2007 Review: SEC Greenlights CCAs

Editorial Staff
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The battle for commission dollars got much hotter in 2007 as the buyside changed the way it conducted its execution and research spending.

Since regulators clarified rules on soft dollars earlier this year, a larger number of buyside firms have been embracing client commission arrangements, or CCAs. And that should continue in 2008, says Robin Hodgkins, president of Cogent Consulting, which specializes in commission management. More CCA use will leave many more brokerages out in the cold, watching their lists of trading partners shrivel significantly.

By the end of next year, two-thirds of the 100 most active buyside firms are expected to be using CCAs, according to analysts at Greenwich Associates. Similarly, Traders Magazine found that 55 percent of the 100 respondents to a survey on CCAs said they will have a CCA program in place by the end of 2007. This means a growing number of money managers are taking greater control over where they execute and how they pay their research providers.

Of Cogent’s 100 buyside clients, Hodgkins says, the majority will be driving down their broker lists to an average of about 10 trading relationships by the end of 2008–some from lists numbering more than 100 firms. “The vast majority of buyside firms will be using CCAs,” Hodgkins says. “We’re seeing companies that swore they would never do soft dollars doing CCAs now.”

But Matt Lyons, senior vice president of equity trading at Capital Research & Management, doesn’t expect his firm to be one of them. At a past STA conference, Lyons said he was skeptical about CCAs and planned to keep his relationships with his brokerages. He acknowledged that he would be loath to combine order flow through fewer brokers and would rather spread his orders around to avoid giving a single broker the mass of information implicit in a single large order.

“We don’t use [CCAs], and I don’t suspect that we will,” Lyons said about 14 months ago. “Order flow is valuable to the brokers. That is why they built their models the way they did. It’s huge.” Lyons says that market impact has been the largest cost of trading, and that by giving too few brokers too much information, he would be exacerbating those costs.

With commissions, there’s plenty at stake. The buyside paid almost $11 billion in commissions last year, according to the most recent data available. Of that, almost 27 percent, or $2.9 billion, went to small- and mid-tier brokers. Now, half of those commission dollars earmarked for smaller firms could soon go to the 12 largest brokers because of their CCA programs, says Integrity Research Associates, a consultancy that evaluates research providers.

CCAs in Europe are called commission sharing arrangements, or CSAs. They are essentially the new, more transparent soft dollars. With a CCA, a money manager gets his research from a broker or firm. He then trades with another broker, who sets aside a specified portion of the commission, which will be used to pay the manager’s research firms. For more than 30 years, since the 1934 Securities Exchange Act was amended to include a soft-dollar safe harbor, portfolio managers had mostly been getting their research and brokerage services through the same sellside firms. But after the Securities and Exchange Commission clarified commission dollar use in a no-action letter to Goldman Sachs almost a year ago, that has changed.

The predicted fallout from increasing CCA use should be extensive for brokerage firms. Money managers will have smaller trading lists, larger research lists and will use more hard dollars–or straight checks–to pay for research, according to Karan Sampson, a consultant who covers hedge funds for Greenwich Associates. As more commission dollars go to the bulge brackets and their CCA programs, smaller firms may close their trading desks to focus entirely on research, says Dushyant Shahrawat, research director at TowerGroup, a financial consulting firm.

Over the next year, or so, the bulge bracket firms will be investing in their electronic trading business to handle the expected increase in order flow, Shahrawat says. Simultaneously, smaller and regional firms fighting to keep their existing trading business will also be investing in technology to ensure that their electronic trading departments remain competitive.

According to Hodgkins, research costs will rise as sellside firms turn increasingly to research. They will become more aggressive about the monetary value of services such as access to management and the priority of analyst calls. “Some firms are talking about auctioning research,” Hodgkins says. “Some people are talking about setting specific price lists for that research.”

For the buyside, the unbundling of research and execution has created more transparency as to how much money managers are spending on research, Integrity president Sanford Bragg says. This allows them to determine which firms provide the greatest value. Such transparency helps regulators verify to what degree the buyside is acting in its clients’ best interests.

 

 

2007 Review: Reg NMS Trade-Through Rule Leaves Mark

Editorial Staff
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Regulation National Market System is here. Now what? The past year witnessed the implementation of what was called the most sweeping rule changes to hit the securities industry in decades. Reg NMS not only forced the once-manual New York Stock Exchange to go electronic, it created competition among market centers and prompted investments in the regionals and ECNs like BATS and Direct Edge.

Industry watchers acknowledge that the Securities and Exchange Commission’s plan to make the markets more electronic has succeeded. And for the coming year, they say, the market dynamics Reg NMS helped accelerate–such as liquidity moving to more alternative trading systems–should continue unabated.

