Sourcing Liquidity in the Modern Market
Despite access to liquidity having improved considerably over the last few years, equities traders are still rating sourcing cash, heavily traded shares, money market instruments, and other forms of liquidity as their number one challenge moving forwards.
In research carried out by JP Morgan in its 2021 Equities Execution Survey, 27.9% of participants confirmed this to be the case, rating sourcing liquidity as a greater challenge then even regulatory changes [16.4%] and the imposition of best execution requirements [12.3%]. This is despite the fact that 38.5% of respondents stated their access to liquidity had improved versus 20.5% who said it had worsened and 41% who had seen no change either way.
With sourcing liquidity continuing to pose challenges, how are traders addressing these issues and ensuring they have access to enough liquidity to carry out their role as effectively as possible?
Dynamic Liquidity Sourcing
One of the more effective strategies for sourcing liquidity is to adopt a dynamic attitude which leverages market intelligence and market structure expertise to adjust aggressiveness on the fly while searching of opportunities to access dark pool liquidity - the trading volume created by institutional orders executed on private exchanges.
BMO Capital Markets, has a dynamic sourcing strategy called Arc, which makes the most of these opportunities.
"Arc’s trading plan sets a smoothed trading trajectory—an execution arc—targeting a trading rate by incorporating intraday volume and historical volume forecasts,” said BMO in a white paper on the subject. "Within the trading plan, Arc’s detection of liquidity is dynamic. As Arc hunts for liquidity, it considers each venue’s probability of fill and rate of decay on a symbol-by-symbol basis. It will adjust a venue’s priority in the routing protocol or systematically engage with multiple venues to maximize fill rates.”
While carrying out this element of the strategy, BMO also accessed a curated list of dark pool venues by leveraging venues and order types where edge has been identified as well as engages with venues that offer differentiated matching logic and order types, as well as Enterprise Cross, a private and unique source of institutional liquidity.
Through this method, the Arc strategy can see where adverse selection is limited by interacting with only segmented portions of available liquidity.
"Arc’s dark bonus logic, when triggered, will source block liquidity when the configured market conditions are met,” continues BMO. "This logic can be customized based on the user’s execution objectives. Specifically, it can be customized to set the exposed quantity and its relative position to arrival price or regime price, as well as customization around the proportion of the parent order that is exposed conditionally and how and when reload occurs.”
Dark Pool Challenges
Dark pool liquidity is legal and regulated by the SEC but can offer significant challenges when it comes to sourcing and accessing liquidity.
The degrees of transparency afforded by dark pools can have an impact on the attractiveness of various exchanges. For example, if a fully transparent source of liquidity identifies the identity of a counterparty, could offer insights into their motives for trading and the information they have access to. Having access to this information can enable liquidity suppliers to incur price discrimination.
Dark pools can also be vulnerable to insider trading practices such as front running or HFC trader pinging. Moreover, due to the way dark pools are accessed they can tend to benefit larger traders more than the smaller firms – which are the ones which tend to need more access to liquidity in the first place.
While dark pools can therefore offer a sound and legal method of accessing liquidity – such as through the Arc method laid out by BMO Capital Markets – care needs to be taken to make sure all regulations are being carefully adhered to and efforts are being made to ensure the equities trading landscape is kept as fair and equitable as possible for the health and wellbeing of all players in the space.
Final Thoughts
As global traders seek to access an increasing volume of liquidity to buy and sell on the open market, the challenges of doing so are likely to increase.
Larger firms are at a distinct advantage here as their liquidity access and ability to leverage dark pools more easily is greater. Smaller firms will need to implement solid strategies to increase access and sourcing of liquidity if they want to remain competitive, while their larger counterparts have a responsibility to lead by example and share their own methods for doing so, such as the way BMO has shared its Arc technique.
Sourcing liquidity is sure to be a hot topic at Equities Leaders Summit 2023, taking place in January at the Eden Roc Miami Beach, FL.
Download the agenda today for more information and insights.