BEYOND THE ATS: REDEFINING DARK LIQUIDITY

Size: px

Start display at page:

Download "BEYOND THE ATS: REDEFINING DARK LIQUIDITY"

Jemima Gardner
5 years ago
Views:

BEYOND THE ATS: REDEFINING DARK LIQUIDITY Over the last few years, the composition of off-exchange volume for US exchange-listed securities has come into sharper focus.

1 BEYOND THE ATS: REDEFINING DARK LIQUIDITY Over the last few years, the composition of off-exchange volume for US exchange-listed securities has come into sharper focus. In late 2015, FINRA began publishing ATS data, which not only made it possible to measure ATS market share, but the percentage of off-exchange volume done in an ATS versus traditional dealer activity, or Over-the-Counter (OTC) trading. However, until recently there was little data into the kind of activities that comprised OTC volume. How much of OTC volume was retail business dominated by wholesalers such as Citadel and KCG versus purely institutional flow? FINRA s recent release of limited data on OTC venues adds key insights into the volume puzzle. For the first time, we have an accurate but incomplete breakdown of OTC volume by broker. When you combine this new data with the well-known ATS data, the liquidity picture comes into sharper focus. Ultimately, this data can help traders identify which brokers or platforms should be used to maximize liquidity access and how that liquidity could be accessed. Quick Takeaways Our top three suggestions for our Members center on piecing the US Humpty Dumpty market structure back together again: 1. Dissolve the distinction between ATS and OTC. A regulatory construct has segmented the liquidity. Now you can measure the liquidity within a broker across its ATS and OTC activities a more accurate picture of liquidity. Only bakers and 90s health food nuts separate the yolks from the whites. 2. Ask the broker the same questions about its OTC activities as you do about its ATS. For many brokers, the OTC liquidity is more than one-third of its total volume (see Exhibit 3). Order your OTC liquidity the same way you like your ATS liquidity sunny-side up. 3. Understand the off-exchange breakdown for your stocks. While symbol-level data is limited on OTC activities, it s important to understand if a stock you re trading has been dominated by an OTC broker that you may not be able to access. Otherwise you might confuse the chicken for the egg. Categorizing OTC Volume FINRA publishes weekly aggregated OTC statistics in a similar format to the ATS data. However, the OTC data is only broken out for brokers that executed at least 200 trades in a given week. For example, during the month of July, FINRA reported specific volume data for 34 brokers. The remaining volume appears under the nom de plume De Minimis. In our analysis, we categorize the disclosed brokers into two categories: 1) Market Maker/Wholesaler, or 2) Upstairs. (We include De Minimis in the Upstairs category). We then categorize most of the ATSs into one of two categories: 1) Investment Bank Dark Pool or, 2) Execution Only. Any broker or ATS that does not fit into one of these four categories, we include under Other. On the following page are the key stats for these five categories for Q

2 Exhibit 1: Off-Exchange Volume by Categories Type* Description % Off-Exchange Shares Avg Trade Size ADV Market Maker/ Wholesaler Brokers whose OTC business includes retail wholesaling operations and internal market making 43% ,973,566 IB Dark Pool A dark ATS operated by a bulge bracket broker 24% 2,093 25,109,633 Upstairs Brokers whose OTC business is largely comprised of traditional upstairs activities 19% 13,007 18,177,252 Ex Only ATSs operated by brokers that only provide execution services 13% 6,323 10,085,287 Other ATS and OTC venues that do not fall into any of the categories above 1% 32,254 1,875,865 *see appendix for categorization of brokers into the categories For those regulators or market observers who fear that off-exchange trading could negatively impact price discovery, the focus should be on the biggest piece of off-exchange trading. Why is it more important to have increased transparency on the ATS market, which accounts for less than half of all off-exchange volume? But the lack of transparency into OTC is more than just a question of arbitrary regulatory standards. It also impacts everyday trading decisions. Volume Volume Volume Volume The Market Maker/Wholesaler segment poses a particular challenge to investment and trading strategies that use volume as a key factor in the decision process. The bulk of MM/Wholesaler volume is done as bilateral relationships as disclosed in a broker s 606 reports. Retail brokers and smaller brokers send orders directly to the wholesaler expecting an immediate execution with some level of price improvement. In many cases, the wholesaler will trade out of that position as quickly as possible by routing to an Exchange or ATS. There is an opinion that this type of interaction inflates volume. It is kind of an echo chamber where the initial trade generates at least one more trade as the wholesaler trades out of the position. But if an order from a retail broker is sent to a trading venue instead of a wholesaler, it could interact with the same liquidity the wholesaler would have eventually found. That would result in one less trade and less volume printed to the tape, but not a decline in end-user supply and demand. This is one example of how excess intermediation can distort the liquidity picture. Even under the assumption that the wholesaler adds value to the execution process, it is hard to debate that the process doesn t obfuscate the liquidity picture. Some VWAP and POV strategies exclude all off-exchange prints to avoid chasing volume or prices that were not truly available, similar to how block trades are usually excluded. The question is whether this same logic should be used within investment strategies that use volume as a component of momentum or some other factor. It can be a particularly sticky issue in less liquid stocks. 2

