Click here to see the ranking.
The last week of June was a remarkable one for the New York Stock Exchange. Fully 71 percent of its trading volume was executed not through face-to-face auctions on its storied trading floor but by computer programs that allow investors to buy and sell multiple stocks at once. It was, by far, the highest level of such trading ever at the Big Board.
The burst of activity came in advance of Frank Russell Co.'s June 30 rebalancing of its widely followed stock indexes to adjust for changes in the size of component companies. Hundreds of money managers whose portfolios are benchmarked against Russell’s indexes simultaneously had to sell stocks that were being deemphasized while buying the gainers.
But the episode underscores a sea change in the way investors buy and sell stocks. Quite apart from the Russell reconstitution, the use of program trading has exploded. During September it accounted for 56 percent of NYSE volume, according to the exchange. That was up from 40 percent a year earlier and less than 20 percent in 1999.
The surge in activity comes as active money managers turn increasingly to programs, which started as a tool for index arbitrageurs and passive managers, to trade more efficiently. Rather than pay a nickel per share for single-stock trades and risk market moves that might make transactions even costlier, these investors are corralling orders into less-risky baskets and shipping them to brokers to execute for a penny or two per share.The embrace of programs is just one way the world of trading is being swiftly transformed by a combination of factors, from rapid advancements in technology to new regulations that protect small-fry investors to, not least, a dawning devotion to cost-control on the part of giant institutions. As stock prices have languished and the expectation of high future returns has dimmed, investors have cracked down on inefficiency to maximize performance. Mutual funds and other big investors have begun putting unprecedented pressure on brokers and exchanges to improve the quality of trade-execution services they have historically provided.
All of this has spelled upheaval. Brokerage firms are replacing scores of human traders with computers that use sophisticated algorithms to chop up block orders and intelligently route the tiny pieces to multiple destinations for execution. Electronic communications networks and other alterna-
tive trading systems continue to gain market share from the Nasdaq Stock Market and the NYSE. The Big Board will soon overturn 212 years of tradition by introducing a hybrid market structure, which will combine an electronic matching system with the floor-based auction. Many see this as a precursor to full automation. And the Securities and Exchange Commission has entered the fray, proposing a wide-ranging modernization of the laws and regulations governing equity trading markets that threatens to turn long-standing ways of doing business upside down.
“We’re witnessing revo-lutionary, not evolutionary, changes in our markets,” says Kalorama Partners founder and former SEC chairman Harvey Pitt, who was an architect of the
May 1, 1975, deregulation of fixed brokerage commission rates. “What’s happening now could certainly be on a parallel with those days.”
Just as with that May Day, there is an awful lot at stake in this upheaval. Following those mid-1970s reforms, scores of brokerage firms went out of business or were driven into the arms of bigger rivals as competition sent commission rates plummeting. Today’s tumult threatens to wreak similar havoc.
“This is the kind of transformative period you maybe see once in a generation,” says Larry Tabb, founder and CEO of Tabb Group, an industry consulting firm. “It’s about survival. If the New York Stock Exchange doesn’t automate, its liquidity will go to the ECNs. In the brokerage industry there are going to be a lot of big firms that just don’t make it. Right now they’re all vying for position.”
Who thrives -- or who even survives -- in this new world will likely be determined by which firms 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 satisfying institutional clients. To do this, we surveyed the head traders at 350 money management firms during the summer and early autumn. We asked these investors which brokers delivered the best overall execution service, for both NYSE and Nasdaq stocks. We also asked about the quality of sales/trading service provided by brokerage firms. And, among other questions, we asked which market centers (including major exchanges and electronic alternatives) investors preferred.
Firms singled out for excellence by clients under these difficult conditions bring to bear a variety of skills and capabilities. Lehman Brothers, which finishes first in NYSE-listed trading, gets high marks for skillfully working large institutional orders through the market over time. Citigroup, which finishes first in Nasdaq trade execution, prides itself on offering clients a balanced array of execution options, from all-electronic, direct-market access systems to experienced sales traders who can either find liquidity or commit capital for more difficult transactions.
Following Lehman in NYSE trading are, in order: Morgan Stanley; Merrill, Lynch & Co.; Citi; and Credit Suisse First Boston. After Citi in the Nasdaq rankings come Merrill; Morgan Stanley; Lehman; and Goldman, Sachs & Co. Goldman also logs top-five finishes in both NYSE and Nasdaq sales/trading.
Investors recognize best-of-breed qualities in both extremes of the man-or-machine continuum. Relatively small Jefferies & Co. finishes in the top ten for both NYSE and Nasdaq trading, outpunching bigger rivals on the strength of its highly experienced and specialized human traders. And three-year-old startup Liquidnet also manages top-ten rankings in both execution categories by providing a Napster-like cyberforum for institutions to anonymously swap blocks of shares with one another. (For more on the winners and standouts, see rankings, page 78; and boxes on Citi, page 83; Jefferies, page 82; Lehman, page 79; and Liquidnet, page 81.)
