The concept of best execution is another area of focus for Credit Suisse. While best
execution has been a familiar term ever since MiFID introduced an obligation on the sell-side to seek it in 2007, under MiFID II that commitment is being reinforced by a
shift of the regulator’s attention to the buy side. In particular, buy-side best execution
policies are being subjected to greater regulatory scrutiny. At K&KGC’s 14th London
Equities Alpha Trader Forum in October, one senior buy-side trader reported a ‘fact-checking visit’ from the FCA, in which a representative of the UK’s financial regulator
wanted to know in great detail about the firm’s best execution policy. In general, the
regulator is demanding a more detailed, lengthy best execution policy which can
explain trading decisions with a level of clarity greater than ever before.
“There is a greater focus on best execution now than before,” said Hilton. “We are seeing more clients building best execution frameworks, and looking at how to analyse their data, and how to use that data to change their tradin behaviour.”
At the same time, this demand for data has led the buy side to push into independent data and analytics – a marked change from a few years ago. While each broker provides its own transaction cost analysis (TCA), the buy side needs to analyse across different portfolio managers and different brokers – a task which does require the buy-side firm to have its own data and TCA. In response to that need, some buy-side houses are hiring quant specialists, although not every asset management firm has the resources to do so.
One potential concern about this trend is the competitive disadvantage it may create
for smaller buy-side companies. Regulation drives advantages to the large houses on
both the sell side and the buy side, since larger players have the resources to invest
in the tools needed to adapt. However, Cousens says that Credit Suisse does attempt to counter this factor by providing more for the buy side than previously in terms of data. Specifically, the firm uses its data to help advise the buy side on how to achieve performance enhancements.
But perhaps the best silver lining may be provided by unbundling of payments for
research and execution, which stands to benefit the smaller players as well as the
“Small buy-side firms can focus their execution on a few key providers with best execution and unbundling, concentrating on the areas where they stand to do better,” he said. “The more they concentrate, the more data it will generate for them. That data can then be used to improve their performance even further.”
Another potential problem with best execution is the way regulators may choose to interpret best execution obligations. For example, does best execution simply refer
to ‘best price’? In Europe, it is understood that the regulator is expecting more
nuance and explanation of what the trader was trying to achieve. Nevertheless, in the worst-case scenario some traders are concerned that they could be penalised by,
for example, trading a block at a higher price when they could have traded in smaller
size at a lower cost. From the perspective of the asset management house, the trader
has done a better job by trading a block, since this accomplishes the bigger-picture
objective of making portfolio adjustments.
However, from the narrow perspective of TCA, trading a block may look bad if a better price was available for a part of that order elsewhere.
“Best execution should take into account everything,” said Hilton. “For example, let’s imagine there is a cheap broker that has one simple algorithm and charges two basis points. That’s one extreme. Now let’s imagine there is a broker that has a large selection of high quality algorithms and charges three basis points. If the trader chooses the broker that is offering the higher quality service, at a slightly higher cost, best execution should be flexible enough to understand the reasons for that choice and accept that it may have been the right decision in the circumstances.”
Uncertain times ahead?
James Hilton, Co-Head, AES Sales, EMEA at Credit Suisse
Matthew Cousens, Co-Head, AES Sales, EMEA at Credit Suisse
James Hilton and Matthew Cousens have been co-heads of AES sales Europe at Credit Suisse since 2012. Over the last ten years, they have seen the rise of MiFID, and now are focused on preparations for the post-Brexit yet MiFID II-compliant world of 2018.
“We’ve had a period of uncertainty,” said Hilton. “That’s starting to change. The structure under MiFID II is starting to clarify. It’s better understood. We are beginning to see more innovation emerging from providers and trading venues.”
Credit Suisse was one of the top algorithm providers named by the buy side in K&KGC’s Buy-Side Perspectives survey of global buy-side traders earlier this year. According to Hilton and Cousens, there is potential for more innovation in complex trading strategies – and particularly, in how to automate these. For example, Credit Suisse is in the process of launching new products focusing on delta one products, indices and custom swap baskets.
