Across trading desks and across continents, changes in market structure driven by technology and regulations are reshaping the manner in which the buy side sources liquidity.

This is true for all asset classes, whether listed or over-the-counter.

Equities liquidity has undergone a massive transformational over the past decade with the influx of dark pools, broker crossing networks, internalization and, most importantly, the advent of high-frequency and algorithmic trading.

“Fragmentation of market data sources raises the cost of operation of buy-side firms and makes it more difficult to identify where ‘best execution’ can be achieved for clients,” said Chris Pickles, head of industry initiatives at BT Global Banking & Financial Markets, a provider of networked-based services.

Transatlantic differences in the meaning of best execution have emerged with the revision of MiFID II in Europe and the ongoing market structure changes in the U.S., stemming from Regulation National Market Structure (Reg NMS) and the Dodd-Frank Act.

“While in the U.S., a considerable onus for achieving best execution lies on exchanges, in the European Union, the responsibility for achieving best execution has been placed squarely in the lap of the party that has the relationship with the end-client—so ultimately, in the lap of the buy-side firm,” said Pickles. “Broker selection becomes even more compliance-critical in the EU as a result.”

Securities markets in North America and Europe have been fragmented for decades. For example, in the U.S. multiple stock exchanges have always competed against each other, while in Europe stock exchanges have only really begun competing for order flow since the advent of the original MiFID document in 2007.

“In the U.S., there is the ongoing struggle to make the national market system work in the interest of investors,” Pickles said.

Impending market structure changes will make sourcing liquidity even harder.

“We expect to see further fragmentation with the addition of new venues,” said Jay Hinton, global product manager at Mantara, a technology provider. “In response to these changes, we expect to see an increased demand for tools that track and display liquidity to the trader, both historical, as well as at-trade. The buy side will also put more pressure on the sell side to tune algos to respond to the current environment.”

OTC Liquidity
For OTC products, the need to demonstrate best execution will also potentially limit the ways that the buy side can access the markets. This means that the buy side will have to connect to more sources.

“Today, most buy-side institutions simply call their broker—it’s usually just one,” said Philippe Buhannic, chief executive of TradingScreen, a buy-side focused technology provider. “Soon, they will need to access multiple brokers electronically.”

To a certain extent, the ‘electronification’ of the equity markets serves as a template for the OTC markets.

“If this holds, you’ll see more fractionalization and more and more challenges around connectivity, which means that the buy side will be forced to have an independent—that is, broker-neutral—system that will aggregate multiple sources of liquidity,” Buhannic said.

As swaps become more regulated and move from an OTC to an exchange-traded model on swap execution facilities (SEFs), there will be more changes to market structure and liquidity.

“Market structure changes in OTC derivatives will potentially lead to liquidity drying up or being concentrated in a much smaller number of sell-side institutions,” said Alberto Corvo, managing principal for financial services at eClerx, a financial services outsourcing firm and BPO. “The liquidity of structured trades will potentially be drastically reduced as they will not be able to be cleared hence attracting prohibitive capital charges.”

Electronification has steadily grown from equities to encompass virtually all asset classes.

“It’s worth noting that even fairly established OTC markets not affected directly by regulatory changes, such as government and corporate bond markets, are facing significant market structure evolution as well, because of the rapid disappearance of traditional market-making by the sell side,” Buhannic at TradingScreen said.

Market Infrastructure
At the Securities and Exchange Commission’s roundtable on market technology held this week, SEC chairman Mary Schapiro noted that market structure—such as multiple execution venues, the presence of high frequency trading and dark pools—is inextricably bound up with market infrastructure, as in the technology that undergirds trading activity.

This interconnectedness raises the stakes for regulators, exchanges and individual firms in policing their activities.

“The benefit of automation aside, if trading systems operate without effective controls, they can cause unintended damage if they malfunction,” said Jamil Nazarali, head of Citadel Execution Services, an equities market maker, at the roundtable.

“All market participants, exchanges and other market centers must have effective controls to protect themselves, their clients and the markets against the malfunction of their systems,” Nazarali said.

The buy side will be under time pressure to comply with impending regulations and to adapt to new trading venues for financial products previously traded by voice. The technical implications of these shifts in the market will be challenging for many buy-side participants.

“They will require investment in trading technology that can effectively manage liquidity in fragmented markets while dealing with the complexities of regulation,” said Jonathan Fieldman, chief operating officer at Broadway Technology, a trading technology firm.

“Companies will also need to focus on reducing system risk—the risk of financial losses due to technology errors—and provide greater transparency as well as invest in superior technology for data collection, monitoring and intervention.”