Westborough, MA and New York, NY, June 15, 2005 â With buy-side customers prowling for better, faster and more anonymous trade execution, brokers say theyâre worried their business model is collapsing and that new technology and overcapacity may eventually drive equity trading profitability to oblivion. According TABB Group in their newest report released today, "The Internal Market: Maximizing Liquidityâs Value", the financial industryâs first-ever study of the internal market, one of the ways brokers are solving this is through the development of internal markets, what many say they view as "internalization on steroids."
"The major question is," writes Chris Morstatt, partner at TABB Group and the reportâs author, "can brokers leverage existing orders to reduce execution costs (implicit and/or explicit) for their institutional customers and increase their own profits?" The development of the internal market is one of the solutions being pursued to answer this question.
The internal market is the marriage of internalization with the gathering and crossing of orders from each of the trading desks throughout the firm, explains Morstatt. While the internal markets are not a new concept, they are drawing increased attention recently as new external crossing entrants have emerged to provide ready liquidity, potential price improvement and controlled information leakage â which in turn are siphoning off order flow from traditional markets and brokers.
TABB Group interviewed 35 traders at tier one and two brokers and at institutions and hedge funds with assets under management (AUM) ranging from $6 billion to $1.7 trillion.
A successful internal market leverages a brokerageâs order flow to offer clients better pricing than the current National Best Bid and Offer (NBBO) with greater anonymity and less market impact, which, in turn should attract more buy-side order flow. Unfortunately, buy-side clients have historically been wary of internalization. They fear proprietary trading desks may view their order flows and "pick off" the best orders or adjust the internal trading style to the clientâs disadvantage. However, as the size of trades continues to decrease and decimalization makes it more difficult to find large liquidity, the attributes that attracted institutional and hedge fund flows to the external crossing networks â ready liquidity, potential price improvement and controlled information leakage â are now attracting the buy-side to the brokerâs internal markets. Both sides acknowledge the historic negative connotation of internalization but express a willingness to find workable assurances to deal with the issue.
As pricing pressure increases, institutional investors are clearly looking for execution at a price better than the NBBO as a requirement to allow their orders to sit in, or be delayed by, an internal system. Meanwhile, brokers are convinced that offering fast, anonymous execution while occasionally improving on price will be sufficient to attract additional flow.
According to Morstatt, TABB Group believes that brokers who consistently demonstrate clear price improvement will flourish. Brokers who do not aggressively offer improved execution will fail to attract additional order flow and ultimately will be unsuccessful in their efforts to create an internal market due to lack of participation. In addition, brokers who emphasize and capitalize on their ability to match orders and cross at the mid-point will be more successful than those who emphasize "black box" internalization models.
"We believe that the development of a robust internal market strategy is essential to managing profitability as commissions continue their march toward zero," said Larry Tabb, CEO at TABB Group. "As the role of the sales trader continues to decline for routine execution business, brokers must respond with products like the internal market, which capitalizes on every potential trading opportunity."
The report also identifies seven internal market drivers; buy-side concerns, including reducing fragmentation, proprietary desk involvement, gaming in the crossing world and delayed market implementation; four broker roadblocks; and the vendor landscape comprised of internal development, vendors Headstrong and Lava Trading and OMS vendors.