Pension funds, money managers expected to follow trading shift
Money managers and internally managed pension funds are expected follow the lead of T. Rowe Price Group Inc. in sending direct equity order flow to high-frequency trading firms, which could chip away at the established use of brokers to direct institutional trades, sources said.
T. Rowe Price in 2015 began directing equity trades to Virtu Financial Inc.
"The T. Rowe-Virtu deal is kind of like the canary in a coal mine, and the canary is doing pretty well," said William R. Harts, CEO of Modern Markets Initiative, a New York electronic and high-frequency trading industry group.
Added Valerie Bogard, equity analyst at TABB Group LLC, New York: "The buy side has gotten more comfortable with high-frequency trading firms, and they weren't before. A lot of their strategies used to make the buy side uncomfortable. But now the buy side understands much better how those firms work and they're ramping up their transaction cost analysis, and HFT firms are providing the liquidity they need."
Ms. Bogard said other large managers have started using high-frequency trading firms since T. Rowe Price announced its move in April 2015 but didn't publicize it. "Most managers release who their brokers are, but not something like HFT firms. But there are other firms that are either already or are likely to begin establishing a direct relationship with high-frequency trading firms."
T. Rowe Price executives said in the past two years the real success of the program has been in finding liquidity — a growing problem for institutions as fewer stocks trade on public markets and more institutional investors move toward passive investing.
"The execution quality has been solid," said Mehmet Kinak, vice president and head of global equity market structure and electronic trading at T. Rowe Price, Baltimore. And although T. Rowe Price only trades a small percentage of its trades through Virtu, Mr. Kinak said, "the level of performance is up there in the top tier." A spokesman for T. Rowe Price said the company does not disclose specifics on trading costs or the impact on trading strategies on returns.
Helping with regulations
The experiment has put the firm in good shape to handle impending European regulations under the Markets in Financial Instruments Directive II to unbundle research and execution commissions. "When you think ahead to 2018 and the unbundled world of MiFID II, the lessons we've learned from working directly with a market-maker have put us in good stead," said Clive Williams, global head of equity trading at T. Rowe Price. "Will it become a bigger part of the institutional trading tool set? Absolutely. Virtu, KCG (Holdings Inc.), Citadel (Securities) and others will take market share on more institutional trading."
Sources, who spoke on condition of anonymity, said the $324.7 billion California Public Employees' Retirement System, Sacramento, which manages $211.5 billion in overall assets internally, and large money managers like Vanguard Group Inc. and Fidelity Investments all have shown interest in direct HFT order flow.
Currently, Vanguard does not send any order flow directly to high-frequency trading firms, said Gerry O'Reilly, principal in Vanguard's equity index group, Malvern, Pa. "When you're trading in the amounts we're trading, we interact with (high-frequency trading firms) through third-party algorithms" provided by brokers, Mr. O'Reilly said. "We pull levers on what algorithms we use, but ultimately it's the third party that directs the routing. We never say never (on direct routing to HFTs), but it's not something that we're looking at right now."
Mr. O'Reilly would not comment on T. Rowe's strategy saying he wasn't familiar with its details.
Spokesmen at CalPERS and Fidelity would not comment.
Fragmentation and negative effects on block trading were big reasons behind institutional investor concern over high-frequency trading. So what's changed?
"Generally, most high-frequency traders don't facilitate block trades, but with all the smaller trades they do, they provide liquidity to the market," said Ms. Bogard. "Along with a better understanding of what HFT firms do, liquidity is more difficult to do today, so they go to high-frequency firms because they can provide that. And managers now are putting new research at the back end of trades into measuring information leakage, which had also been a concern of institutions. Given the technology that high-frequency firms have, that gives the buy side data much faster than through other sources."
Mr. Harts of MMI agreed that high-frequency trading firms are not well-versed in dealing with block trades. "But don't forget that in many cases, the brokers used to take on block trades as a loss leader," Mr. Harts said. "They'd do it at a loss for the broader arrangement with the client where execution and research was bundled. In the case of an electronic trading firm, the relationship is different. There's no research. It doesn't make sense for them to do block trading at unreasonable prices. What they can do is deploy their technology to take those blocks and work the order by splitting it up" on their own platform.
T. Rowe's work with Virtu has been an educational experience, Mr. Kinak said. "The experiment has gone pretty well, for multiple reasons," he said. "It's helped build a relationship with a non-traditional firm. To engage with someone that's not trading as a traditional broker-dealer or bank, that's been eye-opening for us. I'm sure Virtu would say the same thing — both on how a market-maker works, how sophisticated they are, but also how they understand market microstructure."
Stephen Cavoli, senior vice president at Virtu, agreed that it's been a leaning experience. "Working with world-class buyside firms has been a humbling opportunity, one where we have been able to iterate and learn from each other to improve their quality of execution," Mr. Cavoli said. He said work with T. Rowe has been successful for Virtu, "which has led to deeper conversations about order execution."
Spur similar agreements
T. Rowe's use of direct order flow to a high-frequency trader will spur other similar agreements between the buy side and electronic trading, Ms. Bogard said. "High-frequency traders are competing with bulge-bracket brokers," Ms. Bogard said. "I think the trend (toward more direct orders to high-frequency traders) will continue, and I think high-frequency trading firms will look to institutional investors more for business. Bulge-bracket firms were established because they provided both research and execution, which is why they attracted buy-side business. But MiFID II rules will change that. The buy side will no longer be incentivized to get bulge-bracket research, so any order flow through those firms will have to be based only on execution quality. That's why we see the buy side moving in the direction of HFT firms, because of the better execution quality and data they can provide."
T. Rowe's Mr. Williams said the future of trading will see four distinct groups: bulge-bracket firms with Central Risk books; brokers with unique agency capabilities; new disruptors like Virtu and other brokers. "It's the last bucket, the brokers with nothing unique to offer, that will be the most threatened going forward," Mr. Williams said.