Reg NMS went into effect for exchanges in March, became operative for brokers in July and was fully implemented in October. Its centerpiece Order Protection Rule–also known as the trade-through rule–had two results: the decline of NYSE market share and an overall explosion in listed trading. The trade-through rule requires that the best electronically available bid or offer in each market be protected. This means no exchange or broker can trade through–execute an order at a price inferior to–a protected quote, wherever that quote resides.

With Reg NMS, the NYSE stood to lose the most from the SEC’s decree that liquidity go to the best automated quote. Reg NMS also created opportunities for alternative market venues to compete on the basis of price, rather than relationships, history and habit. And by pushing the ruling through, the SEC cut the NYSE down to size.

Both NYSE and NYSE Arca combined traded on average 1.8 billion of the industry’s 3.4 billion NYSE-listed shares per day in October. That gave NYSE Group a market share of 54 percent, down from almost 79 percent two years earlier.

Many predicted there would be an increase in trading volume of Big Board-listed stocks once it went electronic. The industry’s NYSE-listed shares traded per day jumped to 3.4 billion in October, a 41.7 percent increase from two years earlier.

Increased electronic trading at aggressive competing market centers had long been making inroads into the Big Board’s market share, and even necessitated the hybrid. But Reg NMS further decreased NYSE’s market share, says Adam Sussman, a senior analyst with consultant TABB Group.

“The hybrid, as well as Reg NMS, allows for different kinds of investors to more efficiently implement their investment strategies in listed stocks that they may not have been able to before,” Sussman says. “High-frequency trading needs low-cost infrastructure and guaranteed speed. When orders make their way onto the floor, the feedback from a canceled request used to be slower. That really hampered people’s ability to implement these kinds of strategies in listed stocks.”

Still, some think the new rule was a mistake. “I think the trade-through rule has become largely irrelevant,” says Jamie Selway, managing director at institutional agency broker White Cap Trading. “Now that everyone’s electronic, no one’s got an incentive to trade through.”

The trade-through rule change essentially gives NYSE competitors relevance, he adds, by enabling them to establish themselves quickly and easily. Witness BATS’s success. “That’s a pretty powerful gimme to hand to your new entry competitors,Ó Selway says.

But the SEC has also allowed exemptions to the modified trade-through rule–too many, according to Selway. There are already exemptions for derivative trades, benchmark trades, stopped stocks and print protection, he says. “If I have a prediction for NMS, or the trade-through rule,” Selway says, “it will continue to be whittled away by exemptions until it’s essentially meaningless.”

 

2007 Review: More Tools & Fragmentation

Editorial Staff
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Do-it-yourself electronic trading continued to grow this year as the development of new tools gave the buyside more ways to handle orders than ever before.

At the same time, market fragmentation made trading more challenging. The good news is that buyside traders are gaining expertise in handling orders in that fragmented marketplace, as they do more trades themselves and send fewer orders to sales tradersÑthough that trend appears to be slowing.

A November TABB Group study on institutional equity trading says the percent of buyside share volume sent to medium- and low-touch channels–classified as DMA, program trading, algos and crossing networks/dark pools–should continue to grow. It jumped from 53 percent in 2005 to 63 percent in 2007. TABB did not predict electronic trading growth for 2008, but it predicts electronic trading will constitute 68 percent of all shares traded in 2009.

GE Asset Management exemplifies this trend. The firm has been embracing low- and no-touch electronic trading for the past five years. And the percentage of trades it handled with algos, DMA or crossing networks leapt from 5 percent in 2002 to about 30 percent today, according to Damian Maroun, GE’s head of trading.

TABB says the marketplace volatility will affect the amount of orders that sales traders see. But the drop-off in high touch–dramatic since 2004–appears to have started to stabilize this year. TABB estimates the buyside will direct 32 percent of its order flow to full-service sales traders in 2009, just slightly lower than the 37 percent in 2007, but a huge decrease from the 79 percent of business sales traders saw in 2004.

Mark Schlarbaum has witnessed this from his desk as director of equity trading at Conshohocken, Pa.-based firm Global Capital Management. While trading small caps over the past 15 years, he’s seen his job change with the advent and evolution of electronic trading. “You have a lot more electronic tools than you used to have, and it seems like relationships are less important,” Schlarbaum says. “Now I end up talking to the guy that programs algorithms, as opposed to a sales trader. That’s partially a joke, but partially true.”

