Rebound Disrupted

Traders Magazine's Top 10 Stories in 2012

For the equity markets, it was a tough year to say the least. There was optimism among Wall Street trading firms and venue operators at the close of 2011, as many felt the worst of the Pipeline Trading scandal was over, Dodd-Frank reform was now a distant memory, slumping volumes would have to end, and falling commissions were going to be a thing of the past. 

Not quite.

As the year began, brokers on the precipice of death due to 2011’s anemic volumes began closing their doors, when volumes dropped by roughly 20 percent again.

WJB Capital, Ticonderoga Securities and smaller boutiques just couldn’t hold out any more amid the commission slump as trading volumes failed to rebound, despite predictions they would. Even bigger shops such as Nomura Securities International, which undertook a massive buildup of its U.S. equity operations under Ciaran O’Kelly, finally ceded to financial pressures; in October, Nomura shifted most of its U.S. operations to its agency-only sister, Instinet, which pioneered the computerization of institutional trades.

Despite the fact that volume and commissions stayed low through the year, the equity markets didn’t exactly help themselves either. A number of high-profile trading mishaps and glitches plagued the sector: The failed BATS Global Markets IPO in March, the botched Facebook IPO in May (and the corresponding compensation proposed by Nasdaq) and the near collapse of Knight Capital Markets in August combined to turn public sentiment against Wall Street.

Protests raged in lower Manhattan and other cities as Main Street publicly voiced disgust at all things Wall Street-from its arrogant image, compensation practices and greed to its overreliance on unchecked technology.

With Wall Street on the verge of being ostracized by retail investors who demanded answers, Congress and regulators had to respond. The complex market structure was put under a microscope to find out how to fix a system that had strayed from its capital formation roots to become an ATM for a select few. Regulators held a series of meetings and conferences on topics ranging from the basic-how to restore investor confidence-to complex subjects such as kill switches, algorithm testing and verification, tick sizes and disclosure as to where child orders were routed. Nothing was off limits this year.

Wall Street saw the writing on the proverbial wall: Fix yourself or government will fix you. Dark pools, either independently owned or broker-sponsored, began to police themselves. Several pools employed so-called high-frequency trading filters or technology designed to protect large buyside orders from predatory speedy trading strategies.

The exchanges, looking to regain some of their lost market share to alternative trading systems or electronic communication networks, began to court smaller investors through new retail-targeted programs. They also began to conduct thorough examinations of their technologies and how they functioned.

And Congress, in an election year, got in on the action. In April it passed the Jumpstart Our Business Startups Act, designed to promote small-company capital formation. The JOBS legislation aimed to foster research into lesser-known firms and promote the purchase of shares and trading in them.

Securities regulators broadened single stock circuit-breaker rules, passed a “limit up/limit down” rule and took other steps to prevent relapses of the flash crash of 2010 or the market disruptions of 2012. The Securities and Exchange Commission and others held myriad conferences and panels on how to better monitor the trading technology that is supposed to make trading easier, cheaper and faster. It was time for the technology tail to stop wagging the trading dog.

It’s been quite a year. Here are the top 10 stories of 2012. Enjoy!

-John D’Antona Jr., Managing Editor



>>The Year of the Glitch

There’s a good chance the date Aug. 1, 2012, will be burned into the collective memories of stock trading executives just as much as May 6, 2010.

That was the day Knight Capital Group unintentionally built up a gross position of $7 billion in just 40 minutes as it lost control of one of its algorithms at the New York Stock Exchange. The market maker lost $457.6 million getting out of those trades, pushing it to the brink of collapse.

If not for the willingness of a group of broker-dealers to come to its rescue, Knight would have ranked as one of the industry’s most spectacular flameouts since that of Drexel Burnham Lambert in February 1990. And while it didn’t scare the bejesus out of the American public as did the flash crash of May 6, 2010, the Knight catastrophe clearly delivered another jolt to a business almost entirely dependent on computers.

Knight’s gone-wild algorithm was the fourth prominent software glitch of the year and the straw that broke the Securities and Exchange Commission’s back. The public, regulators and politicians pounced on the industry at once; their collective patience had run out. Shortly thereafter, the regulator summoned industry executives to Washington D.C. to participate in a “roundtable” to discuss what might be done to prevent further mishaps.

