Most of the predictions for the coming year point towards a tough environment for traders, marred by market volatility and regulatory uncertainty. However, it seems that many buy-side trading desks have already adapted to these difficulties.
A fall in commissions, shrinking liquidity, and volatile markets have required something of a strategy rethink on the part of the buy-side. Block trading opportunities are becoming increasingly scarce, and as a result traders are becoming very choosy about the quality of the liquidities they interact with. Also, traders are demanding more and more from brokers in terms of service quality. As a result of worsening market conditions, brokers are being forced to up their game in order to compete in a shrinking market.
The TABB Group’s 2011-12 report on European institutional equity trading found that more than half of the 60 European equity desks at long-only buy-side firms plan to re-evaluate their broker lists if commission revenues do not grow this year, and 28% were planning to lower commission rates. A telling 77% of respondents said they had adapted their trading styles to suit the market conditions, with 45% declaring the intent to be less aggressive and 37% aiming to use more non-displayed liquidity. One of the tactics being used by some buy-side firms is to allocate commissions on a per-touch basis, which means that complex trades will become more expensive.
The upshot of all this is that the top-tier brokers are likely to streak away from the lower tiers in terms of market share. The TABB report anticipates an 11% drop in buy-side orders between 2008-2012, with a 17% increase in algorithmic and DMA orders over the same period. The reason for this is that automated trading systems tend to work more effectively in volatile trading environments, which makes them more attractive to traders. Algorithmic trading has been on an upwards curve for a while, partly due to increased awareness and the prevailing market conditions. The increased availability of effective algorithms is also a contributing factor to this trend. Transparency is also an increasingly big deal, with 46% of those who responded to the survey indicating transparency as being their main reason for switching providers.
The ability of brokers to accurately forecast the implications of the incoming MiFID II regulations – particularly those parts of it that refer to BCNs (Broker Crossing Networks) – is going to have a large bearing on how well they perform in the coming year. Under the terms of the new directive, BCNs will fall under the new category of Organised Trading Facilities (OTFs). This will effectively mean that BCNs will be under much tighter regulation than before. The impact of this move will be felt most by UK-based buy-side firms that use them as an alternative to committing their own capital.
In 2011 5% of trading by institutional investors in the UK was done on risk, a drop from 20% in 2008. This pattern is broadly mirrored by the figures for Europe, but only 8% of British survey respondents considered the availability of liquidity in BCNs to be insignificant, compared with 67% of European and Nordic respondents.