Trading Brokerage Value Chain Transformation

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The securities industry is in a period of fundamental transition and broker-dealers are facing many new threats to their business. If market-making and brokerage is an attractive business, why do so many industry players malign it? The old people-intensive business model, for the most part, no longer holds. Huge parts of the business – trading in bonds, cash equities, and standardised derivatives – are becoming commoditised.

Winning in this environment will require banks to reach unprecedented scale, and a handful of them will take the lion’s share of the profits. But emerging technologies will make competing in this new environment profitable for the eventual winners, allowing them to increase dramatically the volume of trades they can process while lowering their costs and increasing their profitability. The leading players will recognise that technology is an advantage, not a threat.

New systems can automate everything from front-end order capture to back-office clearing and settlement. Paradoxically, technology can also increase margins per trade. For example, new order-management software can automatically break up and manage large block trades to minimise their impact on market prices, thereby giving the customer a better price and boosting margins in the process. Provided volume is sufficient, internal matching systems enable banks to capture the full spread and avoid exchange fees; while CRM software can increase margins per account and may boost trading volumes as well. Increasingly, winning banks will need to provide services beyond trade execution, such as prime brokerage.


Drivers for Brokers Value Chain Changes

Generally, banks, especially smaller banks, are justifiably loath to attempt to venture into new markets (to trade on a proprietary basis) in which they lack some form of clear competitive advantage, such as is derived from market- making in the form of informational advantages. While data analytics may eventually serve as a substitute for data asymmetries, programme trading is, as yet, no better than punting in the dark. And while electronic trading networks now provide a reasonably inexpensive delivery channel for price- making to new markets, attracting order flow as a no-name brand lacking in infrastructure certainly isn’t easy either. However, in some of the emerging product markets, smaller regionally focused banks have a real edge.

Ultimately all markets are a fulcrum between risk-sellers (or hedgers) and risk-buyers (or speculators). Credit derivatives and their future derivatives provide a mechanism by which a lender can strip out and sell undesirable risk, leaving him with a relatively stable investment and potential return thereon. Similarly, it provides a borrower with a mechanism to reduce his credit risk premium and hence his cost of capital. The more risk is disaggregated over time, the more borrowers will be able to cut the number of basis points over a benchmark rate attributable to externalities, such as political risk, industrial action, catastrophes and so on. It should be obvious that such instruments are tailor-made for emerging market or developing country FDI.

In addition to product innovation for the hedging of capital market investments (equity or debt), new applications of risk derivatives are also facilitating the hedging of cash flow risk borne by the ultimate physical infrastructure investor (be it a factory, utility, mine operator, or other entity). Swaps, options, forwards and so on are now being employed in many capital-intensive heavy industries (such as steel, pulp, petrochemicals, coal, gas, shipping and so on), which tend to characterise less-developed economies.

The propulsion for the issuance of such risk hedging instruments has been the emergence of liquid secondary markets. In these second-stage product markets that are in the process of liquefying and commoditising, the electronic medium facilitates liquidity sourcing. With the birth of the Net, hedgers and speculators can be connected globally and thereby create liquid secondary markets in these innovative instruments, which ultimately benefits the primary market.

A prominent emerging market intermediary is ideally positioned in this development cycle, as it has both the source of these new issues on tap for origination and will remain linked to the end-users and underlying markets in its secondary trading activities. Over the long term, the growth in this type of market is likely to be exponential. A shortage of capital is the fundamental constraint on emerging market economic growth and, especially since the pre- millennium emerging market crisis, these economies have suffered from risk aversion by the capital exporters. With the convergence of product innovation and Net-generated liquidity in this new era, however, FDI and indirect capital inflows may surge once again.

