Joe Wald, Managing Director and Co-Founder of EdgeTrade
Although European markets have started to see substantive structural change, the party has barely started; with most new trading venues still on the horizon, many of the challenges relating to fragmentation and aggregation have yet to fully materialise. Nevertheless, it is possible to identify some of the opportunities and obstacles that European buyside traders are likely to face in the near future - some similar to those already apparent in US markets, some entirely different.
Opportunity for all
One of the most striking trends yet to fully emerge in Europe will be the buyside trader's chance to access a broad array of actionable liquidity, or the hidden liquidity that's available electronically. The early adopters among them who seize this will have the chance to gain competitive advantage in terms of being able to generate additional alpha through the execution process. Traditionally this has been an element of the business outsourced to brokers, but with MiFID in place and multilateral trading facilities starting to take hold, this is already changing. This empowerment is available to any buyside trader prepared to look for the chance and offers a commensurate opportunity to those members of the sellside that are sufficiently nimble and technologically capable of providing the appropriate execution tools.
"We have started to see the early glimmerings of co-operation amongst the various dark pools in the US…"
Certain other changes are inevitable from the sellside perspective. Principal trades will undoubtedly decline in terms of revenues and be supplanted - in the case of the most adroit sellside participants - by those from next-generation execution services. Smart order executions initiated directly by the buyside will represent an increasing percentage of total volume. This trend will further accelerate as a combination of improved trading tools and an ethos of 'co-opetition' among the various dark pools, multilateral trading facilities and exchanges continues to evolve.
"...in the US some buyside firms took the step of building connections themselves to individual trading venues, with no guarantee as to which venues were likely to prove worthwhile in terms of liquidity."
As the number of available European trading venues and actionable liquidity increases over the next year or two, this will boost the volume of trading done on an agency basis. However, key to this will be aggregation technology and liquidity sourcing across a far larger number of venues than currently exist. The ability to search among an increased number of destinations in order to source liquidity is a smart order routing challenge on a different scale from any that currently exists in Europe.
We have started to see the early glimmerings of co-operation amongst the various dark pools in the US, and it seems reasonable to assume that this will in time also extend into Europe. There is already an air of inevitability about the way in which some sellside firms are starting to accept the reality of being both competitors and collaborators. Particular firms may have some unique advantages but this does not make them unique in every respect. Nobody can assume that they will be the only source of technology or liquidity in Europe. Therefore the solutions and tools with the greatest potential for success will be those that accept the reality of connecting to multiple (potentially competing) liquidity pools and order management systems.
From the buyside perspective, this is nothing but good news - particularly as European traders start to enjoy the benefits of dark execution levels already being achieved in the US. For example, an algorithm that is able to achieve 30% of an order across multiple dark liquidity sources is removing a tremendous amount of market impact from the public marketplace. If out of a buy order for 100,000 shares of a particular stock 30,000 can be acquired in the dark, then from a trader's perspective 100,000 shares have been acquired - but at cost of only 70,000 shares' worth of market impact.
Chalk and cheese
In some respects, European traders are in a far stronger position to seize these opportunities than their counterparts in the US were around the turn of the millennium. For example, the average trader in Europe is far more comfortable trading electronically than the average US trader was in 2000 or 2001. Therefore learning and adoption curves are likely to be far more compressed than they were in the US.
Another important difference is that European traders are comfortable with the concept of algorithms as tools that help them to do their job. An extension of that is that they are interested in the nuts and bolts of algorithms and how they can be customised and adjusted to best advantage for various trading scenarios. By contrast in the early days of algorithmic trading in US markets a lot of traders saw algorithms as a threat to their continued employment - in their view algorithms were going to replace them, not supplement them.
"Another important difference is
that European traders are comfortable with the concept of
algorithms as tools that help them to do their job."
That situation obviously no longer applies, but European traders have had the benefit of being able to observe the widespread adoption and reality of algorithms in the US at arm's length. As a result, they are generally already well-informed and therefore demanding in terms of their expectations and also their desire to see solid quantitative evidence of a trading tool's performance before being convinced of its virtues.
That said, there appears to be a certain amount of confusion and scepticism among European traders about the current situation. While a huge amount has been written about how the market is going to change, it hasn't really changed yet; though other alternative trading venues are on the horizon, the only one up and running so far is Chi-X. By contrast, in the US the order of events was reversed; electronic crossing networks and dark pools were already in existence before smart execution tools came on the scene.
It could be argued that European buyside organisations have also had the luxury of learning from the mistakes made by their contemporaries in the US. For example, in the US some buyside firms took the step of building connections themselves to individual trading venues, with no guarantee as to which venues were likely to prove worthwhile in terms of liquidity. By contrast, European buyside firms seem to have noted the potential downside to this strategy and will instead prefer to use third party aggregation tools.
Looking further into the future, several trends in European equity markets are already discernible. One is increasing globalisation, with high levels of cross-border activity and with algorithms being extensively and simultaneously used for trading both European and global stocks. The corollary to this is increased use of algorithms beyond just equities and across multiple asset classes. Algorithmic execution of true multi-asset basket trades is the logical extension of this, as skilled traders are assigned responsibility for a particular name, be it that name's stock, bonds, or commercial paper - and wherever those instruments are traded.
Technological limitations, such as bandwidth, and regulatory challenges, especially the fragmentation of the clearing and settlement industry, pose some longer-term challenges. However, in the near term European buyside traders have the ability to tap previously unavailable dark liquidity. Those who move swiftly to seize the opportunity will be able to gain significant alpha through execution, to boost both corporate and personal bottom lines.