The Knight fiasco followed a May mishap in which Nasdaq flubbed the first offering of shares in Facebook to the public which itself followed the BATS Global Markets fiasco in March, where it couldn’t launch its own shares on its own market. This was on the heels of options market maker Ronin Capital’s troubles in February, when it spewed 30,000 mispriced quotes into NYSE MKT Options. (See Traders Magazine, September issue for details.)

Why so many glitches all of a sudden?

Some industry veterans argue the media spotlight is just shining brighter. Trading software glitches have been a regular occurrence over the past 15 years, they say, as automation has taken hold in both the stock and the options markets.

In fact, the last major blowup was in 2004 in the options market. The event received little press. Again it was Knight that nearly blew up, trading about $1 billion in notional value at off-the-mark prices. Most of the bad trades were busted, however, and Knight lived to trade another day.

In any event, the problem has come to a head. Industry players and Washington regulators are calling for change. They blame scant testing, poor monitoring and lack of accountability for the problems.

“We’re not going to eliminate mistakes,” Matt Andresen, co-chief executive of proprietary trading house Headlands Technologies, told Traders Magazinein August. “But we can try to minimize them by insuring best practices. That means mandating procedures and policies for how someone interacts with the marketplace.”

For more than 20 years, the SEC has used its “Automation Review Policy” to push exchanges to make sure their systems are working properly and report any outages. Now the SEC is considering codifying the policy into law and extending its coverage to brokerages.

-Peter Chapman


>>Trading Volume Continues to Fall, No End In Sight

The dramatic drop in the trading volume of U.S. stocks continued to be one of the biggest stories of the year, notable not only for what it meant in its own right, but also for the corresponding impact it had on virtually all other major stories of the year. Layoffs, crushed brokerage commissions and shuttered trading desks all had their roots in the decline of trading volume that has gripped the industry over the past three years.

Volume has been dropping consistently since the onset of the financial crisis. Worse yet, it shows no signs of improvement. The decline is deeper and longer-lasting than the market experienced following the dotcom crash in 2000 and the overall market crash in 1987.

To illustrate this downward slope, one only has to isolate any given month. If you look at September, for example, the average daily volume in 2012 was about 6.5 billion shares traded per day, according to data from Nasdaq OMX. That is down more than 42 percent from the average daily volume in September 2008 of 11.3 billion shares. Average daily volume in September has dropped steadily in three of the past four years, and this year’s total is the lowest it’s been since 2008.

And it’s not just a September phenomenon. You’d have to track back to October 2011 to find a single month that posted a better average daily volume than the previous year. That is a slow grind, a death by a thousand cuts, each representing another slow day of trading.

Two negative trends among asset managers have had a strong hand in driving volume lower-allocation and turnover. Simply put, portfolio managers across the board are buying fewer stocks and not trading out of much of what they do own.

Want one example? Ford Motor Co., which manages about $60 billion in defined benefit plan assets, allocates a combined 42 percent of its portfolio to U.S. and foreign stocks. In a filing earlier this year, it said it would cut that figure to 30 percent over the next few years. That move alone takes an additional $7.2 billion out of the equities market. Also, new rules from regulators sped up how loss recognition is recorded for accounting purposes, and this has made many funds unwilling to endure the stock market’s ups and downs.

Turnover, the trading of stocks within a portfolio, also has declined along with the volume slowdown, greatly contributing to it. Turnover peaked in 2009 and has been declining ever since.

Whatever the cause of the volume drop, of course, there is one ultimate victim-brokerage commissions. In its midyear report, Greenwich Associates noted that brokerage commissions have declined dramatically, falling 22 percent since 2009. Greenwich’s 2012 U.S. Equities Investors Study, which tracks brokerage commissions paid by U.S. institutions on domestic trades, showed brokerage were paid $10.86 billion between 1Q 2011 and 1Q 2012. That represents a three-year decline from a 2009 peak of $13.95 billion.

