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The Hidden Alpha in Equity Trading Steps to Increasing Returns with the Advanced Use of Information

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The Hidden Alpha in Equity Trading Steps to Increasing Returns with the Advanced Use of Information THE HIDDEN ALPHA IN EQUITY TRADING STEPS TO INCREASING RETURNS WITH THE ADVANCED USE OF INFORMATION TABLE OF CONTENTS 1 INTRODUCTION 4 2 MARKET FRAGMENTATION AND THE GROWTH OF INFORMATION 5 3 THE PROLIFERATION OF HIGH FREQUENCY TRADING 8 4 FLASH CRASHES, BOTCHED IPOS AND OTHER SYSTEMIC CONCERNS 10 5 THE CHANGING INVESTOR-BROKER RELATIONSHIP 11 6 THE INFORMATION OPPORTUNITY FOR INSTITUTIONAL INVESTORS 13 7 STEPS TO FINDING HIDDEN ALPHA AND INCREASED RETURNS 15 1. INTRODUCTION Following regulatory initiatives aimed at creating THE TIME DIFFERENCE IN TRADING competition between trading venues, the equities market has fragmented. Liquidity is now dispersed ROUTES; PEOPLE VS. COMPUTERS across many lit equity trading venues and dark pools. This complexity, combined with trading venues becoming electronic, has created profit opportunities for technologically sophisticated players. High frequency traders (HFTs) use ultra-high speed connections with trading venues and sophisticated trading algorithms to exploit inefficiencies created by the new market vs. structure and to identify patterns in 3rd parties’ trading that they can use to their own advantage. Person Computer For traditional investors, however, these new market conditions are less welcome. Institutional investors find JUST HOW FAST ARE TRADERS PROCESSING TRADES? themselves falling behind these new competitors, in » Traders that take advantage of technology can create large part because the game has changed and because programs that trade in milliseconds. In many cases they lack the tools required to effectively compete. these traders can operate faster than the venues can accept messages The traditional traders need to catch-up quickly. This » Human traders are greatly disadvantaged when trying Oliver Wyman perspective aims to help by describing to deploy basic arbitrage opportunities in the market; computers are trading far too fast for humans to compete the new game: how it came about (Section 2), how [difference between sending email and mailing a letter HFTs have proliferated in this new environment (Section via snail mail] 3), how the new game has led to negative events and systemic concerns (Section 4), how this is changing REMARKS: The role of the human trader has evolved. They must now also understand how various electronic trading the relationship between investors and brokers methods work, when to use them, and when to be aware of (Section 5), how this has created an opportunity for those that may adversely affect their trades. investors (Section 6). Finally, regardless of your stage of adaptation, we identify a two step process to take advantage of this opportunity (Section 7). 4 Copyright © 2013 Oliver Wyman 2. MARKET FRAGMENTATION AND THE GROWTH OF INFORMATION Market venue competition began with the Alternative formation in equities markets. As new venues have Trading System regulation of 1998. This was introduced successfully competed for trade volume, market to provide a framework for competition between liquidity has fragmented across these venues. trading venues. In 2007 the National Market System Market participants seeking liquidity are required by regulation extended the framework by requiring regulatory obligations to access visible liquidity at the traders to access the “best displayed price” available best price, which may require them to incorporate from an automated visible market. These regulations new technologies that can access liquidity fragmented were intended to promote efficient and fair price across trading venues. These technologies may include routing technology and algorithms that re-aggregate ORIGINS OF HIGH FREQUENCY fragmented liquidity. Dark Pools – trading platforms TRADING (HFT) originally designed to anonymously trade large block orders electronically – began to expand their role and trade smaller orders. This allowed dealers to internalize their flow and institutional investors to hide their block orders from market opportunists. The use of these technologies can lead to leaking trading information that can be exploited by opportunistic traders. Information is leaked when electronic algorithms reveal patterns in their trading activity. These patterns can be detected by HFTs who then make trades that profit from them. Competition for liquidity has encouraged trading venues to move from the traditional utility model, where each side of a transaction would be charged HFT IS NOT A NEW CONCEPT a fee, to models where the venues charge for » Although today HFT is closely associated with high speed technological services, pay participants to provide computers, HFT is a relative term, describing how market liquidity and charge participants that remove participants use technology to gain information, and act upon it, in advance of the rest of the market liquidity. Many trading venues have become » Near the advent of the telescope, market merchants technology purveyors. would use telescopes and look out to the sea to determine the