Investment Technology Group, best known for providing the buyside with electronic trading services, has quietly embraced the sellside.
With the drought in orders from money managers now stretching into its fourth year, the agency brokerage is making a big push to win flow from retail and institutional brokers.
The move is a turnabout from just five years ago when, in a public spat, ITG barred competitors from accessing its Posit dark pool. Now it is dangling access to Posit as bait, as part of a new “open door” policy.
The drive, spearheaded by ITG executives Jamie Selway and Dan Weingarten, has helped the firm keep its head above water while many of its peers flounder.
At the end of last year, 44 percent of the shares traded by ITG came from the sellside. That’s up from next to nothing at the end of 2008, ITG officials say. The growth in sellside volume has offset practically all of the decline in the firm’s buyside volume.
“The goal is to match the sellside business with the buyside business,” Weingarten said. “The overall goal is to grow the buyside business. But as we do that, the revenue associated with the sellside business will grow.”
Engaging the Sellside
ITG is by no means abandoning the buyside. In fact, it is angling to become even more valuable to them. Because many money managers are restricting their business to brokers who provide them with a full range of services, ITG is growing a research business.
The firm has bought businesses and hired a number of individuals with research backgrounds, most notably Terry Gardner, the new chief operating officer for the research division. Gardner was previously chief executive of now defunct Soleil Securities.
Still, the firm’s quest for sellside flow comes in the midst of a three-year industrywide decline in volume that shows no signs of leveling off. ITG’s revenues from commissions and fees declined in 2011 for the third straight year to $446 million.
The drop in commissions, however, has not been accompanied by a drop in volume. In fact, ITG’s volume has remained largely unchanged for the past five years, averaging about 200 million shares per day.
The drop in commissions is due to the fact that the sellside pays less per share than the buyside. So despite the stability of ITG’s volume, its “revenue capture” rate has shrunk. At the end of 2007, ITG earned about $0.0085 per share. In last year’s fourth quarter, it took in not much more than half that.
The drop is a concern, says Richard Repetto, an analyst with Sandler O’Neill + Partners, but the decision to open to the sellside makes sense. “Their sellside business seriously dilutes their revenue capture,” Repetto said. “But the move is understandable because institutional volume has been so sparse.” He added that some volume is better than none. “They have a fixed-cost platform, so any revenue is better than zero,” he said.
ITG has always done some business with the sellside. In the days before algorithms, program trading desks and plain-vanilla cash desks all used Posit to some degree. In 1999, ITG formed AlterNet Securities to take in order flow from retail brokers.
As algorithms emerged, ITG became more selective in granting access to competitors, Weingarten said. Those that had substantive relationships with the buyside-for research, for example-were deemed good partners. But those who were simply selling access to Posit were not. ITG wanted the buyside to use its algorithms It did not want to make it easy for the buyside to use competitors’ algorithms.
But as the number of algorithms available to the buyside proliferated and their relative performance was indistinguishable, ITG came under pressure to relax its restrictions. Also, as more brokers launched dark pools, ITG decided it needed to gain access to those pools. The upshot was, it entered into reciprocal agreements with these firms. ITG gave its competitors access to Posit as long as they gave ITG access to their dark pools.
Then, in late 2006, ITG reversed course. In a bitter spat with Credit Suisse, it revoked the broker’s access to Posit, citing execution quality concerns. In 2007, ITG reversed course again. New chief executive officer Bob Gasser decided to grant access to a half dozen competitors and monitor the situation. By the end of the summer, he’d learned enough. ITG again revoked their access, ending its reciprocal arrangements with the firms.
Gasser told Traders Magazine in 2008 that the main problem was that ITG’s competitors were disintermediating ITG. A broker could offer a buyside access to Posit, cutting ITG out of the picture. Orders would pass through that broker’s dark pool first, potentially filling there and never reaching Posit.
The fear of disintermediation was not limited to ITG, says Harish Devarajan, chief executive of algo vendor Deep Value. A few years ago dark pool operators wanted to know the identities of the ultimate customers.
“These pools wanted to be the folks that actually had the direct customer relationships,” Devarajan said. “That was especially true in the cases where you had broker-dealers with better rates that those of the pool operators.”
For its part, ITG also complained that the setup shortchanged its buyside customers who had placed large “resting” orders in Posit. The incoming orders from competitor algos were too small to put much of a dent in the resting blocks, but the transactions resulted in information leakage. Likewise, the orders found in the competitor dark pools were too small to make much of a difference to ITG’s block-trading customers, Gasser said.
Five years ago, of course, the trading world was a very different place. Business was growing and algorithms and dark pools were relatively new. ITG could afford to be choosy. The crash of 2008 changed all that.
Selway, who is in charge of liquidity management at ITG and Weingarten’s boss, attributes ITG’s renewed interest in sellside flow to three factors. First, he says, there is less flow to go around. Second, there is “less tolerance on the client side for fighting with our counterparties.” And, third, the business has gone global.
