Courtesy of AdvancedTrading Contributor Phillipe Buhannic
Editor Note: This article is endorsed by MarketsMuse sponsor OMEX Systems, Inc.
Buy-side clients need to understand that when they trade on a broker-sponsored platform, they are paying for these systems, whether that payment comes in the form of commissions, licenses, or widened spread. Therefore, the most important thing the buy side should do is to think like a customer.
The last year’s market deterioration made things difficult for brokers, who are seeing tighter spreads, fragmented flow, smaller trade sizes, and compressed commissions. Brokers now face the most difficult operating environment in recent memory, with decreased market liquidity, increased message traffic and lower order volumes from clients.
Brokers also find themselves in an adverse situation, having over-invested in a number of areas, including their trading infrastructure, their capability to generate algorithms and their ability to process trades. Most broker’s capabilities vastly surpass the current needs of their clients.
From Bad To Worse
And just when you thought that things could not get any worse for brokers, they are now increasingly subject to regulation seeking to promote transparency. Brokers also have to deal with plan sponsors who need to justify more effectiveness in trade handling, and, more generally a buy side that wants to clear up the inherent conflict of interest of broker-sponsored platforms.
As broker-sponsored platforms face an uncertain future, sophisticated buy-side firms have to answer difficult questions about how they manage the associated risks of trading on these platforms … and whether those risks are worth taking at all.
Although broker-sponsored platforms can be conceptually acceptable, investors need to protect themselves against the risks that these systems could potentially generate, such as significant market impact, limitation of transparency and higher, undisclosed, transaction costs.
Top 10 Buy Side Concerns
Here are the the top 10 issues every buy-side trader needs to be mindful of to ensure efficient and effective trading on their broker-sponsored platforms:
1. Control Information: In the financial markets, information IS money. To avoid leaking information (and money) every buy-side firm should maintain a clear policy on its data flow, especially in markets with tight liquidity, like corporate bonds or blocks. Using single-dealer platforms or even multi-dealer RFQ platforms in some cases could be similar to advertising positions to the entire market place. The buy side should assume that information is public as soon as it reaches a broker operated single- or multi-dealer platform and check that its business objectives are compatible with this disclosure. (For example, iceberg and registered orders could be read and used by pricing servers.)
2. Use Multiple Platforms: Do you want to show all your order flow to one broker by accessing only their execution management system (EMS)? This can be a risky strategy. If you need to access single-broker platforms, it is best to have a few of them, so you can avoid giving one counterparty too much control over your execution quality. To be sure, to make it worth executing on a single-dealer platform, the capability to tap internal crossing capabilities should be, at the minimum, flawless. Don’t think that consortia platforms are better in that respect — they just distribute the information to more people.
[For more on how the buy side is evaluating EMS systems, read: Market Structure Drives the Buy Side to Seek New OMS/EMS Systems].
3. See The Full Cost Equation: Some execution destinations use the “maker/taker” model. They pay for liquidity — “makers” provide rebates to brokers in exchange for flow — and charge for those who “take” liquidity. Brokers who receive the rebates don’t always include them in the commission analysis and reporting. These rebates can create an incentive to execute at these destinations regardless of transaction quality. Make sure that you broker includes his commission review and discloses its counterparty relationships. The client should also consider in this review the equation of trade internalization as it has become significant as a revenue stream versus commission-only trades.
4. Map The Real Liquidity: Investors need to know not just WHERE orders are going, but in what order and where they’re being shown, as well as where they are really executed. Investors, especially those on broker platforms, need to work with their broker to have an understanding of how orders are executed to avoid unnecessary executions at high-cost locations. Using the FIX Tag 30 or “last market” information can help monitor the real liquidity. If all trades get executed elsewhere, then what is the real value of a proprietary platform?
5. Choose the Right Algos: Although algorithms generally make traders’ intentions more opaque by helping them transact without alerting the market, each sliced order tips the trader’s hand. Traders need to ensure that they are using the right algorithm for the environment and markets they trade in. This means getting a clear and unbiased overview of the strengths and weaknesses of most brokers’ algorithms before selecting a single-dealer platform. A certain trading strategy may call for quickly tapping other brokers’ algorithms on other platforms.
Furthermore, no one broker has a monopoly on good algos. This is where independent platforms offering a high quality algo “hub” shine versus single-dealer platforms, as they offer metrics to evaluate the various algos in real time and the versatility to switch quickly from one to another. Therefore, you need to make sure that the proprietary platform you have selected will have the range of algos that fits your business needs.
[For more on how the buy side is evaluating their algo choices, read: 66% of Buy Side Traders Value Execution Consultants].
6. Beware of Implied Multi-Leg Strategy Trading: For instance, traders who receive excellent transaction quality on foreign securities can see their gains erased by a poor quality of foreign exchange (FX) risk management. Also, buy-side traders need to see what other fees and charges are bundled in with their transaction to avoid unexpected hits to transaction quality. This is especially sensitive in markets that operate away from the main FX trading hours. Few proprietary platforms have reached a level of cross-asset trading that allows for efficient management of multi-leg risk, as they stay mostly asset-class specific.
7. Have an Impartial Third-Party Conduct Your Transaction Cost Analysis: You would not ask your barber if you got a nice haircut. And, in the interest of prudence, you should not ask your broker to do an assessment of their own execution quality. If you trade on a single-broker platform, get an independent transaction cost analysis (TCA) provider to vet the execution quality. Ask around, do the homework, compare yourself using a “peer group,” or use the ratings of algos that are based on independent analysis. It will pay off handsomely. Nice brochures will never replace strong independence.
8. Beware of Hidden Costs: Speaking of costs, there is no good proxy for true price transparency. There is a significant cost to deploy a quality trading system and this cost has to be recovered. For every trading system that is broker-sponsored and owned, multiple ways to recover that cost are possible, making it sometimes difficult to understand. This process is usually more transparent on independent platforms. Even if those costs are not clearly stated up-front, and are hidden in the form of higher commissions, increased spreads or various other techniques, they must be understood. The cost of having a low quality execution will dwarf the economic advantages of a no license policy by a broker.
9. Wear Your Operational Hat When You Select Your Broker Platform: When allocating your execution business, incorporate clear performance criteria in the equation related to your needs, and get details on the system infrastructure and performance. If the system provided is subpar, then ask for a multi-broker system. If it is of good quality, query the inner “plumbing” of the trading engine, with an eye to identifying slow routing of orders because of the system structure. (After all, you don’t want your trade from New York to Chicago to be routed through London.) Ask for a document that spells out the trades’ confidentiality rules, as well as what orders the brokers’ internal desks can see and trade against.
10. Justify the Single-Dealer Platform Choice: Finally the most important thing the buy side should do when approaching the broker-sponsored versus independent platform decision is to think like a customer. At a minimum, the buy side needs to have a long talk with their broker to analyze the reasons why they are taking a broker sponsored platform route. Buy-side clients need to understand that they are paying for these systems, whether that payment comes in the form of commissions, licenses or widened spread. If the system does not demonstrate some unique, lasting, differentiating capabilities to be retained, then the independent platforms are the better choice.
Demand A Fair Platform
Lower volumes, tighter spreads, and increased demands for transparency have raised the stakes for the buy side and sell side, alike. To succeed, sophisticated traders need to have a good understanding of how, where, and when their trades are executed.
This can be made difficult for traders who are not using a multi-asset, multi-broker platform, which can quickly expose workflow, pricing, and execution inefficiencies.
Still, given the state of technology and the markets, and the vast array of available options, the buy side can, and should, demand a treatment on platforms that are fair, with trades executed without bias and effectively.