"Itâs too early to pick winners but we can begin to handicap the contestants," says Larry Tabb, founder and CEO at TABB Group. "Stakes are huge, the judges picky and one thingâs certain. Itâs going to be a bloody fight. At its center is fragmentation."
Written by Adam Sussman, senior consultant at TABB Group, "Institutional Equity Trading in America 2005" spotlights the direction that the domestic equity sector is headed, change drivers and a view over the horizon, given recent market conditions.
The reports is based on interviews with 53 head and senior traders at investment management firms, segmented by assets under management (AUM) over US$50 billion, from $10 billion to $50 billion and fewer than $10 billion, and by investment style, including fundamental, quantitative and a mix of both.
Following up on the widely read and heavily cited 2004 report, which documented how long-term institutional trading changes made equity trading in America a more efficient process, equity traders no longer blame their problems today on external forces like exchanges and brokers. The current perception is that fragmentation is an inevitable part of the landscape, "that true liquidity is hiding in the backrooms of the marketplace," Sussman writes. "In 2005, the percentage of traders challenged by fragmentation nearly doubled to 83% while grumblings about market structure plummeted to a mere 9%."
TABB Group believes fragmentation and the inability to find size are due to higher usage and greater awareness of alternative trading technologies like direct market access (DMA) and algorithms. While broker algorithms have helped resolve some buy-side challenges, such as market impact and information leakage, many in the marketplace blame transparency, fragmentation and small trade size on external forces â specialists, market makers, decimalization and the SEC. "There is a growing realization," explains Sussman, âthat the drive to simultaneously hide and seek liquidity is the culprit.
Resolving these issues requires developing a comprehensive process to analyze and manage order flow, beginning at the portfolio manager level, up to development of an integrated execution management platform to help buy-side traders integrate and adjust to new trading technology tools like delegation, algorithms, crossing, direct trading and real-time, same-day and longer-term transaction cost analysis.
"Fragmentation is by far the most challenging aspect of the buy-side tradersâ world," says Sussman. "But will it get better or will it get worse? Will algorithms, crossing, dark books and sophisticated execution management platforms solve the problem or will these new tools just act to fragment and segment liquidity as before?"
TABB Group expects that as advanced trading technology use grows, transparency and small trade size will become a larger problem. The integration of recently announced mergers of the New York Stock Exchange/Archipelago Holdings and Nasdaq/Instinet will likely not create a totally consolidated, unfragmented market. Consolidating market places reduces arbitrage opportunities for liquidity providers. Competition for orders may narrow spreads, but that does not mean there will be greater size at each price point.
"While we would love to say that the world is getting easier, the converse is true," says Tabb. "These tools help buy-side traders reduce costs, gain efficiency and manage a larger number of orders, but they also make their job more difficult as they speed up the market, reduce trade size and force traders to hide more liquidity. While we donât see this changing, we do see more advanced, integrated technology coming from a wider number of sources for a bit more saner process."
Additional findings and forecasts include:
Â· Buy-side firms will route 20% of their order flow via phone by 2007, down from 48% in 2004.
Â· Buy-side and sell-side desks are becoming more tightly coupled through FIX.
Â· Larger firms over the next two years will direct 12% of their order flow away from FIX and 4% away from the phone. At the same time, 15% more order flow will move away from traditional sales-trading channels to no- and low-touch channels.
Â· All large firms, 80% of medium firms and 57% of smaller firms used algorithms.
Â· TABB Group expects VWAP to be only one of many strategies used, including Arrival Price, Implied Shortfall, EOD/Beat Close, Liquidity Seeking and Liquidity Forecast.
Â· The five top algorithm leaders weighted by AUM include CSFB, Goldman Sachs, Lehman Brothers, Bank of America and Merrill Lynch.
Â· Adoption of pre-trade analytics skyrocketed from 18% in 2004 to 53% in 2005. TABB sees the number jumping to 75% by 2007.
Â· TABB Group predicts 90% of all firms will implement some firm of TCA by 2007.
Â· Nearly 90% of all larger firms stopped or decreased use of soft dollars from 2004 to 2005.
Â· TABB Group believes that the next round of consolidation will hit mid-sized brokers hardest.
The 63-page report with 56 exhibits also covers the liquidity shiftâs winners and losers; the buy- and sell-sideâs struggling partnership; the sales traderâs evolving role; moving beyond VWAP; OMS integration and optimizing efficiencies; the seven leading OMS vendors; OMS/EMS consolidation; crossing networks; the future of DMA; impact of SEC and FSA regulatory actions; future trends in TCA; and the 11 leading pre-trade vendors.