Brokers, exchanges and larger hedge funds need a comprehensive strategy to manage and leverage different forms of internal liquidity, according to an industry research note published by TABB Group.
“Liquidity Management: Pushing Automated Trading Beyond Agency Brokerage” claims that although firms are automating their trading process, they are only now beginning to develop a comprehensive strategy to manage liquidity.
TABB says that, although order management systems (OMS) and execution management systems (EMS) are important components in the electronic trading process, they do not address the way brokers interact with order flow, how sell-side traders decide to leverage capital or how firms develop consistent valuation and trading strategies across non-exchange-traded products.
This creates the need for liquidity management, which TABB Group describes as “the methodology surrounding how firms automate their trading desk, including the rules around valuation and pricing liquidity, the handling of customer order-flow, the matching of internal liquidity and the automated rules and methodologies around provision of capital for internal market making and proprietary trading.”
“The goal of liquidity management is to automatically manage order flow more efficiently and profitably with limited human interaction,” explains Matt Simon, the TABB Group research analyst who co-authored the report with Larry Tabb, founder and CEO. “This means putting tools in the hands of customers to trade themselves, automating the order flow that can be automated, making the most sound automated trading decisions and leaving the difficult trades and risky trades to the most talented traders to analyze and execute.”
Simon says this becomes more challenging as brokers’ profit margins on trading declines. “As cost pressures increase, they are looking to not only reduce fees, including execution fees wherever possible, but leverage the value of their order flow through liquidity internalization and the use of internal crossing networks or dark pools,” writes Tabb. “Nearly all top tier brokers are beginning to internalize equity liquidity, providing additional trading opportunities and enabling greater cross-company synergies. However, as more order flow is internalized, the need for more advanced electronic systems to manage this flow becomes more critical.”
Tabb goes on to point out that it is essential to upgrade order routing and improve management of order flow and liquidity in a trading paradigm that today is far more complex than most current trading systems were built to handle. Once firms create the requisite, integrated, enterprise-wide reference data infrastructure to implement an LMS program, the LMS determines how the orders will reach the firm, e.g., FIX, DMA, Request for Quote systems, how orders move through the firm, how they are valued, risk-benchmarked and eventually priced, hedged and finally whether they will be executed.
While dark pools are currently used for equities, TABB Group sees that as liquidity management solutions expand and order flow, valuation and pricing information become centralized, they will become more multi-asset, multi-product and multi-geography. They also expect that by 2011 equity internalization rates will shift. “The amount of flow matched in dark books will increase as Reg NMS and MiFID make it more challenging and risky to execute equities using more traditional internalization techniques,” says Tabb. “While many firms have considered taking a methodological view of their trading process and procedures for managing the provision of capital, few have a comprehensive strategy. We believe they will need this as customers become more sophisticated and trading technologies make markets more efficient. However, we believe that in three to five years we will see firms move from point-based solutions to more workflow-based solutions that will attempt to be more metrics-driven and more quantitative.”