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The withdrawal of Deutsche Börse’s £1.35 billion ($2.56 billion) bid for the London Stock Exchange earlier this month dealt a stunning setback to the prospects of exchange consolidation in Europe. The reversal in the face of shareholder opposition is anything but a reprieve for the region’s big three exchanges, though. Indeed, competition looks set to intensify among Frankfurt, London and Paris-based Euronext because of growing pressure from their customers. Brokerages and their demanding clients are flexing their muscles in an effort to drive down transaction costs and increasingly turning to alternative trading systems and program trading to obtain better -- and cheaper -- service.
“The holy grail for institutional investors has become finding the greatest liquidity at the cheapest price,” says Anthony Whalley, head of dealing at money manager Scottish Widows Investment Partnership in Edinburgh. “Of course, striving for a holy grail is all about pushing for a goal without ever getting to the end point.”
Even more than the exchanges, European brokerages are feeling the heat. As a cost-conscious buy side pares broker lists and negotiates lower commissions in exchange for
bigger shares of their businesses, the sell side is investing more heavily in technology systems that offer the efficient trading solutions clients want.
“We are in a technological arms race with our competitors,” says Nicholas Holtby, London-based head of European cash markets and sales-trading at Swiss bank UBS. “As in any commoditizing business, unless we can become more efficient and use technology better, we will find it difficult to compete.”
That’s if they can afford to stay in business as profit margins wilt under pressure from higher technology costs and lower commissions. Compounding their woes: pressure from new players like the crossing networks that allow investors to trade big blocks directly with each other, and the record-low volatility in Europe’s lackluster stock markets in recent years, which has drastically narrowed buy and sell spreads. In response, sell-side firms are laying off brokers and building up electronic systems that offer direct market access and algorithmic trading strategies. They are investing heavily in internal risk-control systems and the brainy quants they need to run those operations.
Many firms are putting more of their own capital at risk as some traditional long-only investors, following the example of hedge funds, increasingly turn to rapid buy-and-sell strategies that emphasize profits from arbitraging and put a premium on unloading stakes quickly. Executing these trades in a timely fashion often means asking a brokerage firm to take the other side using its own capital. Consequently, over the past 12 months, many of Europe’s biggest brokerages, according to their own private estimates, have doubled the amount of capital they are willing to commit to trading clients.
“Margin compression and the increasing amounts of capital we put at risk mean brokers are having to price their services more accurately,” says Garth Ritchie, head of European cash trading at Deutsche Bank in London. Those increasingly detailed pricing models are feeding another trend: growing transparency in costs for the buy side. That will surely lead to greater competition in the already tough brokering business.
The drive to achieve greater efficiency will only be accelerated by the introduction of new rules, such as a disclosure code proposed by the U.K.'s Investment Management Association that is expected to receive regulatory approval from the country’s Financial Services Authority this month. It will effectively oblige money managers to demonstrate that they are seeking “best execution” in their trades. The growing pressure on money managers to prove that they are seeking the most efficient deals for their clients is feeding the growth of increasingly sophisticated crossing networks, which can match up big institutional blocks while bypassing both brokers and exchanges.
“It’s ironic, but as liquidity has become more concentrated in Europe’s leading exchanges, trading choices have only expanded, which means my job is less simple than it used to be,” says Whalley. “Whereas ten years ago the trading venue was the exchange and nothing else, now I’ve got to be acutely aware of the strengths and weaknesses of different types of trading technologies and when it makes sense to seek the advice of a human broker or go with software.”
Who thrives -- or who even survives -- in this fiercely competitive environment is likely to be determined by which firms and exchanges do the best job of meeting the demands of newly assertive institutional investors. With this in mind, Institutional Investor set out for the first time to see which brokerage firms and market venues are best at satisfying institutional clients in Europe’s tough markets. To do this, we surveyed the head traders at more than 200 money management firms that generated an estimated $1.55 billion in commissions on European equity trades. We asked these investors which brokerages and alternative trading systems delivered the best overall execution service for all European shares and separately for the U.K. equity market -- the region’s biggest. We also asked about the quality of sales-trading services provided by brokerage firms. And among other questions, we asked which market centers (including major exchanges and electronic alternatives) investors preferred.
