A New Era in Bilateral Liquidity

As buy-side traders cope with fragmented liquidity and stagnant volumes in the continuous, lit European equity markets, institutions have forged direct relationships with market makers as an alternative channel.

While bilateral liquidity has existed for a long time in high-touch, non-electronic block trading, direct interactions between the buy-side and market makers is a relatively recent phenomenon in European equities, which was unlikely before the implementation of MiFID II in 2018.

Under MiFID II’s systematic internalizer regime, market makers formed SIs and morphed into electronic liquidity providers. This led to the creation of ELP/SIs providing streaming quotes via algorithms to the buy side through the broker smart order routers.

“The further evolution that has taken place over the last few years is with electronic liquidity providers, where market-making firms have provided true bilateral streams,” said Evan Canwell, equity trader and market structure analyst at T. Rowe Price in London.

 “These firms are now interacting with the buy side and building relationships with the institutions and offering direct execution streams that we never would have had before,” said Canwell.

In the past, investment managers may have been concerned about interacting directly with market makers’ proprietary risk books. However, this has changed in recent years, as buy side firms sought to avoid market impact that is found in the anonymous, central limit order books (CLOB) on the public exchanges.

“Suddenly with the other market makers coming along, it suddenly got more appealing to the buy side,” observed Canwell.

In April, The Trade reported that more than 25 percent of buy-side firms are currently sending over 10% of their flow directly to market makers. This is based on a recent survey of 225 buy-side head traders conducted in late 2023 by Optiver in partnership with The Trade.

In addition, with stagnant volumes across European equity markets, the survey found that it takes longer for institutions to execute trades, and the demand for liquidity has not changed.

The Shift to Off-Exchange

In 2023, the average daily value traded fell 16% from 2022, the lowest in a decade, reported The Trade. Not only did European volumes reached a low point in 2023, confirmed Canwell, but that wasn’t the only factor. “There was a shift from things moving from on-exchanges to off-exchange and that correlates with a shift to these electronic liquidity providers,” said Canwell.

Meanwhile, during this period, industry experts say that Optiver is leading the recent growth in offering bilateral liquidity directly to the buy side. The trend of trading directly with market makers began in the ETF market and single stock options desks through a request-for-quote (RFQ) mechanism.

About four years ago, Optiver expanded further by directly providing two-sided liquidity from its central risk book to buy-side counterparties on cash equity desks.

As a global market maker, Optiver manages risk by unwinding their positions across a diverse range of equities, futures and options. This helps ELPs offer better prices to the buy side than is otherwise found on the exchanges.

“For us, it’s clear that the best way to add value is by allowing institutional counterparties to trade in a principal capacity with us. We then manage market impact through our hedging and risk-management processes. We are not running an algorithm on behalf of somebody in the traditional agency sense,” said Oscar van Schaijk, Head of CRB Trading at Optiver. “There’s also clearly demand for it, and it’s driven by the execution price, which improves end-investor returns,” said Schaijk.

A Focus on Best Execution

Matt Clarke, Head of European Distribution, XTX Markets in London said, “The key point about so-called bilateral trading is that we can make prices tailored to each specific counterparty.” When an ELP such as XTX knows the nature of flow from an institutional firm and has an open dialogue with them, it’s potentially content to show larger size or mid-pricing. “Trading disclosed with a buy-side firm via an agency broker partner, for example, allows us to offer potentially more attractive liquidity, which is tailored to that specific firm rather than one size fits all,” said Clarke.

In terms of market share, XTX has been the largest ELP systematic internalizer for the last four years and strong in small and mid-cap liquidity stocks.

Referring to the trend, Canwell said that institutions can engage with market makers for executing small cash flow baskets (5% of average daily volume and below), as well as some larger trades (5%-20% of ADV).

If a buy-side firm goes to the public market with a block trade, an institution is going to incur market impact and accept price risk as it works the order over a longer time, said Canwell. “In that context it’s quite appealing for an institutional buy-side firm to be able to execute a large block instantaneously with a market marker.” 

In the case of “low-alpha or no-alpha cash flow trades,” which involve inflows to or outflows from a portfolio that are cash-flow related, the portfolio manager is not making an investment decision, so there is less risk of alpha leakage. These can be small size trades that involve 100 names. Rather than worrying about the execution, Canwell said, “Some buy side see the bilateral provider as a bit of a workflow efficiency.”

EMSs Connect with ELPs

What’s different now is that several major liquidity providers are streaming their bids and offers directly to the buy-side through execution management systems (EMSs). In the past, EMSs could not consume the volume of ELP quotes, but technology has advanced.

For example, FlexTrade has built a mechanism to consume the individual ELP feeds and display them on the EMS blotter. “We’ve incorporated a large amount of SI data, alongside market makers and other sources into a front-end for the buy side,” said Andy Mahoney, Managing Director, FlexTrade EMEA.

With the aftermath of MiFID II, EMSs are also responding to the institutional demand for sourcing bilateral liquidity from the ELPs and market makers. “The buy side should be able to interact with counterparts as they see fit, whether that be a traditional source or alternative,” said Mahoney. It’s no longer the case that firms can route an order to a single exchange, he said. “Systematic internalizers and market makers are an important source of liquidity, alongside exchanges, MTFs and dark pools.”

