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Stripped-down, hyperefficient trading methods are transforming the equity markets, and scandal is hastening the change.
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A little light can go a long way in finance. Consider the often Byzantine world of equity trading. Even as they grew to dominate the stock market, institutional investors paid scant attention to the impact of transaction costs on returns. Institutions did fight to eliminate fixed commissions in the U.S. decades ago, but once per-share transaction costs came down to pocket-change levels, trading became an afterthought, and orders were often routed to brokers as much because of personal relationships and to pay for related services like research as for best execution.
Over the past several years, however, institutions have begun to focus more closely on total transaction expenses, in large part because costs that were once considered ephemeral now can be quantified. Transaction-cost consultants have shed light on the price impact of buying or selling a big block of stock, which can make the total expense of a trade far greater than the few cents per share paid in commissions. Armed with such measurements, institutions have gradually begun to direct more of their orders to nontraditional destinations, particularly those using the latest technology to more efficiently execute transactions.
More recently, a series of scandals and controversies has focused the attention of investors -- and regulators -- on the conflicts inherent in traditional equity trading. Among the biggest of these scandals: allegations in late 2003 and last year that mutual funds were using trading commissions to compensate big retail brokerages for distributing their funds to individual investors. The U.S. Securities and Exchange Commission banned such "directed brokerage" payments last year, saying that funds making them ignored their obligation to trade as cheaply as possible on behalf of clients.
The SEC and the U.S. Department of Justice also are investigating Wall Street's alleged gift-giving abuses. Thus far they have been probing allegations that some brokerage firm traders lavished institutional clients with expensive gifts, including private jet travel, yachting trips and golf junkets, in attempts to win order flow from them. Such gifts may have violated rules limiting gift-giving to goods or services with a value of $100 or less. And like directed-brokerage payments, the gifts also raise the question of whether money managers are trading with brokerages that give them the best executions or those that provide the best payola. Boston-based Fidelity Investments, the world's biggest mutual fund family, said late last year that it is cooperating with the probes and has disciplined 14 individuals after conducting its own investigation; at least two of these individuals have left the firm.
At the same time, traders at money management firms have become troubled by the rise of proprietary trading as a mainstay of investment banks' earnings. Brokerages take pains to note that they wall off their proprietary operations from those executing trades on behalf of customers. But buy-side traders still worry that the two sides share information that gives the prop desks an advantage at the expense of their money manager clients.
"A lot of our institutional clients are very concerned about front-running by proprietary trading desks," sums up Richard McSherry, a co-founder of New Yorkbased transaction-cost analysis firm Elkins/McSherry, which is majority-owned by State Street Corp. (McSherry last year stepped down from day-to-day management of the firm but still serves it as a consultant.)
To be sure, money managers for the past few years have been taking an unprecedented degree of control over their own trading -- and, in the process, marginalizing traditional brokerages and exchanges ("The Buy Side Wakes Up," Institutional Investor, April 2002). But the heightened awareness of conflicts involving directed brokerage, gift-giving and proprietary trading has accelerated that trend, spurring institutions to execute trades in the most efficient manner possible.
"With all these scandals popping up left and right and people being fined for all these transgressions, money managers are trying to protect themselves," says Sang Lee, managing partner of Aite Group, a financial markets consulting firm in Boston. "One way to do that is by paying more attention to execution cost. If you can measure costs and demonstrate that you're doing all you can to minimize them, you at least have a backup in case any oddities turn up."
Such efforts will become even more important when new guidelines from the U.K.'s Financial Services Authority and the SEC regarding the use of brokerage commissions are implemented. Beginning January 1 investment managers doing business in the U.K. must disclose to clients what services other than trade executions are bought with commission payments. In a release issued last month, the SEC proposed narrowing the definition of "research" that can legally be bought with trading commissions, exempting such items as computer hardware. The agency is accepting comments on its proposal through November 25.
The heightened scrutiny of best execution in the U.S. may help explain why the cost of trading there is declining even as most of the world's markets get more expensive. According to Institutional Investor's ninth annual survey of global equity transaction costs, conducted for the magazine by Elkins/McSherry, the average cost of trading a New York Stock Exchangelisted stock was 23.36 basis points during the 12 months ended June 30, down from 25.87 basis points in the same period one year earlier. Nasdaq Stock Market trades cost 30.32 basis points on average, compared with 34.50 basis points one year ago. By comparison, the average cost of trading on all markets globally rose from 46.95 basis points to 51.00 basis points during the same period.
