In a time of fundamental shifts across the sell-side, Adam Toms, CEO Instinet Europe, examines the causes, and consequences, of change.
To what do you attribute the fundamental changes underway in Europe? Equity businesses have been in quite a severe amount of distress of late. Profit margins are being compressed and trading revenues through commissions are challenged given low market volumes. And with the global slowdown in trading by institutions, the commission “wallet” through which the buy-side pays for the products and services they consume has been shrunk considerably. If, as a bank or broker, you are not adjusting your cost base in response to that, you obviously end up with quite a severe economic problem, so we are consequently seeing a number of substantial moves to address the over-capacity currently found in our industry.
This capacity reduction can come in numerous forms. Some firms have shuttered certain businesses and product lines entirely. Others have more specifically defined what they are going to offer and to whom, perhaps servicing only a subset of their former clients in a more substantial manner. And still others have pursued a strategy of merger, acquisition or strategic alliance with rivals.
Is this a new trend or has it been underway for some time? All of these things have been happening over the last few years, but the pace has quickened over the last six to nine months. However, regardless of the strategy a firm is going to pursue to deal with the slowdown, they have to first and foremost analyse whether they believe we’re simply in the middle of a cyclical challenge or whether a longer-term, secular change is underway.
If it’s determined that it’s cyclical, then managing it probably means reducing some PE expenditure, trimming variable expenses and hoping things start to turn around soon. But if one thinks it is secular, then that really calls for substantial change to the business model and all that goes along with that.
How do you come down on the cyclical versus secular question? These are conversations we’ve been having at the Nomura Group for some time, and after significant internal debate, we’re firmly in the secular camp. Unfortunately you can only sit there for so long and say: “No, it’s just cyclical. If we just hang in here for a little bit more, the market is going to get better.” That approach will gradually end up compounding the problem, limiting options to correct the position.
What makes you think it’s a secular shift? We do not think it is one factor but more a number of factors which in unison will result in permanent change, be it the associated equity asset class impacts from the global recession and debt crises through to new areas of focus for global regulators and even taxation initiatives.
Take the French financial transaction tax as an example. From the government’s and regulator’s perspective, it’s natural and appropriate to seek to minimise industry and economic risk through all of the tools available to them. But given the potential for unintended consequences, you hope that laws and regulations take into account their impact on the markets and institutions’ ability to effectively trade for end asset owners.
So how are you adjusting your business in response? The Nomura Group, with its independent Instinet subsidiaries and its Nomura branded broker-dealers, had been running two distinct execution services groups for some time. When the businesses were competing on a different basis — Nomura a full service broker dealer and Instinet a more execution-only provider — we were quite happy with the structure. But once the group came to the conclusion that we’re in the midst of a broader secular change, it was important to identify a solution that would allow us to extract synergies, innovate and bring the two groups together.
We had a very clear decision to make: take Instinet into the bank, or move parts of the bank into Instinet. We believe our move to extract the cash trading channels from Nomura — essentially consolidating into Instinet — is the right decision. Instinet is preserved as an independent agency brokerage that places clients front and centre of our strategy, which is very different to other models and well-aligned to how we see our clients and the market evolving.
Coming to that conclusion presents quite an opportunity. First, there are significant savings to be had by consolidating onto a single platform, the vast majority of which are through the elimination of duplicate infrastructure costs such as algorithmic engines, connectivity, technology and vendor licenses, exchange memberships, etc. Second, it allows us to pick and choose the best components of each platform. And third, it allows us to take a step back and look at exactly how equity execution services should be provided in today’s markets. All in all we are targeting a bigger and more complete business, and when you consider the impact of aggregating the liquidity of both the Instinet and Nomura platforms, we feel this will differentiate our European business going forward.
We hope to complete the transition by spring 2013.
What about the pending regulations you mentioned? Does that play a role in this new strategy? Yes. When you consider where regulation is headed, this model makes a lot of sense as well. First, there is a pressure globally to provide more transparency by segregating risk capital from agency execution, which this clearly does. And second, by moving execution to Instinet and keeping research as a stand-alone business within Nomura, we are effectively internally unbundling our offering, which is very much aligned to how regulators are encouraging our clients to think also.
Is there a downside to the new strategy? While Nomura’s broker dealers can commit risk capital, Instinet cannot. But when you look at the cost of providing capital, it’s a tough game in low-liquidity markets like today’s. So, if you think you can differentiate yourself through an agency-only offering that marries the best of high-touch trading with a suite of electronic tools, we believe we can compensate for any loss due to a lack of risk availability.
How, if at all, will Nomura research clients feel the change? The biggest change will be in terms of how clients pay for content services, as the execution services groups that existed within the Nomura broker-dealer units to monetise research and other services will be moving to Instinet, with Japan being the notable exception. We would obviously prefer that clients of Nomura research compensate for it by trading through Instinet, who will then direct a CSA payment or similar to Nomura. But Instinet needs to provide a compelling trading service alongside best execution in order for this to happen and we believe the strength of our offering delivers this.
