The Best Execution debate is not about transparency, high-frequency trading, dark pools or any of the other common conference panel topics. The core argument is unsurprisingly about money. Specifically, how much of the money that originates from buyside institutions does the sellside get to keep.
The Sellside Slice of the Pie
Prior to RegNMS and the explosion of alternative trading systems, dark pools and other venues offering execution services, the large sellside brokers and major exchanges (NYSE, Nasdaq, AMEX) limited the supply of liquidity. Similar to the days of regulated airlines, options were limited and prices were high. An institution wanting to trade IBM worked through a large sellside broker to either source liquidity from other sellside brokers, or it would execute solely on NYSE where the order would potentially interact with the specialist or a market maker. The monopolies of the major exchanges permitted the sellside broker/market maker/specialist/exchange consortium to generate premium margins on what was essentially a commodity service, such as trading a share of IBM.
When the industrys own deregulation came in the form of ATSs, decimalization and RegNMS, this consortium faced a harsh reality. With supply no longer limited, prices for execution services fell substantially. What had once been a premium business requiring little reinvestment and generating high margins was now not much different than any of the other businesses Wall Street itself would classify as a commodity — high fixed costs, many competitors and low margins.
Similar to the post deregulation airlines, the sellside consortium quickly learned the benefits of selling the primary product near cost and generating profits from often hidden add-ons. The recent fines for companies selling HFTs access to their dark pools or engaging in prop trading against their own customers are the Wall Street equivalent of a checked baggage fee. An admission that simply running one of the dozens of standard dark pools is not much different than being an airline offering service from San Francisco to Los Angeles and with the profits — or lack thereof — to match.
The Buyside Slice of the Pie
No one benefited more from the increased sellside supply than the large buyside firms. Increased competition substantially reduced many of their execution costs at the same time that their assets under management were growing. This created a golden age of profitability on par with the sellsides own golden age during the 1990s, and shifted a much larger piece of the still growing money management profits pie from the sellside to the buyside.
The continual increases in buyside revenue meant that reducing execution services costs were seen as a bonus but not a primary focus required for survival. This is no longer the case. The combination of more than six years of low interest rates, increases in the percentage of assets allocated to passive strategies and intense fee competition from Vanguard and low cost ETFs have now put significant pressure on buyside profits — in the form of both lower fees and reduced assets under management.
The Role of Best Execution
How to divide this shrinking pie is at the heart of disagreements and misunderstandings between the buy- and sellside over Best Execution.
Best Execution for the buyside is simply all-in costs. To visualize all-in costs, imagine $1 million currently sitting in cash. You buy $1 million worth of stock XYZ through your broker, exchange or dark pool. You then immediately sell the same $1 million of stock XYZ through the same broker, exchange or dark pool. Whatever amount less than $1 million you now have is your all-in cost. This is what you paid for electing to trade stock XYZ instead of keeping your $1 million in cash. For a buyside firm, nothing else matters.
Best Execution for the sell-side is quite different. Many firms use it as a marketing differentiator; a way to avoid being labeled a commodity even though every firm seems to claim their algo/liquidity/market making is the best on the Street. The more complexity around Best Execution, the more valuable the sellside becomes and the larger piece of the pie they can maintain. No one needs an expert in market structure to determine if an all-in cost of $X is < $Y, but expertise is absolutely required if the comparison includes smart order router performance, liquidity enhancement, hit rate, and other advanced routing metrics.
Viewed in this light, the reasons for the actions of the large participants become obvious.
Of course the large buyside firms would love an ATS/dark pool/exchange full of other buyside firms with tons of liquidity, low fees and all trades executing at the midpoint. Such a venue reduces their all-in costs and increases the amount of the pie they can keep.
Of course the large sellside firms would love to have numerous execution venues, each with small amounts of liquidity with different rules and order types such that an extremely sophisticated smart router is required to successfully access them. This scenario increases their value to the buy-side and the amount of the pie they can keep.
Regardless of their motivations, having strong evidence of where and when Best Execution occurs is critical to the success of the sell-side. To prove their value to the buy-side by cutting through the complexity of the current market structure to find the lowest all-in cost for a transaction, sellside firms must provide Best Execution data backed up with analytics.
Only by doing so can a sellside provider maximize its percentage of a shrinking pie.
John Standerfer is chief technology officer at financial technology firm S3.
