If the changes taking place at Goldman Sachs these days are any indication, the business of handling institutional orders is entering a new, highly controversial phase.
The firm is in the process of combining two of its broker-dealers–Goldman, Sachs & Co. and Goldman Sachs Execution & Clearing–into one, thereby, breaking down the wall between the two legal entities that handle cash and electronic trading, respectively.
The purpose is to make it possible to offer the buyside a single point of coverage for both their high touch and low touch coverage needs.
According to a Goldman insider, the aim is to achieve technological and operational efficiencies and to offer clients the ability to have one point of contact for both their electronic and block trading needs.
For Goldman’s buyside clients, however, working with a single individual instead of two is entirely optional. Buyside traders can continue to work with a cash desk sales trader and an electronic desk sales executive if they wish, Goldman tells Traders Magazine. Goldman expects to complete the merger sometime in the second quarter.
Mixing Oil and Water
For some in the industry-both on the buyside and sellside-the idea of merging electronic with manual trading is heresy. The two don’t mix. They are like oil and water. Electronic trading is technical and anonymous. Cash trading is all about the relationship and open sharing of order information about positions. The expertise of the two types of professionals can’t be blended, say various market participants. The information inherent in an electronic order is intended to be kept secret and is not to be shared.
But brokers’ commissions have fallen from $17.3 billion in 2009 to $12.7 billion in 2012, according to research consultancy Tabb Group. In that environment, something has to give, traders admit. Which means a single trader may start to take responsibility for some or all of a client’s automated and manual trading needs.
“Consolidation is here,” said Craig Jensen, a principal and head trader at Armstrong Shaw Associates, a New Canaan, Conn.-based asset manager with $2.5 billion in equities. “It’s been here, and it’s ongoing. From when electronic trading first took off, it’s been a natural progression to where, in the end, there’s going to be overlap with cash trading.”
At this point, that overlap, known variously as the “one-touch” or “mid-touch” or hybrid model, is taking one of two forms. Firms are anointing a given individual the single point of contact either for all of a buyside trader’s high- and low-touch orders, or just for a portion of them. The latter scheme permits the buyside trader to “opt in” to the model on an order-by-order basis.
Five of the nine bulge bracket firms are implementing some variation on the model: Goldman, Morgan Stanley, Merrill Lynch, Citigroup and Deutsche Bank. Two of the firms-Credit Suisse and Barclays-have said they are not. The other two-UBS Securities and J.P. Morgan Securities-would not comment.
In Citi’s case, at the same time the firm is implementing its single-touch policy, it is also conducting a broad-based customer profitability analysis. The exercise is intended to determine the profitability of individual accounts, taking into consideration their consumption of the various research, trading and capital markets services Citi offers.
“The point is to ensure we understand our clients better and we manage that relationship in partnership with them,” explained Dan Keegan, Citi’s global head of cash equities. “They want to know what they look like to us. And we want to know what we look like to them. We need to make sure the data presents the full picture. And as part of that, there is a natural discussion to be had around the number of touch points across the different execution channels.”
At Deutsche Bank, the change is also about the bottom line and client service. “We are definitely looking for ways to better serve clients and also see where we can enhance profitability,” said Brian Fagen, Deutsche Bank’s head of sales for North American execution services. “But the key is to create a higher value-added service model as opposed to a lower one. We want to give clients choice and business coverage models that work best for them-the same execution quality whether they trade high or low touch.”
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Deutsche Bank, Citi and Merrill are offering their clients three choices: the traditional two-desk model, the blanket one-touch model and the order-by-order plan. Morgan Stanley continues to offer the two-desk model and, now, the opt-in model. It is not offering blanket “one-touch” coverage.
For all the banks, however, cost control is the driving factor. Not only are commissions down, but so is trading volume. Consolidated volume of 135 billion shares in January 2013 was down 30 percent, compared with 2009, according to Nasdaq OMX Group statistics. And a big challenge for banks’ institutional equity trading businesses is that equities are primarily traded electronically, with minimal commissions, according to Aite Group senior analyst Howard Tai.
None of the firms with whom Traders spoke, however, said that a move to adopt a single point of coverage would lead to layoffs. Deutsche Bank, for instance, denied that the new model would lead to a workforce reduction. Rather, any freed-up capacity would be used to increase the broker’s market share by winning new accounts, the bank said.
As for the buyside, while many traders are worried about the impact of the change on their operations, they readily acknowledge it is their shrinking commission “wallet” that has precipitated the move. “It’s all about right-sizing the ship and making ends meet,” said Rob Felvinci, director of portfolio management and trading at Spinnaker Trust, a Portland, Maine-based money manager with $1.2 billion in equities.
