Independent direct market access may have a short-lived history. Not because the business doesn't have legs but because it's been successful. For several years, Wall Street brokerages have watched DMA providers capture order flow as buyside traders sought greater control over their orders and cheap, anonymous executions. Not surprisingly, the brokerages didn't sit idly by. Those not already chasing electronic flow rushed into acquisition mode: Citigroup acquired Lava Trading, and, last year, Bank of New York bought Sonic Financial Technologies.
Now it's J.P. Morgan's turn. In June the broker-dealer announced it would purchase
privately held Neovest Holdings, an Orem, Utah-based DMA provider and order routing platform, from a group of investors led by CCP Equity Partners.
Neovest will be run as a wholly owned subsidiary. It adds approximately 150 clients, a majority of which are hedge funds, according to a spokesman for J.P. Morgan.
Neovest is known for strong technical analytics, including real-time charting, news and extensive filtering capabilities, as well as advanced order management functionality.
"Large broker-dealers feel they need to be in the DMA game," says Harrell Smith, manager of the securities and investments practice at Celent Communications. "J.P. Morgan recognized that it's easier to buy an established player that already has established clients and has been up and running for a while than it is to go through the pain and cost of building a platform itself."
Pushing Algos
For J.P. Morgan the advantage is clear. The broker-dealer gains a front end that will help it distribute its algorithmic trading tools and execution analytics to clients. This will augment its order flow, which will help offset declining commissions from traditional brokerage activity, enabling it to compete more aggressively with other bulge-bracket firms.
"We expect a meaningful percentage of our DMA activity to come through the Neovest front end, and by the end of 2006 we hope to grow that globally," says Emily Portney, managing director and COO of origination and distribution for the Americas at J.P. Morgan.
Significantly, the Neovest acquisition extends J.P. Morgan's reach into hedge funds, the fastest-growing source of order flow on the buyside. Owning its own front end also gives the broker-dealer greater maneuverability. "We can control how we distribute our content, how fast we can do it, and how seamlessly we can integrate the trading tools we're providing to clients with their existing workflows," Portney says.
J.P. Morgan has been a sponsoring broker of Neovest's platform since last fall. The broker-dealer's algorithmic and execution tools will continue to be available on other execution platforms, and on buyside OMSs.
For Neovest, J.P. Morgan's appeal lies in its deep pockets. J.P. Morgan's resources will allow the DMA provider to expand its offerings across asset classes and globally to include global equities, futures and options. "However long it would have taken Neovest to do this alone, we're going to cut that time in half or better by merging," says Tom Van Riper, the firm's COO.
Neovest, for its part, will remain a broker-neutral platform, offering hedge fund and other clients algorithms from a number of sellside partners.
Morgan's Catchup
J.P. Morgan's jump into DMA is a sign that the broker-dealer firm is aggressively playing catch-up. "J.P. Morgan has generally been late to the party-not that they haven't worked hard to develop algorithmic trading services and offer advanced execution to their clients. But they haven't done anything on the scale of what CSFB, Morgan Stanley or Goldman has done," notes Celent's Smith. The Neovest purchase, in addition to other recent acquisitions and ventures geared toward hedge funds, tries to address this.
"The Neovest acquisition underscores our commitment to compete in this space and client feedback has been very positive," according to J.P. Morgan's Portney. "We have made substantial investments in building out the equity trading platforms over the past few years, including the hiring of top talent and offering first-class algorithms and trading tools," she added.
However, some speculate that too much water may already have passed under the bridge. In a June 25th report on the U.S. Securities Industry institutional equities business, Sanford C. Bernstein & Co. analysts Brad Hintz and Todd Buechs suggested that the institutional equities landscape would soon be dominated by no more than a half-dozen "best-in-class bulge-bracket firms." And. in their view, J.P. Morgan isn't in the running.
Indeed, Hintz and Buechs included the broker-dealer in their list of "casualties"-firms deemed unlikely to rise to the top of the heap. "A history of trading gaffs, poor technology, overcapacity, little retail flow and a lack of scale will all prevent J.P. Morgan from attaining dominance," they wrote.
Spending and Winning
The winners will have global institutional equity franchises, including massive prime brokerage businesses that sop up the expanding and increasingly critical hedge fund order flow. According to the Bernstein analysts, they will also have to invest upwards of $100 million annually in trading technology to stay competitive. They will continue to profit from prop trading. They will also buttress these strengths with substantial equity underwriting.
So far the winners are Goldman and Morgan Stanley, both undisputed powerhouses in prime brokerage and equity underwriting. Around the bend are Merrill Lynch, UBS and Citigroup. Hintz and Buechs note that CSFB trails this group, despite its "industry-leading automated algorithmic trading product," mainly because CSFB doesn't have a hearty prime brokerage business.
J.P. Morgan has a significant prime brokerage business, but one that's perhaps not sufficiently robust. It missed the Tabb Group's list of the 10 most widely used prime brokerages in the consulting firm's report on hedge funds.
While the Neovest purchase spruces up J.P. Morgan's near-term prospects, the recent run of Wall Street firms acquiring independent DMA providers raises broader concerns on the buyside.
Hintz and Buechs insist that the largest sellside institutional equities players will reap the benefits of aggregated order flow through prop trading, the internalization of flow, and the ability to commit capital more efficiently.
"The internalization of order flow is essentially a kind of bulge-bracket dark book that allows order matching to occur at the NBBO," notes Robert Shapiro, a trading strategy and platform consultant in New York. That may help the bulge brackets reduce transaction costs, but potentially at the expense of enhanced price discovery, he says.
Tim Christiansen, an equity trader at Sawgrass Asset Management, in Jacksonville, Florida, worries that buyside order flow could potentially be accessed and viewed by sellside firms offering DMA. "The pure agency broker platform presents a different risk profile from a broker-dealer that executes customer orders or has a prop desk," he says. "The sellside certainly has the technology to filter out what they want."
It's difficult to prove that buyside anonymity is being compromised, Christiansen admits. But "you couldn't argue that the trend of DMA acquisitions has lowered that risk," he adds.
Nhan Bui, the head equity trader at First Quadrant, a quantitative asset manager in Pasadena, California, is also wary of sellside promises of independence and anonymity. "The sellside reassures me they can't see my orders, but I'm not confident that's the real story," she says.
Bui notes that the New York Stock Exchange's proposed hybrid is an additional spur for sellside firms to reinvent themselves as trading portals for the buyside. When the NYSE rolls out more electronic trading, significant volume is expected to move off the floor. "If the large broker-dealers don't adjust, they'll lose out," Bui says. "That's why they're acquiring these DMAs."
All this translates into a bull market for DMA technology and niche electronic execution specialists in the near term.