Dissolving the ATS/OTC Distinction While there are clear differences between ATS and OTC operations, it is primarily a regulatory distinction.

3 Dissolving the ATS/OTC Distinction While there are clear differences between ATS and OTC operations, it is primarily a regulatory distinction. There has always been off-exchange trading, and it has become cliché to say the market has always had some form of dark pools. If we merge these constructs and instead focus on off-exchange trading at the company level, we get a different picture than when looking at ATS/OTC volume in isolation. Of course, the biggest players are still the biggest players. But during this period, while IEX was the second largest dark pool, just behind UBS, it trails behind the total volume figures of four investment banks and is only slightly ahead of TwoSigma, JPMorgan and BAML. Credit Suisse, which operates the third largest dark pool, lags two firms that have significantly less ATS volume. Exhibit 2: Parent Level Market Share, Q Liquidity Distribution Strategies A broker can offer electronic liquidity through a number of methods. One model has customer electronic flow directly interact only with the broker s ATS and not provisioning liquidity externally. Any of the broker s principal orders could be sent into the ATS where customers could choose to interact or not. In this model, the broker is not providing any direct liquidity to customer electronic flow but is just another participant in the ATS. In another operating model, the firm provides capital directly to its clients via electronic channels, including actionable indication of interests and algorithmic flow. The client flow interacts directly with a market making function. In most cases, this liquidity would be printed OTC as well. The bulge bracket brokers in Exhibit Two run at least one ATS and an OTC facility. Comparing the ratio between the ATS and OTC volume among these firms highlights the types of business and liquidity distribution models a firm can operate. For example, six of the bulge brackets have a very similar distribution that favors the ATS with about two-thirds of the liquidity. However, it s not necessarily true that the six firms with similar ratios all operate the same way. For example, UBS has a wholesaling operation while the other five firms do not. However, UBS Pin was the largest dark pool during this time, balancing out the volume within its wholesaling operation. 3

Exhibit 3: ATS/OTC Split Among Dual Operators, Q3 2016 The three other bulge brackets stand out for different reasons.

4 Exhibit 3: ATS/OTC Split Among Dual Operators, Q The three other bulge brackets stand out for different reasons. Credit Suisse has a much larger skew toward the ATS, while Citi and Goldman Sachs favor OTC. Citi looks similar to KCG during Q because it was still operating ATD, an electronic wholesaler (ATD was recently sold to Citadel). The variation in the other two bulge brackets is possibly explained by the amount of internal liquidity the firm provides to its clients and how that liquidity is offered. 4