Creating A Model
Because the idea of moving to a single point of contact is a relatively new one, the Street hasn’t settled on a standard model as yet. The dialogue between the sellside and their customers really just began six months to a year ago. Both sides are casting about for a way to implement the model.
On what basis should it be done? Should there be one contact per money management firm? One contact per trader? Should it be done on an order-by-order basis?
Does the sales trader become the single point of contact? Is it the electronic exec? Is it a new, as yet undefined person? Or is it a team of traders working together?
For the buyside, the concerns are two: a loss of anonymity and a degradation in the expertise of those servicing them. Some don’t want to lose the secrecy they enjoy when using a broker’s electronic services. Others don’t want to lose the distinct skills possessed by both their sales traders and their electronic coverage.
The desire for anonymity largely drives trades to electronic desks and keeps them there.
“There are absolutely some firms that are determined to keep separate church and state,” said Citibank’s Keegan. “They understand both sides of the argument, but just come down on the desire for anonymity above and beyond everything else.”
That a single brokerage sales executive can master two different skill sets is an equally difficult concept for some buyside traders to accept. “Some of the skills are transferable, and some aren’t,” said a trader with a large money management firm. “And if they merge the two, then the customer could suffer.”
In general, traders on the electronic desk are experts on the inner workings of their algorithms and dark pools, as well as market structure. By contrast, sales traders are experts on the day-to-day happenings in the markets and are able to move difficult-to-trade blocks. There is little crossover between the two.
When buyside traders use a broker’s electronic services, they are typically guaranteed that their order information will not be shared with others. By contrast, when they use a broker’s block desk, there is sharing such as details about the size of the order.
To get a better understanding of its customers’ concerns, Merrill Lynch surveyed some of them. The broker asked them to respond either “favorably” or “negatively” to two questions. The first question was: “How do you feel about a ‘mid-touch’ coverage model where your high-touch sales trader can also see your low-touch flow?” The second question was: “How do you feel about a ‘mid-touch’ electronic desk where your low-touch desk provides high-touch coverage?”
In general, Merrill got more favorable feedback in the responses to its second question.
In their answers to the first question, 60 percent of the buysiders responded negatively due to concerns over a loss of anonymity and skills. Forty percent responded favorably. Of that figure, 27 percent liked the idea because they felt they would get better service if their high-touch trader had more information. The other 13 percent said it appealed to them because they preferred fewer points of coverage.
In answer to the second question, about low-touch desks providing high-touch assistance, only 50 percent of the buysiders responded negatively. Their reasons were two: concerns over a loss of anonymity and the potential for a deluge of telephone calls from the electronic desk. Of the 50 percent who responded favorably, the most common reason was the need for more color and consultation on their electronic usage.
In all cases, whether or not they are physically combining their trading desks, the firms say their “one-touch” service is optional. They will not force their customers to choose between their sales trader or electronic coverage. The decision is up to the customer.
“It depends on the client,” explained Lee Morakis, Merrill’s head of Instinct Knowledge. “It depends on their resources. It depends on their needs. How many asset classes do they trade? How many traders do they have on their desk? What is their need for specialization? You need a flexible model.”
Bringing Flow Together
Morgan Stanley has decided that order-by-order is the way to go. That’s because its clients are not overly enthusiastic about the one-touch model. The broker has no plans at this stage to designate a single individual to provide blanket combined high- and low-touch trading services to any particular buyside trader or money management firm, said Rupert Fennelly, head of sales for the Americas in Morgan Stanley’s electronic trading group.
The broker is offering customers of its electronic desk a feature caled “Opt-in.” This gives the buyside trader the ability to share his order information with a pre-designated sales trader on the high-touch desk on an order-by-order basis if he chooses. The buyside trader must check off the Opt-in box on his order ticket. “The intent is not for the order to be shopped,” explained Fennelly. “But if there is a liquidity situation on the desk and the client has opted in, then the sales trader will make the client aware of it and offer them the opportunity to participate in the trade.”
Like Merrill, Morgan Stanley canvassed its customers on the topic of a single point of coverage. It found many of them, especially the larger shops, preferred the status quo of two touch points, according to Fennelly.
“They value each channel separately,” he said. “They value the cash desk for color, for flow information, for the ability to find a natural and for the ability to put up a block. They value the electronic desk for their consultations on algorithms, views on market structure, or for anonymity. So in many cases they want that separation.”
But given the large amount of flow that crosses its desks throughout the day, Morgan Stanley decided to offer that through a single point of contact. “We are executing well in excess of 10 percent of the consolidated tape,” Fennelly said. “That’s significant liquidity. So there are opportunities where we want to collectively bring that liquidity to our customers.”