So, when will this dismal stretch end? Not in the foreseeable future, said Mark Kuzminskas, director of trading at Robeco Investment Management. “Right now, there is such a tight correlation between stocks and the macroeconomic characteristics of the overall economy-like Central Bank intervention and the slow global economy-that it drags on volume,” Kuzminskas said. He added that additional factors, like the proliferance of exchange-traded funds, also have siphoned off volume from stocks.

If this strong bond can be broken, stocks may see some upswing in the coming year, but there is little sign of that possibility. “Given that, I’d expect next year we will see more of the same as far as volume goes,” he said.

-Gregg Wirth


>>Smaller Trading Brokerages on the Ropes

A three-year decline in trading volume and investors’ continued migration to computer-driven and algorithmic trading may mean the end of an iconic fixture on Wall Street: the small brokerage firm. Over the past year, numerous smaller trading firms either scaled back or closed their doors altogether.

These trading houses, at one time legion on Wall Street, hark back to a time when roomfuls of aggressive brokers endlessly worked the phones to ply their money-manager contacts with investment advice in the hope of securing some small amount of trading business in return. Now, the relentless forces of dropping trading volume, especially in U.S. equities, and the loss of business to more popular electronic trading platforms have contributed to the continual grinding down of firms’ capital base, choking off many of these smaller firms.

The average daily volume for U.S. equities has fallen 36 percent since 2009, and volume hit just 6 billion shares traded in the third quarter, the lowest level since the onset of the financial crisis. Worse yet from the brokers’ perspective is the toll all this is taking on commissions. Indeed, the average fee to trade a share of stock fell 31 percent over the past three years, according to Investment Technology Group.

The end result of all of this was not surprising: In early September, Nomura Securities International became the biggest-named casualty as it folded its equities trading groups into Instinet, an electronic broker that Nomura had purchased in 2006. The move was part of a larger consolidation plan by the Japanese bank to seek $1 billion in cost reductions worldwide.

While both a dismal trading environment and a growing prevalence by investors for electronic execution contributed to the closing of Nomura Securities’ equities trading group, these twin pressures were not unique to that situation.

At the beginning of 2012, both WJB Capital Group and Ticonderoga Securities closed their doors after capital shortages hobbled their trading efforts. And Newedge shut down its cash equities and exchange traded funds desks in early September.

In October, ThinkEquity, the San Francisco-based investment bank, shuttered its stock-trading business, while Rodman & Renshaw, owner of brokerage Hudson Holding, said it would stop trading because of lack of capital. Throughout the past year, other smaller brokerages, such as Auriga Holdings, Pritchard Capital Partners, Kaufman Bros. and Momentum Trading Partners have either closed down or shuttered some operations, idling brokers, traders and staff. And the pain isn’t limited to the small fries. Big boys like Morgan Stanley, Citigroup, Bank of America and Goldman Sachs have been quietly trimming their brokerage units this past year, mostly in equities trading.

“It is definitely a challenge for some of the smaller brokerages, especially those without the scale to get them through the tougher times,” said Packy Jones, chairman of JonesTrading Institutional Services LLC, a brokerage based in Westlake Village, Calif.

Jones said he expects to see continued difficulty and further consolidation in the smaller brokers through the first half of 2013, if not through the entire year. “It’s very sad to see these small boutiques shut their doors,” Jones noted. “These smaller players are what make our business great.”

-Gregg Wirth


>>More Tranquil Markets Sought

The mandate for exchange operators and regulators in 2013 will be to find ways to calm markets and make sure they operate reliably, even under abnormal conditions. And little wonder: The failure of the BATS IPO, the flubbing of the Facebook IPO, Knight Capital’s runaway algorithm and the two-day shutdown of markets forced by Mother Nature (see page 56) ensure that a repeat string of disruptions will not be healthy.

The effort to calm markets began in 2010, after the flash crash of May 6. New single-stock and marketwide circuit breakers were put in place after that. Stub quotes were eliminated. “Naked access” to exchanges was forbidden.

In the coming year, the single-stock circuit breakers are giving way to a “limit up/limit down” mechanism. Other antidotes being examined: kill switches, expanded use of drop copies and an auditable trail of all trades.

The “up and down” limits prevent trades in individual stocks from occurring outside a specified price band, above and below the average price of the security in a five-minute period.

