It’s been a funny old year for blocks, with a decline in overall volumes counteracted by a bump in larger size deals. Best Execution speaks to Paul Squires, head of trading for EMEA and APAC equities at Invesco, to learn how the buy side is handling the unusual market conditions.
First things first – why is the market so quiet?
The whole year has been one of waiting for a correction of some sort. People have been relatively bearish on the fundamental macroeconomic backdrop (recession), even though the worst-case scenarios haven’t really played out yet. In fact, equities have been fairly resilient, but the problem is that, certainly for institutional clients, it can create a kind of benign trading range where investors may not have a lot of conviction either way. That uncertainty creates a default of reducing activity unless you buy into the grind higher or continue to believe a correction is imminent.
Another factor is that Q1 is traditionally such a dominant quarter, it’s often the busiest of the year (represented in market volumes, our own turnover and in the investment bank earnings). That didn’t happen this year, and now we’re entering the Summer season which is traditionally quiet, so it’s hard to see any kind of catalyst for a real surge in activity except for a significant and unexpected market move. You never know what’s going to happen and Q4 is often busy too, but right now volatility is very subdued (VIX around 13) and focus is on particular pockets of the market (Semis, cyclicals for example).
Have we seen a decline in block trading, and what tools are you using to find liquidity?
If we look across the market in aggregate, dark trading seems to be down about 16% year-on-year compared to 2022. But within that dark segment, large-in-scale LIS was actually up about 6% year-on-year, so I think there is, actually, still some appetite for institutions to do the larger blocks. However, the sub-LIS trades are not happening so much. We can partially attribute that to the regulatory impact or perhaps some of the platforms focusing less on their dark offering, which has meant they’ve lost market share. But there has also been a notable shift in periodic auctions (PAs), so there might also be an element of substitution.
Sub-LIS dark activity can certainly be done in a periodic auction, and there has been innovation from some venues around their PA offerings.
Where is the innovation in blocks happening?
To be honest, I think there has been a slight lack of innovation in this space recently but there has been ongoing consultation so perhaps we will see something evolve soon. The most significant block channel for us remains via conditional venues indirectly or the direct blotter ‘sweeps’. Our average execution size on those sweep venues is multiple times what we do on dark MTFs (which itself is multiples of that traded on lit venues). Around 5% of all activity is done via the sweep now, so it’s a meaningful amount and the times and liquidity we get there aren’t replicated anywhere else.
What innovations would you like to see – are there problems that still need solving?
One example of a recent innovation is Appital. The original concept of it that interested us was more direct oversight of an equity capital market (ECM)-like process with a relevant universe of trusted members and adopting smart technology for price discovery on very large blocks. Elements of that haven’t materialised yet but it’s early days. It’s hard to create momentum for new offerings – we’ve seen so many great ideas over the years that haven’t quite got off the ground, and it’s very difficult if you don’t get traction almost immediately. Often, people just can’t be bothered to go through the technology changes that are required to onboard a new platform, so they have to be convinced first. You need to see activity on the venue because, although it’s a cliché, volume creates more volume.
What are you looking forward to this year that you think is interesting?
We’ve done a number of ECM deals ourselves in recent years, and I think that the more advanced buy-side dealing desks are increasingly engaging in ECM-type activity – to the extent that some of our peers have dedicated teams now. A workflow is developing where the buy side can talk to an ECM person on behalf of the fund managers, and create a market opportunity where they more directly negotiate prices and hedging opportunities, for example. I think that’s an area that could be developed. For an ECM deal you pay a broker somewhere between 75-125bps. Bear in mind that most buy-side trading desks quibble about 1 or 2bps on execution commission! We were furious when brokers started charging us 12bps to get involved in those secondary placings, because we are generally paying about 5bps of execution commission, so we get uptight just about having to pay the extra 7bps. Then on these ECM deals we’re paying upwards of 75bps? It’s not obvious to me that those elevated rates are justified. Venues have historically tried to replicate the book building process by identifying a select group of institutions who trust each other, and who are prepared to be more transparent about their trading intentions. Now that’s great if it works, but it relies on trust and people proactively showing their interest, and that’s not characteristic for the buy side who are typically wary of showing their hand or are reluctant to trade with a bigger block because there is an inherent fear that they’ll get “run over”.
