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John Turney
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Foreign Exchange Infrastructure: Yesterday, Today and Tomorrow

In this exclusive to Traders Magazine, John Turney, Global Head of Outsourced FX at Northern Trust, discusses the evolution of the fx infrastructure and what is to come.

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April 30, 2001

Direct Access Revolution?

By Benjamin Weinger

Direct access trading, gaining market share from traditional and online brokerages, is revolutionizing the traditional process of order execution.

The emergence of direct access trading has shaken up the status quo because it empowers all market participants. It gives them the tools to obtain the best possible execution. And direct access allows market participants to route orders electronically to all liquidity sources.

The emergence of direct access has exposed the inefficiencies of an archaic market structure, which allows payment for order flow and biased order routing. The Securities and Exchange Commission and the National Association of Securities Dealers have investigated and are discussing how orders are executed (and if, in fact, the orders are executed in the best interest of investors).

Historically, both retail and institutional traders have experienced barriers to obtaining the best trade execution due to market fragmentation and disjointed liquidity. Despite sophisticated technology, even today, some institutional traders continue to trade over the phone with a select group of market makers, paying as much as eight cents a share, not knowing if they're getting the best execution.

Within the next two years, an estimated 75 percent of all financial industry institutional trades will be executed electronically, up from 40 percent today and 20 percent two years ago, according to the TowerGroup. The advent of direct access trading technology has leveled the playing field. It gives all types of investors the ability to effectively compete for the best price and fastest execution. (While the role played by market makers may be diminished in the future, they will still continue to be part of the order execution process).

The savings in direct access trading can be significant. For instance, American Century, a mutual fund, brokerage and investment services company, estimated it saved $500 million last year by using electronic communications networks for most of the Nasdaq trades in its $77 billion equity portfolio.

Important differences exist among leading direct access firms. Order routing technology can mean the difference between orders getting filled or not getting filled at the best price, especially during times of market volatility. The timeliness of quote data is critical for obtaining best execution. Stale quotes, even by a fraction of a second, can render quotes useless in seeking the best price.

Many direct access brokers have little understanding of the needs of institutional traders. Often, firms simply tweak their old professional day-trading platforms and add on a few features for institutional use.

Online brokerages, such as E*Trade and Ameritrade, feeling the impact of direct access, realize they can no longer compete based on commission rates. These firms are already experiencing customer attrition, realizing that they have to compete on speed and quality of execution or run the risk of losing more customers. One analyst recently noted that average daily trading volume originating from direct access trading platforms had grown steadily throughout 2000, while trading volume of traditional online brokerage firms had steadily declined.

Smart order routing technologies vary greatly between direct access brokers. Certain direct access firms have affiliations with ECNs, and as a result, will attempt to obtain executions within those ECNs. Firms without an affiliation to a liquidity source are unbiased.

Direct access has significantly altered the landscape of trading and technology in the securities industry, providing market participants with equal access to online trade execution, increased market transparency, and advanced analytic and research tools.

During the coming months, we can expect continued consolidation among trading technology providers, heightened scrutiny of execution quality and increased competition as technologies mature in scope and sophistication - ultimately benefiting the investor.

Ben Weinger is a founder and managing partner at Blackwood Trading, a financial software development and direct access trading firm in New York.