For the most highly traded stocks, those in the Standard & Poor’s 500, the Russell 1000 and certain exchange-traded products, the band will be 5 percent above and below the average price. For other listed securities the level will be 10 percent. The percentages will be doubled during the opening and closing periods, and broader price bands will apply to securities priced at $3 per share or less.

The first phase, involving the highly traded stocks, begins Feb. 4. The second phase, for all other stocks, begins on Aug. 5. In certain cases, five-minute trading pauses will be triggered.

Also likely to arrive in 2013 are “kill switches” designed to automatically shut off a firm’s incoming orders, to prevent a market disruption or spate of erroneous orders, like the Knight Capital incident on Aug. 1, 2012.

The exchanges are considering a “layered” approach, whereby a brokerage receives alerts five or 10 minutes before trading is shut off.

But the Securities and Exchange Commission appears to favor a faster response. At a roundtable on market stability in September, chairman Mary L. Schapiro said that, with the speed of automated trading, orders need to be shut off within roughly two minutes to be effective.

And while the brokerage houses themselves will be permitted to determine the thresholds at which the exchanges would cut off their orders, brokerage executives worry those thresholds will be set too liberally to be of any use.

In addition to kill switches, reconciling “drop copy” reports from exchanges on traders is on the radar. Drop copies are sent by exchanges to brokers with details of their most recent trades. Firms reconcile their own trading records against the drop copy information. In the reconciliation process, brokers can identify and eliminate erroneous orders before they pile up. Most, but not all, exchanges deliver the information in real time.

The SEC has taken note of the idea. “[Drop copies] seem like a terrific idea,” said James Burn, a deputy director in the SEC’s Division of Trading and Markets, at a market structure conference in September. “They do seem like a promising safeguard.”

Also coming: a consolidated audit trail of all those trade details. A request for proposals from the effort mandated by the SEC and being carried out by the exchanges and FINRA is expected by mid-December. A technical choice and an implementation are scheduled to be filed with the SEC by April 26.

The central repository of all trading data would be updated nightly, allowing regulators to re-create market activity swiftly and analyze the information for causes of disruptions or abuse.

-Mary Schroeder and Tom Steinert-Threlkeld


>>Exchanges and Broker Competition Heats Up

Is the ground starting to shift?

In May, Nasdaq OMX Group announced a plan to offer trading algorithms to the members of its exchanges. While the tools would be low-end benchmark tactics and Nasdaq said it would not market them to the buyside, the move encroached on a business traditionally dominated by brokers.

The plan didn’t sit well with the Securities Industry and Financial Markets Association, a trade organization that represents brokers. It filed a letter with the Securities and Exchange Commission, arguing that Nasdaq, due to its regulatory status, would have an unfair advantage over brokers in offering the algorithms.

Then, in July, NYSE Euronext won approval from the SEC to offer a “retail liquidity program” that will attempt to wrest retail order flow away from broker-dealers. Both Nasdaq and BATS Global Markets have announced similar plans.

The brokerage community wasn’t crazy about this idea either. SIFMA and others protested, but the SEC approved the NYSE plan anyway. Recently, SIFMA filed another letter with the SEC, complaining about the BATS proposal.

In August, Duncan Niederauer, chief executive of NYSE Euronext, testified at a hearing of the House Committee on Financial Services that exchanges were operating at a disadvantage to brokerages’ alternative trading systems, with which they compete. He asked Congress to “level the playing field” between the two by reducing the restrictions on exchanges or increasing them on ATSs or both.

At that same hearing, Dan Mathisson, head of U.S. equity trading at Credit Suisse, operator of the industry’s largest dark pool, also told Congress the playing field was not level. Mathisson, however, argued the advantage was with the exchanges, not the brokers. He asked Congress to eliminate the restriction that limits broker-dealer ownership in an exchange to no more than 20 percent. Then ATSs would become exchanges and the field would be level, he explained.

In November, at an industry conference, SEC commissioner Dan Gallagher suggested the time might be right to strip exchanges of their self-regulatory status. Times had changed, Gallagher said. Exchanges were no longer quasi-governmental mutual associations. They had become profit-driven, shareholder-owned companies. Relieving them of their regulatory obligations would benefit them, he said. Relieving them of their regulatory advantages would benefit the brokerages that compete with them.

