Increasing transparency in trading.

John Kelly, chief operating officer at Liquidnet.

The growth of electronic trading has provided many benefits to equity investors by creating new market efficiencies and reducing trading costs. But it has also led to a complex web of venues, liquidity types, and trading strategies that have contributed to a loss of confidence among investors globally. It is in the interest of institutional trading firms and venues to work with regulators to restore confidence and clarity to the global market structure. Indeed, the industry should take the initiative without waiting for regulatory action. One place to start is transparency and control over liquidity interactions and use of customer information.

Since the beginning of regulated markets, institutional investors have needed mechanisms to trade their large blocks away from the “open outcry” of the exchange floor. These institutions – that manage billions of dollars of pension and mutual fund assets on behalf of millions of investors and often trading in block sizes exceeding $1million – still need to be matched away from the retail market so as not to cause price volatility for the rest of the market and trigger adverse price movements.

With the digitization and liberalization of the financial markets, institutions now have a multitude of trading venues in which to trade. However, each of these venues caters to different, and sometimes contrasting, trading needs. And, while some platforms serve their original intent of providing institutions with a venue to trade large blocks, most have become destinations for algorithms that slice blocks into pieces which are indistinguishable from the trades found in the displayed world of the exchanges. The highly competitive, complex, and interconnected market structure results in block orders being transformed into small orders that move quickly from one venue to another before eventually executing. This results in information leakage, adverse price movement, and an erosion of fund performance. When large institutional investors have big investment ideas, they need to mitigate these risks in order to protect the performance of the fund.

Market fragmentation has also presented challenges to regulators in defining the types of transparency that are – or are not – beneficial to the overall market structure. It is difficult for regulators to implement “level playing field” rules common to all participants and venues while giving consideration to the large number, variety, and co-dependency of trading venues. In such an environment, regulation could easily become a web of micro-managing rules that impede efficiency rather than stand as broad and powerful principles that enhance transparency and improve market structure.

For institutional investors – who have the greatest need for market transparency – the complexity of today’s market structure itself has resulted in challenges in defining and standardizing transparency across different business models. Regulators want greater transparency over the marketplace, which enables a robust and well-functioning market. However, in their quest to increase transparency in European markets, regulators and policy makers have, with their revisions to the Markets in Financial Instruments Directive (MiFID II), potentially created more opacity by proposing volume caps on dark trading. Dark trading reduces slippage costs and is an essential tool in a trader’s arsenal to achieve best execution.

By forcing trading away from these venues, the regulators believe this will direct flow onto the lit markets. No doubt some will, but potentially flow will move more to OTC activity, which will decrease not increase transparency. The technical details in terms of how this will be implemented are currently in progress through ESMA’s technical trialogue discussions but without a consolidated tape, it is difficult to understand how this will work in practice, in the best interests of all market participants.

On the flipside, we have seen some examples of regulators establishing sound principles that strike the right balance between individual participant protection and fostering broader market transparency and efficiency. One example is FINRA’s new reporting standards for venue trading volumes that includes an appropriate delay of two to four weeks, depending on the underlying liquidity available for a particular stock in the US. Regulators in Canada and Australia have been successful in their efforts to improve the quality of dark pools by implementing rules that govern trade size and establish price improvement requirements for dark trading.

Every trading venue is different. The operators of each trading venue are not only best placed to understand individual customer needs and how they interact with liquidity and the various trading technology solutions, but these venues also have a responsibility to their clients to communicate this. One way forward is for the venues to develop tools that give customers ultimate control over how markets are accessed and how their data is managed and utilized.

We recently launched “Transparency Controls”, a simple web-based interface that provides clients with the ability to set their preferences for interacting with different types of liquidity and the different purposes for which we may use their data to create opportunities to trade. The options are detailed and the system sets preferences in real time providing added control and transparency to our platform.

Through the new Transparency Controls, Liquidnet discloses to Members all sources of liquidity with which they can interact and all services and products that use their trading data. Members are required to opt-in to interact with sources of liquidity outside of our core offering and to opt-in to any service or product that accesses predetermined types of data. In utilizing trading data, Liquidnet will never reveal trading parties’ names or attributes. In addition, Members will benefit from existing or new value-added products or services if they have opted-in to allowing that product or service to access the firm’s relevant data.

We believe this new level of transparency and control goes beyond existing industry standards and addresses the concerns of the institutional investor community as well as regulators.

Still, the industry needs to do more. There needs to be an industry-wide focus on protecting and respecting client information. Trading venues need to be responsible guardians of what is, essentially, proprietary information. They should have clear and transparent principles on how they interact with venues, liquidity, and how their information is used. Importantly, they should give their clients complete control over these parameters through simple, user-friendly tools. Institutions have every reason to expect this, and trading venues have every reason to provide it as a matter of good business practice rather than simply the result of regulator pressure.

Both regulators and market participants crave a new level of trust and transparency in the markets. Trading venues themselves must take a more active role in creating it.