Tempted back from the dark

Buy-side firms quit the lit venues in droves in recent years, in part to avoid high-frequency flow, but could they be tempted back?

How likely is it that the buy-side will favour order flow segmentation by trading venues? 

Institutional investors have often complained about being ignored by exchanges in the past so might be expected to treat these developments with optimistic curiosity. They have seen exchanges chase high-frequency trading (HFT) flow through the adoption of new pricing structures and technologies, while also raising a cynical eyebrow at the bourses’ collective opposition to dark pools. Supporting politicians’ calls for greater transparency in the cash equities market – while offering little incentive to bring institutional trading back onto lit books – has done little to endear exchanges to the buy-side in recent years.

The rapid growth of HFT flow to levels of 60-70% on some markets has contributed significantly to a trading climate in which market impact is harder to manage for institutional investors than ever before.

Many long-only managers now complain that super-fast HFT strategies see their orders coming and trade ahead of them, bidding up the price, resulting in higher costs. Asset managers quit the lit markets in droves.

The emergence of dark pools was welcomed by institutional investors specifically because they contained lower levels of high-frequency flow. But since HFT strategies have begun to infiltrate dark pools too, buy-side execution desks are having to spend a lot of time and resources digging deep into post-trade data to examine how their trades fare on different dark pools.

In this context, the ability of exchanges to divide their markets into services that have rules aimed at different market segments, i.e. HFT, retail orders, institutional order, etc, would appear to be just what the buy-side has been calling for. 

At a time of low volumes, is more competition between exchanges a good idea? 

Certainty, fragmentation and a lack of diverse liquidity are the initial obvious disadvantages of exchange-run insto-only ‘ghettos’.

In an environment where fragmentation has necessitated a massive technology spend by brokers and buy-side firms to ensure they hit all sources of relevant liquidity, complicating the market yet further by introducing inter-market divisions would likely require further tweaking of market participants’ underlying connectivity infrastructure.

Presently a smart order router bases routing decisions on factors such as cost and certainty of execution. A further division of liquidity within markets would require even more investment in routing technology among sell-side providers. Even if exchange-based segregation of orders offers new opportunities for institutional-sized trading, buy-side firms will not want to close off existing avenues to retail and HFT flow as these will continue to remain useful in specific circumstances.

However, smart order routing and extensive multi-market connectivity has been with us for several years now. Linking clients to the most beneficial sources of liquidity should be part of brokers’ value-add.

How might segmentation solutions change how the buy-side trades on-exchange?  

The initiative that kick-started order flow segmentation, NYSE’s Retail Liquidity Program, attempts to bring flow that was mainly traded internally by large US market-makers back onto public markets. In short, most institutional market participants don't interact regularly with this, so they are not likely to be affected by rules that ringfence retail orders day to day.

But efforts among dark pools to differentiate flow perhaps offer an insight into future trends. Broker-owned crossing networks can restrict HFT flow, but dark multilateral trading facilities (MTF) cannot because they must offer equal access to all market participants. To attract more buy-side flow, London Stock Exchange-owned Turquoise MTF has introduced a periodic cross that offers a good matching opportunity for block orders that has little appeal to HFT strategies, who continue to use the dark venue’s continuous crossing capabilities. This is not, perhaps, flow aggregation as envisaged by exchanges, but it does show how different rules and functionality can generate the conditions that attract sub-groups of the overall markets.

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