So what is going on? Are exchanges becoming broker-dealers? Are broker-dealers becoming exchanges? Are the two business models converging? Brokers like to match trades because they earn two commissions and save on exchange fees. They now execute one-third of all their volume away from the exchanges.

The relationship between brokers and exchanges has always been an uneasy one of cooperation and competition. But this year, as volume continues to slump, the gloves are coming off. Exchanges are trying to grab flow from brokers. Brokers are trying to grab market data revenue from exchanges. (If Credit Suisse were to win exchange status for one or both of its alternative trading systems, it would be allowed to share in an annual $400 million market data revenue bounty.)

Both sides need the help of the SEC to get what they want. NYSE Euronext got a big boost from the Commission when it approved the exchange operator’s controversial retail program. Credit Suisse may have at least one SEC commissioner on its side.

What’s next? Will exchanges try to move closer to the ultimate prize: the buyside?

They certainly have an opening. Given mounting concerns over information leakage in broker dark pools, the exchanges aren’t shy about highlighting the dark side of dark pools. “The buyside has to accept that dark pools are much less regulated than exchanges,” Bill O’Brien, chief executive at Direct Edge, said at a recent Investment Company Institute conference.

-Peter Chapman


>>Small Caps Trading Increment Poised to Move Higher

Is decimalization to blame for the sharp decline in initial public offerings during the past decade? Are small-capitalization stocks suffering from investor neglect because brokerage houses can’t make money trading them? Would rescinding the rule changes to the minimum trading increment spark some life into these “zombie” stocks?

Congress is wondering if a rescission of these rules passed by exchanges in 2000 and 2001, which slashed the minimum trading increment to a penny, would goose trading in smaller stocks. That’s why, as part of the Jumpstart Our Business Startups Act, passed in April, Congress ordered the Securities and Exchange Commission to study the issue and consider increasing the minimum tick to some amount between 2 and 9 cents.

In July, the SEC reported to Congress there was insufficient evidence that decimalization had impaired liquidity in small-cap stocks to warrant a rollback of the tick rules. The issue needed more study, the SEC said. Any further investigation could include an industry roundtable as well as a pilot program, the regulator added.

As Traders Magazine was going to press, no roundtable had been scheduled. Nor was any pilot proposed. The regulator did broach the topic this summer at two meetings of an advisory committee it formed last year, as the JOBS Act was working its way through the system.

At the second of these meetings, held in San Francisco, Kathleen Hanley, a deputy director and deputy chief economist in the SEC’s Division of Risk, Strategy and Financial Innovation, told the committee the SEC was hoping any roundtable would provide the answers to three broad questions. First, would larger tick sizes lead to wider spreads? Second, if they did, would that lead to an increase in market-maker profitability? And, if so, would market makers use the extra profits to support newly public companies?

Those three questions boil the alleged problem down to its essence: Brokers aren’t pushing small-cap names because they can’t make money trading them. So, the solution is to increase the minimum trading increment so market makers can make money.

“If you can increase liquidity in a name, you will probably increase research coverage,” Patrick Fay, director of sales and trading at Williams Financial Group in Dallas and a veteran market maker, told Traders Magazine this summer. “They absolutely go hand in hand.”

There is no shortage of skepticism, however. Widening the spread means increasing the cost to the investor, which could work against more trading, some trading officials point out.

Also, in its report, the SEC noted the reduction in IPOs might not be solely attributable to decimalization. Other influences, such as the Sarbanes-Oxley Act in 2002 and the Global Analyst Research Settlement in 2003, may have contributed.

Others note that widening the minimum trading increment means returning a subsidy to Wall Street, which may not be politically feasible.

While many in the industry are excited by the prospect of SEC altering spreads, some are skeptical. “I wouldn’t hold my breath,” Ed Provost, chief business development officer at the Chicago Board Options Exchange, said at a recent industry conference.

