Liquidity Discovery in Post-MiFID Europe Intelligent Liquidity Access A New Frontier for Electronic Trading in Europe Algorithmic trading is entering the mainstream. Financial institutions are ready to deploy integrated platforms for connecting to a broad diversity of execution venues, locating liquidity across markets, and executing on that liquidity quickly and efficiently. The more innovative firms have been quick to realise that early adoption of high-performance trading platforms that incorporate smart order routing technologies will allow them to swiftly consolidate their market position. But deploying a platform that meets these requirements is not a trivial task. This Briefing offers guidance on the key factors that should be considered by financial institutions planning to build their own trading platform or evaluating the myriad of vendor systems on offer. An industry briefi ng prepared for Fidessa by A-Team Group 1
Executive Summary The combined impact of MiFID and the emergence of new markets and dark pools has created an increasingly fragmented equity marketplace in Europe that is radically changing the face of electronic trading. The day of the smart order router is here, and the use of algorithmic trading has entered the European securities trading mainstream. A trading firm s technology response to the changing market structure needs to be significant: today, electronic trading is about super-fast intelligent automation of the order routing process, towards the venues where optimal trading opportunities exist. In a competitive market of markets liquidity will move increasingly seamlessly between execution venues. By taking a proactive approach to best execution for clients rather than merely complying with regulatory requirements many financial institutions believe they can gain competitive advantage. This is an experimental time: many traditionally reserved firms are turning to algorithmic trading systems for the first time. It is no longer possible for a trader to trade European equity instruments effectively without smart order routing tools. Firms deploying smart order routing algorithms are attempting to create the right framework for the automation of trading decisions across multiple markets. As market participants build new internal trading infrastructures or assess the strength of vendor offerings, they must address the same set of considerations to leverage the opportunities posed by the new regime. Efficient integration of core functions is key: any trading platform in the new environment needs to integrate several key functions, including order management, market data, market connectivity, smart order routing, trade management, position-keeping and audit trail. Underlying all of this is the need to ensure good static data management, particularly with respect to fungibility between instruments. Despite the complex decision making process, speed of execution must not be compromised, and all elements of the trading infrastructure must be optimised to ensure lowest possible latency. Any trading platform must provide a consistent, consolidated view of fragmented markets, displaying orders and market data for fungible securities on accessible and appropriate execution venues. The deal-capture and position-keeping function must similarly provide consolidated trade records with specific venue of execution information. The trading platform s smart order routing component must offer multi-market and multi-asset execution that optimises trading across the growing number of markedly different execution venues. The smart order router must also be able to perform specific functions designed to meet the needs of the user s investment criteria, and needs to be able to deal with venues conventions around minimum order sizes, dealing capacity and other rules of participation. It s essential to establish the business and technical strategy and approach to connecting to new venues. Clearing and settlement of alternative market trades also adds a significant technical and processing complexity and ultimately cost. The trading system needs to handle not only the instrument fungibility issue but also the hierarchical relationship between execution venues. The smart order routing system needs to be able to determine what the primary market is for any given instrument, allowing positions and trades to be viewed at a single primary instrument level. These important issues are among those explored in this paper and they require the attention of any trading firm that wants to trade in the new European market structure. 2
Implementing a Solution to Trade the Virtual Pan-European Stock Market Implementing a platform that takes advantage of multi-market opportunities while at the same time meeting regulatory requirements is a big challenge for trading firms. Whether building a trading infrastructure in-house or assessing the relative strengths of the various vendor offerings in the marketplace, trading technologists and the business leaders they support need to address the same basic set of considerations to leverage the opportunities posed by the new regime and to avoid its pitfalls. Are the Core Trading Functions Tightly Integrated? The efficient integration of core functions is key. When trading the fragmented stock market you don t want to be using a fragmented technology solution. Many technology vendors propose the use of different core trading technologies loosely grouped together to solve the problem - this is generally not optimal. If too many of the functions involved in electronic trading across multiple markets operate independently