Schlarbaum’s strategy for trading small caps is almost entirely low- and no-touch. He’ll use algos and have orders exposed to dark pools constantly. And Schlarbaum says he’ll work chunks of the larger orders himself, because he’s small-cap savvy and knows how to find the better prices for them. Still, his preferred strategies don’t involve a sales trader.

TABB says that the increase in self-directed electronic trading on the buyside’s part will continue to bring down commission rates, which have fallen from 2.53 cents a share in 2006 to 1.97 cents in 2007 on a blended basis. But as long as the market volatility perpetuates instability, the report notes, blended commission rates should climb with the continued shift in low- to high-touch order handling.

For 2008, industry watchers expect more buyside traders to use electronic tools–such as DMA, algorithms, dark pools and other crossing networks–to complete trades. But they also see a great need for high-touch handling as many still contend with volatility fallout.

2007 Review: Pennies Roil Options Marts

Editorial Staff
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The biggest story of 2007 in the options market was the switch to penny pricing. Under a “pilot” program encouraged by the Securities and Exchange Commission, the nation’s six options exchanges agreed to quote a limited number of options classes in either 1- or 5-cent increments, depending on their prices.

The pilot began in January with 13 names and was renewed and expanded in September with 22 more names. Next March, another 28 names will be added.

The 35 classes now trading in pennies account for about one-third of the industry’s total traded volume. The 63 that are expected to be trading in pennies next March will represent about half of overall volume.

The impact on the market has been significant. Spreads in penny classes declined. Size at the inside dried up. Volume outpaced that of the overall market. Market makers dropped options. And exchanges introduced new pricing models.

This summer the SEC proclaimed itself pleased with the results of the pilot and indicated it was eager to see it expanded. The regulator’s goal was to see spreads decline along with, it hopes, the industry practice of paying for order flow.

Not everyone is happy with the program. Options executives point out that the drop in size at the inside is bad news for institutional investors, a group driving much of the surge in options trading of the past few years.

The largest debate around pennies, though, centers on the future of options exchanges. Since they first came into being about 30 years ago, options exchanges have been supported by dealers risking their capital to quote bids and offers. In return, the dealers were guaranteed wide spreads and sizable chunks of incoming orders.

With pennies, three exchanges–two existing and one on the way–have challenged the traditional order with different pricing models. NYSE Arca and the Boston Options Exchange (BOX), the two newest exchanges, now pay anyone who quotes on their books for providing liquidity. Firms that are specialists elsewhere are welcome to quote on these systems, but their incentive is a cash payment, rather than a piece of the incoming order.

At the same time Arca and BOX charge traders for hitting bids and lifting offers, a practice the other exchanges largely abandoned several years ago. Nasdaq, which has said it would start up its own exchange this month, also plans to use the maker-taker model pioneered by Arca.

So far, the maker-taker model has been successful. NYSE Arca, for instance, reported its market share in the 35 penny classes stood at 17 percent at the end of October. That’s up from 12 percent in April. Ed Boyle, in charge of options at NYSE Arca, attributes the exchange’s success partly to its “uniquely attractive market structure.” The remaining exchanges–the Chicago Board Options Exchange, International Securities Exchange, American Stock Exchange and Philadelphia Stock Exchange–are now faced with the possibility that they too may have to embrace the maker-taker model.

One exchange has already made its decision. As Traders Magazine was going to press, the Philadelphia agreed to be bought by Nasdaq. “The only way you add value in this area and an ability to grow is to have multiple market models under one holding company,” Philadelphia chief executive Sandy Frucher told analysts at a briefing. “Which is what Nasdaq is wisely doing.”

Nasdaq executives maintain they will operate two options exchanges–Philly’s specialist-based pro-rata model and Nasdaq’s maker-taker model. “The only way to grow our share and the only way for Nasdaq to grow its share is to have these two market models,” Frucher said.

2007 Review: NYSE Broadsided by Reg NMS

Editorial Staff
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This was not a good year for the New York Stock Exchange.

The venerable marketplace got slammed by a rule change pushed through by a federal government determined to modernize the U.S stock market. The move stripped the New York of its protective covering, forcing the largely manual marketplace to compete in an unfamiliar electronic world.

The Securities and Exchange Commission’s Regulation NMS trade-through rule gave traders the go-ahead to ignore quotes on the Big Board if they were not automatically accessible. That forced the New York to fully open its display book to automatic executions, rendering the Big Board little different from any of the dozen other electronic marketplaces.

Its new status as one more electronic marketplace has done nothing good for its market share. From 66 percent in January, the Big Board is now only doing about 40 percent of the volume in its listed shares.

