Buy-side increases reliance on brokers in volatile markets

Volatility in European equities markets during May 2010 marked the first time that buy-side traders could consistently access risk pricing from their brokers since the height of the global financial crisis in Q3 2008.
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Volatility in European equities markets during May 2010 marked the first time that buy-side traders could consistently access risk pricing from their brokers since the height of the global financial crisis in Q3 2008.

In May 2010, the VIX volatility index reached a high of 45.79 compared to April’s peak of 22.81. While this is still nowhere near the unprecedented volatility experienced towards the end of 2008 – when the VIX crossed 80 – it is the highest level for more than a year, when the VIX bounced between 42 and 52 in March 2009.

The main cause of volatility during May was uncertainty surrounding the stability of a number of countries in the eurozone, particularly Greece. Equity market volatility was compounded by the steep fall in the price of BP following the oil spill in the Gulf of Mexico, Investor confidence has also been shaken by Germany’s ban on short-selling of eurozone sovereign bonds, credit default swaps and ten German financial stocks.

Despite volatility returning to levels last seen in the first quarter of 2009, traders’ use of execution channels has not mirrored the choices made last March.

“Back in Q1-Q2 2009, there was absolutely no capital commitment available, which led us to send more of our flow – around 60% in total – via algorithms and direct market access channels,” Tony Whalley, head of dealing and derivatives, Scottish Widows Investment Partnership, told “So far in 2010, we have been able to make more use of capital commitment, particularly during volatile periods, and our algo participation has dropped to around 10%.”

“We made more use of risk pricing and capital commitment to speed up trade implementation during the volatility in May,” added Brian Mitchell, head of dealing, Gartmore. “There appears to have been a greater tendency from buy-side traders to try to get 20-50% of an order done straight away on risk, particularly on sell and shorting orders, given many were following the market down.”

According Whalley, trading cost analysis has proved capital commitment to be cheaper in many cases than the implementation shortfall incurred by using certain algorithms or buy-side crossing networks.

“The cost of slippage from being passive during volatile markets can be far greater than matching against natural business, such as IOIs, so it is no surprise that risk pricing can be cheaper than resting orders in dark pools, for example,” said Whalley.

George Andreadis, head of liquidity strategy for Credit Suisse’s Advanced Execution Services division, suggests higher levels of over-the-counter (OTC) activity reported in May were consistent with greater use of capital commitment.

“There was an increase in delayed trades and over-the-counter trades in May, which could be tied to a trend of greater capital commitment,” said Andreadis. “Traders may have favoured greater execution costs in order to receive certainty of execution.”

According to data vendor Thomson Reuters’ European equity market share reporter, OTC trading accounted for 47.09% of total trading in May, up from 44.81% in April. By comparison, trading on displayed exchanges and multilateral trading facilities declined to 40.5% in May, from 41.4% in April.

As well as more dependence by buy-side firms on their brokers for obtaining reliable stock prices, some sell-side firms noted an increase in the use of aggressive, liquidity-seeking algorithms, much like the tactics used to combat swinging stock markets at the end of 2008.

“There has been a greater tendency towards the use of liquidity-seeking strategies, but I think this is a broader market structure shift,” said Adam Toms, managing director, head of market access group, Nomura. “However, in times of heightened volatility, aggressive trading strategies can help clients to capitalise on opportunities and combat uncertainty in the market.”

But Andreadis adds that, compared to previous periods of strong volatility, May has witnessed greater interaction between traders and their broking counterparts while working trades in the market.

“Our team is in constant dialogue with clients so that they can continually monitor algo performance and change the parameters of the algo on a real time basis,” he said.