The ability to execute a natural block has traditionally been and still remains the panacea of equity trading. In a TABB Group white paper commissioned by Thomson Reuters in September 2015, Rebecca Healey surveyed a universe of over 40 heads of trading from some of Europe’s and North America’s leading asset management firms to find that two-thirds attach more importance on finding natural blocks than the choice of venue, broker or execution strategy.
Most important factor in terms of execution
Move away from schedule-based trading back to blocks?
MIFID II – the quest for transparency
With its planned restrictions on broker crossing networks and the introduction of Dark trading volume caps, MiFID II’s pre-eminent goal is to increase transparency but if it prevents brokers from matching riskless principal trades going forward it is likely to undermine block liquidity. Moreover, post credit crunch, given the challenge on brokers’ balance sheets, there has been a continuing decline in the provision of risk capital to facilitate block trading forcing the buy-side to improve their use of technology and their access to information ﬂows to locate natural liquidity themselves.
Increasing concentration in the asset management industry means that fewer firms hold an ever-increasing share of stock and by leveraging more intelligent order management system technology and greater trade automation, they are increasingly able to become the instigator of blocks.
Buy-side to buy-side crossing networks
In parallel, the success of buy-side to buy-side crossing networks such as Liquidnet and ITG POSIT along with the emergence of new initiatives such as Luminex and Plato Partnership would indicate that the buy-side, collectively, is prepared to make more of the running and by doing so, reshaping the traditional buy-side and sell-side relationships still further. More than half of the asset managers surveyed indicated that these peer-to-peer networks are their first port of call for sourcing block liquidity but foresee challenges in their use of other methods of Dark trading owing to the proposed regulation in MiFID II. Nearly half of respondents anticipated an increase in large-in-size (LIS) discovery in order to benefit from the LIS Double Volume Cap waiver whilst fear of information leakage is already altering buy-side interaction in the Dark by reducing the number of trusted counterparties they are willing to deal with.
New kids on the block – innovation from the exchanges
Exchanges such as the LSE and BATS Chi-X have in very recent times launched new auction solutions to respond to the buy-side’s quest for new forms of block liquidity to offset MiFID II’s planned restriction on off-exchange Dark pools. The introduction of conditional order types has been met with a level of skepticism given the fear of them creating more fragmentation and more market noise as opposed to genuine liquidity. Further education regarding the benefits of conditional order ﬂow will be required from those venues if they are to gain traction with the majority. However, those who approve of the use of Indications of Interest (IOIs) under conditional orders see these as an improvement on traditional IOIs given they effectively firm up participants’ orders leading to greater consolidation among certain venues.
IOIs amid the best execution imperative
MiFID II, though, also brings with it a greater regulatory responsibility to deliver and to demonstrate best execution and a buy-side’s propensity to rely upon a block trade will depend on the urgency to complete the trade; hence the buy-side will need to optimise its use of all available forms of liquidity to achieve this imperative. As this best execution focus invariably sharpens, so will the premium that they attach to their brokers with the most unique information ﬂows. At present, given a widely expressed lack of confidence in their brokers’ IOIs and taking into account the already acknowledged block execution challenges, those brokers that are able to improve the quality of the IOIs they disseminate will be best positioned to steer the buy-side firms their way to facilitate their blocks. AFME’s (Association for Financial Markets in Europe ) and The Investment Association joint initiative to launch a new set of codes to distinguish between IOIs is consistent with this trend. Those that can trade immediately without market impact will be labeled “client natural” and those that may incur information leakage will be labeled “potential.” Here the goal will be to limit a broker’s ability to fish for business and win orders on the back of a punt while for the buy-side the elimination of misleading market noise will enable it to establish where the natural liquidity is and obtain the best price in order to achieve best execution for their clients. The success of categorising IOIs to ring-fence and thereby increase natural order ﬂow has also been highlighted in recent data provided by Thomson Reuters. Within the offering participants have been able to categorise IOIs within four buckets; Natural, Natural Actionable, Actionable and Super, which requires both a price and numeric size.
The renewed commitment to IOIs both as a result of greater buy-side demand but also sell-side awareness of the importance of accuracy of information facilitated a jump in usage of natural IOIs this year. This is anticipated to grow as the buy-side looks to seek alternative block liquidity opportunities independent of broker Dark pools. In addition, the inclusion of the misuse of IOIs as market manipulation under proposed guidelines for the EC’s Market Abuse Regulation (MAR) should provide another “incentive” for an improvement in the accuracy of IOIs.
Percentage increase in natural IOIs
The continuing importance of the broker relationship in an unbundled world
The abolition of the use of execution commissions for research payments will make it harder for full service, sell-side firms to differentiate their execution capabilities. Without the accompaniment of advisory services and the provision of risk capital, their traditional strengths of greater ﬂow visibility, global exchange memberships and state-of-the-art algorithmic and smart order routing technology will be less compelling. As a consequence, the brokers that the buy-side trusts will maintain the edge. A stronger relationship facilitates open dialogue which results in greater opportunity to uncover natural order ﬂows and to improve execution opportunities. That being said, once a buy-side trader seeks liquidity and thereby shows his/her hand, the potential for information leakage can create a degree of paranoia which could jeopardise the optimum execution outcome. Similarly and returning to the topic of IOIs as a key facilitator of block trading, buy-side traders often feel obliged to place the order with the broker delivering the IOI as they have already risked incurring information leakage by responding to it.
The way forward …
MiFID II’s aim to increase transparency in institutional equity trading by restricting the levels of trading in the Dark is set to bring about a reemergence of block trading but not in its traditional guise of facilitation by capital commitment. New buy-side-led peer-to-peer ventures coupled with innovative new auction-based initiatives from leading exchanges are set to pick up some of the slack. However, it is clear that locating liquidity will depend on a more efficient dissemination of pre-trade information and a greater level of trust in the relationship between the buy-side and its brokers manifested by a higher level of confidence in the origin and accuracy of IOIs. Whilst there has been much talk of the future equification of the fixed-income markets, it is conceivable that their traditional, negotiation-based trading behaviours could now lead the way in block facilitation for equities. The best execution imperative, which will undoubtedly be felt and acted upon more keenly than ever by the buy-side, will necessitate the provision of greater accuracy and quantity of information to make the decision to trade a block or not. That being said, advances in the adoption of technology and the emergence both of new trading venues and innovation at the existing ones, will give the buy-side trader an unprecedented set of options to choose from.
Read more about bringing back the block in the full whitepaper.