The RCM Experience

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RCM’s Head of Asia Pacific Trading, Kent Rossiter, unmasks the Asian trading scene, sharing insights into how RCM navigates the unlit landscape, identifying the effects of dark liquidity and highlighting ways brokers can facilitate better buy-side decision making.
FIXGlobal: What are the main benefits of dark liquidity in Asia?
Kent Rossiter, RCM:One of the major challenges in Asia has always been accessing liquidity without other parties in the market taking advantage of your position and your need to complete the order. In cases where liquidity is scarce, knowledge that a relatively large order is being worked can expose investors to various risks. In such situations, it is  advantageous for knowledge of the deal whilst it is being worked to be discreet until the order is filled. In dark pools run by brokers we can get priority on our orders through queue-jumping.
Dark pools support such an approach as they allow large block orders to be worked without showing size. In this way, trading in dark pools allows a trader to access a broker’s own internal order flow, without being gamed by the market that would otherwise risk non-fulfillment or less efficient pricing. As a result, size trading becomes the norm in dark pools and a trader gets to see blocks that may never have been available otherwise. With no information leakage we are not disadvantaged by the fading you see on lit venue quotes. From a personal perspective, the challenges that arise from dealing across a number of venues and the resulting increased use of technology make the role more exciting and satisfying.
FG: How do you limit information leakage in dark pools?
KR: With the exception of broker internalization engines, the trade sizes found in dark pools are often multiple of what they are on the exchange. So having fewer, but larger prints reduces information leakage, and in many cases we can get done on our size right away. Minimizing the number of times a print hits the tape reduces the chance of this footprint being picked up and working against the balance of your order. That said, broker internalization engines do their part well, keeping any spread savings among the two broker’s clients instead of giving it up to the general market.
FG: If you decide to seek dark liquidity, how do you decide between broker internalizers and block crossing networks?
KR: The type of dark venues being used for various trades (i.e. between block crossing networks and brokers) are different. As I mentioned, brokers for the most part are matching up little prints that otherwise would have been time-sliced in the general market, and when using these venues the goal is often to save a few basis points along the way while you work an order. You are not often micro-managing each fill, but through the process we are getting spread capture and price improvement. The type of stock you are often trading in these internalization engines are often larger, more liquid stocks; the type of orders often worked by algos.
Block crossing networks on the other hand, while still matching up electronically, are probably more confidential, and take up the function of what brokers still do upstairs – putting blocks together – so size is the real focus here. Both types of dark pools use the primary market for price sourcing since the vast majority of trades get printed at or within the best bid and offer. As the primary markets become too thin, it can cause price formation problems.
While it is not specific to the consideration of dark pools as an extra execution venue, we have to consider potential increased book out costs if we do use dark pools (except via aggregators, since we would only be using one counterparty), just as we have had to for years when deciding whether to execute a block with a single broker versus multiple counterparties. As dark pools proliferate there is an increased chance that we may not have part of our order in that pool at just the right time to take advantage of flow that may be parked there. Dark pool aggregators are aiming to provide the buy-side solutions to this.
FG: How much is fragmentation affecting your trading?
KR: The industry is not yet able to understand the full extent of how dark pools affect trading; by its nature, there is no clear record of all the trades executed in the dark. A lot of the trades done in the dark get no special discerning tag on the tape, and data capture standardization issues still abound. It is this ‘dark’ nature that protects the confidentiality of clients and their actions.
Fragmentation is a double-edged sword; it allows more competitive liquidity to enter the market which can bringspread costs down and it has spawned innovation. Yet, there may well come a point where it becomes cumbersome and challenging to retain perspective as can be considered the case in the US. Several dozen  venues, and the vast web of technology that is needed to piece the market back together present a number of challenges. However, fragmentation is part of the natural evolution of markets, and I expect this to continue in Asia, except in those markets where it is not allowed.
FG: What are the challenges of fragmentation, and how do you need to react to it?
