Three sellside firms are betting that virtual clearing brokerage Electronic Specialist (ESP) has the key to cutting costs for the buyside with its aggregated trade allocation and settlement service. Credit Suisse, Bear Stearns and Susquehanna International Group have invested an undisclosed amount in ESP, an institutional broker and technology provider. The firm’s claim to fame is that it streamlines workflow by offering buyside users a single, aggregated custodial ticket for multiple trades with its central counterparty clearing services.
ESP officials declined to offer specifics about the transaction, as did the three investors. David Sher, managing director and a co-founder of ESP, says the new investors give ESP a shot in the arm toward its expansion goals. Most of the proceeds will go to continued development of its product. The balance goes to an early “angel” investor. The firm would also consider other investors, he adds.
Customers are very focused on lower costs these days,” says Amir Goldman, one of the investors and a managing director at Susquehanna’s private equity arm. Susquehanna views its stake purely as a financial investment. Goldman anticipates additional growth at ESP because its offerings make the trading process more efficient. ESP does not have its own front end. It plugs into front ends.
“It’s a high-productivity tool,” says Manny Santayana, managing director and head of Credit Suisse’s AES sales. “It’s all about high productivity and cost cutting.” Santayana says clients find ESP’s offerings attractive on three levels. First, it has the benefits of aggregating algorithms from various brokers on the front end; second, on the back end, all the various trades done throughout the day can be rolled up into a single custodial ticket, which offers the buyside’s pension fund clients huge savings; and third, ESP provides plug-and-play FIX connectivity that can get hedge funds and smaller asset managers up and running quickly. It’s a way for these firms to outsource their FIX services, Santayana says.
“Clients can aggregate the entire trade, regardless if they trade with the block or program trading desk,” Santayana says. “ESP is the single clearing counterparty.” Indeed, asset managers seeking best execution from an increasing number of venues can create a blizzard of tickets, and this has prompted software vendors to create some unique solutions.
Because of the fragmentation of the market into multiple exchanges, electronic communications networks, dark pools and other alternative trading venues, an active asset manager may have to deal with many brokers and venues each day. This creates multiple deal tickets, each of which adds to the costs of trading for the clients of institutional money managers.
Pension funds were finding that their custodial charges had risen roughly fivefold, one knowledgeable source says. It was impossible to avoid, because the number of custodial tickets had to rise in lockstep with the increased number of trades.
One solution lies in consolidating all the deal tickets into one custodial ticket. Vendors in this space include New York-based ESP, Boston-based Firefly Capital and Los Angeles-based agency brokerage UNX.
ESP’s Sher says the idea for consolidating trade tickets was a creative solution that came from listening to the buyside. “The fragmentation of equities markets and proliferation of algorithmic trading and dark pools of liquidity led to costly increases in the amount of back-office processing,” Sher says.
Five years ago, large institutions such as money managers and mutual funds would send a large block trade to their broker, who would execute it and send the ticket back to their customers’ custodial accounts. To meet best execution, today they have to take a large block and send it to multiple destinations.
“In pursuit of best execution, traders break up their orders and route them to multiple brokers. The more brokers they use, the more allocation tickets they have, so there is an explosion in the number of end settlements. This is the source of the problem,” says Sher. And it was the beginning of an idea.
Sher says ESP decided to create a solution whereby ESP acts as a central counterparty-consolidating executions, and delivering the end allocation only once at an average price.
Firefly Capital also does central counterparty clearing, for the same reason. Firefly CEO Richard Holway says his firm also got into the game due to client demand.
“It was a catch-22,” says Holway. “In order to get best execution, buyside traders had to access multiple venues. When a single order gets executed in multiple places, it generates multiple custodial tickets; and since each ticket incurs a fee, their clients were getting clobbered on custodial charges.”
The benefits to using a technology solution to consolidate tickets are many, says Sher: “It is easier, faster and cheaper.”
But ticket consolidation is not for everyone. The upfront charges incurred can wipe out savings on ticket aggregation if a buyside firm isn’t doing a lot of business.
Jeromee Johnson, an analyst at TABB Group, says: “It is really only for the largest asset managers who are dealing with a lot of brokers. For smaller firms, the amount they would save in ticket aggregation wouldn’t make up for the incrementally higher execution costs.”
The sellside did not exactly embrace this service at the beginning, Johnson says. There was concern from the sellside because the vendors offer anonymity to the buyside. “Brokers would rather know who they are dealing with. They don’t want to lose their relationship with the customers,” Johnson says.
Initially, Sher says, there were questions from both the buyside and the sellside as to what it would mean for their relationships. So ESP now offers both fully attributed trading-where brokers know the client who is routing the order-and an unattributed approach, for those brokers who allow the order to identify only ESP.
There are plans afoot that may thwart vendors of aggregated trade allocation, however. The first is Section 28(e) of the 1934 Securities Exchange Act, which has freed up the buyside to use commission-sharing arrangements to pay for research and other services.
Scott Harrison, CEO of UNX, says that a lot has changed with 28(e), and perhaps ticket consolidation is not going to be a growth area in the near future. “It used to be a large pension fund had lots of brokers. Now one prime broker can pay the other brokers, and there is only one ticket,” he says.
The other hurdle for vendors that consolidate tickets may be clearing firms stepping in to do the job themselves: “The clearing side is addressing the same thing,” Harrison says.
But the business does seem to be growing, especially in the European market, where the Markets in Financial Instruments Directive (MiFID) is leading to greater venue fragmentation.
Johnson says: “There is huge potential in Europe. Post-trade transaction costs are significantly more expensive there, and with the changing regulator landscape, there is a lot of potential.”
ESP is expanding into Latin America this year and plans to open an office in Europe and Asia next year. Jarod Winters, managing director at ESP, says the firm is very active in the European market: “Europe is the largest growth area for our central counterparty clearing product. We are catching a very big wave with MiFID.”
Winters says the new investors will not receive any priority or exclusive treatment over other brokers, so that ESP can maintain good relationships with them: the product is broker-neutral.