this adds latency, contributes to missing trading opportunities and increases the risk of operational inefficiencies and errors. Any trading platform in fragmented European markets needs to integrate several key functions, including: order management; market data; market connectivity; smart order routing; trade management; position-keeping; and audit trail. Underlying all of this is the need to ensure good static data management, particularly with respect to fungibility between instruments - users must be confident that the multi-listed instruments they believe are interchangeable as an asset, truly are. Europe s fragmenting marketplace is forcing market participants to adopt super-fast, superefficient trading systems to seek out liquidity. Financial institutions believe they can gain competitive advantage by taking a proactive approach to the changes in market structure. Firms deploying smart order routing algorithms are attempting to create the right framework for the automation of trading decisions across multiple markets. Is Your Definition of Instrument Fungibility Clear and Consistent? The definition of fungibility between instruments is the cornerstone of any strategy or trading system designed to deal with multiple execution venues. Trading systems need to know what market instruments they consider to be the same for the purpose of satisfying an order for shares. Clearly, there are key differences between securities that at first appearance seem to be like for like. Fungibility is ultimately in the eye of the beholder and systems need to provide enough flexibility to allow individual judgments and preferences as to what instruments are considered fungible. How Do You Handle Multi-Market Execution? The platform s smart order routing component must offer multi-market execution that optimises trading across the growing number of execution venues. The smart order router must be able to aggressively sweep across user-specified, relevant execution venues in order to identify liquidity at the requisite price levels. It must search out and execute against hidden and iceberg orders, and route client orders to appropriate venues in accordance with the user s investment criteria. It must also be able to deal with any volume that is not immediately executable and optimize the passive placement of any remaining volume. Firms will need to adopt the tools required to apply a variety of smart order routing execution strategies with full flexibility to adapt the algorithms to meet the firm s execution goals in different circumstances. 3
Can the Platform Construct a Consolidated Market View? Any trading platform must provide a consolidated market view, displaying orders and market data for fungible securities on accessible and appropriate execution venues. Importantly, this intelligent data display must be a highly functional trading tool allowing traders to interact on multiple markets efficiently as if they were interacting on a single pan-european stock exchange. Similarly, multi-market trade tickers and multi-market trade prints must be available in a consolidated view easily accessible to the trader to assess current and historical market activity. The organisation and ease of access to sensible data consolidation requires careful software design and implementation. The deal-capture and position-keeping function must similarly provide consolidated trade records with specific venue of execution information. Trades in a particular instrument must not be viewed as fundamentally different if the deals are executed across different market venues. Traders will also want to be able to see their stock positions consolidated as a single position per instrument. Does the Trade Audit Trail Meet Regulatory Requirements? The trading platform must provide a complete audit trail of all trading activity and events including all automated algorithmic decisions. This is required to provide proof of compliance with the firm s execution policies and the performance of the execution venues. When trading the fragmented stock market you don t want to be using a fragmented technology solution. A clear and consistent definition of instrument fungibility is the cornerstone of any multi-venue trading platform. The smart order routing algorithm must handle the nuances of each execution venue while directing orders according to the user s investment criteria. It is essential that the audit trail shows the individual order handling and trading events in the life of a specific customer order, in line with a comprehensive view of multiple market prices and conditions at the time of each event. Flexibility Is Key to Adapting to Future Market Changes Before an order can be traded automatically across a multi-venue environment, a trading system must first locate market opportunities. Understanding where liquidity is and the differences when interacting with different venue types is imperative. As different market models evolve it is crucial that any approach can be adapted to reflect market changes and the evolution of market structures. Fierce competition between markets should result in market innovation and lower-cost trading. This is one of the main goals of MiFID. The European market structure is evolving fast and market participants need to adapt fast. Are All Potential Liquidity Sources Dark and Light Taken Into Account? There are a variety of so called dark pools defining the new complex trading landscape of Europe. In recent times, the market has seen a reorganisation and formalisation of the longexisting practice of firms crossing client orders internally. Some internal markets are now somewhat transparent (firms termed Systematic Internalisers under MiFID), while other internal markets take the form of organised dark liquidity, also known as internal broker dark pools. These new dark pools create another dimension of trading venue. As such, any liquidity-seeking mechanism must be aware of potential liquidity across a number of very different venue types. 4
