SIA CONFAB Brings Out: The Order Routers

Editorial Staff
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(Traders Magazine, July 2005) — Vendors in the business of delivering orders from the buyside to the sellside were front and center at Wall Street's annual technology show. The Security Industry Association's Technology Management Conference & Exhibit, held in New York last month, had displays from about a dozen network vendors.

Some of the booth jockeys were looking exclusively for sellside-to-sellside business. Most of the largest though were touting their strengths on the buyside-to-sellside front.

Old stalwarts mixed with aggressive newcomers.

Thomson, Reuters, SunGard, Davidge/GL and TNS were part of the old guard. NYFIX and IMTrader were two of the up-and-comers. All were bullish on growth.

"We've experienced double digit growth in the number of connections we facilitate for the past five years," said SunGard exec Mark Volker. "The buyside is increasing the number of its connections."

Basically, order routing involves the sending of a FIX message containing trade information from a buyside order management system to a sellside order management system. Some vendors though are moving beyond the basics. Others struggle with the basics. At least one player is reinventing the basics.

Below is a sampling of vendors at the show and a look at their strategies.

IMTrader Takes AIM

Possibly the most innovative player in buyside-to-sellside connectivity is IMTrader.

The maverick vendor recently launched the IMTrader Network, which is integrated with America Online's vast instant messaging network. AIM, as it is called, has become a ubiquitous communication tool on buyside and sellside trading desks. And many of the text conversations carried by AIM consist of trade instructions.

IMTrader's technology is able to recognize trade instructions amongst all the other chit-chat within an instant message. It then converts the instructions into FIX messages. The FIX messages are then deposited into the brokers' order management systems.

"People love to send orders without the expense of maintaining point-to-point FIX connections and integration with an OMS," noted IMTrader chief executive Furqan Nazeeri. "Because of the ubiquity of AIM, we've created a tool that gives anybody on the buyside access to a network."

The two-year old IMTrader was spun off from buyside order management system vendor Eze Castle. It has signed up about 300 buyside shops employing some 700 traders for the routing service, according to Nazeeri. It has about a dozen brokers on the network with eight more currently in the pipeline.

The firm is targeting the thousands of money management firms that trade too infrequently to warrant the purchase of an order management system or a relationship with one of the major network suppliers.

SunGard Goes Beyond the Trade

As FIX connectivity becomes something of a commodity, its suppliers are scrambling to differentiate themselves. Some are building out globally. Others are offering additional services.

SunGard is one that believes the game is about more than order delivery. The sprawling financial technology firm is focused on "the whole trade life cycle," according to Volker. "We don't see ourselves as being just an order routing network," he says. "We also do FIX allocations and are signing more brokers to that every week."

Once a trade is completed, shares and cash may have to be allocated to numerous accounts. Volker maintains that a year ago, players would choose one vendor for routing and another for allocation messaging. Sungard, he says, now does both.

The vendor is also keen on leveraging its network for the transport of execution messages to custodians. Those could be institutional custodians, brokerage custody shops or simply a prime broker. For the buyside, the information necessary for settlement is essentially the same as that for allocations. "It's just a different way of rolling it up," says Volker.

Volker counts between 1,200 and 1,400 buyside shops on the SunGard Transaction Network. Not all are direct connections as STN also connects to competitor networks. About two-thirds are direct connections, according to Volker. The six year old STN is also patched into about 180 brokers.

Volker says growth is coming primarily from buyside desks adding more plain vanilla brokerage connections. But connectivity to specific broker algorithms or families of algorithms is also keeping SunGard busy. Some brokers require a separate connection for each of their algorithms. Others require just one to access all of their offerings.

Reuters Reconstructs

For Reuters, the need has been to bring some order to a sprawling collection of networks around the world. Late last year, the information giant announced that it had rolled out a single equities and equities derivatives transaction network.

Called Reuters Order Routing for Equities, or RORE, the system replaced what had been multiple networks requiring multiple connections, according to Reuters exec Tom Gros. "You can now have a single connection to a single resilient network," he says. "It's simply more efficient." RORE supports about 500 buyside and 200 sellside shops.

Reuters' clients want access to global pools of liquidity, Gros explains. They don't want to be limited to market centers situated in their home countries. The new configuration makes that possible. "It is better to have a single resilient network," the exec adds, "than to try to operate multiple networks on different platforms using different standards."

Despite its efforts to build a single worldwide platform, Reuters isn't setting up shop in every country. As part of the global roll-out, Reuters is partnering with other networks in countries off the beaten path. It recently signed deals with networks based in Australia and New Zealand as well as South Africa.

Reuters to-do list includes more than just rebuilding the structure of its network. Customers have also asked Reuters for more flexibility in how they access the network. Traditionally, traders could only send orders through Reuters networks from proprietary front-ends such as the Reuters Station market data terminal.

Lately, though, Reuters has been certifying with vendors of buyside order management systems. "We've made the network, through APIs and other means, elegantly compatible with a number of major OMSs," Gros says. "So it provides an elegant level of connectivity and straight through processing."

RORE is certified with OMSs from Charles River, LineData, and Beauchamp.

NYFIX is Bullish on Bells and Whistles

Until two years ago, NYFIX delivered connectivity solutions to the sellside exclusively. It was best known for transporting orders from upstairs desks to the floor of the New York Stock Exchange.

But now NYFIX claims to get nearly half its revenues by providing routing and transaction services to the buyside. The dramatic change was precipitated by its acquisition of Javelin Technologies, which operated a large buyside-to-sellside network.

As of the third quarter of 2004, the last period from which data is available, NYFIX boasted 150 buyside shops on it network. That number is now higher, according to NYFIX exec Bob Gasser, because of the opening of data centers in Europe and Asia. "This is the fastest growing business NYFIX has ever experienced," Gasser says.

NYFIX is firmly in the camp that believes networks must incorporate bells and whistles in order to compete. One such add-on is Millennium. The blind crossing system intercepts and tries to match orders hurtling down NYFIX' pipes to the Big Board.

More buyside flow is hitting Millennium, according to NYFIX. Indeed, executed volume has remained consistently above 20 million shares per day in recent months. That has not been the case for most of the three years Millennium has operated.

NYFIX is not stopping there. The vendor is building out a transaction cost analysis platform that allows buyside traders to evaluate the quality of their executions on orders sent over the network. If the buyside desk is accessing 10 brokers over the network, it can compare all of their performances as the trades are reported back.

Gasser says the TCA product has convinced some buyside shops to drop their existing network providers and switch to NYFIX. The competition, the exec notes, is primarily Thomson's ATR and Transaction Network Services.

"The network business is competitive," Gasser says. "And one in which we will have to provide more and more product to compete."

Thomson Fixes Algorithms

For Thomson Financial, it's all about the algorithms.

The operator of the AutEx Order Routing network has been adding functionality that supports the FIX tags needed to facilitate the sending of algorithmic trades. With the changes, buyside traders can structure the trade themselves by inputting various parameters.

On the receiving end, Thomson has worked with a dozen of the major brokerage suppliers of algorithms, including Citigroup, Merrill Lynch, UBS and CSFB. On the order-sending end, Thomson has certified with the major order management systems vendors, including Linedata.

The initiative is part of Thomson's push to make order routing a bigger part of its connectivity business. Thomson is best known for its indications of interest services. "We've devoted a lot of time and energy to improving our technology and our sales coverage," Thomson exec Bob Moitoso, says.

On the technology front, Thomson has beefed up capacity. It's original order routing service, TradeRoute, was, for some time, hamstrung by capacity limitations. "We were a victim of our own success," Moitoso notes.

Thomson's AOR network encompasses 200 buyside and 225 sellside shops. Access on the buyside is exclusively through order management systems. That includes Thomson's own Oneva system, deployed at some 40 money managers.

Latent Zero Networks

Editorial Staff
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(Traders Magazine, July 2005) — Latent Zero is going into the network business. The high-end buyside order management system vendor is launching a point-to-point FIX order routing network to transport its users trade instructions to brokers. Latent Zero already performs some connectivity chores for its clients such as FIX certification, but has decided to manage the entire end-to-end process. The vendor's execs offer two reasons for the move. First, they want to grow revenues. Second, they say the sellside, which will pay for the service, wants Latent Zero to take responsibility for the entire message relay process. Latent Zero's move makes it the fourth buyside OMS vendor to latch on to order routing as a way to make extra money. Macgregor has operated a network for nearly a decade. Charles River Development and LineData Services each launched services in the past year.

New Initiatives at BRASS

Editorial Staff
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SunGard's BRASS trade order management system earned its stripes on the back of its OTC market-making ability. For more than a decade, it has been the leading platform for market-makers. About 70 percent of Nasdaq orders currently go through BRASS. But with the trading landscape changing and competition gearing up among sellside OMS's, BRASS has had to emphasize its strengths.

