Nick Holtby, UBS Investment Bank
"As the buy-side uses MiFID to take more control of its execution, this will further accelerate the move away from traditional execution methods toward algorithmic trading."
On November 1, MiFID (Markets in Financial Instruments Directive,
2004/39/EC) replaced the Investment Services Directive as the
overarching rule book for the conduct of investment services in
Europe. While its main aim is to offer common access to Europe's
capital markets for all investors across the EU, the two
important changes for the professional trader are the need to
demonstrate best execution and the introduction of competition
for equity trading services. Under MiFID, intermediaries must be
able to demonstrate to investment clients that they have followed
best execution principles in buying or selling shares, although
best execution is still an imprecise concept due in part to the
fact different client types will rank size and timing of an order
differently, behind the primary matter of achieving best price.
Secondly, traders will be able to buy and sell shares from
trading venues other than established exchanges, such as
multi-lateral trading facilities, crossing networks and banks
internal dark pools (i.e. pools of non-displayed liquidity), as
long as transactions are reported to the rest of the market.
So how will buy-side firms, and in particular users of algorithmic trading tools, continue to access liquidity across the new trading venues in accordance with best execution principles? The answer, according to brokers, is smart-order routing.
This technology, which enables firms to fire orders at multiple exchanges simultaneously to establish price and probability of execution, has been available in the U.S. markets for some time, but is now crucial to algorithmic trading in Europe. "In the U.S., it's already common practice for a proportion of any algorithmic order to be routed to a dark pool," says Nick Holtby, Head of European Client Trading and Execution at UBS Investment Bank. "For a large order, you might post a piece to a dark pool for the duration of the order, but a more aggressive order might ping all the dark pools at the same time to take all the available liquidity." Holtby says that the need to route algorithmic trade flows between exchanges will drive levels of automation higher. "As the buy-side uses MiFID to take more control of its execution, this will further accelerate the move away from traditional execution methods toward algorithmic trading. Already the shift from high- to low-touch execution techniques has very large momentum: more than half of the flows through UBS in Europe are already low touch," he says.
Some brokers are already beginning to factor smart-order routing into their execution policies. "Clients are telling us they will use different execution policies across desks and client types that build in follow-up strategies that allow intelligent smart-order routing for passive flows and partial fills which are switched to another venue for completion," says Ian Salmon, head of technology vendor Fidessa's MiFID programme.
New tools for a new market
Like many large brokers, Citi have been adapting its US-developed smart-order routing technology to meet European needs. Using technology developed by its Lava subsidiary, Citi can route orders to 'primary' exchanges, multilateral trading venues and buy-side crossing networks, but not the dark liquidity pools operated by other large brokers. "Liquidity-sharing agreements between brokers' dark pools already exist in the U.S., but it is likely to be months if not years before this is discussed in Europe," says Toby Bayliss, head of European electronic execution sales, Citi. From November 1, Citi has been deploying six of Lava's 27 US order types to capture fragmented European liquidity. "Traditional order types do not work when you're accessing multiple markets," observes Bayliss. Rather than sending a traditional market order, for example, Citi is sending multiple limit orders to venues simultaneously (known as a 'Sweep' order) based on visible liquidity. A more aggressive order type, ('Probe'), sends kill or fill orders to venues consecutively to discover hidden liquidity or iceberg orders.
According to Matthew Carr, Head of International Equity Sales, BNP Paribas, not all smart-order routers are built equal. "SOR technology has to be intelligent enough to take into account the different types of orders permitted by the various venues, to decide which venues to route passive and aggressive order flows to, and to split up an order between venues based on the probability of execution for particular order sizes using past historical data and latency statistics," he says. This means closely aligning smart-order routing to an understanding of the emerging European marketplace, says Fidessa's Salmon. "People will soon begin to find out how to hit best price across different venues, but they won't necessarily know where there's an iceberg or hidden order or where there's a dark pool or internal book," he says. "Firms will need to analyse their execution performance across venues and adopt the necessary strategies to ensure orders are filled efficiently."
