In February, ATD Financial Services, the wholesaler division of Automated Trading Desk, received NASD approval to make markets in all Nasdaq and listed securities. From its original roster of 2,500 names, ATD is now able to offer executions to retail broker-dealers in over 8,000 National Market System stocks. The ramp-up is a milestone for ATD, a firm that came out of nowhere in 2002 to become one of the pacesetters of the wholesaling industry. The move also underscores the dramatic transformation of a business remade by regulatory fiat and computer algorithms.
At the beginning of the century, wholesaling was a business conducted by hundreds of clamorous traders on sprawling floors. Today, whirring computer servers produce fine-tuned executions for meticulous order routers.
ATD employs no human traders, executing nearly all trades with computers.
"The wholesale market is very strong, very robust," Chris Nagy, director of trading for TD Ameritrade, one of the largest and most sophisticated order senders, says.
"And new wholesalers are providing a significant amount of competition for our order flow. They share a common trait, in that they are highly automated."
The spoils are increasingly falling to those most automated. "[The ramp-up] has opened up some floodgates for us," Steve Swanson, president and chief executive of ATD, LLC, said.
"Volume has increased. Those firms that wouldn't send us flow before unless we were a market maker are now doing so."
Market Share
As of the fourth quarter of last year, ATD was filling orders for some of Wall Street's largest order senders.
On the listed side, for example, ATD handled 16 percent of Ameritrade's orders (non-directed marketable orders of less than 10,000 shares); 20 percent of Piper Jaffray's; 19 percent of Southwest Securities'; and 7 percent of Morgan Stanley's.
On the Nasdaq side, ATD had 31 percent of BrownCos' orders; 26 percent of Edward Jones'; and two-thirds of RBC Dain Rauscher's.
ATD is one of a handful of wholesalers fighting over retail orders not destined for the nation's primary stock exchanges.
Others are Knight Capital Group, Citadel Execution Services, Bernard L. Madoff Investment Securities, Citigroup, UBS Securities and E*Trade.
They all compete for the order flow of a few hundred larger self-clearing retail brokers and clearing houses.
All of the major wholesalers except for Madoff and Citadel also make markets in over-the-counter names as well. (ATD has just launched its service.) There they compete with a group of smaller, lesser-known wholesalers.
For better or worse, government regulation has transformed the business. Two rules in particular, put into effect in the 2000-2001 time period, have forced players to cut costs, provide better executions and invest heavily in automation.
First, decimalization cut spreads and revenues by reducing the minimum trading increment. Second, Securities and Exchange Commission Rule 605 (formerly Rule 11Ac1-5) forced dealers to publish their execution stats.
Dash-5
Both regs pushed brokers to automate more of their operations, but it is the so-called "Dash-5" stats that have impacted wholesalers' competitive positions.
Rule 605 requires all market makers, not just wholesalers, to make public on a monthly basis certain execution quality statistics.
The metrics were mandated to give order senders some guidance when deciding where to route their non-directed (not held), marketable Nasdaq, NYSE-listed and American Stock Exchange-listed orders of less than 10,000 shares.
The statistics show how quickly orders are filled and how often they are filled. They also show how frequently they are filled at or better than the inside market. And they show just how much price improvement orders get.
By and large, they make plain dealers' trading skills and have influenced the order routing habits of the big retail brokerages.
"It's a sharp pencil business," Chris Nagy, director of trading for TD Ameritrade, one of the largest and most sophisticated order senders, says. "There's not a lot of room for mistakes. Everything needs to be fine-tuned."
Some sources maintain the major wholesalers' Dash-5 stats are all almost equal. In other words, automation has turned the executions into commodities. Others disagree.
"Everyone has generally improved their stats as they've become more popular over the past year or two," says Joe Mecane, in charge of broker-dealer sales at UBS Securities, "but I still see a fair amount of differentiation among providers."
(In a 2005 Celent report covering execution quality, Citigroup was ranked the best on the NYSE-listed side. ATD was ranked No. 1 on the Nasdaq side.)
Mecane says the stats didn't really take hold with order senders until the 2003-2004 period. "That was also when you saw a big push for automation because people realized how important it had become," he notes.
UBS automated its operations in late 2002 and 2003. "We were one of the first to go fully automated," Mecane adds. "We tried to jump on the stats as early as possible to make it a point of competitive differentiation."
New Entrant
That hasn't stopped highly-automated newcomers from hanging out their shingles though. Citadel, a unit of the giant hedge fund, just started in the wholesaling game last summer. Like ATD, it employs no human traders. All executions are handled by computers.
Citadel has already captured order flow from four of the top discounters: Ameritrade, E*Trade, TD Waterhouse (now part of TD Ameritrade) and Scottrade.
