The master builder
Following the mergers that created DnB NOR Asset Management, Johan Erikson was given carte blanche to build his ideal equity trading operation. Due to an astute blend of sell-side attitudes and buy-side trading tools, Erikson and his clients have been reaping the rewards ever since.
In what ways does the trading function support DnB NOR’s competitive position in the asset management market?
The combination of a competent trading team and a robust trading platform and processes is an integral part of the asset management value chain. The clients’ biggest interest is in portfolio performance, but the contribution of execution is well understood at DnB NOR. Our portfolio managers can see what’s been lost and gained in dollars and basis points through execution performance.
On the one hand, our traders are driven to beat the market and can monitor their performance against given benchmarks throughout the day via our internally developed transaction cost analysis (TCA) application. By enabling the traders to see the impact of their decisions almost immediately, it helps generate an environment of continuous improvement and competition. On the other hand, our trading platform provides traders with access to the most advanced tools to enhance trade execution services to our clients. From implementing FIX connectivity to reducing latency to using algorithmic trading strategies, we have invested to deliver execution quality results that meet or exceed standards demanded by MiFID and the market.
How are client demands changing and how is the trading function responding to these?
Clients are always concerned about the cost and quality of trade execution. First and foremost, they look at commission costs. Through use of modern execution channels, we have been able to keep commission costs down despite threefold volume growth over the last three years. The days of handing out the majority of our trades to cash traders are long gone. Today, we only use cash traders for very difficult trades and to source liquidity through a block, risk price, or plain ‘natural’ other side.
We’ve also kept a lid on impact and opportunity costs. Through both FIX connectivity to increase our speed to market and algorithmic trading strategies to minimise impact cost, we are better able to identify alpha and select a trading horizon that balances market risk and impact cost to deliver the best possible trading result in the circumstances.
As a result of greater regulation and accountability to shareholders, clients are already sending us RFPs that ask for unprecedented levels of detail on trading. Some of our bigger clients already come to see the trading desk in action and to ask questions about how we trade. This will increase as MiFID focuses clients’ attention on trading costs. As clients become more knowledgeable, the dealing desk will meet endclients more often and take on an executions consultant role.
What technologies do you deploy to measure your trade execution performance?
The critical tool is an internally developed TCA application which serves as an online order flow and execution monitor that has allowed us to capture key data relating to slippage, alpha and performance since January 2005. The TCA application follows the trade from the moment it hits our OMS blotter to the last fill, or until the market closes, depending on the benchmark. The portfolio manager chooses one of seven execution benchmarks when creating an order and costs are reported back into the portfolio manager’s system on completion. Understanding the impact cost as well as the commission has changed the behavior of portfolio managers in some cases.
Because it reports in near real time, we can see the results as the execution is unfolding. This facilitates dialogue between the investment team on whether we executed the trade in the right way or should have chosen a different approach it also means we can see clearly where we’re adding value.
Our TCA application also gives us a lot of flexibility in how we slice the trade execution data. At any point in the day, we compare counterparties’ trade execution results and can filter data by time horizon, instrument, manager, execution type, ADV (average daily volume), market impact, trading venue or even industry sector. We sometimes send execution data to brokers for their comments on a particular trade’s performance and we’ve definitely seen improvements as a result.
What are the major contributors to the reductions in transaction costs you have achieved over the last three years?
Latent Zero’s Minerva order management system has been the cornerstone: a solid platform from which we could adopt new trading technologies. Reductions in implicit and explicit transaction costs have been achieved mainly through adoption of such tools as FIX connectivity, our three execution management systems, algorithmic trading and our increased use of program trades for single stock orders. And because we want traders to focus 100% of their attention on trading, the achievement of full straight through processing in our trading process has been a major contributor to generating alpha, increasing productivity and lowering transaction costs.
We’ve achieved STP from the portfolio managers – who utilise a portfolio construction application that feeds orders electronically into our OMS – to the traders – who review and assess suitable market strategies and destinations then route orders electronically – through to the back office. FIX allocations and integration with our back office environment has been key.
How do you interact with portfolio managers to optimise overall performance?
The trader must understand the manager’s ambitions for a trade as well as the structure and content of individual portfolios. Technology might speed orders to market and improve trade efficiency, but you need human dialogue too. The information and knowledge shared between the trader and portfolio manager not only creates synergy but also adds alpha to the portfolio. On an ongoing basis, traders work with specific teams to provide the trading perspective on their respective portfolios. While portfolio managers tend to think in the longer term, for example, traders can add value by adding an intraday/week perspective. The buy side trader knows the positions that are most important to the portfolio, and so has an insight that the sell side doesn’t really see. If a stock moves, we will know that we already have negative and positive positions and can act accordingly.
Because we work with 60 portfolio managers globally, my traders communicate with them using internal electronic chat communication. Throughout the trading day, we act as a filter for the market information that might affect their positions, using the many sources we have access to. While dialogue is critical, roles must be clearly distinguished: traders must always have execution discretion to meet best execution requirements.
What electronic trading tools do you use and how do you select between them?
We have a natural curiosity for new ways of trading that make the job more efficient and productive; it would also be a disservice to the client to omit any of them. A trader’s main task today is to source liquidity, which means going beyond traditional exchanges. The majority of our difficult orders are those that have high ADV or are thinly traded. Through use of trading tools, we are now able to source liquidity in the alternative trading venues, particularly crossing networks, more successfully than before and have reduced market impact and information leakage. Typically, we start a trade off in the alternative trading venues to see how much liquidity can be sourced. Then, depending on how much gets filled, we may execute the balance of the order on risk via a traditional cash desk. Often, we can complete difficult orders through a combination of alternative venues with some participation in the primary markets.