-Peter Chapman


>>Changing the Speed of High-Frequency Trades

Britain’s Foresight Program found that high-frequency trading has generally benefited investors-but a European Commission task force recommends that all orders live for at least half a second. In the United States, exchanges began putting clamps on excessive messages from trading firms that canceled far more orders than they turned into transactions.

And on both continents, the specter of some sort of tax on transactions still hangs over the heads of firms that consider a single day to hold as many profit-making opportunities as others see in a full year.

The bloom may have come off the rose in 2012 for high-frequency trading. Profits are down from a peak of $7.2 billion in 2009 to 1.8 billion this year, according to Tabb Group. With overall volumes dropping, it’s becoming increasingly hard to cover overhead with a profit of less than a penny a trade, by the calculation of partner Alex Tabb.

Whether 2013 turns out rosier remains to be seen. Programs to curb excessive messaging were implemented this year by both Nasdaq OMX and Direct Edge. While Nasdaq is pleased with the results of its effort, Direct Edge pulled the plug on its plan.

“We’ve seen some change in behavior as a result” of the program, said Nasdaq OMX spokesman Robert Madden. “The traders that were outliers, that had very much excessive quoting traffic, have curbed those quotes to fit closer within the parameters of our 100-to-one [non-marketable order-to-trade] ratio.”

Nasdaq charges its members at least $0.001 per order if their non-marketable order-to-trade ratio exceeds 100-to-1. The policy, which went into effect June 1, affects only non-marketable orders, or those posted outside the national best bid and offer.

For its part, Direct Edge introduced a message efficiency incentive program in June that reduced its rebate by $0.0001 per share for firms that trade only once for every 100 messages they transmit. But the exchange stopped the program in August.

In a filing with the Securities and Exchange Commission, Direct Edge said, “by not adequately isolating purely inefficient message flow, the (program) may have unintentionally captured, and therefore disincentivized, order behavior that benefits market liquidity. For example, the (program) potentially discourages market participants from posting multiple levels of liquidity in less actively traded securities. Thus, while the exchange’s intention was to encourage efficiency and consequently attract more liquidity, the (program) appears to have resulted in the opposite effect.”

Meanwhile, a bill to impose a transaction tax was introduced by Rep. Keith Ellison, D-Minn., in September. Ellison’s bill, the Inclusive Prosperity Act, would tax stocks at $50 per $10,000 traded; bonds at $10 per $10,000 traded; and derivatives at $0.50 per $10,000 traded.

The bill is pending in the House Committee on Financial Services, said a spokeswoman for the congressman. No hearing date has been set. If there is no hearing this year, Ellison is likely to reintroduce the bill in the next session of Congress, she said.

Since 2010, the House of Representatives has introduced 10 different transaction tax bills, and the Senate has introduced four. To date, neither house of Congress has passed such a proposal.

The European Union is also eyeing the regulation of high-frequency trading. The EU is encouraging France, Germany, Italy and seven other nations to cooperate on the creation of a financial transaction tax. However, the 10 states have yet to agree on a common approach.

The European Parliament voted in September that all high-frequency trading orders should be valid for one half second. The rule is proposed to be added to the EU’s Markets in Financial Instruments Directive and would apply to almost all market players.

-Mary Schroeder


>>Facing Pressure, Dark Pools Under Microscope

When the year rolled in, one dark pool went down the tubes for failing to disclose that it fed customers’ orders to an affiliate to fill-and profit from. And it ended with another fighting to escape the same fate, after being charged with failing to properly protect information about its customers, all of whom want to trade anonymously.

Welcome to the fine line between bad and good behavior in these trading venues, which try to protect their institutional clients from being identified by sophisticated, algorithmically driven trading firms when moving large blocks of shares.

LeveL ATS is rebounding as 2012 comes to a close. It says clients are returning since its parent firm, eBX LLC, paid an $800,000 fine and settled charges that LeveL failed to properly safeguard information on customers’ unexecuted orders, which were stored and allegedly reused in a smart order router.

Whit Conary, chief executive at LeveL, told Traders Magazine that 75 percent of the alternative trading system’s customers were sending order flow as of the end of October. The firm is working to get back 100 percent of the clients it had prior to the settlement’s announcement, he said.

