Achieving best execution for large institutional orders involves a lot more than just looking for the best price on various markets it's an overall process. The search for best execution is even more daunting when markets are volatile or if the portfolio to be traded includes low-liquidity stocks and exotic markets.
Electronic trading has spurred an array of different execution venues and market models, which may be confusing at times. But the choice of trading places is a great asset to avoid or at least limit market impact and tailor execution strategy according to changing market conditions.
On Feb. 6, Pensions & Investments staffers and six experts in trading sat down to discuss best execution, the changing competitive landscape and other issues.
Participating in the discussion were:
• Tal Cohen, senior vice president, Instinet LLC, New York;
• Ian Domowitz, managing director analytical products, ITG Inc., New York;
• Brian Hyndman, senior vice president transaction services, Nasdaq Stock Market Inc., New York;
• Timothy Misik, head of institutional equity trading, Northern Trust Global Investments, New York;
• Scot Warren, managing director equity products, CME Group Inc., Chicago; and
• Kyle Zasky, managing director EdgeTrade LLC, Knight Capital Group Inc., Jersey City, N.J.
The moderator was Isabelle Clary, senior reporter with Pensions & Investments in New York.
What follows is an edited excerpt from the 90-minute session.
(Related stories: Institutional investors should ride out the storm of volatile markets to obtain best execution. That way, they won't give up valuable alpha to tumultuous market conditions. Click here.
Round table transcript and audiocast, click here.)
Ms. Clary: Let's talk about market fragmentation. Because we have this way of accessing all of those venues, the market that looks very fragmented, is actually not fragmented at all; the smart guys can go everywhere and allow you to get the best execution for your order. Kyle, you created Edge-Trade with the goal of bringing that liquidity to your customers. What is your experience with all the new tools we have and that market fragmentation issue?
Mr. Zasky: You made a couple points which are important. There is fragmentation. Everybody knows that. But from the end-user perspective, even though you're aware of this chaotic mess, there are a lot of providers out there ...
But what we do is ... provide that value in terms of sourcing that liquidity and managing that confusion on your behalf to serve your needs. And there are a lot of companies that do that. I think that what our philosophy has been is that we can solve these problems through technology. There's a regulatory world which dictates the framework that we can compete in, but ultimately, technology solves a lot of the issues that we're talking about.
You know, I listen to Scot I think you have that centralized book. There's liquidity. There's certainty. Those are very important points. But I don't think that we have to have one centralized exchange that's mandated by one regulatory body to accomplish that particular goal.
What we can do is, through technology, we can have the competitive environment, which creates innovation. But as long as both sides are talking to each other in a technical way, that empowers the end user, the buy side, where you get the best of both worlds.
We've got regulation that protects the retail investor. We've got regulation that protects the integrity of the marketplace for all participants. At the same time, we have innovation without that being squashed.
I think a lot of the innovation that's happened in the United States took place before the regulation. The regulation sort of followed the innovation. I think that happened in the '90s with the (electronic communications networks). They did exist. There was an ECN essentially for a decade beforehand. And the regulators caught up with that in '97 and actually just disclosed that as some sort of mandate. But the technology was really the driver of that evolution.
Ms. Clary: Brian, as an exchange, you are to some extent an aggregator of liquidity. If an order cannot find the match on the best price on your book, you have the mandate of sending that order to a place that does display the best price. So do you think that has changed the role of an exchange?
Mr. Hyndman: Yeah. I would say since the world has become fragmented, in order for an exchange to really be able to compete, it had to be able to build this routing functionality. So, obviously, we'll give you the best execution that we can offer in our book, in our displayed transparent book. We also have a significant amount of non-displayed liquidity. About 20% of our liquidity on Nasdaq is non-displayed. But if we can't offer best execution, then we obviously go outside of our book to all the other protected quotes here in the States. And if we didn't offer that functionality, you know, we just wouldn't be on a competitive level playing field with other ECNs that do offer that.
Ms. Clary: But, of course, as an exchange, you only probe other displayed books, regulated markets.
Mr. Hyndman: Right now, today, we only probe other ... protected quotes. ... In the future, though, that is going to change.
Ms. Clary: Kyle?
Mr. Zasky: Just in terms of the Nasdaq market, which is great at many things and has a lot of liquidity ... I think that the dark liquidity that's out there can't be ignored. So where, you know, we have certain products that seek out liquidity in both the public markets and the dark market simultaneously we're seeing execution amounts over 30% ... taking place in the dark. So if you're a buy-side participant or a sell-side participant and you're thinking that you can just rely on one particular exchange to get the job done for you for example, Nasdaq until you guys have some sort of routing technology out of your own market, no matter how large you are, you might not be servicing the client's complete needs on that particular order at this point ... in the evolution of this environment.
Mr. Hyndman: I think that's a fair statement. Right now ... Nasdaq will obviously execute in its book and go out to all the other public markets, but there's some changes where we could potentially be going to private markets in the future.
