Over the last half century, the U.S. equity market structure has gone under a complete renovation. For nearly two hundred years, the markets were powered solely by human intermediation. But starting in the late 1960s and continuing through today, the potent cocktail of high-profile market events and sweeping reactionary regulations mixed with a steady stream of technological advancements have altered the trading landscape into a highly competitive, electronic marketplace. As a result, market participants have a simple choice – adapt and innovate, or face extinction.
The latest report with Greenwich Associates, “From Crowd to Cloud: The Myth and Magnitude of Fragmentation in U.S. Equities,” builds a comprehensive timeline of the episodes which shaped this transformation of the U.S. market. The key argument is that fragmentation is not the cause of market complexity; rather, it is a byproduct of an industry that is still coming to terms with the effects of its short courtship and hasty marriage with technology. The research also concludes that those brokers who have committed the resources and effort to tackle these market structure complexities are, by far, best equipped to face the changes in its future.
Understanding the differences between brokers’ electronic offerings is key to managing best execution. Here are three examples of shortcuts brokers take in order to deliver an electronic platform to their institutional clients and why the combination of one or all of these decisions can undermine a client’s quality of execution.
A black and white (labeled) world
Given the continuous, nuanced evolution of our electronic marketplace, a dividing line has already been clearly drawn between the technological “haves” and “have nots” with many brokers positioned in the latter category. Although dozens of brokers claim to offer legitimate trading platforms to navigate today’s complicated landscape, very few have been able to keep pace with the rapid changes and technological requirements needed to effectively access the market. Either entering the game too late or conceding that they could not keep pace with the continual developments, these brokers have chosen to borrow technology from others.
Repackaging or “white labeling” another broker’s technology is an effective way of delivering low-touch trading options to institutional clients. The challenge is that, with the deferral of this expertise, many brokers lack the internal know-how and controls to properly monitor the quality of execution their clients receive and some are often tempted to focus on execution cost over best execution. Institutional traders who trade through a broker’s white-labeled offering need to increase their level of scrutiny, which is both time-consuming and sometimes difficult to manage. It’s not surprising that buy-side traders only use on average five electronic brokers and funnel 84 percent of their order flow passing through just the top three.
Half safe: The risks of the outsourced SOR
Not all brokers offer white label solutions. A sizable group have committed to delivering a proprietary offering. But, given the sophistication involved in algorithm construction and dynamic order routing, a more recent trend in electronic trading is for a broker to now outsource one or more components of its trading platform. Most commonly, given the blistering speed now required to access so many different venues, some brokers rely on high-frequency trading (HFT) firms or electronic market makers as the backbone to their smart order routers (SORs).
Brokers with partial technological infrastructures are more likely to have the controls and expertise to monitor these outsourced SORs as compared with a full white label solution. However, it would be near impossible for these brokers to have full transparency into how their order is exposed relative to their routing providers. In the end, one can argue that these hybrid offerings are a better alternative to a fully outsourced solution. But being half-safe does not always comfort institutional traders who often fear information leakage and price impact.
Beyond the concerns of external gaming by a third-party full or partial solution, buy-side traders are now expressing apprehension when routing to a broker who runs one or more dark pools. Given the recent headlines on fines levied due to the use, order flow handling and lack of disclosures related to dark pools, institutional traders have expressed concern that their orders may be held up for an extended period of time solely to optimize the chance of a fill. One argument is that this may unnecessarily increase that order’s opportunity cost. A greater fear is that these pools may be optimized to cross as many shares as possible which increase the likelihood of trading with an undesirable counterparty.
Where routing through a broker who managed dark pools was once viewed as a way to minimize information leakage and maximize price improvement, today many buy-side traders have become less enthusiastic about non-block sized fills in their electronic broker’s dark pool. Many brokers, in response, are now providing venue-based transaction cost analysis (TCA) to reduce this fear.
The conflict-free imperative
In today’s complex markets, institutional traders are challenged to make informed decisions when choosing their electronic brokers. Clever product names are not always a fair barometer for a broker’s electronic execution capabilities. Buy-side traders need to identify the holistic execution solutions that are optimized for this diverse, high-speed marketplace. A broker who does not use white-labeled algorithms, has a direct route to all major displayed and dark trading venues, and does not operate a dark pool or propriety trade, is essentially a “conflict-free” broker. These brokers can offer competitive execution solutions that can help improve execution quality, minimize information leakage and decrease overall execution costs.
FIS offers both highly configurable, low latency strategies as well as venue level transaction analysis tools to help drive insightful trading decisions. Our solutions work orders through algorithms which leverage historic and real-time venue ranking to make second-by-second order placement determinations.
Fox River Execution Solutions and SGN brokerage services offered through FIS' Global Trading Group within the United States and Canada are provided by FIS Brokerage & Securities Services LLC, Member NYSE, FINRA, SIPC.
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