Asset owners are paying a lot more attention to where their money managers execute trades — decisions that have generally been left to the discretion of the managers — and some are considering directing their managers to avoid specific venues.
Conversations among investment executives at pension funds and endowments about banning trading venues has “only just started to happen.” said Monte Tarbox, executive director, investments, for the $11.7 billion defined benefit plan of the National Electrical Benefit Fund, Washington.
Mr. Tarbox said managers' responses to his concerns have varied. “Some are very concerned; others say "commissions and spreads have improved, so we're not going to worry about it.' That's what concerns me. ... High-speed traders are eating somebody's lunch, and it's probably my lunch.”
NEBF is “not quite at that point” where it will direct managers away from trading on certain venues, Mr. Tarbox said. “We're seeing which venues our managers are trading in and if we're getting best execution,” he said. “We're still trying to get a handle on it.”
Interest in trading venues gained in intensity since New York State Attorney General Eric Schneiderman filed suit in June against Barclays PLC, accusing the firm of giving misleading information on its Barclays LX dark pool.
But some industry experts say the increased interest began with the debut of Michael Lewis' book, “Flash Boys.” Also spurring the added scrutiny is the Securities and Exchange Commission's efforts to bring more transparency to dark-pool trading, as well as recent disclosures by dark-pool operators Goldman Sachs Group (GS) Inc., Morgan Stanley (MS), UBS, Deutsche Bank AG and Credit Suisse Group that they're under investigation, either by the SEC or by Mr. Schneiderman's office.
“There's definitely a trend. It's definitely accelerated, in large part because of the publicity around "Flash Boys,'” said Robert Hegarty, former managing director, global head of market structure at Thomson Reuters, Boston, and now an independent consultant. Asset owners “have instructed (money) managers to direct order flows to specific venues, but they're also banning certain venues.”
Investment executives at several pension funds, endowments and sovereign wealth funds contacted for this story would not talk about whether they've directed their money managers to avoid some dark pools, but one who asked not to be identified said he has talked with money managers about not trading in certain dark pools “that have been in the news of late.”
Question of fairness
Dark-pool operator IEX Group Inc., New York — which was thrust into the limelight after its inclusion in “Flash Boys” and has not been named in any investigations — has not seen asset owners directing trades to its venue, said John Ramsay, chief market policy and regulatory officer. But, he added, “We do know of institutional investors that are working with brokers to direct trades to IEX and that their reported experience has been positive.” Mr. Ramsay is a former acting director of the SEC's division of trading and markets.
NEBF's Mr. Tarbox said he's been concerned about the effects of dark-pool manipulation and fairness for the past two years. “I'm concerned that there's real money at stake,” he said. “I'm very concerned about changes in high-speed trading technology and what can result in predatory trading practices. I tell our money managers, "It's costing me money and it's costing you alpha.'”
Barclays' LX pool has seen its trading volume steadily decline, based on data from the Financial Industry Regulatory Authority, Norwalk, Conn.
For the week of July 21, the latest data provided by FINRA, total shares traded on Barclays LX were 87.6 million, down from 94.2 million shares two weeks earlier. Credit Suisse's CROS dark pool has the highest volume for the week of July 21 - 383.5 million shares, up from 372.5 million for the week of July 7, and UBS' UBSA dark pool was second at 306.9 million shares, up from 294 million.
Sources said Barclays' decline was evidence of blocks of trades being directed to other venues, either by asset owners requesting the move or by money managers refusing to trade on Barclays' pools while the firm is under investigation. Mark Lane, Barclays spokesman, said the company had no comment.
Brokerage and financial markets technology provider Investment Technology Group Inc., New York, stopped trading on the Barclays dark pool after Mr. Schneiderman's lawsuit was announced June 25 “because Barclays wouldn't talk with us,” said Jamie Selway, managing director and head of electronic trading. Barclays did speak with ITG officials after the bank filed a response to the lawsuit July 24, and ITG resumed trading on the dark pool on Aug. 4.
ITG allows its clients to opt out of using Barclays' dark pool, and about 10% of ITG's U.S. clients — mostly money managers — have done so, Mr. Selway said. “We haven't seen the bans directly from asset owners, but it's still early days for them to get involved. Ultimately, it's the asset owners' money.”
A temporary ban on trading on Barclays LX remains in effect at RBC Global Asset Management (U.S.) Inc. while the money manager continues to assess the situation, said Ryan D. Larson, Chicago-based head of U.S. equity trading. He said “not many” of RBC's pension fund clients have asked that their trades not be made on certain dark pools because RBC “has usually responded to potential issues” quickly. But although he couldn't quantify it, Mr. Larson said more clients are contacting him about trading and market structure than ever before.
“They definitely want our thoughts on the process, on high-frequency traders and their effects on trading,” Mr. Larson said. “There's definitely more of a dialogue between us and our clients on market structure issues. They want to see that we're taking a proactive approach and have an opinion about what venues to use.”
That interest from asset owners has led investment professionals at money management firms in general, up to and including the chief investment officer, to become well-versed in issues related to trading and market structure — which, on the buy side, historically had been considered by some in the industry to be more administrative than investment-related, Mr. Larson added.
If asset owners decide to direct their managers' trading venues, that will raise the issue of a manager's fiduciary responsibility to get best execution vs. its legal requirement to abide by its clients' wishes, said Eric Hess, managing partner at New York-based Hess Legal Counsel LLC, which advises broker-dealers and money management firms.
“Fiduciary duties are grounded in the law of agency and the money manager is an agent of the asset owner,” Mr. Hess said.
“The best-execution standard isn't meant to eviscerate an agent's duty of obedience. Sometimes there may be conflicts, such as contractual, capacity or authority, but the obligation of an agent to act in accordance with its common law duties overrides meeting a subjective standard of best execution.
“If the money manager cannot act in accordance with the asset owner's instructions, it needs to re-evaluate whether it can continue to act as the client's agent and fulfill its duties of loyalty, good faith and fair dealing.” n
This article originally appeared in the August 18, 2014 print issue as, "Asset owners mull tightening control on trade execution".