Ms. Clary: Ian?
Mr. Domowitz: I think there are two things I can add at this point. ... The first goes back to the regulation and technology. You know, what came first sort of thing. Although I basically agree with you, Kyle, I think Tal had a point about them coming together. ...
If you think back although 1986 was a very big year in the sense that they received their no-action letter that actually allowed them to trade as an ECN Instinet's been in existence since 1969, and the first concept release from the Securities and Exchange Commission aimed at regulating electronic markets was in 1969. It followed immediately upon Instinet's emergence as a company. It took four failed attempts to get to Reg ATS, but they were trying, right? They were trying; they were trying desperately. So, you know, the interplay was definitely there. It dates back quite a bit. And sometimes it's hard with ... how fast markets move to sort of maintain that kind of sense of history. But it is there nevertheless.
As far as the virtual consolidation is concerned, I think that there's a data point to keep in mind. People have blamed a lot of things on Reg NMS. Whether it's the rise of electronic markets, or the spend on infrastructure, or justifying just about anything anybody wanted to do in the last few years in the United States ... you can trace it back to Reg NMS.
But my claim is that this routing function, this consolidation on a routing level, was already there. If we narrow in on the part of Reg NMS that's relevant to this discussion, it all had to do in a sense with making, creating a consolidated top of book. ... Now you think that that would cost money to do. But survey results tell us that, on the sell side anyway, I don't know about the exchanges ... survey results suggested that only about $92 million was being spent over a period of two years to actually make this happen. Now that may sound like a lot of money, but let's put it in context. The annual commission pool for the United States is estimated at ... approximately $13 billion; $45 million a year, $46 million a year is chicken feed, relative to that commission pool. So this consolidation was already complete. ... In other words, very little remained to be done from the sell side point of view, and the regulations fundamentally applied to the sell side and the exchange. So we were already there.
Mr. Cohen: There's actually one thing I would add to that ... and you're rightfully pointing to Reg NMS as sort of the scapegoat for a lot things, but what actually has happened over the last two years is routing's always existed, but now what we're seeing is co-opetition between brokers. So when brokers are taking on exchanges, they realize they don't have the muscle to do it themselves, so they've created this social network of dark pools that sit behind the exchange, and all of a sudden, you have Morgan Stanley talking to Goldman Sachs, talking to UBS, talking to Merrill Lynch, talking to ITG, talking to Instinet.
Mr. Zasky: The MySpace of Wall Street.
Mr. Cohen: Yes. ... It's a Wikipedia/MySpace/Facebook that has sort of emerged in the last two years. And that did not exist. When we thought about routing, it was very rudimentary. It was How do I get your order between the various exchanges' displayed liquidity markets? Now it's How do we keep that order between us? and that conversation between us has expanded itself between agency brokers, principal brokers and anybody who operates a dark pool. So that social network is sort of a phenomenon I think in the last two years. I'm not going to give credit to NMS, but clearly, there's some things that have happened over the last two years that, all of a sudden, people are knocking on each other's doors saying We should talk.
Mr. Domowitz: I agree with that. The interesting thing to me, though, is not the Facebook of Wall Street. Although it's not a bad analogy in some ways. It's the fact that the economics got worked out in virtually zero time.
In other words ... to the extent that I can say things date before NMS, certainly there was third-party distribution of algorithms, for example, which is at the core of a lot of these network interactions ... or co-opetition among the sell side. That dates back several years. ... So then the question was, well, how do you distribute it? And then distribution deals were made, right? There was a lot of it was an important building block I think. ...
Ms. Clary: If we go to a world where as a customer I would see any broker or any exchange as being the single point of access to some kind of routing technology that will go everywhere all the time, and in a way, give me access to a centralized market with a lot of little different corporate names on top of it, what will be the factor that will make the difference between all of those gateways to market liquidity?
Mr. Warren: I'll take a stab at describing what I think the differentiating factors are going to be: What's the level of liquidity? How quickly can you execute there? How stable is that portal? Because at the end of the day, people need to be filled with certainty, and that's going to be the point of differentiation: Do you have liquidity, capacity and stability?
Mr. Misik: I think those are all very important, but quite honestly, I think we're a long way away from that. I think that as a trader on the buy side, I have to have a certain set of tools. ...
Believe me, in the last several years, having done a fair amount of research and having been exposed to every algorithm from every sell-side broker, and understanding every pool that they look into, nobody looks at everything. There's like saying the economics have been worked out to a certain point, Ian, but there's a lot of people who don't talk to each other and won't talk to each other, because they can't work out the economics, and so that goes to the confusion we spoke about earlier. ...
That's where it becomes incumbent on us to have that tool set that does evaluate exactly what Scot is saying: the speed; the access; knowing where the liquidity does lie, and the constituency even within liquidity ... So we have to have great electronic tools at our fingertips with the ability to evaluate them pre- and post-trade to do an effective job.