This content is from: Portfolio

The buy side wakes up

Best execution, getting the most shares traded at the best possible price, has suddenly become the rallying cry of the country's biggest and most influential institutions.

It's an unseasonably warm Thursday in late February, and Michael Callahan is looking to buy 200,000 shares of a small-cap technology stock. All week the 43-year-old senior trader for State Street Research & Management Co. has been chipping away at a 1 million-share order placed by one of the portfolio managers who helps to run the firm's $50 billion in assets.

Eager to get the shares bought by day's end, as fresh orders from State Street's portfolio managers pile up, Callahan has been scanning his array of flat-screen monitors in the firm's cramped trading room on the 31st floor of One Financial Center in downtown Boston. Callahan is in new territory. Two years ago he would have called up a big Wall Street brokerage house and simply handed the traders there the order. Now he works it himself, checking prices posted on electronic communications networks as well as upstart trading systems like Liquidnet, which bypass Wall Street to link buy-side firms like his directly to one another.

All week he has watched this stock gyrate. Now he is sifting through bits and pieces of information, trying to figure out whose offers are real and who is trying to game him. Midmorning he has a brief scare when someone in an Internet chat room starts a rumor that the company is in regulatory hot water, but he makes a few calls and concludes that the rumor is false.

Finally, just before 4:00 p.m., he is ready to move. He splits the order into two pieces, throwing 10 percent to an anonymous matching bid posted on Posit, Investment Technology Group's electronic crossing network, and the rest to a traditional brokerage he has identified as a "natural seller" by using Thomson Financial's AutEx liquidity identification system.

"A few years ago I might have checked our commission list to see who's been trafficking the stock among the firms that provide us research, and most likely I'd send it over to a broker," says Callahan. "But now I'll spend the extra time to get the best execution."

Callahan is not alone. Best execution , getting the most shares traded at the best possible price , has suddenly become the rallying cry of the country's biggest and most influential institutions. Spurred on by a rotten market that has forced firms to focus obsessively on costs, as well as by what many see as declining quality of service from investment banks , particularly a growing reluctance to commit capital, which has made it costlier than ever to buy and sell large blocks of stock , one major institution after another is overhauling its approach to trading and in the process threatening to upend the traditional way these firms have done business with Wall Street.

Just ask Callahan's Beantown neighbor, Richard Leibovitch, global head of trading at Putnam Investments. Every day his 14 traders must buy and sell about 40 million shares of stock for the firm's huge portfolios, which have ballooned sixfold in the past decade, from $52 billion to $310 billion. Million-share orders for a single stock, once rare, are now commonplace. Three years ago Putnam traders routinely entrusted most transactions to their favorite brokerages. Now, dissatisfied with the sell side's ability to execute such big orders without adversely moving markets, Leibovitch and his team are determinedly bypassing the Street and taking matters into their own hands.

Last year Leibovitch created a separate desk that matches block orders directly with companies that wish to buy back shares or issue new ones. Putnam also began designating one day each week as "program day," when orders from throughout the firm are aggregated into baskets and executed by Wall Street program trading desks at far lower costs than if they were processed separately. By the end of this year, Putnam intends to cut its traditional way of doing business , routing orders to buy or sell single stocks to the Street , to less than 50 percent of its volume.

"Ultimately, the markets are just not big enough to accommodate the amounts of capital we have to move through them," says Leibovitch. "And we have a responsibility to do something about that."

His has become a common refrain throughout the institutional world. Mutual fund titan Fidelity Investments, with $900 billion under management, has joined Putnam in establishing a so-called capital markets desk to execute large orders directly with corporations. Barclays Global Investors, the world's biggest indexer, and TIAA-CREF, the pension and mutual fund heavyweight, are among the scores of large institutions that have begun trading directly with each other through Liquidnet. Money managers like Franklin Templeton Investments have so increased their program trading usage that such activity now accounts for a record 27.8 percent of New York Stock Exchange volume, up from only 11.6 percent as recently as 1995, according to the exchange. State Street Global Advisors and Franklin Templeton are among the many firms that either already have or are developing proprietary cost-analysis systems, which traders can use to estimate transaction costs and adjust their tactics accordingly. And virtually all firms are hiring more traders and, in perhaps the most telling harbinger of change, pegging their pay to how well they minimize costs.