"Traditional order types do not work when you're accessing
- Toby Bayliss, Citi
Kyle Zasky, President of EdgeTrade, an agency-only broker and
software developer with deep experience of the U.S. market, makes
the distinction between smart-order routing and smart-order
execution. "Having the technology to source liquidity in an
adaptive way through smart-order execution tactics is simply a
must," says Zasky. "If there are 15 potential destinations for a
trade, I might suspect destinations six or seven have the other
side of the trade but what if destination 13, which I might never
have expected to have the liquidity, is where the executions are
taking place? You need an algo that can ping all the destinations
in real time and learn from the responses by re-routing orders
away from non-performing destinations toward those that are
performing." EdgeTrade's FAN ('Find and Nail') algorithm taps
liquidity across the U.S. market's 40+ displayed and
non-displayed equity trading venues using SOE technology, while
the firm's Covert algorithm operates exclusively in dark pools.
"Are buy-side firms comfortable accessing 40 pools of liquidity?
They love it! If you've been trading for years and all of a
sudden you can select an algo and press a button and within
seconds you're getting chunks of trades filled from different
pools of non-displayed liquidity, there can be quite a visceral
reaction," says Zasky.
Although some large US-based hedge funds have built their own in-house capabilities, these are few and far between as the cost of developing and continually updating smart-order routing is prohibitive. "While the most sophisticated buy-side firms are purchasing smart-order routing technology, the majority of firms will outsource that capability to brokers," says Carr of BNP Paribas.
The hare and the turquoise
There was of course no 'Big Bang' in Europe on November 1. How could there be? Despite the expectations of a rash of challenges to the incumbent exchanges, only one new trading venue, Chi-X, a subsidiary of Instinet, witnessed MiFID's dawn. Nevertheless a new environment is clearly taking shape in Europe. Chi-X will soon be joined by two new trading venues, Turquoise and Equiduct. Broker-neutral crossing networks and dark pools such as ITG's Posit and NYFIX Millenium have announced European products, while LiquidNet already offers anonymous block trading in Europe. Nor have incumbent exchanges been standing idle. The London Stock Exchange, for example, has installed a new high-speed trading platform, TradElect, which it claims has reduced trade processing times - i.e. the time from an order being sent to confirmation - to 6 milliseconds, while boosting capacity to 4,200 orders a second.
Kyle Zasky, EdgeTrade
"… within seconds you're getting chunks of trades filled from different pools of no displayed liquidity,…"
Chi-X appears to have stolen a significant march on putative
rivals. Operational since April, Chi-X offers prices for the
component stocks of the German, Dutch, French and UK equity
indices. Up to 20 per cent of the combined Chi-X and primary
exchange volume of leading European shares are being executed on
Chi-X. The platform reported a 62 per cent month-on-month
increase in its number of trades in October. From an algorithmic
trading perspective, Chi-X offers non-displayed as well as
displayed liquidity (matching is purely price time, with
displayed orders taking precedence) and has a capacity of around
30,000. Like a number of US venues, Chi-X's pricing structure
incentivises liquidity providers. (See Exchange Views on p66 for
AT's interview with Chi-X director Peter Randall.)
Project Turquoise, the bank-led pan-European trading venue, has been criticised for its longer-than-expected time to market, but the recent announcement of a CEO and technology partner underline its backers' commitment to presenting a credible challenge. Founded by Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley and UBS, Turquoise is currently scheduled for launch date in autumn 2008. According to a spokesman, Turquoise will combine an embedded dark pool with a central limit order book and is likely to borrow a number of elements already established in the U.S.. The use of an embedded dark pool to provide clients with anonymity and the ability to cross large blocks with limited market impact, is similar to the market structure pioneered on the International Securities Exchange's equity trading platform. Turquoise is also expected to adopt a pricing model similar to NYSE ARCA's practice of paying liquidity providers and charging liquidity takers. "In terms of attracting flow, algorithmic or otherwise, we will be attractively priced compared to incumbents. Our combination of dark pool and limit order book will support trading styles attractive to users of automated and algorithmic trading. Moreover, our pricing structures will incentivise liquidity providers, similar to those that have been successful in the U.S.," according to a Turquoise spokesperson, who asserts that pricing and rapid response to market demand will be its key differentiating factors. "The incumbent exchanges' unit cost of production has collapsed while their volumes have risen," he says. "Over the last five years their fixed costs have gone down 80-90 per cent but this certainly hasn't been reflected in their prices."
