Banks and brokers are ramping up their equity service offerings, particularly by bundling direct access execution with algorithmic trading and commission management services, to keep institutions and hedge funds coming back to their stock trading desks.
Yet the mere ability to offer electronic, direct execution and automated trading is no longer enough to provide competitive service differentiators. Portfolio managers are facing unprecedented pressure from shareholders and regulators to prove best execution and cost-effective money management. Such demands have thus begun to shift the competitive proving ground among brokers from simple automated or "touchless" trading to one of providing accurate trade cost and execution analysis.
Firms are asking that brokers clarify costs involved with trading services that bundle algorithmic trading and direct access execution. According to buy-side customers and analysts, these costs are unclear and confusing. Offering monitoring or management tools, therefore, or simply providing more transparent access and disclosure to elucidate the true costs of trades is considered an important next step for brokers in facilitating stock trading.
Along these lines, BNY Brokerage has been working at integrating a set of recently acquired commission management assets from Wilshire Associates into its DEx (Direct Execution Services) platform, a suite of direct access trading solutions powered by Sonic Financial Technologies, which BNY acquired in April. DEx, which was first rolled out in July, includes performance reports meant to demonstrate execution quality users have received based on daily benchmarks. The option is also available via BNY's broker-assisted sales desk.
Confusion over costs has cropped up, however, when brokers combine services. Using algorithms to trade through direct access channels, or to break up orders among block, cash and direct trading desks, often draws premium charges. While there is scant difference among brokers between costs of standalone equity services, how the final commissions are arrived at for mixed services remains unclear. This is because "nobody divulges that kind of information," says Dushyant Shahrawat, an analyst at TowerGroup.
In his September report "Direct Market Access Matures, Securing a Permanent Place in Institutional Trading," Shahrawat breaks out standalone stock trading costs thusly: Direct market access (or "DMA") commissions typically render 1 cent per share; algorithmic trades command an estimated 2 cents a share; program trading runs roughly 2.1 cents per share; and block trades tally about 4 cents to 5 cents per share.
The market has clearly grown, he reports. DMA trading alone now represents 33 percent of total buy-side order flow, he says, versus the estimated 11 percent of direct access equity shares tallied in 2000. Hedge funds have been the most aggressive adopters, contributing 42 percent to total direct access trading in the U.S.
Algorithmic trading has also seen increased adoption, again mostly at hedge funds: About 19 percent of total U.S. buy-side trades use algorithmic-based decision making; with 16 percent coming from hedge funds and around three percent from larger institutional desks.
Since a reduction in commissions drove original adoption and remains a primary motivator in the buy-side's aggressive use of DMA trading, firms are demanding clarity around costs. Yet accurate cost analysis is clouded by the lack of historical data to power algorithms that can accurately measure best execution and commission costs together. The combined confusion over bundled services, including algorithmic and direct access has created "a hodgepodge," Shahrawat says.
"Clearly, the larger, more aggressive brokers are looking at taking transaction costs down with revenue wrap-around execution strategies," he said, "but that's still a few months, a year, maybe a year-and-a-half away."
While soft dollar commissions were down 18 percent last year under first-time regulatory scrutiny, according to Greenwich Associates, they remain the staple of hedge funds, where outsize growth has ramped up prime brokerage servicing. Some brokers are even buying leveraged trading units to offer as their own.
DEx incorporates soft dollar management services into the mix, in which commissions pay for market data and other costs. "The number one agenda item here is in the commission management space," says Carey S. Pack, president of BNY Brokerage, which is a subsidiary of the Bank of New York. The unit is part of BNY Securities Group, which is now the largest business within the overall bank.
Yet no matter the client or product mix, Shahrawat says, the trading process still entails some unknown tradeoff between best execution and lower commission rates. For instance, if the sell-side trading desk is working the order, versus simply letting it trade automatically through their DMA platform in "name only," without human intervention, the method might garner a better price on the trade. Whether such price improvement is enough to compensate for the extra commission paid, however, is what remains unclear.
PC-based transaction cost analysis tools "can't be very accurate," according to Shahrawat, "because you need massive amounts of information to prove that you've been able to get the best price or not, and not a lot of brokers have been in the business long enough with the right technology to have this historical pricing information."
Still, firms clearly need to have evidence now to prove that they're upholding their fiduciary responsibility. Sometimes time or confidentiality, though, is paramount versus strict commission benchmarks. "Many of the managers we work with are concerned about anonymity," Pack said. This is why brokers offer both automated and broker-assisted trading.
Firms argue that algorithmic trades are more valued-added, and thus should cost more, at least when combined with other methods. "An algorithm is fetching a premium because you're getting the smart routing but you're also getting the decisioning of the algorithm," says Rob Flatley, managing director at Banc of America Securities' electronic trading services group.
BofA has introduced two algorithmic advances this year, Flatley says. One is based on trading parameters on "arrival price" versus traditional Volume Weighted Average Price (VWAP), to take advantage of dips in daily trading activity. Another involves committing the bank's own capital to buy or sell client trades based on resulting prices gleaned from an algorithm's measure of the trade's market impact. Instead of simply taking the trade to market, the bank offers the client a price at which the bank will buy or sell the name based on the market impact measure. This is a trend across the industry, with banks arguing they can outspend the standalone brokerages using their larger, deposit-based balance sheets.
Still, most buy-side firms, like American Century Investments in Kansas City, are "not out seeking relationships based on algorithmic trading," says Scott Atwell, a connectivity manager at American.
Atwell represents American on a recently formed algorithmic standards working group of the Financial Information Exchange Protocol (FIX) organization. Quants have bred complexity in taking over the trading desk, as each broker markets its own unique suite of algorithms.
Atwell cited Credit Suisse First Boston's Advanced Execution Services (AES) platform as a standout as one of the first established algorithmic offerings. Regarding direct access offerings, BofA has used Direct Access Financial, a firm it bought four months ago, to provide direct execution via a desktop to various domestic exchanges, as well as through its own pipes. The desktop is distributed to interested buy-side clients, including hedge funds, which remain "an area of high growth" for BofA, Flatley said.
"Alliance mania" also continues unabated, as brokers continue efforts to integrate with as many buy-side order management systems (OMSs), exchanges, routing engines and ECNs as possible. BofA just aligned its Electronic Trading Services (ETS) DMA platform with LatentZero's Minerva OMS. Yet firms need to expand beyond domestic borders and outside of equities to readily compete in the direct access space, according to Shahrawat. Neither BofA nor BNY offer overseas direct access, though both say they will expand.
Leaders offering DMA links with overseas exchanges and ECNs, Shahrawat said, include Credit Suisse First Boston, Goldman Sachs, Morgan Stanley and UBS. First-movers in product expansions, meanwhile, include Goldman, Morgan, Citigroup and UBS, he said, though mostly in foreign exchange and options.
