Gill Wadsworth looks at the volatility of last year and the reverberations of current market conditions.
Choppy would be something of an understatement to describe trading conditions on global stock markets in 2022.
As a result of spiralling inflation and interest-rate hikes by the Federal Reserve, traders endured the sixth most volatile year for global stock markets since the Great Depression, with volatility in the S&P 500 Index more than double the 10-year historical average from 2012-2021.
According to the CBOE Volatility Index (VIX), 47% of trading days in 2022 had swings of + or -1%; the highest level since 2009.
At the same time, liquidity drained out of the markets creating dire trading conditions.
Yet crisis, like necessity, is the mother of invention and the challenging conditions of last year have forced financial companies on the front line to get creative.
As Sylvain Thieullent, CEO of trading solutions firm Horizon, notes, “As volatility returns, all market participants need to up their game in terms of efficiently processing the information flowing through their trading pipes.”
Stopping slippage
Managing slippage – the difference between the asking price and the price paid – is a particular problem for traders in such volatile conditions.
Data published by Bloomberg Trade Cost Analysis (BTCA) aggregated from over 350 buyside clients, measuring effective executions against the mid-price at the time, finds significantly worse slippage in highly volatile equity markets, as traders struggle to source liquidity near the mid-price.
The BTCA Peer Benchmark accumulates all trading-cost observations reported weekly by the 350 buyside firms on a rolling three-month average basis, to represent cumulative industry trading costs.
The benchmark, in which more negative data indicate worse execution quality, reports an average slippage of -22.9 basis points across all weekly observations in the most volatile equities. Low and medium cohorts based on an average 20-day volatility, recognised execution slippage of -9.2 and -14.6 bps respectively, averaged over 49 weekly observations in 2022.
“Volatility can be a good or a bad thing depending on your trading and hedging strategies, but it often leads to more instances of slippage as well as increased cost of slippage, ” says Shantanu Goyal, head of product for the sellside operating management system and middle office at Broadridge.
He adds, “To reduce slippage in volatile markets, trading platforms need to provide traders with the ability to act fast, be efficient, and quickly surface relevant analytical and order data. For traders the objective is all about optimising the execution process in real-time.”
This observation implies traders need a robust combination of low-touch trading – which has become far more prevalent as firms move to automate – with competent high-touch teams.
Goyal says, “Both low- and high-touch traders are looking for similar things and in several places, workflows are converging into hybrid ‘mid-touch’. Improved analytics is helping this move by enabling better automation.”
However, he says it is unlikely we’ll get to 100% automation, arguing there is “always a role for humans because a smart, educated trader will have an edge over a computer or artificial intelligence model in more complex situations”.
Goyal says a platform’s objective should be a hybrid approach, which introduces machine learning and creates decision support frameworks “to harmonise, interpret and aggregate analytical data, and surface actionable recommendations allowing for focused exception management”.
One direction of travel
Thieullent says there can only be one direction of travel for both high- and low-touch desks as the regulatory demands and cost reduction push them towards greater automation.
“Market regulation and cost reduction will unquestionably lead to further changes in the trading landscape and trading patterns. This will drive greater automation of order and trade flow – transforming the function of high-touch trading desks as a result,” Thieullent says.
The global algorithmic trading market size was valued at USD 15.55 billion in 2021 and is expected to expand at a compound annual growth rate (CAGR) of 12.2% from 2022 to 2030
Jason LeDell, director, product management at TORA, an order, execution and portfolio management trading system with transaction cost analysis, says the buyside can trade internally – cross-trading – to tackle illiquid and volatile markets, but this too requires more automation.
LeDell says: “A cross can finish a portion of or the entire order without touching the market at all, rendering both irrelevant. That is, a cross eliminates impact from low liquidity at the same time as removing the uncertainty in price that comes from volatility.”
He adds, “High-touch desks have gone ‘higher tech’ in recent years trying to offer easier access to crossing with actionable indications of interest (IOIs). That is, telling the buyside what positions they would be willing to take from them, and allowing them to cross against those IOIs without necessarily needing to involve the high-touch trader at all.”
Meanwhile on the low-touch desks, LeDell highlights cost constraints, in addition to bigger trading workloads, as motivators to diversify into the high-touch space.
“Low touch desks, faced with lower and lower commission rates, higher volumes, and fewer opportunities for interaction with the buyside trader, have begun to offer high-touch services such as crossing from the low-touch desk as a way to differentiate themselves and attempt to win more business,” he says.
Improved analytics
Irrespective of whether a desk is low- or high-touch, Goyal says they all are crying out for more support with analytics.
“High touch traders are looking for more automation, low-touch traders are looking for support of more complex trading workflows, both are looking for integrated analytics. A feature which in the past used to be relevant for high-touch might now also be needed in low-touch and vice versa,” he says.
In the summer of 2022, Coalition Greenwich surveyed more than 100 portfolio managers, traders and analysts from across North America, Europe and Asia-Pacific, and found that more than three-quarters (77%) employ a mix of fundamental and quantitative investment methodologies and want better data analysis tools.
According to Goyal this means vendors must rethink their old operating models. “They must experiment more and become more agile in their ability to respond to customers and rivals. This is where I think the biggest challenges lie ahead,” he says.
Improving and updating processes could also be necessary from a regulatory as well as a competitive angle.
Last October the International Monetary Fund (IMF) hinted that the challenges experienced in the mutual fund market last year, although largely felt in fixed income, could result in policy changes.
“Policymakers should also consider tighter monitoring of liquidity management practices by supervisors and requiring additional disclosures by open-end funds to better assess vulnerabilities. Furthermore, encouraging more trading through central clearinghouses and making bond trades more transparent could help boost liquidity. These actions would reduce risks from liquidity mismatches in open-end funds and make markets more robust in times of stress,” the IMF stated.
Ongoing automation will likely be the focus for both high- and low-touch trading desks, but alongside that there will be demand for improved analytics which will satisfy regulators and investors that traders have achieved best execution even in the most trying of circumstances.
