Buy-side Firms Need to Rein In Out-of-Control Clearing Costs Resulting from Decimalization and a Transaction Explosion Caused by Algo Trading and Dark Pools, Says TABB Group

NEW YORK - 5 September 2007

Identifying Effective Solutions to Reduce Trade Processing Costs and Offset Drag on Funds’ Performance Takes on New Importance.

Traders today have considerable control over decisions dealing with where and how to best execute and process transactions, but according to TABB Group in a new research note, “Buy-side Clearing: Launching Efficiency through Aggregation,” written by Robert Iati, partner and head of research at the financial markets research and consulting firm, “this greater freedom also comes with greater responsibility for buy-side (trade processing) costs” that are dragging down funds’ performances. The solution, he says, is to rein in out-of-control clearing costs by using a central counterparty model where the industry’s algorithm providers can aggregate their trades.

According to Iati, “some of the largest asset managers are now spending over $170 million per year on trade processing costs alone, based on as many as 40,000-plus allocations a day, much of which is a direct drag on fund performance.” With expanding volumes due to decimalization and now algorithms and dark pools, asset managers are forced to address solutions to reduce their back-end costs that, according to the research based on the firm’s outreach interviewing process, are only now beginning to attract serious attention.

While at one time the trader was totally reliant on his broker to execute and process all transactions, he now has gained considerable control over his decisions and profitability. Although traders do consider the overall costs of their choices prior to selecting a specific routing strategy, Iati adds, “it’s too much to expect them to bypass many best ex opportunities based on their back-office processing costs,” leading TABB Group to believe that the most efficient way to reduce the cost of the increased allocations resulting from algo trading is “to implement solutions that aggregate them on the back end.”

Moving from his introduction on processing, titled “The Neglected Child,” to detailing the current settlement process, e.g., algorithms and dark pools, two complicating factors, and the cost of settlement – several highly detailed trading and processing scenarios are presented – Iati delineates the pain-points specific to “the best-ex conundrum.” He then introduces the central counterparty solution model, pinpointing five specific surmountable challenges that stand in its way of widespread adoption. He also explains the importance of central counterparty providers gaining a critical mass of algo providers for this to be a viable solution.

“TABB Group believes that the buy side’s commitment to solving this problem will help stem the tide of this unabated rise in custodial fees, and prevent these fees from having a significant negative impact on their customers’ returns,” concludes Iati.

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