cargo hold of incoming merchant ships. Broker-dealers have realized that they are often the If the merchant could determine which goods were soon party paying the trade execution fee, which is used to arrive on these ships, they could sell off their excess by the venues to pay opportunistic traders a rebate supply in the market before the incoming goods could for providing liquidity. To avoid paying these fees introduce price competition and internalise their valuable uninformed active flow, REMARKS: Although many HFT practices have come especially from retail customers, broker-dealers have under considerable criticism in recent times, citing unfair also established dark pools. By internalising their flow advantages, these firms are simply using technology or, in many cases, selling it to proprietary trading firms, to their advantage, as is equally accessible by all major market participants. they can avoid paying the trading fees that the venues charge for removing liquidity from their order books. 5 Copyright © 2013 Oliver Wyman EXHIBIT 1: CURRENT MARKET FRAGMENTATION FOR THE US AND CANADA LIT MARKETS DARK MARKETS LIT MARKETS DARK MARKETS USA’s Canada’s Nasdaq Fragmented Instinet TSX Fragmented TMX alpha Market Market Intraspread Nasdaq OMX Citi BX Citi Match Nasdaq OMX BIDS TMX TriAct PSX Alpha Match Now NYSE Level ATS EURONEXT NYSE NYFIX TMX Liquidnet Arca. Select NYSE Knight MKT Knight Link BNY Direct Edge CHI-X Instinet ConvergEx ICX EDGX Vortex Direct Edge BNY EDGA ConvergEx BATS Crédit Suisse CHI-X What’s BYX Crossfinder CX2 next? Goldman BATS Sachs Sigma X CBOE Barclays OMEGA LX CHX Super X NSX GETCO OMEGA Lynx … and many more IEX Pure Source: The Trade USA, IEX primed for Friday launch, October 21st, 2013; IEX Websites, iextrading.com/about EXHIBIT 2: US AND CANADIAN MARKET FRAGMENTATION 2007 VS. 2013 CANADIAN MARKETS US MARKETS 2007 2007 Many US dark venues do not report volumes; it is suspected that dark venues have much higher market share 2013 2013 Lit market Dark pool Source: TABB Group, IIROC Copyright © 2013 Oliver Wyman 6 THE BUSINESS OF BEING A TRADE VENUE VENUE 1 VENUE 2 » Some venues promote liquidity providers, such as HFT Price model Maker-Taker; Paying Equal pricing; ELP strategies, directly by offering a “maker-taker” pricing liquidity provider, Liquidity providers model, where providers of liquidity are paid a rebate to charging liquidity and takers are participate, and takers of liquidity are charged a fee which is takers charged equally higher than the rebate. The venue derives revenue from the Advanced series May charge for low- Charges for low- difference between the fee and the rebate latency connectivity latency connectivity » Other venues may not offer a “maker-taker” pricing Institutional High HFT activity Low to no structure, however they still attract liquidity providers by investor perception HFT activity offering advanced connectivity and information services Actual HFT activity ELP, latency Latency arbitrage, for a fee; charging willing clients, typically HFT firms, that arbitrage, mean mean regression, etc. regression, etc. wish to take advantage of low-latency connection speeds or segregated order flow (e.g. Retail only) HOW MOST TRADE VENUES MAKE MONEY WHILE REMARKS: Although the venues that do not have a “maker- ATTRACTING LIQUIDITY taker” structure may seem to have less HFT activity, the low- latency connectivity attracts other HFT strategies that profit » The measure of consummated liquidity (volume) is a off of latency difference from slower-informed order flow; both key variable in determining the successfulness of any venue revenue models attract HFT clientele. trade venue THE CONCEPT OF LIQUIDITY Passive order book representing of an example stock LIQUIDITY IS THE LIFEBLOOD OF ANY VENUE TIME BUYER VOL BID ASK VOL SELLER TIME » Liquidity is the measure of the willingness of participants 1a A 2 10.00 10.01 4 D 1b to transact with respect to particular asset (in this example 2a B 6 10.00 10.02 7 D 2b the asset is stock of an example company). The deeper (more layers) and wider (more volume per layer) the 3a B 6 9.99 10.02 8 F 3b order book, the more liquid the stock is considered to be, 4a C 3 9.99 10.02 10 G 4b relative to historical/expected layer and volume levels 5a A 7 9.98 10.03 9 E 5b » The greater the liquidity in a stock, the more likely an 6a C 10 9.97 10.03 3 D 6b investor is to be able to buy into or sell out of the stock, 7a B 4 9.97 10.03 2 F 7b whenever they wish, and in a timely manner with respect to the size of the investors order, therefore, venues with These orders sit passively until they interact with a marketable the most liquidity are potentially the most sought after by order that actively transacts with them or the passive order is the investor community cancelled by the buyer/seller that posted it. REMARKS: Many venues have pricing models that pay For example, if a marketable buy order for 35 shares with a participants a rebate to passively post liquidity, and charges limit price of 10.05 were to enter this venue, that order would other participants that actively take liquidity away; commonly actively take liquidity away from the first 4 layers of the order called the “maker-taker” pricing model.
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