Shift to dark pools, algo trades and electronic venues lowers trading costs

Date: Friday, September 12, 2008
Author: Hedgeweek.com

Institutions across Europe are gearing up for a major move into electronic equity trading that will include a significant push into execution options such as crossing networks, dark pools and algorithmic trading strategies.

The results of Greenwich Associates' 2008 European Equity Investors study reveal that institutions currently execute about two thirds of their European equity trading volume through "high-touch" trades facilitated by broker sales-traders. The institutions participating in the study say they expect that share to drop to slightly more than 50% within the next three years.

"In our research around the world, it is extremely rare to see institutions predicting such a radical change in practice in such a relatively short span of time," says Greenwich Associates consultant John Colon.

Already, the proportion of European equity trading volume executed through traditional high touch trades facilitated by a broker sales-trader has fallen to just two-thirds, from 69% in 2006- 2007 and 70% in 2005-2006. The institutions participating in Greenwich Associates' 2008 European Equity Investors study expect that share to drop to slightly more than one half of total trading volume by 2010.
 
A substantial amount of the business that European institutions expect to divert from broker sales-traders in the next three years will shift to crossing networks and to self-directed electronic trades incorporating algorithmic strategies.

Algorithmic trading currently accounts for about 7% of European equity trading volume, and crossing networks capture only 2% of total trading volume. But European institutions appear ready for a significant change in strategy: By 2010 institutions expect to be executing almost 15% of total European equity trading volume through algorithmic trades, and more than 10% through crossing networks and dark pools.

"Continental institutions predict that crossing networks and dark pools, which currently receive only 2% of their total European equity trading volume, will grow to 11% by 2010," says John Colon. "While that prediction seems overly optimistic, it nevertheless illustrates just how dramatic an overhaul institutions are preparing for."

If institutions follow through on these predictions, the European market in three years' time will more closely resemble the make-up of the market in the United States, where institutions expect to be executing more than half of their trading volume through "low-touch" or "no-touch" trades by 2010.

The sheer size of the U.S. market has allowed alternative trading platforms to develop there at a relatively rapid pace. While the expansion of these new execution venues has undoubtedly lowered costs and given U.S. institutions valuable tools for achieving best execution, it could also be causing fragmentation.

"It remains to be seen if the build-up of liquidity in these alternative venues in the United States and now in Europe detracts from the overall liquidity and transparency of these markets over time," says Greenwich Associates consultant Jay Bennett.

One thing not in doubt, however: The proliferation of execution alternatives ? combined with stricter regulatory mandates on best execution ? has made the equity trading process in the United States much more complex for institutional investors.

"Our research suggests that European institutions are now experiencing the same phenomenon," says John Colon. "As these new alternatives come online, the task of guaranteeing best execution becomes much more involved, because institutions now have the option ? or the fiduciary requirement ? to choose from among several execution venues, each offering slightly different levels of liquidity, pricing, and other benefits such as anonymity and decreased market impact."

The total amount of commissions collected by brokers on trades of European stocks slipped approximately 5% from 2007 to 2008. Based on the observed level of activity in global stock markets over the period, it appears that most of this decline can be attributed to reductions in the average commission rates paid by institutions on these trades, as opposed to a decline in trading volumes.

While institutions currently pay an average commission rate of 15 basis points (bps) on "high touch" trades of European stocks, commission rates on electronic trades average just 5 bps. Obviously, reductions in trading cost are good news for institutional investors. Given the state of health of the major financial service firms, however, Greenwich Associates is advising its clients and Research Partners to keep a close eye on the level of coverage, service and research they are receiving from their brokers as average commission rates contract.