Market Comparison

The following sections compare and contrast trading within the following markets:

• Equities.
• Fixed income.
• Exchange-traded derivatives (options and futures).
• Off-exchange (OTC) derivatives.
• Spot currencies.

Equities

Equities offer the most robust and viable platform for electronic trading. Equities are the most technologically advanced market. Algorithmic trading is common, and most trades are electronic. Equity exchanges may use different trading systems for stocks depending on their level of liquidity. Equities may be traded on both dark pools and lit exchanges. As a refresher, the former offers no public information about trade sizes, orders, transactions, etc., while the latter publishes all that information (often at a cost and only available to certain traders).

There are over 40 ATS/dark pools globally. In Europe, they are known as Multilateral Trading Facilities (“MTF”) or Systematic Internalisers (“SIs”). In the US, they are known as Alternative Trading Systems (“ATS”) and are regulated by the SEC.

The use of ATS in Asia remains small compared to that of the US and Europe. The same is true of most developing markets. Equities are the most technologically advanced of all of the asset classes.

Common Trading Strategies by Trade Type

• Large, urgent trades, often in less liquid small-cap stocks, are generally executed as high-touch broker risk trades (the broker takes on the risk of trade).
• Large, non-urgent trades may be executed using trading algorithms (particularly for more liquid large-cap stocks) or, for less liquid securities, a high-touch agency approach.
• For small trades in liquid securities, most buy-side traders use electronic trading (algorithms and ATS).

Fixed Income

Electronic trading and algorithms are not as well-suited for fixed income markets due to their unique characteristics. Bonds are diverse, with various options and features, and many investors hold them until maturity. Bonds are also not easily traded, and trades are infrequent, often involving large volumes.

In this market, dealers play a crucial role by providing quotes upon request and acting as counterparties to enhance liquidity. Electronic chat platforms like Bloomberg chat are commonly used for disseminating quotes.

However, in the case of US Treasuries in benchmark maturities and bond and interest rate futures contracts, algorithmic trading finds its place. While it remains a relatively small portion of trading, it’s significant within this specific segment of the bond market.

Exchange-Traded Derivatives (Options and Futures)

Exchange-traded derivatives represent a large, liquid, public, and transparent market. This offers the opportunity to use electronic trading where market efficiency is high. Futures tend to dominate the electronic trading segment as opposed to options, and where market depth is good, ‘sweeping the book’ is common.

Over-the-Counter (OTC) Derivatives

The OTC derivatives markets have been under heavy pressure in the United States to increase trade transparency since the 2008 financial crisis. These markets have historically been very opaque but have recently begun to open up thanks to reforms enacted under Dodd-Frank. Dodd-Frank created Swap Data Repositories (“SDRs”), which collect trade information related to swap contracts.

Due to the opaque nature of the trading, the low frequency of trades, and the sizes of the trades, trading OTC derivatives takes place through dealers. Large trades in this market are typically handled via the following trade types:

$$ \begin{array}{c|c|c} \textbf{Urgency} & \textbf{Trade Type} & \textbf{Description} \\ \hline \textbf{High} & \text{Broker Risk} & { \text{Risk is transferred first to a broker} \\ \text{who takes the contract into his} \\ \text{personal holdings }} \\ \hline \textbf{Low} & \text{High-Touch Agency} & {\text{Broker matches buyers and sellers} \\ \text{directly}} \end{array} $$

Since OTC derivatives are often highly customized, at times, a strong price concession is required to find a buyer or seller.

Spot Currencies

Electronic trading in currencies has grown substantially over the years in parallel with algorithmic trading strategies of equities. The market is large, often with over $1 trillion traded per day. The market is also broken up into many submarkets. The amount of cross-border regulation is almost none. The spot currency market is made up of multiple levels:

The Top Level (Extremely Large Trade Sizes)

Also called the interbank market, consists of mostly large international banks and other financial firms that act as dealers.

The Mid-tier Level

Typically, small and medium-sized banks and financial institutions trade currencies on the interbank market with dealers. This means higher bid–ask spreads.

The Lower-tier

Second-level institutions are used by commercial companies and retail traders for their currency trading. A larger bid–ask spread applies to these markets, due to the layers of fees being charged.

$$ \begin{array}{c|c|c} \textbf{Trade Size} & \textbf{Urgency} & \textbf{Execution Method} \\ \hline \textbf{Large} & \text{High} & \text{RFQs sent to competing dealers} \\ \hline \textbf{Large} & \text{Low} & {\text{Algorithms such as TWAP, or} \\ \text{high-touch agency approach}} \\ \hline \textbf{Small} & \text{Various} & \text{DMA} \end{array} $$

Question

In order from most favorable to least favorable for electronic trading, the following markets would be?

1. Equities, Fixed Income, Exchange-Traded Derivatives.
2. Equities, Exchange-Traded Derivatives, Fixed Income.
3. Fixed Income, Exchange-Traded Derivatives, Equities.

Solution

The correct answer is A.

In terms of electronic trading favorability, equities are generally the most favorable due to their high liquidity and straightforward execution. Fixed income, while electronic trading is growing, can still be less favorable compared to equities. Exchange-Traded Derivatives (such as futures and options) can be less favorable for electronic trading compared to equities as well, primarily due to their complexity and the need for precise specifications.

B is incorrect. This choice ranks Exchange-Traded Derivatives ahead of Fixed Income in terms of favorability for electronic trading, which is generally not the case. Fixed income is typically less favorable for electronic trading compared to Exchange-Traded Derivatives.

C is incorrect. This choice ranks Fixed Income as the most favorable for electronic trading, which is not typically the case. Equities are usually more favorable for electronic trading compared to Fixed Income.

Portfolio Management Pathway Volume 2: Learning Module 8: Trade Strategy and Execution; Los 8(f) Contrast key characteristics of the following markets in relation to trade implementation: equity, fixed income, options and futures, OTC derivatives, and spot currency