(Traders Magazine, July 2005) — Patrick Lynch, president of BRASS, a SunGard Trading Systems business unit, admits that BRASS has not been effective in telling its story. "BRASS has 200 clients and is the market-leading entity in sellside OMS's in the U.S.," he says. "With our Universal Market Access and Broker Direct U2 products, we're also the largest in the direct market access space as well."

Lynch recognizes that BRASS has competitors, but says the firm is well positioned. In the last year, BRASS has emphasized increasing its attention to compliance and compliance-related issues. In addition, BRASS has launched a number of user groups to provide input on various aspects of the ASP model, its testing services and other development initiatives.

In the DMA arena, BRASS's new-generation Broker Direct U2 (which uses Microsoft's .Net platform) and UMA products are being expanded to offer broker-sponsored algorithmic trading to sellside clients and their customers. To extend its reach, BRASS recently struck up an arrangement with Advanced Financial Applications' IMPACT Pro to integrate its sponsored DMA capabilities into AFA's suite of trading tools oriented toward small- and medium-size hedge fund clients. Last month BRASS also unveiled BRASS Buy-Side Direct, a broker-neutral DMA platform that brokers can extend to their buyside clients.

Lynch took over as president in April when James Leman left SunGard Trading Systems to become head of execution trading for HSBC Securities. Lynch, who was COO until then, previously served as CEO of Sector Inc., the telecom services division of SIAC, the Securities Industry Automation Corp.

Mark Clark, executive vice president, heads the BRASS DMA effort. Last year BRASS also hired Andrew Cinquina from Goldman Sachs as head of development. He oversees product integration, product expansion, and the development of new technologies, and will focus on global – not just U.S. domestic securities – markets. Lynch notes that BRASS is primed to win market share overseas because of its OMS and DMA strengths, despite a relatively flat market.

Overall, BRASS execs stress that they are focusing on initiatives to benefit brokers and other customers, address compliance obligations and increase efficiency. Traders Magazine Contributing writer Nina Mehta spoke with Lynch and Clark about how BRASS plans to do that.

Traders: Give us an overview of what you're currently working on at BRASS.

Lynch: We're building on our core products and developing new products and relationships to better serve our sellside clients – and expanding that to help them with their clients. The BRASS OMS is our bread and butter product. On top of that is our DMA suite of offerings – it's an area of fast, important growth for us. We also have an indications-of-interest aggregation service, an allocations product, and we're working on other products that can be bolted onto both the DMA and OMS. In addition, we're expanding our ability to test against our products in various market venues.

Traders: What's the biggest challenge you face as a technology provider?

Lynch: It's the rate of change. It's the regulations that are impacting the industry and the need by clients to be quick to market with new ideas.

Traders: What are you doing first?

Lynch: Our DMA products are being expanded at a rapid pace, with the broker-sponsored model helping our clients reach their customers and making it easier for those customers to trade with them.

Traders: How does that work? Do they get access through the broker's server?

Clark: We're providing the technology link that allows brokers to extend their market memberships and trading capabilities to their buyside clients. They can essentially offer their clients the same front-end trading capabilities they use on their own internal desk-whether for market-making, agency, or proprietary trading. The buyside clients have the market data, the automated trading tools, and the electronic access to the market and to the sponsoring broker. We also give our sellside clients a set of tools that allow them to safely monitor, manage and administer those capabilities.

"We cut our teeth on OTC."

Patrick Lynch

Traders: What exactly do the brokers monitor? Clark: Positions, orders outstanding, how much stock is being traded, and so on. In an unintermediated electronic trading environment where there's direct access, there's always a risk that a big order outside the credit limits of the buyside firm may get placed, or that an error will occur. Ultimately, the risk rests with the broker because it's the broker's market memberships and broker-dealer licenses that are being used for that market access. Traders: Is that a compliance issue? Clark: Yes, not to mention a business risk. Traders: In the U.S. you've faced more competition over the last couple of years. How has your client base shifted? Lynch: We've seen a washing back and forth. The top-tier clients include Wachovia, Deutsche Bank, UBS, Lehman and Bear Stearns. We have large service-bureau-type firms like Fidelity's National Financial Services and Pershing, which caters to correspondent banks. We also have quite a number of market-makers and agency brokerage firms as clients. Traders: BRASS has been known principally for its OTC market-making capability. Lynch: Yes, but it has now been extended out to all aspects of equity trading across desks. OTC markets were the tougher go – and that's where we cut our teeth. Clark: In both our DMA and OMS offerings we have standard listed block trading and now a market-making capability. With the changes coming in Regulation NMS and the combination of exchanges – ArcaEx and the NYSE, and Nasdaq and INET – the industry will probably see some of the traditional trading distinctions between the two markets go away. There will be more sectorization and a dramatic increase in electronic trading in NYSE-listed stocks. Traders: How many firms currently use BRASS for listed market-making? Clark: Fifteen right now. Traders: So where do you see the amount of electronic trading going in a Reg NMS environment? Clark: On the NYSE, we think volumes will go electronic to a dramatic extent in the next five years. The projections are that the message traffic generated by that electronic trading could go up 2-4 times. Lynch: Right now we're planning for a four-fold increase in message traffic over the next few years, although we'll be up that curve sooner. We see ourselves as a strategic vendor to our clients. We openly discuss our development plans, and what our pipeline looks like, and they give us insight into what they're developing and what types of volumes they're looking for their systems to handle. The top-tier and tier-two brokers rely heavily on us as an OMS and DMA provider and on our ASP model in general – they've outsourced that risk to us. And they want to make sure we can handle that.

"We're making a number of algorithmic destinations available."

Mark Clark

Traders: What have you done to your technology infrastructure to ensure you can manage the increase in message traffic? Clark: We've looked at our market data engines and at our bandwidth utilization and availability. All this must be scalable – that's why we've engaged several extranets, so we can increase bandwidth in 24 hours as opposed to six weeks. We are looking at how we integrate our own market data systems, and we're looking at common-services architecture models so we can be more resourceful internally and not have latency issues as we move data around. Traders: How will life change for users of BRASS and U2 under the new trade-through rule? Clark: The primary changes are in two areas: order placement and compliance. On the order placement side, the routing logic has to be modified, although we already have most of the connectivity. Clients also have to be able to deal with the VWAP and block trading exceptions. On the compliance side, we must make sure that orders going out are in compliance with the rule and also that our customers have the ability after the fact to compare where they placed those orders with what was going on in the market at that time. Traders: Are you building your own algorithms into BRASS and U2 or integrating broker algorithms? Clark: We're doing both. Through BRASS and U2 we're making a number of algorithmic destinations available. We currently have five, including Credit Suisse First Boston and Banc of America Securities. We also have a suite of algorithms in the DMA application that are more commonplace – VWAP and various smart orders that give clients basic time-slicing and other capabilities. Traders: Do you plan to provide some sort of post-trade analytics so DMA users will know when one algorithm is likely to perform better than another? Clark: There's a lot of interest in that but there are no clear standards and benchmarks. We've started conversations with some outside providers to create a partnership there, but we have no offering now. Traders: When will you integrate a third-party program trading suite into BRASS/ U2? Clark: We've just announced that we'll be integrating Portware Professional's advanced program trading application into our offerings. There's a real value to our clients in having an integrated turnkey program trading solution on a service-bureau basis. Traders: Have the recent acquisitions of DMA systems by brokers altered your marketing of U2? Clark: We're the only leading DMA provider that's broker-neutral. Our clients whose competitors have a broker-provided DMA system have real neutrality concerns. Not only are they giving money to that competitor, but they're providing knowledge and order flow through those systems. Traders: There's never a shortage of paranoia or fear on Wall Street. Lynch: Yes, but if your product isn't good enough or better, and if it isn't additive to the bottom line, brokers won't make the change. The significant wins we've experienced prove that we solve for both. Traders: How many in the past six months? Lynch: DMA for us started as a product about 15 months ago, so we've had 53 wins in 15 months. Some of them are the largest names on the Street. A year from now we'll probably double the number of clients to 105. We're doing product integration with the UMA product now and then expanding beyond that. Traders: U2 will replace UMA, right? Also, is BRASS planning to offer access to futures, options or currency trading? Lynch: Yes, to the first question. U2 will be the sole platform for DMA. Over time we will see that integrated more tightly into the overall OMS even though it will still be a modular offering. Regarding other products, we're listening to our brokers whose clients are institutions and hedge funds. Those market segments are asking for listed options. And if single-stock futures take off, that will probably be an aspect of our offerings. We're marching down both those paths. Traders: What point would you like to make that we haven't talked about today? Lynch: There's been a real shift in how we perceive ourselves and how clients perceive us. The marketplace is recognizing that BRASS has rejuvenated itself along many lines and has made investments and increased the level of customer service, and that we are engaging our clients more proactively on market strategy in order to position ourselves better. We get input from our 200 clients on the ASP model and we can see what their priorities are. We are making certain that our development programs are in lockstep with that. Traders: How would you quantify that rejuvenation in terms of spending? Lynch: We've increased our capital expenditures and our OMS and DMA client services. We've put an even greater emphasis on QA [quality assurance] and testing – our clients are demanding that we pay more attention to that. We've been investing across the board, and it's paying off. We have gained market share vs. our competition in a fairly static marketplace.