Ultimately, smaller players need to re-evaluate their business from an electronic media perspective. They need to assess their existing target market segments in terms of their current corporate and institutional investor client base’s needs, especially in terms of their international expansion and capital- raising activities. They need to estimate the threat posed by international competitors. And they need to re-evaluate the product and service and channel offering, across the supply chain, and its configuration in an environment of client-centric multidisciplinary solutions. Finally, they need to seek new business opportunities and growth potential arising out of technology, all from a perspective of imagination, not imitation. These players need to position themselves in geographic or other market and product niches (such as debt origination, securitisation in lieu of factoring, distressed debt disposal, trade finance and so on) where they will retain competitive advantage through a focused value proposition and aligned set of competencies

These traditional points of value for both research and execution have already begun to weaken in the face of several recent changes.
The emergence of new trading technologies, new onerous disclosure regulations, the resulting decline in (per-share) commission rates and the growing importance of in-house research capabilities signal an industry in the early stages of flux. More significantly, these developments have begun jeopardising the very source of institutional brokerages’ value proposition, compelling them to begin to attune to such changes, anticipate how their organisations will be affected, and formulate the most appropriate strategic response in order to serve clients in the new and more demanding environment to come.

1. The Emergence of Alternative Markets
First, the emergence of electronic communication networks (ECNs) and electronic trading networks in general, particularly the buy-side to buy-side variety, has provided institutional investors with access to faster, cheaper alternative markets, where they can trade in secret, bypassing the brokers alto gether. This trading channel will become even more attractive as ECNs integrate with asset managers’ in-house order-management systems, using standard industry formats or protocols to facilitate seamless order flow directly to and from portfolio managers.

2. Direct-access Order Routing Technology
Second, allied to this, the increasing penetration of technology that provides direct access to multiple electronic marketplaces is supplanting brokers in order routing.
Transaction costs, speed, anonymity and order control are the factors most often cited by next-generation stock traders when they explain the evolution and growth of so-called direct-access technology.
Direct-access software, which allows stock traders to route orders electronically and expeditiously to multiple execution destinations, without any intervention from an intermediary , has been around, in various iterations, since the mid-1990s. But the technology really started to gain ground in 1997, following the implementation of SEC- mandated Order Handling Rules, which were intended to level the playing field for smaller US equity investors, and which gave rise to a plethora of ECNs (equity trade-matching engines that electronically crossed customers’ buy and sell orders). Following the emergence of ECNs, which quickly seized significant market share in NASDAQ stocks, investors needed a fast and cheap electronic mechanism for routing orders to these matching engines. Consequently, direct-access vendors started to emerge, and today there are more than 20 providers of the technology.

Most of the current direct-access suppliers cater mainly to active day traders. Transaction cost savings was the benefit that initially lured them. Since these rapid-fire traders were actively buying and selling stocks throughout the course of a day, they needed an inexpensive mechanism for entering and routing orders. Direct-access vendors met that need. A recent industry study shows that direct access enables individual investors to reduce their transaction costs by up to 25 to 30 basis points. In fact, at the macro-level, direct-access order routing to ECNS is a key factor contributing to a current average trade execution cost of US$10, compared to approximately US$200 a few years ago.

Other factors – including order control and speed – have also contributed significantly to the rise of direct access. Using a direct-access system, an investor can control which execution destination their order gets routed to, such as a preferred market-maker or ECN, for example. Speedy order routing and filling is another advantage. Using direct access, an investor can route out a 50,000 share order for Cisco’s stock and get filled on the Archipelago or Instinet ECN inside of 15 seconds, for example. What day traders initially discerned was that if they could execute a trade within microseconds, they could take advantage of movement, whether it be up or down, in a stock. Technology vendors provided the platform to realise that scenario. Quicker execution and control of orders ultimately enables investors to achieve a better execution price, which is again related to transaction costs.
Although direct-access trading has experienced most of its growth in the daytrading community, buy-side institutions – particularly smaller hedge funds – have developed an appetite for the technology over the past 12 months. Buy-side traders are less sensitive about best price than active day traders because they have to execute a certain amount of large block orders in a given day and can’t necessarily afford to wait for a stock to move two ticks in their direction. Hence, initially, many were indifferent to direct access. However, as buy-siders gained more knowledge about the cost and other efficiency benefits derived from the technology, they started to leverage it.
One of the reasons that the buy-side’s usage of direct-access software has increased is because the number of trades institutional traders have to execute on a given day has increased significantly over the last decade. With the rise of ECNs, the number of small orders executed in the NASDAQ market began to rise. Since there were fewer large buy and sell orders to be had, institutional traders trying to complete big block orders were obliged to execute more trades. Consequently, since they needed a fast and efficient electronic mechanism for performing more ‘mini-executions’, institutional traders began to warm to direct access. Ultimately, of course, the technology provides a mechanism by which institutional investors can systematically access multiple pools of liquidity on an equal basis.
Another factor contributing to direct-access popularity on the buy-side is the software upgrades performed by direct-access software vendors.

