Wall Street's fastest traders are using their tech to improve how big investors trade foreign companies like Nintendo and Rolls Royce

Nintendo

Japanese gaming company Nintendo is one company that trades off exchange as an ADR in the US.

• Sophisticated, high-speed trading firms have brought their technology and expertise to American Depository Receipts, a derivative used by many US investors to domestically trade foreign companies stocks.
• Traditionally, ADR trading, which takes place off exchanges and in the over-the-counter market, has been extremely labor intensive for brokers.
• Tech-savvy market makers such as Citadel Securities, Virtu, and GTS, have pushed into the space in recent years as they look to increase transparency around how ADRs are traded and make the markets more efficient.
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Stock trading has always remained on the cutting edge of Wall Street's tech innovation. From the use of laser beams for sending orders to smarter, one-size-fits-all algorithms, there's never been a shortage of shiny new toys for banks and investors to use when trading equities.

However, one small - albeit important - portion of stock trading is still working to catch up with the rest of its brethren.

Over-the-counter equities, commonly referred to as pink sheets, are traded off exchanges where automation is limited. While many associate pink sheets to penny stocks - the small companies The Wolf of Wall Street's Jordan Belfort infamously dealt shares in - some large foreign companies' stocks are traded by US investors in the OTC market as well.

In recent years some of the most sophisticated market makers on Wall Street have pushed into the space as they look to improve how trades are done and tap into a market that has a daily notional value of roughly $3 billion. And with US foreign policies in flux, the space has the potential to grow even larger as their is a high value in providing a seamless way to invest in foreign companies, experts say.

"These are some of the biggest companies in the world and yet they're trading in an OTC marketplace that is still point and click," Andrew Brown, head of ADR trading at Citadel Securities, told Business Insider. "The lack of automation up until now has resulted in wider spreads than currently seen in the listed equity market, and we are trying to change that."

From Nintendo to Nestle

American depository receipts (ADRs) are derivatives of foreign stocks listed in dollars and tradable in the US in the OTC market. ADRs serve to benefit both US and foreign companies, as the former doesn't need to set up trading operations outside the US and the latter avoids the costly and laborious process of listing on a US exchange.

Japanese gaming company Nintendo, Chinese conglomerate Tencent, and German automaker Volkswagen are among the companies that trade off exchange as ADRs in the US.

Read more: High-speed trading firm GTS is making a push into the rapidly-changing bond market, and the CEO says 'there is so much we can do'

But the process of trading ADRs isn't an easy one. Brokers tasked with dealing ADRs for clients have to perform a series of complex tasks manually to fill the order.

A client order for shares of Swiss-based Nestle would require a broker to book the actual ADR trade while also performing foreign exchange transactions to hedge the risk between currencies and then buy and sell actual shares of the stock on the local market.

"It's a lot of work. It's very manual, and it's prone to errors," Brown said.

That's starting to change thanks to efforts by some of Wall Streets most sophisticated players applying technology to the outdated market. Citadel Securities, Virtu Financial, Jane Street, and GTS ranked in the top five in ADR trading for notional amount and number of trades in July on OTC Markets' alternative trading system. G1 Execution Services, a subsidiary of Susquehanna, fell just outside the top five for both categories.

There is no doubt about the opportunity in the market. ADRs pricing spreads can often be much wider than listed stocks as brokers account for the risk that comes with conducting the labor-intensive trades. As a result, some investors choose to steer clear of ADRs entirely, or trade sparingly, despite interest in the companies.

"The liquidity profiles of the same foreign shares in the US versus the ordinary shares in the foreign market can differ significantly," Brown said. "Even though it's the exact same company it's going to be more difficult to trade in the US, simply because the US OTC market is less efficient than the foreign market."

Hybrid approach

Citadel Securities is one industry player hoping to evolve how ADRs are traded. The market maker owned by Ken Griffin is already one of the largest liquidity providers in listed stocks. Over the past two years, the firm has looked to use some of its existing technology to improve how it handles ADRs.

Anand Twells, head of OTC trading at Citadel Securities, said improving ADR trading boils down to three things: forecasting prices, risk management, and client service. And while Citadel Securities has the technology to automate many of those processes, it needed the domain expertise specific to the ADR market. That's where folks like Brown, who joined in May 2018 after stints trading ADRs at Deutsche Bank, JPMorgan, and UBS, come in handy.

Between Citadel Securities deep technology resources and hires like Brown's experience in the markets, the two sides were able to redevelop the firm's ADR strategy to improve automation.

"It's all about creating the right recipe," Twells told Business Insider. "If you have a strong domain expert who can properly dictate that recipe and can couple that person with the right technologies, they can turn that recipe into a highly efficient trading strategy, which translates into faster and tighter pricing for clients."

See more: An inside look at landing a tech job at one of Wall Street's largest trading firms, which is harder to get into than Harvard and requires final sign-off by the CEO - even for interns

Technology and humans are equally important to GTS' growth in the space, he added.

"Just because I am really fast in OTC markets doesn't mean I am really efficient in giving my customers the best price," Pleffner told Business Insider. "In some instances, especially OTC securities and even small caps, speed is not really beneficial to the investor. It is really where can I add more liquidity. Where can I give the best price to my clients. A lot of times the lack of speed kind of helps."

The fact the market has become competitive amongst the sophisticated players has benefitted participants, Cromwell Coulson, president and CEO of OTC Markets, told Business Insider. When a broker makes any type of innovation, the others are usually quick to follow, he added.

"One does a push and the others come through, catch up or disappear, and someone new shows up and challenges again," Coulson said. "It's not a great market if all the broker-dealers trading are lovey dovey. That usually creates its own problems. ... They are going to have sharp elbows, and it's good for the client."

Opportunity on Wall Street

For Citadel Securities, and other market makers, the next step is focusing in on institutional clients such hedge funds and asset managers, many of whom have steered clear of investing in foreign public companies previously due to the lack of efficiency in the ADR market. While the firm has built strong market share handling orders from Main Street investors, Twells and Brown said Citadel Securities is now aiming to bring on more large investors and address their large, block trades.

Rob Verderese, who leads Virtu's ADR trading desk, told Business Insider via email ADR trading is a "must see" area for Wall Street clients that want international exposure in USD. As for ways to entice more interest, he noted the firm is working with OTC Markets on ideas for a closing auction-type procedure for ADRs that would create a more clearly defined close to the market.

Pleffner said market makers are hopeful that as more information on ADR trading is made available, Wall Street firms will consider trading them.

"I think there is a lot of room to expand in the institutional area," Pleffner said. "I think as more products come on to OTC markets and we see a lot more retail trading in OTC products - such as an ADR product - you will see institutions get involved. They will see all these volumes going up. They'll see liquidity that is being put up."

Part of that effort includes pushing for more transparency around how quickly and efficiently brokers handle client orders, data that was not previously available. In doing so, the markets will shift from being less relationship driven and more analytical, which is a change Citadel Securities' Twell said his firm will benefit from.

"We're not going to earn business by telling clients that we're the best," he said. "We're going to earn it by having the data demonstrate our superior execution quality."