As political and economic crises rumble on in Europe, a combination of increased regulation and shrinking liquidity has put the buy-side trader in crisis management mode. Once again, market impact and information leakage are the key talking points regarding algorithmic performance in the new risk adverse world.
As illustrated in TABB Group’s latest European Equity Trading study for 2011, buy-side managers are increasingly concerned about the lack of liquidity in the marketplace which some, but not all, directly attribute to the increase of HFT flow. Seventy-seven percent of study participants said that recent market conditions have caused them to change the way they trade.
Market participants feel that exchanges no longer serve the market and are purely commercial enterprises designed to generate profits at the expense of the participants they purport to serve. Whether or not that’s the correct view, there is a growing wish to utilize the growing armory of tools and technology to ensure increased execution performance rather than rely solely on the primary exchange.
As markets fragment and order sizes continue to shrink, the perceived dangers of trading on lit markets due to information leakage and subsequent market impact has also led more than 56 percent of buy-side participants to trade more than 10 percent of their average daily volume in the dark including broker crossing networks.
This trend was particularly prevalent in the UK, where 58 percent of participants were concerned over the impact on liquidity that would occur as a result of greater European regulation on BCNs; for Continental Europe the number falls to 22 percent and for the Nordics, zero. The increasingly risk averse investor and trader means order sizes will continue to shrink, ensuring information leakage and market impact concerns remain an issue on lit venues, and will only intensify the shift to the dark and more automation.
Pension fund managers are only too aware of the difficulties of executing large orders representative of a significant portion of ADV on lit markets. Due to their continuous trading nature, lit markets remain the domain of the HFT trader as it is easier to trade on an automated high speed basis in a continuous market, typically the main exchange; however this over simplifies the distinction between market participants.
The majority of HFT flow is more in line with traditional market making: of the 77 percent of HFT trading in the UK continuous market, 59 percent was attributed to market-making activity where firms look to provide liquidity and trade around the spread.
When an order is placed over the phone to a broker, it will immediately be entered into the firm’s systems and traded electronically via an algorithm – that is standard procedure. It is efficient, it provides a full audit trail, more competitive bid/offer pricing, lower trading fees –everything the regulators require. However the disconnect would appear to be that while the traditional market maker would make a market in all prices and occasionally lose to “make good” a client, banks are no longer willing or able to continue this practice.
HFT has reduced the need for traditional market makers, who have found their outdated trading methods no longer economical in an automated world. But without the valuable service they provide, spreads in second- or third-line names are in fact widening and liquidity is shrinking for small and midsize companies, which HFT largely ignores. As HFT firms are not obligated to make markets in falling market conditions, they have the ability to pull their order flow at any given time or alternatively not make a market at all.
That's precisely what occurred during the Flash Crash, with liquid HFT players pulling out, pushing orders on to wider spread order books and exacerbating the problem. While the finger of blame is pointed at HFT as a potential, systemic danger to markets today, it is worth remembering what happened during the 1987 stock market crash when voice trading was the modus operandi and brokers simply let the phones ring off the hook as market participants frantically attempted to unwind their positions.
With liquidity so thin today, there’s even more reason for a buy-side trader to hold the information closer to his chest. This idea that total transparency is beneficial depends on whether or not you want the market to know your hand before you trade. While the increased liquidity and tighter spreads almost certainly help the individual stock investor wanting to buy 100 shares of Vodaphone, it does not help a pension fund manager looking to execute an order several times ADV, particularly in a second- or third-line European name.
So the buy side is getting smarter and utilizing the tools and technology to their best advantage to ensure they get the best price for their end investor – the man on the street, the pension fund – with 51 percent now utilizing TCA and venue analysis to monitor performance executions and more than 56 percent of participants now trading in excess of 10 percent of their flow in the dark.
Criticizing HFT flow as toxic is one thing but clearly market participants are adapting – as always – to market conditions and finding the most effective way to interact with the quality flow they require to achieve the execution performance they need. Isn’t that market efficiency?
That’s not to blithely ignore the downside of increased automation. There is a significant overload of data firms have to manage that will only increase the more trading is forced out of the opaque shadows of the over-the-counter world by regulators and onto exchange. The global cross asset interconnectedness of the markets will ensure increasing regulatory demands on financial services firms when they can least afford it and the stakes have never been higher.
Trading systems are becoming overwhelmed with the sheer volume and complexity of algorithms and data rendering current control systems and procedures redundant. There are huge challenges when it comes to implementing new surveillance programs within existing legacy systems at a time when budgets are being squeezed into oblivion and available cash for investment in IT and back office services perceived as luxury spending.
However, there are positives. The market has evolved and the increasing number of tools and new technology enable market participants to interact with advancements in trading technology that have been hailed as ushering a new world of smarter, more intelligent algorithms offering enhanced execution performance.
Efficient market surveillance tools no longer just allow firms to efficiently mitigate risk but traditional market surveillance is now viewed as optimal operational control – market surveillance incorporated into automated trading may yet offer the ultimate performance analysis tool for the next generation of market leading algorithms.
The important factor remains retaining the element of choice. One size regulation does not fit all and regulation purely for regulations sake serves no one. While liquidity remains such a critical issue within European markets, HFT will remain the scapegoat until market participants choose to recognize that if they trade electronically, they too have supposed toxic blood on their hands.
All flow, not just HFT flow has the potential to be perceived as toxic – it depends on the type of order and the market conditions at the time. However, if HFT firms are forced out of the market, the efficiencies they have delivered to the marketplace may well disappear with them and European markets run the risk of becoming substantially less competitive, spreads will widen and it will become harder and more expensive for everyone to trade, irrespective whether you are a retail investor or a pension fund manager.
The greater challenge remains to uphold the integrity of the market, restrict abusive behavior and allow a free and fair marketplace to exist for the benefit of all. Otherwise we will all remain victims of yet another unfortunate example of the unintended consequences of over-regulation.