LeveL’s difficulties followed the more eye-catching case involving Pipeline Trading, which stopped taking orders after it was revealed that the firm was sending order flow to an affiliate without disclosing that fact. Clients never came back to the firm’s dark pool, though its algorithmic switching engine and AlphaPro trading system have managed to retain users.

The two cases differ decidedly, according to industry pros. In the Pipeline case, the settlement was based on fraud and resulted in direct charges against individuals. Pipeline failed to disclose that more than 97 percent of orders in its dark pool at times were filled by a trading operation affiliated with the firm.

The company agreed to pay a $1 million penalty. Two top Pipeline executives, founder Fred Federspiel and chairman Alfred Berkeley, each agreed to pay a $100,000 fine for their involvement as well.

LeveL’s case, on the other hand, “is about information sharing, and to the best of my knowledge no one gained a price advantage on any trade,” said the head of one brokerage desk. In the LeveL case, the Securities and Exchange Commission said in its complaint that the smart order router of LeveL’s technology provider, the Lava Trading unit of Citigroup, kept in its memory information about LeveL subscribers’ unexecuted orders. The router then used that information to make routing decisions for the benefit of Lava’s own order-routing business.

According to an industry executive familiar with the operations of the alternative trading system, only 4 percent of all LeveL’s executed trades were processed by the order router that came into question.

In any event, large trading firms going forward will take greater steps to watch what is happening in dark pools with their orders.

Using sophisticated monitoring and analysis techniques, bulge bracket brokers are starting to build profiles of who is trading in their dark pools. Then, they can confront “toxic” participants and ask them to change their behavior or face expulsion.

They can also present the information to their customers-without disclosing identities-and allow them to decide whether to trade with certain sharpshooters. Finally, they can inject the information into their algorithms, and let technology make the decision.

Bulge firms taking the approach include Morgan Stanley, Barclays Capital, Deutsche Bank and Bank of America Merrill Lynch in the U.S., and Credit Suisse in Europe.

Another answer: the Light Pool, created by Credit Suisse. The alternative system classifies users by how they trade. The venue categorizes participants, helping mutual funds, hedge funds, pensions and endowments trade only with parties they are comfortable with.

-Mary Schroeder and John D’Antona Jr.


>>Buyside Demands More Routing Transparency

Buyside traders and fund managers are demanding their brokers shine some light on one of the enduring mysteries in the securities industry: Exactly what happens to an order once the send button is hit?

The advancement of trading technology over the past decade has meant that buy and sell orders are sped around the market virtually instantaneously. But what is not as clear is exactly where the orders go, which venues are favored for fulfillment and which are ignored, and-most important-who gets to see each order and what, if anything, is done with that information. Once a parent order is sliced and diced into thousands of child orders, it is very difficult to see where they get executed.

Indeed, even as trading algorithms and smart order routers allow them to have greater control over their orders, many buysiders-pushed by their fiduciary responsibility as money managers to be able to explain all costs-have been increasingly seeking out trade routing information, demanding that sellside brokerages and traders provide a clear and understandable path of the order route. Most crucially, asset managers and their traders need to be able to quickly identify and correct any trading discrepancies, especially those that exposed the trade order and consequently may have negatively impacted the buyer’s price.

Driving much of this, of course, is the buysiders’ fear of dark pools, or more accurately, fear of the high-frequency traders lurking within them. Usually, brokers will first send orders to dark pools, often within their own systems, and then if not fully filled, the broker will send the order out to other venues-other dark pools or exchanges-until the order is filled. But it’s this end of the routing path that concerns buysiders the most. The more venues an order is sent to, the more likely that information leakage can occur, and in the worst case, damage the price the buyer is paying as other buyers pile in ahead of the big order.

What are buysiders doing now about their desire for further order transparency? Many are demanding upfront that brokers provide more information. In an April survey of hedge funds by Tabb Group, 53 percent said they wanted improved operational transparency in their algorithmic trades and many indicated they would use this information to improve how they use their algos.

Others are pushing further. Morgan Stanley has been urging the Securities and Exchange Commission to require that brokers give customers quarterly reports detailing how they route orders. And earlier, the Investment Company Institute wrote the SEC to suggest the regulator consider new disclosure rules on trade order routing.