There are some other interesting things happening a bit more under the radar. One of these is risk pricing – again it’s a very significant execution consideration for us but one where we only have a small group of counterparts. There are probably fewer than five brokers who would consistently commit capital for risk trading, and by the nature of it, they equally will be very selective about who they offer that to. Cultivating that trust and comfort is helped by a frequency to risk enquiries because that familiarity gives them confidence in pricing to you. A lot of the buy side don’t have the inclination or the trading volume to engage with those opportunities – you do need the skillset and the confidence and the capability to manage those relationships. This has been a big focus for us in terms of our own automated execution workflows but there’s also been an expansion of standard offerings to the market (transparency on outsized risk prices, etc), and that’s a positive market enhancement.
What do you think is happening in terms of the regulatory environment for block trading?
It’s marginal for us in a direct sense. We are interested in the principles of what the regulator is trying to achieve but it’s a bigger deal for the brokers and the way they configure their smart order routers, for example. If you look at the conceptual direction of the regulator – dark pools were meant for blocks rather than small clips – perhaps that’s why dark MTF volumes are lower right now, but LIS is higher. Whether it is pre-emptively applied by brokers and venues or the regulator enforces it, the result is the same.
The other important element is SIs (systematic internalisers). Turnover is up 25% year-on-year for SIs. I think they are increasing their reach, and that could be taking away from dark pools and MTF volume. It’s a really interesting liquidity pool and some have been very successful at tapping into the institutional execution flow – there was some scepticism that it would be sustainable, but we’ve been trading with them for some time now and they are dominant in a certain universe of our orders.
Another part of SI activity is the internalisation of flow targeted for the close, which I think is a natural focus. We’re more aware of the underlying execution costs now, which really eat into the margins on the commission rates that we pay our brokers, and fees on the primary exchange close tend to be expensive. We have seen venue competition start to grow and it is a natural place for brokers to start trying to internalise the flow they have with the same execution benchmark – but we still find the mechanism and the workflows somewhat manual. We need to be talking to the providers on the electronic side about how we can make it a more automated process.
But the closing auction activity is up about 16% year-on-year, and that can’t just be more volumes from index funds – the close has about 22% market share, so it’s a big liquidity event.
How important is the human touch when it comes to block trading?
There’s such a strong drive towards automation, and we’ve developed a lot of automation ourselves, but we try to keep it in the right context. There is still tremendous value in human contact, particularly when it comes to high touch. A lot of the buy side talk exclusively to their high touch sales trader for anything that isn’t traded electronically and that is still a very effective contact point for some scenarios. With a small number of providers, though, we will have access to their head of risk or their block trader so that there is closer contact and more focused conversation. If you limit your access to that market intelligence (a lot of which isn’t transcripted via messaging forums) – because you are trying to automate everything – that’s a missed opportunity.
But there is a way to collaborate with brokers to benefit from automation. For example, brokers who may send out average price stops to indicate they can provide outsize liquidity according to a certain risk matrix. That’s helpful pricing information and something that can be tapped into. You can compare that available pricing with your pre-trade estimates and lock in outperformance – or use your estimates to negotiate. This isn’t AI or machine learning but it’s still a pretty strong signal to recommend how you might execute – and over what time horizon – and can build a source of trade history for future signals. The opportunity to de-risk large baskets – even if it means trading outside of the quote – is a key consideration. A lot of buy-side traders are apprehensive of paying outside the spread so they just won’t entertain the idea, but a lot of the time it’s absolutely the right thing to do to optimise an aggregate basket.
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