“Regulatory change brings changes in market micro structure,” said Cousens. “That means more complexity at the smart order router (SOR) level. We have invested heavily into the evolution of electronic trading – for example, we have hired a number of additional quant analysts and developers this year. As a result, we have a number of products coming through, including new algo strategies. We have a new
Implementation Shortfall model going into beta testing, and we have revamped several existing strategies including Guerrilla, VWAP and a new Dynamic Inline.”
One of the possible effects of new regulation is increased equity market fragmentation, particularly due to MiFID II rules that force broker dark pools to reclassify themselves as either a multilateral trading facility (MTF) or a systematic
internaliser (SI). All MTFs are required to accept any participant that meets the
minimum entry criteria, while the SI will be obliged to publish quotes, effectively
turning it into a lit market. In both cases, the regulator is essentially stripping away
the ability of the pools to use discretion and discriminate between participants, in the
name of greater equality.
“The problem for the buy side is the market will look pretty chaotic, some broker pools will be classified as SIs, some won’t,” said Hilton. “There will be lots of competing SIs and there could also be new participants registering as SIs. The buy side will have to invest more in their own technology to understand this environment. The market is going to produce more data, and that data is likely to come in various different formats. Buy-side traders will also have to work out how best to trade stocks that have been constrained by the MiFID II dark pool caps.”
Credit Suisse is already registered as an SI and the Crossfinder dark pools functions
under that banner. However, this does mean that aspects of the way it operates will have to change. Under MiFID II, traders in SIs will trade against displayed liquidity, and the concept of matched principal is unlikely to be allowed. One of the difficulties that this creates for Crossfinder is the dark pool’s Alpha Scorecard.
“In Crossfinder, our Alpha Scorecard was designed to profile every individual strategy and client to allow our clients choices about the types of flows they interact with,” said Cousens. “Under MiFID II that may not be possible. The discretion is effectively removed. We use the Alpha Scorecard as an education point for clients, to help them understand the kinds of flow they will be interacting with. If that is removed, then the buy side choice is reduced. Sadly, it is unlikely we can continue that.”
Nevertheless, there are also positive aspects – in particular, new venues that are a direct response to regulatory changes. These include Turquoise Block Discovery and
its merger with the Plato partnership, as well as BATS LIS which is due to launch in
December and BATS Periodic Auction Book that launched in October 2015. Credit Suisse is a supporter of the Turquoise platform, and has its default smart order router turned on to interact with that platform, among others.
“These initiatives can be seen as part of a move to prepare for the MiFID II world of 2018,” Cousens added.
The world of algorithms (algos) has been a key part of the electronic trading landscape for many years. Now though, the way the buy side uses algos is changing, once again driven partly by regulation. MiFID II places a greater obligation on the buy side than ever before to understand the algorithms it is using and how they work, and to be able to explain this to the regulator on demand.
Arising partly out of incidents such as the Flash Crash of May 2010, when $1 trillion was briefly wiped off the value of the US stock market by algorithms feeding off each other in a spiral to the bottom, MiFID II demands a new approach to algorithms. Many buy side firms report that they are cutting the number of algos they use, and paring down the amount of different customisations. The reason given by many is that the regulation suddenly makes having a large number of different algos a risky proposition, since any firm that finds itself unable to explain exactly how each one works faces punishment from the regulator.
“We see two competing forces,” said Hilton. “One is a focus on decreasing complexity from the buy side. They feel they have a greater regulatory obligation to understand what the tools do, so want to simplify the strategies they have access to. On the other hand, there’s a huge focus on performance and TCA. The buy side want to get into the guts of performance and understand what they can do to improve things. There’s more focus on tweaking things to improve outcomes by a small degree. For example, figuring out a more intelligent minimum when trading in the dark, or modifying the VWAP curve because the trader has momentum in the names they are trading, or maybe just a small tweak that makes better use of the closing auction. These are the kinds of changes that are popular.”
The other factor, said Cousens, is a better in-depth understanding on the buy side in terms of what drives alpha for their flow. This greater awareness feeds back into the trend already noted above, since it leads the buy side to consolidate its algo providers and the number of algos that it uses. Credit Suisse notes that most buy-side clients are using two customised algos, on top of a selection of headline strategies.
