Head of Direct Execution Services Europe, UBS
By increasing the number of trading venues available to investors, MiFID will undoubtedly fulfil the European Union's aim of bringing greater competition and transparency to the market. Indeed, it is enlightening to compare the current European market with the US, which has long been quite fragmented. Despite our very similar GDPs, there is currently twice as much trading in the US stock markets as there is in European stock markets - a sign of the increased liquidity that comes with competitive markets.
New Multilateral Trading Facilities (MTF) such as Turquoise - the pan-European equities trading platform created by seven investment banks, including UBS - are set to increase participation in European markets by dramatically reducing the cost of trading there. As well as reducing the costs of trading, clearing and settlement, the new MTFs should provide improved functionality, leading to better execution for investors.
This technological revolution in trading venues mirrors the massive transformation that has been taking place for some years in both buyside firms (which, thanks to the increase in direct execution, have become much more focused on their trading processes) and sellside firms (which are having to innovate in order to continue offering clients best execution). Importantly, the changes in market structures are themselves driving further technological developments on both the buyside and sellside - and both will have to rise to the challenge of keeping up with the pace of change.
Research shows buysiders must be agile
In a recent study titled The European Buy-side Trader: A profile for tomorrow, the research firm routing TABB Group polled, on UBS's behalf, 1,000 buyside professionals at April's TradeTech Europe. They were asked about the potential impact of MiFID on their business and what they wanted from their brokers and service providers. The report concluded that the buyside trader needs to be more agile than ever.
Figure 1 - Order Flow Allocation (on a value-traded basis) Source - TABB Group
As self-directed orders increase to 24% of all buyside trading by 2009 (see Figure 1), those traders who lack the knowledge of crossing networks and new trading venues, or who do not have a firm grasp of algorithmic strategies and fail to use transaction cost analysis to improve their decision-making skills, will be at a great disadvantage to their technologically savvy peers. What is more, the study uncovered a lack of understanding of algorithms' capabilities among buysiders - and a lack of confidence in their ability to choose the right ones (see figure 2).
How smart is your smart order router?
As an example of the kind of technological change that the industry is seeing, all sellside firms have been ocused on building the smart order (SOR) technology that is necessary to handle the multiple points of liquidity afforded by MiFID. The challenge for those on the buyside lies in establishing which sellside firm has the best SOR - indeed, when deciding which broker to trade with, it is essential that buysiders understand that while all SORs on the market may be smart, some are most certainly smarter than others.
Some SORs cannot access dark pools, for example. Others may be able to access dark pools but they search for liquidity venues sequentially, moving from one platform to another until a trading TABB Group polled, on UBS's behalf, 1,000 buyside professionals at April's TradeTech Europe. They were asked about the potential impact of MiFID on their business and what they wanted from their brokers and service providers. The report concluded that the buyside trader needs to be more agile than ever.
Figure 2 - Rate Your Ability for the Following Skills Source - TABB Group
UBS's SOR has been designed to address these issues. European-tailored version of the SOR that UBS has been using in the US, will search for opportunities within the UBS liquidity pool before hitting all the available trading venues simultaneously - dark pools included.
We obviously cannot be sure that some of our competitors do not have similarly intelligent SORs. But what we do know is that buysiders will be pressing their sellside providers for details of how their SOR technology works. It is a conversation that every buyside trader should be having with their broker.
MiFID will also put pressure on sellside firms to develop alogorithms that enable clients to make the most of fragmented markets. At UBS, for example, clients can use a new series of algorithms called TAP, which allows them to balance the amount of trading they are doing with the amount of information they are giving out to the market.
Algorithms TAP into liquidity
TAP works by enabling clients to specify how urgent their order is on a spectrum of one to five. At level one, the order will passively access dark pools only; at level five it will aggressively take liquidity without constraint. The levels in between allow clients to adjust their participation in public markets according to the urgency of the order. Typical factors determining the final execution venue include the size of displayed liquidity, the probability of detecting hidden liquidity, the cost of sending outsized orders, the effect of the order being routed out to other destinations, the life of the existing quote, and the possibility of price improvement.
