The new (and renewed) liquidity sources
The valuable liquidity sources for the new era are fourfold:
1. Venues and brokers that offer Conditional Order Types
2. End Of Day Auctions
3. Frequent Batch Auctions
4. Reformed Protocol for Broker “Indications of Interest” (IOIs)
Conditional Order Types
Liquidnet, POSIT have gained significant institutional market share over the last 10 years (Liquidnet celebrates its 15th birthday this year). Turquoise BDS too has made excellent strides in the last two years and these three are set to be joined by BIDS (backed by BATS in Europe) as a significant force. These mechanisms allow for large privately negotiated trades to be negotiated away from the CLOB. These can be viewed as forming the basis for “Dark Trading 2.0” after the failure of the first version and they will all thrive under the proposed MiFID II pre-trade transparency rules.
End of day auctions
Institutional dealers are often pilloried by the sell-side for migrating their flow to the closing auction. But the biggest challenge for institutional dealers is not intra-day alpha generation but actually limiting overall impact. If up to 15% of the day’s volume is transacted in the close and an institution can participate at more than 15% of that expected auction volume without moving the price (vs 3% for the CLOB), then the auction provides a good source of liquidity.
Development of frequent batch auctions
Whilst conditional order types look set to meet the needs of those trading in the dark, the frequent batch auction solution looks set to provide a lower impact solution for lit trading. Information leakage and market manipulation are likely to be far reduced compared to the CLOB. National exchanges such as the Korean stock market have already fully adopted the model, Turquoise Uncross (strictly a dark venue) has been extremely successful and BATS is rolling out its own version and the signs are encouraging. The US is focusing on “speed bumps” (invented by IEX) for the CLOB currently, when batch auctions already perform the same function but in a more robust and transparent manner.
Greater use of reformed broker IOIs.
Those on the IA/AFME working group should be applauded for safeguarding the future of this uniquely valuable and significantly European facility. In recent years the very existence of IOI’s was threatened by the proliferation of falsified orders. Institutions neither responded to nor submitted an indication because they knew they were giving away significant information with little chance of trading. The new industry protocol will mean greater hit rates and lower reversion.
The future is bright
Challenges clearly remain and institutional investors are still finding it much more difficult to source liquidity than was the case 10 years ago when solutions were amply provided by the investment banks. Over the past 18 months however the outlook has started to improve. Thanks to the innovation, courage and determination of venues, brokers and institutional investors, answers are being found; the old regime of failed dark pools, febrile limit order book and disadvantaged market makers is coming to an end. A landscape where low impact agency trading makes its welcome return is slowly emerging.
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Oases Forming On The Liquidity Landscape
