Shining A Light On Market Structure

With Anthony Godonis, Senior Equity Trader at Aberdeen Asset Management
I don’t think markets are broken, I just think they are very complicated. They’re complicated to the point where we really need to sit back and think about all of the intermediaries within the market, across the 13 exchanges, various pricing models and many dark pools.
There doesn’t appear to be much transparency in terms of understanding just what happens to your order. The recent conversation around IEX is encouraging as it has a lot of people asking the right questions. So, while I don’t think that markets are broken, I do think that they can become a lot more forthcoming in terms of how orders are routed, how algos choose certain venues, and why things are routed the way they are.
This is the first time that brokers find themselves just as frustrated by the lack of transparency as the buy-side, in regard to accessing liquidity. Brokers offer less risk because there is simply less volume available to offer. I think the issue is that they aren’t willing to take risk because they are experiencing the same situation as the buy-side. We would see a million offered in a given stock, but we’d realise that there’s no way to actually get that whole million. So brokers can’t make a market in that stock because they’re continuing to lose money due to the lack of actual available volume showing on the screen. It is the same situation even when we trade electronically. What we see on the bid or offer available, is simply not available when we try to interact with it. It disappears.
Typically the buy-side is not very vocal in terms of what they want to see; the brokers are normally our eyes and ears to the exchanges. But a positive result from this conversation will be unified communication in terms of talking to regulators and exchanges.
In terms of specifics, we have to ask why should some exchanges have inverted pricing models or order types, but not others? Some orders via routers/algos may go ahead and execute on a particular exchange, not necessarily to jump the queue, but to get involved; as they start crossing the spread there are now signals sent out to the market. Without uniform pricing and order types, there doesn’t seem to be a level playing field.
A big part of this inconsistency is driven by Reg NMS. The question is should we rely on brokers to do our routing? I don’t know. I think changing this would alter the relationship between the buy- and sell-side. For instance, if the buy-side starts taking on all the routing on their own, what role would the broker play in terms of helping us execute trades? It becomes about us just using their pipes.
So what is the role of the broker?
There will always be a need for someone to take on risk on both the buy-side and sell-side. I think that if things change to the point where the sell-side knows that they can actually get the published volume that they’re looking at, you might not just see more block trades occurring, but potentially more volume will go back to the exchanges as well. And I don’t think trading on the exchanges is a bad thing; you have much better price discovery there than you do somewhere else.
For instance, on some of the dark pools when there is a lag in time, we have to ask what the best way to measure them is. The more volume that stays in the exchange the better opportunity you’re going to have for larger volume trades. I don’t think that’s a bad thing.
This wider conversation is very encouraging for investors because it has ramifications globally. The US is supposed to be the most efficient market in the world, but this whole high frequency conversation having been exported globally, is affecting every asset class. It’s encouraging to know that there is now a really big focus on it.
What would be on your shopping list to change market structure?
Well, I think a lot of internalisers should attempt to force liquidity back on to the exchanges. I think that would be positive. When you can bring buyers and sellers together in one place, it’s better for price formation, and it’s better for volume. Even if you look at auctions: I don’t know many people that don’t agree with how the auction process works whether it’s countries that have VWAP auctions for 20 minutes or those that just have the Dutch auctions. I don’t necessarily think that’s a bad thing because everyone is on a level playing field. You put in your order, there’s price formation, there’s discussion and you’re not alone. Everyone is included.
A similar situation happens in Brazil, where there are certain parameters that drive an auction. There can be intraday auctions, and when everyone knows what those parameters are, everyone feels like they’re on a level playing field. Admittedly there is only one exchange, but if you trade over a certain amount of the outstanding shares, or the price moves more than a certain percent on a block trade, or if more than a certain percentage of moving volume gets traded; it goes to auction. It could be one minute, two minutes, it could be one day, two days but everyone knows what the rules are. And I think that we should be aiming to get to a point where everyone knows what the rules are explicitly. We have 13 different exchanges with different pricing and different order types. It’s over-complicated. The market is simplifying some of this on its own initiative: there’s been some consolidation amongst exchanges which I think will probably continue, especially if the rules change, which will probably result in more volume going back to the exchanges.
And the buy-side is getting much sharper as to where their money is going?
I think that the most encouraging part of the current situation is that the buy- and sell-side are equally encouraged to find out answers to get a better solution. There are certain aspects of executing trades where there’s a relationship involved and it definitely adds value. In this unique situation, the sell-side brokers are having as much difficulty executing as we are. We are all agreed; things need to be made more transparent and the rules need to be more explicit and less complicated.
The role of the buy-side trader is to execute trades with the least amount of impact possible. When you trade a block, it isn’t all about speed: you have a conversation, you negotiate and come to an understanding of what the price is going to be and why, what the volume is and you put it on the tape and move on.
It’s difficult when there are no blocks to be had; what’s the best answer other than trading the closing auction? You sit there and work something in the pipes which leads to all the noise and leakage from the market.
I don’t know what the best outcome would be, but it’s encouraging to know that it’s not just one buy-side shop or one sell-side shop out there deciding everything.
Whatever the answer is going to be, it’s going to be positive because it’s going to bring a lot of things to light; information, transparency, clarity. I think it will be very good for market structure.