POSITIONING FOR THE FUTURE : Gaining competitive advantage. A buy-side perspective.
By Richard Coulstock,
The only certainty is change. Never has this been truer than in recent times. But change, Prudential Asset Management’s Richard Coulstock believes, brings with it the opportunity for the buyside desk to gain competitive advantage, especially in Asia.
How do we position ourselves for the future and gain that competitive edge? The starting point for a buy-side dealing desk is to ensure that your role is recognized as being an integral part of the overall investment process and not a stand alone operation. People, workflows, systems and benchmarks should all be built on that crucial foundation.
When we look at people and workflows, we should understand that the days of having dealers acting merely as order clerks are long behind us. Dealers can begin to help themselves by raising their profile internally through engagement with their Fund management teams. Contribute at meetings, listen to investment ideas, share flow information, and understand why trades are being placed, not just concentrate on how to execute.
We live in an age where the balance of power has swung away from sell-side traders to those on the buy-side. Historically, access to information and sophisticated trading systems with direct exchange access was the preserve of the sell-side. That is no longer the case. With direct market access, broker algorithms, crossing networks and sophisticated Order Management Systems (OMS), the role of a buy-side dealer carries more responsibility and opportunity than ever before.
These are responsibilities and opportunities we should eagerly embrace. The buy-side has been empowered, it is now up to us to seize the opportunity and prove our worth to our businesses by accepting responsibility for execution quality and by more firmly embedding our role into the overall investment process. There are a number of ways in which I believe dealing desks can demonstrate the growing importance of this critical role.
Dealing with the dark pools
I shall start by discussing the increased attention on buy-side dealers, largely led by regulatory issues; – a recent good example being the proposed U.S. regulation regarding the use of ‘dark pools’. Publicity such as this increases focus from both clients and internal compliance departments on the role of a dealing desk.
It is our responsibility to be in a position where we know the pros and cons of dark pool utilization. Accessing dark pools can facilitate the very principle of ‘best execution’ demanded of us by regulators. It is important to remember that the principle of crossing stock offexchange, with subsequent reporting to the exchange, is not new.
While the name can cause alarm, ‘dark pools’ in many ways, simply automate an existing process.
Another important principle to remember is that you will, or should, only trade on a dark pool if the terms of the trade facilitate ‘best execution’. Contrary to some reports, these are not uncontrollable electronic monsters that force you to trade on terms that are unfavourable to your underlying investors. Instead, as we seek to attain ‘best execution’, we should ensure that our desks are equipped to access all relevant liquidity pools, light or dark. To do otherwise is verging on negligence. Our responsibility is to be aware of suitable liquidity pools, current and proposed legislation in Asia and elsewhere, and to educate our own companies to gain approval for their use where appropriate.
Aside from existing dark pools, we need to be aware of other developments in the Asian trading landscape. The Chi-X/SGX announcement earlier in 2009 is a live situation we have a duty to monitor. We should look to the US and Europe for guidance on how changes in market structure will impact our roles. For example, according to Chi-X, on July 14 this year, it reached 22.65% of market share in FTSE 100 stocks and executed 92% of trades at, or better than, the primary market spread. Most remarkably, this has all happened within two years of MiFID. Could Chi-X have as dramatic an impact in the Asian arena?
While we need more details before a reasoned judgment can be made, it is safe to say this is a development we cannot afford to ignore. We have a duty to raise awareness of such developments within our own organizations and to ensure that, when the time comes, we are in a position to trade on any alternative exchanges where we believe we may find meaningful liquidity.
Despite operating in a multi-market and multi-regulatory environment that makes it harder for new entrants to gain a pan-Asian foothold, we have seen advances in the last two years, for example, with Liquidnet and Blocsec. Now, with the Chi-X/SGX announcement, we are surely likely to see more changes in the coming months and years.
Competition among established exchanges can be a good development as it may see lower overall execution costs. However, we should be wary of over-fragmentation. The proliferation of alternative execution venues in the US has been extreme, but the multimarket environment here should be a natural barrier to a similar situation arising in Asia.
Putting the right technology in place
When we consider these new alternative trading venues, we also have to ensure that our systems are robust enough to cope. It still surprises me when I hear of asset managers that are not FIX-enabled, despite the undeniable benefits of Straight-Through Processing (STP). Having a FIX-enabled order management system that allows you to access DMA and broker algorithms is a basic requirement of any professional dealing desk. An execution management system (EMS) would be even better, and there are a number of those to choose from, each with its own strengths and weaknesses and pricing structures.
An EMS helps dealers to monitor and manage trades in a number of ways. By incorporating DMA and algorithms, live market data, and pre and post-trade costs on the same blotter, an EMS should help your team execute more effectively. EMS development will continue and the end result may well be an EMS that, upon receiving a trade, will look at pre-trade data, decide on execution strategy/broker/algo, and then automatically send the trade with appropriate parameters. This may even change dynamically as the trade progresses and the market moves. This scenario is unlikely in the near term – and would risk putting many of us out of work – but it is development we need to monitor.
Measuring the value of execution
Another area where buy-side dealers can prove their worth is in the field of transaction cost analysis (TCA). We must benchmark ourselves in such a way as to demonstrate that execution is a crucial element of the overall investment process. Dealers must be aware that execution performance has an impact on underlying fund performance and they should be prepared to be measured and accept responsibility for their results. Having a robust TCA process will become an area of focus from regulators and clients, both existing and potential. We already use TCA tools to measure our own dealing team, as well as our relationships with our counterparties. This is an important point. TCA is a measurement of broker relationships, not of broker performance. Any buy-side dealing team has to accept responsibility for execution quality and not blame a broker when things go wrong. If a buy-side dealer with adequate systems, trading a live market does not accept execution responsibility, then his or her suitability for the role has to be questioned.
Sharing the benefits and responsibility
As dealing desks prove the value that they can add to investment performance, a natural follow-on is increased dealing discretion. Commission Sharing Agreements (CSAs) can and should be used, where permitted by regulations, to allow dealing desks the freedom to execute where they believe they can obtain the best results. The principle of dealing with a broker because they offer good research has to be dropped. An extreme example is in Australia where one asset manager has effectively outsourced all its dealing to a single broker. This broker uses their pre and post-trade analytics to decide upon execution strategy and uses CSAs to pay research brokers as instructed by the asset manager.
So, what does the future hold for Asia? I believe we will see more money flow into the region and that this will be followed by people, changes to market structures and increased pressure on buy-side dealing desks, in terms of performance results, as regulators and clients look more closely at how those desks manage their executions.
Our role is to be prepared for the future. We must monitor regional and international developments, and inform and educate appropriate people in our own organizations –fund managers, compliance departments and IT – and to readily accept increased responsibility for our execution performance. In short, we must prove our worth.