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Pace of Change

The financial marketplace is always slow to implement change, always cautious when taking the first step in a new direction – especially with regard to technological change. What seem to be most effective, even if after a period of hesitation, are the products that arise from a need or a market opportunity, not the regulatory expectations. T+1 and STP both collapsed; they were pushing for change the marketplace did not need, nor for which was it asking. Algorithmic trading is becoming increasingly more popular – because it makes sense in this market at this time. Reg NMS is still on the desk of the Securities and Exchange Commission, and the difficulty firms will have in complying if the rule passes is clear, as it is clear the trouble firms are having trying to meet compliance guidelines for Sarbanes-Oxley Act.

The truth of the matter is that the marketplace is naturally progressing to a level that, once it is reached, will make all of the Reg NMS and the Sarbanes-Oxley debates moot. The marketplace is not unlike a child in its developmental stages. When pushed faster than it is comfortable moving, it loses confidence and falters. When presented with a task, it must be allowed to integrate it into its processes at its own pace which, inevitably, is slower than most of us would like, given the speed the industry demands these days. However, if we are patient and allow the industry to continue to move in the direction it is headed, we will find that it develops into a stronger, more efficient and more dependable system ready for the next logical developmental stage.

Internal Marketplace

Part of the market’s current development is tied into internalization, or the ability of a broker to match congruent buy and sell trades internally with an automated system. The significance of internalizing order matching with an automated system is the potential cost savings through achieving best execution without having to pay the execution costs on each side of the transaction, thus reducing the explicit costs of the trade. Granted, this methodology certainly does not apply to the majority of trades, but for the percentage for which it is effective, it is those trades that will reduce market impact and seek out the liquidity that otherwise may not be apparent. The remainder of the order flow still needs the external marketplace, which means there still is a significant driver of price discovery. Another notable advantage to the automated internal marketplace is the verifiable audit trail that accompanies any electronic trade order, which is much more difficult to track with manually processed trades.

Headstrong, a Virginia-based consultancy firm, acquired Elind at the end of last year, thus providing Headstrong with “an array of customizable internal matching services/components for investment banks and prime brokerages to consolidate order management systems, cross orders internally, and route those orders appropriately,” according to the release published in November. STRIDE is Headstrong’s flagship product that is designed to provide the sell-side with an automated internal marketplace. “The internal marketplace is part of an evolutionary cycle,” commented Gregory Johnston, former CEO of Elind, Inc. and current Director of Financial Products at Headstrong. “Things do move cautiously. In a few years this will be a widespread need in order for firms to be competitive in the way they process transactions.”

Johnston believes the internal marketplace is the next logical step in electronic trading evolution.   When you think of what FIX did for order and trade processing when the buy-side had to call an order down to the sell-side to work the orders on the exchanges or the OTC markets. The orders, which were then handled primarily through phone calls and paper tickets, came within a couple of years to be handled electronically between the buy- and sell-sides as FIX grew and became more popular. “By late 1997 to today, the marketplace has seen a proliferation of FIX compliant order management systems that could manage information to various desks within the firm,” commented Johnston. “Order routing networks evolved, then algorithmic trading.  As a result, this formed an electronic infrastructure internally within firms and externally to the marketplace, now making internal crossing possible. The problem,” continued Johnston “became implicit costs and inefficiencies as a result of decimalization and market fragmentation. Now, we have the ability to apply rules for electronic matching within the firm to reduce trading costs and create more efficient markets.”

This progression of the internal marketplace has stemmed in part from the advent of decimalization and its effects, which contribute to what now makes it difficult for institutions to find large pools of liquidity. Add to this already existing situation the algorithmic trade providers, and it simply adds to the dilemma of orders being hidden from the external marketplace due to attempts to reduce impact costs. With the mergers and acquisitions that are common in the industry, order flows within a firm or company are in a multitude of different places, making it difficult for firms to create efficiencies between them without the implementation of an internal exchange.

Cross Cost Examination

Indeed, Headstrong is not alone in its vision of increased efficiencies in order flow. In a report published last year, Larry Tabb, founder and CEO of The TABB Group, commented on the increasing amount of control the buy-side is taking over its order flow, made easier with – or perhaps due to – “FIX, order management systems, ECNs, aggregation, crossing networks, algorithms, and virtually an other equity trading advances.” One phenomenon being seen as the buy-side is accepting increased responsibility for its order flow is the decreased number of brokers a firm is using (see related article “Electronic Trading Strategies Force Buy-side and Sell-side to Rethink Relationship,” Feb 7) to execute its trades. “While the number of brokers that investment managers and hedge funds use is declining, firms report that they are increasing their connectivity to their remaining brokers across the board,” commented Tabb. “This enhanced connectivity enables more efficient analysis, trading, and trade processing, lowering the cost of service throughout the investment lifecycle.” The internal marketplace allows the sell-side to decrease costs, which is reflected to the customers, who also have access to larger pools of liquidity. There are two apparent types of cost savings with the use of the internal marketplace. One is the quantifiable cost, seen if even 10% of a firm’s order flow is crossed as there are substantial savings simply with the lower cost of execution. It is the implicit costs, though, that are critical. The impact and delay costs associated with trading fall into this cost bucket. If a large block is traded internally, that cost of the potential market impact and cost of execution had the trade been executed through the external marketplace are saved.

The purpose of the utilization of the internal marketplace to match trades is to create more efficient markets. Headstrong’s Johnston commented, “You can’t ignore that if you can decrease costs, both implicit and explicit, make liquidity more accessible and create transparency in markets you have a winning formula for firms looking to establish a competitive advantage.”

Regulatory Compliance

Obviously there are questions surrounding regulatory compliance when faced with the option of internalizing trades. Beyond even ensuring that best execution is being achieved, there are matters of sustaining the Chinese Wall and how this would interact with the passing of Reg NMS.  “From a compliance standpoint, crossing agency orders is very different than crossing principal orders,” explained Johnston. “Today, most large firms manually cross agency orders "upstairs".  This is common practice.  As long as the execution is done at or inside the NBBO, having an electronic capability to do this only enhances the speed of execution and improves liquidity, all while reducing the cost of the execution.  This is a good thing from an NMS perspective.  Crossing principal order requires more complex compliance rules to assure that agency orders receive appropriate priority.  Compliance reporting to reflect this is critical.”

Change of Pace

As we move into and through another electronic development stage – whether that be in the implementation of an internal marketplace or otherwise – the markets continue to increase in efficiencies, reporting capabilities and transparency, among other improvements. In time, the regulatory requirements firms currently are being asked to meet by bending over backwards will, in all probability, naturally be met through the needs associated with the increased acceptance and more widespread use of the electronic marketplace. All things change with time. The financial marketplace is not an exception.