ITG’s Clare Rowsell and Rob Boardman outline the best practices for liquidity management across multiple regions, focusing on Asia Pacific, North America and Europe.
In an increasingly global and fragmented trading environment, finding and managing liquidity is the top priority for buy-side traders. The practicalities of doing so are complex, and are underpinned by the trade-off between the time taken to find liquidity – which can result in delay costs as the price moves away, and the quality of that liquidity – trading against certain counterparties can increase market impact costs.
Meanwhile, the global liquidity environment is changing rapidly due to evolving regulation, market structure and the trading tools available. What follows is a short summary of some of the most significant developments affecting liquidity management in different regions around the world.
Often cited as having a ‘last mover advantage’ in coming latest to the world of dark pools and alternative trading venues, Asia is now catching up rapidly. Growing awareness of the region’s higher trading costs (approximately one third higher than those of the US and UK) is creating market demand for both new lit and dark liquidity sources.
Japan is the only major market that currently allows ‘lit’ or quote-publishing venues to compete directly with the exchanges, and in the past year market share on these venues (including SBI Japannext, Chi-X and Kabu.com) has risen, although they still average around 2-3% of total turnover.
Australia will be next, now that the launch of Chi-X to challenge the ASX exchange’s monopoly has been confirmed for early in Quarter 4 2011. As alternative lit venues develop, the importance of smart order routing grows and in Australia this has been a core component of consultation which will result in changes to regulation affecting brokers and exchanges and mandating Smart Order Routing (SOR) as a mechanism to achieve best price in a multi-market environment.
For other Asian markets, buy-side traders have been turning to dark pools as a way of managing trading costs and finding quality liquidity.Most of the large banks and brokers now offer a dark pool or internalization engine in markets including Hong Kong, Japan and Australia; but given Asia’s already-fragmented market structures, adding more broker liquidity pools threatens to complicate the buy-side trader’s life. This is where liquidity management, and specifically the aggregation of dark pools, is coming to the fore. Increasingly the buy-side are turning to dark pool aggregating algorithms to connect into multiple sources of liquidity through one access point.
Canada has long benefited from trading in an auction market supported by a highly visible electronic book. Even though it was not until the latter half of the decade that ATSs began to spring up in Canada, they quickly gained traction and in 2010 ATSs represented 34% of volume. As these changes have taken place, Canadian regulators have continually reviewed emerging regulation in other regions as Canada continues to parallel more mature markets.
With the proliferation of alternative trading venues came an emphasis on the consolidation of data to ensure market integrity. In addressing the need for a consolidated tape, the CSA accepted RFPs and appointed the TMX Group to the role of Information Processor. Also arising from the multiple-market trading environment is Reg.NMS-style regulations to protect against trade-throughs. February’s Order Protection Rule shifted the best price responsibility to marketplaces and also requires full depth of book protection (unlike the US’s top of book protection).
About 3% of Canada’s equity trading is done in dark pools, and although Canada has only two dark pools (Liquidnet Canada and ITG’s MATCH NowSM), Instinet plans to open two this year and Canadian stock exchanges are making moves to offer dark order types. The regulatory body has kept a watchful eye on this development and has already issued early-stage proposed regulation, including minimum size restrictions and the curtailment of direct market access. These moves may be premature and have the capacity to diminish market efficiency and lead to information leakage.
Trailblazing the electronic trading realm, Europe helped lead global adoption of trading technology with the early demutualization of electronic exchanges into profitseeking institutions. The passage of the Markets in Financial Instruments Directive (MiFID) transformed the marketplace by opening up competition among trading venues. Multilateral Trading Facility (MTF) activity has grown substantially since 2007, with some estimates predicting that dark flow alone could account for 6.1% of turnover by the end of 2011. With these swift developments in the European trading landscape, policymakers are now set to use MiFID II to address the issues considered in the MiFID II public consultation document which included an increase in transparency, data access and the classification of trading entities.
Of note in emerging regulation is the theme of minimum order size restrictions for dark MTFs. By imposing a floor on the number of shares traded via dark pools, many investors will be denied best execution. This will curtail the use of dark pools, which empirical evidence suggests decreases transaction costs and increases lit market efficiency. In addition to regulatory innovation impacting the trading landscape, the global exchange world is in a state of flux. The industry is bracing itself for further shifts in the structure of the European market as exchanges not only attempt huge cross-border purchases but also look to develop new businesses such as derivatives trading and clearing services.
As electronification has taken hold of the US, the region has exported innovations like execution algorithms, dark pools and highfrequency trading. Prior to the credit crisis, regulators generally took a laissez faire approach to US market structure but with heightened scrutiny particularly in the wake of the Flash Crash, many technological innovations have come under scrutiny. As directives emerge in the US, global regulators are keeping a watchful eye on where to reevaluate rules on their home turf.
As the Commodity Futures Trading Commission (CFTC) drags its feet on Dodd-Frank rulemaking for OTC derivatives, eyes have turned to the CFTC-SEC’s 14-step plan in the wake of the Flash Crash. Replacing single-stock circuit breakers, a new limit up/down mechanism will help prevent erroneous trades and guard against another Flash Crash event. More controversial regulation focuses on half-cent price improvement for internalizers and a ‘trade-at’ rule with full depth of book protection. These proposals conflict mandates for competition among market centers and would ultimately end up costing investors.
While regulation spurs controversy and discussion in the US, innovation in liquidity-seeking tools continues. Sophisticated liquidity-seeking tools have been on the scene since 1986, and they have evolved and grown to now offer integration with algorithms to access natural blocks combined with technology to filter and differentiate liquidity types. With the range of tools now available and the increasing fragmentation of markets, it is extremely important for the buy-side to implement real-time transaction cost monitoring tools.
Bringing it all together
Globally, market structures are at various stages of development but the differences are becoming smaller and the rate of change quicker. The interconnectivity of markets has become increasingly apparent, particularly in light of recent cross-regional exchange merger activity which promises to bring new technologies to the fore. Regulators are continually reviewing these developments and the industry awaits feedback on this changing landscape. It is now crucial for the buy-side to select the right tools for liquidity management and to monitor how market structure changes will affect their performance in the various regions.