Is This Niche Trading Business Becoming Crowded?
When the direct access broker Neonet purchased competitor Lexit Capital last year, the deal underscored the drive by small tech-savvy players to capture institutional order flow. But with direct access services now becoming standard fare at the top full-service and agency brokerages in the U.S., is there still room for these upstarts?
The Lexit deal gave NeoNet, best known in U.S. circles for cross-border trading, a platform on which to conduct a direct access business in the U.S. Previously, the firm relied on a link to the Brut ECN for access to the U.S. markets.
With the deal inked, NeoNet replaced its head of U.S. operations, Peter Gaffney, with Lexit's chief executive, Peter Kearns. Kearns is now spearheading NeoNet's push into domestic direct access. "We are going after the U.S. market," Kearns said. "We have access to all the ECNs and SuperMontage. We have partnered with a lot of order management systems vendors."
Neonet is one of several small shops to set up an electronic trading business in the past four years with hopes of capitalizing on an historic convergence of trends in the U.S. stock market.
Colliding all at once has been the complete electronification of the Nasdaq marketplace; the reduction of the minimum trading increment to a penny; and stepped up scrutiny by the buyside of its trading performance.
These three events have opened the door for technologically sophisticated trading houses to pitch cheap trades to traditional money managers, plan sponsors and hedge funds using computers. Direct access trades can range from a penny to two cents per share. That compares with three, four and five cents for executions requiring human expertise.
Among the newcomers making their mark, using ECN aggregation' software, are such firms as NeoNet, Pulse Trading, White Cap Trading, EGS, Electronic Specialist, EquityStation, Terra Nova Institutional, UNX, Vie Financial and Paravane Partners. Almost all are staffed with execs from the formerly fringe world of electronic trading. All are agency brokers promising "unconflicted" executions. That usually means no banking, no proprietary trading and no market making. It can also mean no research and no shopping of orders.
The group is not the first to tout itself as an extension of the buyside trading desk. Agency brokerage is an old game with entrenched players such as Instinet, ITG, Bank of New York Securities to name a few.
So, the competition is stiff. And just about every institutional brokerage is either installing or considering the installation of direct access technology. Examples abound.
CAPIS, of Texas, licensed Sonic Financial's front-end, branding it SlingShot. Nutmeg Securities in Connecticut recently released eNutmegdirect. SunGard brought daytrading shop Andover Brokerage. ITG, which practically invented the direct access business in the early '90s, took a stake in front-end vendor Radical.
More Players
Agency brokers, which have traditionally operated on the edges of the market anyway, aren't the only players offering automated fills. Of greater threat to the electronic upstarts are the bulge firms which control most of the order flow by virtue of their research, IPOs and soft dollars. Nearly all are establishing agency-like electronic groups within their cash equity departments.
At least one newcomer believes he can compete against the offerings of the full-service players. "A lot of their services are a couple of doors down from the stat arb desk," said Jamie Selway, founder and president of White Cap Trading and the former chief economist of the Archipelago ECN. "They are not in our game if they are doing proprietary trading."
The eight-person White Cap is one of the newer firms in the game, having been launched just last fall by Selway and a few colleagues from Arca. The idea for the firm came to Selway out of the feedback he got from buyside traders intrigued with the prospect of executing on the Archipelago Exchange.
"At Archipelago, when we pitched the buyside," Selway said, "we heard: very interesting, but can I give you guys the order?' Of course, as an exchange, the answer is no.' Only a broker can handle the order." In other words, traders liked the idea of trading electronically, but didn't feel comfortable doing it themselves. The complexity of the tools necessitated help from the sellside. "The tools are getting a little ahead of the client," Selway said. "There are lots of bells and whistles, but not an awful lot of expertise using them."
The Veteran
The same story is told at Pulse. John Palazzo, Pulse's head trader and a veteran of Instinet, says the need for firms like his arose from the explosion of electronic trading venues in the Nasdaq market and the complexity of dealing with them.
"On the one hand, the buyside trader must deal with all his portfolio managers," Palazzo explained. "On the other hand, he's got 150 different brokers plying him with research and capital. Then, all of a sudden, he is deluged with six or seven ECNs pitching different order types. He just didn't have the time to learn. There was an opportunity there." Pulse opened its doors in 2000.
Palazzo counts about 30 different order types available in the aggregate from all the ECNs and SuperMontage. Each one serves a different purpose, depending on the urgency of the trade.
At Pulse, which does about 80 percent of its business in Nasdaq securities, one trader may have three different trading systems on his desk. That's RealTick, Lava and Sonic. The need for three reflects the different approaches of the systems.
One front-end may rely on the so-called "native logic" of the ECN to provide the order types. Another may use an order server that holds the order in the server and synthetically creates the order type.