"Our traders aren't just clerks filling out orders for the portfolio managers anymore," says Anne Hartwell, head of trading at $150 billion-in-assets MFS Investment Management. "We've become an integral part of the investment process."

So integral has trading become, in fact, that Putnam now incorporates cost as one factor in helping its stock pickers decide what to buy or sell. "A portfolio manager might have a list of 100 potential buys, which he has generated using the traditional research tools at his disposal," says Putnam's Leibovitch. "But there's a big difference between identifying something as attractive and whether we can actually trade it. He may wind up replacing ten or 20 names on the list simply because it would cost us way too much to get those trades done."

All this portends perhaps the biggest shift in the balance of power between the buy side and the sell side since May Day 1975, when fixed commissions on stock trades were abolished, unleashing enormous trading activity and prompting the consolidation of Wall Street houses desperate for the huge sums of capital that suddenly became necessary to compete. More recently, traditional trading methods have been challenged by technological innovations like the Internet and regulatory fiats like the imposition of decimal pricing of shares and the reform of Nasdaq order routing. These events upended sell-side practices, gave rise to electronic communications networks, and , remember the day-trading craze? , put unexpected power in the hands of mom-and-pop retail investors. Now it is the big institutions that are revamping the way they trade, with potentially enormous consequences for the structure of markets and for the Wall Street firms with which they have worked for decades in lucrative if at times rocky symbiosis.

"There has been a significant migration away from getting orders done through traditional sources," says Andrew Brooks, head of trading at T. Rowe Price Associates in Baltimore. "Should Wall Street be worried about this? You bet."

Adds renowned money manager Michael Price, the former chairman of Franklin-Mutual Series Funds who now runs $500 million hedge fund MFP Investors in Short Hills, New Jersey: "No one paid attention to these problems during the 1990s, but now the costs of trading are taking a bite out of shrinking returns. To me this is an absolute revolution."

This revolution, like most, has its roots in simple economics. Before May Day 1975 commissions were the focus of cost; now it is the subtler, though potentially more devastating, notion of market impact, or the effect big orders can have on the price of shares, making them more expensive to execute. One popular tool for measuring market impact is comparing the average price at which a large order is executed with the volume-weighted average price for the stock during the same period. If a trader executes too much of a buy order too soon, for instance, it may drive up the price of the stock, making the price of the implicit execution higher. These costs can add up in a hurry. According to research firm Plexus Group, institutions pay up to 46 cents per share in hidden expenses on every trade, costing the industry as much as $100 billion annually.

Clearly not all of this money is lost. There are two sides to every trade, but each money manager wants to be the winner in this zero-sum game. And a good bit of that eye-popping sum is soaked up by intermediaries directly or lost by them through inefficiency or ineptitude.

"Getting orders done has become tougher. If we are not working as effectively as we possibly can, we are going to get creamed on trading costs," says Scott DeSano, head of trading at Fidelity.

In fat times money managers were only too glad to overlook excess costs that might occur over the standard commission of 5 cents per share in return for access to deal flow, research and capital. But those ancillary benefits are declining in value or disappearing. Hot IPOs are a thing of the past. Sell-side research has become suspect, and a consolidating, risk-averse brokerage industry is providing less capital to keep markets moving. In January Goldman, Sachs & Co., Merrill Lynch & Co. and several other big firms began charging commissions for matching Nasdaq orders with others in the marketplace, rather than filling them from their own inventory and profiting from the difference between the quoted bid and ask prices as had been the practice on Nasdaq for decades. Holding inventory requires capital they are no longer willing to put up.

