Institutional investors that have embraced the electronic revolution in the financial markets over the past decade are being forced to rely more than ever on technology to find the best returns in the face of a slump in trading volumes.
Despite a surge of activity in May, when equities worth €1.2 trillion were traded in Europe, volumes have fallen for three consecutive months – to €979bn in June, €846bn in July and €763bn last month, according to data provider Thomson Reuters. These figures are well short of the pre-crisis heights of January 2008, when volumes reached €1.5 trillion.
The outlook is grim too. The annual value of trading in UK equities relative to the size of the market is set to hit its lowest level for eight years, according to a report last month by share registrar Equiniti.
This depressed level of trading has brought with it more volatility, making it increasingly important for investors to seek out liquidity from the automated trading venues that have proliferated in Europe.
Rob Goldstein, managing director at asset manager BlackRock, and head of its technology division, BlackRock Solutions, said: “The amount of demand from the buyside for risk and investment platforms is at the greatest I’ve ever known it.
This is largely driven by a much greater awareness among firms that these platforms are incredibly complex to build, expensive to maintain and need to rapidly evolve with market changes.”
By 2006, 96% of buyside firms had adopted front-office trading technology, which includes systems to help execute a deal as opposed to portfolio management or compliance tools, according to a report published by consultancy Tabb Group in May. This figure is expected to reach 100% by the end of this year.
With such a high uptake of automated trading systems, it is not surprising that buyside firms are looking to use this technology more effectively in the face of thinner markets.
Chris Sims, head of investment operations at asset manager Gartmore, said: “We are not currently looking to radically invest in or change our trading technology, but are instead focusing on using the systems that we do have in a more efficient way.”
According to Sébastien Jaouen, head of trading community services in the trading solutions group of technology firm Orange Business Services, this focus on technology is putting pressure on vendors to be more innovative.
He said: “The combination of lower trading volumes and the impact of the financial crisis has resulted in less assets under management at hedge funds and other asset managers. As a result, our customers are looking for solutions that are not off-the-shelf, and that they can easily and quickly integrate with their existing systems.”
These solutions range from systems that allow multi-asset class capability, to algorithmic trading capability, as well as improved information management tools, all in bid to home in on venues offering the most liquidity, the narrowest spreads and the best prices.
Rob McGrath, global head of trading at asset manager Schroders, said: “Whether it is identifying ‘problem’ trades or sectors within a programme, or working out the best venue and way to trade a block, the more information traders have at their disposal the better.”
It is not just market forces that are causing buyside institutions to take stock of their technological capabilities. Firms will also have new legislation to contend with, as the European Commission seeks to overhaul its equity trading rulebook later this year.
The changes are set to include the introduction of a consolidated data feed showing prices across all of Europe’s venues, as well as limits on the amount of activity that can be conducted on dark pools, venues that allow orders to be matched anonymously.
Financial News looks at three areas of trading technology that are capturing the attention of buyside institutions: algorithmic trading, transaction cost analysis, and multi-asset class platforms.
Algorithmic trading
The way in which buyside institutions look to execute their trades is becoming an increasingly pertinent issue, particularly as what little liquidity there is left is fragmented across several venues.
For many, the solution lies in the use of tech-savvy systems that allow orders to be conducted with the click of a mouse.
Miranda Mizen, a principal at Tabb Group, said: “The buyside have turned heavily towards algorithmic trading strategies, and have invested in the time and technology to give them this capability.”
Algorithmic trading is a process whereby computer programmes automatically enter orders on to a venue, within parameters defined by the investor, and these often determine certain aspects of the trade including timing, price and quantity, in a bid to secure the best deal.
It is a method that is particularly favoured by the buyside, as it allows larger orders to be broken down into smaller units to help manage the impact of a trade on the market.
Sims said: “We’ve seen a gradual increase in the use of algorithmic trading strategies and I would imagine that a substantial and growing proportion of our trades are now conducted in this way.”
Goldstein said: “Algorithmic trading is on the up, largely as a result of an increase in the number of automised trading venues and less dealerisation.”
However, not all buyside institutions share the view that algorithmic trading is the only answer, particularly with equity volumes being so thin.