SEC Explains: Reg NMS Passage
Order Protection Rule Finally Clarified

Editorial Staff
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(Traders Magazine, July 2005) — The long-term needs of individual investors must trump those of professional traders.

That was the gist of the reasoning used by the SEC in explaining and justifying its huge Reg NMS market structure reform. It argued that the regulation would provide "strengthened assurance that orders will be filled at the best prices," according to the SEC Reg NMS release.

This will give retail investors, "greater confidence that they will be treated fairly when they participate in equity markets," according to the SEC.

Reg NMS is a package of reforms (See "The Basics of Reg NMS") that includes order protections, limiting sub-penny trading and access fees. It is a package that constitutes the most comprehensive market structure changes since the mid-1970s, market observers said.

The jewel in the Reg NMS crown is the reform of the controversial trade-through rule-or what the SEC calls the order protection rule-for top of the book quotations and the extension of the rule to all Nasdaq stocks.

A trade-through happens when one trading center executes an order at a price that is inferior to the price of a protected quotation, often representing an investor's limit order displayed by another trading center.

The SEC staff, in a study of Big Board and Nasdaq trades, found that one in 40 listed and non-listed trades are executed by some form of a trade-through. The SEC contended that this is a significant number. This is burdening individual investors with superfluous costs and decreased investment returns, the SEC said.

"The transaction costs associated with the prices at which their orders are executed represent a continual drain on their (individual investors') savings," according to the SEC.

The expansion of the limit order rule, which will have a few exceptions but no opt-out provisions, will encourage the use of limit orders, the SEC said. It will also promote greater market depth and liquidity, the regulators claimed. This will lead to more competition between orders as well as competition between exchanges, regulators said.

But officials of several electronic trading venues had implored the SEC to junk the controversial rule or permit significant exceptions to the rule. The latter was called "a relic" by U.S. Representative Richard Baker (R-La.), the chairman of a key House subcommittee. (See "Baker Q&A").

The SEC staff released the much-awaited Reg NMS order in early June some two months after the SEC approved the NMS policy.

This came after a three-to-two vote in which dissenting commissioners bitterly complained NMS constituted "excessive" regulation. The maverick commissioners insisted on publishing a minority opinion. (See "Dissenting").

But the majority commissioners and the staff held, in an adopting release of huge length, that the needs of the general public outweighed those of professional traders.

"Should the overall efficiency of the NMS defer to the needs of the professional traders, many of whom rarely intend to hold a position overnight?" the SEC rhetorically asked.

The regulators answered the question by arguing that their mandate was to "avoid excessively volatile markets." These are markets that short-term traders can exploit, but put long-term investors at a disadvantage, the SEC wrote.

The returns of long-term investors today are hurt by explicit and hidden costs, according to the SEC.

The regulators claimed annual hidden trading costs were "dwarfing" explicit trading costs. They said that these hidden, or implicit, trading and liquidity costs are "estimated at more than $30 billion a year" for mutual funds and other institutional investors. They pay through the unusual volatility of markets, regulators asserted.

"These investors thus are inherently less able to exploit short-term price swings and, indeed, their buying and selling interest often can initiate short-term price movements," according to the SEC release.

The SEC also built its case on a staff finding that a "significant amount of trade-throughs are occurring in both Nasdaq and NYSE stocks. And that these trade-throughs are resulting in inferior prices" for the general public.

"It" (the SEC staff) "found that the overall trade-through rates for Nasdaq and NYSE stocks were, respectively, 7.9% and 7.2% of the total volume of traded shares."

Trade-throughs, the staff found in a year-long study of trading patterns, resulted in inferior prices of between 2.2 cents and 2.3 cents.

The regulators, in advocating the expansion of the limit order protection rule, also argued that, without one rule governing all NMS stocks, market players would be confused.

"A uniform rule for all NMS stocks," the SEC wrote, "by enhancing protection of displayed prices, would encourage greater use of limit orders and contribute to increased market liquidity and depth."

The Basics of Reg NMS

1)Order Protection Rule.

"Requires trading centers to establish, maintain and enforce written policies and procedures reasonably designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers, subject to an applicable exception. To be protected, a quotation must be immediately and automatically accessible."

2)Access Rule

"Requires fair and non-discriminatory access to quotations, establishes a limit on access fees to harmonize the pricing of quotations across different trading centers, and requires each national securities exchange and national securities association to adopt, maintain and enforce written rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations."

3)Sub-Penny Pricing

The rule "prohibits market participants from accepting, ranking, or displaying orders, quotations, or indications of interest in a pricing increment smaller than a penny, except for orders, quotations, or indications of interest that are priced at less than $1.00 a share."

4)Market Data

"The Commission is adopting amendments to the Market Data Rules that update the requirements for consolidating, distributing, or displaying market information as well as amendments to the joint industry plans for disseminating market information that modify the formulas for allocating plan revenues."

Dissenters Challenge: Trade Through
Atkins/Glassman Attack

Editorial Staff
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(Traders Magazine, July 2005) — Reg NMS "contrived" problems that were not "substantiated," according to Paul Atkins and Cynthia Glassman, the SEC commissioners who voted against it.

The problems came out of complaints by individual investors and unnecessary transaction costs on the NYSE and the Nasdaq. "Excessive" volatility and high trade-through rates were also documented in a study by the SEC. But the majority of commissioners in favor of Reg NMS "cherry picked" statistics from a study to fit their prejudices, Atkins and Glassman charged.

"The Reproposing Release claimed that 7.9% and 7.2% of the total share volume on Nasdaq and the NYSE, respectively, were traded through," the two commissioners wrote in an unusual dissent that ran to 40 pages.

But the "Release failed to point out, however, that these trade-through rates were calculated, not on the basis of a quotation's displayed size, but on the size of the order. Thus, an order executed at an inferior price was considered to have been traded-through at its full size even if the order was for a large number of shares that were available in the market," according to the dissent.

When exceptions are factored in for the trade-through rule, the Nasdaq trade-through rate was actually between 1% and 2%, Atkins and Glassman said. They added that the majority's cited trade-through figures were "overstated." That's because they didn't include trades for institutions, intermediaries and sophtisicated individuals.

"The minimal trade-through results reflected in the study," the two commissioners wrote, "do not support the conclusion that trade-throughs are a significant problem-certainly not one that justifies regulatory intervention on the scale of Regulation NMS."

The extension of the trade-through rule will likely hurt competition among market makers, the pair said. They will concentrate on price, paying less attention to other aspects of the trade, the two commissioners warned.

"Given the rule's sole focus on price," they wrote, "incentives to improve execution quality above and beyond the trade-through rule's mandated execution methodology may be reduced."

Atkins and Glassman offered their own plan for market structure reforms. Better access to quotations, improved connectivity among markets and market participants as well as a clarification of what constitutes a broker's best execution obligations.

The Reg NMS Debate Goes On:
NMS Decision

Editorial Staff
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(Traders Magazine, July 2005) — Representative Richard Baker, the chairman of the House Subcommittee on Capital Markets Insurance & Government Enterprises, opposed the recently passed Reg NMS plan. He was critical of the extension of the trade-through rule, or what the SEC calls the order protection rule.

Baker (R-La), in the months leading up to the final adoption of Reg NMS by the SEC, called the trade though rule a "relic" and an "anachronism." Along with much of the electronic trading industry, he has advocated the end of the rule.

In the days after the controversial three-to-two SEC vote, Baker and others on Capitol Hill hinted that they might try to reverse the SEC's decision. However, no lawmaker would commit to trying to override the commission's action until the unveiling of the order. That 500-page order was recently released. Rep. Baker discussed Reg NMS issues with Traders Magazine's Gregory Bresiger.

Traders: The SEC, in passing Reg NMS, said it was putting the best interests of individual long-term investors-who it said are paying excessive transaction costs because of undue volatility-over those of professional traders who often hold stocks for very short periods.

Congressman Baker: I don't know that I agree with their reasoning. I agree with the underlying premise that investors should be treated the same regardless of the dollar flow they bring to the market, regardless of in which profession they engage. The overarching mission of the Congress and the SEC should be to ensure transparency and that all orders are treated in an equitable manner. But I don't necessarily agree with all the SEC conclusions.

Traders: The SEC staff built its case on an OEA (Office of Economic Analysis) study that found that trade-through rates on both the Nasdaq and the NYSE are excessive. They said that they were 7.9% and 7.2%, respectively. That is resulting in "inferior prices," the staff said. That study's authenticity was disputed by the two dissenting SEC commissioners. Who is right?

"If we want to have uniformity, let's abolish the trade-through."

