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May 31, 2002

An Explicit Endorsement

By John A. Byrne Editor

A good case for explicit commissions on institutional trades was made by a veteran buysider.

Explicit commission, or agency style trading on Nasdaq, will benefit the institutional investor, according to Tom Bardong, head of trading at Alliance Capital Management. Dealers will initially reap the rewards, but then will ramp up market making in small- to mid-cap stocks. Later, the dealers will take a fresh look at expanding their galaxy of larger names. "Firms will once again build up research and expertise in both small- to mid-cap names," Bardong said. "In the past the cost of carrying these names did not justify the amount of resources a dealer was committing." The shift to commissions will also, indirectly, encourage dealers to risk more capital for institutional accounts on large-cap stocks. Dealers will be handling an expanded universe on a more profitable basis, according to this Bardong.

Bardong's comments are significant because some on the buyside see another dynamic at play: the continuing disintermediation of the dealer market. The evidence suggests that dealers are taking it on the chin. For instance, about 40 percent of trading volume in the largest stocks are now executed on ECNs. Dealers, under competitive pressure, are lowering commission rates. As of April 1, Nicholas-Applegate lowered, by a penny, the maximum amount per share it will pay dealers. Now the buyside firm pays from three to five pennies a share. Still, as Nicholas-Applegate's Jamie Atwell remarked, "If you trade with a traditional broker you get everything they've got to offer, if you trade with an ECN you get zero." Perhaps, the balance of power is tipping too heavily in the buyside's direction? "When an institutional [dealer] executes a trade today, the reality is that it no longer pays for the infrastructure such as research and the sales guy who gives away Knicks tickets," said Brad Hintz, a brokerage industry analyst at Sanford Bernstein. "So, in the end, you have a [dealer] business at some firms that mainly exists to support areas such as underwriting, convertible and equity derivatives business. A long time ago executions were profitable. Now institutional investors have helped bring down the commission rates. But the Street is stuck with a loss leader."

One firm that knows about the road back to profitability its Merrill Lynch. Merrill, among the first to pioneer explicit commissions on Nasdaq, is featured in this issue's Cover Story. Back in August, 1996, Merrill's acquisition of Smith New Court was the Cover Story in Traders Magazine penned by my distinguished predecessor, Michael Scotti. This latest story is about the integration of both Herzog Heine Geduld - which Merrill acquired in 2000 - and Merrill's Nasdaq operations. The story is not about the multi-million dollar settlement reached by Mother Merrill and New York State Attorney General Eliot Spitzer. That's itself a ghoulish drams worthy of a Tom Wolfe novel. This story is about the merger of two of the titans in the Nasdaq and OTC trading game. Some aspects of the integration produced the usual elements of drama and suspense. One buyside trader confided to me how his Herzog trader attempted to keep him as his account even though he was covered at Merrill. But the deal has more remarkable elements which we dare you to read. John A. Byrne