In general, institutional traders hate volatility. Huge spreads and erratic price swings attract speculators to the markets and can cause retail panic. Bigger players usually prefer trading in more stable markets.
It isn’t hard to see why this is typically the case. Institutions generally traffic in significantly larger positions and order sizes; the bigger a transaction, the harder it is to execute, even in an orderly market. Added turbulence only increases the risk.
For this reason, two telltale signs of institutional trading activity in the marketplace — block and dark pool volume — tend to narrow in periods of prolonged market volatility. We saw this happen when market conditions turned choppy this past summer and fall.
The minicrash that gripped markets in late-August 2015, for example, had its roots in a variety of technical pressures and was noteworthy for the number of limit-up and limit-down halts that it triggered in individual stocks and exchange-traded funds. (To give some context, there were almost 1,300 such occurrences on August 24, representing more than 30 times the daily average of 40 halts during the prior year. On August 25, 130 stocks were halted, the second-largest number.) Volatility crept up again a month later, as September 2015 closed out with the CBOE Volatility index at levels not seen since the winding down of the late-2000s financial crisis. During the 2015 bout of volatility, swings of 2 percent were a regular occurrence in those weeks, highly unusual for the typically sleepy months of August and September.
In these instances, dark trading was fairly light, accounting for less than 30 percent of transactions. Block volumes were similarly depressed. (Interestingly, some blamed the lack of liquidity as a contributing cause, not just an effect, of this volatility.)
Fast-forward to the first two months of 2016. A fresh bout of volatility hit U.S. equity markets. This gave us at ITG a fresh opportunity to compare the market gyrations of early 2016 with those of the previous summer. We studied numerous equity market attributes, such as transaction costs, volumes, intraday volume curves, quote sizes, spreads and opening and closing auctions. We also measured our own brokerage usage and performance of algorithms and smart routers.
An initial look at the results revealed similarities between the two periods. In many ways, a volatile day in August is very similar to a volatile day in October is very similar to a volatile day in January. But there was one key difference: Institutions, notably absent during the final tumultuous weeks of summer, despite the markets’ jitters, seemed to be gritting their teeth and jumping in in the first two months of the year.
To illustrate: During the volatile days of last August and September, dark trading accounted for 28.1 percent, compared with an average of 31.5 percent in January and February. Block trades also appeared to have rebounded. Trades of more than 5,000 shares accounted for only about 7.5 percent of all trading activity during the summer 2015 round of volatility. Conversely, block volume surged by a third to nearly 10 percent of total trading during the early-2016 volatility.
Assuming that institutions prefer to avoid volatility, what made them change their minds this time?
For one thing, last summer’s volatility appeared more speculative, whereas the turbulence we’ve seen so far this year has been motivated by specific macroeconomic factors, including questions over various global market issues such as China’s rebalancing and the Federal Reserve’s future interest rate policy. Markets may still be volatile, but institutions are getting involved because they need to.
That they feel comfortable doing so says a lot about the quality of the market. Unlike last summer’s extreme volatility, which was exacerbated by a drought in global liquidity, institutional traders seem more confident in the present liquidity situation. It’s also worth noting that some of the market structure quality issues that aggravated August volatility have improved. So long as market conditions are such that large blocks can be executed successfully, institutions are going to do what’s necessary to manage their positions — even if the waters are choppier than they would like. And that appears to be the situation at the moment.
Going forward, it will be interesting to see whether institutions’ faith in underlying market quality — and the ability to transact block and dark trades — will endure to the extent that we see greater institutional presence in volatile markets in the coming months and years. One thing is clear, however: Given the greater availability and sophistication of trading tools, institutions are realizing that they can execute blocks successfully in a wider array of market conditions.
Philip Pearson is director of algorithmic trading at ITG in New York.
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