Conditional Orders and Alternative Liquidity Pools in Asia
By Stuart Thompson, Head of Execution and Quantitative Services APAC, Liquidnet
What are conditional orders, and what problems do they solve?
Conditional orders are orders that allow a buy-side or sell-side trader to maximise their opportunity to cross a block. It does this by posting what is effectively an executable Indication of Interest (IOI) in venues that are able to support it. The simplified thinking behind this is the more venues there are, the better is the opportunity to run into contra liquidity.
When a contra is found, a corresponding firm-up request is sent to the venue which turns the conditional order into a firm order that’s ready to execute.
Conditional orders allow traders to position their parent order across different venues concurrently. For example, if a trader holds an order for one million HSBC shares, those one million shares could be represented in as many pools that support conditional order types and in the order’s entirety without having to split it up into firm slices.
This conditional order approach offers a range of benefits:
-Increased opportunity to execute a block by tapping into different sources of liquidity in fragmented markets;
-Enabling traders to work an order in lit markets and not miss a block opportunity (including in the dark);
-No disruption to scheduling of an algo;
-Reduction in market impact by minimizing information leakage, and potential reduction in order time horizon – therefore reducing market risk due to block size; and
-Smoothing out inefficiencies of posting firm orders.
BRINGING CONDITIONAL ORDERS TO ASIA-PACIFIC
Conditional orders in Asia are still in their nascent stage. Outside the APAC region, they have been incorporated into traders’ workflows throughout Europe and the Americas for some time. Regulation was a key driver for adoption in Europe, as market structure reform such as MiFID II increased the focus on venue/exchange and broker innovation to meet best execution expectations.
Banks and other brokers have historically had their own iterations of conditionals, sometimes referred to as ‘shadow posting’, among other monikers. The impending additional market entrants in APAC have acted as a catalyst for greater interest across all participants (buy and sell side) to seek more broker interconnectivity.
New venues (and exchanges) serve to create further acceptance of conditional venues. Overnight and cross-border traders also have a greater awareness of other regional order types and are more open to adoption.
CONNECTING TO CONDITIONAL VENUES
There are multiple ways to connect depending on workflow. Dark pool aggregators like Liquidnet’s dark strategy would provide conditional access to their ‘house’ liquidity pool as well as other venues, effectively stitching together the liquidity landscape as it evolves.
Broker algos can access conditionals and optimize the way liquidity is accessed depending on the benchmark that is being sought. Blotter scraping and block venues allow conditional access into the pool from front-end applications as well as ability to negotiate a trade.
THE CONDITIONAL CHALLENGE: MEASURING QUALITY
One key challenge will be adjusting the perception of portfolio managers and investors to trading blocks ‘at a price’. Conditional orders trade at a price in a region where 40% to 50% of orders, on any given day and in this case APAC, trade at Volume-Weighted Average Price (VWAP). For conditional (and dark) orders to be successful, benchmarks and trading strategies will need to change or adjust.
Measuring conditional performance and articulating that to the buy-side traders and their portfolio managers can be done through impact models that demonstrate ‘basis point savings’ in real money terms. Another beneficial tool is reputational scorecards – how do venue order firm-ups actually perform and rank? Applying market impact analysis, reversion and venue toxicity adds another layer of complexity to determining which conditional venues outperform others.
Across Liquidnet’s European pool, the expectation is a 70% firm-up rate which is actively monitored over time, while other competitor pools have much stricter intra-day criteria.
Based on Liquidnet’s experience in established EMEA and US markets, we can conclude the following:
-It is critical that all market participants work with a stagger into the market, preferably on initial routing to market. This proves useful when an order goes out of limit and comes back into limit, reducing negative impact on firm-up rates across venues (especially as more venues offer conditional opportunities).
-When choosing the order of the stagger (ie which markets we go to and in which order), based on performance and return, we prioritize our Liquidnet pool, and then randomize the order of the other venues sent to. It is evident that this logic performs well in a mature conditional landscape. With the APAC landscape just beyond early adoption, the approach will be more aligned to evaluate new venues as they enter, performance around fill rates, and market impact. This flexibility will determine whether adjustments are needed for a firmer prioritization mechanism.
-When faced with multiple firm-ups for the same order from different venues, Liquidnet currently takes the initial firm order received.
As the search for liquidity continues with conditional orders, expect to see more broker interconnectivity, further innovation around Market-on-Close (MOC) and VWAP, among the addition of more pools.
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