Artur Fischer, Equiduct
"The fact that our latency figures are below 10 milliseconds shows we want algorithmic and automated trading flow,"
Equiduct, the third of the declared new trading venues and
recently acquired by Börse Berlin, offers a very different
proposition. Expected to launch in the first half of 2008,
Equiduct will offer two trading market models. First, Equiduct's
hybrid book combines a limit order trading book with quotes from
market makers. Second, is a more tailored service called
PartnerEx, which matches order flow providers in a bilateral
agreement with liquidity providers. PartnerEx brokers a framework
that specifies in advance details such as instrument coverage,
transaction size, price improvement and clearing and settlement
arrangements between the two counterparties. Multiple PartnerEx
relationships can be used to fulfil larger orders across multiple
liquidity providers. When an order comes in, Equiduct will scan
firm quotes from the agreed reference exchanges and trading
venues for the partial fills that will provide the best possible
price for the order (the volume-weighted best bid and offer or
VBBO). It then executes the trade between the two participants at
this 'virtual' price. "This is emphatically not smart-order
routing, where you run the risk of not getting best price if you
can't execute all the partial fills at the same time," explains
Artur Fischer, Chairman, Equiduct and Joint CEO, Börse
Berlin. "With PartnerEx, the market maker commits to providing
best execution to their client at the Equiduct VBBO price with a
single transaction, a single settlement and a single fee."
While Fischer predicts greater initial interest from banks and brokers that cannot - or are reluctant to - invest in the infrastructure necessary to be a systematic internaliser (i.e. an ivestment firm that executes orders outside a regulated market or multilateral trading facility), he expects Equiduct to be attractive to all banks in time. "We will be a niche market at first. But even the big players will have entities that want to do things in a certain way that we can help with" he says. Fischer says attracting algorithmic trading flow is a medium-term priority. "The fact that our latency figures are below 10 milliseconds shows we want algorithmic and automated trading flow," he says. "Firms that arbitrage between different markets are unlikely to be interested in the PartnerEx approach. However, they will find an alternative source of liquidity on the hybrid book from day one. And as market makers join, they will add liquidity to the hybrid book, increasing its attractiveness to algo and auto traders."
Them and US
While in Europe brokers are charged with securing best execution, in the US, it is the exchanges that are responsible for achieving best price. Nevertheless, the US experience is instructive. The International Securities Exchange built its US equity trading platform taking into account the growth of dark liquidity pools and the changes wrought by Reg NMS, the SEC regulation that obliges US stock exchanges to pass trades to other exchanges to find best price. "We felt that a neutral, continuous dark pool that could take all order sizes would fill a niche that was not being served," says Andrew Brenner, Head of the ISE Stock Exchange. "At the same time, Reg NMS was being formulated, so we decided not only to offer a dark pool, but also a fully-displayed stock market because if we could offer the best price, people would have to trade with us," he said.
Andrew Brenner, ISE
"If the existing exchanges are not focused on improving technology they will fall behind very quickly."
The ISE has designed its dark pool to interact with its full-displayed stock market. Every displayed order that comes to the market also checks the ISE's dark pool, the MidPoint Match, for potential price improvement. And firms that place a dark order can access both the dark pool and the displayed pool. Having opened for business in September 2006 with just 10 stocks, the ISE Stock Exchange reported an average daily volume of 90m shares in September 2007. As well attracting the large brokers, the ISE worked closely with vendors to capture flow from services bureaus established to provide connectivity to the US's nine stock exchanges for smaller brokers. Another factor was to make the exchange as 'algorithmic-friendly' as possible. "We needed to offer continuous trading on our dark pool rather than a timed cross that occurs at intervals throughout the day," says Brenner. "We also needed to be able to trade all order sizes. While some exchanges still trade minimum block sizes of 5,000 or 10,000 shares, our smallest order size is one round lot, which is 100 shares."
ISE's Brenner acknowledges the differences between MiFID and Reg NMS, but says that the European and U.S. markets are increasingly similar and expects the new alternative venues to attract substantial flow away from traditional exchanges. "If the existing exchanges are not focused on improving technology they will fall behind very quickly," he warns. "First, they've got to make sure that their technology can handle the throughput. Second, they must be able to make their systems faster because speed is only going to become more important. Third, they must work with their membership to come up with the best platform possible. The markets are changing so quickly now that if you don't truly listen to your members, you will be left in the dust."