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With spreads narrowing and commissions dropping, the major dealers all are moving to automate their executions for multileg transactions to gain a trading edge. Sell-side firms are turning to liquidity management systems to leverage both customer and proprietary order flows first against internal order books and then against external execution destinations to improve transaction efficiency.
"Liquidity management is the science of automatically managing order flow with limited human interaction," explains Larry Tabb, CEO and founder of TABB Group, in a report on automated liquidity management that was published a year ago when the phenomenon was first taking hold in the equities space. "Liquidity management is simply how brokers handle customer orders and their decision process behind how and when to provide liquidity."
Today, the practice is well-developed in the U.S. equity markets, in which brokers use low-touch technologies such as direct market access (DMA) and algorithms to route agency flows and search for hidden liquidity in dark pools rather than pay the exchange fees at Nasdaq or the New York Stock Exchange. But in the fixed-income and OTC derivatives markets, in which dealers risk their own capital as the source of price formation and maintain two-sided markets, the process is more complex. Still, firms such as HSBC are looking to expand liquidity management to structured products.
HSBC Gets FIERCE
With the goal of streamlining its transaction process and migrating it across asset classes, HSBC is developing a set of technologies for pricing, executing and hedging the components of structured products. The multiyear project - known as Finance Instrument Enterprise Resources for Consolidation and Execution (FIERCE) - began in 2005 and involves building a liquidity management system (LMS) for complex financial products so that multileg trades can be priced, executed and hedged electronically. A multileg transaction is a trade with two or more instruments that are bought and/or sold simultaneously to achieve an investment goal.
The LMS encompasses smart order routing, internalization, matching of customer and proprietary flows, and hedging with multileg transactions, according to Ken Yeadon, CEO of Yeadon Financial Concepts and chief enterprise e-trading strategist for HSBC. "Our objective is to minimize execution slippage," he emphasizes. Slippage occurs when the trader executes one leg of the trade but the price moves in the market...