Don’t call it a comeback, but risk bids on program trades are on the rise. With competitive pricing, manageable volatility and ever-improving technology, industry watchers expect to see growth in principal bids for program trading.
According to Goldman Sachs, its clients’ use of principal bids is on the upswing this year. In fact, Goldman sees a rise in program trading across the board-both risk and agency business, when comparing 2007’s figures to last year’s. Goldman has a good vantage point on the popularity of principal bids. Joe Montesano, who heads the firm’s risk business on the U.S. program trading desk, estimates that it wins about 40 percent of the risk programs that it bids on.
Still, industry insiders say the bulk of the program business-roughly 75 percent-is executed on an agency basis. But they also say principal bids are growing. This growth stems from the ultra-competitive nature of the business, which has produced tight pricing for institutional clients. Some clients are big fans of principal bids because they lessen their market risk, as the clients can lock into a price for the basket of stocks at once.
The head of program trading at a top Wall Street firm-who declined to be identified-confirms Goldman’s assessment of the growing nature of risk bids. “Risk bids remain a popular strategy,” he says.
Sweet Technology
Ken Marschner, the head of the U.S. portfolio trading desk at UBS, has seen better trading technology create opportunities for more risk trading. That includes better algorithms and the greater ease in crossing stocks in dark pools. Thomas Weisel Partners, whose program desk does not commit capital, has seen the tight pricing of principal bids eat into its program trading business, according to Robert Redfield, managing director of portfolio trading.
The program desk at BNP Paribas Securities is considering adding risk bids to the list of services it offers, says Alan Rubenfeld, a managing director. And in a new TABB Group study of buyside firms, almost nine in 10 large firms said they see their principal program-trading use staying the same or increasing over the next two years.
“That’s a very high number,” says Matthew Simon, a TABB Group analyst. “We’re seeing more of a shift toward principal trading during volatile market conditions.”
In addition, TABB Group says the numbers are up for all program trading. TABB says the buyside traded about 9 percent of its flow via programs in 2006. TABB projects a rise to 12 percent this year.
Still, generalizations about risk bids can be complicated. Doug Rivelli, who oversees Weeden & Co.’s agency electronic trading, says it’s hard to say if risk bids are up because every broker has its own set of clients: Are they index clients or fundamental clients investing in small-cap, illiquid names?
The New York Stock Exchange defines program trading as a trade which involves “the purchase or sale of a basket of at least 15 stocks with a total value of $1 million or more.” Furthermore, the program trading realm is divided into principal and agency trades. In a principal trade, a broker commits capital to take on a client’s basket, as well as its accompanying risk, for an agreed price and finds the liquidity for trading its components. The biggest brokerages in the risk bid business include Lehman Brothers, Goldman Sachs, Bank of America, Deutsche Bank, Morgan Stanley and Merrill Lynch. With agency trades, brokers work orders for a commission, or the buyside trader handles the basket himself. Rubenfeld lists several reasons why more brokers than ever are willing to do risk bids.
Volatility and Pricing
One, it has become an additional way of servicing an important client need,” he says. “Two, it is a way to create an environment for additional avenues of business with a new or existing client. Three, technology has improved to where you can either build or buy the systems needed to help you manage risk.” Others in the industry add that it’s a way to hopefully get more agency business from the customer through committing capital.
But without the right market conditions-say, in a highly volatile span where spreads are particularly wide-traders typically will adjust risk pricing parameters dramatically to reflect the changing market.
After a long stretch in the low- to mid-teens range for much of the past three years, the Chicago Board Options Exchange’s Volatility Index-or VIX-jumped past 30 on August 15 and 16. In fact, much of the third quarter was rocky, and the pricing on principal bids reflected this, Weisel’s Redfield says. In some cases, prices climbed more than 100 percent, BNP Paribas’ Rubenfeld adds. Consequently, investors paid a premium to trade a basket quickly. But by the third week in October, pricing returned to more normal levels, which many expect to continue.
Before the “summer of volatility,” Rubenfeld says, the pricing on principal bids was in some cases at levels comparable to those of agency, “if the portfolio had the right liquidity tracking and the sector characteristics. That is not happening right now. I think prices have improved from the highs in August, but probably this past spring and early summer could be the benchmark low it will be for the reasonable future.”
Seasons Change
But the seasonal arc of traders’ objectives can shape the cyclical nature of the principal bids as much as rogue waves of phenomenal volatility can disrupt it. Typically, risk bidding is fairly aggressive in the first quarter, mostly because traders’ P&L is zero to start the year, and they can recover a client’s losses throughout the year by doing more business with the client, UBS’s Marschner says. In addition, turnover at different banks climbs at year-end and after bonuses have been paid, so traders in their new firms are aggressive and eager to prove themselves, he says. But by the fourth quarter, the reverse happens: Traders’ year-ends are coming to a close, and they become more risk-averse, so market pricing tends to widen out.
“So far, we’ve seen that this year,” Marschner says. “Right now, starting the fourth quarter, people are generally being less aggressive and pricing is widening out. And it will be wide the rest of the year, given that volatility is higher than it’s been most of the year, and given that it’s closer to people’s year-end.”
These days, pricing for risk bids is aggressive enough that TradeTrek Securities President Fred Graboyes says he’s seeing it poach some of his firm’s agency business-despite the fact that agency pricing is below 2 cents a share-down to less than a penny a share for many clients.
Being Disciplined
Throughout the cycle, UBS holds to its own consistent pricing discipline and, in effect, doesn’t compete. It tries to price portfolios with commission levels commensurate to the risk, and tends to win more trades when pricing widens out and fewer trades when it’s tight. UBS benefits by managing most of its equity trading from a central book, so it can “risk manage” its positions to lessen losses, Marschner adds.
“We have all these different streams of order flow-whether it’s a risk bid, or a single-stock facilitation, or an ETF trade or a swap that we’re doing with someone-and all these facilitations, if you manage them centrally, you get some netting or crossing effect, which cheapens the cost for you to provide that service.”
The arsenal of trading tools available to buyside and sellside traders both facilitates and eats into principal trading. With better portfolio algorithms and direct-market-access tools, the buyside has increased ability to trade more liquid securities itself. “Algorithms have changed the dynamics of the program trading business,” Weisel’s Redfield says. “The business is still there-it’s just getting executed in different fashions.” This is true for technology in general. UBS’s Marschner sees a split with clients’ orders: The more liquid, easier names to trade go to direct execution or algos, while the riskier, more illiquid names head to principal desks.
