Volume is up. Profits are up. The stock is up. Investment Technology Group, by any measure, is a success. Still, the story is not all brass bands: ITG's crown jewel, POSIT, is getting old and its growth is slowing. And that's forcing the agency broker to spread its wings.
How successful is ITG? 2000 was a stellar year. It traded an average of 65 million shares per day, a whopping 40 percent jump from the previous year. Revenues increased by 34 percent in the same period to $310 million.
The rub was POSIT.
The electronic crossing mechanism – ITG's most profitable asset – accounted for only 48 percent of those shares, down from 56 percent in the prior year.
Ray Killian, chief executive of ITG, admits POSIT is a mature product. "But POSIT is not the whole ship," he stressed. "It's an important part, but the other parts are growing quite rapidly."
The "other parts" are the basket trading front-ends, QuantEX and ITG Platform, and a 55-person trading desk. They are growing quite rapidly but then so are their associated expenses. Revenues from the front-ends must cover the salaries of a 45-person research staff. Revenues from the desk must cover the salaries of the traders. Both must cover rising transaction and clearing charges. POSIT, on the other hand, largely pays for itself.
Product Mix
"There is a shift in ITG's product mix toward lower-margin, third-party executions," Salomon Smith Barney analyst Matt Vetto writes in a recent report. "Margins could come under pressure if there is a further increase in executions outside of POSIT – particularly ECN executions."
The analyst notes that revenues per share fell from 2.0 cents to 1.9 cents last year because of the increase in non-POSIT executions.
POSIT trades earn ITG two cents per share. The front-ends bring in 1.25 cents on average. The trading desk brings in between two cents and three cents per share. Customers include indexers, quants, single-stock players, and the sellside.
POSIT is by no means fading away. Despite encroachment by several new order matching systems it is still very popular with both buyside and sellside traders. But last year's volume growth of 21 percent is well below its annual compound growth rate of about 50 percent over the last five years.
ITG's front-end business is now in the driver's seat. In last year's fourth quarter, users of QuantEX and ITG Platform executed an average of 26 million shares per day. That's more than double the 10.6 million shares tallied in the fourth quarter of 1999. On the other hand, POSIT was flat with the year-ago quarter at 27 million shares.
The vigor of ITG's front-end business is a testament to the buyside's increased scrutiny of its trading costs and ITG's knack for creating technology to help manage those costs. Indexers and single-stock traders are under pressure from their managers and clients to reduce implicit trading costs such as market impact. That's industry jargon for the price spikes that occur when the Street gets wind of a big trade.
Lower Costs
QuantEX and ITG Platform help basket traders lower their costs in three ways. Traders route to the market center with the best price. They program the system to execute their orders at the most optimum times. And they access ITG's pre- and post-trade transaction cost analysis products.
Killian adds that growth in ITG's front-end business has also benefited from technology improvements; new research products; and market structure changes. (QuantEX has been criticized in the past as old and limited in its order processing capabilities, according to sources).
The product was developed in the early 1990s to help ITG's agency desk manage lists. It was then adopted by quants to automate their trading strategies and route their orders to POSIT, the New York Stock Exchange's DOT system, regional exchanges and Nasdaq market makers. QuantEX was essentially a very sophisticated DOT-box.
Then came the ECNs. They now make up about 30 percent of Nasdaq's liquidity. Instinet, the most popular ECN with institutions, trades about 250 million (single-counted) shares per day. That's about 15 times POSIT's (single-counted) volume. ITG's trading mix is roughly 65 percent listed and 35 percent Nasdaq, according to Killian.
Some QuantEX and ITG Platform users petitioned ITG for access to ECNs. Although their trades can be large, they tend to be made up of hundreds of small orders that can be executed on ECNs. ITG responded by connecting clients to Bloomberg's TradeBook, another institutional favorite, and four other ECNs. It has not put in a link to Instinet.
It was not an easy decision. DOT charges are cheap and getting cheaper. Market makers don't charge to access their quotes. But ECN fees mean double trouble: They both decrease ITG's revenues and increase its expenses.
ECN Trading
Last year, ITG reported an 18 percent drop in its revenues per share attributable to its front-end business. That's partly due to a big jump in ECN trading. It also saw its execution expenses soar 36 percent to $44 million, mostly because of an $8 million increase in ECN charges.
Trading on ECNs by ITG's customers exploded last year. In the fourth quarter, ECN executions accounted for nearly nine percent of ITG's revenues, according to the company. ECNs are a significant catalyst in the rise of ITG's front-ends to their current prominence in the order flow mix. The trading desk has also seen strong growth, but volume there is still only half that of QuantEX and ITG Platform.