Today’s direct-access technology is infinitely more flexible than trading software developed a couple of years ago, allowing institutions to perform more sophisticated transactions, such as:
¦ Electronic block order working
¦ Basket trading
¦ Program trading.

New order-management software, as we have indicated, can automatically break up and manage large trades to minimise their impact on market prices, thereby giving the customer a better price. This is particularly useful in port folio reallocations, which entail the trading of large blocks of many different securities. Using new electronic trading algorithms, trades of 100,000 (or even a million) shares may soon be executed electronically. Although the need for manual order working of large block trades still exists, the minimum size that qualifies as ‘upstairs’ is increasing immeasurably. The effectiveness of asset basket trading algorithms has also improved significantly, enabling investors to trade a bundle of securities simultaneously in a virtually unified market, instead of dealing in discrete ones, helping them to balance a diversified portfolio more efficiently and effectively. Moreover, the mechanism performs the function of market intermediary, automatically recombining stock price combinations from different sellers to satisfy the buyer’s request for a specific bundle.
Programme trading applications linked to order routing has also become a force majeure, but this is beyond the scope of this book. In addition, direct access has also given buy-side firms the ability to either supplement or replace their legacy-trader order-management and portfolio management systems.
Interest from the buy-side, supplemented by the launch of aggressive institutional strategies by a range of direct-access vendors, has helped the technology sustain its growth.
While there is, undoubtedly, scope for further direct-access growth on the buy-side, it is predicted that large buy-side firms will, in the future, increasingly use direct-access technology to supplement their existing relationships with broker/dealers, but are not, however, expected to terminate their relationship with the brokers altogether.

3. Effect: Disintermediation
As technology advances and participants throughout the financial markets become more electronically connected, manual execution will wane, and the proportion of trading conducted directly between institutions will continue to increase dramatically. This shift will be driven primarily by asset managers’ fiduciary responsibility to reduce costs. The pressure for cost savings through automation will be greatest for unmanaged funds – historically one of the best performing classes – because their research needs are minimal and trading expenses and related costs are often the largest drags on fund performance.
From an institutional brokerage perspective, these trends equal disintermediation, and in the face of the mounting challenge to retain business, brokers need to find ways to reintermediate in the new configuration, in order to remain relevant.

4. The Internet, Regulation, and the Impact on ‘Info-mediation’
In addition to the erosion of the value of trade execution, the criticality of the brokers’ role in ‘info-mediation’ is also being diluted by both technological and regulatory developments. The Internet has made tools and data such as analyst recommendations, estimates and first call revisions, news feeds, charts, trading oscillators, market forecasts and insider trading available instantly online. Once the exclusive province of leading-edge institutional traders, these tools now are readily accessible by asset managers and even small retail investors. Moreover, new best execution rules and the US SEC’s ban on selective disclosure3 will narrow the relative information and analytic advantage that brokers have enjoyed over asset managers. Brokers are being forced to upgrade their advisory capabilities in order to convince investors that they still add superior value.

5. Straight-through-processing
Institutional brokerage firms are facing pressures related to massive volume growth and deteriorating operational efficiency. This pressure is particularly acute in cross-border trading, which is growing exponentially. Consequently, the need to expand capacity, mitigate risk and contain operating costs has become urgent. At industry level, this has manifested in mandatory trade settlement cycle compression to T+1 by 2005, achievable through a high degree of automation in transaction processing – the ultimate version of which is dubbed straight-through-processing (STP).

6. Market Structure
More broadly, the unprecedented changes taking place in the macro technological and regulatory environments are altering the very structure of markets.
Institutional brokerage firms function within and are directly affected by this macro-environment and therefore need to stay attuned to these changes and adapt time to new structures as they evolve.