Citadel sends out execution reports to its customers daily, according to president Matt Andresen. "Retail brokers are highly focused on their best-ex numbers," Andresen says. "They monitor on their side and we monitor on our side, so there is consistency."
For TD Ameritrade, consistency is a major goal. "Being able to provide our client with a consistent offering is key," Nagy says.
"So, if they buy stock today, the experience will be exactly the same tomorrow and the next day and so on. Not only for them, but for their mothers, their brothers and their sisters. And for all the other seven million clients."
Consistency for TD Ameritrade means the customer can push a button and receive an execution back instantaneously at a price better than that available when he placed the order.
To achieve consistency, some wholesalers-but not all-have taken to customizing executions to order senders' needs. It is a practice not without controversy.
"We don't do that," said one exec. "It's a dangerous game. It is also complicated. Everybody who sends me an order gets the same execution."
Qualms
Other wholesalers have no such qualms. "Different clients have optimized around different metrics," explains Citadel's Andresen. "They say, I want it to look like this,' and you have to go out and get those executions."
Ameritrade's Nagy says: "We want to have that execution tailor made for each and every client. So, if a wholesaler can craft their execution services in that manner, that creates a very appealing product for us."
ATD, for its part, spends considerable time working with clients to craft their executions, Swanson says. "That is the important part of getting to know your customer," the exec adds. "So that you are meeting their definition of best execution."
On Display
Order senders' routing decisions are on display in their Rule 606 (formerly Rule 11Ac1-6) reports. The "Dash-6" reports, complements to the Dash-5 reports, are released quarterly by the order senders. They list an order sender's trading venues and whether or not it accepted payment for its orders.
Take TD Ameritrade, for example. In the first quarter of 2004, the giant discounter was sending 80 percent of its listed orders to Knight, Madoff and the Chicago Stock Exchange.
By the final quarter of 2005, Ameritrade was sending only 35 percent to Knight and the CHX. About 60 percent was going to Citadel, ATD and UBS.
Ameritrade is part of a group of 30 to 40 large self-clearing retail brokers that account for most of the retail order flow sent to trading venues. The group can be broken down into four sub-groups: the large New York wirehouses, regionals, discounters and clearing firms.
On the listed side, very few of the discounters are NYSE members. As a group they send very little flow to the Big Board. Most goes to wholesalers.
The story is similar when it comes to the regional brokerages. Most of the larger regionals are typically Big Board members. Yet, they send much of their listed flow to wholesalers.
Raymond James, for instance, last year cut its NYSE allotment from 42 percent to 20 percent. Madoff, Knight and the CHX benefited.
"The Dash-5 stats have added a level of comfort to anybody who has routed away from the primary market," noted Mark Madoff, co-director of equities at Madoff, "and there is no question that that has increased year after year."
By contrast, much of the flow from the large wirehouses is off-limits to the wholesalers. Merrill Lynch, for example, sends 100 percent of its Dash-6 reported orders to the NYSE. Morgan Stanley, Wachovia and Citigroup send similar quantities to exchanges.
On the Nasdaq side, all four groups act similarly. Those without market making operations send all of their flow to wholesalers. Those with dealing desks internalize some flow and route the rest to wholesalers.
The large New York wirehouses tend to internalize more of their Nasdaq flow. For the regionals, the trend seems to be to route out. Both RBC Dain Rauscher and Southwest Securities, for instance, ceased internalizing last year, according to their reports.
Both these shops now divvy up their Nasdaq flow between ATD and Knight. That's good news for Knight. Once the largest wholesaler, Knight had fallen behind the more automated players and watched as its market share slipped.
Knight Comes Back
After Knight's broker-dealer division reported lousy results in the first quarter of 2005, Knight took action. It disbanded the entire unit and built a new one from scratch. Jim Smyth, a 24-year Merrill Lynch veteran, who was running soft dollars at Knight at the time, was asked to run the group.
As part of the revamp, Knight dramatically increased the amount of incoming flow it traded algorithmically. About 90 percent is now done with algos, according to chief executive Tom Joyce, an "eight fold increase" over levels of a year ago.
"In this day and age," Joyce says, "computer-driven algorithmic trading protocols are the only way we can efficiently handle the order flow as well as provide the cutting edge stats our customers are demanding."
Better Stats
The change improved Knight's execution stats "almost immediately," Joyce added. Order senders' reports bear him out. Several sent Knight more flow in the fourth quarter than in past quarters.
On the Nasdaq side, Citigroup sent 24 percent of its Dash-6 reported flow; up from 5 percent a year earlier. Merrill Lynch sent 22 percent; up from 16 percent in the third quarter.
Southwest Securities sent 38 percent; up from 22 percent in the second quarter. ADP Clearing & Outsourcing sent virtually all of its orders; up from zero in the second quarter.