Congressman Richard Baker

Congressman Baker: Based on historic information, that is material provided to me over time, those reported rates appeared to be inconsistent. I'm not conversant with the individual who developed the data on which this report was based. I haven't had the opportunity to do any due diligence on how the report was prepared. But it does seem to be inconsistent with the historical data in my review of the trade-through patterns of both the Nasdaq and the NYSE. Traders: You have been a critic of the trade-through rule and have agreed with those electronic market officials who wanted the rule scrapped. Do you think getting rid of it would have been the best thing? Congressman Baker: As an interim step, I think there was a political, not a policy, compromise that could have been achieved. That is, if they would have adopted Reg NMS without extending the trade-through to the electronic exchanges, that would have been a tolerable circumstance, especially in light of what would subsequently occur with the Nasdaq/INET, New York/Arca arrangements. That indicated to me that even the New York recognized that its future is in a more automated system. Clearly, to extend the trade-through to the electronic exchanges was unwarranted and ill-advised policy. I have likened it to a two-person working family household having a single car and selling the car to buy two horses in order to save on parking costs. It just makes no logical policy sense at all. Traders: The SEC said that one of the arguments for a uniform trade-through rule is that everyone should have the same rules in trading. Doesn't that make sense? Congressman Baker: That seems to argue for the principle that where we have a bad rule everybody should be under it simply because that creates equality. When you get the quote from the New York market, as the individual investor, that is not necessarily the best price at the time of execution. In fact, it may not be the price at which you closed. I suggest that the rule itself misrepresents the market's conditions to the non-professional trader who doesn't understand the trade-through's function. If we want to have uniformity, then let's abolish the trade-through rule. Traders: The SEC's decision was heavily criticized by senators Crapo, Shelby, Bunning and yourself, congressman. But the mechanism exists for Congress to override a controversial decision by a commission, the Congressional Review Act. Will you or someone else utilize it? Or is it possible that a new SEC chairman, Christopher Cox, will consider undoing some or all of the Reg NMS plan? Congressman Baker: It would be entirely inappropriate for me to talk about the new SEC chairman's disposition in this matter, although I have high regard for Mr. Cox's intellect. But I have some expectations about where he will lead the SEC in the months after his conformation. I'd rather have the chairman take his time and do his analytical due diligence with his own view of what market structure should look like, not just tomorrow but going into the next decade. But I believe chairman Cox will try to construct rules that are equitable for all, but will facilitate the advantages of modern technology. Traders: And what about you and your colleagues on the Hill. Will you do something about Reg NMS? Congressman Baker: I have had staff examine the legislative opportunities available to us in light of the commission's decision. And there's more than one direction that we could take. Again, in light of the change in SEC chairmanship, and I'm not certain where chairman Cox would come down, but I have a pretty good feeling, it might be that the regulatory review by the SEC chairman might yield some benefits without the political difficulty of managing something through Congress. However, there are other options that could be exercised and I would exercise them if I came to the conclusion that was the only direction we could go. Traders: You mean hearings or instructing the SEC to do certain things? Congressman Baker: No, there are other procedural remedies that my legal counsel has examined and are putting together plans of action that could be taken. The most appealing is working with chairman Cox. It has no time constraints and we could decide at sometime if congressional action might be or should be taken. Traders: This is not invoking the Congressional Review Act, which requires action within 60 days, right? Congressman Baker: No Traders: So what exactly are we talking about? Congressman Baker: I've got attorneys preparing documents to give me comfort that the legal position that they are espousing is one that I can share. I believe it could be defended. But I would prefer to wait for documents from counsel before I make a claim that I might later back away from. But at this juncture, work is under way to establish a course of congressional action that I could take at a later time. Traders: In their dissent, the two SEC commissioners voting against the final Reg NMS version wrote, "Given the rule's sole focus on price, incentives to improve execution quality above and beyond the trade-through rule's mandated execution, technology may be reduced." Do you agree?

"Techonology-based markets are basically going to have to develop a dumb market."

Congressman Baker: Yes that's a possibility. I'm struck by the fact that technology-based markets are basically going to have to develop a dumb market to be able to handle orders in the slower manner that is dictated by the extension of the trade-through. All of it, from any perspective from which I have viewed it, seems to be illogical. And I would have a difficult time disputing the opinions of the two dissenting commissioners. Traders: The dissenters also offered their own market structure reforms. Better access to quotations, improved connectivity among market participants as well as a clarification of what constitutes best execution. Is that what is needed? Congressman Baker: It would seem on the face of the statement to be a logical summary of where we should go. And I believe that it is a direction that chairman Cox would be comfortable with as well. Traders: Congressman, thank you. Congressman Baker: You're welcome.

Traders Bemoan: Compliance Headaches

Editorial Staff
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(Traders Magazine, July 2005) — Paging trading compliance pros. This is your kind of market. Potential regulatory problems today worry buyside traders as never before. That's according to a new study by Tabb Group, a Westborough, Mass.-based consultant to the securities industry.

The study also pointed to two other major concerns among the 53 buyside traders it interviewed: fragmentation and liquidity. The one surprise in the study? Market structure dropped far down on the list of buyside concerns.

"When asked what the largest change in their role was over the past year, 32 percent of all

firms mentioned compliance," according to the annual report, "Institutional Equity Trading in America: A Buy Side Perspective."

"Compliance is the big buzz word today," said Benjamin Sylvester, an equity trader and managing director at Boston-based Babson Capital Management. Sylvester was a participant in the survey.

Compliance was the number one category in the study, which asked traders about the biggest change they have seen over the past 12 months. Trading technology and assets under management were the next most commonly mentioned topics, with each registering at 19 percent of respondents.

"Compliance is the big buzz word today."

Benjamin Sylvester, Babson Capital Management

Still, most traders polled said that regulatory risk is paramount. And several traders contacted by Traders Magazine agreed. Those contacted also pointed out that the regulatory sands are shifting, so longstanding rules and policies can often be the subject of reinterpretation. And that can be an intimidating development for any head trader. Anxious Sylvester said that traders are usually "anxious" about any rule changes. But the amount of changes coming from the implementation of Reg NMS, the New York Stock Exchange's hybrid plan and the mergers of the two biggest exchanges will be unprecedented, Sylvester says. "We're facing so many questions about connectivity, latency and how market centers will link up with these regulatory changes that a certain amount of anxiety is understandable," Sylvester added. Indeed, in several ways regulatory issues affect the way the desk conducts business. Reducing this potential risk has led to the popularity of low-touch and no-touch trading, the booming algorithm business, the intensive use of pre-trade analytics as well as the reduction or the elimination in the use of soft dollars at many firms, according to the report. Busy Traders "Traders are spending about 40 percent more time today than in the previous year reviewing paperwork and making sure that everything is in order," according to Adam Sussman, the author of the report. "Some of that is because of soft dollar programs, many of which are being discontinued by large firms that don't see them as worth the potential trouble," he added. The Tabb report also predicts that the unbundling of soft dollar services-a proposed measure pending before British regulators-will eventually become the universal standard. That's a debatable point among traders. "I don't think that unbundling is going to happen with the SEC. But I do believe that there are going to be more soft dollar rules and regs on disclosure," David Brooks, director of global equity trading at the Boston Company, told Traders Magazine. More Rules, Regs But Brooks explains that his firm is devoting more time than ever before to regulatory paperwork. Brooks said that regulation is a growing problem for the buyside. Why? "The lack of guidance" from the SEC, Brooks said. "We're waiting for them." Brooks said the buyside wants direction on commission management. "Who pays them? How do we report them? We're spinning our wheels on issues of trading and execution until the SEC weights in," Brooks said. Still, Sylvester argues that some regulatory uncertainty is inevitable. Every firm has unique situations, he noted. "And after all, if everything was clear, then there would be a lot of compliance people out of work," Sylvester said jokingly. He added that firms with "a clearly stated and strongly monitored trading process" generally are given leeway by the regulators. But the head of another desk, who didn't want to speak on the record, says even a tight process might not protect a firm over soft dollar and entertainment expense issues. "How do you classify golf? Is it a business expense?" he asked. "Is it entertainment? Or is it a gift?" "Soft dollars," Sylvester agreed, "is one area where we would all benefit if the SEC gave us more direction." Sussman added that the average buyside trader also has put regulation at the top of the agenda as a result of "one upmanship." This, he explained, is a kind of competition for headlines between aggressive state regulators and the Securities and Exchange Commission. "Careful What You Wish For…" The other big issue for traders demonstrates one of the contradictions of the trading industry. For years, traders have asked regulators to fix the problems of market structure. Now-with the Reg NMS reforms on the way in an effort to solve market structure woes-traders are concerned about the fragmentation/liquidity issue, according to the study.

"Year over year, traders spent 40% more time on compliance."

