Having recently moved to L.A., I’ve been thinking more about the ocean lately, particularly about waves. They fascinate me. They often break on the beach with a violence that belies their calm nature in open seas. I also see waves in our industry right now. The past five years have been akin to a tremendous swell crashing violently on shore.
The industry has been tumbled upside down in the break. Quite literally, in fact, with the buyside-sellside relationship turned so topsy-turvy.
But many in the industry are taking a second look, as some recent stories in the press have indicated. Average commission rates have seemingly bottomed out. The industry has moved toward tiered structures, paying less for commodity executions and much more for value-added trades. This has happened in the midst of the dark-pool revolution. As the number of non-displayed venues (and tools to access those venues) has exploded, many traders have become overwhelmed with choice, and are beginning to ask for more visibility in trading.
We are coming to a collective realization that the recent wave of change we’ve endured momentarily submersed a powerful tool in a trader’s tool belt-color. The ability to discern market color and to use it as an integral part of a best execution process has always been a must-have for the professional trader. But traders had eschewed color in the rush to try out the latest electronic gadgetry, and with good reason, given the impressive creativity on display in so many of those new tools.
But color is making a comeback.
Color can imply many things, so I’ll define what I mean. I’m not talking about research or news on a stock, or technical analysis, or rumor. All of those may be components of color, but color, as classically transmitted on Wall Street, is more than all that.
Color is the who, the what, and the why of a block trade. Discovering the answers to these questions, to whatever extent possible, allows a trader to formulate the where, when, and how of an execution. Those decisions form the basis of best execution, in fact.
Any discussion of color seems to lead quickly into a discourse on leakage, or the improper use of information that results in a detrimental execution (at least, from the perspective of the person whose information was leaked.) In talking about what color truly is and how it fits into a holistic best execution process, we can also define and compartmentalize leakage as well.
Let’s break down color’s component questions. The who is the most frightening to traders, especially at the biggest institutions. While one can say that the who can contain information about brokers and venues that have an axe in a name, in the minds of these elephantine firms, the who can also include the leakage of their firm’s name, which is taboo.
Likewise, the why can be a tricky question to answer. Clearly, there is a tremendous difference between a fund trimming a holding to manage cash and a fund someone is selling because they almost slipped in a pool of leaking hazardous waste while visiting the company’s manufacturing plant. The more unique the why, the less likely a trader wants to share it with the marketplace.
Both the who and the why can be viewed as zero-sum pieces of information. If they get into the wrong hands, someone may win at the expense of another. That is leakage, and as such, one can see that leakage is not the opposite of color, but the improper use of part of the picture. But the use of the third part of color, the what, is not zero-sum at all. If handled correctly by professionals, it can lead to an exchange of information that benefits both parties in a negotiation.
The what refers to an order’s true size, not just the size reflected in an IOI. That means taking into account the part of the order held in reserve, whether in an EMS, a dark pool, a trader’s uncommitted blotter, or even in a portfolio manager’s head.
The what is currency. It can be used in order to draw out a counterparty’s trading interest. It can be used in timing. It can be shared or not shared, depending on the comfort level and trust one places in an agent or a venue.
I mention venue because it is necessary to explain why the need for color is making a comeback. The use of color carries a moral obligation. The buyside enters into every trade with the mindset that “I want to see yours, but there’s no way I show you mine.” Typically as traders, we parcel out our own color-the whats, but even rarely the whos and whys-when we feel that the person receiving that information has both a moral obligation and a financial incentive to protect us. Our trading intent is a tremendous asset; we know it, and only part with it openly when we trust the person to whom we impart it, or at least when we trust their motivations.
In non-displayed venues, there are no moral obligations. We cannot see whom we are trading against. Worst of all, the gaming that exists often seems to be able to discern our whats, or at least those whats we’ve risked placing, without our permission. Certainly, we can complain to the entity that owns the venue about gaming (leakage’s systematic cousin) and the like. I worked on the buyside for a long time and at a dark pool after that, and I can promise you the first question I asked, and then that was asked of me, was “What do you do about gaming?”
Recently, that question had been nearly always followed by a second question: “Can you send me indications of orders in your dark pool?” In other words, people have begun asking for some display within non-displayed pools, or at the very least for blotter interaction that is essentially the same as display.
Why? Well, the wave of change that hit the market inundated traders with different ways to approach block trading. These improvements were meant to correct the inefficiencies that preceded them. They did, for a time. Some still do. But many have failed to give traders a mechanism by which they can share their whats in order to achieve both price and size discovery.
Without that mechanism, and with certain technology-intensive trading shops seemingly able to sniff our whats without having to offer information in return, we lose faith in the new ways. We turn back to what we know worked previously-an exchange of information that can benefit both sides of a trade.
As the wave recedes, we’ve discovered again what we’re missing. We’ve begun to turn back to color.
Brian Pears is senior vice president for sales at JonesTrading in Westlake Village, California. The views expressed here are his own and not necessarily those of Traders Magazine.
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