Since 1997, II has spotlighted in our November issue the lowest-cost institutional brokerage firms in the U.S. We continue to present these findings this year, thanks, as always, to the work of Elkins/McSherry, a New Yorkbased transaction-cost analysis firm (see story, page 87). With giant money managers putting an ever-tighter squeeze on brokers to efficiently execute trades, this analysis is as important as ever. Transaction cost, however, is one of many factors that institutions consider when evaluating overall quality. Others, such as a brokerage firm’s willingness to facilitate difficult trades by putting its capital at risk, or the market knowledge of individual traders and sales traders, can be just as valuable to the buy side. In an attempt to provide a more complete qualitative assessment of institutional brokers and exchanges, II has surveyed clients about many of these factors (for complete rankings, go to www.institutionalinvestor.com).
As intermediaries rush to keep pace, the world of trading continues to change at a breakneck pace. Much of the ferment stems from a raft of regulatory actions taken over the past decade -- from order-routing reforms promulgated by the SEC in 1997, following a Nasdaq price-fixing scandal to the 2001 introduction of decimal pricing -- that were designed to make the market more fair for individual investors. They did, but they also led to unintended consequences. ECNs, like Archipelago and Island (now owned by Instinet), took advantage of rapid advances in technology to swipe most of Nasdaq’s trading volume; and the advent of decimalization compressed the minimum spread in quoted stock prices to a penny from six and a quarter cents, dramatically scattering buying and selling interest in stocks. Fragmenting liquidity among multiple market centers and reducing the number of shares available in the average quote made life far harder for institutions seeking to move large blocks.
The financial industry is still grappling with the consequences of these reforms as mutual funds and other big investors seek creative ways to guide giant orders through an increasingly tight market. In the past these institutions simply outsourced trading to brokerage firms; today many are taking greater control of their orders to avoid both explicit and hidden transaction costs that can eat into returns. Often this means directing trades to alternative networks or bundling single-stock orders into program trades. Brokers are fighting to hold on to institutional flows -- and keep their own costs down in a business of declining margins -- by souping up their program trading systems and introducing high-end transaction engines that employ sophisticated algorithms. Threatening the position of the NYSE and Nasdaq directly, investors are increasingly willing to bypass the exchanges and trade through such innovative block-trading systems as Liquidnet and Pipeline Trading Systems. The buy side is also pushing hard for the NYSE to automate its bustling, all-too-human auction system, which it contends no longer meets the needs of today’s evolved execution strategies. The push turned into a groundswell after five large NYSE specialist firms were accused of systematically trading for their own accounts rather than letting customer orders meet, allegations they settled with the SEC in March for $240 million.
The buy side’s disaffection with the existing exchange system can be seen in its embrace of alternative trading venues. When investors were asked to rank their favorite destinations for executing trades, including both the major exchanges and electronic rivals, upstarts overwhelmingly defeated the NYSE and Nasdaq. Bloomberg Tradebook, Liquidnet and Instinet Group’s INET ECN take the top three spots in the ranking. The NYSE finishes seventh and Nasdaq ninth, while low-touch platforms offered by Investment Technology Group; the Spear, Leeds & Kellogg unit of Goldman, Sachs & Co. and Credit Suisse First Boston’s Advanced Executions Services, finish fourth, sixth and tenth, respectively. (This last group technically doesn’t compete with ECNs and exchanges for orders, but their appearance in the rankings clearly indicates that clients increasingly see them as an end-to-end trading solution.)"The big event that everyone is waiting for is when New York opens its market share to competition with the electronics,” says Robert Shapiro, an industry consultant who retired earlier this year as head of trading for Iridian Asset Management. “It’s going to be huger than huge.”
To be sure, these market changes are not taking place in a vacuum. Recognizing the need for a sweeping overhaul, in February the SEC proposed a 192-page plan to modernize U.S. equities markets; it’s called Regulation NMS, for National Market System, an idea that dates to 1975, when regional exchanges first began cross-listing NYSE stocks and the government tried to connect the markets so investors on any one of them could access the best prices available nationally.
Meant to straighten out structural inefficiencies wrought by decimalization, fragmented liquidity and the rise of alternative trading systems, Reg NMS is unnerving the markets and participants. The Big Board, Nasdaq, electronic rivals like Instinet and Archipelago and even huge institutions like Fidelity Investments have all become embroiled in an intense battle to shape the final Reg NMS proposal, which could come before year-end.