The exchange’s new electronic profile is best illustrated by statistics published by the NYSE. In the third quarter of last year, about 28 percent of all trades were executed automatically. In the second quarter of this year, between 82 and 84 percent were.

The big leap into electronic trading has left the denizens of the NYSE’s floor, the heart of the “old” exchange, in disarray. Many are gone. Those who remain are trying to adapt. Some are thriving. Many are not. The once-vaunted specialist has been hit hardest. Once the central player in the floor’s auction process, the specialist has been sidelined by the migration of trading to other marketplaces. Two specialist firms abandoned their posts this year, giving up their stocks.

Van Der Moolen Specialists, which handled about 400 stocks, and SIG Specialists, a unit of Susquehanna International Group, with about 150 stocks, quit the business. In last year’s third quarter, specialists participated in anywhere between 5.5 and 6.8 percent of all trades, depending on the activity level of the stock. In this year’s second quarter, specialists are involved in between 2.5 and 3.5 percent of all trades.

That decrease may be behind the decline in the quality of quotes at the Big Board. In last year’s third quarter, among the most active stocks, the NYSE set the national best bid or offer two-thirds of the time. In the second quarter of this year, that number declined to 55 percent. The change was similar among less frequently traded securities as well.

Price improvement is down on the NYSE, too. In July 2006, the exchange found, the percentage of orders price-improved by specialists was 1.47 percent. A year later, it was down to 0.03 percent. The amount of price improvement provided by other traders also declined. That figure was 10.66 percent in July 2006. It dropped to 1.39 percent in July 2007.

To some observers, the high levels of auto-ex and low levels of price improvement suggest that the NYSE has devolved into nothing more than a large ECN. The open question is whether or not NYSE Group, the Big Board’s parent, which also operates the all-electronic NYSE Arca, should be supporting two electronic marketplaces.

The changes have done nothing good for the NYSE’s financial picture, either. NYSE Group’s margin on its trading activities, which include cash equities and derivatives, was little changed in the first nine months of the year from the same period last year.

Despite the hard times, the exchange is plugging away. New management is attacking old ways of doing business in hopes of recapturing lost block trades. Duncan Niederauer, an alumnus of Goldman Sachs, has been in charge of NYSE Group’s trading activities since April. He was joined by second-in-command Larry Leibowitz, another electronic trading veteran, in July.

The two executives have vowed to make the NYSE competitive in an electronic world by revamping the culture of the institution and the way the floor functions. “The demise of the floor system has been greatly exaggerated,” Leibowitz told a gathering of top trading execs at this year’s Security Traders Association annual conference. “It continues to be a differentiator.”

Niederauer and Leibowitz are taking steps to revive the NYSE on at least three fronts–pricing, rule changes and technology. Prices are coming down. Rules governing specialist trading are being loosened to encourage more aggressive quoting. And old technology is coming out, while new technology goes in.

The most dramatic move so far has been a decision to insert an electronic “dark pool” for the trading of large blocks into the floor environment.

Through a joint venture with BIDS Trading, operator of one of the newer electronic crossing systems, the NYSE is establishing a facility to match orders residing in BIDS with those sitting on the NYSE Display Book.

The facility is expected to bring more block-size orders down to the floor, as well as permit floor brokers to expose their orders to a large external pool of liquidity. At least one floor broker told Traders Magazine he was “cautiously optimistic.”

 

2007 Review: Riding in Comfort with Customized Algorithms

Editorial Staff
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Industry observers agree that over the past 12 months, algorithmic trading has taken on a new identity, maturing into more adaptive strategies with better routing features. Algorithms are no longer just another innovative trading tool available to the marketplace. Algorithmic trading has become a necessity for savvy traders seeking to gain access to dark liquidity pools. It is no longer just about volume-weighted average price (VWAP).

Looking back on 2007, algorithmic trading has become a vital tool in any trader’s electronic tool chest, says Brad Bailey, senior analyst with the Boston-based research firm Aite Group, explaining that the rapid change in the U.S. equity market structure has driven and added complexity to how the average institutional trader gets a trade done. “You have to think about where all of this liquidity is,” he says. “That drove a lot of people to look at aggregation tools, such as dark algorithms, and algos looking to aggregate this liquidity.” That’s been one of the big themes in 2007–trying to gain access to the dark liquidity and access to this fragmented market structure.

Along with this has come the migration away from simple benchmark algorithms, such as VWAP or arrival price, to algorithms that provide more flexibility with specific tactics used to target those benchmarks, said Carl Carrie, global head of algorithmic products and head of Neovest at JPMorgan. “It’s no longer good enough just to say, ‘Trade according to arrival as a benchmark,'” Carrie explains. “A trader typically wants to have a lot more control over how that’s done. With more fragmentation, there’s more granularity and richer texture to trading then there ever was before.”

