Nearly two-thirds (61%) of market participants consider sales trader indiscretion the most significant source of information leakage in today’s markets, according to August’s poll on theTRADEnews.com.
The fear that a sales trader may share buy-side order information with other parties – inadvertently or otherwise – has existed for decades. Although the Volcker Rule, contained within the Dodd-Frank Act in the US, has prompted many banks to wind down or divest their prop desks, theoretically helping to reduce the risk of leakage within brokerages, many market participants remain cautious.
“Sales trader indiscretion is almost impossible to prove – you have no idea if the broker you speak to is sitting next to a prop trader, runs his own book or speaks to people after work,” said Sören Steinert, associate director, equity trading
at Quoniam Asset Management, a Frankfurt-based buy-side firm. “I manage this on the basis of sell-side relationships. There are only a few brokers that I would give full order information to, i.e. stock name, size and direction. The others – most of them – would only know the name of the stock I am looking to trade.”
However, the growing automation and fragmentation of trading has given buy-side traders more options, including the choice of deploying direct execution or algorithms from their own desks. While this gives the buy-side more control over their trades, it has also opens the door to other perceived dangers. Some 25% of poll respondents considered that predatory high-frequency trading (HFT) algorithms represent the most severe risk of information leakage. The fear that a long-term investor could be ”gamed’, for example by a high-frequency trader working out its intentions are and trading against them, is tangible for a sizeable minority of the market.
Yet these risks are played down by Adam Toms, head of market access at Nomura, who argues that most of those who see predatory HFT algorithms as a source of information leakage are largely voting against fear of the unknown.
“Even basic algorithms such as a VWAP algo try to conceal what they are doing from the market,” he said. “They also use high-frequency signals to trade the order, i.e. short term statistical indicators. A lot of people seem to forget that.”
Nevertheless, Steinert at Quoniam believes that buy-side market participants should be aware of HFT strategies and adapt their own behaviour to avoid the risk of being disadvantaged.
“To avoid the predatory strategies, it is important to be an active trader, and treat your order in the same way a broker would handle it,” he said. “This means you have to monitor the performance of a trade whilst it is being executed and makes changes to limits or strategies where appropriate. Using an active approach will make it more difficult for an HFT firm to trade against you.”
Only 13% of respondents considered dark pools to present the most serious risk of information leakage, with some suggesting that non-displayed venues may actually attract flow that is particularly sensitive to information leakage, on the basis that market impact may be minimised in the dark.
“Dark pools are ironically one of the most quantifiable sources of information leakage in any case, since it’s easily possible to infer from negative selection what your impact in a dark pool is,” says Toms. The existence of tools that enable market participants to study the impact of their trading in terms of negative selection, as well as control it using various limits, also helps diminish the buy-side ”fear of the dark’, he suggests.
For Toms, the best means of preventing information leakage is to ensure that processes are in place to enable the buy-side market participant to quantify negative selection; and to consider the workflow, using sales trading where it can add most value.
“Electronic lines can be useful, but it’s also true to say that sometimes you really need a high-touch approach,” he says. “Sales traders provide lots of knowledge in terms of what’s going on in the market, the stock, the average size traded, etc – that’s very valuable sometimes when you’ve got a larger order and you want to manage your order flow.”