The greatest fight concerns what’s known as the “trade-through” rule, a 1975 stricture that forbids market participants from executing a trade at a price different from the best available bid or offer for any NYSE-listed stock. The idea was to prevent brokers from internalizing, or executing customer orders against their own quotes, at inferior prices on regional exchanges. In practice, because the NYSE had the greatest liquidity, the rule helped to preserve the exchange’s near monopoly on trading in listed stocks, allowing NYSE specialists to simply match better quotes from rival markets within a 60-second period (established for telephone-era communications) and for as little as 100 shares.
Today many institutions want to trade through for efficiency. If 100 shares was a small order in 1975, it’s infinitesimal today. Consider a buy-side trader with an order to buy 20,000 shares of a particular stock. If the best offer on the NYSE is $10 for 100 shares, but there are also 2,000 shares offered on an electronic exchange at $10.01, the trader in many cases will prefer the higher price because it gets her closer to buying the whole block. Buying 100 shares at a time means 200 separate transactions -- and 200 chances for the quoted offer to rise -- versus only ten if she buys 2,000 shares at a time. Trading through, then, can mean a lower average purchase price for the block. But for trading in NYSE stocks, that’s against the rules. Worse, because the NYSE floor isn’t automated and owing to the 60-second grace period for accessing quotes across markets, hitting the 100-share NYSE quote can take so long that the 2,000-share electronic quote might be withdrawn in the meantime.
Reg NMS would solve the problem of this 30-year-old rule by extending the prohibition of trade-throughs to all stocks, but with one critical exception: It would allow electronic markets to trade through manual ones. That exception, a powerful regulatory push in the direction of modernizing markets, cuts to the core of the NYSE’s trading hegemony and would be a boon for electronic markets that want to challenge the Big Board. It has the exchange racing to embrace more automation. Meanwhile, Nasdaq and its customers are irate, as they don’t currently have a trade-through rule and object to the government mandating how they should pursue best execution.
In a classic case of politics’ making for strange bedfellows, a group of otherwise fierce competitors last month formed a coalition to urge the SEC to lift the trade-through rule from NYSE trading rather than extend it to Nasdaq -- or at least to allow traders to opt out of the trade-through rule under limited circumstances. Among the coalition members are Fidelity and Ameritrade, rivals in the discount brokerage business, as well as Archipelago, Bloomberg Tradebook, Instinet, Nasdaq and the National Stock Exchange, which on various levels compete for order flow from brokers and institutional investors.
“No single issue is bigger than the trade-through rule,” says Gerald Putnam, CEO of Chicago-based Archipelago Holdings, which operates an electronic exchange called ArcaEx -- the old Pacific Stock Exchange -- that competes with the NYSE and Nasdaq. “Our customers don’t care if they’re trading at a penny away because they get an automated execution. Instead, they have to route to the NYSE and wait forever, or not get the trade done at all.”
The NYSE, meanwhile, has taken the position that a trade-through rule is absolutely necessary to ensure that investors -- particularly individuals trading in small sizes -- aren’t cheated out of the best prices for their orders. But, perhaps seeing the writing on the wall, it is also racing to develop a hybrid market that would allow at least some of its quotes to be designated as “fast” under Reg NMS and thus potentially not subject to trade-throughs. That’s important because
if NYSE doesn’t automate and the trade-through protection is lifted, most industry practitioners expect order flow to migrate to automated exchanges, just as it has on Nasdaq over the past eight years. Still, many questions remain unanswered about the NYSE’s hybrid-market proposal, which awaits SEC approval. Critics say the exchange has offered insufficient detail about when and how NYSE specialists would be able to pause the automated system and let brokers on the floor offer better price quotes, essentially reverting to the way things are today.
“The New York Stock Exchange is trying to take the position that any progress is a good thing,” says Michael Plunkett, CEO of Instinet Group’s agency brokerage business. “But we have seen historically at the exchange that some progress is often very close to no progress. When it comes to efficiency, the chain is only as strong as its weakest link.”
Or, as Ameritrade chief strategy officer Phyllis Esposito puts it: “You can’t be electronic when you want and then turn it off when you want. That’s not going to inspire investors to believe the NYSE is a truly competitive market with the others.”
Robert McSweeney, senior vice president for competitive position at the NYSE, says the exchange will file early this month an amended hybrid plan with the SEC that will address critics’ questions. Although conceding that automated markets should probably be allowed to trade through manual ones, he stresses that trade-through protection for all other situations is essential: “Some people have proposed that best-execution principles would be sufficient to protect best prices. But we have seen that in not all instances will intermediaries behave in a way that is necessarily in the best interest of customers.”