Another major trend in 2007 was the push toward using algorithms in different product sets, such as foreign exchange, says Tom Price, senior analyst of securities and capital markets at the Needham, Mass.-based consulting firm TowerGroup. “What I think is the trend or has been the trend is the migration of successful equity strategies into alternate asset classes such as foreign exchange,” he says, noting that the equity model is already fairly mature.

When discussing algorithmic trading trends in 2007, one term jumped out over all the rest, and it isn’t a four-letter acronym–it’s customization. And in 2008, most agree, it will continue to prevail as the industry’s favorite buzzword. The customization of algorithms is far from becoming yesterday’s news anytime soon.

“Customization isn’t even a trend–it’s the driving force now, and fewer and fewer clients want a one-size-fits-all solution,” says Carrie. “Nearly every client we talk to wants variation on what we offered them the previous day. And even within the same client institution, there are traders that trade differently, and they want special parameters exposed. Very often traders want an algorithm to behave differently under different conditions, and when they do that often enough, it becomes a customized algorithm for them.”

Over the last year, the sellside has been developing its strategy around customization, agrees Adam Sussman, senior analyst at the Westborough, Mass.-based TABB Group, noting that there were one or two firms that formally launched marketing and sales efforts around the concept in 2007.

“I think we’re really going to see [customization] come to the forefront in ’08,” he says. “It’s going to be one of the top trends moving into ’08, and there are a couple of different reasons for that. One reason is that it’s difficult for the sellside to get the ear of the buyside these days, as more and more trading becomes electronic. Customization has been a pretty powerful tool for a number of banks to re-engage the client.”

One aspect of that will be the shift to clients self-customizing their own algorithms, says Carrie. “Another emerging trend will be products that tie in algorithms much closer to the alpha-generating process and the emergence of algorithmic management systems to improve workflow for trading,” he explains.

Aite’s Bailey asserts that the industry is still only in the early days of customization. “People are going to demand more and more out of the algorithms,” he says. “They’re going to demand more metrics around the trading and more integration of pre-trade and post-trade analysis.”

 

2007 Review: Progress Made on OMS-EMS Integration

Editorial Staff
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Mating an OMS with an EMS moved beyond the realm of theory this year, easing some frustrations on the buyside.

Three of the five major suppliers of buyside order management systems claimed victory in successfully integrating execution management systems into their platforms. The other two are hard at work doing the same. The achievements are notable and expected to make life easier for busy buyside traders.

Until this year, the EMS and the OMS were largely separate tools. Some OMSs could communicate with some EMSs, but none of them were seamlessly integrated. An order could travel via the FIX protocol from the OMS to the EMS, but the process was slow and error-prone. The goal for many vendors and brokers was to integrate the coding of the OMS into that of the EMS, creating, in effect, a single system.

Fidessa LatentZero was the first vendor to merge its OMS with its EMS when legacy buyside vendor LatentZero mated its Minerva OMS with its EMS. The new setup means buyside traders “no longer need to stage orders to third-party EMSs, manage orders in two or more separate systems, or be hampered by inefficient, error-prone workflow,” the company said in February. (LatentZero merged with sellside OMS vendor Fidessa in April.)

Fidessa’s triumph brings together two systems that were developed for largely different purposes but have been pushed to work together in recent years because of two related trends: the rising status of the buyside trader and the growth of electronic trading.

Buyside OMSs, at the heart of which are databases, were originally meant to serve the internal needs of money management firms. They allowed traders to keep track of orders and allocate trades to a firm’s many accounts. EMSs, on the other hand, were originally developed to enable traders to interact with the outside world of exchanges and electronic communications networks.

There has been overlap. OMSs, like EMSs, sometimes come with order routing so traders can send orders to brokers and receive reports from brokers. And relatively newer systems–Portware and AFA, for instance–offer both EMS and OMS functionality.

But aside from those specialty products, OMSs and EMSs remained independent of each other, prompting buyside traders to clamor for their integration. It took LatentZero 18 months to complete the job, Richard Jones, its chief executive at the time, said when it happened. “Now that the market demand is there,” he added, “we expect EMS functionality to become a standard and necessary feature of an OMS very rapidly.”

Four short months later, in June, BNY ConvergEx became the second OMS supplier to fully integrate an EMS into an OMS. BNY ConvergEx, the result of a merger between agency broker BNY Securities and buyside OMS vendor Eze Castle, mated Eze Castle’s Traders Console OMS with BNY’s Sonic EMS. The firm is characterizing its offering as an “enhanced Eze Castle OMS” or a “single-system OMS that includes global EMS capabilities.”

