Cover Story: Keeping Watch
Traders Magazine, May 2012
Morgan Stanley will consult with participants it considers aggressive takers of liquidity. A common occurrence is for a trading firm to hit bids or lift offers in a dark pool and then do the same in the public markets with such speed and in such quantities that they move the price. Contra-parties in a dark pool could suffer an immediate loss from this type of behavior. Morgan Stanley focuses on a pattern of this behavior to maintain the integrity of MS POOL.
“Certain types of activity are not healthy for our pool or our clients,” Morgan Stanley’s Johmann said.
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Consistency is a key factor when judging the behavior of a particular participant, Morgan Stanley execs say. A trader that consistently provides “good” liquidity will score high in the firm’s monthly surveys. One that consistently provides “bad” liquidity will score low.
For firms in the business of providing liquidity, Morgan Stanley prefers them to make markets across several names and not just trade when they want to. “We would prefer to see someone make a market in 100 names throughout the day, over someone who makes a market in one name and only trades in brief stretches of the day,” Johmann said.
Barclays distills a trader’s activity into a “modified” take ratio. The stat is calculated by dividing the number of times a participant takes liquidity by the number of times he supplies it. In general, a higher score signifies a more opportunistic trader. A lower score signifies a more benign or “good” provider of liquidity.
The calculation is modified, meaning it is not one of simple division. The ratio takes into consideration such factors as the size of the order and the liquidity of the stock. Taking liquidity in a very liquid name like the QQQ, for instance, does not factor into the calculation as much as taking liquidity in an illiquid name.
The broker combines that ratio with a measure of market impact, or short-term alpha, to create a profile of the trader.
The short-term alpha variable is calculated by dividing the price at which the trader bought or sold stock into the price of the stock shortly after the trade. A positive short-term alpha suggests an opportunistic trader. A negative score suggests a more benign trader. That trader is less concerned about short-term profit and more interested in just getting the trade done.
It is only by weighing the two together that an accurate picture of behavior emerges.
For instance, a trader that only takes liquidity may or may not be considered predatory. If he consistently makes money on every trade, or has a positive short-term alpha, then some might consider him a dangerous trading partner. But if he generally loses money on every trade – in other words he is trading even though the market is moving against him – he may be a desirable counterparty.
Likewise a trader with a low modified taker ratio may appear to be a friendly supplier of liquidity. But if prices in the market consistently go his way after his trades, he might appear to be too “informed” for some counterparties.
For Barclays, the end result is a scatter graph that divides the players into four quadrants: the toxic, the benign, and those in between. ING’s Cacciatore, for one, says the breakdown is useful.
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