By Dmitry Rakhlin, Greg Lee, Steve Grob, Ned Philips, Glenn Lesko
AllianceBernstein’s Global Head of Quantitative Trading, Dmitry Rakhlin, discusses the problem of fragmentation and what makes a good aggregator, along with Ned Phillips of Chi-East, Greg Lee of Deutsche Bank, Steve Grob of Fidessa and Instinet’s Glenn Lesko.
Dmitry Rakhlin, AllianceBernstein
How does aggregation improve trading and best execution?
Institutional traders usually demand (remove) liquidity from the markets, which in turn creates market impact. Being able to interact with aggregated liquidity (e.g. all available liquidity) lowers this market impact. Aggregated liquidity also gives a trader the ability to interact with many more liquidity sources randomizing the way the liquidity is taken from the market. This decreases the amount of information leakage and protects the trade from being exploited by predatory strategies.
Does aggregation spell the end of fragmented markets?
No. The US equity market is highly fragmented, yet all liquidity centers are interconnected, which allows traders to build various aggregator strategies. No doubt, there is cost and complexity associated with this. Fragmentation also introduces so called latency arbitrage and a potential increase in information leakage (the information leakage can be drastically reduced by using appropriate trading strategies).
The positive aspect of fragmentation is that it creates rich market microstructure (traditional exchanges and exchanges with inverted fee structures, block crossing networks, auctions, conditional order types, aggregators of retail liquidity, etc.). These choices give the buy-side the ability to match their investment strategies to the appropriate liquidity sources and ultimately benefit by being able to trade more nimbly and at lower cost.
From your perspective, is aggregation about greater access to liquidity or reducing trading costs?
Both.
Ned Philips, Chi-East
How does aggregation improve trading and best execution?
A good aggregator brings order to fragmented markets by concentrating order flows, and liquidity, from a large number of matching venues. It is a tool that allows all participants to access multiple venues from one easily accessible point, reducing the technology costs and other difficulties involved in monitoring different trading venues.
Does aggregation spell the end of fragmented markets?
No. Even if one good aggregator attracts a majority of trading flows, it would not represent a throw-back to a single exchange monopoly. Aggregators are there to make the process of using multiple markets easier and more efficient and can only exist as long as participants have a choice of matching venues.
What are the risks inherent in aggregation and how can an aggregator ensure improved execution?
Theoretically there is a risk that an aggregator will be so successful that it monopolises the market but competition and risk management would keep things in check.
An aggregator ensures improved execution by concentrating liquidity which reduces spreads and improves execution.
Greg Lee, Deutsche Bank
How does aggregation improve trading and best execution?
As markets evolve and become more fragmented, liquidity aggregation has become a core part of the modern broker electronic offering.
Does aggregation spell the end of fragmented markets?
A good aggregator today will leverage both smart order routers and dark aggregation algorithms to access a wide range of liquidity pools to ensure they have access to as many sources of liquidity as possible. Once connectivity to different venues is established products can apply logic to ensure execution performance is improved from using alternative sources of liquidity. The best of these products rely on sophisticated anti-gaming protection, easy to use interfaces and transparency of where liquidity was found.
How does aggregation augment the services offered by brokers to their buy-side clients?
Anti-gaming or other protection methods are key to making a good aggregator. Simple features such as minimum quantity settings can help to avoid people fishing for your order. More advanced products will use real time models to adjust limits and venue selection to ensure no execution is done at an unfavorable price.
While technology is essential to be a good aggregator, being a trusted partner who is transparent about the methodology and source of liquidity is still the key part of any trading relationship.
Steve Grob, Fidessa
How does aggregation improve trading and best execution?
The process of aggregation is all about a broker trying to get to the front of the queue for buy-side order flow. The basic idea is for a broker to offer to sweep or aggregate other sources of dark liquidity in the event that a match cannot be found in that first broker’s pool. In this way the broker takes responsibility for scanning and executing a client order across his and his competitor’s liquidity. In theory this should offer better execution by automating the process of interrogating sources of dark liquidity.
Does aggregation spell the end of fragmented markets?
No because market forces and competition will always mean that multiple sources of liquidity reside across the lit dark spectrum. The irony is that whilst regulators are introducing competition and fragmenting markets, firms like Fidessa are providing the tools to glue it all back together again.
What are the risks inherent in aggregation and how can an aggregator ensure improved execution?/What technology is required?
Naturally there are some signalling risks if every broker is trying to aggregate each other’s liquidity, as a client order or a portion of it may find that it runs into itself through another broker’s aggregation service. On top of this there is an inherent risk around information leakage as orders are broken up and sent across multiple pools of liquidity. These risks need to be managed by effective use of technology. The starting point though is forming a realistic view of the potential pools available for any given client instruction. This needs to be based upon historic analysis of how different sized and shaped orders have performed against different dark pools and resting times.
On top of this, a buy side may wish to avoid a particular source of liquidity and so this will need to be reflected in the routing tables of the aggregating broker as well. A number of different algos are required to ping each dark pool and then adjust subsequent activity according to the success they have had. So in many cases after an initial sweep an algo will then revisit those sources that were successful whilst “listening” to other destinations and making adjustments accordingly.
Glenn Lesko, Instinet
How does aggregation improve trading and best execution?
Aggregation enables clients to access as many points of liquidity as possible. This is very important because, increasingly, accessing all pools is a staple of best execution mandates from regulators, clients and brokers. Additionally many dark pools only trade at midpoints, so there are also significant spread savings that can be attained.
Does aggregation spell the end of fragmented markets?
Aggregation is a solution for fragmented markets. It resolves some of the issues that people see as negative about fragmentation, and allows clients to react to fragmented markets. In and of itself, it does not impact the physical fragmentation of markets, but it does give institutions the tools to make the issues of fragmentation go away.
What is the profile of a firm who wants their flow to be aggregated and what benefits do operators of pools and ATS’s/MTF’s receive from participating in aggregation?
It’s the really big, long-only fund groups who tend to hold positions that are very large relative to volume. The benefits are that the users are getting high-quality, nutritious long-term investment block flow.
