With the acquisitions of Lava Trading by Citigroup and Sonic Financial Technologies by The Bank of New York, the brokerage industry has solidified its movement toward offering direct-execution services to its institutional-investor clients.
Though direct execution upends brokers' historic business model, they would rather cannibalize their own business by steering some of their customers to direct-execution platforms than lose those customers altogether. "Sellside firms are very competitive and they don't want to seem like laggards. No sellside firm is holding out; everybody's in the game," say Dushyant Shahrawat, an analyst at TowerGroup.
The need to offer direct execution is all the greater now that the New York Stock Exchange, the greatest single pool of liquidity in the world and the last major bastion of the time-honored auction system, is pushing ahead with it Direct Plus program. In August, NYSE chief executive John Thain proposed that the exchange allow for more electronic trading, potentially taking business away from the 1,366 floor traders.
The program will allow investors to buy and sell thousands of shares of stock directly over computers, bypassing the market makers that have been at the heart of the exchange since 1792. Investors currently can trade just 1,099 shares directly. Thain presented the plan in a filing to the Securities and Exchange Commission, which must approve it.
Many large investors, such as Fidelity Investments and other mutual fund companies, have demanded that the NYSE offer more automated trading. They say they want to be on par with floor traders who may get better information by being physically present. Market makers, known as specialists, referee trading and also buy and sell for their own account. Thain is trying to ensure that the NYSE continues to benefit directly from trading in its listed companies' shares. At present, the NYSE handles 80 percent of the trades that involve its companies, with about 10 percent of trades, or 140 million shares per day, handled electronically.
Jodi Burns, an analyst at Celent Communications, says there are several macro trends driving institutional investors' demand for direct execution, not the least of which are the scandals that have rocked the NYSE and growing concern that specialists do not have the best interests of customers at heart. "There's frustration that they're simply handling over orders, losing control, and paying more than they need to," Burns says.
The second factor is the buy side's reexamination of soft-dollar relationships and focusing on actual transaction costs in response to questions raised by regulators and their own investors. "There's a sense of being very cost-conscious and looking at costs on a very micro level, and direct execution is a way to know your fees," says Burns.
At the same time, the growth of block trading has made the buy side more sophisticated and comfortable with direct- execution technologies. Liquidnet, an electronic marketplace for block trading, saw U.S. equity trading volume rise 16 percent in the second quarter from the previous quarter, and 131 percent from a year ago. "Liquidnet's growth in the second quarter, despite overall declining trading volumes, indicates the institutional investor's desire for greater control over executions and greater comfort with the Liquidnet platform," said Seth Merrin, Liquidnet's CEO, when announcing the results.
The Liquidnet community grew by 41 percent year-over-year. At of the end of second quarter, the community included 271 member firms that collectively manage $6.6 trillion in global assets. Among Liquidnet's membership are 50 percent of the top 100 U.S. buy-side firms, based on equity assets under management. According to the Plexus broker ranking of 1,500 brokers, Liquidnet is the 15th and 17th largest for NYSE and Nasdaq stocks, respectively.
In combination with the buy side's growing sophistication and comfort with trade execution is the development of smart-order routing technologies, which Burns says goes hand-in-hand with direct execution. With these technologies, in effect, buysiders don't need to be experts in trade execution. "So once again, the question becomes: What do I need my brokers for?"
The recent direct execution-related acquisitions by Citigroup and BNY are intended, of course, to answer this question and keep them relevant to their buyside clients.
For instance, Lava Trading provides Citigroup with a state-of-the-art product. Lava consolidates market data from electronic communication networks (ECNs) and exchanges to help its clients realize best execution via a low-cost, high-speed, multi-broker electronic trading platform. Lava's clients include most of the top 20 U.S. investment banks, market makers, hedge funds and institutional investors.
James Forese, managing director and head of Citigroup Global Equities, said when the deal was announced: "By joining with Lava, we are poised to offer our institutional clients the benefits of the most sophisticated and robust electronic trading system in the market with technology that complements and enhances our existing platforms and product suites. ...Electronic execution currently accounts for a significant and growing portion of total trading volume."
Explaining his firm's direct-execution strategy, Carey S. Peck, president of BNY Brokerage, notes that "clients want more control. They want the same technology as the sellside. They want to make the decision where the order goes and when to engage a broker and when not to."
BNY has rolled out DEx, a suite of direct market access trading products to help institutional investors take direct control of their trading strategies and execution management. Powered by Sonic Financial technology, DEx provides clients with direct access to all primary ECNs, Nasdaq, market makers and multiple listed markets through a set of self-directed trading tools for single-stock and program trading.
Critically, says Peck, is that BNY is rolling out the same technology to the buy side that it itself uses. Thus the broker now offers two trading models using the same technology: DEx, where the investor "pulls the levers" and has access to all the liquidity, plus a dedicated DEx help desk and technology team; and the broker-assisted method. "We think you should be a client of both," he says. "The key is that we're rolling out the same technology to our guys, so if an investor wants us to finish a trade, we can do that."
Despite the power of these direct execution platforms and smart-order-routing technologies, analysts say there are good reasons for investors to opt for broker-assisted transactions. When dealing with smaller less liquid stocks "you want someone working your order," Burns says.
Adds Shahrawat, "If you're an aggressive money manager, or a hedge fund, direct execution makes sense. But from the buyside perspective, not all buysiders are so excited to use direct execution as conventional wisdom might say."
Still, Shahrawat says, the sell side must offer direct execution in this day and age. The trick will be differentiation. He cites three ways that direct-execution platforms can differentiate themselves in the marketplace: hooking into as many end points as possible (each endpoint-exchanges, ECNs, etc.-require complex technology integration); how smartly and quickly those connections are made; and gaining scale. He predicts that leading innovators will be Citi's Lava unit and Goldman Sach's REDIPlus. But beyond a few leaders, he expects there to be "not a tremendous amount of difference" among offerings.
