Equity Trading Update: Relationships, Liquidity and IOIs (by Ivy Schmerken, FlexTrade)
Equity Trading Challenges
With stricter regulations, capital constraints and technology costs impacting the sell side, large brokers are rationing their services and this trend is being felt on equity trading desks.
Brokers are catering to the biggest institutions, while medium and small asset managers feel neglected, according to a recent TabbFORUM webinar based on the firm’s 12th annual Institutional Equity Trading Study on liquidity and other trends in U.S. equity trading.
“The industry is being squeezed by regulations, competition and certainly technology,” said Tabb Group founder and CEO Larry Tabb.
Calling this a “pretty challenging environment,” Tabb suggested that the medium tier of investment firms was being squeezed the most, but that relationships were very important to the buy side.
Tabb analyst Valerie Bogard said senior coverage has been taken away from some of the medium size asset managers. Where some firms once had two people covering the account, they now have one person who is more junior and has less time to spend on communications and different trading strategies.
The massive shift from active to passive investing based on tracking stock indexes and ETFs is also an issue reverberating across the industry. Passive investing based on tracking stock indexes involves less trading and puts pressure on commissions. With the passive channel adding up to $3.3trillion of assets and still growing, Tabb said that the buy side sees this and ETFs as a significant issue. The buy side is transferring that pressure to the sell side and other partners, he noted. “It’s virtually impacting everyone in the value chain,” said Tabb.
Meanwhile, the buy side is shifting its focus to liquidity and away from research, a trend that reflects commission pressures and awareness of the MiFID II research unbundling rules. “Liquidity is Job No. 1 for the buy-side trader,” said Tabb.
Based on interviews with 100 head traders at asset management firms in 2015 and 2016, including 71 long only and 29 hedge funds, the Tabb study covered issues such as order flow allocation, liquidity, algorithms, indications of interest and market structure. Our analysts saw a significant shift year over year in the importance of liquidity to the buy-side trader, said Tabb.
However, buy-side traders are less interested in non-execution services such as research and corporate access than they are in liquidity, said Tabb, citing the potential impact of MiFID II regulations requiring the unbundling of research as a possible reason.
Part of the commission pool that is allocated to proprietary research has declined by 15% from 2014 to 2015, according to Tabb’s research. Sell-side firms that want to catch the attention of the buy side should not necessarily invest in research, said Tabb.
That said, Tabb interviewed head traders, as opposed to portfolio managers, who select securities and might have had a different view. “The PM still thinks that research is important,” emphasized Bogard during the webinar.
Shifting Broker Lists
While the sell side is under pressure from regulations, liquidity, and pricing, Tabb said the buy side is shifting its broker lists as well.
More than half of the buy side in Tabb’s study indicated they are shifting their broker lists the most, while 45% were not. Sixty-four percent of large buy-side firms said their broker lists were shifting, versus 54% of medium and 40% of small firms.
“The largest asset managers have the ability to put more pressure on their brokers and shift around,” observed Bogard in a follow up interview.
At the same time, buy-side firms are allocating their order flow away from the high-touch desk toward direct market access (DMA) and algorithms as a mechanism for balancing their commission pools.
According to Tabb’s US Institutional Equity Trading study there has been a three percent jump in flows moving to DMA/algorithms from long-only asset managers, and a two percent move on the hedge fund side.
In moving order flow to low-touch desks, asset managers are trying to keep their average blended rates stable, said Bogard.
Overall, the blended rate commission structure was 2.19 to 2.22 cents per share. Over a five-year period, the blended rate was roughly consistent around 2.2 cents per share. Rates on high-touch desks ticked up 5 mils and down a couple of mils on the lower-touch DMA flow, noted Tabb.
Though the commission pool has been “pretty consistent” year-over-year, rising from $10.3 billion to $10.5 billion in 2015, most buy-side respondents expect the commission pool to decline in 2016. Based on interviews in the first quarter, hedge-fund traders expect the pool to drop by 4%, while those with long-only firms said commissions would go down by about 1.7%. Given the lack of volatility this year, Tabb estimates that commissions could shrink by about 3%. Higher commission rates on sales desks increasing by 1.5% are pushing traders toward algos and DMA where rates have fallen below 1%.
Driving Order Flow
However, liquidity and execution quality is still the main driver for where the buy side sends it order flow. In 2015, 65% of respondents said that liquidity and execution quality are what drive their order flow, while 51% said the same in 2014.
In terms of algorithmic trading, the buy side is always looking for good performance and customization parameters, said Bogard. Increasingly, the buy side is seeking more transparency into algorithms and clear routing logic. Both the SEC’s Reg ATS looking specifically at dark pools to get more clarity around matching, and the SEC’s disclosure rules on providing more standardized data about order routing, are for the buy side to consume, said Bogard.
Sourcing block liquidity is still very important for the buy side.
Tabb found that block trading —defined as 10,000 shares — rose 2% form 17% to 19% of asset managers’ total flow. But where firms go for liquidity differs by size. While larger firms are leveraging their relationships on cash desks to get block liquidity, medium and smaller firms tend to go to the block crossing networks, like Liquidnet and BIDS Trading.
Response to IOIs Plummets
Another interesting finding is that buy-side firms are responding less to indications of interest (IOIs) and actionable IOIs. For 63% of buy-side firms, less than 10% of their trading flow are due to responding to an IOI, said Bogard. Even among larger buy-side firms, 17 % of large firms attribute none of their flow as responding to an IOI. “The buy side is emphasizing liquidity, yet they are not turning to IOIs a much,” said Bogard. Why?
According to Bogard, one possible reason is that the buy side may see IOIs as spamming them, and not necessarily introducing them to natural liquidity. In the cases of actionable IOIs, this varies by size. Larger buy-side firms are likely to use actionable IOIs, but half of large buy-side firms indicated they are not,
According to Tabb, the drop off in IOI usage relates to the brokers rationing the actionable IOIs by size of firm. “The brokers are sending their actionable IOIs to the larger guys, and if they don’t get taken they are sent to the medium guys,” and so on. By the time these actionable IOIs get to the smaller firms, “they have been picked over,’ said Tabb.
Some of the top providers of IOIs are Citi, Credit Suisse and Barclays, said Bogard. IOIs provide the opportunity to do a block quickly if a buy-side firm is active in the name. Also, some of the active IOIs can be used for algorithms, while another factor is technology.
“One of the trends around actionable IOIs is you should be able to hit them electronically,” said Bogard. Yet, there are a high percentage of firms that still call their broker either because they don’t have the functionality or prefer to get more color around the block trade. Not all asset managers have the functionality set up on their OMS or EMS, and that may be a reason why they are reluctant, said Bogard.
Despite the declining responsiveness to IOIs, buy-side traders are taking increased control over their executions through algorithms, DMA and crossing networks.
“The buy side has greater discretion on execution than they ever had in the past,” said Tabb. But if brokers continue to ration their services toward their largest, most profitable clients, medium and small buy-side firms could look for other brokers to fill the gap, which could spell opportunity for mid-tier brokers.
While relationships on the buy and sell side continue to evolve, there appears to be tension over the buy side wanting more coverage and the sell side measuring and managing their resources vs. revenues. It remains to be seen how this issue will shake out in 2016.
There are many variables such as the shift from active to passive investing and the influence of MiFID II on unbundling research that are worth watching in 2017.
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