A lot has been written about the development of Electronic Trading in Derivatives, and specifically the rise of algo usage and the evolution of the agency algo space. What we’ve witnessed over the past 5 years is an accelerated version of the story within Equities, albeit with different market structure, and even a different client to broker relationship. But as Larry Tabb mentioned in a recent Tabb Forum piece, we are at an inflection point. Are we truly about to see the “Equitification” of Derivatives Trading?
Maybe it’s worth summarizing the different flows I’m talking about. High Touch is High Touch. We all know what it is, and conceptually, the difference between Equities and Futures is marginal. As we move to Electronic Trading, this is where things diverge. In Equities, we understand that most Electronic Trading is Low Touch. Low Touch is all about the service you as a broker provide the Buy Side, from access to liquidity, breadth of strategies, and even customization. Workflow and indeed the trading platforms in Equities have evolved to handle all these elements and provide the broker with the tools they need to differentiate their execution.
In Derivatives however, Low Touch as a concept simply doesn’t exist. Electronic Trading is considered No Touch, where the broker provides the pipes, but little oversight or service beyond maybe a cursory heads up on an issue. As a Buy Side, you make your choice of provider and their service, but you own the risk. But as the algo service landscape opens up with specialist algo vendors and in-house algo platforms becoming the norm, is the Buy Side going to start to ask for more from their FCMs in terms of execution? Note that this is happening at the same time that the Buy Side is grappling with their own cost pressures, and the drive for commission $ efficiency will continue to pull flow away from the High Touch route. It does seem like the timing is right for Derivatives to move toward Low Touch, the bigger question is how will this actually work, and what challenges are in the way?
Now, before the High Touch Traders get offended that the Electronic folks are trying to eat more of their lunch, I truly don’t believe this will be the case. There are two main reasons to send an order down the High Touch trader route – expertise and execution risk transfer. In Low Touch, both of these are still required, but they are applied differently. Low Touch requires the trader to work collaboratively with the client on how particular orders should be handled both before and potentially during the entire life of the order. The only difference is that the execution strategy they create is then targeted electronically by the client whenever they want. In this case, traders are not physically trading each order, but they maintain the ability to scale the number of trades they’re managing by simply dealing with the exceptions. Low Touch therefore is more aligned to the electronification of High Touch, than the evolution of No Touch.
The proliferation of additional algo services ironically creates another issue for the current No Touch service – choice. As the Buy Side, it’s complex enough knowing which broker’s particular benchmark algo may be the best for a particular contract, but what if for a certain broker that same benchmark had 3 or more choices based on the underlying algo service you’re looking to hit? Add to this the potential for different order parameters or FIX certification requirements. This becomes unwieldly at best, to unusable at worst, and the Sell Side will soon realize there’s a need to simplify things to a single strategy and manage the routing based on whatever logic they choose as part of their service. This may sound counter intuitive, but as the amount of choice increases, the broker that wins is the one that makes it more accessible. This may be a new concept for Derivatives to grapple with, but these tool are increasingly being leveraged by other asset classes, and are simply awaiting adoption in Derivatives.
It’s clear that Low Touch does not replace the High Touch business, it merely adds a new channel that the Sell Side is able to demonstrate their trading expertise, while giving the Buy Side an avenue to reduce their commission spend. But does it replace No Touch? In my view, the answer is no. And there’s no reason why Low Touch and No Touch can’t operate as distinct channels the same as High Touch. Some clients will be happier with the lower toll, and handle the increased complexities that surfacing multiple algo providers represents. They’ll accept the lack of customization or oversight of their orders as the service they get for the amount they pay, and continue to leverage the broker’s No Touch service. Others will want more from their broker in terms of the service provided electronically (whether through normalization, strategy customization or a greater level of oversight), and will ultimately recognize the value of Low Touch service over No Touch.
Supporting Low Touch may be a new phenomenon for Derivatives brokers to handle, but they are at a distinct advantage being able to learn from the technology evolution of Low Touch order management in Equities. This is not a shoe-horning of Derivatives into an Equities model – Derivatives markets are substantially different to Equities – but simply adopting the right solutions to pair the expertise of a High Touch trader with electronic order flow, will accelerate the move to Low Touch.
Chris Monnery is Regional Head of Electronic Execution at Fidessa