In June, BNY ConvergEx chief executive Joseph Velli told Traders Magazine that the “workflow resulting from the combined solution is much more efficient, with fewer clicks needed to trade and lower latency between the OMS and EMS.”

By August, another major buyside OMS vendor had an integration tale of its own to tell. Linedata Services announced its LongView Trading OMS would include “innovative technology designed to keep OMS and EMS blotters in perfect sync.” The company plans to sign agreements with a number of third-party EMS suppliers, so that traders using its platform and theirs will be able to work seamlessly with both systems. Linedata’s first deal is with Goldman Sachs and its REDIPlus EMS.

Users of both platforms will no longer need to move data between their LongView and REDIPlus blotters, the company said, and they can trust that the order data on each is kept up to date with changes on the desk or in the market.

Linedata is one of the few remaining independent suppliers of OMSs or EMSs to the buyside. Most are controlled by major broker-dealers. Linedata chief operating officer Annie Morris believes that is an important distinction.

“We strongly believe that buyside traders not only want access to their preferred tools,” she said in August, “but that they want to do so in a truly broker-neutral manner. Linedata is not owned by a broker-dealer, nor do we participate in commissions on trades that flow through the LongView platform. This integration technology supports our broker-neutral mandate.”

With the pace set by three of the leading firms, what of the other two? Investment Technology Group, which bought buyside OMS vendor Macgregor two years ago, says it is working on integrating its portfolio trading EMS software, Triton, into Macgregor’s XIP platform. It has not set a date for completion.

Charles River Development, for its part, announced at the start of the year that it intended to migrate its Investment Management System OMS to a new underlying service-oriented architecture. That will permit it to release Version 9 of the OMS software, which will feature “fully integrated execution management capabilities,” the vendor said. So far, no word on when.

2007 Review: MiFID Spurs Competition in Europe

Editorial Staff
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After years of anticipation, MiFID rolled into action on Nov. 1. The Markets in Financial Instruments Directive is a set of rules developed by the European Commission, the European Union’s policy arm, that lays the groundwork for an eventual overhaul of the European markets.

MiFID’s goal is unprecedented but simple. It seeks to create a single European market for trading and securities in lieu of 30 segregated domestic markets–the 27 EU countries, plus Iceland, Norway and Liechtenstein. It expects to do that by foisting competition on the mainline exchanges that have a monopoly position in their markets.

MiFID’s biggest change to the status quo is the abrogation of so-called concentration rules. In France, Italy and Spain, trades by domestic brokers previously had to take place on the national exchange.

Other markets can now compete with those exchanges. Transactions can also be internalized by brokers. “It’s almost impossible that there won’t be more off-exchange trading in those countries,” says Nick Holtby, head of European client trading and execution at UBS. Big brokers are setting up dark pools in Europe, and U.S.-based crossing platforms such as ITG’s POSIT and Liquidnet are expanding their London-based footprint to the Continent.

The permission to open up trading, however, doesn’t translate into direct competition between the kingpin exchanges. So far, the biggest exchanges are sticking to their domestic knitting, trading equities they list and not going after other trading.

But MiFID also gives a green light to new markets and venues, called multilateral trading facilities, or MTFs. Eager new players, such as Instinet’s Chi-X, have sprung up. Launched in March, Chi-X went after trading in Europe’s most liquid stocks, adding the component stocks of the benchmark index in one country after another. Chi-X’s monthly turnover in October was 14 billion euros, up 27 percent over September’s turnover.

Turquoise, an MTF created by a consortium of nine giant broker-dealers, has run into setbacks, but remains ambitious. The platform, which will include both a displayed market and a block crossing platform, expects to launch in mid-2008. New exchange Equiduct intends to go live early next year with a market model tailored to the new environment.

Meanwhile, the standard-bearer exchanges are readying for battle. The London Stock Exchange, Euronext and Deutsche Bšrse are each considering new order types, new ventures and new businesses to keep liquidity within their markets. Exchange operator NYSE Euronext–perhaps after seeing close-up the erosion of the New York Stock Exchange’s market share in response to market-structure changes–announced it would form a block trading platform with BNP Paribas and HSBC. The system is due to launch in the second quarter of 2008.

The general expectation is that eventual competition will fragment Europe’s market, although perhaps not to the extent it’s happened in the U.S. In the meantime, brokers are revving their engines. They’re developing or adapting U.S.-tested smart order-routing technology for European trading. Algorithms will also become more important, as traders look for ways to stitch liquidity back together.

