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What's in Focus for 2007 Beyond MiFID and the Exchanges

Published in Automated Trader Magazine Issue 04 January 2007

MiFID has been a key focus for many months now,given both the tactical and strategic impact it will have on the buy and sell-side,and market microstructure in particular. There is no doubt the MiFID themes play largely in our plans,but they are not the only things in focus for Goldman Sachs in 2007.

Brad Hunt

Brad Hunt, Managing Director Equities Electronic Trading, Goldman Sachs

There are several key things, some related to the changes being driven by MiFID and the Exchanges, which should be front of mind for both the buy and sell side. We would categorise these into three areas:

  1. Liquidity Aggregation and Smart Access
  2. Execution Quality
  3. Multi-Asset Trading

Liquidity Aggregation and Smart Access

  • Post MiFID, we anticipate that there will be further migration of liquidity to electronic trading venues, and a proliferation in the number and type of venues available for Pan-European shares trading. This is due not only to the removal of concentration rules post MiFID and the fact that firms will be able to create new Pan European liquidity venues as alternatives to the existing regulated markets, but is also due to technological innovation and micro-structure changes themselves.
  • Fragmentation is not new to the European market. Given the high level of OTC trading, often for larger block trades, that takes place primarily between and among the buy and sell side and market makers, we estimate that in some markets, up to 50% of the volume is already traded off the order books of the main domestic exchanges.
  • OTC liquidity can best be defined as anything that is non-displayed, and consists of unexecuted orders in the systems of brokers and orders resting on the blotters of buy-side traders. There is also non-displayed liquidity available at established venues such as crossing networks and hidden order types on existing exchanges. Visible liquidity is just a portion of the total liquidity available at a given point in time.
  • A fundamental structural change that is taking place is that many of these traditional sources of non-displayed liquidity are now becoming electronically accessible where they previously had not been, and available to the next generation smart routers and algorithms.
  • The result will be an increase in the need for access to these new electronic liquidity pools via Execution Management Systems (EMS) and smart order routing to navigate between them.
  • We have extended our GS smart order routing technology, SIGMA, in Europe in preparation for the impending changes. SIGMA enables GS to electronically and anonymously execute client trades against both displayed and non-displayed liquidity. As liquidity venues become available, we will connect to them, providing customers with an ability to reach any publicly available liquidity pool in an intelligent and fast manner.
  • The unique feature of SIGMA, however, is that in addition to Exchange and GS liquidity, it routes to previously untapped liquidity sources, primarily large existing market makers with whom GS has formed partnerships.
  • We've made this service available via our EMS and via FIX interfaces to OMS systems
  • Additionally, we've added a range of next generation algorithms to our GSAT suite that specialise in accessing these non-traditional pools of liquidity.
  • Sonar, for example, uses an array of order types to seek liquidity in harder to trade names without ever representing anything on the order book. Sonar serves as the traders "market eye" by constantly monitoring multiple liquidity sources and then executing at optimal levels, meanwhile avoiding market impact given no representation on the book.
  • We have also added our Dynamic Scaling algorithm which provides an intelligent overlay to a traditional "percentage of volume" (POV) based strategy. Dynamic Scaling enables clients to actively manage their participation based on the absolute or relative price of the name. Clients can make decisions based on a price view, while at the same time managing market impact.
  • Lastly, we have extended our sophisticated implementation shortfall algorithm to portfolios, Port X, enabling clients to execute a basket according to a customized execution schedule, which balances transaction costs against risks in a number of ways."As liquidity venues become available, we will connect to them, providing customers with an ability to reach any publicly available liquidity pool in an intelligent and fast manner."

"As liquidity venues become available, we will connect to them, providing customers with an ability to reach any publicly available liquidity pool in an intelligent and fast manner."

A new focus on execution quality - increasing importance of TCA and Flow Segmentation

  • In addition to the focus on electronically accessing liquidity, there is now more importance being placed on measuring execution quality.
  • The drivers for this are many: the increase in unbundling and CSAs which enables a sole focus on execution performance; MiFID's "best execution" requirements; and, an increasing focus on costs as a result of both reduced spreads and the ability to now identify and track these costs.
  • Given this focus, the rationale for the innovations we are bringing to the market - smart routing tools and next generation algorithms - seems well understood by the buy-side, but we think it is important to clearly prove the benefits of using these tools to clients. As a result, we will be upgrading our Transaction Cost Analysis (TCA) and post-trade reports to incorporate alternative liquidity sources.
  • Sophisticated and comprehensive transaction cost analysis tools are no longer "nice to haves" but rather "required features" of any EMS, trading system or execution provider.
  • Given the increasing number of venues, strategies and styles that can be utilized, clients are often not sure how they should be directing and monitoring their flow; we advise clients to pursue a "flow segmentation" approach. Even when using the "flow segmentation model", given the increase in the number, complexity and pace of development of execution of options, it is almost impossible for clients to remain up to speed on the best ways to manage their flow. To address this, we have experienced trading and sales trading professionals, located in a separate building from the "upstairs" desks, that monitor all of the
    electronic flow and advise clients based on market conditions and the client's execution objectives.
  • We describe this essential new function as "execution consultancy", as the professionals provide clients with on-going, pro-active, advice on why, where and how they should be executing their flow.

Multi-Asset Trading from a Single Platform

  • We are seeing changes not only in how clients are trading, but in what they are trading and where. We are seeing diversification in both asset classes and markets.
  • In attempting to find new ways of gaining exposure to certain names or sectors, or for hedging large positions, clients are expanding beyond simple cash Equities into sector products, Futures, options, FX and Commodities.
  • It is now commonplace for us to set-up clients to trade across multiple asset classes, and in multiple regions. We now have well-over a hundred REDIPlus® installations that are trading Futures and Cash Equities on REDIPlus®, and in some cases Options and FX too. We have also done a considerable amount of work to integrate the back-end processes to enable true STP for
  • The "flow segmentation" approach factors in: size of the order, liquidity of the name, and urgency with which the trade needs to get done, and then advises on how to direct the flow based on those parameters.
  • As demands increase on the buy-side trader, this helps seperate the "hard to trade" from simply flow which could go to an algorithm.
  • This provides clients with a broadly applicable framework to help manage all of their flow.
  • The "flow segmentation" approach factors in: size of the order, liquidity of the name, and urgency with which the trade needs to get done, and then advises on how to direct the flow based on those parameters.
  • As demands increase on the buy-side trader, this helps seperate the "hard to trade" from simply flow which could go to an algorithm.
  • This provides clients with a broadly applicable framework to help manage all of their flow.

Consolidated risk reporting and post-trade processing.

  • These are products that were previously traded separately and often by different people, but this is changing as the demand for electronic trading capabilities increases. We think there is a significant benefit to clients if all the electronic execution functions can be supported in one platform, both from a trading system perspective but also from a relationship perspective.
  • We expect this multi-asset trend to continue and to see both broker-sponsored and vendor systems aggressively pursuing these capabilities in 2007.
  • In addition to expanding the asset classes, both the buy and sell side are making a strong push into the emerging markets.
  • As we know, many firms are currently focused on establishing their "hi-touch" presence in markets in the BRICs (Brazil, Russia, India, China) countries, as well as the other growing Eastern European countries.
  • We are seeing that the push for electronic trading capabilities in these markets is not lagging far behind. This rapid pace of development comes as no surprise given the growth expectations for these
  • countries.