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June 30, 2002

A Brave New World of Fees: How a Common Mission Unites Industry Foes

By Peter Chapman

Also in this article

In a Jersey City conference room earlier this year, representatives from twelve of the Street's biggest institutional brokerages sat down to discuss a mutual problem. It was a rare event and most of the reps weren't enthusiastic about breaking bread with competitors.

But the task at hand - building an order management system for fee-based trading of Nasdaq shares - was mission critical for all of them.

The dozen institutional brokerages had something else in common: Each uses the BRASS order management system. The conference room, unsurprisingly, belonged to BRASS vendor, SunGard Trading Systems.

"It was an exception for all of them to come in," said Tom King, SunGard's president. "I don't think it will ever happen again. But this is a real paradigm shift in the market."

That shift occurred this year as Nasdaq market makers moved away en masse from net to fee-based trading, in response to the introduction of penny increments in a decimal pricing system. Spreads on a huge roster of stocks were, in effect, practically obliterated in the decimal environment.

Higher Price

Now net trading - or spread-based trading, in which a dealer buys shares of stock at one price and sells them to his customer at a higher price - likely accounts for just 30 percent of all executions among the top 25 dealers. Indeed, 70 percent of trades are executed by market makers for commissions, or commission-equivalents, according to a recent Traders Magazine survey. Among dealers as a group, 50 percent of all trades are executed for commissions, the survey noted.

(Under "fee-based" trading, the brokerage charges its institutional customer an explicit fee for the service of executing an order. The dealer may handle the trade on an agency, riskless principal or risk principal basis.)

King brought his biggest customers together to find out what they expected of their order management systems in this brave new world. The firms had been able to use BRASS for fee-based trading since last summer, but the new functionality was cumbersome. Traders were complaining.

What's more, last December the Securities and Exchange Commission extended its Section 28(e) soft dollar safe harbor to trades executed on a riskless principal basis.

Principal trades are deemed riskless if the market maker has an order in hand and fills it from sources other than firm capital. Previously, the ruling was considered only applicable to trades done on an agency basis as is the case in the listed market.

The SEC's new interpretation of the rule expanded the definition of "commission" to include fees paid for trades done on a riskless principal basis. Previously, the word "commission" was only associated with agency trades.

The new ruling meant institutions were free to direct a portion of any fees they paid for executions done on a riskless principal basis to the purchase of research and other services. That pleased the buyside. Overnight, they became more amenable to paying explicit fees for such trades. That pleased the sellside.

More Work

But, for the sellside, it also meant its order management systems had to accommodate fee-based riskless principal trades. Up to that point, BRASS, for example, would only permit fee-based trading in an agency capacity. More work was needed.