News + Events

Misery loves company

By Isabelle Clary

John Barker, managing director of Liquidnet Europe Ltd. in London, was surprised to hear in mid-July that institutional traders wanted more help from their brokers and were prepared to pay more for the service.

He heard that not once, but twice within the same week.

“I had a conversation with a buy-side trader and, a couple of days later, another with an agency broker. They were both saying the same thing: ... If institutional traders feel they are getting the level of services and market color they need, they are prepared to pay for it, definitely,” said Mr. Barker, who heads the European institutional block-crossing business of Liquidnet Holdings Inc., New York. In the U.S., Liquidnet is the largest block-trading agency broker, according to Rosenblatt Securities Inc., New York, which monitors crossing networks' volumes.

If continued, this change would mark a reversal of a multiyear trend that, as a result of technology, has turned trading into a commodity and lowered commissions.

Commissions started declining in early 2000 amid a budding price war among new electronic execution venues. The trend accelerated beginning in 2004, as technology gained strong acceptance on the institutional desks because of the New York Stock Exchange's move to a part-electronic hybrid format.

According to data from research and consultancy TABB Group LLC, New York, commissions fell to an average 3.41 cents per share in 2007 from 4.5 cents a share in 2004 for placing an order through a trading desk. Fees charged for electronic trading were slashed, to 1.1 cents a share from 2 cents a share for crossing networks and to 1.05 cents a share from 2.5 cents for direct market access.

The change in attitude by institutional money managers is being driven by the highly volatile markets of recent months. In particular, trading in small-cap stocks — both domestically and overseas — has become much more difficult at times.

“Buy-side desks are starting to be comfortable about paying higher commissions if they are getting quality of services and certainly quality of execution. They'll pay for some level of voice broking or for being able to talk to sell-side traders at an agency broker,” Mr. Barker said, referring to placing orders over the phone to a desk for really difficult trades.

Richard Vigsnes, senior vice president and global head of equity trading at Northern Trust Global Investments in Chicago, agrees that communication with brokerage desks provides valuable support in a difficult market environment. The firm, a unit of Northern Trust Corp., Chicago, has $751.4 billion in assets under management.

“Communication has more value in more stressful time. It's a new reality. Now, you can get color and an opinion and come up with a strategy. A lot of this comes from phone conversations,” Mr. Vigsnes said.

Finding the right match for thousands of shares in a little-known U.S. or European stock amid dozens of marketplaces is never easy, but trying to do so in a hectic market is a real challenge for the institutional trader.

“We are in the area of high-touch electronic trading,” said John Giesea, president of the Security Traders Association, a non-profit industry group in New York.

“I know it sounds like a contradiction in terms — high-touch, which means broker-assisted trades, and electronic trading, which means no broker intervention — but this has been the trend since last summer,” Mr. Giesea said.

Dealing with fragmentation

Recent volatility has highlighted how the advance of electronic trading has fragmented markets in the past few years.

Investors trading equities in the U.S. have a choice of 10 exchanges, a handful of electronic communications networks and at least two dozens alternative trading systems — known as “dark pools” because they do not display their quotes — operated by either full-service or agency brokers.

Exchanges themselves have their own dark pools of sort, as they keep some orders non-displayed and automatically match them.

Not surprisingly, fragmentation was by far the single largest concern for 67% of the respondents in North America and 78% of those in Europe who took part in a Liquidnet survey of buy-side traders in late 2007.

Even the institutional desks equipped with the most powerful trading technology had to rethink their systems and strategies in the face of widely dispersed liquidity.

“We are building out our own infrastructure to deal with (liquidity fragmentation). Volatility is difficult, but our platform is built on expectations of fragmentation and volatility,” said Ray Tierney, managing director and global head of equity trading at Morgan Stanley Investment Management Inc., New York, which has $604 billion in assets under management.

“We want to be able to turn these difficulties into competitive advantages for us. We've been working very hard to measure our ability to deal with these phenomena. We're using a fairly advanced TCA (trade cost analysis) to answer those questions,” Mr. Tierney said.

He said Wall Street firms, too, are adapting to the major changes that have occurred since the heyday of voice broking — when placing an order simply meant picking up the phone to talk to a broker.

Along with the changes in market structure, the commission system has evolved to fit the execution services involved, from low flat fees for electronic trading to different rates, based on volume or related services provided by the broker.

“Bulge-bracket firms are trying to make their models make sense. They have gone to tiered services for large institutional clients and midtier clients,” Mr. Tierney said.

As for low-commission trades, global firms are pushing as much order flow as possible into their unmanned, proprietary crossing systems, which they register as an alternative trading system in the U.S. or as a multilateral trading facility in Europe.