Adam Sussman, Tabb Group

"Finding liquidity is the biggest problem today," one trader told Tabb Group. Indeed, fragmentation complaints nearly doubled to 83 percent of respondents compared to the previous year, according to the study. Traders are coming to see that-in their attempts to serve clients and because of competitive pressures-they are causing many of their own problems. The report said it is the relatively new technologies and strategies that cause fragmentation. "Tabb Group believes fragmentation and the inability to find size are due to higher usage, and greater awareness, of alternative trading technologies, such as DMA (direct market access) and algorithms." Boston Company's Brooks said he is unfazed by market fragmentation. "As long as liquidity is out there and you have the right tools to find it, you don't have a problem," he said. Tabb Group's Sussman says that these technologies mean that the buyside has gained more control over the order-execution process. However, control of the process has its downside. "As they won that control, the buyside has learned that the game that they are playing is hide and seek," according to Sussman. "And, since everyone else is now doing that, the amount of liquidity that gets displayed in the marketplace is diminished," Sussman said. Find A Solution The liquidity/market structure anomaly, he adds, is that the brokers say that they want a solution to fragmentation. "Nevertheless no broker or trader wants to stick his neck out and be the first one to show his hand." Sussman added that he sees no immediate solution to the problem other than the greater use of crossing networks. "That's the solution out there that everyone loves. But until a critical mass develops, we still have the same problem," Sussman explained. Fragmentation, Babson Capital's Sylvester continued, is not a marketplace, but a product issue. "Thanks to Posit, Liquidnet and others, there are now some 150 million shares a day trading away from exchanges. This is a self-imposed problem as buyside firms are breaking up orders, going to so many different places, looking for best execution," Sylvester said. The Answer Technology, by providing more choices, has complicated the problem, Sylvester said. Yet, ironically, he agrees with Brooks that the answer to the buyside search for liquidity will come from technology. "The popular answer will be an algo system that will aggregate crossing networks and market centers," he said. Tabb interviewed about four dozen head and senior traders at various investment management firms. The firms were segmented into three categories: large, with $50 billion or more in assets, medium, holding between $10 billion and $50 billion, and small firms, which had less than $10 billion in assets.

From P & L to Nirvana

Editorial Staff
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(Traders Magazine, July 2005) — As a former market maker, Joseph Feeney has gone from reviewing his P & L daily to a more holistic approach toward trading.

"On the buyside, it's more about teamwork and how the firm, or the team does," confides Feeney, the head trader at the $4.2-billion Sentinel Advisors in Montpelier, Vt. "When you're a market maker, it's all P & L, so it's very simple: You either made money, or you lost money."

"I like the buyside," Feeney said. "There are no egos here, and we're beating our benchmarks." Both the Sentinel Common Stock Fund and the Sentinel Small Company Fund are in Morningstar's top quartile, sometimes elbowing their way into the top decile, he points out.

Feeney confesses that it is easier to trade for successful stock pickers. But there is a driving force behind this former market maker's desire to get the best prices. It's more than just fulfilling his fiduciary duty, Feeney says, and that added incentive is the leeway the portfolio managers give their trading desk.

And he doesn't want to disappoint them. "They give us the opportunity to do what they pay us to do," Feeney says. "We don't have any problem with pulling an order, if we think we can buy it cheaper later on in the day."

It might make sense, then, that Plexus Group ranks the desk as "positive value-added" vs. its peer group.

"There are no egos here [at Sentinel], and we're beating our benchmarks."

Early in his career, after short stints at the NYSE and the CBOE, Feeney earned his M.B.A from New York University's Stern School of Business. It was the following four years spent as a market maker at UBS in New York that began Feeney's education as a trader and his ability to tolerate risk. Feeney's appetite for risk was further sharpened when he moved to Vermont and began trading futures for his own account in 1996. For two years, he traded wheat, soybeans and T-bonds. But Feeney missed the camaraderie of the desk. Outside of Brutus, his faithful Yellow Labrador Retriever, there was no one to talk to. Feeney took a job at H.C. Wainwright in Boston as a market maker, spending roughly three-and-a-half years there. But then the buyside came calling, and Feeney took the trading job at Sentinel Advisors in Montpelier. Feeney no longer had to take the weekly two-hour commute to Boston and crash in an apartment he had been renting there. Feeney attributes the skills he honed as a market maker and from trading his own account as best preparing him to be an aggressive trader on the buyside. It was the multi-tasking as a market maker, making from 20 to 30 names, that gave him a great feel for the marketplace and how stocks react. But it was the "greed and fear" he experienced from trading his own account that may have made the biggest impression on him. "Every dime and nickel is your dime or nickel, when it's your money, so you learn to be greedy with it," Feeney says. That mindset, he adds, has helped him to capture alpha on the buyside. Some might remember Feeney's father, Joseph Thomas Feeney, who retired in 1991 as head trader at Kemper Financial Services after 18 years there. Although not a Jr.-the son's middle name is Anthony-Joseph Anthony Feeney followed in his father's steps and knew in high school he'd like to give the trading world a shot. Feeney recounts dinner table stories and conversations about the "characters" in the Chicago trading world, which first caught his attention. But it was the intrigue of trading-and less the money-that attracted him. "Trading is such an interesting game," says Feeney. "I was attracted to the profession and the psychology of it."

DMA Developers Add Multi-broker Payday

Editorial Staff
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DMA Vendors say they're now responding to the buyside

(Traders Magazine, July 2005) — Direct market access providers, bowing to buyside complaints, are making their technology multi-broker friendly.

To mollify buyside traders frustrated by the limitations of their DMA platforms, the vendors and brokers who supply the technology are scrambling to incorporate functionality that allows users to trade for the credit of more than one broker.

The trend could lead to fewer systems on buyside traders' desktops as traders remove unwanted programs and settle on one system to handle all their trading and payment needs.

"There is a huge request for this among the traditional asset managers," says Justin Brownhill, a senior executive with Lava Trading. "They feel it will take care of a host of their needs and relieve them of many burdens."

Buyside traders are complaining they must support too many direct market access platforms when only one is necessary. They want just one system to access trading venues and credit all of their brokers.

The issue becomes especially acute as buyside desks incorporate more low-touch DMA trading into their workflows. Currently, about one-third of their business is done via low-touch DMA, according to a recent survey. That figure is expected to grow.

"We do think our clients are going to try and consolidate the number of platforms on their desktops," says Adam Mazur, an executive with Goldman Sachs. "As they try to manage their commission rates down using a mix of high-touch and low-touch services, low-touch will make up a larger percentage. They will have no choice but to use those commissions to pay a number of their relationships across the Street."

Short-List

Most buyside shops get their DMA platforms from a short-list of very large or specialized brokers. Very few actually pony up for vendor-built systems. The result is that many desks support more than one broker's system. And each system only allows them to trade for the benefit of the sponsoring broker.

"There's a huge request for Multi-broker."

Justin Brownhill, Lava Trading

Bulge bracket firms such as Morgan Stanley, Goldman Sachs and Merrill Lynch, for example, "sponsor" their own or vendor-built platforms for favored clients. In return, they get their order flow. Execution houses such as Instinet, ITG, BNY Brokerage and UNX do the same.

The benefit of such an arrangement for the buyside trader is that he gets a system at a price he can afford. The downside is that he must often install multiple systems from multiple brokers in order to satisfy his commission commitments to those brokers.

In other words, traders have not been able to trade on and pay all of their brokers with one system. They have had to jump to a different system each time they needed to trade for a different broker.

Until recently, for example, traders using Goldman Sachs' REDIPlus platform could only trade through that system for the benefit of Goldman. If they wanted to do a trade for the benefit of some other broker, they were out of luck. If that other broker was, say, Morgan Stanley, though, and they had Morgan Stanley's Passport system on their desktop, they might do the trade in Passport.

(Buyside traders cannot trade on ECNs or stock exchanges under their own names. Even when they decide to trade their orders themselves, without broker assistance, they must still enter the market under some broker's ID. They generally pay the broker up no more than one cent per share for that privilege.)

Trading Goals

The payment problem is exacerbated by the fact that a large buyside shop may have commitments with 80 or 100 brokers. Most do not sponsor direct market access. Many do not even have trading operations. The buyside shop, though, may still want to trade direct-to-market for their credit.

"Traders will try and consolidate the number of their platforms

Adam Mazur

"The buyside trader needs the ability to pay different brokers for such services as research and soft dollars," explains Jim Kwiatkowski of DMA vendor FutureTrade Securities. "But sending an order disclosed to his broker may not be consistent with his trading goals. So, he may choose to route that order to an ECN. But he still needs to pay this broker."

Goldman's Mazur agrees. But he claims that the demand from the buyside is to be able to pay its many smaller research brokers, not its bulge bracket partners. "We don't have clients lining up saying: 'I need to pay Morgan Stanley through REDIPlus,'" he notes. "This may happen in time. But not yet."

Generally speaking, the firms building direct market access platforms fall into two camps: software vendors and brokers. (Importantly, though, some of the vendors operate broker-dealer subsidiaries.) Each, as according its status, is taking a different approach when building out multi-broker payment functionality.

