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As MiFID opens the door to competition between equity trading venues in Europe, Chris Hall looks at how algorithmic trading will adapt to the new era of fragmented liquidity.
The Smart Money
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. ...