Although alternative trading systems and multilateral trading facilities operate as quasi-exchanges, they come under a much lighter regulatory burden than traditional markets and can adopt models with different criteria for access. For instance, some require firm quotes, others welcome simple indications of interest, some allow negotiations and others auto-execute at the midpoint between the best bid and offer — all adding to the complexity of hunting for liquidity.

Most bulge-bracket alternative trading systems mix liquidity from a variety of sources, including substantial retail flow against which institutions can trade. In volatile markets, a key feature is to access as much liquidity as possible — meaning, either be a very large pool or have top-notch access to dozens of trading venues.

For the astute trader who knows how to navigate different market models, market volatility in itself can be a play, so, access is an important consideration in the new buy-side, sell-side relationship.

“We love volatility, we can actually add alpha through those volatile days,” said Ted Oberhaus, director of equity trading at Lord Abbett & Co., in Jersey City, N.J., which has $100 billion in assets under management

“The more volatility increases, the more we implement strategies that will actually not follow momentum but act as passive catchers of these swings,” Mr. Oberhaus also said. He added that retail brokers are now sending order flow to alternative venues, which benefits the institutional order flow, at a time when liquidity dwindles on exchanges.

Whose liquidity?

Equity markets are not only fragmented in the U.S. and, to a lesser extent, in Europe as well, they are also increasingly diverse. Even for the technology-savvy institutional trader, getting a sense of the overall market in a specific stock before pulling the trigger is an important part of the trading process. That's where brokers provide valuable intelligence.

“Changes in market structure have resulted in very fragmented markets, and this makes the role of a trader very difficult, particularly regarding the sourcing of liquidity,” said Nanette Buziak, head equity trader at ING Investment Management in New York. The firm has $560 billion worldwide in assets under management.

“Sourcing liquidity is important because it is differentiating in terms of natural liquidity that institutional orders can stand up to vs. those that are fishing for orders,” Ms. Buziak said. She noted the difficulty in feeling confident that the contra side to a trade is a bona fide liquidity provider — not an astute black-box wizard that will take advantage of that information.

While technology has empowered institutional desks, it has also armed electronic arbitrageurs with powerful tools and smart strategies to “sniff out” large orders. Once software programs locate a target through “pinging” or sending phantom orders to a number of venues, the raider can influence prices in his favor by buying a few hundred shares on an exchange and jumping back to the dark realm to execute an order at a favorable price.

Brokers are an important source of information for buy-side traders when it comes to getting a sense of where the “gamers” and the true players are.

“In particular for midcap and small-cap stocks, the boutique agency brokers or liquidity providers know where all the bodies are buried. They'll know where to go to for liquidity and at what price they can find liquidity. They are more plugged in with numerous buy-side firms or hedge funds. They know where the liquidity is and who the buyers and sellers are,” Ms. Buziak said.

In the trading “arms race,” institutional investors use algorithms to find desirable matches, gamers run programs to spot them and independent software makers develop anti-gaming systems to keep institutional flow out of reach from arbitrageurs.

Sniffing out arbs

For instance, Pragma Financial Systems LLC, New York, a quantitative financial software provider, has created OnePipe Lifeguard, an anti-gaming program jointly developed with Weeden & Co., the Greenwich, Conn., broker which invented the “Third Market” or off-exchange trading.

“We started building the product because there is more volatility in markets, and we have also seen structural changes in the marketplace where the average size of a trade has dropped by an order of magnitude and where there is a fragmentation of destinations,” said Peter Fraenkel, director of quantitative services at Pragma.

Weeden's way to work orders is to dispatch all of it right away in different pieces to a number of venues in a bid to quickly locate the desired match. The model also addresses the “sitting duck” problem of static orders, which passively reside in a book at the mercy of a volatile market.

“We are not in every destination, but we are in more destinations than most of our competitors are,” said Weeden Managing Director Douglas Rivelli.

As technology gives access to a greater number of trading venues, the “dark” pools are no longer as dark as they claim to be.

Michael Plunkett, president, North America, at agency broker Instinet LLC in New York, said “dark” pools as a misnomer because of the need to be accessed by other sources of order flow. “As dark as any pool may be, it does not mean it's dark. Once someone on the contra side accesses you, your order is linked. If you are totally hidden and dark, you have less chances of getting executed. Once you leave an order static in a dark pool, you are only dark in the sense you are not physically quoted anywhere,” he said.

Mr. Plunkett also noted the benefits that arbitrageurs bring to the marketplace.

“People send IOIs (intentions of interest) or other pinging strategies and you give up some of your information. But if you remove this (arbitrageur) volume from the market, volume would be much lower. Technology has changed markets so much. These types of players have created new layers of volume we never used to see,” Mr. Plunkett said.

