Wednesday, November 16, 2005

Sellside turns to consultancy

Lynn Strongin Dodds
1,061 words
13 November 2005
Financial News
(c) 2005 Financial News Ltd. All rights reserved.

Fund managers and their brokers are changing the way they do business. New regulations and advanced technology have forced a renewed focus on best execution - obliging both parties to re-evaluate their operations. The buyside, especially the larger houses, is taking greater control of trading, while the sellside is reorganising its trading desks to provide a more bespoke service to make up for lower commissions on electronic trades.The generic description of best execution - dealing for a client at the best available price given the size and type of transaction - sounds simple enough. However, this is far from the reality. Best execution is increasingly seen as a trading process that gives the best return. The complication occurs when fund managers ask to trade against a benchmark that may not provide the biggest return.

One market participant said: "For the most part, the onus is on the buyside to get the best price for the client. The sellside offers a service and its agenda is to offer what the client asks for. If a fund manager gives instructions to trade against volume weighted average price, that is what the broker will do although implementation shortfall may have been the best execution strategy. Fund managers must decide what trading process is most appropriate to achieving best execution in the context of their own broader investment process."

Brokers will argue best execution has always been their top priority, but now it is a requirement thanks to recent legislation and guidelines in the US, Britain and Europe. The Myners report in 2001 kicked off the debate in the UK while the Financial Service Authority is expected to issue new rules next year that will require UK investment managers to reveal how their dealing commission is spent.

Meanwhile, regulators in the European Union are discussing the final details of the Markets in Financial Instruments directive, which will compel fund managers to find brokers that offer best execution.

Those brokers that stay one step ahead of their clients and offer the latest sophisticated trading tools and analytics to help them achieve best execution will undoubtedly steal market share. However, the sellside also needs to develop other services and products to offset the lower commissions that are generated by using advanced electronic trading systems. The aim is to continue capturing the volume through technology while offering higher margin, bespoke and consultancy services.

Alasdair Haynes, chief executive of ITG Europe, said: "Best execution today consists of pre and post-trade analysis and the implementation of the trade. The brokers who will succeed are those that have responded with more sophisticated pre and post-trade analytical tools as well as advanced trading systems such as direct market access and algorithms."

Despite their growing independence, fund managers still value the relationship they have with the broker. They continue to rely on them to provide capital and act as counterparties in illiquid stocks. They also value their help navigating through the plethora of systems and strategies that are available.

Algorithmic trades are automatically sent to the most efficient execution venue using computer-generated models and direct market access. This is the process by which orders are sent straight to the market without the involvement of a trader or broker. DMA may be today's new accessory, but some fund managers lack the sophistication to understand the most effective way to use this and other technologies.

Doug Hampton, head of trading at State Street Global Advisors, said: "We are not looking for brokers to provide best execution but to give us the flow and tools to get that execution. We want them to commit capital and provide us with the other side of the trade plus advise us on the best way to trade."

The larger brokerage houses have been more than willing to step into the role of consultant. In the past two years, top-tier firms such as Citigroup, Morgan Stanley, Deutsche Bank and Credit Suisse First Boston have honed and bundled their execution services under one banner incorporating products and services such as algorithms, direct market access, portfolio trading, cash trading and advice. In this way, they can separate a client's order flow into what they call the "high-touch", "low-touch" or "no-touch" categories.

This enables the more straightforward, liquid trades to be handled by a broker's direct market access or algorithmic software while the trickier, illiquid trades are handled by a sales trader.

Richard Balarkas, global head of advanced execution services sales and head of equity trading services at CSFB, said: "The buyside is under pressure to take more control of trading, so it needs direct access to efficient trading tools provided by the broker - typically to handle the simpler orders. However, it is unlikely to have the resources to handle its more difficult trades. It will go to a broker. Clients are asking us for advice on how to segment their orders and choose the most appropriate execution destination."

Garth Ritchie, head of European equities trading at Deutsche Bank, added: "We offer a full execution suite of products such as portfolio trading, algorithms, direct market access, pre and post-trade analytics. In this way we can provide a range of services from execution only to high touch, with ancillary services in between. The value we add is in the high touch trade because it is in the less-liquid smaller to medium names where the fund manager can add alpha to the portfolio. The analogy I use is internet banking: most of us have migrated to online banking, but for large transactions human interaction is still required."

Ritchie would not be surprised to see the risk or principal side of trading separated from the agency business. "In this environment of unbundling, if you separate the two functions, it will make the price of the capital commitment much more transparent," he said.

Others are gearing up for the arrival of commission-sharing arrangements, where fund managers trade with a handful of well-capitalised banks, which are then asked to pass on a proportion of their commission to other research specialists including independent houses. In this way, fund managers trade with those firms offering the best execution while rewarding firms with the best research, regardless of their execution acumen.

These are changing times and only the fittest will survive.

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