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Regulatory Risk

A chance to shine: MiFID II and the buy side trader

Chris Hollands

11 Sep 2015

A man looks at the Pudong financial district of Shanghai November 20, 2013. With a shift in tone and language, China's central bank governor has dangled the prospect of speeding up currency reform and giving markets more room to set the yuan's exchange rate as he underlines broader plans for sweeping economic change. The central bank under Zhou Xiaochuan has consistently flagged its intention to liberalise financial markets and allow the yuan to trade more freely, even before the Communist Party's top brass unveiled late last week the boldest set of economic and social reforms in nearly three decades. REUTERS/Carlos Barria (CHINA - Tags: BUSINESS CITYSCAPE TPX IMAGES OF THE DAY) - RTX15LH0
REUTERS/Carlos Barria

Over the past few years with the continuing advances of technology, the economic challenges brought by a new, lower volume paradigm in Equity markets and the rising influence of regulatory reform, the future role of the buy side trader has ‎been the subject of significant debate.

MiFID I and now MiFID II …

While MiFID I brought about greater competition and hence liquidity fragmentation at a venue level for order execution, the generalized adoption of SOR technologies on the sell side and their distribution to the buy side of next generation liquidity seeking algos, meant that the industry was able to cope very satisfactorily  with the ensuing changes.

MiFID II, however, will bring with it more profound and wider reaching implications and challenges for Equity market participants.

Unbundling and the rise of TCA

The recent changes to the dealing commission regulations in the UK and Europe have significantly impacted the ability for firms to use dealing commissions to pay for services provided to them, and have gone further to clarify the situations where their use is permitted or not permitted. Under this new regulatory framework, it is clear that buy side traders will be accorded considerably more discretion and control of the management and direction of order flow.

With this increased level responsibility and autonomy for execution decision-making, will come greater accountability and a heightened level of scrutiny on execution performance.  In turn, this will drive an increased need and hence usage of broker neutral TCA services at all stages of the order life cycle (pre, in and post trade.)   To the extent that a buy side trading desk is more visibly contributing positively to the alpha generation process of the investment firm, it is likely that its status and importance will be raised commensurately.

Increased interaction with the PM and the sell side trader

At Tradetech Paris 2015 a few months ago, a number of leading buy side firms stated that they expect the level and frequency of dialogue with their PMs to increase substantially stemming from a greater need for transparency and explanation of execution decision-making and the consequent performance of the orders.

The increasing availability of real-time analytics and sophisticated alerting capabilities, for example re outlying/underperforming in-flight orders will underpin this evolution by informing and increasing both the quality and the frequency of the dialogue between the buy side trading desk and the PM.  Moreover, the increasing availability and improving quality of these real-time analytics in the desktop solutions used by both the buy side and the sell side trading communities, will afford a renewed level of communication and openness towards the third pillar of this dialogue, namely the sell side trader/sales trader.

The widespread adoption of the EMS (Execution Management System) at buy side firms over the course of the last 5 years has undoubtedly given the buy side trader the key tool to ply its trade.  They have provided the functionality to stitch together the multiple sources and hence options for accessing liquidity and also offered an unparalleled level of automation, something which is set to increase and to evolve in the coming years.

Increased automation

One or two of the more progressive sell side firms, in the latest iterations of their algo suites, have offered an algo builder capability offering the buy side trader almost infinitesimal levels of customization.  In addition, in the pursuit of end user automation, some EMS providers now offer auto-routing capabilities whereby configurable rules can readily be created to automate the routing, typically of the lower value/lower importance orders to the appropriate electronic channel, for example DMA or a specific broker algo.  The usage of broker sponsored algos and auto-routing tools have largely been driven by the need to increase trader productivity in electronic markets characterized by greater fragmentation of liquidity and a wider range of order routing types and execution alternatives to choose from.

The accepted wisdom – that this then enables the buy side trader to concentrate more of its time and energy on the bigger, more difficult to execute orders – certainly seems to be well founded.  For the most part, these types of tools are the preserve of the buy side trading desk and sit within the EMS as opposed to the OMS (Order Management System) though in recent years, there has been some vertical integration from the latter to provide some of the former.

In parallel, with the much documented contraction and de-layering of the front office within the sell side resulting in less outsourcing of the execution function to the broker, the buy side trader has been obliged to bridge the gap and become more knowledgeable regarding all the available types of execution and when and how to use them, fast evolving market structure and the growing impact of regulation.

Back to block

On this regulatory note, one very apparent consequence of MiFID II and the double volume caps on Dark Pools will be the reprise of block trading.  This will require more of the old fashioned skills of a buy side trader and the management of its key sell side relationships, where with capital provision seeming set to continue to decline, a greater onus will be on finding ‘naturally’ the other side to the order.  To a large extent, this explains the recent industry focus on the quality of IOIs and a desire led by the Investment Association and the Association for Financial Markets in Europe (AFME) for more consistency and granularity in their content across the community of sell side contributors.

In conclusion, it is clear that with the advent of MiFID II and the consequent changes to market structure, the buy side trader is going to be faced with an unparalleled level of complexity and indeed choice regarding the sourcing of liquidity and execution decision-making.

Increased automation and richer functionality offered by the latest generation EMSs will continue to be a facilitator but will not replace the traditional sell side relationships with whom there will be an increased appetite to execute blocks.

Equally, in an unbundled world there will be greater scrutiny on execution performance and hence an increased dialogue with the PM to explain and to demonstrate the measurement of this performance using desktop solutions incorporating TCA tools able to offer pre, in and post trade analytics.

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