A Vendor Gears Up for Even More Internalization
A designer of trading platforms for small stock markets is betting its future on a growing Wall Street trend: internalization.
Elind, a vendor from Bangalore, India, got its start automating regional stock exchanges in the sub-continent. But now it sees potential in the U.S. to create mini-stock exchanges within large brokerages and money management firms.
"We see significant opportunities in the North American market and others for technology to internalize order flow," said Greg Johnston, Elind's new chief executive. "It's what brokers and even the large institutions are looking for in order to minimize their costs."
Johnston, formerly a marketing exec with OM Group and a one-time trader, became Elind's top man just this past December. The hire of an American to run Elind speaks to the seriousness with which the Indian company is taking the American market. Although most of its staff is located in India, Elind opted to relocate its headquarters to New York and recruit much of its senior management from the U.S.
Elind still markets its technology to small bourses around the world. But it expects most of its growth to come from sellside and buyside shops looking for technology to aggregate order flow from their various desks and departments.
In bringing together orders from disparate order management systems, firms hope to cross or trade against more of their flow. That way they can save money by eliminating fees charged by market centers and also, potentially, provide a value-added service to their customers.
An exec from one large house that is building a crossing engine put it this way: "The goal behind this is to get clients to send us more orders because they get price improved. And it helps us with our cost infrastructure because we don't have to send the orders to the floor. We cut out some of the fees."
The practice is not new. Some of the behemoths of the industry, including Knight Trading Group, Schwab Capital Markets, State Street and Barclays Global Investors, have been matching order flow internally for years.
But with margins on stock trading still poor due to the market slump and the advent of penny ticks, others are following their lead. Most of the largest ten or fifteen sellside trading houses are thought to have crossing engines in various stages of development.
The market for such technology does appear limited though. "Our order flow isn't consistent enough," said Nick Karos, head of Nasdaq trading at mid-tier firm Piper Jaffray.
Even Bear Stearns apparently has no plans to invest in the technology. Aldo Parcesepe, co-head of Nasdaq trading, says it's "silly." The probability that a buy order and a sell order in the same security will hit the system at the same time is low, Parcesepe explains. And typically, at any point in time, there are more buyers than sellers or vice-versa in a given security, further reducing the opportunities for a match. "What is the probability?" Parcesepe asks rhetorically. "Ten percent?"
Earlier Attempt
Elind is not the first vendor to attempt to market internalization technology to the bulge bracket. About four years ago, Trading Technologies, a builder of derivatives trading systems from Chicago, tried to branch out into the equities space. It failed and its founder and chief executive later lost his job. The firm would not comment on its reasons for pulling back from equities.
Elind may have some wind at its back though. Johnston says at least one firm is testing the system, although he declines to name names. "Obviously, we didn't go into this cold," Johnston said. "We have been talking to a select group of brokers that have indicated this is an area they are looking into."
One customer in the equities space that Elind has announced is UNEX, a start-up micro-cap alternative trading system based in Chicago. UNEX paid $2 million for STRIDE, Elind's stock exchange product.
Among brokerages, Elind is targeting the smaller Tier One and larger Tier Two firms. Its biggest competitor for brokerage business is the "internal build," according to Johnston. Large shops with the resources can build their own systems.
The perfect prospect is a firm with many sources of order flow. That may be from various desks – listed, Nasdaq, portfolio and proprietary – or various divisions. Because of all the mergers and acquisitions of the recent past, order flow is fragmented within some of the larger shops. For instance, Morgan Stanley bought Dean Witter. UBS bought Paine Webber. E*Trade bought a variety of small trading houses.
Most brokerages already internalize as much order flow as they can. The practice is most common in the over-the-counter business which, by definition, is an internal business. Dealers buy for or sell from their own inventory.
On the listed side, some of the larger firms are in various stages of putting into place an internalization strategy. Since 2000 and the rescission of the New York Stock Exchange's Rule 390, firms have been permitted to internalize all listed orders. Most have not done so though. If two orders are crossed upstairs, the trades are typically reported to an exchange.
That cross can be accomplished by STRIDE, Johnston notes. Where the trade is printed is up to the brokerage.
Another trend working in Elind's favor is the proliferation of order management and order routing systems in recent years. It is now much easier for Elind to inject its technology into a firm's systems mix. "With the plumbing in place," Johnston said, "here's an opportunity to install what is, in essence, an internal marketplace."
Executions within that internal marketplace must take place within the best bid and offer, Johnston notes. That's necessary to comply with a firm's obligations for best execution. In order to make sure trades go off at the right price, Elind continuously tracks quotes and executions in all securities via a market data feed.
If a match cannot be found inside the firm, it is still possible to avoid sending the order to a market center. STRIDE will interface with a firm's indication of interest infrastructure to distribute IOIs to sales traders or the firm's customers.
The Block Trader
Such automated decision-making replaces or augments the role of the block trader in the handling of IOIs. Johnston says it is very difficult to identify when there is an IOI to go out without some sort of electronic coordination.
"If there is a balance on a buy order, for instance, that cannot be executed, I can automatically generate an IOI from the internal book," the exec said, "to actively source liquidity from potential sellers."