Like Morgan Stanley, most of the firms are pitching the single-touch model as a benefit to their customers, rather than an exercise in cost control. Because industrywide volume is down, bringing together internal flow should alleviate some of the problems in getting trades done, they say.
Still, the buyside is skeptical. According to a survey done by Tabb Group last year, the buyside “has yet to buy into the idea that this is done to improve customer service. Some buyside traders believe this model is only being rolled out to them because they are a less profitable client.”
While Morgan Stanley is stepping gingerly into the brave, new one-touch world, Credit Suisse says it’s going nowhere near it. “We have no plans to combine sales trading with AES sales,” said Dan Mathisson, head of U.S. equity trading at Credit Suisse, speaking of the firm’s Advanced Execution Services group, which handles electronic trading.
“We built AES from the ground up as an offering that was confidential and anonymous and walled off from the rest of the trading floor. No one who does any risk trading or any shopping of order flow will ever see an AES order, unless the client has specifically given us written permission to do that,” Mathisson said. The AES group has been audited for its adherence to that principle by PricewaterhouseCoopers since 2006, he added.
Credit Suisse is in the minority however. At Citi, execs see a need to breach the wall between high and low touch. Keegan argues that wall needs to come down and that technology can play a role.
Citi, in fact, has been offering an electronic block trading service for the past two years called Total Touch. Keegan says his group will continue to promote that product as it looks for ways to innovate, introducing hybrid solutions that blend Citi’s high and low touch capabilties.
Both Keegan and executives at Merrill Lynch make the point that a merging of the two services is not only good for their bottom lines, but also good for their customers. As more and more flow consolidates with the largest broker-dealers, the danger for the buyside is that the other side of the flow is split between various trading desks within a single firm. Accessing that can be an inefficient process of multiple calls to multiple desks.
That’s why a sharing of information and blotters across desks accrues to the benefit of the institutional customer. “It’s not just about cost rationalization,” Keegan said. “If I’m right and the top five firms eventually control 80 percent of the volume, then the biggest risk the buyside firms run is that we fragment their order flow inside our own four walls, obviating the benefit of scale that otherwise exists by way of said consolidation.”
Merrill makes the same argument. In tandem with its move to a single-touch model, Merrill is tackling the problem of internal fragmentation by making available large block positions on it cash desk to the algorithmic orders traveling through its dark pool, Instinct X.
The new service, Instinct Natural, available initially to its largest customers, integrates the order management systems of several of Merrill’s internal trading desks with the Instinct X dark pool. “Instinct Natural gives you the opportunity to trade with another block that might be on the other side of the floor, or with an order that is being worked by the electronic desk,” explained Adam Inzirillo, a Merrill director of global execution services. “It aggregates natural liquidity.”
One Touch, One Call
As seen in the Merrill Lynch survey, there are many on the buyside who actually do favor a breach in the wall that separates high from low touch. David DeVito, head trader at Madison Investment Advisors, a money manager based in Madison, Wis., with $7 billion in equities under management, is one of them.
DeVito, a former Nasdaq market maker, believes the combining of desks could potentially add more value to the buyside-value, he thinks, the buyside is willing to pay for. The electronic desk does a fine job explaining the technology being employed to execute trades, he said, but should provide more in terms of using it to create above-market returns and color on market movements and trends. By contrast, the high-touch desk doesn’t do enough with technology, relying instead on market intelligence and color. DeVito would like to see more block trading done electronically.
“I don’t view this, if done right, as less coverage,” he said. “If a firm can add value in multiple ways, such as sourcing block liquidity, generating incremental alpha and providing best-of-breed technology from a single touch point, then continued efficient consolidation makes sense to me.”
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Indeed, Merrill’s Instinct Natural is sort of an electronic “one-touch” service. Does it represent a takeover of the high-touch desk by the low-touch desk? Is there a subtle internecine war breaking out between the high- and low-touchers for the hearts and minds of the buyside? Is a single desk-Ã la Goldman Sachs-the future for the bulge bracket?
At least one buyside trader thinks so. Enrico Cacciatore, a senior trader at ING Investment Management, says he can see the logic in high- and low-touch pros working together as a team.
“You might have a desk with 10 sales traders and five electronic guys,” Cacciatore explained. “Over time that might go down to eight.” The trader figures the entire process might take between two and five years to complete across the Street.
Under this scenario, there might be two “pure” sales traders with the experience and skill to work block trades manually over long periods and then someone who acts as a bridge between them and the more technical, quantitative types, who help move as much of the trade as possible electronically.
“They help each other out,” Cacciatore said. “It’s like a pod.”