Legions of institutions, led by hedge funds, are taking a straight, speedy, and anonymous path to the New York Stock Exchange and to the major ECNs.
It is a path that many say provides lower transaction costs than the service offered by market intermediaries.
The vehicle is called direct access trading. And its proponents contend that it represents the next generation of online trading.
Nevertheless, its growing popularity may cause problems.
It could crimp business for traders who earn a living through conventional arrangements, according to several experts.
Floor brokers, specialists, market makers, sales traders, all of these intermediaries and more could see direct access encroach on their franchise, these experts say.
"Direct access offers anonymity and institutions love that because they don't want to tip their hand," said John Petschauer, senior vice president at Fixchange.com, the direct access unit of Javelin Technologies. "Information comes directly from the point of sale. The institution's name is only given to the third-party clearing firm. It's a pure agency transaction."
One buyside trader, who declined to be named, said he attended a conference promoting direct access services. "We were told our trades would be routed to one execution-only broker," he said. "That definitely cuts into upstairs sales traders relationships and pockets. Trades go right by the desk."
Direct access trading has grown up from a mostly retail, day trader-based technology associated with electronic communications networks, to one that also seeks out fat institutional accounts.
Proponents remind skeptics that, just about three years ago, a small core of market-making firms handled over 85 percent of all the volume in Nasdaq stocks. Now up to 50 percent of Nasdaq volume is handled by ECNs, according to a J. P. Morgan analysis.
Within the next two years, an estimated 75 percent of all institutional trades will be executed electronically, up from 40 percent today and 20 percent two years ago, according to TowerGroup, the Needham, Mass.-based securities industry consulting firm.
"Let's face it, we're moving away from traditional trade brokers and toward direct access," said Jim Valente, managing director at New York-based IDI, Institutional Direct, a provider of direct access services to institutional traders. "It reduces the need for a middleman."
Other providers agree. "Direct Access is coming to the trading floor and market makers will take a hit," contended John Forlines, chief executive at New York-based Blackwood Trading, one of the bigger direct access players. "There's no doubt that the people in the middle are going to have to demonstrate their ability."
However, others say the middleman will adjust, and may thrive in the changes unleashed by direct access. Indeed, part of IDI's strategy, it says, is having its affiliated floor brokers "determine the depth of liquidity and indications of buy and sell interest by talking to the [NYSE] specialist." There is, in effect, an intermediate step, before the final execution.
IDI's pitch: The buyside trader can bypass a trading desk, placing his order or requests for a market look via a dedicated line or electronic submission. IDI receives that information at its booth on the Big Board floor. IDI, a subsidiary of Bear Stearns, says it is the only player in the crowd aware of the buyside customer's identity.
Forces at Work
Several forces conspired to stimulate the growth of direct access trading. Regulations, such as the order handling rules, spurred the growth of ECNs. Another streamlined the tedious trade execution processes. "When I started on the [NYSE] trading floor ten years ago we had speed dials and direct phone lines between the institutional trading desks and the booths on the exchange," Valente said.
"To make a trade people had to call the phone clerk, who would page the broker to get market information," he added. "Then the broker would call the clerk back who would call upstairs to the trading desk with the information."
Direct access providers have connections to the institutions via order management system, or directly via proprietary trading desks.
"I remember the $2 brokers having specialized transactions farmed out to them by bigger brokers. Now these brokers are dealing with the public right from the floor," said Petschauer of Fixchange.com. "The day traders forced direct access onto the Nasdaq and onto the ECNs," added Petschauer, former director of technology at the Big Board. (He contends that the term direct access' was hijacked from the floor where he said the technology originated.)
How big is direct access trading? Ask 10 Wall Street observers and you get 10 different answers. But indications are that the technology is starting to take a big bite out of traditional order execution programs.
A report last May by Boston-based Celent Communications says that direct access providers "have consistently reported rising volumes, which are expected to continue to grow."
"While the occasional or recreational day trading community has quickly dropped in numbers," the report added, "those professional, experienced traders are still driving volumes in the market."
Direct access vendor, Blackwood Trading, says it executes up to 30 million Nasdaq trades daily.
Indeed, direct access programs parallel the growth of ECN business overall. Many brokerages are getting into the act, introducing both retail and institutional services out of their core offerings. Janney Montgomery Scott in Philadelphia has a program in the pipeline, according to Jack Hughes, head of Nasdaq trading. Some direct access firms, such as CyberTrader and TradeCast have been bought by larger retail brokerages (Charles Schwab and Ameritrade, respectively). Specialist firms are climbing aboard the bandwagon. Wall Street giant, Spear Leeds & Kellogg has a direct access program.
"It's sort of ironic," said Rob Hegarty, an analyst at TowerGroup. "Direct access firms like ProTrader and Tradescape have provided intelligent routing and multi-access point capability for years to day traders. The technology exceeded the abilities of the institutional trading community, so it began clamoring for it. The real growth is on the institutional side right now."
Cost Conscious
Price-wise, direct access offers some advantages that big trading houses may not normally receive. According to Valente at IDI, direct access costs anywhere from one to three-cents per share, which is less than the average six cents many market makers charge institutional accounts.
But TowerGroup's Hegarty cautions that, if a company wants to integrate its services with a direct access provider, it could face problems. That's because direct access execution is accomplished in fewer steps than a traditional broker's existing order routing system. "Institutions have to ask themselves what it's going to cost to integrate a direct access program with the trading technology they already have. What's it going to cost to change things?" he said.
Many direct access companies, such as Edgetrade, add a "software licensing fee" of up to $200 monthly.
Hegarty also adds that direct access, like many nascent trading technologies before, may have problems cracking Wall Street's old boys' network. "Institutional trading firms like their relationship with their brokers," he said. "They may not all go for direct access."
Then there's the sentiment on Wall Street that direct access is only suitable for order flow limited to smaller trades. "Most institutional firms focus on larger blocks," Hegarty said.
Still, direct access is raising eyebrows. The next step for direct access vendors may be to crack more of the big institutional accounts.