Ironically, the buy side's actions are being driven by the unintended consequences of recent market reforms. New regulations and technological innovations, designed to improve transparency and liquidity for the investing public, wound up helping individual investors at the expense of big institutions. Such changes as the decimalization of stock prices have heightened the influence of small orders and compressed the profits Wall Street can earn from making markets.

The buy side's response is only tightening the screws on investment banks, threatening to squeeze even further their already-thinning trading profits. In the latest quarter, for example, Goldman, Lehman Brothers and Morgan Stanley saw equity trading revenue decline by 91, 61 and 38 percent, respectively.

Widely feared for its exacting standards, Fidelity has spent millions on technology to track sell-siders in real time. Over the past two years, head of trading DeSano has systematically slashed the number of brokerages his firm uses; they compete for orders on the quality of execution.

Wall Street feels the pressure and is trying to respond. "There's definitely more demand from clients for liquidity and efficient executions than I've ever seen before," says Goldman trading head Joseph Dellarosa.

The NYSE and Nasdaq will soon allow investors, for the first time, to access big orders away from the best market prices, in an effort to address buy-side complaints that the best published quotes are often for only 100 or 200 shares. Major brokerage houses are seeking ways to piece together larger amounts of fragmented order flows to achieve more efficient execution of big institutional orders. Goldman has spent $8 billion in the past two years acquiring several electronic trading and exchange specialist firms. But big brokerages are also developing their own tools to analyze profits on a client-by-client basis, and some are talking about shifting their resources out of big penny-pinching money management complexes into smaller, higher-margin hedge funds.

In some Fundamental ways stock trading in the U.S. hasn't changed much in its 210-year history. For philosophical and political reasons, it has favored the little guy over big institutions. As late as 1959 retail investors accounted for 70 percent of NYSE volume, to institutions' 30 percent. One decade later the proportions reversed and Wall Street began to adapt its services to the growing ranks of mutual funds and pension schemes that dominated the market.

During the go-go 1960s all the major investment banks added block trading desks to facilitate big trades. Firms like Goldman, Morgan Stanley and Donaldson, Lufkin & Jenrette began offering clients in-depth research as well as capital to foster large transactions. Activity exploded, and in an era when commissions were fixed at rates as high as 25 cents per share, Wall Street made gobs of money.

Then came May 1, 1975, when the federal government ended the era of fixed commissions, requiring brokerages to compete on price. Predictably, a race to the bottom ensued, with discounts rampant for both retail and institutional investors. Commissions shrank by 80 percent over time, and institutions lived large. Still, the sell side made good money; small firms sold out to big players who turned their profits doing a larger volume of business and trading against the flows.

In the 1990s a series of market changes made life much more difficult , and trading more costly , for institutions. First, in 1997, the National Association of Securities Dealers imposed new Securities and Exchange Commission,mandated rules in response to a price-fixing scandal on the Nasdaq Stock Market. Dealers allegedy acted in concert to keep bid-ask spreads artificially wide, thus inflating their profits. Their main technique: hiding limit orders they received from customers that would have improved dealers' quoted prices for a given stock. Consequently, the linchpin of the reforms was the so-called limit order display rule, which required market makers to publicize customer limit orders in a timely fashion.

This presented two problems for dealers. Customers frequently offered more attractive prices, which narrowed the fat bid-ask spreads of dealers. More significantly, market makers lacked the technology to widely disseminate limit orders through Nasdaq's electronic quoting system. Rather than spend untold millions building new systems, dealers began shipping these orders to electronic communications networks, such as Instinet, Bloomberg Tradebook and Island ECN, which possessed the technology to easily integrate limit orders into their public quotes. Within two years ECNs handled one third of Nasdaq volume. Today analysts estimate that they account for more than half, and they are making inroads into the more protected arena of NYSE trading.