New Brokerage Value Chain Elements
1. Enhancing Order-routing Capability
Competition from buy-side to buy-side markets, as well as from multiple market access vendors, market fragmentation, increasing globalisation and demand for multi-asset class trading capability are inducing brokerage firms to reach an ever-increasing number of execution venues. Thus, in the first instance, firms need to boost their order-routing capabilities and maintain links to the best pools of liquidity, so that they can better compete with the vendors. These liquidity pools include the new entrants, such as ECNs, which exist across numerous asset classes, such as equities, fixed income, FX, commodities and derivatives, as well as ‘electrified’ traditional exchanges.
While some of these platforms are competitive threats, others provide a means to increase liquidity. The dilemma is deciding which platforms will provide access to the best liquidity while remaining extant. Brokerages must also meet the need for increased foreign trading by connecting to foreign execution venues in an electronic format, developing robust multi-currency capabilities, increasing risk management capabilities to handle more complex exposures, and beefing up the back office to enable cross-border clearing and settlement.

Additionally, as direct-access technology providers and new forms of crossing networks court the buy-side, broker/dealers must strive to increase anonymity and reduce slippage, leakage and front-running.
Essentially, brokers must find ways to make themselves integral to the new trade flow by adding value to it. One of the ways to achieve this, of course, is to acquire or enter into joint ventures and alliances with the order-routing technology providers. By partnering with one or more leading technology providers, brokerages could offer market-making capabilities for extended trade matching and routing solutions. This approach would also allow brokerages to provide liquidity and order working expertise for large orders, and thereby generate revenue through commissions, spreads, and return on risk capital. Additionally, brokerages could invest directly in an ECN.
There are already a number of precedents. Several of the NASDAQ ECNs are owned by an individual brokerage or a consortium of brokerages. Among the leading direct-access software suppliers, Investment Technology Group (ITG) is positioned as a hybrid broker/software vendor, that markets its own direct-access front-end Quantex exclusively to buy-side institutions, and also owns and operates the E-Crossnet electronic trading network. Interactive
Brokers Group (IB) is another example. IB, which owns and operates market-making firm Timber Hill, is among the few suppliers of direct-access technology that actually originated on the buy-side. Initially, IB built its Trader’s Workstation direct-access platform in support of its own market-makers, but eventually made it available to a wider market, and now the Trader’s Workstation universe of users is comprised of 50% institutional investors.

