As one of Britain's biggest institutional investors, Scottish Widows Investment Partnership, the asset management arm of Lloyds TSB Group, has always done the bulk of its equity trading with big securities firms because of the liquidity and breadth of coverage they provide. New U.K. regulations that were introduced in January, mandating greater transparency in brokerage commissions, are only accentuating that approach. Scottish Widows now directs more than
80 percent of its trading to the 12 largest securities firms in Europe, up from 70 percent previously.
"We do the vast majority of our business with the big integrated houses because they see the flow," says Anthony Whalley, head of derivatives and dealing at Scottish Widows, which manages £100 billion ($189 billion) in assets. The firm still deals with as many smaller brokerage firms as ever, though, so it can tap niche markets or exploit the specialized expertise of certain brokers. "From an execution point of view, we still need to access as many pools of liquidity as possible," Whalley explains. "Therefore if there is a chance that someone out there is buying what we are selling or vice versa, we still need to talk to them."
As Scottish Widows' experience demonstrates, the clout, reach and technological strength of the big European and global securities firms continue to attract liquidity, bankers and fund managers say. At the same time, alternative trading venues such as Liquidnet, the U.S.-based electronic platform for institutional block trading, and electronic brokerages like Sweden's NeoNet Securities and New York-based Investment Technology Group are moving aggressively to win market share.
"There is a recognition that execution is a product and that it could affect performance," says Alasdair Haynes, chief executive of ITG Europe. "About 80 percent of the cost of trading comes from 20 percent of the portfolio, and it is important to identify that 20 percent. I think fund managers will be willing to pay for the value-added services such as pretrade, posttrade and real-time analytics in order to identify and trade the more illiquid and difficult stocks."
Europe also remains a patchwork of different markets. That allows niche players with a particular national strength or specialization in sectors such as small- to midcap stocks to thrive despite the intensifying competition.
"Fund managers have become much more selective and are splitting their order flow into the plain-vanilla stocks and those that need more time and attention," contends John Romeo, managing director of Mercer Oliver Wyman in London. "We will eventually see the execution wallet in a smaller number of hands, likely the top big banks. Execution is about scale, which is what these firms have. The less liquid and more difficult stocks are likely to be traded through the specialists."
With changes in technology and regulation tending to concentrate order flows, the business of equity trading is becoming more and more cutthroat. In this high-pressure environment, one brokerage firm stands head and shoulders above the pack, according to leading fund managers, when it comes to its ability to efficiently execute equity trades: Credit Suisse.
The Swiss bank ranks a clear first place for its overall trading capability in European equities in Institutional Investor's exclusive survey of portfolio managers. Voters praise Credit Suisse for its ability to work an order, its capital commitment and its discretion -- respondents rated it best for minimizing the leakage of information about trades. They also gave the Swiss bank top marks for its capabilities in algorithmic trading, which uses sophisticated software to automatically route orders to the trading venue that offers the cheapest price.
Goldman Sachs International comes in second in overall trading capability, followed by Merrill Lynch, Lehman Brothers and J.P. Morgan. Goldman ranks first for minimizing the market impact of trades and for its ability to use derivatives to enhance equity execution. Merrill also rates highly for its derivatives expertise.
Two European houses that typically rank highly in terms of trading volume win lower ratings from our voters: Deutsche Bank comes in eighth in overall trading capability, and UBS ranks No. 11. Voters commend Deutsche for its prowess in using derivatives, though. Credit Suisse also comes in first when buy-side voters were asked to rank firms' overall sales and trading relationship. A surprise runner-up, considering that the list is dominated by global rather than regional players, is Dresdner Kleinwort Wasserstein, which is followed by J.P. Morgan, Merrill Lynch and Goldman Sachs.
Among exchanges, fund managers rate Euronext.liffe, the London-based, Anglo-French futures and options exchange, as the best overall trading venue, followed by the Bolsa de Madrid and OMX, the Stockholm-based Scandinavian exchange. The region's Big Three stock markets fare less well: Deutsche Börse is ranked fourth, Euronext sixth, and the London Stock Exchange trails all the main markets in eighth place, a stark contrast to its position as one of the industry's most sought after merger partners.
The results are based on a survey of fund managers at nearly 190 money management firms that manage some $2 trillion worth of European equities and generate an estimated $1.48 billion in trading commissions each year. We asked these investors which brokerage firms and which exchanges provided the best execution service for European shares. We also asked about the quality of sales and trading services provided by brokerages.
The biggest change to hit equity trading is the new transparency on commissions promulgated by the U.K.'s Financial Services Authority. Under the rules, which were introduced in January and take full effect from July, money managers must tell clients exactly how much of their commission costs covers trade execution and how much goes to pay for research. The rules have exposed to the harsh light of scrutiny long-standing soft-commission practices, under which brokerage firms would provide everything from research to trading screens in exchange for order flow.
