A Win-Win Scenario?
With so many choices, how can participants be
sure they have the right trading strategy?
Less sophisticated clients often prefer to
compete on a level playing field, on a central
limit order book—the exchange model;
otherwise the information they disclose in
a bilateral relationship can be used against
them. That can be even more pronounced
with the RFQ model, which guarantees that
multiple liquidity providers benefit from full
knowledge of trading intentions.
to have a ‘last look’ at the market price when
they receive an order. This option allows the
SI to have the final say on whether they will
execute at a particular quoted price and size.
The client knows this, so they also might
act rationally in response, sending only a
portion of their order to the SI, leaving them
exposed to the market. If they both view
the relationship as long-term and mutually
beneficial, there are mutually reinforcing
incentives to behave ‘well’. In this scenario,
the client sends the whole order, while the
SI honours their quote while not taking
advantage of any information asymmetry.
Overall the challenges can be greater for
sophisticated market participants looking to
trade more than the available liquidity at the
‘touch’, or best price. In this case, the trade-
off between information disclosure and best
execution is often not so clear-cut, and it’s
here that a solid understanding of the relative
incentives is so important.
The ability to customise trading, down to
the individual strategy, gives the power to
participants to calibrate exactly who, how and
when their orders get executed, lit or dark,
depending on their needs and risk tolerance.
It also increases the value of relationships.
So how might it work? Let’s take the case of
an SI. If an SI views the client relationship as
a one-off trade, they are incentivised to act
entirely in their own interest, and perhaps
employ their option to decide whether or not
In this new market structure, where the
customer once again sits centre stage, it is in
no-one’s interest to burn any bridges.
SI GAME THEORY.
EO
Client
Bad 11/2
Good 11/2
•
•
•
•
$
$$$
$$
-$$
•
•
$$$
$$$
Low Quality is a dominant strategy for the SI
Client knows this so rationally decides to be a
bad client!
Repeated Game
Game theory, in its strategic form, can help us
better understand the incentives and payoffs
at play between the client and the SI. The best
strategy for each party will depend on whether the
trading is a repeated or a one off interaction.
Autumn 2017
Bad: sends only a portion of the order and
follows on to the exchange
Good: sends the whole order to be traded at the
price quoted by the SI
One-Off Game
•
6
High Quality: honours quotes
Low Quality: employs last look
Client Strategies:
-
$
SI Strategies:
•
In a repeated transaction both sides can
agree on a strategy up front which is mutually
advantageous
Good and High Quality is self policing —
provided the client has the correct data!
THE IMPACTS OF A NEW LIQUIDITY PARADIGM
www.buysideintel.com
33