At the same time, regulators and legislators pushed Wall Street to stop quoting prices in increments of one eighth of a dollar. In 1997 the industry voluntarily cut the minimum "tick" to one sixteenth. Last year the markets adopted decimal pricing, in which the minimum price movement is one penny. All too quickly, the minimum bid-ask spread shrank from 12.5 cents to 1 cent. Consequently, Wall Street firms became far less willing to risk their capital making markets. "Finding liquidity was tougher," says Fidelity's DeSano.

"The capital hasn't been there for big blocks for a few years now," says Leo Smith, Putnam's veteran head of equity trading. "Brokers want to reduce their risk exposure. We've been making do with less for some time. That's why we're building up here, so we have some alternatives."

In short, the market that adapted to the rise of institutions during the 1960s and 1970s was once again skewed toward meeting the needs of individual investors. Individuals can move markets simply by entering 100-share orders at a penny better than the quoted price. And with 100 price points between each dollar rather than eight, prices fluctuate far more frequently. Liquidity has fragmented among ECNs, Nasdaq market makers and the NYSE floor. For buy-side traders trying to move large blocks, it's a nightmare.

One measure tells the tale. In the late 1990s, as institutional assets under management soared , and with them the buy side's need to make bigger and bigger trades , the average size of stock transactions plunged. According to Plexus Group, the size of an average trade on the NYSE fell by 30 percent from 1996 to 2001, from 1,489 shares to 1,041. Nasdaq experienced an even more dramatic decline of 43 percent, from 1,400 shares to 800. In that same period, assets committed to equity mutual funds nearly quadrupled, from $1.2 trillion to $4.1 trillion, according to the Investment Company Institute.

As a result, many more small trades are necessary to execute ever-larger orders. That creates additional opportunities for prices to move and transaction costs to soar. "The quoted spread in many stocks right now is a penny wide. But there's only 100 shares there, and it's moving so fast," says Roger Petrin, head of trading at State Street Global Advisors. "The problem is we don't see where the institutional market is. The real size may be at 4 cents wide, but we can't see it. That's what institutions are grappling with now."

Institutions have more than their bottom lines at stake in finding answers. The SEC is closely scrutinizing execution quality as well. It wants to ensure that money managers route orders to destinations that offer the best execution, rather than merely as payback to brokerages that provide services such as fund distribution or preference in new-issue allocations. "We have made reviews of best execution a priority as part of routine exams and continue to find problems," says Lori Richards, director of the SEC's Office of Compliance Inspections and Examinations. Richards declined to elaborate on what examiners have found or what the agency might do about it.

"It was an issue we knew the SEC was going to focus on, but it's long overdue," says Theodore Aronson, managing partner of quantitative asset manager Aronson + Partners. "It all comes down to whether trading is done purely in the best interests of the end clients, period."

ALL of these factors have JOLTED THE BUY side out of years of complacency. Consider Fidelity, the Street's biggest and most powerful customer. Like many of its counterparts, it is paring the number of brokerages it does business with and squeezing the ones that make the cut. Over the past two years, DeSano has sliced the ranks of the firms Fidelity uses from 500 to 75. Some 20 to 30 brokerages receive 75 percent of its business. But even these firms don't have it easy. Fidelity has developed systems that allow its traders to monitor their sell-side counterparts in real time.

"Through technology we can see them as they are working our order," DeSano says. "If we see we're not getting the best price, we'll get right on the phone."

And Fidelity's traders have a real incentive to ride herd on the Street. The firm bases 80 percent of its traders' bonuses on systematic reviews of their quality of execution: The measuring stick is the volume-weighted average price of the stocks they trade.

Analytical tools are critical to measuring costs. For many years money managers have used posttrade cost analytics generated by firms such as Plexus Group and Elkins/McSherry. Although helpful, the data provided by these services are designed to evaluate trades after they occur. More valuable are estimates of what a particular trade might cost before it happens. Several firms are developing proprietary algorithms that generate these numbers.

