Global Equity Trading: On the Cusp of Automation Apr 03, 2006 URL: http://www.advancedtrading.com/showArticle.jhtml?articleID=184425843
While capital is global, trading is local. Regulation, taxes, market structure, exchanges, liquidity providers, connectivity, vendors and local participants shape the color, trading and mechanics of each market.
While most traders cite finding liquidity as their chief challenge, the way liquidity is provisioned and located is very different depending on the market. Some markets are very intermediated, to the point where most volume is matched upstairs; some are transparent, and significant liquidity is exchange-matched. Some markets have greater connectivity and are FIX-compliant, and others use proprietary linkages. All of these factors influence how traders find the other side.
The most significant trend in global trading certainly is the push toward more self-directed trading. While the migration from traditional channels toward low-touch channels still is nascent - only 5 percent to 7 percent of buy-side flow currently is allocated to low-touch channels (i.e., DMA, algorithmic and crossing networks) - brokers have repositioned their models for global use, initiated global marketing efforts to automate the buy side's trading desks and pushed their clients toward low-touch channels.
While the order flow directed toward low-touch channels has been nominal, TABB Group believes that DMA and algorithmic migration will occur fairly quickly (within the next two to three years) as 44 percent of firms voiced a preference to increase the order flow placed through low-touch channels from the current 7 percent (see chart below).
The use of DMA is expected to more than double between 2005 and 2007, reaching 11 percent of order flow, at the expense of phone and FIX usage, which are expected to decrease by more than 15 percent over the same time period (see chart, page 42). Once traders are comfortable with DMA, they likely will progress to algorithms and other advanced execution tools.
Presently, more than 90 percent of all orders are routed via phone or FIX, which are viewed as traditional channels. So while markets in Asia, Europe and Canada have been introduced to advanced execution tools, their use still is considered to be a minor portion of their potential. But there is evidence for future change, as the projected growth of DMA, crossing and algorithms is projected to triple, while reducing the use of traditional channels to 79 percent of order flow by 2007.
What Does This All Mean?
Why do buy-side firms want more direct access? They are moving to advanced execution tools mostly for execution control and efficiency, and to reduce market impact. It is not that current intermediated brokerage does not suit the buy side; it is that buy-side firms would like choice. For certain orders, brokers have or know where to find liquidity, and that is fine. However, for orders with available and directly accessible liquidity, why not take more control, automate the execution, reduce impact and better align the execution with the order?
As this occurs, the migration toward low-touch trading will mean significant changes to the business. The focus will be placed squarely on connectivity. As markets grow more global, traders increasingly will turn to electronic trading mechanisms in their quest for best execution. The lack of connectivity among trading counterparties and systems now is a significant point of dissatisfaction among global investment managers. However, without effective connections from their OMSs to their brokers, DMA platforms, algorithmic trading systems and TCR tools, their ability to progress to a more-automated market will be severely inhibited.
This also will have an impact on exchanges and data providers. Exchanges will need to become more transparent, providing greater levels of connectivity, data and access as more brokers and buy-side firms will want higher-speed and cleaner data. If the U.S. is any model, it also will mean a reduction in trade size, an increase in data velocity and messaging rates, and an overall increase in transaction volumes. This will tax the entire industry as everyone involved will need more bandwidth, storage and processing power.
As the global markets turn toward more direct access, the other significant question mark is pricing. While we have not seen significant price discounting in the European, Asian and Canadian markets, as more brokers and vendors look to amortize their advanced execution technology over a wider geography, it will be interesting to see how long the brokers will hold off discounting their direct-access channels. Currently, it does not seem that commissions are playing a significant role in spurring adoption; however, the discount pricing model certainly is a card in brokers' implementation strategy deck.
Since connectivity, integration and retrofitting this technology to each geography and market is a considerable factor in launching a low-touch trading product, we don't see the discounting card being aggressively played in the next year or two. However, once firms have made their investments and built out their platforms, there is nothing like a good price war to jump-start adoption. And in the end, that will have a great impact because the most important factor to the buy-side trader still is getting the trade done at the most economical cost.
So where do we see this market headed? TABB Group believes that Europe will lead the advanced execution adoption ahead of both Asia and Canada. European exchanges already have begun the consolidation process, marked by the pending acquisition of the LSE, the multiple exchanges run by OM, the consolidated exchanges owned by EuroNext and the Deutsche Bourse.
We project that Asia will follow Europe. While FIX adoption in Asia is more advanced than Europe and Canada, the Asian markets are more heterogeneous, less integrated and less consolidated, which will make it more difficult for brokers and vendors to develop the differentiated technologies to play in each market.
Canada will be the laggard as most of the Canadian flow is intermediated by the limited number of large Canadian brokers/banks. While this may seem like a disadvantage, many Canadian buy-side firms feel that, while it may be a bit more expensive to trade in Canada, liquidity is easier to find.
How Will the Markets Adapt?
TABB Group expects to see the traditional sell-side institutions penetrate the global markets by differentiating their technological capabilities. The most-successful brokers will gain share not only by tailoring their electronic tools to the particular markets, but, more important, by effectively integrating these tools into a readily usable suite of products. With improved technological capabilities, the enhanced quality of the tools will accelerate the routing of order flow through them.
Recognizing the opportunities presented by the availability of automation, global markets will be driven to address their market structure to accommodate the improved efficiency. With a goal of a more-integrated global execution platform, the structure and regulatory oversight of the markets will need to adjust to accommodate the impending transformation.
Although we are on the path to a simpler, more-direct trading environment, that path is littered with obstacles that likely will make the transformation more difficult before it gets easier. Change and transition never is easy - only inevitable.
Our Analyst
Robert Iati joined TABB Group as a partner in charge of research in December 2004, following seven years with TowerGroup, where he was the research director of the securities and capital markets practice. He has extensive experience in capital markets technology, covering areas of securities operations training, planning and development, and IT strategy and implementation for nearly 20 years.