Recent events such as the Knight Capital trading glitch and the May 2010 flash crash showed that buyside managers are smart to seek more transparency for their trades and should keep pushing for that in the future, said Craig Jensen, principal and head of trading at New Canaan, Conn.-based Armstrong Shaw Associates. Asset managers need to ensure there is an easy flow of information from their brokerages about trade routing, prioritization and access to fill data, he explained.

“Now, it’s more important than ever that managers know how and where their trades are being routed and if there are problems,” Jensen said. “We just want to have clear answers.”

Gregg Wirth and John D’Antona Jr.


>>ConvergEx Asset Sale Receiving Tepid Interest

Few suppliers of trading technology, banks or other potential buyers appear interested in buying ConvergEx’s Eze Castle and RealTick units because they fear they could wind up overpaying for systems that don’t fit well into their product lineups, according to three industry executives interviewed by Traders Magazine.

New York-based Eze Castle makes order management systems, which are popular among hedge funds. RealTick makes execution management systems, which are designed to provide better execution and investment performance. RealTick, which began as Townsend Analytics in 1985, was bought by ConvergEx in December 2010. RealTick sells its services to asset managers. Goldman Sachs has been shopping the proposed package sale of Eze Castle and RealTick, as Traders Magazine first reported in October. The asking price: $1 billion.

But industry executives told Traders Magazine that potential buyers are thinking twice about buying.

“It feels like it’s going to be a tough sell when you look at the OMS vendor space,” said one equity trading executive familiar with the two properties. “I think their OMS is tied more into hedge funds than plain-vanilla asset managers.”

Plus, vendors of order and execution management systems are plentiful. They include Charles River Trader and Fidessa Latent Zero in the OMS space, and TradingScreen and Bloomberg in the EMS space.

The way these vendors are proceeding, the systems could get merged. Charles River, for example, has spent the last five years rewriting its OMS into an “OEMS”-an order and execution management system. TradingScreen began as an EMS and has developed an OMS for hedge funds. Layering on Eze Castle and RealTick systems wouldn’t make sense, one of the executives interviewed said.

The acquisitions might be more appropriate for a bank looking to broaden prime brokerage relationships, said one equity trading executive.

Institutional brokerage ConvergEx declined comment on the pending sale, when contacted for this story. ConvergEx parent BNY Mellon also passed on commenting.

Eze Castle, parties familiar with ConvergEx’s operations say, has been the company’s crown jewel, since Eze Castle Software merged with the Bank of New York’s brokerage division in October 2006 to form BNY ConvergEx Group. The goal of the merger has been to build a technology provider to the brokerage industry. That would presumably make the brokerage less dependent on commission revenue, as trading volumes fall.

However, another equity trading executive questioned whether the package was a good fit for any potential buyer and whether both are needed. He said the most valuable part is Eze’s routing hub, which is a multi-strategy order management system for all asset classes. That hub is designed to provide portfolio management, compliance, trading and operations services in one place.

“The advantage,” said one trading executive, “is one can get more than one asset class on the same system. Being able to get order flow and executions back and forth between assert management and broker-dealer desks-that electrical connectivity is high-margin business. That’s what the real prize is.”

The order hub makes sense, but paying for the whole OMS doesn’t, a competing vendor said.

“But to me, all the painstaking effort in developing and maintaining this OMS, at the given cost structure, just doesn’t seem like a good business,” the competitor said. He added that buying both Eze Castle and RealTick “seems like overkill.”

And there are also many better solutions out there than RealTick, from an EMS perspective, the trading executives said.


Asset management firms are not switching OMS providers that often anymore. OMS developers are facing a tough time.

Just selling Eze Castle would make more sense, these executives said. One executive at an asset management firm, who recently used RealTick on his desk, complained that RealTick is a laggard.

“RealTick’s functionality is behind many other EMS platforms out there. So somewhere looking to buy it will say ‘OK, it’s going to cost me all this money to buy it and it is really isn’t great,'” the asset management executive said.

It “would not make sense to buy that package and then have to renovate it for our uses. It would be better just to develop our own systems,” he said.

-Gregory Bresiger

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