By James Cooper, Head of Execution, Troy Asset Management.
The three-way relationship has been a mainstay of execution since the days of the Buttonwood Tree and the London coffee houses. The broking community, originally banished to the coffee houses from the Royal Exchange for their rowdy behaviour, has always been expert in bringing buyers and sellers together; they have continually innovated the hard technology and new commercial initiatives whilst maintaining (in nearly all cases) a reputation for trustworthiness and discretion.
Traditional exchanges meanwhile have provided not just a safe environment in which to transact but have always helped to form the rules of engagement well before regulators were even dreamt of. Since Thomas Gresham founded the Royal Exchange in 1571, there have been clear rules and exchanges remained broadly self-regulated until June 1985 when the forerunner of the FCA, the SIB, was created. Indeed self-regulation of the exchanges only really came to an end following the collapse of Barings in the 1990s. From the rules applied in the original London or New York coffee houses, to the circuit breakers and randomised electronic auctions of the present, public exchanges have provided a robust infrastructure upon which to transact.
The relationship, however, hasn’t always been cosy and the past few years have been especially tense.
Since the liberalisation of exchanges under Markets of Financial Instruments Directive I (MiFID I), the incumbent exchanges have been buffeted by heightened competition that has occasionally threatened their very existence and very often their own independence. Initially the broking community didn’t compete directly with the exchanges on their own patch, preferring to leave that to either competing foreign exchanges or start-up technology outfits. However, the development of Broker Crossing Networks (BCNs), originally envisaged as a means to allow the brokers’ institutional clients to cross large blocks discretely, soon offered a means for the brokers to apply even greater pressure on the exchanges.
At the same time, brokers have been raided by the buy-side for both their human capital and their technology. The buy-side has felt the regulatory pressure to deliver better and more transparent execution and much of the required expertise have come from the sell-side. Demoralised brokers have moved to the buy-side to develop the dealing desks and help develop the in-house, direct-to-exchange routers that were first pioneered by the sell-side.
Finally, both sell-side and buy-side have felt let down by the exchanges on two counts of late. The first has been their apparent reluctance to lower data charges and the second has been their perceived kowtowing to the high-frequency traders (HFT) at the expense of the “real investors”. The exchanges and their shareholders have benefitted greatly over the past ten years from the volumes traded by the HFT – as indeed have many of the banks. Institutional clients have felt that their ability to transact large blocks effectively has been made much more difficult. Many buy-siders have become so frustrated by these perceived conflicts of interests that radical initiatives are often threatened. Occasional flashpoints highlight the tension in the three-way relationship. Most recently the lobbying of EU parliamentarians and regulators by the exchanges and the brokers about the dangers or otherwise of “dark liquidity” and “off exchange” transactions has cut some particularly deep scars that will take time to heal.
But heal they will
As we enter the second half of the decade, and as the various stakeholders think about the shape of the industry post-MiFID, there are signs that the industry is rediscovering the value of the three-way partnership.
I was fortunate enough to be involved recently in the development of the Turquoise Block Discovery Service (BDS). The buy-side working group for BDS felt strongly that transactions should take place on a public exchange and that the service should be broker neutral. Some of us were worried that the broking community might be cautious of such an initiative. The reality has been the opposite: the brokers have understood the value of the service, have helped police it and have been instrumental in making it available to all. At the same time, the stock exchange involved in the BDS project, showed how adept it could be at implementing the buy-side’s specific requests. Although exchanges have tried to become more commercial in recent years and have tried to understand the buy-side’s requirements more comprehensively, they will always remain a long way behind the brokers in understanding investors’ all-round needs and guessing how they might improve their service. Brokers will always own the nexus bringing clients together especially for the purpose of large block transactions.
As the industry faces the end of BCNs and tighter regulation on dark pools, both sell-side and buy-side are appreciating how difficult it is to create the scale and integrity needed for a successful trading venue. Importantly, the public censure and fines received by Barclays and Goldman Sachs for the failings of their own venues combined with the sometimes sensationalist allegations made in “Flash Boys” by Michael Lewis, mean that politicians and the public may find it hard to ever trust bank-owned venues. Public exchanges have the expertise embedded deep within and have earned a valuable reputation for neutrality and competence. The current attempts to influence the shape of European trading ahead of MiFID II implementation and beyond have revealed that recent tensions between the actors have been a cause for positive change. Recent spats have helped to clarify where the role of one party ends and that of another begins.
It is true that there is a surfeit of European trading venues currently, but sensible regulation and market forces are gradually reversing this. True, also, that brokers are finding it hard to earn a decent risk-adjusted return on agency execution. But again, market forces and a growing reluctance to subsidise loss-making execution platforms are both correcting this.
It is clearer than ever, that exchanges are required in the system for their neutrality and their technical heritage. Brokers meanwhile are vital for their skill in bringing buyers and sellers together in a discrete and ever more efficient manner.
For its part, the buy-side has two distinct roles in the game. Firstly, it should focus on its core competence of managing other people’s money and not on building buy-side to buy-side venues from scratch. Secondly, it should visibly support and promote this three-way partnership that continues to provide the best possible structure for long term savers.
By James Cooper, Head of Execution, Troy Asset Management.