In addition, Mahoney said, “XTX, Optiver, and other electronic liquidity are now able to move up the food chain of the order,” said Mahoney.

Industry sources say that nearly all buy-side heads of trading are interested in experimenting with direct bilateral liquidity, but the actual volumes are still relatively small. Some believe that volumes will dramatically change when ELPs become more efficiently integrated into the buy side’s workflow.

In terms of its approach, Schaijk said that Optiver’s focus is on providing a better price; second, the workflow needs to be integrated; and third, the post-trade lifecycle needs to be efficient with no settlement issues.

However, there are different views on how access to bilateral liquidity is going to evolve.

Direct Streams with IOIs

For example, Optiver works with EMSs to stream its bilateral liquidity direct to the buy side. In cash equities, where institutions are concerned about information leakage, it presents its liquidity though indications-of -interest (IOIs). “For us, it’s crucial that these IOIs are updated, that they are actionable and live,” said Schaijk. Because it presents the IOIs as actionable, the buy side firm can trade at a certain price level without the risk of information leakage.

Since there are no delays in updating the IOIs, Schaijk said the fill rates are in the high 90% range, without information leakage, and ideally 100%, he added.

Anish Puaar, Optiver’s Head of European Equity Market Structure, said there’s a key difference between what Optiver is doing and the approach taken by other ELP SIs where there is an intermediary in the middle. “An ELP SI is still providing quote streams, but these are more generic and sent via broker routers. These quote streams can look very different to what we’re providing in that direct relationship.”

Schaijk asserts that the best way of creating or gaining trust with the buy side is through direct interaction. “We see the best way [of] creating or gaining trust – as direct interaction. Once you have this trust, we can show size that is very significant.”

Agency Broker Model

Others maintain the optimal way for buy-side firms to access the bilateral liquidity model is via specialist brokers which retain independence. These firms act as a bridge for clients to access liquidity from the ELPs – and therefore obtain high quality liquidity and improved pricing. This could include competing bids and offers from the likes of XTX and potentially others from the ELP peer group. Industry sources cite this approach as delivering maximum value.

In this scenario, buy-side firms gain access to bilateral liquidity via their EMS, which would consolidate bilateral liquidity streams from multiple ELPs into one place. A key advantage is that the buy side only needs to book and settle the trade against a specialist equities broker, avoiding multiple new relationships.

Commenting on this approach, XTX’s Clarke said: “It’s more convenient for the order to be sent from the EMS to an agency broker who acts as a conduit to the underlying liquidity providers.” In fact, the only way that XTX offers its liquidity to the traditional buy side in Europe today is through agency broker partners. Another positive is that buy-side firms have already onboarded with these firms, so their credit committee is comfortable, and the agency broker owes them a best execution obligation. “This eliminates any onboarding friction that could result from every buy-side client needing to connect with each ELP on its own.”

The advantage of a broker sitting in the middle is that it polls all the prices from multiple ELPs in one place, enabling the buy side to pick the best one. This would represent most of the market share in terms of liquidity provision.

If the head equity trader wants to buy BMW, and likes an ELP’s offer, it can click on the price and execute the trade. If the trader doesn’t like the price, the agency broker or trader can still route the order to the AlgoWheel, for example.

At T. Rowe Price, Canwell said his firm evaluates all liquidity providers and is aware of the bilateral liquidity available via agency brokers. “If the buy side already has a relationship with the agency broker, then the role of the agency broker potentially makes this more palatable to the buy side,” said the equity trader.

On the workflow side, there are huge benefits because it doesn’t require additional onboarding paperwork for the buy side and the EMS makes things easy, said Canwell.

On the other hand, Canwell said there are nuances of trading with a market marker – whether that’s direct or through an agency broker. If the buy side trades through an agency broker which then passes on the trade to the ELP, there may be other client flows with a different liquidity profile being sent down the same feed, which means the market maker will likely adjust the price and sizes of their quotes.  “If you are a passive buy-side firm, you could potentially be detrimentally treated because there is a more aggressive client in the same flow,” he said.

Speaking further, Canwell said: In a direct bilateral relationship, the market maker gets the full commission, but when the agency broker is in the middle, it needs to split the commission with the market maker, so the quote will be adjusted. “In the bilateral relationships, the buy side probably gets more tailored pricing, since there are no ambiguities around commission.”

Future Direction

With bilateral liquidity to the buy side in its nascent stage, it remains to be seen how access will evolve. Canwell suggests that it’s possible that both models will converge as market makers offer both the direct relationship with tailored pricing and the agency model with more adjusted pricing.

However, Clarke predicts that bilateral liquidity in European equities will follow the precedent that already exists in foreign exchange, block ETFs and US equities. While FX banks and brokers initially started with their own single dealer platforms with only one price, today FX liquidity providers stream their quotes directly into EMSs or multi-dealer platforms which aggregate all available prices to each client and result in tighter spreads. In European equities, he expects the EMSs will consolidate streaming quotes from multiple ELPs and potentially expand to include several of the major bank’s central risk books. “Having an EMS or an agency broker aggregate pricing from diverse liquidity providers in true competition has worked well for buy-side clients elsewhere and that’s the model that excites us most,” said Clarke, who expects bilateral liquidity in European to evolve in this direction.