Online brokerage: Trading up

With the Nasdaq composite index plunging and retail investors reconsidering the merits of full-service brokerages, online trading firms are targeting a new class of client: institutional investors.

With the Nasdaq composite index plunging and retail investors reconsidering the merits of full-service brokerages, online trading firms are targeting a new class of client: institutional investors.

By Jeffrey Kutler
April 2001
Institutional Investor Magazine

With the Nasdaq composite index plunging and retail investors reconsidering the merits of full-service brokerages, online trading firms are targeting a new class of client: institutional investors.

It’s a case of technology moving up-market while the mainstream consumer lies low. Online brokerages, such as Charles Schwab & Co., are increasingly pursuing the most profitable professional and semiprofessional investors - including day traders - vying with smaller companies that have long specialized in the active trader segment.

Both sets of competitors, in turn, are going after institutions. Hedge funds, in particular, are interested in the kind of high-speed order execution that day traders get by connecting directly to electronic communications networks through what are known as direct-access systems.

“Direct-access technologies are coming into vogue in the institutional arena,” says Omar Amanat, founder and chief executive officer of Tradescape Corp., a leader in the active trading field. Through its ECN subsidiary, MarketXT, Tradescape has a 39-member team selling to institutions a “neutral portal to liquidity with superior speed and intelligence,” says Scott Graczyk, co-president of the unit.

Tradescape and other direct-access shops had the institutional market in their sights long before the Nasdaq crash, but it took time to get up to speed. Taking a cue from The Innovator’s Dilemma, an influential 1997 book on corporate strategy by Harvard University business administration professor Clayton Christensen, Amanat calls day trading an example of “a disruptive technology that begins in a penny-ante area of the market and swims upstream. Direct access is now swimming upstream.”

Austin, Texas-based ProTrader Group, which operates 19 day-trading offices, is also paddling into institutional waters. Says CEO Jay McEntire: “Our traders are a lot like institutional traders. They are among the most successful professional traders in the country, and their input has helped us in making institutional sales a priority.”

McEntire signed six hedge funds last year. That was before the formal announcement in February of ProTrader’s institutional thrust, which is led by Craig Howard, a former manager of financial institution sales at Federated Funds. Unlike Tradescape, ProTrader doesn’t own an ECN with large-institution clients like Salomon Smith Barney and Merrill Lynch & Co.'s Herzog Heine Geduld. But McEntire shares Amanat’s view of bottom-up evolution. “A few years ago,” he says, “these clients were not price-sensitive. Now the price of execution is more of an issue for them and everybody else, and our model addresses that.”

Realistically, with brokerage relationships based on research and payments for order flow, the vendors cannot hope to sweep away all of the old institutional trading practices. Even one of ProTrader’s new entry-level customers, $7 million hedge fund Bazbaz Capital Partners of Dallas, still calls brokers. “In a fast-falling market, the electronic system trumps institutional traders, but in a slow market or for big orders, the firms do better,” says founder Simon Bazbaz.

“We’re getting very quick access to the market, with the least cost and friction,” agrees Michael Himmel, partner of Austin-based hedge fund Lambeth Capital, which also uses ProTrader. “If we managed $3 billion, we’d need a different system, but we plan to remain under $100 million.”

An estimated 5 to 7 percent of institutional order flow has gone electronic. “As the economics of intermediaries are exposed, and we move more to pay-per-use research, I see that going to 40 percent within two years,” says Greg Ferris, president of CyBerCorp, a day-trading leader that Schwab acquired in March 2000 for $488 million to get in on the direct-access action. Underscoring that “this is the wave of the future,” says Ferris, are Goldman, Sachs & Co.'s minority stake in the Archipelago ECN and its acquisition last fall of market maker Spear, Leeds & Kellogg, which provides direct access through its REDIProducts division.

Over time, says Tradescape’s Amanat, direct access will impress upon the institutional side, as it did the retail, that “brokers have to deal more honestly with investors to give them the best execution.” For institutions, he adds, direct access also holds the promise of “getting rid of fragmentation and reducing the ten screens required to access all liquidity pools down to one.”

