Commentary

Tim Quast
Traders Magazine Online News

We're All HFTs Now

In this guest commentary, author Tim Quast looks back at the history of HFT and how the market has evolved to where many firms now fit the definition of high-frequency trader.

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June 30, 2002

The Cost Squeeze Continues On Wall Street

By Brian O'Connell

The so-called implicit costs on an institutional trade comprise the largest proportion of the overall costs of an order, according to research published by ITG's POSIT. Those costs are under attack in an era of razor-thin profit margins.

With institutional commissions hovering around $0.05 per share, the buyside is demanding more efficiencies. The sellside, handicapped by penny trading, is also feeling pressure for cost savings.

The switch to commissions, or agency-based trading, could help dealers and institutional customers. "The improvement in profitability for market makers will likely increase the capital the sellside commits to the buyside, improving liquidity," according to a report by Ken Worthington, an analyst at CIBC World Markets. "The greater liquidity should benefit the largest asset management companies, which have found it increasingly difficult to execute large trades."

Among the winners could be Instinet, which garners roughly 80 percent of its volume from the sellside, says Worthington. A sellside that becomes more profitable will likely send more business to a third-party firm like Instinet.

If that occurs, it will mark a turnaround for Instinet, which acknowledges that the current environment is difficult. "The risk-reward ratio is in tremendous flux," said Jean-Marc Bouhelier, executive vice president at Instinet. "Broker dealers, in particular, have met with tremendous competitive and financial challenges in a world of decimalization, and yet they must meet the obligations of their industry roles as the traditional providers of market liquidity."

Losing Business

Still, the move to commissions could raise profitability at firms that charge commissions but still cause them to lose market share. Commissions should help offset the declines caused by trading net in a penny environment, some pros say. But firms that continue to charge mostly on a net basis may actually attract orders from institutions that see this as a lower-cost approach than paying commissions. The pricing system used in commission-based trades may convince some that they are paying dealers more per share than on net trades.

CIBC's Worthington said many on both sides of the aisles are proponents of commissions. "The buyside and the sellside were pushing for [commissions]," said Worthington, in an interview. "Buyside firms need the liquidity and the sellside felt they weren't profitable enough or getting good executions, especially with large firms trying to execute block trades."

Benn Steil, a senior fellow at the Council on Foreign Relations, who's an expert in market structure, says that the buyside should benefit from agency trading. "If you look at non-intermediate ECN trading in Nasdaq and listed stocks, you see that ECNs control around 40 percent of Nasdaq's order flow," Steil said. "The average ECN trading on Nasdaq saved about 33 percent in commissions [for investors] while the New York Stock Exchange saved about 28 percent in commissions."

Commission dollars are also easier to track than net trades, according to Worthington. "Now the sellside can offer buyside firms credit for OTC trades done for a commission. There was not much of that in the past,"he said.

The losers are likely smaller firms. "Smaller firms don't have big technology budgets and they were already coming under significant pressure from decimalizations and the narrowing of spreads," Worthington said. Smaller market makers "may be driven out of business," especially because of the need for technology, according to the CIBC report.

"Market making technology like UMA and BRASS are not compatible with agency trading," the report said. "The investments required to enable such trading systems for both agency and principal transactions are significant. With profitability already low, many smaller market makers may decide that such an investment to upgrade Nasdaq trading systems is a poor investment and may leave market making altogether."

One market participant says that firms must ensure that they receive value.

"The challenge is making sure all the players are working hard and fair," said Andy Brooks, a trader at T. Rowe Price. "You want to make sure there's no double dipping with someone earning a spread and charging a commission. You want to see your executions. As long as there is clarity of communication things should be fine."