The Risk of “Unintended Consequences” is the Most Important Issue Facing US Equity Markets

As the US equity markets approach 2010, investment banks are putting their houses in order, trading volumes are surging and the floods of balance sheet losses and asset devaluations from 2008 have receded. But the calm after the storm can be deceiving. Buy-side traders tell TABB Group that the risk of “unintended regulatory consequences” is the number one market structure concern facing the US equity markets today.

In a new TABB Group annual benchmark research study published today, “Institutional Equity Trading 2009-2010: Dark Pools, Transparency and Consequences,” head traders at buy-side firms say that they are more concerned about this singular issue than any other possible market structure changes that may occur in the coming months.

According to Laurie Berke, principal at TABB and author of the study with TABB research analyst Cheyenne Morgan, there is a grave concern on the part of buy-side traders that inappropriate action could be taken on multiple pending issues that would have a dramatic negative impact on their ability to trade effectively.

While regulators and legislators have the holistic market’s best interests at heart, she adds, traders fear that liquidity will be impeded in some way or withdrawn from the market just when it’s needed most. “There is a lack of confidence that the requisite data has been captured and the requisite analysis completed to determine cause and effect or even the need for additional regulation beyond what is already on the books. Further, they would like to have a voice in these matters, to provide input into these possible regulatory decisions, before any incremental regulation is enacted.”

On the issue of high frequency trading (HFT), Berke says that traders are not concerned about this trading approach, explaining that nearly 84% of the head traders interviewed recommend “no action” be taken to restrict their activity. “Over half say they’re indifferent to HFT’s presence, while another 28% say that HFT is actually good for their trading style.”

For this year’s buy-side trading study, TABB spoke one-to-one with 66 buy-side traders at US institutional equity management firms managing an aggregate $12.1 trillion in assets. These in-depth, interview-based discussions covered post-crisis regulatory scrutiny from regulators and legislators; head traders’ views on short sales, flash orders, high frequency trading and dark pool restrictions; top dark pools and dark pool selection criteria; impact of electronic indications of interest (IOIs) and immediate-or-cancel orders (IOCs) on the use of dark pools; and changes in buy-side budgets and their impact on changing commission rate structures. The study also examines continued growth of low-touch trading; order allocation trends across high- and low-touch trading venues; trends and selection criteria in algorithmic trading; growing demand for transparency into electronic trading infrastructure and its impact on broker relationships; leading broker algorithm providers; and new expectations of low-touch sales trading coverage.

The study details two primary trends, says Berke, starting with a rising call for transparency from their brokers. “Buy-side traders want greater clarity covering the behavior of algorithms, dark pools and smart order routers, from preferencing and rebate deals, to the use of IOIs, IOCs and interactions with electronic liquidity providers (ELPs).” Increasingly, they tell TABB they want a direct say in how these technologies are configured and the flexibility to customize configuration on a trader-by-trader basis. A second trend is increased electronic trading, where algorithms are capturing greater share of flow than even buy-side traders projected in 2008, as reported by TABB in “Institutional Equity Trading 2008: Crisis, Crossing and Competition.” Block crossing, on the other hand, which has seen only a slight increase in market share from 11% in 2008 to 12% in 2009, has yet to recover its 15% share in 2007. “Volatility continues to impact the way traders manage their order flow. There are fewer resting orders and less of a willingness to be patient,” says Berke.

In her conclusion, Berke says that Wall Street has adjusted to accommodate the post-crisis paradigm. With an uptick in electronic trading, more slicing and dicing and traders trading more aggressively in smaller share sizes, she says, “Volatility is down, but not out and change is in the air. There is much to be considered, much work to be done. Regulators and legislators need more data. Market structure needs protection. Traders need choices. Brokers need to raise the bar. And investor confidence needs to be fully restored. Through it all, the one standout marketplace that has continued to operate without a glitch, in the face of the greatest disruption in financial structures ever witnessed, is the US equities market.”

The 64-page study with 45 exhibits is available now for download by TABB Group Equity Research Alliance clients and pre-qualified media at https://www.tabbgroup.com/Login.aspx. For an executive summary or to purchase the report, visit http://www.tabbgroup.com or write to info@tabbgroup.com.