Paul Squires, Head of Trading AXA Investment Managers systematically analyses the consequences of structural market change and sell-side head count reduction across the street.
Amid the current market and trading environment the expression “A Perfect Storm” springs to mind because, clearly, the entire industry has seen decreasing margins and volumes since 2008. At the same time, there has been an arms race to invest in technology just to maintain position. Those two things aren’t exactly the best backdrop for cash equity. Furthermore, even if the cash equity business is seen as a loss-leader for other more profitable asset classes, Basel 3 and global banking reforms seem to be impinging upon those commercial realities as well. 2012 was a very tough year for banks and brokers, and I think we’re finally seeing a little bit of fallout from that in terms of strategic reorganisation. It’s not just a seasonal thing now; many in the industry had sustained hope that it was just a tough period, that we would come out of it and that volumes would return to 2008 levels; however, I believe people are realising it’s much more structural.
Splitting Hairs Commission Sharing Agreements (CSAs) are increasingly an essential facility for the buy-side. CSAs were really the avenue to enable CP176 (FSA consultation paper on unbundling). They reduce the extent to which trade execution might be constrained to where fund managers are getting their advice and service. In other words, the buyside executes with the broker where they have a CSA (provided they can give good execution), paying both an execution and an advisory component at the same time thus building the advisory pot, which can then be used to pay for independent research (or gives the fund managers the freedom to pay for advisory services from a broker whose execution service is not as strong).
More recently, the FSA has said that fund managers weren’t embracing the opportunity to split the different commission components as much as they had hoped, and the FSA is pushing again for that to happen. This is entirely appropriate from a client’s perspective, in my view. It’s the client’s money that’s being used every time the buy-side trades; if you’re paying a bundled commission, that’s effectively the client paying for the execution service and the advisory service and they should expect the best decision for both elements of that.
There are a couple of areas of focus within the current consolidation of advisory services and execution services. On the execution side, we’ve seen most impact from a more strategic ‘top-down’ view of sales trading. In the past, electronic sales trading was seen as supplementary to the traditional cash equity sales trading. There’s been a hard push to set up the provision of algorithms, and that has created a duplicated set of execution services. Now, my desk has taken a decision to focus our contact with our primary cash equity sales traders, but enabling them to see our algorithmic flow. This means that if we’re trading a significant volume of a stock and the cash sales trader can see what we’re doing, we’re optimising all our execution avenues. There is electronic access to multiple venues, but there is also the traditional broker distribution channel.
As part of our regular trading reviews, we explained to our brokers that our cash sales trader is the one who knows our account and our style of trading. We’ve had the historic relationship with them and they are best placed to disseminate the most relevant market information to us very quickly. For example, if we self-direct an algorithmic order, they could see that we were looking to buy a chunk of a French small cap; if they happen to see flow in that stock from another source internally, then they would be able to pick up the phone and say, “I know you’re working an algorithm, but if you’re interested, we’ve got the natural seller.” This is the level of service we want, but it’s taking the market quite a long time to get to that point. Based on our conversations, we’ve discovered that we are in the minority in wanting the sales trader to see the algorithmic flow. In contrast to our view, we believe many in the buy-side see anonymity as the key benefit of an algorithm.
A lot of the buy-side use algorithms almost primarily for the anonymity, which means they end up with a duplicated set of coverage with electronic coverage and cash sales trading. Clearly, that’s an expensive way to organise coverage for a typical asset manager whose volumes have declined substantially in the past couple of years. Therefore, I think we will continue to see brokers moving their electronic teams much closer to the program team or the cash sales traders.
Sell-Side Headcount Changes The impact on the buy-side isn’t just caused by the fact that the headcount of sales trading has shrunk, it is that the number of clients has expanded. There are now so many small hedge funds and boutique asset managers. In many instances, the sales trader is doing his best to pick up the phone and put the orders into the system but, in our view, he often no longer has time to closely scrutinise the markets and stocks in the way that we used to benefit from.
At AXA Investment Managers, we trade with approximately one hundred brokers a year. But within that, it’s a very concentrated focus with our top 20 or so brokers being absolutely key. In addition, there’s a significant tail of brokers that we need access to less frequently for very specific orders.
There will likely always be two or three brokers, who, while market consensus suggests a certain direction, may feel that it’s worth their while taking a different view and who see an opportunity to gain market share by going against the trend.
Does a buy-side firm these days need more than two or three execution-only brokers who are the traditional sort of agency guys who are very driven to get your flow? They do a lot of work to be close to the market; talk to a lot of people; give you a lot of market colour. I think what this means is that the emphasis has shifted from the buy-side trader picking up the phone to someone on the sell-side who then directs how to execute your order, to the buy-side trader now having all the relevant tools. This concept of “best selection” as a process for us is one of the main aspects of “best execution”; in other words, the due diligence before we decide exactly how we are going to trade the order. Do we pick up the phone because, in fact, we just want a risk price; we want instant liquidity and the immediacy of execution? Do we want to park it passively in a couple of dark pools, and know a particular algorithm that is going to do that for us? Do we want to just pick up a phone to the sales trader and say, “Just keep it to yourself for a while, but I’m looking to buy a chunk of this particular stock in case you see anything in it”? Maybe we want to have a look around the shareholder list, see who might have been active in it and see if we’ve got any opportunities to do cross a block naturally? There are so many different ways to execute now and hence this concept of ‘total liquidity management’.
