Jan 30, 2012
Bringing it all back home
The world’s equity markets have taken the US as their
blueprint for highly automated, highly efficient order execution for at least a
decade, but the home of electronic trading still retains a number of unique
characteristics, according to Owain Self, global head of algorithmic trading at
UBS.
Too much choice?
First, says Self, is the sheer degree of venue
fragmentation, which requires means that off-exchange sources of liquidity can
account for a larger proportion of fills than many non-US market participants
are used to.
“With 13 lit venues and as many as 40 dark pools available
to the buy-side in the US, their approach can’t be quite the same as in other
markets,” Self observes.
Fragmentation is a common phenomenon in markets worldwide
and has prompted an upsurge in the usage of liquidity-seeking algorithms on the
trading desks of institutional investment firms. In both 2011 and 2010, around
four-fifths of respondents to The TRADE’s annual Algorithmic Trading Survey
said they used dark liquidity-seeking algorithms, compared with 60% citing use
of VWAP. Self, also global co-head of UBS’s Direct Execution business, warns
that buy-side traders need to take a cautious and calculated approach when
sourcing dark liquidity among diverse US venues.
“If you open your orders up to all possible sources of dark
liquidity in the US you’re going to get an inconsistent experience,” Self
explains. “To avoid being flooded with liquidity of a lesser quality, many US
buy-side traders are being much more discerning about how they source dark
liquidity. This leads to a lot more demand for customisation, a greater degree
of automation, particularly for smaller orders, and more quantitative analysis.”
As the menu of non-displayed liquidity options on offer in
the US has widened, the appetite of buy-side traders for details on how their
orders are treated in the dark has not diminished. While the recent revelation
over Pipeline’s use of a prop trading affiliate caused a number of firms to
revisit their previous due diligence, Self says the buy-side’s focus on routing
and execution in dark liquidity pools has steadily intensified over the last
couple of years. “The more recent change is that these queries are now becoming
much more formalised,” he says. “While they might previously have been
satisfied with a broad explanation from a salesman, they now want a more
formal, written response from their providers. This is encouraging
the brokers and other dark-pool operators to become even more transparent.”
The customer is always right
Another key feature of the US market is the bespoke nature
of the strategies deployed by the buy-side. Self spends almost a third of his
time in the US and claims that American institutional investment firms lead the
world in analysing execution data to improve the performance of their trading
desks in minimising trading costs and therefore retaining alpha. For the
sell-side firms like UBS, this means that the US includes some of its most
pro-active and demanding clients.
“We work closely with clients globally but in the US there
is currently more differentiation in the outcomes. We’ve been tailoring the behaviours
of our core algorithms to suit different clients needs for some time, but now
the customisations we’re being asked for are so bespoke that they’re not really
comparable to the algos we already offer,” says Self.
The impact of constantly evolving buy-side requirements on the
electronic trading client service models of brokers has been profound. Algorithms
were first marketed to the trading desks of money managers as a cheap,
productivity-enhancing alternative to sales traders, but prior distinctions no
longer hold.
“The challenge is to be able to deliver on a scalable basis,
allowing rapid response, almost real time to clients’ needs,” notes Self. “Five
years ago, electronic trading was a truly low-touch business, but the levels of
service and analysis required today means that it is no longer low-touch in
terms of the client relationship.”
Growing familiarity with electronic trading tools leads inevitably
to increased requests for tweaks and enhancements, but it also drives diversity
in terms of the coverage preferences of buy-side clients.
“Some clients value the absolute anonymity of electronic
trading while others prefer multiple touch points. There are also clients that
use electronic trading for its efficiency and lower blended cost but don’t mind
their sales traders seeing their flow as well,” says Self. “The need for
segregation and anonymity won’t disappear completely but there will be a
blurring of the lines between execution avenues for some clients.”
Familiarity breeds confusion
Other markets may have adopted many practices and processes
pioneered in the US, but typically they have adapted them to suit their own
local needs. The result is that US equities trading environment may look more
familiar than it really is.
“European firms that trade into the US do understand this
market, but there are nuances that are worth bearing in mind. In Europe, the
tendency when gauging liquidity is to look at the electronic order book volumes
of the primary and maybe of some alternative venues, but in the US the
consolidated tape gives you a more complete view: lit, dark, other OTC trades
all combined, which means you might want to lower your target participation rates,”
says Self.
Of the US equity markets exports, it is perhaps
high-frequency trading (HFT) that has caused most controversy. Now accounting
for substantial amounts of trading and increasingly in some Asian markets, the
preponderance of HFT in the US nevertheless has the capacity to surprise, says
Self. But subtle adjustments to strategy can yield positive outcomes.
“The view that high-frequency trading accounts for a larger
percentage of volumes in the US than in European markets, implying a lower
percentage of natural long-term liquidity, incentivises clients to lower
participation rates,” says Self. “Fortunately the sheer size of the volume in
the US and the large number of dark venues means you may be able to take a more
passive approach to accessing liquidity and still achieve your execution over a
similar time horizon.”
Chris Hall
+44 (0)20 7397 3819
chris.hall@thetrade.ltd.uk