Similar gains were seen on the listed side, especially from ADP Clearing & Outsourcing, Raymond James and Piper Jaffray. Knight's gains here came at the expense of the NYSE and Madoff.
Despite making changes to better accommodate order senders, Knight has also become more choosy about which orders to handle.
Both Knight and UBS, have actually segmented their client bases and are being less generous with their services. That's especially the case when it comes to payment for order flow.
As part of last year's re-organization, Knight took a hard look at the levels of service it was offering and decided to "rationalize" them, Joyce explained. Everything was open for review including payment for order flow and automatic execution levels.
Clients were divided into different groups. Those receiving payment for order flow were encouraged to participate in revenue-sharing agreements with Knight. Some agreed to; some did not.
Business Out the Door
Some of those that did not took their business elsewhere. Joyce won't disclose any names. A glance at TD Ameritrade's Dash-6 report, however, shows significant drops in the amount of listed and Nasdaq flow sent to Knight.
(TD Ameritrade's Nagy maintains receiving payment for order flow is consistent with a broker's best execution obligation.)
Knight took sterner steps with some of its other customers. For those whose order flow it deemed hazardous to its health it eliminated the PFOF rebate altogether. In some cases, it began charging for their orders.
With the re-org and the cutbacks in payment for order flow, Knight saw a sharp drop in the number of Nasdaq shares it traded. In January 2005, Knight traded, on average, 310 million Nasdaq shares per day.
By October, that figure hit 196 million. This February, it rebounded to 233 million. Listed volume was not much affected. Those figures include trades done on behalf of money managers as well as broker-dealers.
"Certainly, the change in our offering drove a lot of that order flow away," Joyce says. "But that was order flow we didn't really want. We view the changes as a success."
Success for Knight now means profitability, execs there say, not market share rankings. That speaks volumes about just how much the wholesaling business has changed.
Knight was once the dominant wholesaler of Nasdaq and listed securities. Now UBS is the largest trading house on Wall Street. The more automated players are clearly in the vanguard.
"I guess it is no surprise that more and more firms are looking more like ATD today," Swanson says. "If a firm does not have a nearly automated model, they will find it a very difficult business."
Wholesalers Like Reg NMS
Implementation of the sweeping regulation's new trade-through rule later this year is likely to drive more listed order flow their way, some execs say.
Now, the New York Stock Exchange controls nearly 80 percent of the order flow in its securities.
"When Reg NMS rolls out and everyone is better connected," says Mark Madoff, co-director of equities at Bernard L. Madoff Investment Securities, "we will be in a better position to compete for that 70 percent to 80 percent."
Because Madoff's quote (on Nasdaq or wherever) will be both protected and more accessible under Reg NMS, Madoff maintains, he will be able to assure his clients of better fills. That assurance could lead them to send more order flow Madoff's way, the exec believes.
Another wholesaler sees the likelihood of pricing changes undertaken by the NYSE work in his favor. "It won't be very long before the pricing structure of the Nasdaq world is overlaid onto the NYSE world," says Steve Swanson, president and chief executive of ATD.
That means the New York will start charging traders to take liquidity from its book. "And that's a great opportunity for wholesalers," Swanson says, "because we provide executions for free."
Dealers Losing Out To ECNs
While not yet widespread, some order senders are beginning to route their limit orders to ECNs rather than to wholesalers.
At least one wholesaler is taking steps to head off the threat. Last year, Knight bought the Attain ECN, re-christening it DirectEdge. The ECN is part of Knight's broker-dealer group. The goal is to convince clients to send their limit orders to Knight. "We have clients who send a significant amount of their business to ECNs," said Jim Smyth, head of the broker-dealer at Knight Capital Group "So we are building an industry utility which is cheaper [than the established platforms] and hopefully fill it with lots of liquidity."
Among retail order senders, Ameritrade is perhaps the most aggressive in pursuing an ECN strategy. For about a year, it has been sending 45 percent of its orders to Brut, Archipelago and INET.
Wholesalers snipe that the order senders use ECNs merely to earn the rebates paid to liquidity providers. Ameritrade's Nagy disagrees.
He claims one of the biggest complaints of Ameritrade's customers was that market makers were gleaning information from their limit orders.
"With ECNs," Nagy says, "no one can discover the origin of an order. It's completely anonymous. That provides a great sense of comfort to our clients."
The exec adds that a higher percentage of Ameritrade's limit orders are filled when they are sent to ECNs than if they were sent to wholesalers.
Other order senders using ECNs are National Financial Services, Fidelity's clearing operation. It sent about 38 percent of its orders to Archipelago in last year's fourth quarter. Discounters Muriel Siebert and Charles Schwab also sent orders to Arca.
