While funds managers pride, and sell, themselves on their skill and while asset consultants and super funds forever debate their ability to identify skill, it is only recently that there has been a serious discussion about investment implementation and execution skills as an area also demanding of scrutiny. And we can thank the much-maligned high-frequency traders for that.
The increased usage of high-frequency trading and their use of dark (off market) pools has prompted regulatory changes in many markets. In Australia, ASIC has moved at a fair clip after commissioning an academic study last year and issuing a consultation paper (2012). In May it issued revised market integrity rules on price improvement and gathered submissions on the consultation paper. Decisions are expected later this month or next, however in June it signaled that it would not, at this stage, proceed with minimum trade size thresholds or small order resting times. It also cited its new meaningful price improvement rule as already having its desired effect of directing non-block activity back to the lit market.
It may be surprising to learn, for instance, that while the average trade size on the “lit” ASX market is about $6,000, the average across dark pools, according to ASIC, is only $400. ASIC would like these very small parcels back in the lit market. It was the advent of algorithms mainly used in high-frequency trading and the ability to slice large orders into many small ones which drove the average parcel size down.
ASIC also suspects that excessive pinging to test if there is liquidity in dark venues contributes to smaller trades, a practice, it says, is at complete odds with the original volume-discovery purpose of dark pools.
Dark pools in general, which have been offered for years by the big index managers and most investment banks as a way to reduce market impact for large trades, and more recently to internalize order flow, seem to have been caught in the regulatory and commentator crossfire.
According to James Chatfield, director of Liquidnet in Australia, ASIC’s measures are likely to reduce predatory trading, lower the level of fragmentation, which had been going on, and preserve dark trading measures as they were originally intended – for big investors to trade efficiently with each other.
That focus on efficient trading may be the big benefit from ASIC’s activities, prompting fund managers and even super funds and consultants to look more closely at all aspects of their traditional investment operations in order to reduce costs in a low-return environment.
Liquidnet is not a dark pool, as such, but rather an automated trading system which allows institutions across 42 markets to deal directly with each other in an orderly fashion, using the ‘national best bid and offer’ pricing drawn from the lit markets.
There are about 700 fund managers around the world, including 56 in Australia, which have signed up as members of Liquidnet. The Australian contingent, which have come on board since the Sydney office opened in 2008, is estimated to account for about 60 per cent of total Australian investment management FUM. Importantly, the average size for the Australian Liquidnet trades is $1.3 million.
Chatfield says that there has been massive change in implementation and execution of investment strategies in just the past two or three years.
“Any investment manager whose processes are the same as two or three years ago now has a long way to catch up,” he says. “There’s the alternative exchange, Chi-X, there’s the shifting execution landscape and there’s the regulator trying to get a handle on it.”
Liquidnet competes with the big investment banks such as UBS, Citi and Credit Suisse, however, the proportion of the total market which is dark has not changed much in the past 10 years. It is still about 25-30 per cent of all the action. What has changed is its composition.
Chatfield says that the dark-trade market has gone from being purely block trades to now only about 50 per cent block trades. He wants the dark market to get back to what it was.
Liquidnet was established by former risk arbitrage trader Seth Merrin in New York in 2001. He had set up an order management, compliance and electronic order system company which he sold in 1995. He then founded, with a partner, VIE Systems, an application integration systems company.
His idea for Liquidnet, of which he is still CEO and largest shareholder, was to allow fund managers to more efficiently access a dark pool and integrate this with their multifarious daily trading. But it required a lot of trust in the system by the fund managers. These days, with safety in numbers and 12 years of history, trust in the integrity of the pool and its members is still key. Members have to have at least $200 million in funds under management, a proper order management system and defined investment process.
How it works is that members allow all their non-allocated trades to be accessible by the Liquidnet technology until the manager is ready to buy or sell. As soon as the manager pushes the button, the trade is met by the first available other side. Remember, they are trading at the lit market’s midpoint price. Then follows an on-screen dialogue between buyer and seller. If a deal is not reached, the next in line is elevated for a dialogue. All this happens very quickly.
For managers concerned about how their broker researchers get paid, given they don’t get commissions in a dark pool, Liquidnet has a commission sharing system whereby the broker which generated an idea can be paid from a commission pool provided by Liquidnet members.
The savings for managers, according to Chatfield are roughly half on trading brokerage, which is an “explicit cost”. Liquidnet charges 10bps per trade in Australia and says it has saved its members an estimated $47 million in trade price improvement over the past five years. But the firm believes the saving on market impact, an “implicit cost”, where big orders can otherwise drive up or down the share price before the deal is complete, can be five times that.