Internalisation in Europe has traditionally represented in excess of 30% of total European trade execution. As such, internalisation does not represent a new source of liquidity. The proliferation of so-called broker dark liquidity pools has been regarded as making liquidity and price discovery more complex. This is not necessarily the case - internal dark pools have never been better organised or more accessible to the customers of the firm. The issue is how to access these pools if not already a customer of the firm hosting the internal market: these pools do not advertise trading opportunities through price distribution and a trading relationship with the host broker is required to access them. Alternatively, Systematic Internalisers under MiFID are obliged to report their available prices to the public domain if the order size available is below standard market size and the stock is liquid. This will reveal more, but not nearly enough, of what is available for execution inside the large firms. There is now an opportunity through the use of advanced smart order routing to make these key liquidity pools more interactive and available to a broader set of market participants who want to trade. Of course, this is not the only type of dark pool; the much touted Multilateral Trading Facility (MTF) dark pools and new hybrid exchange models are currently either prelaunch or still in their infancy. Those live have yet to report significant transactional volumes. But with growth in use, and unique business models, some of these dark pools will establish themselves as important alternative execution venues, and how a firm interacts with these markets will become vital. In short, it s essential to appreciate that any effective liquidity discovery mechanism s methodology for identifying opportunities across markets needs to recognise Instrument Venue Venue Instrument ID Fungible ID Multi-Market Applications Vodafone Ordinary Shares (GBX) LSE Chi-X Turquoise Equiduct SWX Europe BOAT VOD.L VOD.L.CX VOD_L.TQ VODGBP.EQ VOD.VX VOD.XLON-GBX.BT VODGBX Consolidated o Price Feeds Consolidated d Trade Tickers Multi-Market Mar t Algo Models Virtual Market Depth Views Consolidated ol Market Metrics Smart Order Routing Consolidated o Audit Trail Market Preferencing Multi-Market Mark t Passive Trading Client Reporting Multi-Market Mar Benchmarks User Friendly Symbology y Multi-Market M t Pairs Trading Consolidated Profit & Loss 2008 Fidessa Equity data across different venues streamlined using a single flexible identifier 5
the difference between these different types of matching platform and business models. Smart order routers and execution algorithms need to interrogate the most appropriate dark pools in the right way to seek out opportunities that beat visible liquidity on other markets. A Strategic Approach to Market Connectivity In the context of new market structure evolution in Europe, it is of paramount importance to establish the business and technical strategy and approach to connecting to new venues. The decision to establish a direct connection to the latest hot venue is not a trivial one. It involves substantial effort, resource and investment to build and maintain good quality market gateways, and firms will want to ensure this investment is worth it. Clearing and settlement of alternative market trades also adds a significant technical and processing complexity and ultimately cost. Using indirect gateways has positive and negative implications. Member firm brokers can offer fast direct market access (DMA) and the use of smart DMA services. This may be an attractive market route for smaller firms, taking much of the complexity out of the trade processing of alternative market execution. As different market models evolve, it s crucial that a trading platform can adapt to reflect future changes in business models and market structures. Emerging dark pools, both private and public, must be considered as potential sources of liquidity. Smart order routers must be able to understand the different types of matching platforms and their rules and conventions. On the downside, this approach will reduce the firm s involvement in the trade execution process and increase dependency on other, potentially competitive parties. The use of third-party brokers will also add unwanted latency to the trade execution process. This can encourage their buy side customers to establish a direct relationship with the executing broker or market member. For the broker, the loss of control over execution strategy and process will be apparent when utilising the services of another party when executing, as opposed to using member gateways and their own smart order routers and execution logic. The approach taken will be different for different market participants. Those who do not depend on execution quality may find the use of third-party brokers attractive. The firms that want to show and sell their competency in the trading and execution process will need to invest in the technology and supporting processes. It is likely that the strategy of a mix of direct and indirect market routes will be attractive for all but the top tier of executing brokers with pan-european execution and clearing