It was 2010 when electronic trading first hit the headlines. Trade automation was hardly new. Technology-driven innovations had been accommodated in the US and Europe under Reg NMS and MiFID respectively. But execution algorithms and high-frequency trading (HFT) were still a mystery to senior executives at asset management firms, not to mention their institutional and retail clients.
This changed on May 6, 2010, when a combination of factors – speed, structural weaknesses and a looming European sovereign debt crisis – ignited the ‘flash crash’, a brief but alarming collapse in US stock prices. The Dow Jones Industrial Average plunged almost 1,000 points, only to rapidly regain composure, leaving regulators, traders and investors to wonder: what on earth just happened?!
First, a poorly parameterised index futures order from a mid-market fund manager was identified as the trigger. Later, the finger was pointed at Navinder Singh Sarao, the ‘hound of Hounslow’, an autistic amateur trader who played the markets from his bedroom.
Closer to the truth was author and ex-bond salesman Michael Lewis, whose 2014 expose, ‘Flash Boys’, suggested the flash crash was an accident waiting to happen. Exchanges, regulators and brokers had facilitated a new form of high-speed market-making and the entry of a new breed of market participant, allowing revenues to blind them to the systemic risks.
By this point, a cat-and-mouse battle between traditional buy-siders and HFT firms was in full swing. Buy-side traders were already treading carefully on the major stock markets, alert to the potential risks of interacting with counterparties deploying sub-millisecond technology to front-run them.
Asset managers looked to alternative trading venues, including dark pools, but here too they could encounter danger, especially when venue operators, typically brokers, were less than transparent about the identity of other participants.
“Ten years ago, the buy-side probably relied too heavily on their brokers. But the flood of questionnaires from plan sponsors and other clients in light of ‘Flash Boys’ gave trading desks a mandate to take more responsibility, investing in staff and technology to take control of their order flow,” says Chris Jackson, global head of equity strategy at Liquidnet.
Learning curve
Buy-side traders were embarking on a decade-long learning curve, gradually deploying faster technology, better analytics and more granular data, driven partly by greater regulatory and investor scrutiny.
Often dependent on the execution services of still-conflicted brokers, they interrogated post-trade execution performance to identify more accurately where they could execute large orders safely, and where they were under greatest threat. Sometimes, there was a balance to be struck, and the risk was considered worth taking.
Better data and technology have enabled more effective interaction, says Gregg Dalley, global head of trading at Schroders Investment Management.
“We still don’t have a consolidated tape, but we have much better access to quality data, particularly since MiFID II. When trading in systematic internalisers (SIs), we get a lot of granular data back on our fills which feeds into our post-trade analysis. HFT firms are a significant part of the market now, not just in terms of liquidity provision, but also execution services such as algorithms as they look to diversify their revenue streams.”
Access to more detailed data has not only put the buy-side on more of a level footing with newer market participants. The insights that trading desks have achieved through deeper analysis has increased productivity through process automation and streamlining. Both on they buy- and sell-side, the economic realities of lower margins and higher regulatory costs over the decade have fuelled innovation.
Schroders now has a global equities team of 17 traders located in four countries, having previously employed more in London alone, trading multiple times the volume, covering more instruments in more countries and far more investment teams and portfolio managers (PMs).
“This is all down to technology,” says Dalley. “In the time it took to pick up a paper ticket when I first started, time stamp it and pick up the phone to a broker, you can now hit a single button that optimises the execution strategy based on thousands of data points and back testing, as well as route, execute and book the trade. Traders have had to evolve and embrace technology and the progression has been amazing.”
Dalley’s traders must have a broader set of skills, operating and understanding beyond their specific field of responsibility and collaborating with technologists and data scientists to improve execution performance.
“The quantitative execution research team can back up traders’ hunches with solid evidence, independent of selection bias,” he explains. “By matching algos to specific stock characteristics, we can automate more trades in small size, whilst the human traders focus on orders with larger ADV (average daily volume) or complexity.”
