The RCM Experience
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.