State Street Global Advisors has a team of quantitative analysts working on a proprietary cost-estimate algorithm and expects to have one in place before year-end. Putnam implemented its own system, dubbed ACE for agency cost estimate, one year ago. The firm's traders, portfolio managers and CIOs can access the Web-based system on their desktops and receive cost estimates for any stock in real time by plugging in a ticker symbol, an order size and an investment style (aggressive, passive or neutral). The information helps the firm decide what approach to take when executing the trade, or whether to even go through with it. The estimate for a volatile small-cap stock, for instance, might show that the cost of buying a large number of shares would eat into potential returns so much that the firm would be better off buying a different stock.

Estimates also give institutions a better benchmark for evaluating the performance of their own traders, as well as that of the sell side. Industry leader Fidelity and $270 billion Wellington Management Co. are said to have developed similar systems last year.

Armed with these estimates firms can better evaluate alternatives to traditional trade executions. One increasingly popular option is program trading. Also known as "basket" or "portfolio" trading, this technique bundles scores or hundreds of individual stock trades into a single order, which is typically transmitted to the sell side as an electronic file and executed for a penny or two per share rather than the standard nickel. The key is assembling a portfolio of buys and sells that balance out , such as selling three energy companies but buying three others, and trying to achieve the same neutral exposure to other sectors , thus minimizing the risk profile and justifying more aggressive pricing from brokerages. Once confined to speculative arbitrageurs, passive portfolios or funds going through a change in style or manager, program trading is increasingly being adopted by active equity managers as a way to minimize transaction costs.

Putnam, for instance, did no program trading at all in 1998. It began experimenting with the technique in 1999; by the third quarter of last year, programs accounted for 21 percent of its trading volume. Franklin Templeton last year increased its portfolio trading activity from 3 percent of the firm's volume to 5 percent. State Street uses a variation of program trading in which its traders aggregate orders into baskets and manage the execution themselves through a number of venues, rather than turning one electronic file over to a brokerage.

A more radical alternative involves pursuing "capital markets" transactions. In such deals, money managers go straight to corporations and inquire whether they are interested in issuing new shares or buying existing ones back. Sometimes third parties , companies or other investment managers , may want to part with or acquire a minority stake, and the capital markets desk will take the other side of the transaction. Trades are negotiated privately, with no market-impact costs. Often investment bankers at big Wall Street firms get paid for helping arrange transactions, but the fees pale beside the costs of executing a big order using traditional means.

The first firm to take advantage of this tactic was Janus Capital Corp., which in January 2000 bought a 10 percent stake in Healtheon Corp. for $930 million in a private deal with the company, bypassing Wall Street entirely. The deal blew up in Janus's two faces when shares of Healtheon plunged from more than $70 to the single digits within one year because of increased competition and software integration problems. (The shares remain at about one tenth of what they were worth at the time of the transaction.) The rest of the buy side nevertheless learned a valuable lesson from the deal , namely that Janus had acquired the shares at a 6 percent discount to the market price and paid nothing in transaction costs.

Since then Fidelity and Putnam have established similar operations of their own. Putnam portfolio managers automatically route orders exceeding 10 percent of a stock's average daily volume to the capital markets desk, which completed about 75 deals last year. The firm hopes to handle 5 percent of its volume through the desk this year, doubling last year's level. Other firms have not hired dedicated capital markets staffs but frequently complete one-off deals. Franklin Templeton, for instance, executed two such transactions during one week in January, though trading head Matthew Gulley declines to provide details.

Firms are also finding new ways to "cross" their orders with identically matching ones elsewhere in the market. Crosses represent the ideal: no transaction costs. Existing alternative trading platforms, such as ITG's Posit system and Instinet, have for years offered electronic crossing of orders. Until recently these systems never quite developed critical mass, in part because investors were less focused on costs. Now money managers are increasing their use of these systems and developing their own, internal systems to identify crosses. Volume on Posit, for instance, has tripled during the past three years to more than 100 million shares daily.