As with many aspects of the market today, data lies at the heart of the issue – and there are a number of issues to tackle. Hilton notes that trying to compare performance across different data sets, whether that be two strategies, or two brokers, is not easy. The data needs to be as similar as possible for any conclusions to be meaningful, but this is not always a simple task. It’s necessary to consider whether the data has been impacted by events in the market (such an election), or that the data is simply not homogenous, which would make broad comparisons flawed. The best way to analyse data may be to test different trading scenarios side by side, for example by running an order to strategy A and then running it to strategy B in a randomised way over a period of time, to see which produces better results.
The shift to the close
The profile of the trading day is changing. A number of market participants have observed in conversation with K&KGC that there is a shift of trading activity towards the close, with liquidity thinning out in the intra-day trading sessions. The scarcity of intra-day liquidity led one buy-side trader to ask, half-jokingly but not entirely without serious intent, whether traders should just start trading at 4.30pm and trade the close. Credit Suisse estimates that intra-day depth of order book has been at its lowest level in the last four years. However, one possible criticism of the close is that since it is still based on the national exchanges, it is quite monopolistic – a situation that plays into the hands of exchanges, which can then charge higher costs.
“There has been a growth of the closing auction,” said Hilton. “That goes hand in hand with investment in passive products. Active fund managers are struggling to beat bench marks. Passive fund managers have done well. They often have the close as their benchmark. On the FTSE 100, 18% of daily volume goes in the closing auction. It’s a huge event and on rebalance day it can be as high as 40%. Even if you’re not focused on the close, you need to take account of it.”
From a Credit Suisse perspective, one area of focus has been predictive analytics. As Cousens points out, if the close has become more important than the ability to predict what liquidity will be present in the close becomes more important. If a trader can predict that, then the trader can figure out what they should trade earlier in the day. Credit Suisse has been researching this area, and has created a quant model that produces predictions. It looks at factors such as volume and volatility. A new model introduced in the last six months has significantly improved error-rate of the predictions the bank is making, he says. This becomes important, because a more accurate prediction helps the buy side to trade during the close.
“The close is hugely important,” added Cousens. “It has grown so much to the point where it is a standout liquidity event that attracts liquidity from all types of houses. As a result, the active managers are now looking at the close in closer detail, because there is so much liquidity available at that one point in time.”
ETFs and passive style
The other major factor at work in today’s equity market is the shift towards passive investing and the related growth of ETFs. This trend owes much to the increased correlation in the market between different asset classes, which has been partly driven by central bank policy since 2008. In general, the value of assets under management in passive funds has been increasing significantly in recent years, with many funds switching from active management to passive management.
According to Hilton, the main driver is performance versus cost. In the current environment, cost has been a problem for the active asset manager. This is particularly severe given that it is difficult to provide outperformance in equities today, which then makes it very challenging to compete with passive products that run at a fraction of the cost.
“A number of traditionally active managers are looking to launch passive funds,” he said. “Passive is increasingly becoming a part of the active landscape too. The question is, can the active asset manager make better use of passive products to diversify their business.”
Credit Suisse has been educating clients on the impact of passive trading. In general, the firm notes that the ETF market is seen as a useful way to trade macro events such as Brexit, the US election in November, and other significant events, including the upcoming elections in several European states. However, it is worth noting that regulation is pushing ETFs towards a similar environment to single stocks.
“We see an increased appetite from the buy side to interact with different ETF providers,” said Cousens. “There’s a potential for a big change in how ETFs trade. In the US, ETFs are very liquid. In Europe, it’s still largely OTC driven. We are also investing in ETF products, which will help bring liquidity together for the buy side.”
Different buy side traders have differing views on the trend towards passive investing. At the recent K&KGC 14th Alpha Trader Forum equities in London, one trader highlighted as his priority how to stop the trend. However, at the same meeting another trader stated that his objective is the opposite; not to stop the trend, but how to benefit from it. So could the trend to passive reverse at some point, particularly given the impact of major macro-shifts such as the election of Donald Trump in the US and his statements concerning deregulation of US banks?
“Passive trading and high correlation in the market are linked,” said Hilton. “If that link were to break down for any reason, the market could move back towards active trading. It was the high correlation that made it more difficult to generate performance in active trading. The election results will clearly impact the opportunities that exist. Some sectors will do well, and others… we will see.”
Head of Global Buy-side Research