BAML is hoping to attract long-term investors

Bank of America Merrill Lynch is seeking to attract long-term investors who have become disillusioned with equity markets through its new trading system, Instinct Natural, a crossing network geared towards customers that want to trade in blocks. But some market participants expressed doubts about the potential of bank-operated platforms to meet the needs of long-term investors.

“Instinct X is a close-knit, carefully selected community,” said Rod Burns, head of US West Coast portfolio products, BAML. “There’s a good reason for that. Institutional investors want to trade with other long-term investors. They want counterparties they are comfortable with – and we are providing a strong platform for them to do that.”

Instinct Natural is a part of Instinct X, BAML’s own alternative trading system. It is a matching engine that does not display quotes on the public market, but sources liquidity from the flows available within BAML and its private client pool. The idea is that the buy-side trader will rest their order conditionally in Instinct X and await an invitation to firm up; in time, it is hoped that users will find natural crosses in larger sizes while avoiding market impact.

Average order sizes in US equities have gradually declined over the last several years. For long-term institutional investors that are trying to make portfolio adjustments, trading in smaller sizes can be less than ideal. At the same time, diminishing trade sizes and the presence of high-frequency traders have combined to make the danger of market impact more pressing for institutional investors, since a large block of stock becomes more and more conspicuous in a market of small, fast-moving orders.

In response, buy-side crossing networks such as Liquidnet have emerged, targeted at business from long-only investors. Several bank-owned dark pools exist, including Goldman Sachs Sigma X, UBS MTF and BAML’s Instinct X. These platforms generally operate a mid-point cross, which means that long-term investors will never have to cross the spread and therefore potentially gain a better price for their transactions.

BAML insists that its own pool offers a better deal for long-only investors because of the bank’s internal liquidity, and because of the differences in the way that the technology works, compared to a traditional buy-side crossing network.

“If you were to put the aggregate liquidity of BAML against some of those other services, it would compare very favourably,” said Burns. “We had 12.9% of US composite volume as of the end of last month. The other difference is that unlike other crossing networks, we don’t use blotter scraping.”

Blotter scraping is a form of trading connectivity in which a dark pool such as Liquidnet will connect to client order management systems, so that when a portfolio manager enters an order, it can be registered in the system and circulate until a cross is found. But according to Burns, changes in market structure and technology mean that investors may be cautious about the security of such an arrangement.

“There’s a sentiment from institutional traders that they don’t want sensitive information pulled from their own systems,” he said. “The buy-side has suffered scandals such as Pipeline, and they are demanding more control over their order flow and transparency around it. We believe clients should have complete control of the order and be able to trust in the venues where they trade. That’s why we created Instinct Natural.”

Pipeline was a buy-side block crossing network that closed down after it was discovered that, unknown to buy-side participants, their orders were secretly being matched by a high-frequency trading firm owned by Pipeline chief executive Fred Federspiel. The company had lied to investors and deliberately misled participants to believe that their orders were being matched with legitimate counterparties.

Instinct Natural is due to roll out over the new few weeks, according to Burns. Later this year, BAML also plans to release an improved set of trading algorithms. The bank’s last major algo release took place in October 2011, and consisted of two new algos for futures.

Buy-side market participants have expressed some scepticism about the new trading tools from BAML, however, as well as the notion that blotter scraping is a problem for long-only investors.

Seth Merrin founded Liquidnet in 2001

“Why do you think the buy-side community allows Liquidnet to scrape their OMS?” said Adrian Fitzpatrick, head of dealing at UK asset management firm Kames Capital. “It is because they trust the platform and have bought into the idea that they are in control. The buy-side would want to know who has access to this pool and who controls it. I somehow do not believe a bank-owned platform will match the likes of Liquidnet due to lack of trust and transparency.”

Fitzpatrick pointed to figures from Rosenblatt Securities, which show that average trade size on Liquidnet in December was close to 42,000 shares, while the average trade size on bank-owned platform Goldman Sachs Sigma X was 167 shares. The implication, he suggests, is that a bank platform is unlikely to provide the kind of crossing opportunities that asset managers are looking for.

Other participants see the BAML move as part of a growing trend, which encompasses other recent platforms that also target trading in blocks, such as  Squawker, which is due to launch in March. Tony Mackay, founder of Chi-X Global, is also working on a platform that he says will provide a better service for long-term investors by allowing them to decide which specific counterpaties will have a chance to interact with their flow.

“I think trading blocks are back in fashion certainly,” said Paul Squires, head of trading, trading and securities financing London at AXA Investment Managers. “Participants are fed up with fragmentation and HFT toxicity on some venues so it’s a smart move from BAML.”

However, Squires added that most traders like the fact that Liquidnet has a like-minded ‘community’ of members and argued that blotter scraping is actually an advantage for the buy-side because the trade instantly sees if there is an opportunity to cross against another natural block.

“We do use the big broker algos mainly because we find good liquidity in their internal pools, but we would see it as something most of the top 10 brokers offer,” he said.

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