US Institutional Equity Trading 2009/10: Dark Pools, Transparency, and Consequences
The most important issue facing US equity markets today is the intense regulatory scrutiny coming from both legislators and regulators. There is a drive to restore investor confidence in a post-CDS, post-Lehman Brothers, post-Madoff world. Short sales, flash orders, high frequency trading, dark pools, indications of interest, and the role of electronic liquidity providers are all under review and subject to potential restrictions. While the regulators and legislators have the holistic market’s best interests at heart, many of the actions being considered raise alarm amongst buy-side traders. There is concern that a severe regulatory or legislatively-mandated market structural shock will have major and long-term unintended consequences.
High frequency trading volume has captured the attention of the marketplace, the media and the regulators, and has continued to grow as a percentage of overall daily equity activity. The majority of traders are indifferent to the presence of high frequency flow, primarily because they do not have the necessary data or quantifiable metrics to determine whether this flow is hurting or helping their cause. The potential consequences of ill-informed market regulation on high frequency flow are of a far higher concern to traders than any concerns about the presence of the flow itself. Head traders we spoke to call for a period of reason and analysis, of education and clarification over hysteria and hype.
Lack of transparency is a growing issue for the buy-side trading desk, and the call for information is getting louder. Best execution obligations and TCA reports provide some level of comfort that their interests are upheld, but trust isn’t what it used to be and buy-side traders are a lot more sophisticated than they once were. Traders are starting to ask for concise information about their algorithms and smart order routing criteria. Many want a say in how these technologies are configured, while some are now demanding full control. The sell side is asked to provide specific information about the factors that go into their smart order router (SOR) logic, including preferencing of certain venues, along with any financial arrangements between the broker and various dark pools partners. Increasingly, clients are demanding the ability to customize these configurations according to the nature of an individual order.
There is a call for more transparency with reference to dark pools as well. They do not want regulatory changes that would impair their ability to trade anonymously and in large sizes, or that would allow information to be telegraphed to statistical arbitrage traders. Traders would be comfortable with relatively high-level information about total dark pool volumes and a standardization of volume reporting. They also want full disclosure about the use of Indications of Interest (IOIs) by certain dark pools, including how much information they contain, where and how often they are sent, and whether they result in a matched trade or information leakage and adverse selection.
Buy-side traders fight daily skirmishes to seek out liquidity in a market where volumes continue to grow as trade sizes continue to shrink. Armed with algorithms and smart order routing technologies, pre- and post-trade transaction cost analytics, and increasing control over where and how their orders are executed, equity traders say the complexities and challenges of execution decision-making just continue to advance.
Algorithms continue to be the stand-out winner amongst trading strategies, and they are continuing to grow in importance and volume as traders increasingly turn to low-touch execution methodologies. The rate of growth in the use of algos on the buy side has exceeded even their own expectations as recently as one year ago. Competition for market share amongst the top algorithm providers is intense, and buy-side firms now expect a lot more than technical support from their low-touch sales coverage. Meanwhile, the increase in allocation of order flow to the traditional sell-side sales trader, seen during the height of the credit crisis, has turned out to be a temporary phenomenon. Sales traders are once again losing market share, and electronic block crossing facilities have yet to return to their peak market share seen before volatility became a fact of daily trading life.
At the same time, the trend toward steeply lower commission rates has slowed dramatically. The year-over-year double-digit decline in commission rates has finally come to a halt. Traders express little inclination to press rates lower for fear of losing valuable services from the sell side. Indeed, buy-side desks struggle to pay for those services with a shrinking asset base and a smaller commission wallet. With less to spend, buy-side firms are finally unbundling commission rates. They are now formalizing the split between the “execution-only” and “execution-plus” components of their rates. With greater use of low-touch trading, head traders at buy-side desks are carefully negotiating the execution component to manage toward payment for research and services.
So there is yet much to be considered. Regulators need data. Market structure needs protection. Traders need choices. Brokers need to raise the bar on transparency. The one marketplace that has continued to operate without a glitch, in the face of the greatest disruption in financial structures ever to be witnessed, is the US equities market. It needs to be handled with care. May it continue to thrive.
US Institutional Equity Trading 2009/10: Dark Pools, Transparency and Consequences
For this year’s buy-side trading study, TABB Group spoke with 66 head traders of US institutional equity management firms. Laurie managed an aggregate $12.1 trillion in AUM. The discussions covered post-crisis regulatory scrutiny from regulators and legislators, as well as the views of head traders with regard to short sales, flash orders, high frequency trading, and dark pool restrictions; dark pool selection criteria; the impact of electronic IOIs and IOCs on the use of dark pools; and changes in buy-side budgets and their impact on changing commission rate structures. Laurie also examine the continued growth of low-touch trading; trends in order allocation across high- and low-touch trading venues; trends and selection criteria in algorithmic trading; and the growing demand for transparency into electronic trading infrastructure and its impact on broker relationships, leading broker algorithm providers, and new expectations of low-touch sales trading coverage.