Interviewing buy- and sell-side sources for The TRADE’s 10th anniversary special edition – The TRADE 100 – has provided a welcome opportunity to consider some of the longer-term trends in institutional investment and trading beyond the day-to-day diet of product announcements and regulatory updates.
Over the past month or so, our editorial team have been reinterviewing the buy-side heads of trading who have appeared on our 40 issues to date, as well as senior representatives for the brokerage, exchange and trading technology communities. It’s unwise to over-generalise of course but it’s also hard to resist the journalistic tendency to identify themes and join the dots, while appreciating they might be tenuous to others. My overall impression is that some themes are reasserting themselves following a period of upheaval driven largely by regulatory and technological change, while other elements of the trading landscape have changed forever.
The development of separate equity trading desks at asset management firms, with growing but varying levels of autonomy from portfolio managers, took place in parallel with the automation of equity trading since the turn of the century and was then cemented by the growing complexity of equity market structure, facilitated in part by regulation. It was not practical or efficient for portfolio managers to pick stocks, construct portfolios and master the tools of the electronic trading environment sufficiently to minimise market impact. While maintaining a keen understanding of the portfolio manager’s investment objectives, the buy-side trader has been increasingly left to use his or her knowledge of the market and its methods to implement the trade. Traditionally, putting on a trade had involved some level of risk transfer to the broker, especially for the large blocks funds typically require to make a meaningful difference to their portfolio performance. Before the buy-side got their hands on algorithms, the only way many trades could be done without wiping out the upside was for the broker to accept the implementation risk and then unwind the position at its own cost. At a time of asymmetric information on trading costs, broker-client relations grated at times, understandably. But the tools made available to buy-side traders, particularly the algorithms that allowed orders to be sliced smaller to avoid market impact, made capital commitment a requirement for fewer deals (crisis-induced constraints on bank balance sheets subsequently reduced this activity further). Over time, the buy-side has taken on more of the risk and responsibility.
Technology only moves forward of course, but other themes do tend to wax and wane. A number of recent interviewees for the TRADE 100 have talked about the market coming full circle. By this, I think they often mean that trends that had appeared to be in permanent decline are showing signs of permanence.
It is now possible for buy-side trading desks to analyse trade outcomes in ever greater detail, to understand at a very granular level how costs were incurred for every share bought or sold. Though not perfect (and can never be), this tick-by-tick, micro-second by micro-second information is providing unprecedented levels of transparency to the buy- and the sell-side and now increasingly to regulators. It has changed the conversation, but it may not have changed the paradigm, yet. As shown by Greenwich Associates data released last week, electronic trading levels have reached a plateau in the last four to five years, despite the growing availability of real-time transaction cost analysis and the ability to factor more sources of data into trading decisions. There are good reasons to think this is a temporary pause in the share of trading executed electronically. But the current situation also underlines the continuing importance of the human element of trading, whether you call that trust, understanding, communication, partnership or judgement.
In short, portfolio managers, traders and brokers are using the new insights provided by technology not to reinvent the investment process but to refine it. More detailed information on what happens to a stock after a trade is leading to a more valuable feedback loop between portfolio managers and traders. Brokers are looking to knit back together order flow after years of Chinese walls between sales and electronic trading, but using technology both to maintain anonymity where requested and to provide more cost-effective means of sourcing liquidity across multiple channels. Similarly, brokers are using technology to support a more quantitative approach to the provision of trade facilitation. In a world where liquidity can never be taken for granted – especially as the greatest alpha often lurks in the more obscure assets – risk transfer between brokers and institutional investors is unlikely to recede entirely. And when technology is eroding imbalances in information flows, relationships between the main actors are becoming less adversarial and more like partnerships.
Transparency and trust are key plans of these partnerships. Portfolio managers that once told traders what stock to buy, through what broker and at what price are now asking traders to help them gain a particular exposure, and leave the details of the implementation to them, confident that the analytics available to the trading desk will ensure the desired outcome is reached. And while brokers previously competed to demonstrate superior execution performance, they are now asked by their execution clients to supply specific types of data on which the trading desk will base their judgements of value added. Portfolio managers, traders and brokers will continue to have an important part to play in trading and execution. While their relationships may still grate occasionally, at least now they are on the same page. Risk and responsibility may still be shared between buy- and sell-side, but with more certainty about the costs and the outcomes.