According to industry estimates, electronic arbitrageurs account for 30% of volume not only in equities but in derivatives as well, with dark pools representing less than 7.5% of overall equity volume. Repricing the relationship

Two reforms, Regulation NMS in the U.S. and the Markets in Financial Instruments Directive or MiFID in Europe, have contributed to changing the buy-side/sell-side relationship. Implemented last year, they have a similar goal of boosting competition and market transparency by allowing alternative markets to flourish or mandating execution at the best price.

One unintended consequence of the reforms is that institutional traders do not like transparent venues, where they fear the negative price impact that large orders would have when immediately displayed and executed against. As a result, buy-side orders have moved away from exchanges in favor of the broker-owned alternative trading systems.

The New York Stock Exchange, now part of NYSE Euronext, used to control more than 80% of its volume before it endorsed a hybrid model that resulted from the Reg NMS reform. Today, the NYSE floor handles less than 30% of the trading volume in its own stocks. In Europe, national exchanges already feel the competitive pressure from alternative trading systems such as Chi-X Europe Ltd., London, a unit of New York-based global broker Instinet, itself a subsidiary of Nomura Holdings Inc., Tokyo. Chi-X controls between 8.1% and 13.4% of the volume for the stocks listed in the four main European indexes.

The changing landscape is forcing brokers to reassess the services — and their costs — they offer to institutional orders.

“That relationship is being actively negotiated and not just in respect to money,” said Ian Domowitz, managing director at Investment Technology Group Inc., New York, a pioneer in alternative trading systems.

“We've talked about the empowerment of the buy-side and the move toward self-directed trading. As buy-side desks have done that, they got to the point where they actually have many of the DMA (direct market access) tools that the sell-side had,” said Mr. Domowitz, who heads the analytics and research unit at ITG.

“The buy-side/sell-side relationship is being renegotiated at all levels, such as how much in the way of high-touch does the buy-side really need now?” he added.

“There's a lot of high-touch services in the customization of the tools we are providing to the buy-side. Because of a difficult market, we have certainly experienced demand to customize products, such as the interface within (ITG trading terminal) Triton, how to distribute other people's algorithms or their own ... The demand for customization goes up with different problems.”

Just like the execution choices and the need for services, the range of commissions varies greatly, from as little as half-a-cent per share for plain-vanilla direct-market access trades to 1 cent or 2 cents to reach multiple destinations, and 3 cents to 4 cents for full-service, hard-to-work orders.

“Commissions vary widely. It depends on what you are looking for in terms of the total relationship. Going through a broker's desk is not a requirement any more,” said Mr. Vigsnes at Northern Trust.

“The nice part about it is the choice. You can decide how to pull the trigger: whether it's best to give the order to a broker to work on his desk, or if it is better to use the tools available to you to execute in a low-touch manner,” he said.

“I feel the most important thing is to know who is your counterparty, whether you decide to participate with that type of order flow or not. You have to decide where your value is, where your alpha is. The volatility during the day makes the trading of that much more difficult,” Mr. Vigsnes said. “I agree I want to pay for value-added. But it varies widely, depending on what you are looking for in terms of total relationship. It all depends on what is included in all the services provided.”

Instinet's Mr. Plunkett said the closer ties between brokers and institutional traders particularly matter when it comes to work a difficult order, which, most of the time, involves a small-capitalization stock lacking liquidity.

“Some brokers are willing to commit capital to help out a large client,” Mr. Plunkett said, referring to trades involving a hard-to-work name. “The client may throw an easier order the next day to make up for the effort.”

Difficult market conditions have brought back a new appreciation for brokers' services, and institutions are prepared to pay a little more for this when needed.

While hyperactive traders pay as little as a half-penny a share for their high-frequency trades, the most difficult trades can result in a 4-cent charge, more than the average 3.4-cent rate charged by sales desks, according to industry data.

“From what we have been hearing from the buy-side community, it is true that over the past five years, commissions have been significantly reduced,” said analyst Matt Simon at TABB Group. “But the price play is no longer as much of a factor, because the deterioration in price has also coincided with deterioration in service.”

Mr. Simon noted that, ironically, electronic trading has made trading more complicated by multiplying the array of venues, asset classes and countries that can be accessed.

“The buy side is still willing to compensate sales traders if they can give them some good advice and help execute some sensitive trades. People on the buy side are willing to pay a little more for that extra market color because they can justify it to their investors. We're at a point where commissions have stabilized,” he said.

“There is no price tag that can be put on a good relationship,” the TABB analyst concluded.

For all the technology that has landed on trading desks, the most important part of the relationship between brokers and institutions remains the human aspect.

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