5 What Average Execution Sizes Means Neither model excludes the broker from also providing traditional upstairs liquidity in the form of block capital commitment. However, it would seem easier to discern which brokers are offering traditional upstairs liquidity when employing the first model. For example, when we view average trade size of ATS/OTC venues among dual operators, the firms with the largest average trade size tend to have a smaller portion of OTC volume. Let s go back to the outliers we identified earlier. Credit Suisse s OTC Average Execution Size is 47,644, but has the second smallest proportion of OTC volume among the group as seen in Exhibit 2. Goldman Sachs has the second highest proportion of OTC volume and the third smallest OTC average execution size. However, there is no clear differentiation among the rest of the group. We need more clarity and granularity to better understand these numbers; one has to know the underlying businesses that are included in the OTC numbers, such as the wholesaler models within UBS and Citi. Exhibit 4: Average Trade Size (ATS vs OTC) per Dual Operators, Q Parent Company ATS OTC BAML ,674 Barclays 5,791 5,655 Citi 8,339 4,141 Credit Suisse ,644 Deutsche Bank 199 8,651 Goldman Sachs 180 1,687 JP Morgan ,237 KCG Morgan Stanley 203 1,883 UBS ITG

6 What to Do With the Liquidity You Can t Get The cliché volume is not liquidity is used in a variety of situations. One common usage is in regards to high frequency trading and the belief that HFT creates/generates volatility that leads to volume that would not have happened otherwise. In this use of the phrase, high-frequency traders are said to create the demand for liquidity that they are happy to supply. Nice job if you can find it. Volume is not liquidity is also used to describe volume associated with latency arbitrage volume that occurs only because the HFT is exploiting a structural flaw. Whether or not one subscribes to these theories, the OTC data does highlight the challenge that off- Exchange trading poses to any volume sensitive strategy. If a good deal of the volume is executed OTC, what does that say about the validity of the Volume Weighted Average Price (VWAP) and percentage of volume (POV) benchmarks? Block trading is not immune from this accusation either; many POV algorithms ignore block prints to avoid overreaction. However, the advice to exclude OTC prints can be as sub-optimal as including it; in any case, we cannot reliably distinguish between ATS and OTC volume in real-time. Despite the lack of real-time data, even the high-level OTC data can be actionable. At the highest level, it s better to think about off-exchange liquidity at the parent-company level, and then work with those brokers to understand when and how to access these destinations. Dealing with market makers or HFT directly may not feel like the most desirable outcome, but there are times when our decisions are being influenced by the activities of these participants anyway. Burying your head in the sand isn t the best reaction to an earthquake. It is also important to monitor the split between ATS and OTC trading among the names you care about. At the very least, this can give you some indication of the accessibility of the flow, if not the exact location. Hopefully, FINRA will continue to push equivalent levels of transparency among ATS and OTC venues which would allow traders to better track and source liquidity. Liquidnet is actively monitoring these trends. If you are interested in viewing the data for a particular stock or list, please contact us. Adam Sussman is Head of Market Structure and Liquidity Partnerships at Liquidnet. He was formerly Partner and Director of Research at TABB Group. Liquidnet.com NEW YORK LONDON HONG KONG SYDNEY SINGAPORE TOKYO TORONTO ON A DIFFERENT SCALE 2016 Liquidnet Holdings, Inc. And its subsidiaries. Liquidnet, Inc. Is a member of FINRA/SIPC. Liquidnet Europe Limited is authorized and regulated by the Financial Conduct Authority in the UK, is licensed by the Financial Services Board in South Africa, and is a member of the London Stock Exchange and a remote member of the Warsaw Stock Exchange and SIX Swiss Exchange. Liquidnet Canada Inc. Is a member of the Investment Industry Regulatory Organization of Canada and a member of the Canadian Investor Protection Fund. Liquidnet Asia Limited is regulated by the Hong Kong Securities and Futures Commission as a licensed dealer and a provider of automated trading services pursuant to the Securities and Futures Ordinance and is regulated by the Monetary Authority of Singapore as a Recognized Market Operator. Liquidnet Japan Inc. Is regulated by the Financial Services Agency of Japan and is a member of JSDA/JIPF. Liquidnet Australia Pty Ltd. Is registered with the Australian Securities and Investment Commission as an Australian Financial Services Licensee, AFSL number , and is registered with the New Zealand Financial Markets Authority as a Financial Service Provider, FSP number FSP /16

Mechanics, Fading, and Performance

Mechanics, Fading, and Performance Mechanics, Fading, and Performance The performance of conditional orders has been a growing point of discussion as more Alternative Trading Systems now support the order