Tradescape, CyBerCorp and ProTrader are among 12 to 14 providers of the core technology that powers most day-trading activity, estimates Russell Keene, an electronic-brokerage industry analyst with Keefe, Bruyette & Woods. Those three and a handful of others - including Blackwood Trading, Townsend Analytics and TradeCast - are actively pursuing institutions. Although dozens more firms sell the high-speed connections to ECNs that typify day trading, most license others’ systems.

Direct-access vendors differ in their approaches to institutions. Blackwood, for example, stresses versatility and flexibility as it tries to cover every base, from mom-and-pops to the institutional high end. Even within the latter segment, “there are many different types of trading entities that each have specific needs,” says Kirk Oberliesen, Blackwood’s director of institutional sales and trading. The New York firm drafted its institutional strategy a year ago and in January began marketing in earnest. “We have a lot of customers in process. It takes a while to get [communications] lines installed,” says Oberliesen.

CyBerCorp is nearing the end of a direct-access trial begun last September with 27 Schwab-connected investment managers. That number could go up quickly - Schwab has links to 7,000 managers.

Townsend’s RealTick platform, by contrast, has been on many institutional desks for as long as three years, because it is integrated with the Archipelago ECN, which Townsend also developed. But usage remains low. “It’s difficult to get institutional traders to actually use direct access,” says co-founder and president Stuart Townsend. “They’re people who tend to keep doing things the way they always have done them.”

But the Chicago-based firm is investing in client education and hand-holding. “Things are coming together to get these trading techniques accepted,” Townsend says. “Traders will get more comfortable with direct access and with electronic order entry in general, and risk managers will also become comfortable trusting electronic order entry. Administration is already in favor from a cost point of view.”

Still, Keefe Bruyette’s Keene says day-trading firms face many behavioral and operational challenges in this new market: “Selling to institutions isn’t a layup. It becomes almost a consulting project.”

None of this would have a chance of coming together if day trading were not a raging success. Bear, Stearns & Co. brokerage analyst Amy Butte estimates that a mere sliver of the U.S. retail electronic trading market - 50,000 out of 18.5 million total online accounts - was responsible for 81 percent of 5.4 million average daily trades at the end of last year. That hyperactive group, who demand the utmost in direct-access capabilities, averaged 44 trades per day in the fourth quarter, up from 28 at the end of 1999. The remaining 99.7 percent of online investors reduced their average activity to 17 trades per year, from 27.

Most of the major online firms acknowledge that volumes declined in January and February. “We saw some drop-off in the active trader space, but not nearly as much as with other retail customers,” says James Ditmore, chief information officer of Ameritrade Holding Corp. He calls the active segment “the real engine of growth, and direct access is the most important part of that space.”

That explains why Ameritrade agreed in February to pay $67 million for Houston-based Tradecast. Ditmore, who is overseeing the purchase, says Tradecast “has unsolicited business approaching it all the time from small hedge funds.”

The Ameritrade and Schwab direct-access acquisitions and the target companies’ institutional ambitions are dual reflections of how “direct access is moving up the food chain,” says Keene.

“It’s a natural progression,” says John Palazzo, Graczyk’s co-president at Tradescape’s MarketXT. “We started with the active trading model, but the volume was going to other destinations. Owning an ECN allows us to pass efficiencies back to clients. Now it makes sense for our team, with its institutional contacts, to take those same technologies further upstream.”

For one aspirant, Paris-based Tradesoft, the upstream metaphor doesn’t apply. Founded in 1999 by Samantha Topola, former CEO of New York investment firm Hudson Sloane and Co., Tradesoft built its Global Direct Access Execution System, or GDAXS, specifically for institutions. The system turns an Internet browser into “a single access point to as many markets as possible,” she says.

For now, Tradesoft is focused mostly on European and emerging markets. Topola is waiting for her next software upgrade, scheduled for September, before actively pursuing large U.S. institutions, which have more exacting requirements.

“The institutional trend is toward electronic execution, and we’re just tapping into that,” Topola says. “The major investment banks have a role to play, and we don’t say, ‘Don’t use them.’ We say, ‘Do it the way you want to, not the way you are told to.’ We want to empower institutions to empower themselves.”

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