McGrath said that while the use of algorithmic trading techniques was increasing, the rate of adoption was slowing, as firms weighed the costs of different execution methods and lower volumes made certain types of algorithms less effective.
He said: “The rate of change is slowing as the blend between algorithmic trading and traditional broking finds its balance. In this environment the value of blocks increases, both in terms of speed of execution and reduced market impact.”
Block trades allow an institution to quickly and efficiently move into, or out of, a large position, and offer an alternative to breaking up an order into smaller sizes, but anonymity is important when trading in this way.
If a large block is placed on an exchange, negative signals may be sent to the wider market, for example that an asset manager is looking to sell, causing a downward spiral in prices, as traders observe a significant increase in the supply of a stock.
The ability of large institutions to trade large orders, or blocks, has improved with the advent of anonymous electronic trading venues such as Liquidnet and Posit, which aim to directly match corresponding orders away from lit exchanges, preventing adverse price movements.
Jim Conway, head of trading at asset manager Standard Life Investments, agreed that these venues were proving more valuable in the current climate.
Conway said: “Over the past three months we have been using our execution management system less, using capital commitment more and using crossing networks, such as Liquidnet and Posit, whenever possible.”
Transaction cost analysis
The use of technology is also gaining favour among the buyside for its analytical virtues, particularly as investors try to better judge the performance of their brokers.
McGrath said: “With electronic trading the ability to access the market quickly has increased dramatically, but one area where there has been a gap is with the integration of the tools that allow the trader to analyse the trade and therefore make their trading decisions.”
A process known as transaction cost analysis, or TCA, aims to close that void and Conway said it was becoming more important and high-profile across the industry.
TCA is essentially a reconciliation of the difference between two amounts – the first being the value at which a transaction could be executed at the moment a portfolio manager makes a decision to trade, without any additional costs, and the second being the amount realised.
The transaction costs that buyside institutions incur come from several sources. They include commissions from brokers and the fees and taxes paid to exchanges and regulators, as well as expenses that are less easy to define, such as market impact, which is determined by the forces of supply and demand.
The result is that TCA has become integral to the buyside’s trading process, allowing firms to achieve best execution, control trading costs and bring greater efficiencies to their operations.
Sims said: “We’re spending a lot more time on TCA, looking very closely at execution data and having conversations with our brokers in an effort to ensure we’re achieving the best deals.”
This view was shared by Goldstein, who said it was becoming a more effective tool as the quality of data improved. He said: “We are aggressively leveraging our TCA systems across different asset classes.
The quality of these systems is dependent on the quality of data, and with trading becoming more standardised and electronic, we have been able to improve our analysis.”
The popularity of TCA has risen in parallel with an increasing demand for execution data from regulators, according to Sims. He said: “I think it is also going to become increasingly important that we keep hold of transaction data, as this is something that will soon be required of us by regulators.”
Multi-asset class capability
As volumes in equities markets have remained thin, investors are seeking to diversify their portfolios into other asset classes, and technology is developing to meet this demand.
Goldstein said: “If we look at the trends across the last few months, we’re spending much more time developing technology solutions by sharing ideas across asset classes – we believe that the market structure evolution seen in equities over the past decade provides a significant amount of intelligence for how fixed income will evolve over the next few years.”
He said algorithmic trading was moving into new products such as foreign exchange and fixed income.
Other asset classes already account for a substantial portion of electronic volume. According to Tabb Group, 53% of buyside firms now trade financial products other than equities through their trading platforms.
Of this group, 29% said they traded futures and options electronically, and 16% of firms said they traded foreign exchange low-touch. Some 12% of firms said they exchanged their fixed-income trades on electronic platforms.
Jaouen said traders “want to be able to trade a whole range of products and trade globally and the onus is on vendors like us to develop these sort of systems”.
James Davies, head of sales and client services at Trayport, a company providing connections to commodities exchanges and which has buyside firms among its clients, said the demand in other asset classes was in its infancy.
“We’re experiencing increased demand and pressure from hedge funds that want to be able to automate their commodities trading.
“Commodities are not quite as developed as the equities market yet in terms of electronic trading, but it’s going down the same road and we very much see it as a market with a big potential for growth,” he said
