E-TRADING and LIQUIDITY. BEWARE MISLEADING CLAIMS.

A spate of articles has recently appeared on LinkedIn and elsewhere written by the various providers of electronic trading platforms trumpeting large rises in transactions volumes. The rise in volumes is clearly accurate. The same articles typically go on to claim that e-trading has therefore been a provider of much-improved liquidity. This is only partially accurate. Platforms are enablers of greater liquidity, but they are tools and do not themselves create the liquidity.  Trading conditions depend upon a whole host of factors. 

(i)                 This year markets have been highly volatile stemming from unforeseen events such as Covid and a sharp deterioration in US-Chinese relations.

(ii)               Inflows and outflows have also increased in size in response to uncertainty, therefore necessitating a rise in trading by fund managers to keep asset allocations and cash rations stable.

(iii)              As aggregate AUM of institutional funds under management has been on a steadily rising trend for many years, logically trading volumes will have risen even if institutional turnover ratios remain stable.

(iv)              The rise of ETF tracker funds versus traditional active management has led to increased turnover due to frequent adjustment in order to shadow underlying indices. ETF turnover ratios will typically be higher than that of active managers.

(v)               The demise of hedge fund AUM has been compensated not only by the rise of real money, but the growth in size of bank proprietary trading desks encouraged by the Trump-inspired easing of regulatory constraint.

Given that background it would be far more surprising if electronic trading volumes had not risen sharply. Another factor needs to be considered as well. Publicly traded markets are falling as a percentage of the investable asset universe, conversely private equity, closed loan deals and alternative asset investments have increased hugely in the last few years. As just one example: private equity is estimated to have quadrupled since 2010 exceed $4.1trn last year whereas the capitalisation of the US stock market has less than doubled over the same period to $35trn. The dominance of e-trading and the statistics quoted by e-trading platforms relates almost entirely to publicly traded markets, thus they are becoming more dominant in a shrinking part of the universe of investable assets.

The trading game is not just about numbers. I have been told time and again by both buy and sell-side market participants that they regularly post requests for trades that they have no intention of executing, simply to acquire market information. This may constitute greater “transparency” at one level, but it is also capable of being misleading, wasting time and potentially an aide to market manipulation. Then there is the choice of how many market participants to include on any inquiry. One approach, especially by those seeking to create possible market influence is to have as many as possible, others favour a smaller universe for inquiry focused upon those participants believed to be active and competent in the security being bought or sold, possibly as a “reward” to a small group of counterparts believed to have offered good service. How well widely and frequently traded a particular instrument should also influence how an inquiry is conducted.

The reaction of market makers to any given inquiry is also a more complex subject that it might appear. I have seen traders lower their bid prices or raise their offers if they are aware of many others seeing the same inquiry “because the whole market will know what is going on” making it difficult for them to cover their position after a trade. Thus the apparently efficient way of seeking the best price can misfire. There is also the converse “ego” reaction when only a small group of traders are asked: “I am sure I know the other two traders who have been asked, I am better than they are so I want to show prices more favourable to the client to prove the point”. Contrary to conventional economic theory, oligarchic rather than a fully competitive environment can sometimes work favourably rather than adversely in favour of the buyer or seller.

Finally there is “created demand” which e-trading largely misses. Some of the world’s most successful businesses (think Apple or Uber) invented a demand customers did not know they had. Salespeople used to perform this role for the likes of investment banks and brokers, but regulation and juniorisation have reduced the role to little more than trade assistants and secretaries. The role of sales/trader and often researcher has usually become a single role in equities, and fixed income is now following suite. Market makers and traders themselves spot opportunities and create demand. E-trading captures only a small part of this opportunity through algorithms usually dependent upon past data, it cannot capture the functionality of originally-generated demand for those seeking to sell or nudge-selling for those seeking to buy.

In conclusion, my message is simple. E-trading has a huge role to play and is rightly growing in popularity, not least for large swathes of trades it saves a great deal of time with no material cost or may indeed be beneficial in getting the best price. However it is not the whole story. There are many situations where it will not achieve the best price versus alternative forms of execution and mindless reliance on e-trading without considering alternative forms of execution would be wrong.