The firms singled out for excellence combine a variety of skills and capabilities. Morgan Stanley, which finishes first in pan-European execution and trading, including the U.K., gets high marks for consistently putting its capital at risk. It also wins praise for having some of Europe’s savviest traders. UBS, which comes second in pan-European execution, reverses position with its rival Morgan Stanley in pan-European sales-trading finishing first. Investors praise UBS for skillfully working big institutional orders through the market over time, for closely guarding information that could affect trades and for excellent pre- and posttrade analytic services. Merrill Lynch, the winner in both U.K. execution and U.K. sales-trading, excels at a variety of measures in Europe’s biggest equity market. Among them: ability to work an order through the market, minimization of market impact, topflight market analytics and confidentiality of sensitive trading operations. It does less well in the pan-European ranking, finishing sixth in both execution and sales-trading. Citigroup, which prides itself on offering a balanced array of execution options and services across the man-to-electronics continuum -- and across the globe, for that matter -- garners the third spot in all key tables: pan-European execution, pan-European sales-trading, as well as in U.K. execution and U.K. sales-trading.
The final two finishers among the top five in pan-European execution and in pan-European sales-trading are identical: Deutsche Bank and Credit Suisse First Boston, fourth and fifth, respectively, in both rankings. UBS finishes second in both U.K. execution and U.K. sales-trading, and Deutsche Bank holds fourth and fifth place, respectively, in those rankings. Morgan Stanley gets the fifth spot in U.K. execution, while CSFB holds down the fourth position in U.K. sales-trading.
Although a half dozen bulge-bracket firms dominate equity trading in both the U.K. and Europe, investors clearly appreciate the benefits of specialization in local markets and in achieving specific investment goals. British firm Cazenove, which has merged its investment banking business with J.P. Morgan’s U.K. investment banking operations to become J.P. Morgan Cazenove, finishes tenth for both U.K. execution and U.K. sales-trading and was particularly praised by investors for local market knowledge. Crossing networks ITG Europe and Liquidnet also earn top-ten places in the niche category of preserving the anonymity of buyers and sellers in the U.K. market and Europe-wide, respectively. Top spots in equity execution in a number of national or regional European markets also go to some relatively big local banks or brokers, including Exane BNP Paribas, No. 1 in France; Carnegie Investment Bank, first in Scandinavia; ABN Amro, the leader in Benelux; Santander Central Hispano Bolsa, second in Iberia (Spain and Portugal); and Euromobiliare, third in Italy.
Whether leading executors are pan-European or local, one thing is certain: They have to offer the most up-to-date services. As mutual funds and other big investors put unprecedented pressure on brokerages to execute more efficiently, program trading, which started as a tool for arbitrageurs and passive funds, mostly in the U.S., has exploded in Europe. Rather than conduct a series of trades in different shares over an extended time, increasing execution risk and multiplying commissions, investors, aided by their brokers, are using increasingly sophisticated software to create customized baskets containing tens of millions of shares, typically from more than a score of different companies. Survey participants reported conducting an average 13.3 percent of their day-to-day pan-European shares trades as programs.
“Program trading has clearly become the most popular tool for rebalancing a portfolio efficiently, streamlining not just trading but settlement processes,” says Deutsche Bank’s Ritchie. That’s largely because advances in software programming have allowed institutional investors to design and trade baskets much more quickly than in the past.
“Two years ago it would have taken us two and a half days to get anything other than a plain-vanilla program trade ready,” says Paul Squires, global head of equity trading at Axa Investment Managers in London. “Because of vastly improved systems that allow us to cut and slice the portfolio better, it now takes us minutes.” Squires says that program trading has risen from about 5 percent of Axa’s daily volume in 2002 to about 30 percent today.
“From nothing two years ago, we now do more than 20 percent of our daily turnover through program trades,” says Stéphane Trezzini, head of markets at private bank Lombard Odier Darier Hentsch in Geneva. “More than anything else, that has helped us cut costs by about 15 percent over the same period.”
Growing hand-in-hand with program trading have been new electronic systems provided by Europe’s biggest brokerages that give institutional investors direct access to Europe’s exchanges. Direct market access, or DMA, systems provide pipelines straight into Europe’s exchanges for investors that want to trade their own shares using their brokerages’ exchange memberships but not their services as middlemen. In addition to reducing fees to a fraction of the cost of brokerage commissions, DMA systems provide institutional investors with greater anonymity, which can significantly reduce the market impact of sales and purchases, as there are no human brokers involved in such transactions. Trezzini estimates that Lombard Odier will double its DMA trading to about 40 percent of daily turnover by the end of the year, as a means of lowering both direct costs like commissions and implicit costs like market impact.
