Should the sell-side welcome the trend of greater segmentation of order flow by trading venues?
In a sense, if trading venues tailored their services to different types of market participants, part of the executing broker’s job is made a little easier.
At the moment, brokers may send client order to venues with specific instructions that target the most optimal type of liquidity.
For example, many algorithmic strategies are now configured to avoid high-frequency trading flow – such as this recent algo redesign by Société Générale – or target dark liquidity from selected ‘low toxicity’ pools, if an order is deemed to be particularly susceptible to market impact. Growing sophistication in the way institutional investors use algorithms means buy-side traders also adjust parameters themselves.
While there is the argument that order flow segmentation further exacerbates the fragmentation of liquidity encouraged by MiFID and the US equity market structure, the ability to pinpoint counterparties exactly by venue could negate the need to tinker with electronic trading strategies.
This prospect could be particularly attractive to buy-side firms that want to trade large blocks to manage market impact.
This appears to be the model in development for former Chi-X Europe CEO Tony Mackay, who is launching a venue based on social networking principles that lets users pick counterparts for each trade.
However, there is the possibility that the sell-side could be disintermediated completely, if new venues allow direct buy-side participation, thereby allowing investors to control orders themselves. Brokers could see segmentation as a way of market operators grabbing revenue that does not really belong to them.
So segmentation allows more discretion on execution. Is this another way of solving the problem that broker crossing networks were designed to address?
There are some parallels with the long-running industry dispute on the rationale for broker crossing networks (BCNs).
A core selling point of BCNs to the buy-side is the ability for their operators to discriminate via entry criteria and pick and choose how they match orders. Brokers say using of BCNs as part of an overall strategy gives them a better chance of achieving best execution for clients.
Detractors argue, among other things, that such venues create a two-tiered market where only some participants have access to a certain portion of liquidity.
While it’s possible venue operators could use features such as pricing models and order types to create a separation of order flow on different markets, the issue of favouring some market participants at the expense of others may well resurface.
However, a core difference between BCNs and segmented markets will be transparency. For the time being, BCNs don't necessarily need to explain why or how they match orders, whereas segmentation initiatives – like NYSE’s Retail Liquidity Program in the US – will need to have clear rules and procedures.
But surely there are times when orders need to interact with more than one type of liquidity?
Of course, and it’s likely that services will offer the option to trade against multiple participants. But there is an opportunity cost here.
In a fragmented market, there remains the likelihood of valuable liquidity locked up in other segments of a market that you simply can’t trade against, no matter how benign your flow might be.
The question is whether the industry can really afford to go down this route at a time of anaemic trading volumes that show no sign of recovery.