KR: The challenge includes calculating the benefits using these tools, and gauging which brokers are doing the best job of getting the best price. As fragmentation in Asia grows so will the concern of how market data is being calculated and how this will impact pre and posttrade TCA benchmarks. This causes core market behavior assumptions to change with regards to which trades should or should not be included in market metrics. As aggregators step in, it also changes the behavior of the buy-side trader so they can view in real-time the FIX tags of ‘last venue’ to see where they are getting filled, which may lead to modifying whom they are executing with.
Fragmentation has affected trading making it more difficult for sales traders to source liquidity as they now need to check various pools for the best price before executing. Brokers’ technology allows them to do this automatically and much quicker than would be the case manually. As fragmentation increases, and more lit and dark venues arise, more and more technology development will be needed to ensure best execution.

FG: How is the buy-side using technology to adjust their approach to fragmentation, and its impact on executions?
KR: We believe that as more fragmentation comes to Asia the benchmarks will change from VWAP to more Implementation Shortfall and Participation Weighted Price benchmarks (IS/PWP). RCM is using PWP15% against peers as our global benchmark. VWAP is still the most common market benchmark as clients feel insulated from sharp market movements just spreading their orders out over the day, which could cause less impact on the stock due to liquidity restraints.
A lot of investors do not want to take the risk of having outlier executions. They feel more comfortable with an ‘average’ execution and cannot deal with the volatility of a poorly timed intraday fill. It is a sort of comfort in crowds I guess, even if everybody is suffering. But I think this will change as more liquidity comes in through other venues, the same size orders will be able to get executed without having to cause as much impact on prices.
For the most part we like negotiating blocks, but there are many times you cannot locate the other side, or agree on terms. In these instances you need to work in the market, or be patient and hold out. As markets have become more fractured, you do not want to miss liquidity that could be hidden from primary exchanges or alternative lit venues, so you need to use brokers who have the best chance to access most of this liquidity. You may choose to rest part of an order in a dark pool, employ a liquidity aggregator or try a Smart Order Router (SOR) in markets where there are lit venues, while probably at the same time shopping part of the order around to your normal Street contacts.
Japan is leading Asia’s fragmented market pack with Australia looking like a promising second with the impending Chi-X Australia launch. Hong Kong has long had its own fragmented market via the brokers’ internalization engines, while Singapore stock executions have minimum crossing amounts, which essentially limit brokers’ internalization of flow.
FG: How big of a role does liquidity aggregation have in your approach to fragmentation?
KR: Considerable influence. There are a couple execution focused brokers offering liquidity aggregation services to a dozen or more different venues. While this is still the exception rather than the norm, these firms are seeing their market share increase and have begun to do a thriving business. More and more, buy-side clients are feeling comfortable self-directing some of their orders, or portions of their orders, directly into venues like Instinet’s Nighthawk and ITG’s Marketplace. Other brokers are now discussing alliances to access each other’s pools and this is a trend set to continue. For the buy-side, the advantage of having such providers is not to have to manually split an order into a dozen different pieces themselves, routing some to each broker with a dark pool or alternative venue to see where they start interacting with dark liquidity. And they do not have to manage those routes to pull some from one venue as another is having greater success in executing. Fragmentation is probably greatest and most observable when trading  Japanese shares. The boom in Proprietary Trading Systems (PTSs) over the last couple years, but particularly this year, has made broker selection one of the most important choices buy-side traders can make. For the most part RCM will not be using brokers who do not have access to such technology, and even now that includes a couple brokers who have decent flow, but still have not made the connection.
FG: How much value do Smart Order Routers actually provide in fragmented markets?