“DMA is growing rapidly, but it works best for easier, smaller trades,” cautions James Cowles, Citigroup’s London-based European head of trading. “If people have large, difficult-to-work-through orders, they are probably better off going through a human broker rather than going directly to the marketplace.”
To get optimum pricing for big trades, many investors are turning to algorithmic trading, which is based on sophisticated software that shaves costs using a variety of timing mechanisms, such as buying below or selling above a constantly recalculated volume-weighted average price for a stock. Brokers are increasingly making the technology, widespread in the U.S., available to their European clients, even offering to install algorithmic programs on buy-side computers, allowing customers to design customized trading strategies.
“Although money managers in the U.S. have been using algorithms as a means of optimizing their trading for the past three years or so, Europe is still behind the curve,” says Octavio Marenzi, chief executive of Celent, a Boston-based consulting firm that frequently advises money managers on trading tactics. “In-house technology and programming abilities have always been more important at U.S. money managers than at European money managers, in part because exchanges in the States are open-outcry and thus less efficient than Europe’s mostly online exchanges, putting a premium on U.S. money manager expertise to improve execution.”
“Like many of our European peers, we will start using algorithmic trading programs in-house this year,” says Peter Raab, head of centralized dealing at fund manager Activest in Munich. “Used in conjunction with things like program trading and direct market access, it should further bring our costs down.”
Europe’s more-efficient electronic bourses have slowed the growth of alternative trading systems like crossing networks, compared with U.S. markets. Nearly two thirds of survey participants who answered the question said that they conduct less than 5 percent of their European equity trades through crossing networks, electronic communications networks or ATSs. Executives from some of Europe’s biggest crossing networks think their use is likely to increase sharply through this year, however, spurred largely by new regulations in the U.K., Europe’s biggest financial market. In addition to the new disclosure code for money managers, the FSA is preparing regulations that are likely to be issued this month, mandating that brokerages unbundle the fees they levy for such services as execution and research. Once the new rules go into effect, probably early next year, investors will for the first time be able to see clearly what research and execution cost them, making it easier to pay separately for them.
“We expect the disclosure and unbundling rules to give an enormous boost to our European crossing business,” says John Barker, London-based managing director of Liquidnet, the biggest crossing network in the U.S. “Traditionally, the European financial community is more closely knit, with a more closed mind-set than the U.S. financial community. But with the growing emphasis on best execution and low price, whipped along by the FSA, that will change.”
Although the U.K.'s initiatives have not been adopted by regulators on the Continent, institutional investors think that they may nonetheless set the industry standard. “To compete with the huge money management community in the U.K., Continental money managers are basically obliged to adopt FSA best-practice initiatives,” explains Activest’s Raab.
Does the growing emphasis on efficiency and technology mean that human brokers are going the way of the horse and buggy? Their numbers have been dwindling in Europe through attrition and layoffs at most of the bulge-bracket firms, but brokers still account for the majority of the equity trading executed on behalf of clients -- and that is likely to remain the case, say brokers.
“Our smarter and more-experienced trading staff have a very bright future, albeit in a broader advisory role rather than in the simple position of executor,” insists UBS’s Holtby. “With a growing array of choices for the buy side when it comes to executing and how to keep costs down, our role is really shifting to that of adviser rather than trader.”
Also, although brokerages like Citigroup and Morgan Stanley have been cutting the human element out of many trades in big, liquid stocks, they are increasing the number of traders who specialize in less frequently traded small- and midcapitalization European stocks. For such stocks, “knowing the market players and having specialized knowledge are key for executing at the optimum price and size,” says David Russell, head of European cash trading at Morgan Stanley in London.
Spurred along by unbundling and the increasing need to invest in technology, many professionals are predicting a shakeout in equity trading in the next couple of years. “The new rules and the growing emphasis on getting the best value for the money will polarize the equity trading community,” says Scottish Widows’ Whalley. On one side he foresees a handful of bulge-bracket firms, trading systems and exchanges that have the technology, capital and market-making abilities to offer the full range of execution services that demanding investors want. On the other side will be a much bigger number of small and midsize players engaged in tough battles for either research supremacy or execution prowess in specialized industries or geographies.
“While the shakeout will be unpleasant for participants, the good news is that investors will be the beneficiaries,” Whalley says.
The rankings were compiled by II staff under the direction of Director of Research Operations Group Sathya Rajavelu, Assistant Managing Editor for Research Lewis Knox and Senior Editor Jane B. Kenney, with assistance from Associate Editor Svetlana Anoschenko.