TAP has been developed by teams comprising traders, quantitative analysts and IT developers, so it draws on the expertise of people who really understand how the market works.
ts ability to source liquidity is aided by the fact that UBS is the largest distributor of equities globally, which opens up opportunities to match the orders of buyers and sellers. Within our electronic execution platform we have crossing rates of between ten and 15 per cent.
Measuring performance - pressure on the buyside
TAP is just one example of how the changing regulatory environment is fostering technological change. And if the pace of change is increasing buyside dealers' expectations of executional excellence, it is also raising the bar in terms of how buysiders measure both their own performance and that of their brokers.
With the introduction of MiFID, buyside dealers will be expected to conduct regular reviews of their execution arrangements: in seeking to minimise their total cost of execution, they will need transparency around their reasons for choosing one particular broker over another. And deciding who to trade with will not just be a one-off decision, but rather an ongoing process of evaluation that will vary from trader to trader and will take into account a range of factors, from the broker's ability to find liquidity to their ability to assist with order segmentation.
Buyside firms themselves differ greatly - in their level of sophistication, in the needs of their own client bases, and in terms of their own investing styles, so there'll never be a 'one size fits all' method of execution. Rather, dealers will start to use different brokers for different reasons - it might be that they use one broker for electronic access and another for their ability to maximise natural liquidity. Either way, the challenge for sellside firms is to provide the broadest possible range of execution services to clients.
Demand for more data
Unsurprisingly given this diversity of the marketplace, buyside traders do not actually find it very easy to compare one potential sellside partner with another. Consequently, one of the most important developments is likely to be an intensifying demand for access to the kind of meaningful data that can be used to support buyside decision making.
There is likely to be increasing pressure on sellside firms to develop ever more sophisticated tools for quantitative pre-trade analysis to help buyside traders segment their orders. Quantitative analysis can tell a trader a great deal about liquidity, volatility, momentum and spread - as well as the potential market impact and market risk inherent in trading a particular series of orders. However, there will be an increasing onus on the buyside trader to interpret what the pre-trade analysis tools are telling him or her. Quantitative analysis can provide the numbers to back up a decision about whether to go for cash trading, direct market access or portfolio trading, but it is up to the dealer to understand and interpret their motivations for choosing a certain method of trading.
Figure 3 - Most important differentiator for algorithmic providers Source - TABB Group
The question of how you evaluate an order's performance post
trade will become more complex too. Currently, price performance
is often a question of how well you executed your trade versus a
single benchmark. But increasingly, investors are looking at
several different benchmarks in their transaction cost analysis
and are having to decide which benchmark is
the most appropriate for each trade.
One benchmark no longer enough
Should the benchmark you look at be the prevailing market price when you started trading? Or should it be the average price throughout the period in which you traded? Again, a quantitative analysis will need to be supported by qualitative considerations, in which the dealer takes the context of the order into account.
For example, with a highly illiquid order in which a trader is having to strike a balance between market impact and market risk, the trade's success might be judged not just on price but also according to crossing statistics - such as how much of the order was crossed outside the market, and how long the dealer had to wait for the cross to happen.
Indeed, UBS has already started generating transaction cost analyses on a client-by-client basis - including crossing statistics - with the aim of making such data available to clients in the near future. This is the sort of information sophisticated investors are beginning to take into account when deciding who to trade with - and brokers will increasingly be expected to provide them.
As the market continues to evolve, buyside traders will need to constantly re-evaluate their brokers' offering to ensure they are still accessing the best execution and technology. The TABB Group report noted, for example, that when it comes to selecting an algorithm provider, the need to test drive the almost constant stream of new releases makes it impossible for a buysider to settle for one algorithm indefinitely. However, it did suggest that the ability to customise algorithms is becoming an increasingly important to the buyside (see Figure 3).
Our clients on the buyside tell us that by the end of 2008 they expect the market to look very different from today. Change will be the only constant, so for UBS and others the challenge will be to future proof our client relationships by continuing to innovate.