ITG sends its ECN-bound orders to Bloomberg TradeBook, the most expensive of the bunch, and Archipelago. In fact, ITG and B-Trade nearly became partners. In 1999, they announced they would connect TradeBook to POSIT, forming a "superECN." ITG's hope was to pull B-Trade order flow into POSIT, thereby increasing liquidity. The plan later died, but an ITG official says, in recent weeks, B-Trade has rekindled the idea.
ITG's embrace of the ECNs suggests a company morphing into a direct access e-broker such as CyberTrader or Tradescape. Those firms offer daytraders direct access to the ECN with the best pricing via "smart routing" technology. ITG is, in fact, building its own smart routing server to help QuantEX and ITG Platform users navigate the ECNs, according to Scott Harrison, a front-end product manager.
But ITG is taking the model one step further. In what is probably the most radical move by any Wall Street brokerage in recent memory, ITG now allows users of its front-ends to route their orders to other brokers. Very quietly, last year, ITG inaugurated RouteNet, an order routing service that connects QuantEx and ITG Platform to about 30 market centers and 40 brokers.
"One of the biggest factors of our growth is our willingness to route orders into 70 different locations," Killian said. "That's more than anybody on Wall Street." If a client wants to route an order to Goldman Sachs or UBS Warburg, he can use ITG's front-ends to do so. The buyside pays nothing for the service. The brokers pick up the tab.
Killian suggests he had little choice in the matter. "I can't get 100 percent of every client's business," he said. "If I insist that everything that goes through my system ends up at ITG, it's going to be a short summer for me."
Behind the scene is pressure by the sellside on the buyside to send their orders electronically. The goal is to reduce errors and telephone time. To comply, an institutional trader can either pay for the services of a routing network such as Thomson's TradeRoute or install individual links to each broker. Apparently, some QuantEX and ITG Platform users did not want to do either.
At least one buyside trader believes the new service will be welcomed by smaller shops. Greg Rogers, head trader at Philadelphia quant shop Aronson + Partners and an ITG Platform user, says his firm plans to use the service to access some brokers, but is already connected to most of the necessary destinations. "They're building the platform up to be an order management system of sorts," he said. "We already have our own third-party OMS. Also, we are big enough so we had those connections anyway."
The RouteNet move takes ITG out of the realm of the e-brokers and into that of the front-end vendors. The broker begins to look more like a MacGregor Group, for example, which sells the popular Predator order management system, or a FlexTrade which sells a competing basket trading front-end. Vendors such as these don't care where the orders go. They simply license the software.
There is one difference: ITG also maintains the routing network. Vendors generally configure their systems to interface with a network, but leave it to the client to manage the routing.
"Direct access is a very important business these days," Killian said. "Every institution wants to directly access liquidity points. It must be complex underneath, but transparent to the user. He just wants to hit a button, send the order out and get the best execution."
Direct access means much more to ITG than simply moving an order from Point A to Point B. It's betting that its proprietary research will enable it to add value and stay ahead of the pack. That's important. Both Tradescape and CyberTrader have set their sights on the institutional market. So have a host of other e-brokers. Also, Bloomberg TradeBook recently came out with its own list-trading front-end.
"We must have a value-added component other than crossing and executing orders at the New York Stock Exchange," Killian said. "Research is the underpinning."
All research at ITG is geared towards reducing clients' trading costs. As a discount broker, ITG does its best to convince the client it does not need the capital of a full-service shop to reduce market impact. Technology, ITG stresses, is a cheaper substitute.
The program desk of a full-service shop might charge about nine cents for an S&P portfolio principal bid, according to Killian. If ITG's ACE system calculates a market impact of four cents and ITG charges two cents, the trader will save three cents executing through ITG.
ACE was developed by ITG's research division to help institutions predict the cost of a trade before they execute. Its sister product, TCA, is used to compare the trader's execution price with benchmarks such as VWAP or the previous day's close.
The research division also works with users of QuantEX and ITG Platform to build models that automate their strategies, enabling them to monitor and trade hundreds of stocks at the most optimum times.
Finally, the research division builds servers that monitor the market and execute trades as would a human trader. One such "SmartServer" continually monitors a stock's volume-weighted average price (VWAP). It feeds a customer's order into the market at the optimum moments to achieve an execution equal to or better than the VWAP.
Another server monitors a stock's short-term fluctuations and employs limit orders to try and achieve price improvement. If a seller is willing to sit on the offer with a limit order for up to 30 minutes, the technology will monitor a stock's momentum to determine whether or not the bids are moving towards him. If, instead, conditions worsen, the system can move the trader's limit down to the middle or the bid side of the quote.
"Instead of just giving up the bid-offer spread, stay on the offer side of the market for a little while," Killian said. "See if the bids come to you. See if you can get some price improvement. Don't just take a small order of 5,000 or 10,000 shares, hit the bid and let the market maker make the entire spread."
Spoken like a true agency broker.