The broker-dealers sponsoring DMA to their buyside clients also fall into two groups. Firms such as Goldman, Morgan Stanley, Knight Trading Group, UBS, BNY Securities, ITG, UNX and Instinet offer proprietary systems. Firms such as Credit Suisse First Boston, Merrill Lynch and Bear Stearns sponsor vendor-built systems.

Many of the proprietary systems owned by brokers used to be vendor systems. Big brokers have gone on a spending spree in recent years, buying up these systems. Among the remaining "independent" software vendors are FutureTrade, Townsend Analytics, Royal Blue, SunGard Trading, and TradePortal.

Again, the lines aren't always clear. Lava Trading calls itself an independent software company, despite its ownership by Citigroup.

In any event, there is a growing number of ways for a buyside trader to trade direct and pay a different broker. Some suppliers have offered one or two methods for a few years. Others are just adding them now.

The oldest and most common way to trade direct and pay the broker of choice is the "done away" or the "away trade." As an example, assume a hedge fund is priming with Goldman Sachs and uses the REDIPlus system.

The hedge fund trader calls up his Banc of America Securities sales trader and tells him he is trading on behalf of Banc of America, but inputting the trade into REDIPlus. Banc of America gets the commission and may pay Goldman a small "delivery-versus-payment" fee during the settlement process.

Audit Trail

This method may be falling by the wayside. As hedge funds are being pressured to register with the Securities and Exchange Commission, they are inclined to maintain an electronic audit trail.

The practice of making telephone calls to brokers and writing paper trade tickets after the fact is now under review, according to Ameet Shah, a hedge fund operator and software firm executive.

"A hedge fund cannot do a "done-away" trade now without a compliance trail," says Shah. "We can't just pick up the phone anymore and call in an order because it won't be captured in the middle and back office."

A variation on the "away trade" is called 'repatriation.' UNX, a Los Angeles-based agency broker servicing do-it-yourselfers, has offered repatriation for a few years. As an example, consider a client who trades over the UNX platform, but wants part of his commission directed to a research broker.

UNX executes and clears the trade, but sends half of the four cent commission to the research broker. "This was an early model designed to help clients use a separate tool to trade with UNX and pay [the research broker]," explains Randy Abernethy, UNX' chief executive. "We can send them two cents a share for the research piece and keep two cents for the execution piece."

Introducing Broker

Despite UNX's status as a broker, it considers itself 'broker-neutral.' "We are not a bulge-bracket firm," says Abernethy. "We don't provide research or commit capital. We won't take risk trades. We don't make markets. There is no conflict of interest."

What may have been an 'early model' for UNX is new for some brokers on the Street. Goldman, for instance, recently introduced a program that allows buyside traders to credit research houses for trades done in REDIPlus. It has signed up 10 to 15 research houses that clear with Goldman Sachs Execution & Clearing (the former Spear, Leeds & Kellogg) for the program.

Under this "introducing broker" concept, the buyside shop trades with Goldman's REDIPlus per usual, but tacks on an additional fee. At the end of the day, it informs Goldman by an allocation process of the identities of the research brokers. "Because we have an introducing broker/clearing relationship with these research brokers," explains Mazur, "we clear on their behalf, they get the majority of the commission."

"The buyside trader needs the ability to pay different brokers."

Jim Kwiatowski, Future Trader

As with UNX' repatriation scheme, the trade is executed and cleared by Goldman. The commission is split between Goldman and the research broker. Mazur notes: "this is a model that could potentially work with bulge brackets, but we haven't approached them. I'm not sure they would be interested."

It is telling that Goldman's repatriation program is (a) only just launching and (b) only focused on small research brokers. In contrast to the software vendors and small 'broker-neutral' brokers such as UNX, big houses like Goldman are not keen to facilitate their clients' use of their DMA platforms to pay their major competitors.

They got into DMA sponsorship and the related measly commission rates in order to hold onto their clients. The hope is that by supplying them with low-touch features they'll also hold onto the shrinking pool of high-touch commission dollars.

It should be noted, though, that Goldman does allow its customers to route orders to its competitors. This service is especially popular among buyside traders sending program trades to desks other than Goldman's, according to Mazur. Goldman does charge the recipient brokers a connection fee for the service.

Step-Outs

After 'away-trades,' the next most popular multi-broker payment option is the "step-out" or the "give-up." Here, the DMA provider acts as executing broker for the broker who carries the account. Again, the buyside trader wants to trade over his sponsored DMA system, but pay another broker.

In this case, he trades through his DMA platform under the mnemonic of the broker (or the vendor's broker-dealer subsidiary) supplying the platform. During the settlement process, though, the trade is "given up" to the broker the trader wishes to pay. "This allows the buyside trader to trade with FutureTrade," explains Kwiatkowski, "and for FutureTrade to flip those trades to another broker-dealer."

Step-outs though are not universally liked, either by the sellside or the buyside. On the sellside, the sponsoring brokers may not like being stepped out of a DMA trade. The per-share rate is small to begin with and the broker incurs costs to facilitate the trade. And then he has to give the trade to another broker.

"If I am the DMA broker," notes Royal Blue exec Mark Ames, "and you are using me to put order flow into the market in my name. And then you try to direct away the little bit of commission I am being paid…I might have a hard chat with you."

"Repatriation was an early model.

Randy Abernathy, UNX

FutureTrade's Kwiatkowski notes there may be limitations on DMA step-outs in cases where the buyside trader accesses the New York Stock Exchange via SuperDOT. At those times, it is the broker taking over the trade who may have issues with the practice. The receiving broker would prefer the trader use its DOT line and not a competitor's. "They don't want DOT give-ups," says Kwiatkowski. One of the biggest problems with step-outs, though, and the reason savvy hedge funds shun them is that they result in information leakage. The trader using the DMA platform does not want to share his trading information with two brokers – one executing and another clearing the trade.

One large agency broker has found a way to capitalize on this fear of overexposure. For the past year-and-a-half, Instinet has offered its BrokerShare program, a scheme similar to Goldman's new introducing broker program.

Under BrokerShare, traders access the markets with Instinet's DMA technology and build up credits for eventual payment to independent research providers. At the end of every month, Instinet sends checks to over 140 research brokers. The buyside trader never has to share trade or position information with those brokers as he would with step-outs.

"The reason why Instinet's Newport system does as well as it does," says Tabb Group analyst Josh Galper, "is because Instinet writes checks to other brokers.

On Behalf Of

With away-trades and step-outs falling into disfavor, DMA providers have had to latch onto something better. And possibly the hottest new feature from the more forward-looking DMA shops is the "on-behalf" trade.

Due to the technical complexities and problematic business issues involved in adapting their systems to this new animal, it is not surprising that only a few players are going all the way here.

Vendors such as Lava, FutureTrade, Royal Blue and an up-and-comer, TradePortal, are some of those building out the functionality. Brokers such as Goldman and UNX are not.

On the surface, an on-behalf execution looks simple. The buyside trader clicks on a drop-down menu, selects a broker's name and trades. He is, in effect, going out to the market under that broker's pneumonic. And it may not be the pneumonic of the broker sponsoring his DMA platform.

Behind the scenes, though, a lot of work is involved. "This is not a trivial task," says Lava's Brownhill. "It is pretty difficult to do. It can take between three and six months to set these programs up."

The problem, according to Brownhill and others, is that broker-dealers aren't crazy about buyside traders using their name to trade outside of their technological and legal infrastructures.

The broker-dealer lending his good name wants to make sure that the right controls are in place before the trade happens. They need to be assured there is no violation of credit limits or "anything defined by their relationship," adds Brownhill.

Everything is done anonymously. The broker doesn't know anything about the trade: the name of the stock, the size of the trade, or the side. "That's why it takes three to six months to set these programs up," Brownhill says. "Everybody has to sign off: the compliance officers, the back office people, the clearing people. Then you've got all the testing."

Lava has signed 15 brokers to the program with 12 more in the pipeline. It counts five of the top 10 brokers in the plan and a host of lesser lights. The vendor started adding on brokers in early 2004, but has done the bulk of the work this year.

One of the top five brokers reluctant to sign on to these programs is Goldman. "From surveillance and compliance perspectives," notes Mazur, "we are not comfortable allowing our clients to use our name without going through all our checks and balances."

The complexities run the gamut. With Nasdaq trades, for instance, someone has to report the trades to Nasdaq's OATS facility.

"If a Nasdaq trade is done through FutureTrade, on behalf of another broker-dealer." FutureTrade's Kwiatkowski explains, "then the broker-dealer is not a party to all the trade information. But an OATS file needs to be created for that broker-dealer."

In that case, the broker-dealer can either allow FutureTrade to create the OATS files on its behalf without looking at it. Or, it can request that FutureTrade send it that OATS file and it will attach it to its own file for submission to Nasdaq.

Definitely not trivial.