While not all buyside shops need the expertise of brokers in navigating electronic markets – some of the more sophisticated ones have licensed the technology outright – they all need to cut costs and prove to their customers they are getting best execution. "Big buyside shops are doing what hedge funds have always done," said NeoNet's Kearns, "and that is really scrutinizing their bottom line. They're looking at how they can lower their execution costs in order to improve their results."
Paravane also jumped into the game last year. Launched by veteran quant trader Fred Graboyes, the shop is marketing slice-and-dice algorithmic trades. Of its 35 customers, three-quarters are hedge funds. "Either we give them access to the algorithms," explained Graboyes, "or we trade on their behalf using the algorithms."
Algorithmic, or rules-based, trading is in vogue now because it allows traders to deal with the lack of visible liquidity at the inside – a result of decimalization. Traders can break up their orders into tiny pieces and enter or exit the market at times deemed suitable by the computer.
The service, made popular by certain bulge bracket firms such as CSFB and Goldman Sachs in the past two years, has spread to the agency world. Vie Financial, owned by OptiMark, was one of the first with its offering of guaranteed VWAP trades.
Vie's algorithms have not worked as planned, though. The firm, according to statements filed with the Securities and Exchange Commission, is losing money and has scrapped its algorithms, at least temporarily. It relies on liquidity providers to conduct its business.
Paravane is taking a different tack: it has no plans to guarantee anything. "We think our performance is such that there is no need to provide a guarantee," Graboyes says.
The exec also stresses that, as an agency brokerage, his shop is free of the conflicts of interest found in a full-service shop. In short, there is no book to trade against at Paravane. "The reason you cross with a book is to get liquidity or some advantage," Graboyes said. "It's not done on behalf of the client. It's done on behalf of the broker to increase commissions or [trading] revenues."
Two Pillars
Paravane's trading model rests on two pillars: price prediction and order staging. Price prediction involves "so-called" factor models that take into account price correlations with other stocks, momentum and slippage. Order staging deals with entry and exit points.
The entree into the market of a firm of Paravane's sophistication suggests the electronic trading game maybe maturing. That certainly appears the case in single stock direct access trading anyway. At least two of the small players, Pulse and Terra Nova, are diversifying.
Pulse, for its part, recently launched a program trading service. Run by industry vet Jim Willsey, the desk seeks to compete with capital-committing bulge bracket program desks. Willsey, who worked on the program desks at CSFB, D.E. Shaw, J.P. Morgan Securities and Knight Trading Group, maintains the quality of the trading tools is so high nowadays that the buyside need not worry about transferring the risk of the execution to a broker.
Typically, a buyside shop will conduct an auction with a group of elite sellside firms for the right to buy its portfolio trade. The winning broker pays a commission – nowadays about two cents – to the institution and takes on the risks (and rewards) of trading a basket of orders.
The rewards can be substantial while the risk, according to Willsey, is much less than it used to be. That's because modern technology has made the trading more of a science than an art. "By trading as agent, Willsey says, "I will leave more of the money with my client. I'm not taking the alpha out of his portfolio."
Willsey notes portfolio bids have dropped in recent years from a range of 10 cents to 15 cents per share to two cents or three cents. "Why is that?" Willsey asked rhetorically. "It's because the brokers are making more money on the actual trade. They don't have to have the money in the bid."
Pulse uses the FlexTrader system to process programs. The trades account for about 10 percent of Pulse's business.
For its part, Terra Nova Institutional (TNI), a unit of the daytrading brokerage Terra Nova Trading, decided that trading alone wasn't cutting it. Last June, it aligned itself with a boutique research outfit headed by West Coast research sales vets Jack Sholl and Eddie Barretto. The two had previously worked with the now defunct Montgomery Securities and Robertson Stephens, respectively. The group has six staffers in San Francisco and six in New York.
Research Partnership
Three months later TNI increased its commitment to research by entering into a partnership with Foresight Investment Solutions, a New York-based independent research firm. Last year's moves almost completely change the complexion of the firm, positioning it more as a traditional institutional brokerage. Sholl says the reasoning behind the move was straightforward. "It's no secret direct access is now a commodity," Sholl said. "By layering on a research component, Terra Nova adds a whole new value proposition. And, of course, it's a higher margin business."
Research is not totally off the table at some of the other small agency firms either. Pulse has a small division that offers independent research to the buyside. White Cap is part of two different networks of execution shops and independent analysts run by the Westminster division of Bank of New York Securities and Donaldson & Co., according to Selway. NeoNet is also "in talks" with research providers, says Kearns.
That the direct access business is getting tougher appears evident. No one knows exactly how much discretionary order flow the buyside has to shower on small independent trading houses, but the numbers are certainly smaller than the boom years of the Nasdaq market.
"It's a lot less today than it was," Pulse's Palazzo said. "But look at the market. They still have to pay their bills. In the late 90s with the dot.com boom, that was order flow they could easily pay back."