Elkins/McSherry measures transaction costs as a combination of commissions, fees and market impact. The latter is calculated by comparing the actual average price for a block trade with the volume-weighted average price -- the mean of day's high, low, opening and closing prices -- of the stock in question.
The world's most cost-efficient market, according to the survey, is Japan, with an average execution cost of just 19.55 basis points per trade. The most expensive? Colombia, at a whopping 99.75 basis points. The results for major European markets are a mixed bag. In the U.K. the cost of buying shares rose from 74.01 to 76.14 basis points (including a 50-basis-point stamp duty), while the cost of selling stock increased from 25.53 to 28.80 basis points. In France and Germany costs declined, but trading grew more expensive in Italy. Technically, buying shares in Ireland cost 137.53 basis points on average, but that includes a 100-basis-point stamp duty on all such transactions (see table).
The increased emphasis on efficiency has spurred growth at nontraditional intermediaries, such as agency-only brokerages and firms that rely on computerized algorithms to execute trades. Indeed, fully 50 percent of U.S. institutional trades are now handled in some "low-touch" fashion, according to a recent Aite Group study. Twenty percent of all volume, the consultants say, comes from program trades, in which baskets of stocks are bundled together by computers and executed in a single transaction, at a cut-rate commission. Slightly fewer trades, about 18 percent of the total, are being handed by so-called direct market access, or DMA, systems, which provide buy-side traders with simultaneous connectivity to multiple markets and allow big orders to be split among them. And 12 percent of transactions are being handled by algorithmic platforms, which combine the features of DMA systems with sophisticated programs that automatically parcel out pieces of orders among different destinations and over time to minimize implicit costs.
Underscoring the growth of these trading alternatives, Aite's Lee says that DMA systems accounted for just 2 percent of institutional trades in 2001, while algorithmic trading accounted for less than 1 percent of volume. Commissions on DMA business have shrunk from 1 cent per share to just four tenths of a penny per share.
It's no surprise, then, that firms employing these techniques perform well in the Elkins/McSherry rankings. Alternative-style firms such as Lava Trading, Wave Securities and Liquidnet dominate the rankings of the lowest-cost brokerages for NYSE and Nasdaq trading. The only bulge-bracket firm to crack the top ten in NYSE trading, Credit Suisse First Boston, is a leader among bigger firms offering sophisticated algorithmic platforms; its Advanced Execution Services trading engine is regarded as the best such system in its class by head buy-side traders who responded to a separate II survey of Wall Street's best trading firms. Other big houses that perform well in the Elkins/McSherry cost rankings -- Goldman, Sachs & Co. and Citigroup (sixth and seventh, respectively, in Nasdaq trading) -- also offer popular algorithmic systems. Lava, in fact, is a DMA subsidiary of Citigroup.
"What we're doing is putting control of orders back into the hands of buy-side customers," says Joseph Lombard, president of Wave Securities, a Chicago-based brokerage that is in the process of being spun out of electronic-exchange operator Archipelago Holdings. Wave began offering proprietary algorithms to customers in May but until then offered only a DMA system that let buy-side traders work their own orders. "I wish we could take credit for our low transaction costs, but it's mostly our clients' skill in using technology we provide," Lombard says.
He acknowledges, however, that the recent concern over trading scandals and conflicts of interest represents a big business opportunity for firms like Wave: "There's a growing recognition that maintaining tight control over your own trading information and using technology reduces transaction costs. We've seen a greater receptivity among some large shops, which were quite content to rely on traditional brokers up to now, feeling that they need to have an electronic solution."
The bulk of U.S. cost reductions have come from lower commissions, which fell from 17.83 basis points to 14.81 basis points for NYSE stocks and from 21.19 basis points to 16.67 basis points for Nasdaq shares. The next-biggest component of all-in costs, market impact, actually rose by a slight margin over the past year on those two markets. The significant reduction in commission costs tracks with the increased use of DMA, program trading, algorithmic systems and crossing networks like Liquidnet, which generally charge 2 cents or less per share, compared with about a nickel per share for traditional, "high-touch" brokerage.
Another factor contributing to cheaper trading in the U.S. may be simply that costs are easier to measure there than in other markets globally. "Here you have an incredible amount of competition among brokers and a lot of clients using transaction-cost analysis," notes Joseph Gawronski, chief operating officer of Rosenblatt Securities, an independent agency brokerage that employs brokers on the NYSE floor and has an "upstairs" single-stock and program-trading desk. "But it's very hard for people to get high-quality cost analysis and use it to pressure brokers on the international front. As a result, the algorithmic offerings and other alternatives are not as sophisticated in some of those markets."
A scandal or two might just change that in a jiffy.