In their June 2021 paper, Why fragility is the new reality for the stock market, our colleagues Brian Hughes and Gordy Lawrence conclude that: ”An imbalance has developed between the supply of and demand for liquidity, and as a result we’ve seen a significant increase in the potential for the public equity market to jump from a state of calm to one of chaos.”
Within our global trading department, we couldn’t agree more. Here are our latest thoughts from a trading perspective on ways to potentially navigate those states of “chaos” that may arise, often unexpectedly, amid market shocks or bouts of heightened volatility.
How do our order routing procedures change during periods of excess volatility?
At a high level, our process is as follows:
- When a trade order is generated within our global trading system, it is immediately profiled for complexity through modeling that anchors on the expected market impact cost of the order. This expected impact cost is dynamically scaled using real-time market volatility data.
- Orders that fall under a specified threshold (satisfying all necessary criteria) are routed onward to our cross-asset desk for deployment via a systematic execution strategy designed to produce optimal outcomes in “normal” volatility environments (prioritizing a reduction in impact risk over market/timing risk).
- Orders that exceed the threshold are sent to one of our high-touch trading specialists to manage and process. During periods of elevated volatility, we automatically funnel more orders through to the specialists rather than the systematic strategies.
- For small orders that still get routed toward the systematic strategies, the emphasis shifts away from reducing impact risk and toward market/timing risk.
What strategies and tools do our high-touch traders use during highly volatile periods?
- Enhanced communication: Our approach to seeking best execution during periods of high volatility amplifies behaviors that shape our process during more “normal” times.
For example, we have always invested in building deep relationships, both internally and externally, believing they provide stability during challenging periods and improve client outcomes over time. We overcommunicate with portfolio managers (PMs), ensuring that the trading desk and the PMs are fully aligned on trade strategy and that execution outcomes match manager intent given all the factors in play. Our cross-desk dialogue also ramps up through multiple mediums of communication when volatility spikes. Global markets are increasingly interconnected, so knowledge of what’s driving credit spreads, outsized options activity, commodity moves, and sector rotations can be crucial inputs to execution strategies. Lastly, we strive to overcommunicate with our sell-side partners, gathering intelligence, sharing perspectives, and reiterating clear order-handling instructions for our trades to help ensure favorable outcomes.
The shared ownership of execution outcomes also allows us to optimize access to dealer balance sheets when needed. We track capital usage (which generally declines during periods of stress), as well as “natural block” liquidity via the Manager Interest Monitor (MIM) process. Engaging in these natural blocks can reduce costs during volatile markets, while having tools embedded in our order management system (OMS) to source historical context is critical to making informed decisions swiftly.
- New proprietary OEMS capabilities using custom ATDL: We created our own Algorithmic Trading Definition Language (ATDL), allowing us to deploy a fully functional Order and Execution Management System (OEMS) designed to retain all data in-house and to be flexible enough to stand the test of time. This new system gives traders the ability to layer orders in multiple strategies at the same time, tap into bespoke customizations designed on the fly to target specific scenarios, and generally access markets with greater efficiency, precision, and speed. Additionally, by fully controlling all logic and data, we are able to build our own performance-based strategy “wheels,” which reduce clicks to market, improve execution quality, and free up capacity for the traders.
How can we quantitatively identify potential volatility shocks going forward?
Currently, our trading data and analytics team is developing a “Market Health Monitor” (MHM) that aims to highlight potential volatility shocks. The initial rollout will focus on the bid/ask spreads of securities within major market indices across all global asset classes. The MHM will compare current spreads to a rolling trailing average and use a “heatmap” style to illustrate changes in excess of 1.5 standard deviations. In so doing, we hope to be able to identify volatility shocks as they occur within a subsector, put them in context with respect to recent history (including the exceptional March – April 2020 period), and track them should they spill over from one asset class to another. We expect this effort to be completed by the end of 2021.