KR: Having SOR technology at RCM’s fingertips gives us access to extra liquidity, price improvement, or both. For certain stocks, particularly those with wider spreads, say, a recent trading history with many crosses and married trades, we pretty much limit our broker selection to those who have got the technology in place to seek out where this off-exchange activity is occurring. If you are trading in the Australian market, for example, you would not consider using a broker without Centre Point (CP) access in even one of the ASX’s largest stocks like Telstra, where the spread is more than 30 bpts, and over 10% of trades are being executed in CP.
Usage of CP continues to grow, partly as new brokers join, and as already established participants find better ways of posting flow. Initially, brokers found themselves being gamed on liquidity provision (i.e. flow being posted in CP), but they have now found smarter ways of doing so. Brokers are also using CP for trade reporting.
FG: Are the buy-side properly equipped for fragmented markets?
KR: Many trading systems used by buy-side trading desks in Asia are unable to split an order that is executed across two venues for confirmation purposes. While RCM’s EMS can handle dual markets seamlessly, some of our peers are using systems which do not accommodate multiple exchange fills. One of the largest brokers with SOR connectivity in  India has told me that only about 10% of their clients are demanding dual exchange fills, which is surprising as that same broker says using a SOR in India has led to an average performance improvement of about 10 bpts. They say the worst case savings is as low as 2 bpts, and they have had discussions with some clients as to what the minimum order value needs to be before it makes sense using both exchanges.
That is dependent on the clearing and custodial fees of the client, but generally the order will be $250k or more. Unfortunately it is not as simple as setting a minimal threshold because it would vary widely on a stock by stock basis, and is not consistent as to which stocks provide the least or most savings.
FG: How is the FIX Protocol facilitating information sharing between you and your brokers?
KR: Initiatives by the Global and Regional FIX Committees to increase available FIX tags have also begun to pay dividends; e.g. FIX tag 29 (Last capacity, i.e. agency or principal),  FIX tag 30 (last market), and FIX tag 851 (Liquidity provider/taker), and to a lesser degree of usage in Asia, FIX Tag 9282 (Re-routed Broker). OMS vendors and brokers alike have  been working to make sure their clients can see more information. With this additional information being provided we have begun to see more consultative feedback from brokers and the venues we interact with. This has been an important development at RCM.

FG: What trends are you seeing among your brokers? How do you gauge your broker’s technology offerings?
KR: One positive development I have seen is the realization by some larger brokers who had previously rejected participation in alternative trading venues, now, to change their  stance. As many of these brokers have decent market share they thought they would have more to lose than gain by opening up to reciprocal broker pools. That mindset is  changing a bit and some of these stalwarts have done an about-face. A related development is the brokers’ willingness to invest in the technology to connect to alternative liquidity sources.
Another trend is for opt in/opt out of interacting with certain types of flow. While imperfect, it is a start at reducing the chances of getting gamed. SOR and dark pools should help to alleviate market impact instead of create it. But there is one area where there might be a concern and that is gaming. There is the chance of a large block sitting in a dark pool and someone coming in and discovering it through ‘pinging’ much smaller amounts.
Anti-gaming preferences, such as being able to choose which participants you allow your broker to interact with, help to ensure that this does not happen. For instance, a long-only client can select to only cross with other long-only, ‘natural’ flow, or choose to include or exclude, for example, hedge funds, stat arb clients, HFT clients or internal broker prop flow. Brokers are able to provide clients significant details of their algos’ development and operations.
Development of post-trade execution reports and TCA monitoring statistics are also on the upswing. Unfortunately there is not much standardization in reporting the cost of trading and the broker’s calculation ofsavings. Think of going into a shop, seeing something priced at a thousand dollars and being told at the register that the items are 30% off. You feel good that you have still got $300 bucks in your pocket, but it is important to remember you have just spent $700.
FG: Are markets only going one  direction with technology and automation?
KR: Certainly not, the role of a good sales trader will be here for years to come. Block trading desks, with all their learned knowledge of who owns the stock and who may be interested in trading is something that the buy-side will be happy to use. It is hard to trump experienced brokers and trusted relationships with technology alone.