However, the new opportunities are not without potential obstacles that will need to be overcome. For example, should a conditional order be rested in one pool at a time, or in multiple pools at once? If it is the latter, McLoughlin fears the outcome would then boil down to whichever platform has the lowest latency, potentially triggering a latency war which “would not be in the interests of anyone”. In addition, there are regulatory issues that could impact the trading desk too. For example, the LSE’s Turquoise trading platform currently has a threshold order size at 25% of the large-in-scale pre-trade transparency waiver under MiFID, but that figure will have to increase to 100% by the time MiFID II takes effect in January 2018. Whether this will impact liquidity remains to be seen.
The relationship between the buy side and the sell side are another area of focus for McLoughlin. Recent years have seen many buy side firms reducing their broker lists – a process which he believes makes sense on the algo side of the business but which should not be pushed too far, especially when it comes to high-touch relationships. While the global regulatory push for investment firms to understand and be able to explain their algorithms has provided a push to reduce the number of algos, there may well still be room for high-touch relationships where these add value, particularly for small and mid cap stocks.
“I do see some room for reducing the broker list but I don’t want to cut too much and reduce our ability to source the right liquidity,” said McLoughlin. “We have a slightly larger list than average, but that is largely driven by the wide variety of funds that we manage. I believe that the majority of the buy-side community is looking to reduce the number of algo providers they use to around five or six and we are no different. We will review them regularly and change them when we deem necessary. At the same time, I do not want to put up a barrier to entry or block out new providers, as you don’t want to shut the door to innovation.”
From a market-wide perspective, one of the significant changes of the last few years has been the increasing shift of volume towards the close of the trading day. This change is linked partly to another equally long-term development, the rise of passive trading and passive funds, which now account for a significant portion of daily trading activity.
“It is eye-opening to see how much volume there is at the close now, especially on index rebalancing days,” said McLoughlin. “A lot of it is driven by passive funds, index rebalances and ETFs, which have gained traction over the past few years. On a personal note, although I have a lot of experience trading in the close, I find it more enjoyable to trade intra-day, especially where micro- and small-cap is concerned as I feel there is a lot of value that can be added.”
One further complication to consider is that the rise of passive trading does put some traders off trading at the close, especially at times of index rebalancing, which is a time when passive traders are present in the market. This is because passive flows can exacerbate market swings, leading to performance that is far away from the expectation.
A related case of the buy side exercising judgement may be the relationship with trading venues post-MiFID II, which could see some venues switched off by the buy side, according to McLoughlin. Under MiFID II, all broker crossing networks must reclassify as either an SI or an MTF, and they are no longer allowed to be discretionary in deciding who does and does not have access; they must be open to anyone who meets the minimum criteria.
“We could see traders switching off venues that were previously operating as ELPs within BCNs, but who will most likely become SIs in preparation for MIFID II. Although I agree that we may want to interact with some of that type of liquidity and it is definitely not all bad, we may see investors requiring more compelling reasons before they access their new SIs. We currently use a range of methods to protect ourselves from interacting with toxic flow including venue analysis and using minimum fill sizes for example,” said McLoughlin.
Navigating the equities jungle
Matt McLoughlin, head of trading, Liontrust Asset Management
Matthew McLoughlin has had an interesting and varied career. Now head of trading at UK-headquartered fund manager Liontrust, he started out as a credit and rates junior before joining AIG Asset Management, where he was active on the portfolio management side of the business. He then moved to the hedge fund RAB Capital, seeking to become more involved in trading, before joining Liontrust in September 2015.
“I’ve seen the industry from many different angles,” he said. “There’s so much more involved in successfully trading a block nowadays. I think both the buy side and the sell side are recognising the need to be more patient in order to find the right liquidity and are doing a lot more research in selecting the appropriate venues in which to find it. We use a combination of dark pools, cash desks and conditional order books to find block liquidity, as well as dedicated block crossing platforms.”
In a market full of constant changes, one of the first questions is which developments are useful. McLoughlin is a big supporter of conditional order books. For example, Liontrust uses the new Bats LIS service, which describes itself as a large-in-scale IOI negotiation and execution platform for block crossing in European equities.
“The willingness to trade in larger size is largely driven by the confidence we have in the relevant venues and some of the new block trading order books are definitely of interest, especially with MIFID II around the corner,” he said. “Conditional order books are attractive to us because they allow us to avoid missing out on other flow, which would otherwise be a risk when resting an order in a dark pool for example. Depending on what percentage of LIS you have to rest in a conditional order book, you can still actively trade in the market, but at the same time get access to the possibility of a block. Reversion rates have been good on the conditional orders that we have seen.”
Liontrust is a specialist fund manager launched in 1995. Based in London, it operates in the UK, Europe and Asia. Its fund managers invest in the funds they run, a feature the company says shows “belief in and commitment to their investment processes and fellow investors”.
The closing of the BCNs could itself throw up some interesting dilemmas, such as whether or not to interact with new SIs that have been created by electronic liquidity providers. The new rules could lead to a period of unintended fragmentation as new platforms emerge, but McLoughlin believes that in the medium to longer term there won’t be much fragmentation as the buy side will simply exercise discretion in deciding where to route flow and switch off or avoid connecting to any venues that don’t offer value.
“There may not be as much fragmentation as some feared,” he said.