What key features do successful exchanges share that encourage liquidity; how automated trading drives growth and why markets will attract incremental liquidity with the advent of global CSAs. Robert Barnes, Managing Director, Equities of UBS Investment Bank explains.
The execution arms race continues. The prize is order flow that concentrates to those most capable, particularly in navigating market structures.
Market structures comprise the rules and institutions that determine competition and the framework of interaction, including Exchange fees, which ultimately shape order execution strategies. The focus includes external factors that impact business and operating models, driving opportunities to grow revenues and reduce costs.
Exchanges rebuilding liquidity is a priority market-wide theme in 2010 in the context of competition, transparency, and investor choice at trading and clearing layers. From a User perspective, we wish to work in a spirit of partnership with Exchanges and Regulators to promote liquidity and new business, and we thank the Authorities as they provide a framework within which we can behave as entrepreneurs.
Macro trends include rising number of trades, coincident with automated electronic trading. Regulation promotes competition, transparency, investor protection. This leads to a better result for clients via competitive execution policies. Competition, thus fragmentation, makes the world more complex. Not all brokers, however, can keep up with the technological arms race. Direct Execution models of electronic trading are evolving to address this. Latency reduction increasingly is sought for competitive advantage.
There is increasing awareness of a positive dynamic involving non-displayed pools and high frequency trading. The key insights are that markets allowing discretionary non-displayed broker crossing processes and non-discretionary dark pools effectively speed net liquidity onto order books. The benefits are lower market impact, greater efficiency, and a better result for end investors.
These benefits multiply if statistical traders are active. When orderbook liquidity increases, so too does the proportion of trading opportunities; and these stimulate further orders to the orderbook from automated strategies. This incremental liquidity, aggressive and passive, narrows spreads.
The world’s markets are split into those that support and benefit from high levels of automation, and those with the opportunity to encourage more. Investors’ current focus include global macro trends and emerging markets which means that moving toward more consistent electronic access models will help markets to take advantage of this burgeoning liquidity. A good start is to implement and enhance FIX specifications to offer advanced electronic flexibility. This adoption of standardisation can aid emerging markets in growing their scale of business.
One of the more “seismic” changes to Equity markets in recent years is the proliferation of commission unbundling and Commission Sharing Agreements, “CSAs”, or Client Commission Agreements,“CCAs”, in the USA. Initiated by UK regulators in 2006, this commission unbundling initiative spread across Europe (at the end of 2007) with the arrival of the Markets in Financial Instruments Directive, or “MiFID.” Global clients, preferring one consistent process world-wide, have led the demand for CSAs to become a market convention. With many CSAs established on a global basis, it can be easier than ever before for a newly automated market joining a broker’s network to attract liquidity.
George Kledaras of FIX Flyer discusses how FIX enables buy-side firms to get better value for their research using commission sharing agreements.
There was overwhelming interest from the buy-side member community at the FPL Americas Electronic Trading Conference to discuss Commission Sharing Agreements (CSAs), also known as Client Commission Agreements (CCAs) depending on your buyside or sell-side perspective. CSAs allow asset managers to separate the fees paid for trade execution from the fees paid for research and other services such as FIX connections and market data.
A survey of the buy-side conducted by Integrity Research Associates reports that in the US, “CSAs have gained in popularity over the last five years, and now account for 30% of research commission payments on average. Respondents [to the survey] typically use 5 CSA providers, although some large investment firms use 12 or more.” In the UK, this number is 70% of research commission payments on average.
CSAs allow asset managers to “unbundle” the sell-side trade commission into separate execution and research spending, so that the manager may pay for the execution service with a portion of the commission fee, and use the rest to pay for research or research related services to one or more places. Often this is because the research provider is not necessarily the broker that executed the trade.
The Securities and Exchange Commission (SEC) in the US and the Financial Services Authority (FSA) in the UK both encourage the use of CSAs in order to allow the manager to optimize the services that they receive, and at the same time, increase the transparency of these fees to the end investor.
The most critical element to understand is how commission breakdowns could be reported to the buy-side with FIX, in order to comply with CSA regulations and describe the workflow from the buy-side that tells the sell-side what research and other services that the sell-side pays for. The significance of CSAs to electronic trading is evidenced by the recent FPL Americas Electronic Trading Conference panel on CSAs.
How FIX facilitates CSAs
Commissions generated by the buyside are reported using back office systems that feed into settlement. After settlement, the broker keeps a breakdown of what portion of the commission is going to be used for execution versus research using rate tables agreed upon with their asset manager clients. While CSA systems right now are based on T+1, delivering commission breakdowns in FIX will allow OMS vendors to provide commission systems in real-time, leading to increased service for the buy-side and further growth in the CSA market.