The growing gap between trading and investing is changing the face of equity markets, argues Per Lovén
The recently published review by John Kay on ‘UK Equity Markets and Long-Term Decision Making’ raises vital questions about the equity trading and investing ecosystem. One of the fundamental issues is the divergence of trading strategies and the emergence of related behaviours. In short, long-term investing versus short-term trading.
Over the past decade, technological innovations, globalisation of trade and supporting regulations have transformed equity markets, especially the interaction between investors, companies and intermediaries. Electronic trading has enhanced cross-border capital flows, tightened spreads and reduced margins to the benefit of end investors and listed companies.
The flip side of this ‘progress’ has been increased volatility associated with equity trading, creating a business opportunity for a new breed of trader. Often described as high-frequency traders, this new category of market participant is motivated by short-term gains, buying and selling equities based on minimal price movements with disregard for a company’s fundamentals. The liquidity these traders bring to the equity markets and to a company’s stock is, at best, temporary and, at worst, non-existent. Technology is often cited as a distinguishing factor for these types of traders. While this is partly true, the damaging aspects of their activity stem, not necessarily from the speed their technology enables, but from their motivations.
Not all high-frequency trading is detrimental to the market, but a significant portion of strategies deployed by such traders are simply exploiting supply-demand imbalances which they detect by closely following the order-flow information from institutional investors. They use this information in order to realise profit from tiny price differences over a time horizon of microseconds.
Traditional investors, on the other hand, make their investment decisions based on a fundamental analysis of a company’s current and future performance. However, far from being able to execute on those decisions, they often find themselves on the receiving end of high-frequency trading strategies.
This change in market dynamics is slowly distorting the efficient functioning of equity markets. Traditional stock exchanges and multilateral trading facilities have a difficult task. They need to offer a choice of execution for a multitude of investors and constituents - such as retail, institutional, high-frequency, listed corporates and others - but they can no longer provide a safe pool of liquidity for one of the major constituents responsible for long-term investment in listed companies. Institutional investors who are responsible for the assets of millions of savers around the world today find themselves disenfranchised in a market which no longer serves all its participants equally and fairly.
This situation exposes a fundamental flaw in the current structure of UK equity markets, which operate a single market for retail and wholesale investors. When retail investors trade a stock, they trade in small sizes and are relatively immune to other market dynamics and interactions. Conversely, when an institutional investor takes a position and trades a stock, it can have a strong impact on the market. To avoid this, institutional investors can try and split their large orders into many ‘child’ orders. However, high-frequency traders have sophisticated mechanisms for detecting both types of orders, causing a price move against the original investor.
The proponents of high-frequency trading argue that it contributes to liquidity. It is important to dispel this myth, given the (often deliberate) confusion between liquidity and volume. High-frequency trading adds volume to the market, but volume does not equal liquidity, and nowhere is this difference between volume and liquidity more obvious than in the equity markets.
If liquidity is defined as the ability of market participants to buy and sell with minimum market impact, then volume equates to the number and monetary value of transactions realised, regardless of the price impact on those transactions. Just as much as institutional investors sit firmly in the liquidity camp, high-frequency traders are the poster child for the recent growth in volumes. The two cannot continue to co-exist as long as there is an uneven playing field. High-frequency traders benefit from institutional order flow on exchanges. Institutional investors, on the other hand, whose purpose is to deliver on an investment strategy based on long-term fundamentals, are suffering at the hands of high-frequency trading which disconnects the relationship between company performance and share price.
If this behaviour continues to spread, the risk is that equity markets will no longer be able to provide real liquidity for listed companies, with detrimental consequences for long-term growth and shareholder value. We are already seeing these trends materialise. Faced with the challenge of capturing liquidity that disappears in microseconds, listed companies are increasingly using debt capital markets and their own cash reserves to fund growth and expansion.
Disintermediation - back to basics
A solution for the equity market needs to be based on freedom of choice that will create a more level playing field for all market participants. While imposing minimum resting times for orders on exchange might limit the impact of high-frequency trading on the public markets, it does not provide a solution to the issue of long-term investing versus short-term trading.
As the dust settles and the different constituents in the equity markets learn to cohabit, a back-to-basics approach to equity investing and trading might be the only way to resolve the stalemate. If we consider the primary purpose of the market, it is to provide a meeting place for buyers and sellers, allowing them to efficiently implement investment decisions. If a market cannot fulfil the needs of one of its major participants - institutional investors - then it needs to create and allow viable alternatives.
When executing large orders, institutional investors are increasingly trading away from public markets, opting instead for ‘dark pools of liquidity’ in order to minimise the market impact. Dark pools, a label used to describe various types of non-displayed liquidity, are numerous but they do not all serve the same purpose. Some are competing directly with exchanges for the same multitude of investors and traders; others are offering viable alternatives and often working with exchanges to create a safe environment for equity trading.
It is not only institutional investors that are adapting to the shifting liquidity in equity markets. To preserve the much-needed flow of capital, and fund the long-term growth of both pension portfolios and the companies that are the engine of the economy, traditional public markets are also finding ways to service the needs of all constituents. Innovative exchanges around the world are partnering with non-public liquidity providers to facilitate long-term investing.
The road ahead is not without hurdles. As pointed out in the Kay Review, the default reaction of policymakers and regulators is to demand more transparency. But transparency is not the panacea for all distortions in UK equity markets. The right level of transparency should be based upon an understanding of the consequences, especially the unintended ones, which would end up damaging the end investors that they seek to protect, and hinder the efficient functioning of both lit and dark markets.
Preserving the choice of venues for real investors, and understanding the trade-off between having an environment in which liquidity is not displayed and the fairness in price formation for investors and companies must be a priority for those concerned with the future of markets.
The debate over longer-term investing versus short-term trading is an essential and timely one. What is needed is a policy response that reflects the evolution that has taken place in equity markets, and a market structure that is ready to reassess its role.
Per Lovén is head of international corporate strategy at Liquidnet