WHAT IS THE VALUE OF A BLOCK?
Gareth Exton, EMEA Head of Execution Consulting at Liquidnet describes how it’s possible to measure and prepare for the new trading environment.
Why has there been a growth in block trading in the dark markets recently?
Two very distinct events have led to a growth in block trading over the recent years. One is the MiFID II regulations coming into force in January 2018, bringing with them the move towards large-in-scale (LIS) trading, which has certainly focused minds on the way people handle their orders. In addition to that, MiFID II is forcing trading firms to think carefully about their workflows, for example do I always look for block trades at the start of my order, do I go outbound to all conditional venues, or do I want to continue to trade on a schedule.
The second reason was Brexit in June 2016, when we saw a much higher number of block trades being done in the days immediately after the vote. I think a lot of people fell in love again with block trading as they could trade in and out of large positions in a short space of time, with very little price and market impact.
Do you think this trend towards trading in blocks will continue?
Most definitely, because a significant number of venues are entering the market offering a new, automated, conditional order type and a focus on ensuring trades are over the LIS waiver threshold. Liquidnet is already future-proofed for this new liquidity landscape; currently 94% of our trades are above the LIS threshold, but there are a lot of new initiatives in the market such as the UBS MTF offering a large-in-scale preferencing service or Euronext announcing their block trading MTF. And of course, there is also Turquoise Plato BDS and BATS LIS, which are growing in size and highlighting a clear direction of travel towards more conditional LIS orders.
How does this move towards more block trading benefit the end customer?
Generally, end customers should get their orders done quicker and see improved performance. If you’re looking for a block, you tend to do that at the start of an order, either via a manual workflow or via a conditional order that is part of an algo. This means you should get closer to your arrival price, which has become the primary benchmark for a lot of trading desks. Furthermore, as conditional orders are executed in the dark, they don’t cause the impact that these large orders would do if traded in the lit.
What changes will this bring?
The big change I think people will see is that the fill profile of their orders will change significantly. In Europe we are very used to people trading along a fairly predictable volume curve. This has meant it has been easier to predict how long it would take for an order to trade, based on a stock’s typical volume curve and how much liquidity they tend to have in certain venues.
This predictability will be blown out of the water with the rise of the conditional order type, the removal of the BCN liquidity and the move towards systematic internalisers. The liquidity profile of a stock will completely change and this means smart order routers will need to be re-configured and the way that algos work will need to be adapted. This will result in more variability to an order’s duration and performance vs different benchmarks. It will be important therefore, to measure the value of block liquidity when assessing execution performance, often placing a higher value on liquidity over an average market price. Managing that variability in both execution experience and performance is going to be key.
So how do you track and measure the value of a block?
We will need new metrics in place for valuing the percentage of average daily volume that is getting done, the price reversion around the time of that trade, and how liquidity is valued. All this comes down to how you’re measuring your fund performance and the style of trading that you are doing.
There will be much more variability in how you track different styles of trading. At the moment, a lot of people have some standard benchmarks that they use across all of their trading and brokers. In future, I think we will see a move to more granularity by tracking the monitoring and performance of these type of orders in different ways than standard flow trading, including POV / VWAP / Close. This kind of block / LIS-style trading will have to be looked at separately, with a focus on the impact that you’re having around the time of the trade and the liquidity that you are capturing being key to the way that you value that block liquidity.
What should asset managers be doing to prepare for these changes?
One important area is to look at the best execution policy that you have in place, and how you factor in block trading into your workflow. Best execution policies post MiFID II will need to be quite specific about how you take into account the seven ESMA factors and how you build your workflow to reflect those. For example, for large percentage ADV orders you might state that your first port of call is a block trading venue in order to minimise information leakage and capture available liquidity, then move on to conditional venues and finally start trading via an algo. Every firm’s trading workflow will be different based on the type of orders they receive but all firms need to consider these issues in designing their new best execution policies.
What is Liquidnet doing to help?
Block liquidity it at the heart of what we do. Our dark pool will be fully compliant and ready to go on 3rd January 2018 when the new MiFID II rules come into play. Our members are looking for that large-in-scale block at the start and their algo orders rest fully conditionally in the Liquidnet pool.
To help with the quest for liquidity, we also offer conditional access to BATS/BIDS and Turquoise BDS in the full size of your order, from the moment the order starts to the time the order ends. We are also enhancing our TCA consultancy service to factor in block trading and show the value placed on block liquidity, and adding a specific section to our TCA product that looks at conditional orders and the performance around your block orders.
In terms of venue analysis, we have built out a Venue Ranking Model, taking into account average order size, large-in-scale, and the way conditional venues work in terms of fading and behavioral score. All these elements are taken into account when our smart order router is configured. This information will be available to our members and their clients, to ensure we offer full transparency about what’s happening to their orders, what liquidity they’re capturing and at what price.
With MiFID II on the horizon, we feel that we have a responsibility to provide as much information as we can and be as transparent as possible to our members on how we are handling orders. We owe it to our members to prove that we are trading in their best interests at all times, and that our solutions are configured in such a way that they are compliant with the best execution rules and our own policies. We have invested a lot of time to ensure that this information is available to members and being explained, so that we can help them as much as possible to capture the liquidity that they are seeking.