capacity. For firms opting to connect directly to new venues, it s essential to create the flexibility to build high-quality and robust exchange gateways quickly. Multimarket connectivity can be a complicated and expensive business and it s essential to adopt the right strategy and technology to ensure future-proofing - with the ability to maintain and enhance market gateways as they upgrade and enhance their platforms and business offerings going forward. Using SORs and Execution Algorithms Once connections to market data and appropriate execution venues are established, attention can turn to the cornerstone application of operating in a multi-venue marketplace: the smart order routing (SOR) mechanism. Seeking out liquidity and determining the overall market s best prices while challenging can be perceived as an eminently achieveable aspect of smart order routing. Efficient software processing and today s computer processors are capable 6
of consuming vast quantities of data to provide an overall picture of price and opportunity across multiple markets. Knowing and understanding what trading opportunities exist across multiple markets, and comparing those opportunities in real time and acting upon them, are all quite different challenges. Algorithms are needed to understand and interpret what is happening and deal with the nuances of different venues trading models and rules. Without them, it s difficult for a manual trading process to prioritise access to different venues in an optimal way. Among the issues that need to be handled are: the venue s conventions around minimum order sizes, the notification of dealing capacity and other rules of participation. Similarly, institutions that use specific types of orders must ensure that their smart order routing systems are capable of handling these order types in the appropriate manner. For example, a fill-or-kill order will fail if one element of a multi-leg order isn t completed. A smart order routing algorithm must take into account this risk and deal with it appropriately. The algorithm must also ensure that by splitting an order between venues it doesn t create an odd-lot that can t be traded because the venue in question doesn t support trading of odd-lots. The SOR strategy must ensure that when order placement is passive and opportunities become available on an alternative venue, there is a mechanism to reduce the possibility of missed trading opportunities. It s essential to adopt a business and technical strategy for connecting to the growing number of execution venues. Market participants must weigh the pros and cons of using indirect gateways, with their control and latency issues. Understanding what trading opportunities exist across multiple markets and comparing and acting upon them in real time, are all quite different challenges. Firms will need to have a clear view of how the smart order routing process works in the myriad of specific cases. Traders and sales people need to be able to see what happened easily in order to deconstruct what the algorithm just decided to do with their order. This is very important. Lack 2008 Fidessa An example of order depth for a single equity instrument across multiple European markets in a single consolidated view 7
of human visibility and supervision of the process could present significant risks to the trading business. For this reason, a clear audit trail must be available immediately to the user of SOR. The algorithm is likely to be made up of multiple distinct tasks or phases: for example, a phase to aggressively sweep transparent markets; another distinct task that looks for opportunities in dark pools dynamically and intelligently; and finally a follow-up strategy for dealing with remaining unexecutable volume. It should also have the ability to uncover and trade on hidden liquidity opportunities. This might entail a fast and efficient aggressive sweep of appropriate and available markets, followed by a pause before a second sweep to catch markets refreshing with hidden liquidity, like icebergs. Where is the Primary Market? The trading system needs to handle not only the instrument fungibility issue as discussed previously but also the hierarchical relationship between execution venues. The SOR system needs to be able to determine what the primary market is for any given instrument. This allows for positions and trades to be viewed at a single primary instrument level. Primary market identification is also essential in order to value positions with a sensible end of day mark-to-market price. It also allows the system to take into account MiFID-related metrics, such as average daily turnover on the primary market, currently used to determine when an order or trade is large in scale and therefore how it should be processed and handled by a firm. It will also assist in the smart order router for market preferencing and passive order placement. Algorithms need benchmarks and a benchmark market is still an unavoidable requirement. The ability to look at multiple markets as one, using a flat instrument model, and having the ability to look at market instruments in a hierarchical model when appropriate becomes an essential feature of European multi-market trading systems. The SOR algorithm must be designed to avoid unintended and undesirable consequences, such as creating odd-lots where odd-lots cannot be traded. It s essential for traders to be able to deconstruct and analyse precisely how an algorithm has handled an order, particularly during the adoption of new algorithms. The trading system must be able to handle the hierarchical relationship between