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December 1, 2001

Upheaval and Work

By Jim Marks

The institutional equities business is about to meet a powerful force called disaggregation. And it won't be pleasant. Disaggregation, a process that has repeated itself time after time in the financial services industry, a process in which technological change is met by an open regulatory environment, occurs when a financial product or process breaks down into its value-added components.

The forces of disaggregation - technology, capital and regulation - are evident in the institutional equities business. The technological catalyst is the introduction of second generation automated execution systems. SuperDOT, which handles about 90 percent of orders arriving electronically on the NYSE, is being supplemented by the new Common Access Point (CAP) on the New York Stock Exchange. However, this flood of data is still squeezed through 9,600-baud modems, a system that was state-of-the-art back in 1986, but is now hopelessly out of date. Although still only utilized by less than a dozen brokers and two vendors, CAP provides trading access with modern bandwidth.

SuperSOES Executions

Similarly, automated executions over Nasdaq were once through SOES and SelectNet, a system so slow, so restrictive, and so expensive, that traders turned to ECNs-parallel execution systems for over 30 percent of their trades. Nasdaq let SuperSOES loose this summer in response, lifting volume restrictions, ending built-in delays, and reducing costs for electronic trading. Now institutional equity traders have more options than they did 12 months ago.

These electronic options bring substantial benefits to buyside desks. The primary first-generation benefits are in cost, speed, and trading management. Trading desks can reduce the four to six cent commissions they typically pay to institutional trading desks down to two cents or less, and accrue the even larger savings in more efficient executions. Speed is also a critical advantage. Traders receive confirmations instantly, allowing them much greater flexibility in their trading strategies.

These benefits will spur buyside traders to make adjustments. Eventually, they will move away from the traditional institutional equity arrangement, an arrangement in which they are paying double to triple in the pure execution rates. It is a gradual process. It will be slowed by general inertia involving trading systems and relationships. Commissions today are not just for execution, but for research, IPO access and a bewildering array of other services in soft-dollar arrangements. Institutional desks will still want to compensate brokers for these services. There is also a portion of trades that will never go electronic. Large orders do not work well in fully transparent electronic order books.

An increasing percentage of liquid orders will be gradually routed directly from the trading desk of mutual and hedge funds to the point of execution, bypassing institutional desks. Early users of this technology include index funds, index arbs and ETF component traders. These quantitatively-driven traders are moving quickly to exploit automated execution systems and brokers. (Disaggregation is evident on the NYSE, where floor brokers are offering direct access, using technology to bypass institutional sales desks.)

Ultimately, the majority of orders will be routed to firms that specialize in delivering the best possible execution available, primarily through electronic channels. Research will be sold on its own merit and paid for directly, or through soft-dollar arrangements. There will be continuous downward pressure on commissions and reduced profitability in equity departments, especially in the commitment of dealer capital. (That will remain mostly constant.)

In the end, fewer traders, sales traders and institutional sales staff, will be employed. There will be fewer analysts overall, and an increasing disparity in pay, as value-added analysts are compensated more. This does not mean the complete elimination of the salesman. The best departments will offer electronic execution alternatives to clients at reduced commission rates and provide alternative payment mechanisms for research.

The immediate effect will be a sharp reduction in the current profitability of equity operations. This shift will probably not happen until the pain is evident. Until then, it will be a time of plentiful opportunity for electronic execution specialists to reap the benefits of technological disaggregation.

Jim Marks, jmarks@belzberg.com, a former brokerage industry analyst, is president of Belzberg Technologies in Toronto, a provider of trading technology and routing services.