Brokerage firms face similar life-and-death issues. Profit margins in the traditional, high-touch brokerage business continue to shrink as clients demand more sophisticated, efficient approaches to order execution. One solution: algorithmic trading platforms. Firms like Goldman, through its Spear, Leeds & Kellogg division, and CSFB have long been leaders in this realm. Now rivals like Citi and Merrill are devoting more resources to this low-touch business. In July, Citi acquired Lava Trading, a provider of smart-routing technology. Merrill, a licensee of Lava’s technology, continues to use it but also has purchased algorithmic tools from ABN Amro’s U.S. brokerage operation, among other sources. Merrill last month signaled its commitment to the low-touch business by bringing on as its global head of trading Rohit D’Souza, a former Morgan Stanley and Investment Technology Group executive and a proponent of automation.
“The business model of the broker has always been that the customer is not that smart. Now that’s all out the window. Instead of saying, ‘Just give me the order and trust me to do a good job,’ they’ve got to have an algorithmic platform or some other sophisticated way of committing capital,” says industry consultant Tabb. Some 28 percent of respondents to II’s trading survey say they use such low-touch or direct-access systems for at least 10 percent of their orders. Thirteen percent of respondents say they execute more than a quarter of their business this way. And the use is expected to increase. When asked how much they will use low-touch trading in the coming year, 35 percent say it will account for more than a tenth of their trading.
Yet even the algorithmic business is in danger of commoditization. Technology is advancing so rapidly that multiple com-
petitors can all provide some of the most basic tools. Less-
sophisticated algorithms, such as those that attempt to execute trades at or near the volume-weighted average price for a stock, are now widespread. Many institutions, like Fidelity, believe that meeting or beating the VWAP can substantially reduce transaction costs and boost their funds’ investment performance. But big institutions are increasingly seeking more-advanced tactics that can cut costs even further, and they are likely to consolidate more of their business with firms that can provide such tools.
“The days of institutions directing order flow to ten different brokers that have a VWAP engine are over,” says Ross Stevens, chief operating officer of the equities business at Banc of America Securities.
Increasingly active trading strategies are supplanting VWAP algorithms that have tended to be essentially passive -- for example, waiting for heavier-volume periods to execute the largest portions of an order. One newer algorithm, known alternately as “arrival price” or “implementation shortfall,” sets a time limit for execution and seeks to get as much of an order as possible executed at the price where the stock was trading when the order was created. Only the most-advanced platforms, such as CSFB’s AES system, offer arrival-price algorithms. BofA is in the process of launching one."Arrival price is the best benchmark to rate investment performance by when you’re looking at a transaction,” says Robert Almgren, a University of Toronto mathematics professor who’s working with Citigroup’s low-touch alternative execution unit on algorithmic trading software for clients. Almgren’s December 2000 paper, “Optimal Execution of Portfolio Transactions,” co-authored with Neil Chriss, head of quantitative strategies for giant hedge fund SAC Capital Advisors, helped lay the groundwork for the arrival-price algorithms currently being developed on Wall Street. “With VWAP, you’re saying, ‘As long as I don’t do worse than anyone else in the market, it’s okay,’” adds Almgren. “But what you really should want is to get the stock at the price that caused you to want to buy it.”
In adopting all this new technology, brokerage firms have to be careful not to let their high-touch businesses wither on the vine. Particularly for low-capitalization, thinly traded stocks, sales-traders’ relationships, market knowledge and capital commitment can often make for a more efficient execution than a low-touch platform. Firms like Jefferies are making hay with this strategy, by investing in high-touch trading and focusing it on small-cap and midcap stocks. Even bulge-bracket outfits like Goldman and Merrill have launched small-cap desks in recent months to respond to this concern among buy-side traders.
Indeed, though institutional investors are benefiting from all this high-stakes strategic positioning by brokers and exchanges, they must tread with care. Taking greater control over the trading process brings increased risk. In a more high-touch environment, institutions off-load that risk to brokers, who will fix mistakes by making the customer whole.
“There’s a risk in taking 100 percent control of your order flow,” says Benjamin Sylvester, head of equity trading at Boston money manager Babson Capital Management. “The buy side is going to have to find a balance between total control and managing that risk.”
Adds consultant Shapiro: “Trading is becoming a very complex process. There are so many tools at your disposal that you get an order and say, ‘Okay, what do I do now?’”
Some brokerage firms see an opportunity in providing clients with advice about how to make sense of the multitude of options they have for executing orders. “We’re increasingly performing a consulting role for our clients,” says Joseph Gawronski, chief operating officer of Rosenblatt Securities, an NYSE direct-access floor brokerage that also offers over-the-counter, program and algorithmic trading to its institutional customers. “Just because a client is trading for himself or herself does not mean we have nothing to do.”
Lehman, for instance, believes that if its human traders are experts in alternative execution strategies, it will get more low-touch and high-touch business. “We’re raising the bar for our people to be execution consultants,” says global trading chief Patrick Whalen. “This is very complex for our clients, and they need someone to be their consultant -- their expert -- to help them get the best execution, however they go about it.”
The rankings were compiled by IIstaff 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 Researcher Normand Morneau.
