Cronin: The for-profit exchange model poses a threat to capital formation

Regulatory debate surrounding market structure must be developed with the interests of institutional investors at its heart to ensure markets serve their core function of capital formation, Kevin Cronin, global head of equity trading at buy-side firm Invesco, has said.
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Regulatory debate surrounding market structure must be developed with the interests of institutional investors at its heart to ensure markets serve their core function of capital formation, Kevin Cronin, global head of equity trading at buy-side firm Invesco has said.

He was addressing the new challenges facing the buy-side following the liberalisation of market structure and the rise of high frequency trading (HFT), at the TradeTech conference in London today.

“Regulators need to understand that institutions represent the interests of the individual investor,” he said. “The evolution of the hunt for liquidity has made trading an essential part of the investment process. As such, markets need to be efficient, fair and transparent, and regulators should be grounded in these principles.”

Many of the problems facing institutions, believed Cronin, stem from the prevalence of the for-profit exchange model, which has detracted from the role of the market as a utility. “Maximising shareholder value is incongruent with investor interests,” he said.

HFT: good in parts

Cronin pointed to a number of exchange initiatives that he considered enticed high frequency order flow at the expense of long-term investors. For example, flash orders – whereby a select group of a market's members get a peek at orders before they are publicly posted – create a two-tier market that favours active investors.

In addition, access to co-location, which allows trading firms to place their servers as close as possible to exchange servers to minimise latency, was also deemed to cater for short-term investors at a cost to more traditional market participants.

“Co-location is designed to give a certain breed of participants high-speed access to markets that is not commercially available to all investors. Exchanges argue that it is, but in a lot of cases it is simply not affordable,” said Cronin.

There was also criticism for the maker-taker model, a fee schedule that offers rebates for posting liquidity and charges for taking liquidity that is favoured by many alternative marketplaces in the US and Europe.

“HFT firms – which aim to have flat positions at the end of the trading day – can make money simply by posting more often than they take,” said Cronin. “While some argue this creates more volume, this is not the same as liquidity; 100 or 200 share lots are not really useful for institutions.”

While Cronin is generally considered a critic of HFT – admitting that he faced boos during his last presentation to an audience of HFT firms – he acknowledged the usefulness of some strategies, i.e. statistical arbitrage activity and electronic market-making do serve useful functions such as adding liquidity to the market and keeping prices inline.

But he expressed concern at a number of other HFT characteristics that could encourage manipulation, such as momentum ignition strategies, which attempt to bait other algorithms to take an action in order to take advantage, and the high proportion of order cancels that can manipulate the market by giving the impression of inflated order book activity.

If the buy-side does not have the means to manage high-frequency flow, institutions could be left on the sidelines, said Cronin.

“If there is a risk of a high frequency trader jumping in front of your order every time, it is not a great incentive for institutions,” he said. “When there are people waiting for us to give them some sort of signal, we are better off just hiding until the right opportunity presents itself.”

To ensure that institutional buy-side firms can act in the best interests of their underlying clients, Cronin stressed the importance of giving buy-side firms the tools to help them manage the evolution of market structure. This means ensuring access to execution tools, such as dark pools, direct market access and alternative pools of liquidity, which he described as “crucial in allowing investors to thrive.”

Cronin urged European regulators in particular to be mindful of the role that dark liquidity plays as an invaluable part of the institutional investor process.

In a consultation period that ended in February, the European Commission proposed measures that could restrict the activity of many dark pools. These included a minimum size threshold for orders transacted in dark pools that use MiFID's reference price waiver and tighter regulation of broker crossing networks, which were not strictly captured by the first version of the directive.

Data ”mind scramble'

Cronin also sympathised with his European buy-side counterparts on the difficulties they face with post-trade transparency. “Transaction cost analysis in Europe is currently a ”mind scramble',” he said. “As it stands, European data does not allow the buy-side to see whether they made the right choice of venue or missed opportunities. Good data is vital in order to make good investment decisions.”

Although much of his presentation focused on the flaws that are apparent in today's market structure, Cronin did recognise the advantages that market competition has provided, in particular innovation, execution choice and lower trading costs. While too much fragmentation poses its own problems in terms of efficient price formation, he added that the best way of achieving the appropriate balance is to encourage competition instead of regulating against it.

Future regulation would also need to address the asymmetric benefits of new technology and market structure innovation.

“There is a population of stocks that are clearly better off now compared to five years ago, in terms of better liquid, narrower spreads and more volume,” he said. “But the same does not hold true for stocks that have a lower market capitalisation. Technology has been good for some, but it is not the magic elixir for all,” he said.

“These imbalances must be addressed and regulators must ensure that they do not apply a one-size-fits-all approach.”