The new rules could have a big impact on brokerage firms, our survey indicates. Fully 45 percent of buy-side voters say the rules either will or may lead them to review their relationships with brokers, and 48 percent predict that execution costs will fall as a result of the regulation. Three quarters of those anticipating a decline see rates falling by 10 percent or less this year, and 17 percent expect a decline of up to 20 percent.
In anticipation of the unbundling rules, Credit Suisse decided four years ago to develop a full range of execution options for clients, from full-service sales and trading to direct market access, says Richard Balarkas, the bank's London-based head of advanced execution service sales. "We realized that it was not just about unbundling execution from research but about disaggregating the different trading services we offer, each of which has different value-added propositions, which should be reflected in their pricing."
The bank increasingly relies on analytical tools to win business from major fund managers. Its execution performance reporting system generates quick posttrade reports detailing the trading costs -- from commissions to market impact -- for a single stock or basket of stocks. "In the past people did not measure these things,'' Balarkas says. "Now we can go back to the client a day later and tell them how they can trade more effectively."
By spurring firms to seek out the cheapest, most efficient means of trading stocks, the new U.K. rules should encourage fund managers to concentrate more trading with fewer firms, says Ian Firth, head of equity trading at Morley Fund Management, the £147.8 billion asset management arm of U.K. insurer Aviva. Morley so far hasn't reduced the number of brokerages that it deals with, but the fund manager is keen to take advantage of today's increased transparency to win cheaper commission rates from brokers. "We are engaging our execution partners in more detailed discussions about the quality of their executions and will continue to discuss and negotiate rates," says Firth.
Big brokers are only too happy to encourage a trend to greater concentration. Institutions ''are consolidating their brokerage list and looking more carefully at the way they trade due to regulatory pressures as well as commercial reasons,'' says Emad Morrar, managing director of execution services at Lehman Brothers International. "Their liquidity needs are growing due to increasing portfolios and trade sizes, and there are really only a handful of brokers who can provide solutions to their liquidity needs on a global basis."
In addition to spurring intense competition for order flow, the spread of trading technology is also causing a continued decline in brokerage rates. Merrill Lynch estimates that trading commissions fell to an average of 0.10 percent of the value of a trade last year from 0.12 percent in 2004 and 0.22 percent as recently as 1998. The firm predicts that the pace of decline will slow this year, giving an average rate of 0.09 percent.
One of the most common methods of shaving trading costs is commission-sharing arrangements, under which fund managers mandate brokerages to share a portion of their commissions with third parties, such as independent research specialists. Such arrangements put a premium on brokerages' ability to provide competitive execution services. According to a survey published in January by financial consulting firm Greenwich Associates, about three quarters of U.K. fund managers have set up such arrangements or plan to do so.
To maintain their competitive edge and pare costs, major brokerages increasingly bundle their execution services under one umbrella. By offering everything from direct market access and algorithmic trading for large, liquid stocks to bespoke advisory and trading services for smaller stocks, brokerage firms can segregate clients' order flow into high-touch, low-touch and no-touch categories. The aim is to capture as much volume as possible with state-of-the art technology, while offering higher-margin services for special situations.
"Clients are making more of their own decisions today, and there is much more focus on the quality of execution," says Brad Hunt, managing director in charge of European electronic trading at Goldman Sachs. "We view ourselves as execution consultants and offer the full range of products, such as direct market access, algorithms, and pre-, intraday and posttrade analytics. Our objective is to be a one-stop execution shop and to expand this across all asset classes."
Two years ago, Citigroup integrated five separate execution functions -- program trading, DMA, algorithmic trading, trading strategies and best execution consultation services -- under one banner called alternative execution.
"The big question that brokers have to ask is, 'How do I add value?'" says John Quaile, managing director in the bank's Institutional Client Management department. "You need to have the capacity to offer the whole spectrum of what clients want to do. There is much more discussion between fund managers and brokers about the relationship. This enables us to apply our resources where they are valued."
Lehman's Morrar believes that the segmentation of execution -- automating straightforward trades and providing tailored services for complex transactions -- will intensify. "Looking ahead five years I think all agency trades will be done electronically, and the commissions will drop," he says. "The risk trades, however, will still be done by the trading desk and a sales-trader because they are more difficult and need human intervention."
François Gouws, head of European equities at UBS, argues that scale will continue to be a major factor in the execution game. "Our value add is that we have one of the largest liquidity pools, which combined with our large balance sheet enables us to provide best execution for clients," he says.
Still, many European fund managers aren't quite embracing all of the latest trading technology. Many low-touch trading tools require that buy-side desks take on some of the workload formerly handled by brokers. Direct market access, for example, can require fund managers to monitor more trading screens from individual brokers. "The lower commissions they may be getting trading via DMA may not be offsetting the cost they may have in increasing staffing levels to monitor these trades," says Wyman's Romeo.
What fund managers really want is choice and advice in making the best use of the trading technology on offer. "We want a menu of execution options, ranging from alternative trading venues to DMA, algorithms and capital commitment," says Morley's Firth. "We also want brokers to offer advice and apply a more analytical approach on the most-appropriate trading strategies. Going forward we will see brokers competing more on the quality of their execution service."