One new system that is capturing much attention from money managers is Liquidnet. Founded by Seth Merrin, a pioneer in creating the electronic order management systems that are now ubiquitous on buy-side trading desks, Liquidnet links institutions together through these order books. Consequently, the system can easily detect and execute matching orders from disparate money managers, automatically and anonymously , all for 2 cents per share and without a brokerage or an exchange. "People can come to Liquidnet and find a natural match for a 100,000-share order," says Merrin. "For a buy-side trader, that's nirvana. You can't do that on the exchanges."

To be sure, similar "black box" systems have threatened to upend the established order over the years and never lived up to the hype. But buy-side traders appear more enthusiastic about Liquidnet, chiefly because it is easier to use than its predecessors that failed because of their complexity. Additionally, traders are getting results by using the system. Ten months after launching, Liquidnet boasts 126 participating institutions. Its mean trade execution is for 70,000 shares, and it averages about 6 million shares per day. That's still minuscule in the grand scheme of trading, but it's a promising start.

"It's kind of like Napster for order flow," says William Cline, a partner at consulting firm Accenture who specializes in trading technology. "The software is embedded in institutions' order management books, and it helps them trade with one another, expanding the internalization pool among many firms." One big believer in Liquidnet is Paul Davis, head of trading at giant retirement and mutual fund complex TIAA-CREF: "Trades that took a month now can be done in two days," he notes.

TAKING ADVANTAGE OF ALL these alternative approaches can yield big savings. Leibovitch says Putnam reduced its transaction costs by 27 percent in 2001, the first year its revamped trading strategy was in place. Since 1997 Fidelity's trading costs have come down from 15 basis points per transaction to 5, says trading head DeSano. And the industry's efforts are only in their infancy. Knowing that they can achieve these kinds of results, money managers are bound to focus even more intently in coming years on alternatives to the prevailing market structure.

For Wall Street, whose profit margins from trading are already razor-thin, the message is clear: Adapt or suffer. It's too early to tell how successful systems like Liquidnet will become, but the driving force behind the early interest in the system is obvious , institutions want to find natural matches for their biggest orders, anonymously and among themselves, rather than with the help of a traditional intermediary. "If this is a trend that is not to be stopped," says Accenture's Cline, "then the number of trades requiring broker-dealers on the other side of the trade is going to decline."

Like good traders, sell-side firms are attuned to what's going on and are acting to blunt the impact on their bottom lines. "There's no doubt that buy-side initiatives to reduce transaction costs are forcing significant changes in the way the sell side does business," says Ciaran O'Kelly, head of equity trading at Citigroup. "For us that means trying to be the low-cost provider of commoditized executions while striving to add value in more complex situations."

Goldman Sachs has been busy acquiring trading firms such as Hull Group and Spear, Leeds & Kellogg, which give it a wider variety of options for handling buy-side orders. Hull's electronic trading engine allows Goldman to more efficiently execute pieces of large orders across several venues. Says Goldman trading head Dellarosa: "In the past we might have gone out to clients with five execution products. Now we offer them 25." Morgan Stanley has built and honed a similar system on its own during the past several years. Having sophisticated, efficient systems in place to handle small orders also provides firms such as Goldman and Morgan Stanley with more opportunities to profit from proprietary trading, an area the Street is increasingly looking at to help ease the pinch of shrinking margins from institutional brokerage.

Spear Leeds, as one of the biggest specialists on the NYSE floor, gives Goldman access to a wide swath of retail order flow it never previously saw. Some sell-side officials see harnessing these orders, even though they are not very profitable in and of themselves, as absolutely critical to survival in the institutional brokerage game because they provide traders with more captive liquidity to help fill very large orders. That's especially true in light of new SEC rules that require all brokerages to publish best execution reports for retail customers, showing how they execute orders and at what cost. Morgan Stanley, for instance, believes that by becoming known as an efficient venue for executing retail trades, it will attract more retail flow, which in turn will make it a better provider of liquidity to institutions.

"The numbers have only been published for a couple of months, but we have done very well, and we've been called by many people asking if we'll execute their retail order flow," says Matthew DiSalvo, head of North America sales and trading at Morgan Stanley. "We expect to be the recipients of additional retail order flow from the Street, and that will result in improved crossing rates for institutional orders."

