Buy side firms have shown signs of impatience with U.S. equity market structure. While they are leery of radical reforms, institutions have seeded a number of trading venues lately.

The topic of buy side firms investing in alternative trading system came up during a recent industry conference discussing 40 years of the National Market System. “Why are institutions investing this money in alternative trading systems?” asked Pete Jenkins, managing director at PDQ Systems, moderator of the buy-side response panel at Baruch Financial Markets Conference on November 11.  “This would suggest to me that those firms investing are unhappy with the market structure,” suggested Jenkins.

On the heels of several high-profile dark pool scandals, the buy side has been investing its own money in alternative trading systems, including Luminex in the U.S., Plato Partnership in Europe and IEX. Both Plato and Luminex are buy-side led trading venues designed to allow the trading of equities in large order sizes, according to Financial News.

While Luminex is exclusively for the buy side, Plato Partnership is a consortium of asset managers and broker dealers, which are collaborating to create a not-for-profit trading utility in Europe. IEX’s ATS is owned by a collection of mutual funds, hedge funds, and venture capital funds as well as family offices that saw value in its model. Currently operating as an ATS, IEX built a speed bump to prevent high speed participants from front running other investors’ orders. IEX has filed to become a stock exchange.

Solution to a Crowded Field

Asset managers have access to a crowded field of 11 exchanges and over 40 dark pools, so the formation of a buy-side led consortia is not for lack of choice. The trend toward financing their own equity trading venues is aimed at seeking a safer environment, lower transaction costs and more transparency into order routing.

One reason for the buy side’s frustration with stock trading is the difficulty in executing block-size orders. Dark pools were originally established to help the buy side execute block trades. But order sizes have shrunk to 10-year lows with average trade sizes hovering above 200 shares, according to Tabb Group’s Liquidity Matrix for October. “Despite all of the desire of the buy side to trade blocks, trade size continues to whittle down,” according to Larry Tabb, CEO of Tabb Group in the firm’s Market Structure Weekly report, who attributed this a combination of algorithmic trading, liquidity provision and difficulty in finding the other side of the trade. “If Luminex is able to consolidate and provide a better experience for those trades that are really appropriate and best suited for block trades, that is a modest percentage of our order flow,” said Andy Brooks, VP at T.Rowe Price, noting that T. Rowe Price is a 5% owner of Luminex, which is run by nine large money managers.

According to the Luminex Trading & Analytics web site, “Luminex seeks to create a trading venue that satisfies the liquidity needs of buy-side firms and prevent the main challenges of dark pools, such as intermediation, fragmentation, fall downs, information leakage, and concerns around ownership and control of trade data.”

Another purpose of Luminex is to “cause better behavior on the sell side,” said Brooks. Though the buy side trader said he usually likes the sell side most of the time, he cited a number of criticisms.

“We’re unhappy about the incentives for order flow routing. The complexity of where people send orders, and where they don’t get executions, and where they keep sending them and don’t get executions,” said Brooks. “It really begs the question of who you are operating for,” said the buy side trader.

While agreeing with other buy-side panelists that a lot of good things had happened, a lot of innovation and competition, Brooks said, “I worry about what’s going on behind the curtain. I think the buy side senses that there’s a better way to do some things and perhaps identify some of the conflict and maybe make the trading experience better.”

ATS Regulations Coming Down the Pike

Realizing that hidden conflicts of interest can exist beneath the surface, regulations are moving to increase the disclosures required of ATS operators.

On November 18, the Securities and Exchange Commission proposed new rules that will increase the operational transparency of ATSs, and boost the oversight of the private trading venues. The rules, which are now open for public comment, would require ATSs to provide detailed information through a proposed, newly created Form ATS-N about ATS operations, including:

• The activities of the broker dealer operator and its affiliates.
• Products and services offered to subscribers
• Arrangements with unaffiliated trading centers.
• The smart order router.
• Information on algorithms utilized.
• Personnel and third parties used to operate the ATS.
• Procedures and safeguards to protect subscribers’ confidential trading information.

Under the proposed rule, ATS operators must also provide details on types of orders, connectivity, order entry and co-location procedures, segmentation of order flow, order handling and execution procedures, outbound routing services, fees, market data, trade reporting, and other factors. According to the SEC, ATSs operators would need to publish Form ATS-N filings on their web sites and provide a link back to the SEC’s public web site.

Better Order Handling?

With more information available, the buy side should be able to evaluate the business conduct of ATSs so they can make better order handling decisions.

“The Commission preliminarily believes that if market participants have more information about the operations of NMS Stock ATSs, and the activities of the broker-dealer operators and the broker-dealer operator’s affiliates, they could better evaluate whether to do business with an ATS and make more informed decisions about where to route their orders,” states the SEC in the proposed rule.

Other Solutions

Meanwhile, head buy-side traders on the Baruch buy-side panel suggested they were considering other solutions to their block trading challenges. Aside from investing in their own block trading venues, traders indicated they were exploring the use of auctions and conditional indications of interest.  Panelists predicted the growth of conditional orders and conditional IOIs. Take the example of an institution with 100,000 shares to sell. Rather than fragment the liquidity of 100,000 shares into 10 different ATSs, through conditional IOIs the trader can go to all the liquidity providers, show their intention is to trade 100,000 shares and firm it up, explained one panelist.

“When I get enough interest, I can trade a lot more and I have a higher probability of getting a larger print,” said Enrico Cacciatore, Senior Quantitative Execution Trader with Voya Investment Management, who spoke on the panel.  Institutions will also see more use of auctions, predicted Cacciatore, citing MicroAuctions from PDQ ATS, a patented auction process with a 20 millisecond pause that gives control back to the liquidity seeker. “This lets an institution convey its liquidity needs directly to the market maker, and take out the liquid market,” said Voya.  “You’re going to see a lot of different venues creep up and they are all going to serve a different purpose,” he said.