[For more on the evolving European equity execution landscape and the rise of low-touch trading, please contact TABB Group about our latest research, “European Equity Trading 2014, Part 2: Low Touch Domination Takes Off.”]
With the capital constraints of Basel III biting, regulators intensifying restrictions on the OTC market, and politicians extolling the virtues of the buy-to-hold model, traditional execution methods are fast disappearing into an exclusive club few asset managers can afford to join. The consequential reduction of overall turnover since 2007 may have been abated by recent European activity (see Thomson Reuters' Equity Market Share Reporter), but overall volumes are still down more than 50% pre-crisis, and they are increasingly dictated by country and market cap.
Europe already struggles with vastly disparate liquidity given the country-specific nature of equity trading, as well as higher market data costs relative to the US. The concentration of country, products and services are spiraling the European fund industry inward to increasingly larger-cap names traded by larger asset managers via standardised algorithms; while trading among the small and mid-caps is slowly being restricted to a select minority.
This not only affects execution. At the selection process, the liquidity of the stocks illustrates the likelihood of alpha lost when exiting a position. Lower liquidity levels can deter investors from opting to put small and mid-caps into their portfolios; some funds even are opting to shift their activity away from the small and mid-cap space entirely. But as funds become larger, the shift to more large-cap stocks at the expense of small-caps is harder to maintain. Outperformance in large-cap companies is harder to achieve, as stocks tend to be more efficiently priced and are harder to enter or exit.
What Next For Europe
It is in this environment that some firms have chosen (or been forced) to focus an increasing proportion of their activity down the low-cost route. Firms that in the past paid an overall rate of 15 bps may now choose to spend only 3 bps on execution via an algorithm, keeping 12 bps back for research payments, making the sales trader appear an expensive option at 7 bps. However, the European equity trading environment is increasingly complex, and as the industry has focused its attentions on lowering the explicit cost of execution, the implicit costs appear to have been overlooked by some. This is set to change.
The FCA’s recent focus on unbundling and the increasing role of investor protection in wider European regulation will focus minds on what best execution is and ultimately how it can be achieved. Best execution may in fact mean trading via high-touch channels at times – high or low touch, it should be the correct style of trading for the order in hand. Therefore, institutional traders will increasingly need to assess execution performance robustly, independently and, ultimately, in real time.
The End of the Sales Trader
This will not automatically mean the end of sell-side sales trading. However, the danger is that at the very time good sales traders can really add value, they may have less value to offer as the market shifts trading toward the larger-cap stocks. This is where we need to tread cautiously. The shift in control from the sell side to the buy side will come with its own set of complications.
While the UK currently retains a robust AIM market, many other countries in Europe have already witnessed a demise in small and mid-cap activity. This needs to be protected through the transition to greater automation or the true purpose of capital markets – the creation of economic growth through the efficient allocation of capital – has the potential to become yet another unintended consequence in the evolution of European equity trading.
Buy Siders in the Driving Seat
While liquidity remains the No. 1 priority for the buy side, electronic access will continue to encroach on traditional business models as the industry turns in on itself in search of efficiencies. Asset growth and operational efficiency are prerequisites for achieving essential economies of scale. Automation is not just algorithms, but rather automated, multi-faceted interaction. Declining liquidity in specific stocks and countries will ensure fund performance is ever more reliant on alpha retention and cost controls.
As the fiduciary responsibility of the buy side increases, the ability to demonstrate best execution will dominate, enabling asset managers to see not only where orders are executed but the impact of executing on individual venues. As results continue to influence the execution process, bulge-bracket success in algorithms linked solely to research capabilities may be in for a rude awakening. Likewise, liquidity aggregators may be viewed in a different light as participants become better informed as to the benefits of limiting information leakage versus a potential decline in the speed of execution.
The increase in technology will undoubtedly impact smaller institutional and retail firms that lack the capabilities to hold their brokers to account or access all trading venues. Sell-side and buy-side stark choices remain – compete, partner or outsource. As automation in the execution space permeates across the asset classes and into additional products and services, low touch will no longer reflect merely a dumbing down of execution but a wider quantitative adaptation of technology encompassing short-term alpha within the investment decision. This in turn will change what the sell side needs to offer, what the buy side elects to pay for, and whether independent vendors will in fact become the conduit between the future buy and sell sides. One way or another, technology will be pushed to the fore.