US Institutional Equity Trading 2014: Part 2 Undercurrents of Change

Changes to the trading process over the last several years have largely been driven by the sell side implementing new coverage models and creating new products; now the buy side will be the driving force of change. Brokers face a new wave of competitive pressure as the buy side streamlines processes, automates, harnesses technology, and continually redefines what it will pay for and how. Commission wallets remain strapped, and the buy-side is developing tools to increase automated flow, backing new crossing networks with simplified execution structures to reduce costs, and expanding their reach to new markets. A lack of regulatory action and a flurry of recent publicity surrounding high frequency trading (in the form of “Flash Boys”) again stoke the debate about market quality. Yet time has improved the resilience of the buy side with regard to market structure and they will take progressively greater control over how they interact with brokers and how order flow is delegated for execution.

Scrutiny of the value-add of the buy-side trading desk in turn puts the brokers’ coverage desk under the microscope, as measured proof of differentiation replaces perception of value. Found wanting, order flow will be routed automatically with a higher research component in the commission rate to fund the CSA pool. With more than half of commission wallets paid to the top ten brokers, brokers in the shortening tails are at an ever greater risk of being paid by CSA or being cut out altogether.Despite a growing need to put a number on value, coverage models are still grounded in trust. The importance of coverage – whether high or low touch – remains a driving force with regard to how buy-side firms execute their flow with individual brokers. Despite a warming towards single points of contact, more than half of our participants never want the cash desk to see algorithmic flow.

This year we asked our participants to nominate brokers who stand out as ‘best-in-class’ across eight categories - market color, flow, risk, agency trading, algorithmic broker, execution consulting, analytics and market structure- , independent from any commission or amount of order flow directed to that broker. We wanted to compare their perception of excellence with the actual distribution of commission wallet and explore the extent to which these services bring in incremental revenue, are prerequisite table stakes, or shape the brokers’ products.

As the end-to-end investment-to-settlement process is tightened, there is a window of opportunity for brokers to ensure a good match of products and services with specific clients’ needs because only those who consistently perform well will improve their statistics, and consequently win more flow. As the buy-side takes more charge of individual components in the trading process through their initiatives, brokers must beware a change in the landscape again, this time driven firmly by the buy-side.

For this year’s institutional equity trading study, TABB Group spoke with 108 head traders of asset management firms across the US during Q4 2013. We included in our conversations the commission wallet; shifts in order allocation and rates; broker preferences; trading in the dark as well as trading with blocks and algos; and views on current market structure. In our report US Institutional Equity Trading 2014: Bellwethers of the Buy Side, published earlier this year, we focused on buy-side drivers and the emerging trends amongst bellwether firms. In this second report, US Institutional Equity Trading 2014, Part 2: Undercurrents of Change, we explore the impact on brokers of buy-side initiatives, decisions, commission allocation, broker preferences and some of the changes that lie ahead.