But many in Europe don’t expect the main exchanges to bleed volume. European markets are in a different position from their U.S. counterparts, and may not be as vulnerable to competition from upstarts. “I doubt they will attract enough liquidity in a broad range of equities to provide significant order-book depth,” says Andreas Willius, an executive in the cash-equities segment of Deutsche Bšrse.

MiFID is also prompting changes in two other important areas: market data and clearing and settlement. MiFID doesn’t mandate a consolidated quote or trade system, leaving it to markets, brokers and vendors to pick up the slack. As a result, myriad businesses are being hatched around the provision of market data and related services, most notably a consortium called BOAT. Clearing and settlement remains a historical challenge to efficient cross-border trading in Europe.

However, last year, with MiFID on the horizon, the European Commission forced key players to agree to a code of conduct intended to gradually eliminate barriers. That move produced cautious optimism from many quarters. “It will take a long time to assess whether this will result in real competition,” says Patrick Cirier, global head of professional trading group solutions for Fimat, the brokerage arm of French bank Societd Generale.

 

2007 Review: Darkness Spreads: Who Turned Out the Lights?

Editorial Staff
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The year Regulation NMS was implemented also turned out to be the year of dark liquidity. But in retrospect, the connection isn’t simply ironic.

The Reg NMS-spurred decline in order size on exchanges prompted traders to look elsewhere for larger fills. At the same time, Reg NMS put its stamp of approval on the national best bid and offer as a benchmark price for crosses. The electronification of the markets and desire to avoid exchange fees and market-impact costs further fueled the appeal of remaining dark. Finally, the presence of alternative trading systems ensured that dark liquidity–which previously existed on blotters, on upstairs desks and in brokers’ vest pockets–could be quantified.

There are now upward of 40 dark pools that cross non-displayed order flow. Buyside firms direct 15 percent of their order flow to crossing networks and dark pools, up from 9 percent in 2006, according to research firm TABB Group. And those numbers do not include hidden and reserve orders sent to exchanges and electronic communications networks.

Credit Suisse and UBS executives speculate that 5 to 7 percent of the market volume takes place through crossing systems and broker dark pools.

But the real story behind dark liquidity may not be its growth. Greg Tusar, head of electronic transaction services at Goldman Sachs, noted at a recent Financial Times conference that what’s more striking is the “profound impact technology has had on market structure.” There are now few venues that do not have dark order types and hidden midpoint pegs. And these order types are immensely popular. Nasdaq’s Chris Concannon, executive vice president for transaction services, says 18 percent of the exchange’s Nasdaq-listed executions involve dark liquidity.

Even the New York Stock Exchange is getting in the game. It announced in October that it would join hands with BIDS Trading to form a block crossing system, due out by mid-2008, whose orders can interact with the Big Board’s displayed book.

As dark liquidity has become commonplace, distinctions have emerged. There are the crossing veterans–ITG’s POSIT, Liquidnet and Pipeline–and there are broker internalization engines. There are block venues and dark pools that cross exchange-size flow; utility-like consortia and proprietary venues; continuous crosses and point-in-time matches. There are dark pools that attract “patient” flow and pools that are the last check on the way to the market.

Meanwhile, buyside traders became more comfortable sending order flow into dark pools. Concerns about gaming continue, but traders pay closer attention to the type of flow in various pools, as well as trading and matching-engine rules. Traders avoid predatory executions, particularly in pools with low average trade sizes, by putting limits on their orders and indicating a minimum crossing size.

To cope with the multiplicity of dark pools, the sellside has provided–and buysiders are adopting–algorithms that hunt for hidden liquidity in many venues at once. Around 30 broker algos aggregate that dark liquidity and piece orders out to pools, relocating liquidity based on where executions are occurring and how those prices relate to the NBBO. Some of the algos create complex virtual order books of dark liquidity that parallel displayed order books.

The use of these algos has surged–including, as this summer proved, during times of volatility. Many of these algos access traditional crossing networks as well as hidden orders in the markets. Credit Suisse’s Guerrilla now represents more than half of the firm’s algorithmic customer agency flow. Goldman Sachs, ITG, UBS, Lehman Brothers, and others have also seen their dark algos take off.

Some dark pools are also quietly linking to one another. Dan Mathisson, head of the Advanced Execution Services group at Credit Suisse, notes that a dark pool’s “currency,” in terms of connecting to another pool, is how much that broker crosses. He says the need for scale, which allows firms to lower their fees, is the catalyst for connectivity between pools.

