The following originally appeared similarly as an article on Futures & Options World on January 4, 2016.
In a previous blog post, I wrote about the concept of sell-side retrenchment and how many buy-sides are re-engineering their trading environments in response. This was based on extensive research Object Trading conducted over the last twelve months into how trends in the futures markets are affecting the buy-side. During our research, we interviewed a range of buy-side representatives including large asset managers, systematic hedge funds, proprietary trading houses, market makers, and medium and long term CTAs. We also convened two round-tables, the first just for proprietary trading shops and the second for CTAs, hedge funds and prop firms.
[Download a copy of our research paper, Velocity of Change Demands a New Approach]
Buy-sides are increasingly being forced to find and fund their own market access technology solutions. There is however, a valuable silver lining to this extra effort. In taking the opportunity to build a single, normalised market access infrastructure, they gain the benefit of substantial increases in control over their business models, by managing execution quality and slippage, mitigating the effects of liquidity fragmentation, and responding quickly to volatility extremes.
Managing Execution Quality (Slippage)
Firms participating in our research defined execution quality and slippage differently based on their trading outlook. Firms using latency-sensitive arbitrage strategies tend to need to be first to a book, whereas firms with long-term or large positions are most concerned with the equity curve impact of slippage. For example, if a firm pays for immediacy (crossing the spread), they will pay a few extra ticks. This may not seem like much on an individual basis, but when you scale it up for size, the cost of slippage becomes much more profound. A position-taking firm trading size can lose more in slippage in one position than most proprietary traders can gain or lose in their entire P&L.
Regardless of whether a trader needs to get to the book first, manage slippage on larger positions, or pay for immediacy by crossing the spread, their market access infrastructure has a dramatic impact on execution quality. This can be a key determinant of a strategy’s profitability and longevity.
Running production trading and simulated models for trading strategy R&D on an integrated, single market access infrastructure allows for real-time tracking of system performance, slippage, and risk, and allows direct comparison between modelled and actual equity curves. This will help firms better predict slippage and model potential market impact prior to scaling-up their strategies in production.
Dealing with Fragmented Liquidity
Regulations designed to increase competition have spawned a plethora of new trading venues globally. Venues frequently launch look-a-like contracts with rebate incentives in an effort to attract liquidity away from incumbent products on competing venues. When proprietary trading firms and market makers trade the new look-a-like contracts to take advantage of rebates, the broader result can often mean fragmented and shallower liquidity in the established local and global futures markets. While firms that trade in and out of the markets many times a day benefit from lower fees; for CTAs and managed futures funds, the benefits of competition and innovation are often dulled by increased complexity and distortions of liquidity and price discovery across venues.
[For more insight on the “disincentives of incentives”, download the Futures and Options World Magazine special report, CTAs Piece Together Fragmented Market]
Some market-making firms actively look for opportunities to capture first mover advantage and take advantage of new product pricing incentives, and for them, market access is a major concern, particularly when it comes to more obscure global marketplaces. While most clearers offer access and connectivity to the high volume, established exchanges, they rarely offer this connectivity to the less established. In years past, brokers were accommodating to clients requesting new connectivity. But today, sell-sides are more reluctant to take on these costs without substantial initial customer demand and upfront commitment from buy-sides.
Implementing their own, normalised, single market access infrastructure means market-making buy-side firms can more easily access multiple markets, for a lower TCO, while maintaining use of their existing preferred execution platforms and brokerage relationships required for managing risk constraints. And for the bulk of buy-sides not competing in the latency arms race or focusing on latency arbitrage, market macrostructural forces eventually require diversification. But coding new connections to each exchange slows down strategy R&D, market onboarding, and the ability to maximize ROI on trading strategies. Therefore a normalised interface also facilitates testing strategies on new markets without needing to re-engineer market infrastructure, thus vastly improving strategy portability and decreasing time to access new profitable markets.
Changing Levels of Volatility
Most buy-sides are impacted by volatility. However a significant number of prop trading firms that relied heavily on volatility-based strategies have been forced into retirement following the steep decrease in volatility after 2009. More recently, however, firms have suddenly had to cope with a marked increase in volatility. Neither extreme is favourable, and firms comment on the search for “Goldilocks volatility”—not too little, not too much, but just right.
Market access is a key determinate of success for firms that rely on volatility and trade in a variety of market venues. If firms can trade in the same fashion and tooling across markets and products, then they can focus more resources on strategy innovation instead of the market interface or idiosyncrasies in handling order flow.
The Bottom Line
With buy-sides increasingly footing the bill for market access, trading firms need to optimise their infrastructure so they can achieve the best results with the lowest TCO. Leveraging an integrated market access infrastructure that uses a single interface for pricing, execution, and risk constraints across markets can reduce the effect of inconsistencies, improve trading results, speed up the R&D process, and reduce overall costs.
For more insight into this topic, see the full buy-side research report, Velocity of Change Demands a New Approach; and the special report we co-produced with Futures and Options World Magazine: FOW Special Report: CTAs Piece Together Fragmented Market.