The Growth Challenge at GM Asset Management

Editorial Staff
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A long-time specialty painter at the General Motors plant in Linden, N.J., learned a while back that machines can't do everything. They make mistakes, too. This 30-plus-year veteran, now in retraining classes at the factory idled since May, is terse in describing his job: "I had to fix what the robots messed up." He also handled the more intricate painting that the machines couldn't do. Once the union contact runs out in September, 2007, this member of the United Auto Workers will be retired and find that his past and future are oddly tied to the trading desk at General Motors Asset Management (GMAM), less than 20 miles away in New York City.

The money that will pay for his retirement will pass through the GMAM trading desk. But professionally, this painter may never realize how similar his old job is to what the GM trading desk does daily: Work the outliers, the tough stocks that cannot be traded by machine.

"Sometimes you have to be ready to interject human judgment into a trade," said George Bodine, director of trading at GMAM. Bodine, who considers himself a traditional trader at heart, executes about 70 percent of the volume that flows through his desk via programs, or packaged trades. The balance-the trickier and less liquid stocks-is worked the old-fashioned, manual way. It's worked through crossing networks and traditional brokerage.

"Sometimes you have to be ready to interject human judgement into a trade."

This has served the pension fund well, since the equities managed internally are quantitatively driven. It would be impossible for the four-person staff to deal with hundreds of trades at a time. Add the fact that commissions are in the 1-cent range, and program trading is even more attractive.

Big Player

GMAM employs roughly 75 outside managers in all asset classes. It manages about $150 billion overall, with about $70 billion-47 percent-in equities. Exactly 15 percent of its assets are internally managed. About $8.5 billion in equities are managed at 767 Fifth Avenue, its headquarters.

The $150-billion pension fund, which manages $90 billion of its own money, will certainly be called to the test to deliver the benefits that it promised to employees. According to a GM spokesman, recently announced plant closings and layoffs-expected to affect 25,000 workers-will not put additional strain on the pension fund. The layoffs will equal normal attrition rates, he said. (See "GM Pension Fund Challenge.")

Bodine acknowledges the challenges ahead for the pension fund and the responsibility that his trading desk faces in its effort to add basis points to performance. Still, after 30 years in trading, the Auburn, N.Y., native has seen the evolution of institutional trading, with its basics essentially left intact. Trading is about making market calls and decisions, regardless of the increasing use of electronics. The life cycle of a trade may shrink, as the number of steps in the trading process is reduced because of technology. But ultimately, there still needs to be decision-making along the way. "I don't think a machine can interpret how the market will react when Alan Greenspan speaks," Bodine said.

High of the Day

The greatest feeling in trading, Bodine said, is making the right call on a stock. "That's why they pay us," Bodine said. From a management standpoint, the challenge is getting the desk to achieve a camaraderie and chemistry. "Having a desk that really flows and operates as a team is really important," he said. "That's what makes the day fun." He's also of the opinion that it adds to performance.

Traders on the GM desk have specialties: Zesa Gewertzman, single-stock trading, Steven Ulbrich, futures and international equities and Mark Dupuis, who oversees programs.

Traders Magazine caught up with Bodine last month, wanting to know the story behind trading at the largest corporate pension fund in the USA.

Hub and Spoke

It starts with the process. Bodine called the investment process-both the stock picking and the trading-a "hub-and-spoke model." Aptly named for a car company, it's not universally called that internally. But it does describe the interaction that takes place between GMAM's investment professionals and its outside managers, with GMAM staff acting as the hub and the external managers, the spokes.

"We're basically all like player-coaches," said Bodine, a former linebacker at Syracuse University in the early '70s. As players, GMAM's portfolio managers are picking stocks, and its traders are trading them. As coaches, both portfolio managers and trading oversee the external managers' activity.

But there is a huge benefit: Stock pickers can also take the best big-picture ideas from the external managers. In other words, the GMAM portfolio managers can pick the brains of its outside managers and incorporate the investment ideas that they like best.

The breakdown is simple. Within each asset class is a portfolio manager who monitors the outside managers, while running his own portfolio. It should be noted that all stock picking is quantitatively driven, so GMAM is not in competition with the outside managers. One example Bodine gave would be a sector rotation that an internal portfolio manager might begin to see from the outside managers.

"Having a desk that really flows and operates as a team important."

That manager, for example, might then adjust his model and change the weighting in chemicals from 3 percent to 4.5 percent, he explained. From there, it's a bottom-up exercise with the portfolio manager choosing the stocks that would get the heaviest weighting.

At the end of each day, the GMAM trading arm puts any cash at the outside managers to work. It's called a futures overlay program. The desk purchases S&P 500 futures for additional market exposure. Internationally, the same strategy is employed. No leverage is used to juice performance.

Bird's-Eye View

Bodine, as the head trader, also has a bird's-eye view of what the external managers' trading desks are doing. "Obviously, as a good student, I try to pick up information that is valuable," Bodine said. "Nothing proprietary, but if I see a system that looks good or a process that looks worthwhile, I will come back and share it with the group here."

Bodine wears both a plan sponsor and a money manager hat. Each morning, Bodine reviews the previous day's commissions paid to brokers by the external managers. The reports only show the particulars of the trades allocated to GM, but there is tremendous value in seeing daily reports from between 40 and 50 managers.

Besides the size of the trade and the commission paid, Bodine sees which broker executed each trade. That info, aggregated over time, can demonstrate clear trends that often provide an edge in running his own desk.

Insights

But there are other benefits to reviewing daily manager reports. "I can see how much traction a new system or broker is getting, and it might prompt me to look into it," he said. It is a good way to double check on claims that sales people might be making, he added. "That's an advantage when I can see something happening among 20 or 30 managers whom I respect."

Two trends have jumped out at him over the last couple of years: Declining commission rates and usage of soft dollars. "The soft dollar decline seems to have stabilized," he said. This decline of soft dollars was quantified recently in a study released by Greenwich Associates, which concluded that soft dollar usage was down about 10 percent over the last year. Bodine said there should soon be more clarity on soft dollar rules, as the industry awaits U.S. Securities and Exchange Commission guidelines.

"Open lines of communication to trading often translate into better performance."

"The question we ask ourselves as a plan sponsor is, 'Are we getting value for these dollars that are being spent on research?' We think we do," Bodine said. "There is a strong feeling that the General Motors pension fund is getting these commissions back in the form of performance."

In the Beginning

When Bodine joined the firm nine years ago, he looked at the morning commission run. His goal was to find a way to cross trades internally among GMAM's external managers. That would lessen market impact, which benefits pensioners. But that initial thought died when there just weren't enough opportunities, and the few that existed, were made even more difficult to achieve because of ERISA rules. When Bodine joined GMAM, he spent a good deal of time traveling. He held quarterly meetings with the head trader of each outside manager, but that grueling pace has slowed down in recent years, as he's become more familiar with each shop's process. Still, Bodine keeps tabs on each manager, primarily through the daily commission runs, an occasional phone call and his quarterly trade-cost analysis reports from Elkins/McSherry. When Bodine had heavy contact with outside desks, he came to the realization that there was often a correlation between performance and the relationship between the portfolio managers and the traders on the desk. Bodine looks at the chemistry between them, as well as the respect the desk is given. Consequently, the better the trading desk communicated with portfolio managers and the freer the traders were to do their jobs, the better the firm's overall performance. "It really showed when a lot of the decision making was put on the desk," he said. "It helps in the performance, because [portfolio managers] are brought into the process much sooner."

Discounted Commissions

GMAM also participates in commission recapture – the rebating of commissions paid back to a plan sponsor by broker-dealers. The commission recapture business has come of age, maturing to the point that just about every major broker now participates. GMAM uses the brokerage affiliate of consultant Frank Russell. Bodine pointed out that its list of participating brokers is a 'Who's Who' of Wall Street. "We'd be using these brokers anyway, so it's just a way for the pension fund to trim its commission costs, and it's worked out well," Bodine said.

Setting recapture targets-a percentage of trading volume-is worked out with the external manager. Bodine is mindful that setting parameters too high, in an inappropriate asset class, could negatively impact performance. Having traded many of these stocks himself, he knows the burden that can be placed on a manager with unreasonable demands for direction. Only certain strategies are in the program-external quantitative managers are not. The targets are set up by Bodine, Frank Russell and the manager. They range from 30 percent direction on a large-cap value, for example, down to 5 percent for a small-cap growth. James Bryson, President of Elkins/McSherry, N.Y., GMAM's trade-cost analysis vendor, said plan sponsors need to be in recapture programs. "It doesn't make sense to leave that money on the table," Bryson said.

A Certified Financial Trader?

When commissions were deregulated in 1975-May Day-George Bodine was a greenhorn. He had three months experience trading at the large insurer, The Equitable.

The business today is hardly recognizable compared to then, according to Bodine. He pointed out that there has been an evolution in how traders have learned their trade over the years. He now wonders if buyside traders shouldn't be accredited or certified.