2. Value-added Services
Over time, compensation for research and advice will become unbundled from trading compensation, leaving brokers even more vulnerable in trade execution (pursuance of the above strategies notwithstanding). To counter the continuing erosion of commission-based margins, institutional brokerages must develop new value-added and premium-priceable products to bolster their traditional fare: execution and research.
Moreover, as alluded to above, market data, and generic, static research (economic, sector, industry and company) will not be sufficient in the information age. Brokerages need to offer a suite of dynamic, customised or personalised portfolio (and, therefore, risk) management or investment decision- support services. Many of the leading Wall Street brokerages have already invested in developing a fairly sophisticated set of online tools or toolboxes in this sphere. Morgan Stanley’s current offering, one of the best in equities, provides a good template. However, this is but one example of the multitude of features offered by the power brokers.
Clients access all the bank’s online equity products through a single point; ClientLink. From the ClientLink site, online research via Research Link, trade execution via TradeXL and portfolio analytics via Basket Link are all just a click away.
• Basket Link is a pre-trade analytics tool. It allows clients to screen their portfolio for any liquidity, market impact, tracking or other risks that may be incurred from trading the constituents. The system can also optimise the portfolio to match specific targets set by the client, and can create buy and sell lists to achieve them.
• Research Link boasts one of the most comprehensive sets of useful functionality. Obviously, it is customisable, allowing clients to filter the research and news that greets them when they open the homepage and also the alerts that they receive via e-mail. A useful feature on Research Link is a window dedicated to the analysts’ intra-day notes. This too is customisable, so that clients are not bombarded with irrelevant e-mails all day. The stock screening tool allows users to build up a selection of stocks based on an almost limitless number of criteria. It integrates all the economic, sector and stock research and allows the user to flow through a constructed argument. It also has a section designed for the dedicated number cruncher. It provides access to the bank’s cash flow, earnings and balance sheet estimates plus all the operating, financial and valuation ratios derived from company modelling. Research Link is also impressive because of its intelligent use of webcasts. Opinion is divided about how useful they are – large institutional investors will still want to have direct access to the analysts – but for smaller clients the webcasts can add value. The best use of this functionality comes in displaying interviews with people that the clients wouldn’t usually have contact with, such as corporate CEOs.
• TradeXL provides execution functionality with some impressive complementary auxiliary services. Clients have online access to a daily statement with a summary of all trading activity and also a reference diary. The system can also be linked to risk and portfolio analytics tools, be they the client’s own systems, or Morgan Stanley’s Risk Link and Basket Link products. Clients can customise the system so that the live data flowing from the exchanges can be fed into trading analytics tools to update positions and manage performance and market exposure, in real time. Other functionalities on the system include the ability to see the depth of the liquidity in the markets both numerically and graphically, and the ability to track volume weighted average price (VWAP). By automating trading to a VWAP benchmark, TradeXL enables users to work the 10% most illiquid stocks manually, and then route the other 90% through an automated system, which helps to optimise users’ time. On average, trading confirmation is submitted to the client within 5 to 10 minutes. Since this far exceeds the industry standard (banks are only required to confirm trades the day after they are executed), TradeXL’s speed of response wins the bank a lot of mandates.
• Finally, in terms of order management and settlement tracking, Ops/Tracker clients are given direct access to the broker’s internal systems affording real-time local environment data. The system allows clients to view, in real time, the entire lifecycle of a trade, from execution to settlement. Clients select a securities tab, then see a quick view, which shows them trades that are due to be settled on that day or the following day, trades that are open, and failed or failing trades. The aim is to allow back-office users to see what they need to do that day as soon as they log on in the morning. The site can also be used to search for specific trades or within certain time frames and it is possible to drill down through any of the trades to get further details. This has reduced the need for communications and has assisted in the management of failed and failing trades. All of the information can be downloaded on to Excel and is time stamped.

Although not many clients have the capability, files can also be downloaded into XML so that clients can upload the information into their own system.
Finally, in terms of bolstering the value-added services offering, brokerages can also find new products in the realm of technology via increased connectivity to market utilities and market data via FIX capabilities, as well as through business operations, such as outsourced clearing and settlement services.

3. Middle- and Back-office Enhancement
As firms begin to trade more globally and even domestically, with a wider array of counterparties, credit and market risk exposure management systems as well as operational risk and disaster recovery management systems need to be overhauled. Risk management systems need to be evaluated for their effectiveness as well as for their ability to interact with the rest of a firm’s trading operations on a real-time basis.
Efforts to achieve straight-through-processing are necessary to comply with pending mandatory T+1 settlement cycles and to address deteriorating operational inefficiencies. Moreover, both the risk and front-office capabilities described above (especially the provision of value-added analytics) derive in large measure from a high degree of back-office automation. STP initiatives include internal work necessary to link disparate systems together and bring the operation up to real-time status, as well as external links to improve data flow both pre- and post-trade, as well as among counterparties, exchanges, clearing agents and custody providers.
As with retail firms, institutional firms must centralise e-commerce operations in order to increase efficiency. This will help organisations to leverage technology developed for one line of business across the entire operation.
Finally, firms can adopt a defensive response to these trends by focusing on a specific institutional segment – ‘the human factor ’ segment – which comprises those investors who prefer direct human market interaction because they do not believe an automated system can ever achieve the execution prowess of a savvy trader.

The securities industry is in a period of fundamental transition and broker-dealers are facing many new threats to their business. In fact, all aspects of the sell-side’s business – trading intermediary, proprietary trading, information provider – are being contested. Following many years of economic bounty, a global slump is putting additional pressure on their business. How will broker-dealers respond to these events to retain their position, which is more fragile than ever?