Buy-side firms are employing a combination of high- and low-touch techniques to tap liquidity that has fragmented across dozens of trading venues, including exchanges, alternative trading systems and dark pools.

“One of the considerations for choice of venue is the need for research,” said Craig Jensen, principal and head trader at Armstrong Shaw Associates, a Connecticut-based large/mid-cap domestic equity manager with $2.5 billion in assets under management.

“Bulge brackets get a lot of flow from people working trades through algorithms and we have access to most algorithms,” he said. “I have contacts on the Street that tend to be on the other side of a trade, which helps in finding a block. If I need to buy a significant number of shares I can make calls to people I trust to find liquidity.”

Traders are increasingly interested in executing block trades to improve execution quality; however, they are growing concerned over execution opaqueness, information leakage and liquidity control.

Low Volumes, High Fragmentation
High fragmentation and low volume in the equities markets creates significant challenges for buy-side traders to find good liquidity and fulfill best execution obligations. In addition, given their size and depending on other market factors, block trades can affect the price of a security.

Fidelity Capital Markets, the institutional trading division of Fidelity Investments, late last year launched Block Liquidity Opportunity Cross, which goes by the acronym Blox, a new execution venue focusing on block trades, which was an extension of the company’s alternative trading system (ATS), CrossStream.

“Blox, the institutional segment of our ATS, offers what we consider a safe venue to interact with a robust source of retail and channel order flow that we possess,” said John Donahue, senior vice-president and head of equity trading at Fidelity Capital Markets. “It provides them with the opportunity to cross with other participants who look like them.”

The venue offers institutional investors the ability to interact with orders from Fidelity’s retail brokerage business—34% of the shares coming from its retail brokerage business are considered block size.

This allows Fidelity’s institutional clients to leverage the liquidity of Fidelity’s retail brokerage business, which trades approximately 535 million shares on average per day, as well as other firms whose order flow is handled by Fidelity.

“The institutional segment of CrossStream Blox is composed of ‘40 Act funds, pensions and other institutional investors,” said Donahue. “It’s a pristine venue within our ATS that allows clients to interact with non-toxic liquidity.”

Going With the Flow
Changes in the equity markets themselves have been brought about by regulatory, economic and technological forces.

On the regulatory front, Regulation NMS in the U.S and the original Markets in Financial Instruments Directive (MiFID) have fostered the growth of trading venues with dozens of exchanges, ATSs, multilateral trading facilities (MTFs), dark pools and broker crossing networks all competing for the same business.

While this has promoted greater choice for investors, and greater competition among trading venues, it’s also led to fragmentation of liquidity, which in turn has put the onus on firms to develop algorithms that can sniff out liquidity on lit and non-displayed venues.

“Among our buy-side customers, we are hearing that they’re experiencing a challenge in finding liquidity, especially in large blocks,” said Steve Grob, director of group strategy at Fidessa, a trading technology firm. “The first factor is fragmentation, both lit and dark. The second factor is lower volumes overall, which means that any block stands out so people are concerned about information leakage. The third factor is that high-frequency trading has shrunk average trade sizes, which adds another dimension to the problem.”

Noted Jensen of Armstrong Shaw: “When adding or reducing an existing position, trades can be as small as a few hundred thousand shares. If we’re taking a new position or eliminating an existing one, however, it could be two or three million shares.”

The fragmentation question, though, is about more than just dark pools.

“There are 13 public exchanges in the U.S.,” said Richard Johnson, head of U.S. quantitative electronic services at Societe Generale. “Over 95% of order flow is controlled by four operators. Exchanges will offer some variant or differentiate to attract flow. You have inverted models (taker-maker), although most are the classic maker-taker model. Some are price size versus price time priority.”

Societe Generale provides access to 38 electronic exchanges including ATSs and MTFs, as ATSs are known in Europe, through its quantitative electronic services (QES) unit.

“One of the main themes for a number of years has been fragmentation of markets, and the buy side needs to understand how to deal with it,” said Johnson. “There are 40 different dark pools out there. We connect to around 15, which is the bulk of dark pool liquidity of publicly reporting dark pools. The buy side is asking, what type of liquidity am I getting and is it helping me satisfy my mandates?”

AlphaY, SocGen’s internal liquidity pool, “captures agency flow generated from the cash franchise, but more significantly flows from client-driven risk businesses and delta hedging activities in derivatives”, said Johnson. “As a result, AlphaY has been built with an emphasis on leveraging this internal liquidity over which QES has complete control,” he added.