Goldman and its competitors are also placing more emphasis on program trading to keep up with buy-side demand. Last year Goldman built a new program trading system to accommodate its acquisition of Spear Leeds, which is also a major Nasdaq market maker. The system now handles some 6,000 Nasdaq stocks , more than double its previous capability. Credit Suisse First Boston hired Daniel Mathisson, the longtime head of trading for quantitative hedge fund firm D.E. Shaw & Co., to boost its program trading desk.

Still, devoting more resources to portfolio trading is far from a lucrative proposition for the sell side. Says one big-firm head trader: "I don't want to call it a loss leader, but it's pretty close. Program trading is a low-margin, high-risk business. It's not a good business for the Street."

Another sell-side response has been a move by the major firms to execute Nasdaq orders on an "agency" basis , matching them with others in the marketplace and collecting a commission. The compression of bid-ask spreads over the past five years made this an economic necessity for the Street.

But perhaps the most significant adjustment brokerages will make has yet to be seen. All the major firms have made it a top strategic priority to analyze the profitability of their trading operations on a client-by-client basis and adjust the level of service provided accordingly. It's not an easy project, and firms are just now getting to the point where they are getting accurate, meaningful data. But for the very largest players , such as Citi, Goldman, Morgan Stanley and Merrill , the process could mean diverting manpower and attention away from giant money managers and to less-demanding clients.

Whether Wall Street firms can afford to reduce the number of clients they deal with , and chance losing touch with order flows , is an open question. But it's clear that some are encouraged by the emergence of hedge funds as a permanent force in the stock market , and an alternative source of business to the giant money managers. At last count there were some 2,400 hedge funds investing in U.S. stocks. Although the largest of these shops have only a few billion dollars under management, compared with the hundreds of billions a big mutual fund house brings to bear, they are highly active traders. What's more, they typically have fewer in-house analysts, greater risk tolerance and the flexibility to invest in a wider array of securities. Thus, more than their giant brethren, they value the assorted goodies Wall Street traditionally has bundled with execution services, and they don't mind paying for them.

"If the big accounts are putting us in a position where we are at an economic disincentive to continue providing them the service we have in the past, we have to think about broadening our distribution base," says Robert DiFazio, co-head of global equities at Citi. "Some firms might never want to cover 2,000 accounts. But I'd certainly think about it. There's a huge group of smaller firms out there that will give you 80 percent of their business if you are their No. 1 broker. That's real money."

The exchanges are also responding. Nasdaq hopes to ease some of the concerns about the fragmentation of liquidity among several trading venues with the imminent release of its new order-routing and execution system, dubbed Super-Montage. "Our hope is that this will accelerate the trend we've seen in recent months of having larger executions in Nasdaq and greater liquidity," said Dean Furbush, head of Nasdaq transaction services, while demonstrating the new system for about 300 traders in New York earlier this year. Buy-side traders like the fact that the system will more efficiently aggregate the best prices from disparate market makers and ECNs.

The NYSE also is taking steps to placate the big institutions. The Big Board last year unveiled with much fanfare a system called Institutional XPress, which promised to provide a more direct conduit to the specialist post , where trades are executed , for institutional orders. But many floor members objected to the proposal, and the watered-down version that survived has seen hardly any orders.

Catherine Kinney, president and co,chief operating officer of the NYSE, says the problem with Institutional XPress is that buy-side traders can't tell when another order in the market is eligible for matching via the XPress system. "I've sat on two institutional desks in the past week and they keep asking me: 'Show me an XPress quote. How do you know something is XPressable?'" she says, noting that some ECNs, such as Redibook, push alerts to users when an order in the book can be accessed through XPress. "We have to do a better job of pushing the data to them."