Two factors have pushed him toward that thinking are: 1) The rapid change in the industry; and 2) Conversations between the buyside and the sellside have dropped dramatically with the increasing use of electronics. Outlining the development of how traders learned their craft, up until the early- or mid-'90s, there was an apprentice-like transition into the business, Bodine said. Brokers were still considered 'customers' men', and traders on the buyside and sellside learned the job by talking to each other and by trial and error.

"A lot of the old interaction and information flow is diminished," Bodine said. "I'd say it's about 25 or 30 percent of what it was just 10 years ago." But he also believes that more experienced traders would benefit from such an accreditation. "The business today is much more challenging," he said. "It's just not just about trading."

Long Live Block?

As more trades are blended into the market-i.e., fewer blocks-the trader's job is made more difficult in judging supply and demand. There's less information in the marketplace, so traders do not have a comfort level to make pricing decisions regarding larger prints, Bodine said.

Right now, Bodine is of the opinion that one of the impediments to a resurgence in block trading is the lack of pre-trade analysis. He mentioned that several brokers are hot on the trail in developing pre-trade for single stocks. Interestingly, pre-trade has been a staple on the program trading side of the business for years. But it has proven elusive for single stocks.

"I think once you get more sophistication and predictability with pre-trade analysis, and you put that on the desk of traders, that will give them the confidence to commit to a price sooner."

"Block trading is not going to die," Bodine predicted. "It's going to come back more than we've seen as of late." But it is not likely to be as prevalent as it used to be, either, he pointed out. Bodine drew an example of a stock that traded 200,000 shares a day. If the pre-trade analysis showed a market impact of 15 cents per share, a trader could justify to a portfolio manager that it's OK to execute up or down 8 cents or a dime. Bodine said that each year machines have taken increasingly more orders from the trader's hands, but he now believes that sophisticated pre-trade analysis for single stocks should stem that tide.

VWAP Mentality

"I think that skill of knowing where supply and demand is has been lost a little bit, and we've delegated that to machines." Overall, Bodine likes VWAP (value-weighted average price) as a benchmark. "It's a pretty tough measure to beat," he said. But it needs to be tinkered with. He offered an example of a trader receiving a buy order at 3 p.m. Instead of being aggressive, the trader keeps the order out of the market because VWAP would be hard to beat or come close to. "Who wins if the stock moves up a point?" he asked rhetorically.

Yet, Bodine would like to see traders get away from a VWAP mentality. It lessens the so-called 'value proposition' that traders on the buyside bring to the table. "Where is the value? You're letting someone else make a pricing decision," Bodine said. "You're not initiating, you're reacting, and that's what I'm philosophically opposed to. It undermines what a trader is paid to do."

The GM Pension Fund Challenge

The future of roughly half a million Americans is depending on the success of the pension fund at General Motors. GM's money management arm, General Motors Asset Management, which oversees a total of $150 billion in assets, has no shortage of challenges. First, retiree benefits eat up about $6 billion a year, making it necessary for the firm to meet a bogey of 7 percent annually just to stay even. Its target is actually higher, at 9 percent.

That magic number of 7 percent might seem a tall order when taking into account the current low-return investment environment with factors such as retirees living longer and the increasing cost of health care. Interestingly, and contrary to the dire fundamentals at the parent car manufacturer, the story at General Motors Asset Management (GMAM) has been a bright one. For the last 15 years, GMAM has delivered a blended return of 10 percent annually. And the last two years, performance has been an eye-popping 22 percent and 14 percent, respectively. "We are pleased with the results," said Allen Reed, president and chief executive officer of GMAM. "But we deal in very competitive markets and never stop looking for new and better ways to generate returns and to manage risks." Managing a pension fund is a "long-term game" that brings "new and greater challenges" everyday, Reed added.

Indeed, there's no minimizing the challenges that lie ahead for the nation's largest private pension fund, as GMAM looks to earn the greatest return that it can for the $90 billion that it oversees for its own retirees (GMAM also invests for other plan sponsors like Xerox and Delphi.)

But the issue of earning enough through investments is a national one for both public and private defined benefit pension plans. Although GMAM is not underfunded as of the end of 2004, according to a GM spokesman, many plans are. Nationally, corporate plans alone were underfunded to the tune of $354 billion at the end of 2004, according to the Pension Benefit Guarantee Corp.

Public pension funds covering state and municipal workers are in the same fix, many believe. Is there an answer for these struggling private and public plans to wrestle with all of these issues? Certainly they need to be fully funded. But they also need consistent investment returns.

Could the answer to their problem partially lie in how these plans are structured and the investment process itself? Might GMAM, with its hybrid model of investing with external managers and internally, be an example for others to follow? (About 85 percent of its assets are invested with external managers. Its asset allocation is 47 percent equities; 35 percent bonds; 8 percent real estate; and 10 percent others investments such as hedge funds and private equity.)

GMAM made an asset allocation call recently and increased its weighting in real estate and hedge funds, which raised the firm's risk profile. As the head of one public pension fund said, "What GM's doing isn't radical, but they are ahead of the curve. One way or another, you will see more plans-especially public ones-moving in the direction of what GM is doing right now."

But GMAM's Reed pointed out that each plan is different, and thus has different needs. "There is no single solution to pension management. Each plan sponsor needs to decide on an investment strategy that meets specific requirements."

The public fund head agreed, saying that a plan sponsor needs to figure out where its expertise lies. "Plans sponsors need to know where they can add value, what they are really good at," he said.

Reed praised his investment team and offered up a big-picture philosophy. "When you look at the impact the pension fund returns can have on GM's financial results, it is obvious that this is an area that GM must manage as effectively as the rest of its business," he said. "We view pension fund management as a core competency."

Outside managers are about to participate in a new program to measure their trading costs, Bodine said. The plan is to evaluate how much value the trading desk at each external manager is adding to the process. The goal is to time stamp each incoming order received by the desk. Then, capture the last sale in the marketplace of that stock, and have that trader do a pre-trade analysis of the expected market impact. From there, after adding the market impact to the last sale, it will be easier to judge how the trader added value, he said. "If someone decides to stay out of the market, that's a trading decision," he said.

"Block trading is not going to die."

Bodine believes that traders need to understand the market and their stocks. He is a proponent of algorithms. Namely, they reduce commissions for a plan sponsor, but also free up a trader to monitor supply and demand for the tougher stocks. "We use them when we feel a trader can't add value," he said. "Once you get into the mid-cap and small-cap names, it gets difficult to find that liquidity."

"I like algorithms, but it's a tool, not a substitute for a trader," Bodine said. "Once we hit a period of stress, and emotion takes over, then you might as well take [the algorithm machine] off the autopilot, because you've got to be the decision maker again." When it comes to trading, there's no such thing as one size fits all, he said. Asked if he had concerns that his algorithmic orders were read by opportunistic traders in the marketplace, Bodine said there was no evidence of that. "It might be happening, but I haven't seen it or been able to quantify it."

Program Trading

There are about 10 major transitions a year that GM's desk executes, Bodine said. A "major" transition is defined as either the firing of an external manager or a major reallocation of assets internally, he said. "These can take about two weeks, from start to finish, " he said. "It's very intense."

Still, the desk doesn't begin trading until a series of administrative steps are completed, primarily making sure that stock from the fired manager is available and the settlement is completed. Other issues like matching CUSIP numbers and symbols can also be major headaches. "Just trying to get the administrative part completed, before we even analyze the portfolio, is pretty difficult," Bodine said.

Fortunately, GMAM has outsourced its back office to its custodians, JP Morgan Chase and State Street. The two firms have employees working on-site at GMAM. This is a huge advantage before, during and after a transition, Bodine said. "They are really acquainted with the process."

But trading doesn't begin until a final sign-off from the custodian is received. Once all the assets of the fired manager are reclaimed, and a list of the new manager's stock selections is in Bodine's hands, he then does his first trade-cost analysis of the transition. If, for some reason, a new manager has not been hired, the desk will convert the cash from the sells into the purchase of S&P 500 futures, keeping exposure to the market.

For pre-trade analysis, GMAM uses Citicorp Stock Facts Pro III. Bodine is impressed with the accuracy of these market impact measurements. In fact, he said that impact models for individual stock are on the way, and they may make traders more comfortable to trade blocks if they become as accurate as the ones in the program trading arena. Experience is often the best teacher, and Bodine said that the GM desk has become adept at doing these transitions. "Our experience and comfort level in doing this really benefits us," Bodine said

Programs offer the pension fund efficiencies as far as manpower, but also provide cheaper commissions.

A transition could be valued anywhere from $100 million to $1.5 billion. However, most are in the $200 million to $600 million range.

For programs greater than $500 million, it becomes very difficult to find a broker willing to accept the risk for a portfolio that large, he said. Most of the programs are done on an agency basis, but Bodine pointed out that there are times when brokers are looking to buy market share and using their capital is advantageous.

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