole trading landscape. For example, we can see what is happening in France and the debate that is going on in Sweden, which are quite hostile towards HFT, so those countries can expect some changes.
Personally, I think that HFT is a good thing for the market, as long as you have the proper tools to deal with it. There are a number of small firms that have been suffering from HFT since MiFID I because they lack the proper technology and tools to measure and deal with it. We have not suffered in our dealings with HFT, and I would actually say in many cases, it is the opposite. HFT firms seem to add liquidity and when you have the proper tools to deal with it, you can take advantage of it.Speaking of tools, we started building our own Smart Order Router (SOR ) a year and a half ago. The goal was to create an un-conflicted way to interact with the aggregated liquidity. In this process we went quite deep into the data and turned processes upside-down with the result that we have full control of how we interact with the market.
On the other hand, I welcome technological innovation from the sell-side; for example, brokers now disclose the venues where they execute trades on an annual basis. The surveillance responsibilities that brokers have are beneficial. Many of the small, local brokers and buy-sides, however, are now finding it challenging to upgrade their technology.
Trusting your Broker
Our approach was to take control of our order flow and only use our brokers for sponsored access. We chose full control because, in some cases, I do not fully trust brokers to deliver what I am asking. These questions first arose a few years ago, and we realized we needed to create a transparent, fully-controlled, non-conflicted path to the market. How you interact with different venues – even lit venues, where you have more transparency – will affect your choice of strategy. In most cases, you are better off without brokers making decisions for you. The root of the problem is, when you send an order to the broker, what happens before it goes to the venue? What control do we have over the broker infrastructure, including their proprietary flow, internalization, market making and crossing, not to mention the routing logic?

When we dug into the data, we were quite surprised to see that, although a broker was connected to all the dark liquidity, many of the fills were coming from that particular broker’s dark pool, suggesting there are preferences in the routing logic. Brokers want to internalize flow, which is not a problem, if you are aware of potentially higher opportunity costs. When it comes to dark liquidity, that is an even bigger problem, since our trades were often routed to the broker’s own dark pool or those it has arrangements with.
To interact with multiple liquidity pools, we decided it was important to define our own routing logic, separate from our brokers’. It all comes back to whether we trust our brokers to deliver what we requested, and in our case, we found it hard to believe.
In theory, broker internalization can add value to our trades, but when we looked at our TCA, there was quite a consistent pattern that brokers with their own order books and market making operations, perform worse than agency-only brokers, which tend to have fewer activities. The reason for this is not technology or limited resources, which bulge bracket firms have plenty of. We think that we are suffering because they are internalizing and making markets. Since we began using our own smart order router, we have seen better numbers than the best agencies. Just looking at our numbers, this decision has made quite a difference.
TCA Best Practices
There are two ways of looking at TCA. The traditional use for TCA is very important to us. We analyze all of our trades, and because we only have one executing broker (our own technology), we do not compare brokers anymore. We do pay a lot of attention, however, to venue quality. We get more dark fills today because we have full control of the apparatus. In the past, I would have been concerned, if we used a broker dark algo, that there would be a lot of liquidity coming from that broker dark pool. Now, we are connecting to most of the European dark pools through our logic and I have seen an increase in dark fills.
More specifically, we use TCA to look at the fills coming from the dark pools, and how much noise they make on the lit market, before and after I get the fill. Admittedly, it takes hundreds of fills from a particular venue before you can actually see that the numbers are stabilizing, but through this process, we try to avoid toxic venues that create volatility in the lit market after or before we get the fill. To do this, we measure the midpoint standard deviation of the lit market just before and after we get the fill. Our benchmark is implementation shortfall, and since we are not comparing brokers, we use TCA to see if the numbers are consistent. Nonetheless, hiccups in volatility will increase slippage in our TCA numbers.

When it comes to pre-trade TCA, the interesting aspects are around adding that kind of logic to our smart order router. We incorporated the real-time TCA into the smart order router, itself, so we do not use it on the trading desks. Our traders are not using that knowledge, but we utilize it in our SOR , which makes a lot of trading decisions for us. This is obviously different from a desk that uses 10 to 20 brokers and broker algos. We focus on technology and building for all possible scenarios to utilize the market data in real-time.
New Priorities
Volatility and risk have pushed us to bring more of our trading operations in-house. We still use other brokers, with about 80% of flow going through our SOR and 20% using our brokers’ trading methods. It is our understanding that discussing the effects of different market environments and strategies is more important than discussing the brokers themselves. We used to ask that question, but we have discussed our numbers with our PMs and they are convinced by the way we interact with the markets. In the kind of market where close-to-close volatility and intraday volatility is high, the challenge is to demonstrate for the PMs what effect this will have on trading strategies. For example, when the intraday volatility picks up, you need to be more aggressive. If you are using reactive strategies and trading over the day, then you are more likely to be impacted by volatility than implementation shortfall strategies. Most of the time our desk has full discretion to trade, but some orders come with parameters and in those cases, we focus on maintaining the feedback going back to PMs.
Portware’s Harrell Smith details the development of the Nordic markets with regard to risk management, custom algorithms and interacting with HFT.