The Big Board is unveiling a number of additional improvements. In January it introduced a utility called "OpenBook," which for the first time allows a full range of market participants to view the backlog of limit orders that had previously been the sole preserve of specialists. Some traders remain skeptical, arguing that the additional transparency will only dissuade institutions from placing large orders on the book. But later this year the exchange will improve on OpenBook with a new system called DepthQuote, which will essentially create an additional set of quotes for each NYSE stock. The DepthQuote will be displayed alongside the traditional best bid and offer, displaying larger orders at slightly less favorable prices than the inside spread. Institutional brokerages could hit these quotes on behalf of their customers rather than executing larger orders in small pieces over time at the best market prices. To ensure that retail investors' orders at better prices aren't ignored, the system will require institutional traders to "clean up" the orders between the best bid and offer and the depth quote. The system is the NYSE's answer to SuperMontage, which lets traders see and access orders several levels beyond the best bid and offer.

Additionally, the NYSE in February asked for SEC permission to repeal the exchange's Rule 36, which for decades has prohibited "upstairs" traders in brokerage house trading rooms , as well as buy-side traders , from communicating directly with floor personnel as they stand in the crowd around a specialist post. Currently, floor brokers can speak with their upstairs counterparts only from designated booths, which are located away from the point of execution. Lifting the rule would decrease the turnaround time for executing institutional orders, because the floor broker could take advice from and provide feedback to the upstairs trader without having to pause and return to his booth. And that could potentially reduce market-impact and delay costs. But it remains to be seen how such a measure would be implemented, particularly as the exchange community got an opportunity to comment on the proposal and revisions. And even if the measure went through without major changes, there would still be several layers of intermediation between investors and the point of sale.

"I've been here a long time, and this is really a very big change," says Kinney, a 28-year NYSE staff veteran, of the rule repeal. "There are other competitive models that the buy side supports. But we still have a huge liquidity pool here. I'm not sure we've gotten exactly there, but these changes provide a very competitive model."

To be sure, several factors may act to limit just how often institutions can bypass or marginalize the role of brokerages and exchanges. For one, using emerging alternative trading tactics means building lots of infrastructure and shelling out millions at the same time that those institutions are trying to slash costs. Increasing program trading activity requires systems that can aggregate orders from scores of fund managers within a firm, package them into a single file and then redistribute the pieces to individual portfolios. Similar systems are required for processing internal crosses. Proprietary algorithms for measuring and es-timating costs are also expensive and labor-intensive to develop. And institutionalizing the capital markets approach to alternative trading means investing in people to work the phones and draft the contracts. Not all firms regard the savings as worth the investment. "The buy side has the same margin issues that we do," says Goldman's Dellarosa. "They don't necessarily want to go out and invest the kind of time and money it takes to do that much trading on their own."

Moreover, the success rate of techniques such as crossing and capital markets transactions is naturally limited by the lack of intermediaries. A buy-side trader might find a natural match for a 2 million-share order on a crossing network or by calling a company directly. He might even do so 25 percent of the time. But when he doesn't, he'll either need to break the order into small pieces or seek an intermediary to facilitate the transaction. Another potential stumbling block: Corporations may fear that by executing a large private transaction with one major shareholder, they will alienate others that might have been interested in similar deals.

Even more significantly, there's no escaping the fact that institutions , particularly big mutual fund complexes , rely on the retail sales forces of securities firms such as Merrill and Morgan Stanley to distribute their investment products and are thus reluctant to alienate these firms by cutting off the flow of institutional commissions. That kind of behavior, of course, is exactly what the SEC is trying to root out in its current compliance crackdown. "For the mutual fund firms, it's an unpleasant fact of life that the big wire houses sell a huge chunk of their product," says one consultant to investment managers who declined to be named. "I've seen big firms that allocate commissions this way , 'Okay, firm X sold 12 percent of our funds last year, so we have to give them 12 percent of our commissions this year.'"

These issues notwithstanding, there's no escaping the fact that declining returns and the unintended consequences of government regulations have awakened a sleeping giant. As customers, institutional investors have always held sway in their relationship with the sell side. They're just now awakening to how much.

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