Survey Reveals Buyside Views of High-Frequency Trading

Buyside traders are emerging from the financial crisis of last year and this year with a greater reliance on their own trading tools, but also with deep concern about regulatory changes that could upset trading in the equities markets.

The vast majority of buyside firms surveyed by research firm TABB Group–84 percent–said they wanted regulators to "take no action" to constrain about high-frequency trading, according to Laurie Berke, a principal at TABB and the author of a new study about institutional trading. The study examined a variety of trading practices in the context of a regulatory environment that is changing.

The Securities and Exchange Commission is considering a broad array of market structure changes. It’s working on a concept release about high-frequency trading and various types of dark liquidity, due out early next year. The SEC this fall proposed new rules curtailing certain types of messaging activity in dark pools and on displayed markets, and is contemplating other changes, partly in response to concerns about how technology has altered the trading landscape.

For the institutions surveyed by TABB, high-frequency trading is not the burning issue it has become in the press and among some U.S. senators. Fifty-five percent said they were indifferent to high-frequency trading, while 28 percent said it was good and 17 percent said it was bad. The public outcry about how high-frequency trading is altering the markets is "much ado about nothing," Berke said. "This concern is not being driven by institutional traders."

The TABB study was based on interviews with 66 long-only buyside firms representing $12.1 trillion in assets under management. Large firms, with at least $150 billion in assets, represented 86 percent of the assets in this universe. Berke highlighted the key findings from the study in a webinar on Wednesday.

The reasons for the apparent indifference toward high-frequency trading vary. Of those surveyed, 28 percent said traders must always deal with the tradeoff between liquidity and gaming. Gaming and trading ahead of institutional orders is a concern with some high-frequency trading strategies. "That’s the nature of the marketplace," Berke said, summarizing the views of traders. "We’re used to that. This is just happening in electronic form."

Another 43 percent of firms surveyed said they could not quantify what impact high-frequency traders have on their trading. Berke added that, in the view of these traders, "there’s just not enough data, there’s not enough analysis done."

At the same time that institutional traders are contemplating the prospect of new trading rules, and how that could affect the trading ecosystem, they are continuing to take more control over their own trading. This translates into more algorithmic and electronic trading and a decrease in the use of upstairs trading desks.

"I think we saw a momentary blip in high-touch [trading] when the high-touch traders captured much more order flow [as a share of institutional trading] in 2008 than they did in 2007," Berke said. That development ended this year.

This year, 38 percent of institutions’ volume went through sales traders, down from 44 percent in 2008. Traders executed 31 percent of their flow via algorithms this year, up significantly from 24 percent in 2008. Program trading, direct market access and the use of crossing networks remained roughly the same this year, compared to 2008 levels, according to the study.

TABB speculated that usage of brokers’ algos would rise to 36 percent in 2010. If that happens and sales traders see a smaller portion of institutional flow, algo trading could represent a bigger share of trading than what’s sent to upstairs desks. And, as the crisis continues to abate and volatility decreases, there could be a "more permanent shift to slicing and dicing" and away from printing blocks, Berke said. This shift is also fueled by changes in the types of firms now providing liquidity to the markets.

Berke suggested that this transition might already be reflected in traders’ shifting expectations of "low-touch sales traders." She noted that buyside traders are now looking to these traders for market color, information about the algo and execution strategies their peers are using, and the types of liquidity that reside in particular dark pools they access. Traders are also looking to the sellside for more insight into market structure changes the SEC is considering and what impact those changes could have on trading.

One sign of the continuing shift in institutional trading is that blended commission rates are still declining, according to TABB. The blended commission rate buysiders paid brokers this year through November was 1.74 cents, down from 1.89 cents last year. In 2007, the rate was just under 2 cents, while in 2006 it was just over 2.5 cents.

The use of client commission arrangements is also continuing to grow, TABB found. This is being encouraged by developments in the trading landscape. Institutions have fewer assets now than they did two years ago, a "smaller wallet," and they must find ways to pay for critical execution capabilities such as smart routing, algorithms and transaction cost analysis, Berke said.

Another trend on the buyside, Berke found, is a greater willingness and desire to get more involved in decisions formerly left to sellside firms. Institutions are "increasingly asking for customization and control" over how their orders are routed to dark pools, Berke said. Some want particular pools preferenced, or favored, based on the type of liquidity they contain. Firms are also asking more questions about what factors affect a broker’s routing decisions, including the cost of accessing various venues.

In the current fragmented market, buyside firms, she said, are also willing to access more dark pools if those pools offer more liquidity–and especially more unique liquidity. About 86 percent of firms connect directly to crossing networks, and 39 percent connect directly to broker-operated dark pools.