Who’s Responsible For Transparency?

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By John Kelly, Chief Operating Officer at Liquidnet
The growth of electronic trading has provided many benefits to equity investors by creating new market efficiencies and reducing trading costs. But it has also led to a complex web of venues, liquidity types, and trading strategies that have contributed to a loss of confidence among investors globally. And while it may sometimes feel like “us vs. them”, it is in the interest of institutional trading firms to work with regulators to restore confidence and clarity to our market structure. Indeed, market participants should take the initiative without waiting for regulatory action. One place to start is transparency and control over liquidity interactions and use of customer information.
Since the beginning of regulated markets, institutional investors have needed mechanisms to trade their large blocks away from the “open outcry” of the exchange floor. These institutions – that manage billions of dollars of pension and mutual fund assets on behalf of millions of investors, often trading in block sizes exceeding 200,000 shares – still need to be matched away from the retail market so as not to cause price volatility for the rest of the market and trigger adverse price movements.
With the digitisation of markets, institutions now have a multitude of trading venues in which to trade. However, each of these venues caters to different, and sometimes contrasting, trading needs. And, while some platforms serve their original intent of providing institutions with a venue to trade large blocks, most have become destinations for algorithms that slice blocks into pieces, indistinguishable from the trades found in the displayed world of the exchanges. The highly competitive, complex, and interconnected market structure results in block orders being transformed into small orders that move quickly from one venue to another before eventually executing. This results in information leakage, adverse price movement, and an erosion of fund performance.
Market fragmentation has also presented challenges to regulators in defining the types of transparency that are, or are not, beneficial to the overall market structure. It is difficult for regulators to implement “level playing field” rules common to all participants and venues while giving consideration to the large number, variety, and co-dependency of trading venues. In such an environment, regulation could easily become a web of micro-managing rules that impede efficiency rather than stand as broad and powerful principles that enhance transparency and improve market structure.
For institutional investors – who have the greatest need for market transparency, the complexity of today’s market structure itself has resulted in increased needs for transparency and, at the same time posing greater difficulty in defining and standardising transparency across different business models.
Recently, we have seen some examples of regulators establishing sound principles that strike the right balance between individual participant protection and fostering broader market transparency and efficiency. One example is FINRA’s rules for new reporting standards for venue trading volumes that include an appropriate delay; two to four weeks, depending on the underlying liquidity available for a particular stock. Regulators in Canada and Australia have been successful in their efforts to improve the use of dark pools by implementing rules that govern trade size and establish price improvement requirements for dark trading.
Each venue is different. The operators of each trading venue are not only best placed to understand individual customer needs and how they interact with liquidity and the various trading technology solutions, but also these venues have a responsibility to their clients to communicate this. One way forward is for the venues to develop tools that give customers ultimate control over how markets are accessed and how their data is managed and utilised.
Liquidnet recently launched “Transparency Controls”, a web-based interface that provides clients with the ability to set their preferences for interacting with different types of liquidity and the different purposes for which we may use their data to create opportunities to trade. The options are detailed and the system sets preferences in real time. We believe this new level of transparency and control pushes existing industry standards and addresses the concerns of the institutional community as well as regulators.
Still, the industry needs to do more. There needs to be an industry-wide focus on protecting and respecting client information. Trading venues need to be responsible guardians of what is, essentially, proprietary information. They should have clear and transparent principles on how they interact with venues, liquidity, and how their information is used. Importantly, they should give their clients complete control over these parameters through simple, user-friendly tools.
Institutions have every reason to expect this, and trading venues have every reason to provide it as a matter of good business practice rather than simply the result of regulator pressure.
Both regulators and market participants crave a new level of trust and transparency in the markets. Trading venues themselves must take a more active role in creating it.