As the acceptance of supplemental trading grows, one of the more popular use cases is helping buy-side traders source liquidity in small and mid-cap stocks.
Coalition Greenwich, in their December 2022 report – Globalisation of Algorithmic Equity Trading: A Buy-Side View, highlights that fragmented markets and a general lack of liquidity are key challenges for buy-side traders.
“Buy side trading desks are seeking out providers who can deliver essential features like liquidity in small/mid-cap stocks, access to dark pool liquidity, anonymity and fast execution, and low latency on trades,” says Jesse Forster, senior analyst at Coalition Greenwich Market Structure & Technology and author of the report.
“We clearly see this in our global trading business,” said Tim O’Halloran, Managing Director of Tourmaline Partners. “With broker lists down, buy-side traders routinely engage us to source liquidity from brokers with whom they don’t interact directly1. While common with small and mid-cap names, which tend to have greater volatility overall, supplemental trading is also being embraced to source block liquidity and trade offshore markets.”
Scale and independence matter greatly in this regard. A sound supplemental trading strategy provides a single point of execution for an investment manager to tap into a global pool of liquidity without the need to maintain a long tail of brokers. It becomes a valuable lever for a buyside trader and, importantly, can dovetail within their existing workflow.
This is not ‘outsourcing’ but simply onboarding a single broker to gain access to liquidity from many brokers.
O’Halloran continued, “Tourmaline, positioned as a large buy-side trading firm, engages over 400 brokers to source liquidity while facing our clients as a single counterparty. We provide complete anonymity or transparently attribute research credit, while measuring performance on all execution. This delivers an improved path to trading alpha and reduces operational risk.”
Why Supplemental Trading?
It is worth noting that investment managers have embraced the use of CSAs to pay smaller brokers and rarely onboard brokers with whom they anticipate trading infrequently and opportunistically. There has been a conscious effort to strategically reduce broker counterparty lists to save cost and minimize complexity.
However, while these initiatives have helped to reduce administrative and compliance costs, they have also curtailed a buy-side trader’s access to natural liquidity.
Supplemental trading addresses this challenge and provides a broad path to liquidity and market intelligence without the burden of additional costs and operational risk. Once fully institutionalized, supplemental trading will become part of a best-practices execution framework.
Tim O’Halloran is a Managing Director at Tourmaline Partners.
1 Bloomberg Intelligence also highlighted liquidity access as a significant concern of buy-side traders in a 2002 survey.