“Now that we are trading globally with our counterparties, it makes a lot of sense,” Selway said. “We worked pretty hard to get those relationships back to a place they needed to be.”
Now, ITG accesses about 25 of the alternative trading systems. It has reciprocal arrangements with most of their owners.
“We have bilateral agreements where we access their pools of liquidity via our dark aggregator, and in return, they have an aggregation product that is coming into Posit,” Selway explained.
Dark Pools
Most traders who spoke with Traders Magazine say most dark pools are relatively open to algorithmic access from their competitors and have been for several years. Some say the question of openness is old news and that ITG is late to the party.
Others, however, note that there is still some tension between dark pool operators and those who would access them. The concern has moved from one of disintermediation to toxicity. Driven by customer concern, some pool operators are scrutinizing their inflows for signs of gaming. Orders that take liquidity rather than provide it are most suspect. “If you are passive, meaning you are mostly just contributing flow, then they are less concerned that you could be toxic,” explained Deep Value’s Devarajan.
At least one pool operator says that discriminating behavior is alive and well. “We take a very selective approach to whom we allow in and to which pools we ourselves access,” said Rupert Fennelly, head of sales for the Americas in Morgan Stanley’s electronic trading group, speaking of the firm’s MS Pool.
“You will find varying levels of openness from one venue to another,” Fennelly added. “Some pools are extremely open, while we limit the number of participants we allow to access MS Pool. Our philosophy values quality of liquidity over size, so being ranked first in dark pool execution volumes is not a primary focus for us.” According to a recent survey from Rosenblatt Securities, MS Pool is the sixth-largest U.S. dark pool.
Opening Up
As for ITG’s concerns over execution quality, Selway points out that ITG’s offering has adapted since the drama of the 2006-2007 period. It now operates two very different ATSs and closely monitors the quality of its executions.
The flagship Posit system has been converted from a periodic cross to a continuous cross, and accepts all comers. Average trade sizes are between 4,000 and 5,000 shares, estimates Rosenblatt Securities. Posit Alert, originally a joint venture with Merrill Lynch, is a buyside-only block-trading venue, where the average execution size is about 30,000 shares, according to ITG.
“Now that we’ve segmented the market, we’re probably open to any sellside customer from the outset,” Selway said. “So we’ve evolved from a firm that said ‘no’ to certain sellside, to more of an open tent. But we monitor our execution results quite carefully.”
That’s no less a part of the job of filling retail orders – wholesaling. Securities and Exchange Commission rules require ITG to report execution-quality metrics for orders of fewer than 10,000 shares on a monthly basis. Rule 605 requires effective spreads, price-improvement levels and execution speeds to be reported.
The stats also reveal how much flow ITG is processing. In December, for example, the firm reported inflows of about 13 million shares per day, according to Thomson Transaction Analytics. That makes it a small part of the total 90 million shares or so in total sellside volume ITG does every day. It’s also peanuts compared with the intake of the Big Five wholesalers.
Still, there’s room to grow, Weingarten says.
“Over the past 18 months, we’ve been able to offer services to retail and smart order routers and other types of firms,” the exec said. “Retail has been a good driver of our overall volume.”
Weingarten joined ITG in December 2010 from clearing firm Penson Worldwide, where he was co-director of global sales and marketing.
Despite Weingarten’s optimism, wholesaling is a tough nut to crack. It’s a sharp pencil business dominated by five large market-making firms that pay for order flow.
Selway acknowledges the challenges. “This is really hard to do,” he says. “We’re not going to commit capital. We’re not going to pay for flow. So, what can we do?”
ITG offers retail brokers two options. They can pay for the service or accept net pricing. As retail brokers are not accustomed to paying for execution-they are used to being paid for their flow-they invariably choose the latter.
So how does ITG trade on a net basis, or capture a spread, without committing capital? It’s all done on a riskless principal basis through ITG’s AlterNet.
“We never trade unless we have an order in hand,” Weingarten said. “We don’t fill the customer and then go looking for liquidity. We don’t take on positions with the idea of getting rid of them. We take an order, and, then, in a very efficient and low-latency manner, we find liquidity for that customer.”
In a riskless principal trade, the broker technically takes on a position. But because the firm has a contra order in hand and immediately does an offsetting trade, the trade is deemed riskless by the regulators.
In ITG’s case, once receiving an order, it will check Posit for a contra order or send its smart order router out to the Street to find the other side. Only then will it trade. ITG is, in effect, mimicking the work of the market makers, albeit on a riskless basis. If ITG cannot fill the order, it will cancel it or route it away, sometimes to a market maker. With ITG’s sellside volume accounting for an ever increasing portion of its business, the question is: How high can it go? Will it someday exceed the amount of buyside flow? Is ITG on its way to becoming a broker’s broker?
“It’s hard to envision that number heading much further north than 50 percent,” Selway said. “There’s a natural plateau at 50 percent as we are pairing off sellside flow with buyside flow.”
Weingarten seconds that notion. “The goal is not to take the sellside business higher than the buyside business,” he said. “The goal is to match the two.”
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