The news coverage recently on the SEC settlement with Citigroup, where the firm lied to its buy-side clients about the nature of the order flow in its dark pool, has predictably missed the most important point. Instead of the usual fear mongering over HFT triggered by the case, the real story is how Citi was able to deliver poor execution quality for YEARS without either being detected or having its story challenged. In this case Citi lied to their clients by telling them that they were trading against uninformed retail order flow, while their clients were, in actuality, often trading on other dark pools or with HFT firms as the counter-party. This is like earlier cases against Credit Suisse, Barclays, Merrill and ITG as they were all based on misrepresentations to clients. There is no excuse for lying to clients, and, for the record, it is good that Citi was caught and experienced consequences for their behavior.
Apart from the operators of dark pools misleading their clients, however, the blame here should not be placed on the HFT firms legally providing liquidity in those pools. Some blame needs to be shouldered by the buy-side institutional clients that used these systems, without measuring their effectiveness or even questioning the value of trading with retail flow.
Over the past decade, one story told repeatedly and believed by buy side traders is that interacting with retail flow will improve their performance. Sadly, while that could be true in rare circumstances, in most cases, waiting for such order flow incurs more in opportunity cost than is gained by so called spread capture. Speaking from experience as someone who established and operated a market making business, which derived profit explicitly from trading against retail order flow, the margins in that business are very small, particularly compared to the institutional commissions paid by the buy side. Plus, to realize those profits, the market makers portfolios risk needs to be quantitatively managed and positions could be held for long periods of time. Neither of those attributes pertain to buy side trading, which generally seeks some immediacy in the establishment or liquidation of positions. It is a well-known fact to participants in that business, that the story of retail flow desirability is overblown, but since some market makers operate businesses to essentially sell that story to institutions, (as Citi did during the time this case occurred) there is little motivation to set the record straight.
I wish I could say that I am surprised by how easy the asset managers were to dupe, but sadly, I am not. For years, I have observed the ambivalence displayed by the asset management industry over the impact of trading costs on their performance. In fact, it is somewhat cathartic to rant on this subject, so here goes…
The best analogy for my thoughts on this topic is the famous 5 stages of death and dying: Denial, Anger, Bargaining, Depression & finally, Acceptance. (Although in my case, I never experienced depression)Denial (stage 1) started several years ago, after I left Two Sigma (a firm that prioritized execution analysis from its inception) to head an execution quality measurement business at a small software company. The goal for that business was to sell analysis that would show the actual cost of trading, including the measurement of opportunity costs and analysis of the effectiveness of both routing strategies and venues. What I came to realize, however is that the majority of the traditional asset managers do little analysis of true trading costs, or how such costs impact their performance, choosing instead to prove they trade in a manner similar to their peers. They utilize benchmarks such as VWAP (volume weighted average price), that have no relation to the cost of acquiring or liquidating positions, and rarely even collect the data necessary to do proper analysis, such as the unexecuted orders that are routed on their behalf.
For a while, I refused to believe that buy-side trading desks would resist the obvious logic that measuring trading cost should be viewed as mission critical. After some time, I did get a bit angry (stage 2) but focused on trying to improve the product suite being sold by my firm at that time. When I left that firm and joined ViableMkts, I entered the bargaining phase. During that time, I published article after article attempting to explain to the asset management community what they should be doing. This continued for a while, before I came to understand that, at investment managers, the trading function was treated as subordinate to both portfolio management and marketing. Some of the best buy-side traders understand what they should be doing to improve the firms performance but have difficulty in persuading management. At that point, I reached acceptance… (It helped that around the same time, I was diving headlong into Crypto, by founding CoinRoutes with Ian, and building a suite of products that would allow traders of crypto-assets to achieve best execution. The irony is that, as nascent and unregulated as the crypto markets are, it has been much easier to persuade crypto traders that execution quality is important.)
Ok, with that out of the way, the simple fact remains that most asset management firms dont properly analyze venues, nor do they evaluate true trading costs. The fact that investment managers are willing to pay higher commissions to interact with retail flow means either they massively overvalue that flow, or they didnt evaluate Citis trades (or both). Otherwise, they would have been able to discern that they werent, in reality, trading against retail. Amusingly, I think the answer is both…
While ViableMkts is certainly available to help asset managers properly design their own analytics, or find vendors that can do so on their behalf, I am not holding my breath. Every time there is a media covered event, I used to think that “NOW” managers will be willing to pay for proper analysis, but have been wrong every time. Perhaps this time will be different, and if any readers want help, feel free to contact us or reach out to those vendors who you feel might be able to do so.