execution venues, allowing identification of any instrument s primary market. Latency as a Differentiator Between Venues The issue of system latency in the automated multi-market trading process is hugely important. Over time, execution venue system latency may emerge as a differentiating factor in choosing where to send an order, at least until all credible and appropriate venues reach the lower physical limits of latency. End-to-end latency is an important consideration in any trading system and it s about to become even more critical. The initial aggressive phases of the smart order algorithm need to be executed at the highest possible speeds. The speed of the decision-making algorithm itself and the resultant performance of the software and hardware infrastructure in response to these algorithms more generally will throw latency into a very bright spotlight. Elements of the trading infrastructure that hinder the performance of a very fast algorithm will need to be removed, replaced or tuned for speed. Speed used to be an issue in all trading systems; it is fast becoming the issue. Are Your Benchmark Algorithms Fit for Multi-Venue? With the use of standard benchmark algorithmic trading models, such as VWAP (Volume Weighted Average Price) and POV (Percentage of Volume), widely accepted and used by the trading community, it s crucial that trading strategies are clearly defined in line with a multivenue market structure. It is important for a buy-side client to understand, for example, whether a broker s VWAP or POV model takes into account a single market or multiple markets. Indeed, the question of what multi-market VWAP is and how many versions of it will 8
A Blueprint for Intelligent Liquidity Access Customer Connectivity Direct Market Access (DMA), Direct Strategy Access (DSA), Client Orders The ability to look at market instruments in a hierarchical model when appropriate remains an essential feature of European multi-market trading systems. Program Trading Client Baskets Care Order Management Institutional OMS Execution venue system latency may emerge as a differentiating factor in choosing where to send an order. List & Wave Trading Waves, Trading Lists & List Level Algos Compliance & Risk Analytics Market Data If VWAP as a benchmark is to survive, the industry will need to align on multi-market standards for this type of data to be able to compare like with like. Benchmark Algorithms Multi-Market VWAP and POV Execution Algorithms & Smart Order Routing Multi-Market Aggressive & Passive Trading Liquidity Access Regulated Markets, MTFs, Dark Pools Internal Markets, Crossing Networks 2008 Fidessa The trading system flows from customer to market in the new multi-market structure exist is still unanswered. If VWAP as a benchmark is to survive, the industry will need to align on multi-market standards for this type of data to be able to compare like with like. Singlemarket VWAP is likely to become obsolete in a thriving multi-market environment. Similarly, POV algorithms require adaptation to multi-market volumes. With other advanced trading methods, such as program trading and pairs trading, contingent orders need to also adapt to a multi-market structure and this will require considerable technology adaptation. All order-level algorithmic techniques need to be closely coupled with execution-style smart order routing algorithms. This is a significant change that requires firms with algorithmic ability to adapt their models considerably. The trading system will also need to pre-consolidate multiple market prices or trade information inputs before this data is fed into an algorithmic trading engine. This is because quantitative traders need to focus on their trading strategy from a programming perspective and it s important not to overburden the strategy algorithm with price and trade data consolidation duties. 9
It is helpful to look at algorithms in at least two distinct categories with distinct functions. Benchmark, or order-level, algorithms like POV and VWAP are concerned with when and how much quantity to execute, while execution-level algorithms, like smart order routers, are concerned with where and how to execute the order. Orders generated from a benchmark or order-level algorithmic model can then be directed into the smart order router which, as stated, handles any fungibility considerations and all aspects of multi-market execution, without burdening an orderlevel algorithm with, in this case, low-latency execution issues. Creating a Full Audit Trail for Best Execution It is essential in today s regulatory environment to implement a record-keeping system that enables users to retrace what has happened in the order handling and trading process. Regulations require the ability to reconstruct the entire trading lifecycle with every point of the process logged. Firms need to regularly assess the performance of best execution policies. Regulators are interested in the trading activity of the firm. Increasingly, clients will want to understand what happened and why or may even challenge that the firm s execution policy was not followed in a particular case. The trading platform needs to provide in-depth activity and event logs to a well organised record-keeping system, so that it is possible to show which venues were considered for a trade in a given security, which venues were not considered and why, and which other factors led to the automated trading decision. Firms need full trading lifecycle audit data in order to regularly assess performance against best execution policies. The trading system must be able to monitor each execution