In recent years, Nordic asset managers have demonstrated an increased focus on and responsibility for the quality of their executions. Even as recently as a few years ago, buy-side trading desks were viewed as cost centers, but now they are significantly upgrading their technology and attracting top tier traders. Rather than handing off orders to the sell-side to execute as they see fit, Nordic buy-side traders are ensuring that sell-side execution strategies meet their specific trading and order routing criteria.
Risk Management
The depth of trading functionality at many Nordic asset managers is somewhat shallow. Legacy order managements systems, none of which were designed for electronic trading, remain deeply entrenched at most traditional buy-sides. Structural issues, including a lack of widespread FIX connectivity, also impeded electronic trading adoption. However, as market centers and brokers have modernized their services, Nordic buy-side firms are increasingly turning to advanced execution management platforms, and not simply for their trading capabilities. Many of our clients are just as concerned with their trading system’s ability to integrate with in-house and third-party analytics services. As a result, system flexibility and ease of integration are key requirements for firms who are deploying new trading solutions.
Nordic firms are also looking for vendors to provide a consultative approach to their service offerings, particularly when it comes to analytics and TCA. Firms want a range of services that will give them greater insights into their execution performance and the performance of their liquidity providers. Given the variety of TCA services available from brokers and independent providers, and the various ways that information is collected and distributed, the buy-side is often faced with an analytical landscape that is a fragmented as today’s global equity markets. As a result, they are turning to trading system vendors to help them normalize and aggregate various TCA service offerings and bring them directly into their blotters.
Custom-built vs. Off-the-shelf
The majority of Nordic asset managers rely on algorithms provided by leading brokers and broker dealers. Although a few Nordic buy-side firms, such as Pohjola, have taken algorithmic development in house, it is still a relatively rare practice. Increased development and use of alternative SOR’s and trading strategies will likely follow as firms deploy more sophisticated trading and analytics tools that provide granular information about order execution history.
Another reason that Nordic buy-side firms rely on execution strategies from the largest brokers is that the use of CSAs is not as common in the region as it is elsewhere. However, as the use of CSAs becomes more widespread in the Nordic countries, firms will route orders to additional liquidity providers and leverage a wider range of algorithmic strategies.
Multi-asset Trading
Among traditional asset managers, divisions between trading desks remain fairly distinct. Most institutional traders are comfortable hedging different asset classes for hedging purposes – for example, trading the cash underlying versus a listed derivative – but trading different asset classes independently as part of distinct trading strategies is uncommon at that level. At the hedge fund level, divisions are less distinct, particularly at funds that run cross-asset algorithmic trading strategies. But even at hedge funds, the number of traders actively trading multiple asset classes for separate alpha-generating strategies is low.
What we have seen, however, is a breakdown of technology silos as opposed to trading silos. At the asset management level, the true value of multi-asset trading is not necessarily the ability to execute multiple asset classes simultaneously; rather, it is an efficiency play. Having a single trading solution supporting multiple trading desks and asset classes greatly streamlines systems integration, internal support and development efforts. Some of these larger asset managers use multiple in-house risk management systems, OMS’s and data feeds. All these different applications have to be tied together, so providing a consistent interface for multiple desks is a major efficiency gain for these firms.
Effects of HFT on the Nordic Region
Most market participants view high frequency trading as beneficial to the development of Nordic market structure, given the increased liquidity and reduced spreads that high frequency traders bring. However, some traditional asset managers have expressed concern about more aggressive high frequency order flow and it’s impact on their execution quality. As a result, high frequency trading is something that they are starting to monitor more closely, both independently and with the assistance of their liquidity providers.
This is another example of how Nordic firms, much like their European and US counterparts, are taking greater responsibility for monitoring their execution performance. Regardless of where MiFID II takes us, high frequency trading is here to stay and the burden is on buy-side to effectively manage how they interact with this type of order flow.
Over the last few years there has been a marked increase in the availability of advanced trading strategies as well as a proliferation of liquidity venues in Europe and the Nordic region. As a result, Nordic firms are rapidly improving their technology solutions to address the challenges of an increasing complex trading environment.
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