The title of the opening session at Institutional Investor's International Trader Forum (ITF) last week in Barcelona summed up the concerns faced by many at the conference: 'Managing Liquidity through the Evolving Market Structure'.
Firms are facing an array of challenges as they look toward trading in a post-MiFID-II world, yet the future landscape has never looked so unclear. Institutions are beginning to understand that 3 January 2018 is not just a deadline to meet — more importantly, it’s the start of an evolving and potentially volatile trading landscape. With so few buy-side firms represented on the panels at ITF, and the conference debate dominated by the sell-side, many of the 150+ global buy-side attendees felt that key questions remained unanswered. The unspoken question in the room was “just how I am going to trade post MiFID II?”. Firms need to find the answer by establishing what is known now, so that they can be ready to trade in January.
Three key themes stood out from the panel discussions and conversations in the corridors: the impact of unbundling research, how Systematic Internalisers (SIs) will operate, and the need to evidence best execution.
The impacts of unbundling
Recent announcements on the number of firms that plan to pay for research using P&L will have a significant impact on where liquidity will reside. Given the growing industry shift to P&L, firms yet to announce research payment plans noted privately that it is becoming harder to justify using client commissions. There will be a significant impact on brokers given that:
- they will no longer receiving captive order flow to top up CSA pots
- they can no longer operate BCNs
- operating an MTF will be challenging given the impact of the Double Volume Caps (DVCs).
Whether you can trade in the dark will depend on which instruments will be subject to the DVCs, which is only likely to emerge in February 2018. First, ESMA will need to collate the 2017 data, then make the calculations, and finally distribute these to market participants. In the interim, firms will need to trade either with the Large in Scale (LIS) waiver, via an SI, or in the lit market using a periodic auction.
Continued uncertainty around SIs
Given the existing uncertainty around SIs, the immediate beneficiary appears to be Large in Scale (LIS) activity. Mark Pumfrey, Head of Liquidnet in EMEA, noted the recent rise in LIS flow in Europe, now accounting for 10% of all dark trading (up from 5% a year ago). However, for this number to grow further, behavioural change is required. Innovation in the LIS block space will continue to evolve, but cannot solve all liquidity challenges. The dominance of passive investing will ensure that VWAP and Market on Close (MOC) trading flow will remain, as will a firm’s ability to interact with both liquidity streams. Some see a further dislocation between the sell side and asset managers as liquidity formation evolves further away from trading natural blocks to the repurposing of latent liquidity — sourced from other areas within bulge bracket organisations and fed through central risk desks.
Another panellist commented that the industry is over-estimating the impact of change in the short-term, but underestimating the longer-term impacts. The switch to more automated forms of trading not only includes algos and algo wheels but also the automation of risk. Those with the technology to effectively manage risk will be those who truly understand the cost of trading — implicit as well as explicit costs — and can manage their exposure effectively. Access to accurate and complete datasets will drive who are the winners and losers, and those with the best technology will continue to challenge the status quo, hence the continued rise of electronic liquidity providers (ELPs) within the SI space.
The SI regime came in for the highest level of frustration from the buy side. 60% of buy-side participants in a recent Liquidnet survey said that they see zero consistency in bulge bracket explanations of Systematic Internalisers. Brokers are still seen as being elusive over the structure of their models. The sell side claim that with the regulatory environment still so unclear, they have no other option. Dr Kay Swinburne, MEP, who attended the buy-side-only day at ITF, noted that some firms are marketing SI plans to clients without first registering plans with their relevant regulator. She also noted that releasing plans before receiving clarification from their NCA may only add to buy-side confusion. Dr Swinburne made an outright plea to the buy side to use the SI regime in the manner that the regulator intended, rather than as a replacement for broker crossing networks (BCNs) — and whenever possible to return to trading on lit markets. However, the panel noted that this is unlikely given that, quantitatively, the lit market remains the most toxic market. They also confirmed that liquidity may well shift to new SIs, such as ELPs, creating mini multiple venues focusing on different specialisations.
Some on the sell side recognised the potential risk they face if the industry focuses on literal interpretations, rather than the spirit, of MiFiD II. While no firm plans to link between Sis, given the regulators concerns regarding networks of SIs, a broker can be a client of multiple SIs. Entering into a sub-tick price war could leave lit exchanges devoid of liquidity, which would lead to a prompt closure of the SI regime — potentially not only for equities but also for fixed income. However, there is also the need to get the best possible result for the client and some see sub-tick price improvement as a legitimate offering.
Managing future SI interaction will not happen overnight — establishing which venues provide the greatest price improvement will be a discovery period over the next year. Successful SI interaction requires a trade-off between providing greater information to receive tighter pricing and incurring signalling risk. Understanding those transactions where signalling risk is acceptable versus those where the risk would be too impactful, again, must be built-up over time. Known norms of trading will need to be re-assessed, accepted, or rejected as traders learn how to operate in the new environment. To achieve this, sell-side firms are already redirecting flow structures to build up their datasets to help their selection processes moving forward.
Some on the buy-side openly questioned whether the SI regime is even necessary for equities. One question from the floor was “if brokers are able to cross flow on periodic auction, why do they need to interact with an SI?”. The issue for traditional brokers is how limited their options are in providing liquidity to their clients outside of an SI. This was a point backed-up in a presentation Citi gave later in the event, which showed 59% of attendees seeing agency brokers as the main beneficiaries of MiFID II versus just 12% seeing SI brokers benefiting.
The need to evidence best execution
Single stock transaction cost analysis (TCA) no longer provides the granular level of detail now required to leverage the increasingly fragmented liquidity options that will be available. The balance between exploring and exploiting the new liquidity sources not only requires data to improve the selection process, but also technology to optimise selection strategies. More than 50% of asset managers plan to use greater automation in trading, with an increasing use of algo wheels to optimise trader workflows and manage time effectively. Because of this, access to reliable and accurate data is increasingly important to make appropriate selection choices. If you are trading 1,600 tickets a day, the need to use a wheel to establish which trades can be automated, versus those that require human oversight, is self-evident but also poses interesting questions regarding the growing gulf between those with access to good technology and those being left behind. Following a recent Liquidnet survey of 55 global asset management firms about best execution ahead of MiFID II, it is clear that firms must now move from ad-hoc best execution policies to a systematic process that is understood, controlled, and monitored across the firm. Unbundling traditional broker relationships requires a strategic re-think of which brokers to engage with, and where to trade, to achieve best execution.
70% of participants in the survey stated that they are now reviewing new liquidity providers, with 35% planning to make this adjustment ahead of MiFID II. In addition, selecting the right partners to access liquidity is diverging. High-touch broker lists are expanding as capital commitment declines and low touch becomes commoditised. However, the increased scrutiny over evidencing broker selection requires firms to move away from a static ‘look back and check’ on trading performance to a more holistic approach of Best Execution Analysis (BXA). This represents a step-change — not only for European firms but across the globe — as clients demand more detailed best execution evidence.
With less than 90 trading days to go, ITF demonstrated that there is much firms still have to understand and implement before they will be ready for MiFID II.
Stay tuned for further updates as part of our 'Making MiFID II Work' series. Got a question about any of the information we’ve covered here? Email us at firstname.lastname@example.org