For Neil Joseph, head of equities trading for EMEA at JP Morgan Asset Management, the story of the decade is a shift from automating execution to automating a wider range of workflows between traders, PMs, and the sell-side: “This has helped our EMEA team to execute 50% more orders per trader than three years ago, whilst reducing trading costs by 20% over the same period,” he says.
Examples of technology-assisted workflow innovation include the automated generation of targeted notices of liquidity opportunities to relevant PMs and a mechanism for flagging block trading signals from the sell-side.
As at Schroders, Joseph’s team work closely with dedicated technologists to develop, test and implement incremental improvements, then measure their impact on execution performance. “Technology teams are co-located on the trading desks around the world. This enables us to develop using agile methodologies: we now deploy multiple new releases per week,” he says.
Growing up
These changes make for different requirements on – and relationships with – the sell-side. Trust in the ability of an individual sales trader to find liquidity has given way to a more forensic, data-driven approach.
“By 2010, broker relationships based on personal franchises and networks were already eroding. In light of MiFID II’s unbundling and best execution requirements, these relationships are now highly strategic, based on compatible approaches to electronic trading,” says Carl James, global head of fixed income trading at Pictet Asset Management, noting a broad-based increase in transparency.
“The buy-side has had to grow up. In the past, there was a tacit understanding that the sell-side would supply infrastructure and other execution-related services. Today, if you want it, you pay for it.”
Sales traders have had to change just as much as their buy-side counterparts, according to Mark Goodman, president of UBS MTF: “Today’s electronic sales trader helps the client to navigate the market, advising on how to get the best outcome. This role was only just emerging in 2010, when the priority was just getting the trade done,” Goodman observes. “A strong relationship is not going to get broker A the business if the data says broker B can get a better outcome for a particular order.”
Accordingly, provision of data, analytics and other decision support tools is as central to serving the buy-side today as access and liquidity. Progress has not always been smooth. In an era of low margins and high transparency, it is harder to justify the more labour-intensive services still valued by the buy-side, such as research, market colour and capital commitment.
Highly-automated central risk books have been developed by larger brokers, whilst some buy-siders are paying high-touch prices to maintain access to sector-specific insights, despite executing via low-touch channels. As such, today’s sell-side service model is based on execution choice and support. Known primarily for its buy-side liquidity pool, Liquidnet’s offering has expanded over the decade, for example, encompassing a broad, flexible set of tools.
“We may be seeing the emergence of a mid-touch sell-side model, where trader expertise and experience in certain sectors is allied with services that provide insight through data-driven analytics,” says Jackson. “And as buy-side desks reengineer their processes to achieve better outcomes, we need to have the skills and analytics to support them.”
Revolution
If the central story of the decade is one of buy-siders levelling up with brokers and HFT firms, enhancing technology and skills to improve the efficiency and accuracy of their trading activities, two caveats are necessary.
Schroders’ Dalley insists the human element is still important, from generating liquidity in mid-market names to observing etiquette to preserve long-term relationships. At Pictet, James says the data revolution has barely begun.
“We won’t recognise the front office in three-to-five years’ time. We might not have seen much change yet, but the hiring of data scientists is the start of a journey of discovery. Traders will increasingly oversee trading operations, becoming portfolio strategists,” he says. “If one considers the fundamental changes in how investment ideas are generated, it’s clear that the old model is dead and we’re now in an exciting new phase.”
Some things changed even less. Despite MiFID II’s measures to bring more trading back onto lit trading venues, off-exchange volumes have stayed remarkably steady. The battle between exchanges and brokers that first opened the door to HFT goes on.
Barely a week after Sarao finally learned he would not serve jail time, the European Securities and Markets Authority unveiled proposals to reform MiFID II. Plans to restrict dark trading and periodic auctions and increase SI pre-trade transparency are designed to ease the introduction of the consolidated tape, still much desired by the buy-side.
But they are also seen as a response to political dissatisfaction at MiFID II’s failure to boost on-venue volumes. As Rosenblatt Securities noted, “Exchanges on the continent will likely push for SI restrictions and further limits on dark trading, while banks and buy-side firms will fight to keep a more diverse competitive landscape.”
Plus ça change!