For the time being, there’s no slowdown of interest in dark liquidity. BNP Paribas has said it will soon launch a dark pool. Four other brokers–two large and two mid-tier that don’t already have internalization engines–are in the process of making LeveL, a low-cost utility-like ATS, their outsourced internal crossing system, according to LeveL’s president, Whit Conary.

 

2007 Review: ECNs Get A New Lease on Life

Editorial Staff
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Call it: The Rise of the ECNs, Part 2. Led by Kansas City-based BATS Trading, new electronic communications networks, or ECNs, have once again gobbled up exchange execution volume. Their popularity is reminiscent of the late 1990s, when new order-handling rules gave birth to ECNs such as Island and Archipelago.

In 2007, BATS and rival Direct Edge rapidly built reputable franchises, handling double-digit percentages of Nasdaq-listed stock executions and making headway into Tape A and Tape B securities.

BATS’s growth has largely stemmed from providing streamlined and cheap pricing, plus fast technology, and receiving an early liquidity kick from its broker-dealer owners. The ECN launched in January 2006 with abundant liquidity provided by high-volume electronic market makers Getgo and Tradebot, which were also stakeholders. It also helped that CEO David Cummings, a majority owner of BATS and sole proprietor of Tradebot, was intimately familiar with how to attract that type of liquidity.

By the end of 2006, BATS had pulled in more owners, including high-profile Credit Suisse and Morgan Stanley, and had connected 50-odd subscribers that traded upward of 130 million shares a day, or about 6 percent of Nasdaq consolidated volume. Cummings said then that executing 10 percent of Nasdaq shares was crucial to achieving “critical mass.” That prompted the ECN to institute the first-ever inverted fee schedule. The “January special” rebated $0.003 per share to provide liquidity and charged $0.002 per share to take it.

This aggressive strategy defied conventional wisdom that liquidity couldn’t turn on a dime to other markets. By the end of the month, BATS had more than doubled its volume, capturing low double-digit percentages of Nasdaq volume. Since then, its Tape C volume has hovered around the 10 percent mark, but overall volume had more than doubled by November, mostly from executions in Amex- and NYSE-listed stocks, the latter of which began trading over BATS in early February.

The exchanges–including the regionals–took notice of BATS’s aggressive pricing and adjusted their fees schedules to compete. “BATS has been very effective in holding rates to a reasonable level,” says George Hessler, head of business strategy at Lime Brokerage, an investor in BATS and an agency brokerage whose customers choose their order-routing destinations.

Like other alternative trading systems, there’s more to BATS’s volume numbers than meets the eye. The ECN drew 2.8 billion shares in the first 10 trading days of November, but it actually matched 2.3 billion, routing the difference.

Even so, BATS is still drawing that liquidity, charging a lower routing fee than Nasdaq to all but the biggest order providers. Indeed, says Hessler, BATS’s flat fee structure and lack of other fees have bolstered its success. Nasdaq, on the other hand, has several execution fee levels depending on volume. It also charges $400 per month for FIX connectivity and other fees.

BATS’s technology also receives kudos. It currently can turn around orders in as little as half a millisecond, and it plans to shave that to 300 microseconds over the next several months, according to Joe Ratterman, president and CEO of BATS.

Ratterman acknowledges that Nasdaq’s technology, stemming from the Inet ECN it purchased in 2005, is a “good quality system” and fast, a factor treasured by electronic traders. That, no doubt, is partly why Nasdaq’s matched volume has actually picked up this year, despite the gains of ECNs.

“There’s definitely been growth in BATS market share this year, but not at the expense of Nasdaq,” says Brian Hyndman, senior vice president of Nasdaq’s transaction services unit.

Hyndman notes that the exchange executed 44.8 percent of Nasdaq’s consolidated volume in January, climbing to 47 percent by mid-year and dipping to 46 percent by November. “Pricing matters, but it also comes down to liquidity, and we are the largest destination for Nasdaq-listed securities,” Hyndman says.

BATS’s success, instead, appears to have come partly at the expense of NYSE Arca, which reported October and November execution-share volumes, respectively, at 14.1 percent and 15.5 percent, down from 19.1 percent last January.

Cummings, who still owns Tradebot, left BATS management in June to make way for the ECN’s next big step: becoming an exchange. BATS talked earlier this year to regional exchanges about possibly acquiring one to achieve exchange status. Finding their asking prices too high, BATS filed its application with the Securities and Exchange Commission on Nov. 5, a daunting endeavor given ECNs’ past difficulties in gaining exchange status via regulatory channels. Given that BATS’s execution volume has far outstripped any of the regionals, one insider called the move a bargaining chip for future negotiations, adding, “If BATS could get approval, those regionals’ exchange licenses would become effectively worthless.”

 

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