venue s status at any given time. The system needs a single underlying data model for handling any instrument type that may be added in the future. At any point in time, markets and the technical routes to markets may be in a different status and that will affect the automated decision on where to execute. An effective smart order routing system will reject opportunities that aren t appropriate, given the user s execution policies or strategy, and the audit trail needs to explain why and what prices and volumes were available at the time of trade. Trading activity requires a full event log, including lining up the order handling and trading events with market prices and volume for all instruments that are considered fungible, across all venues that are being considered for the lifespan of the order. This is not a trivial data record and storage exercise. Gearing Up for a Multi-Asset Future The ability to handle multiple asset classes from a single technology platform, or indeed single trader screen, may not be a top priority for many in today s marketplace. It is almost certain, however, to become a more widespread requirement for at least some types of institution. As such, it s important that any trading infrastructure has a single underlying data model for handling a broad range of instrument types. Today, the industry is addressing multi-markets for European cash equities in the post-mifid landscape. It is plausible that other asset classes such as exchange-traded derivatives will in the future require the same set of technology adaptations discussed in this paper. Hence, whatever technical solution is deployed for multi-market trading of equities must be similarly transferable to other asset classes as appropriate. This approach essentially ensures future-proofing of the trading platform, extending the shelf life and ultimately return on investment in a high-performance trading 10
infrastructure. Only by taking an open approach to future capabilities can firms be sure that their trading systems will be capable of handling emerging, unpredicted requirements. Fidessa It s Easy When You Know How Fidessa believes the trend toward liquidity fragmentation will gather pace as a number of new ventures launch new regulated markets, MTFs and newly formalised dark pools. As advanced ways of accessing and trading on the new venues mature, Fidessa believes that its integrated Fidessa platform is best placed to leverage the rapidly changing markets. The Fidessa Intelligent Liquidity Access (ILA) strategy has multiple development streams that will evolve the Fidessa product set in line with the market as it develops in response to the new regulatory environment. ILA is closely coupled with the Fidessa Compliance Suite and the Fidessa Advanced Trading Tools strategy, whereby Program Trading, List Management, Wave Trading, Pairs Trading and Algorithmic Trading (Fidessa BlueBox) will be able to seamlessly integrate and leverage new functions such as Fidessa Smart Order Routing, which is the core technology of ILA. Underpinning the entire strategy is Fidessa s continued investment in performance and latency optimisation. Fidessa believes the changes in the market require a significant commitment from market participants in order to access new venues and employ the technology required to interact with them effectively. Fidessa shares that commitment and acknowledges that the marketplace is only at the beginning of what will prove to be a revolution in European equity trading. Fidessa Intelligent Liquidity Access As part of Fidessa s global Intelligent Liquidity Access strategy, and leveraging the experience and success of Fidessa Montage, a market leading smart order routing solution in the US, Fidessa now offers a smart order routing solution for Europe. Fidessa s Smart Order Router delivers a multi-venue execution service fully integrated with Fidessa s leading multi-asset order management system. Coupled with market access to new and existing European venues, including Chi-X, Turquoise and Equiduct, Fidessa s SOR enables firms to optimise execution across Agency, Prop, Program, DMA and Algo trading flows. Key Benefits: Low-latency Smart Order Routing service Fidessa s high performance market access technology Multi-market execution optimising trading across liquidity venues Consolidated tradable multi-market views displaying accessible execution venues Multi-market trade tickers and Time and Sales Full audit capability enabling proof of compliance with execution policies Seamless integration with the Fidessa Compliance Suite 11
Liquidity Discovery in Post-MiFID Europe Intelligent Liquidity Access A New Frontier for Electronic Trading in Europe About Fidessa Fidessa group is a leading supplier of multi-asset trading, market data and global connectivity solutions for both the buy-side and sell-side globally. The Fidessa suite, used by 85% of tier-one, global equity brokers, provides sophisticated trading, market data, order management and execution capabilities to all tiers of the sell-side. The Fidessa LatentZero suite provides the buy-side with comprehensive portfolio analysis, real-time P&L, what-if analysis, investment compliance, order and execution management, and post trade processing tools, across all asset classes. Fidessa s global network links over 1,800 buy-sides and 310 brokers across 100 markets worldwide. Fidessa group serves over 22,000 users at around 600 clients globally. Contact One Old Jewry, London EC2R 8DN T: +44 (0) 20 7105 1000 F: +44 (0) 20 7105 1001 E: info@fidessa.com 12 An industry briefing prepared for Skyler by A-TEAMGROUP