In Europe, we’ve a 50/50 split between DMA and algos, but we use algos for almost 100% of US trades (DnB NOR has been using DMA for almost 10 years). For passive (non urgent) orders, we might start with an algo that participates in the public markets while hunting the crossing networks and alternative venues for liquidity and size using a stealth algo. If the stock is fairly liquid, we might use a DMA style algo to tap liquidity on the primary markets, then move to a more commoditised algo strategy.
What’s your view on the electronic execution capabilities of the sell side?
For certain types of trade, the local Swedish brokers miss out because they don’t have the electronic execution services that we can get elsewhere. All the main international houses offer risk prices and invest in technology to increase market share and if they don’t change soon the majority of Scandinavian brokers won’t know what hit them. One of my major challenges here is to get all the local brokers up on FIX. We trade Swedish stock programs ourselves rather than sending them to local brokers. We also have basket functionality in our DMA tools because it’s more efficient than handing out trades to local brokers for certain types of trade. We also use the (algorithmic trading) channels of international banks to trade into the Swedish market because the process is so much smoother and quicker and gives the desk greater control.
But some brokers rely too much on algos, and put too many orders through their algos, which can hurt performance. We’ve seen algos being used in stocks they shouldn’t, i.e. where the spread’s too wide or the stock’s too illiquid. There are also some cash desks that will push orders through their algos rather than giving them the attention that you pay for.
What are the skill sets required for running a global buy side trading operation today?
In a continuously changing trading environment, you need staff that are willing to adapt and want to take on new, sophisticated tools that can improve performance. Now that we have so many tools that were previously only available to the sell side, it is also an advantage to have traders with sell side experience.
As a small team of seven spread across three time zones, we ensure that all our traders understand the different daily operations of the other desks so they can offer good backup and support when needed. For example, our US trader will work out of Hong Kong for a period this summer.
How has MiFID changed the trading environment so far?
A primary benefit of MiFID has been to increase the focus on execution outside of the trading room, both within DnB NOR Asset Management and beyond to clients. We must now keep TCA records for five years and be able to demonstrate execution quality standards over time, but there’s been relatively little change to our internal workflow because we were already tracking and improving performance well before 1 November 2007.
We will get a better idea of how the European market will develop once additional new trading venues open after the summer. What we’re most keen to see is market data aggregation and consolidated order books for European markets. We don’t really want to pay multiple sources to get the full picture and are looking to the new trading venues and exchanges to provide combined statistics for European trading.
One issue of concern is the lack of guidance on the information you need to have in place. I spent time last year trying to get practical examples from the local regulator who just referred me to the information on its home page; there’s no guidebook, you just have to do what’s practically possible. Although I am confident that we can give our clients the information they need, it would be hard to customise this information to the specific needs of each and every one.
Today, you can see the separation between execution and research fees more clearly than ever. For us to be able to execute on the same terms wherever we’re located, we need a common European standard for commission sharing agreements.
What are the key future challenges for you and other buy side traders?
Firstly, we have to avoid becoming too comfortable. We need to continue to improve by leveraging new liquidity sources, more sophisticated metrics, new algorithms, and functionality upgrades to the OMS. Secondly, and specific to Scandinavia, we need to push sell side firms to improve their electronic trading capabilities. Very few are connected to ChiX at present or have even developed algorithms for their home market. Finally, it’s going to be a bigger challenge to attract and keep the best traders when more buy side desks reach the same technological level. At the moment, technology has given us the advantage of executing at half the transaction cost compared to the manually driven desk across the street, but that won’t last.
Bio
Johan Erikson, global head of trading, DnB NOR Asset Management, spent 10 years at sell side institutions before switching to the buy side seven years ago. During this period, DnB NOR has established itself as a premier Scandinavian trading desk and initiator of advanced trading technologies, methodologies and strategies for the buy side. Erikson and DnB NOR have been recognised for ‘Best Buy side Use of Advanced Trading Tools’ in 2007 and 2008 and as ‘Buy Side Achiever of the Year’ in 2008 at the Trade Tech annual awards.
DnB NOR Asset Management is the product of a series of mergers and acquisitions completed in the early 2000s. One of the Nordic region’s largest asset managers, the firm services pension funds, companies, municipalities and other institutional investors. Its equities trading activities are centred in Stockholm, Sweden, but it also has trading desks in Oslo (for Norwegian stocks), New York and Asia. The team of seven provide mutual back up and share expertise across the four desks. “Within the Stockholm team we have our different areas of expertise, e.g. program trades, but generally we try to ensure we work on all different types of trades. Our practice of moving around desks also helps us pick out the most efficient trading methods and processes in each desk,” says Erikson.
Erikson says the merger of the three predecessor firms’ equity trading operations created the ideal opportunity to create a new, efficient and highly automated dealing facility. “Technologically, the timing was fortuitous because we were looking to replace our legacy systems just as order management systems were developing the sophisticated capabilities we needed,” he recalls. “We also had management support to build the trading setup that we as traders believed would achieve the best results.” The autonomy of the firm’s equities dealers is enshrined in the fact that Erikson’s reporting line is to the CEO/CIO of DnB NOR Asset Management.
A key characteristic of DnB NOR’s equity trading team is its sell side mentality. ”The majority of us come from the sell side and we act, to a large extent, as sales traders to our portfolio managers. We have access to execution channels now that were previously only available to the sell side,” says Erikson. “If you’re on the sell side, it’s easy to tell whether you’ve had a good or bad day, so we’ve tried to find a P&L proxy on the buy side to inject the same kind of energy into our trading activities.”
