Although equity electronic trading has gained

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1 GREENWICH ASSOCIATES GREENWICH REPORT Q3 U.S. Equities: The E-Trading Stalemate Craig Viani is Vice President of the Firm s Market Structure and Technology practice. He helps clients navigate market structure changes driven by the technology side of equities including ATS, e-trading infrastructure and HFT. Although equity electronic trading has gained mainstream acceptance, institutional volumes through e-trading technologies such as algorithms and smart-order routers have clearly flatlined. It seems a wedge has formed, inhibiting this growth. On one side, e-trading offerings are multiplying while market structure is becoming more complex. On the other, buy-side traders seeking simplicity, stability and quality consultancy have concentrated their order flow to a select number of brokers who provide this level of service. The net result of these opposing forces is essentially a stalemate. Add pre-existing competing demands, such as commission management and capital commitment, and things really get stuck. Until brokers allocate resources to more workflow-friendly projects rather than expanding their strategy suite, e-trading usage is likely to continue to stagnate. Study Participants Greenwich Associates conducted in-person and telephone interviews regarding U.S. equity investing with 243 U.S. equity portfolio managers and 321 U.S. equity traders between November and February. Respondents answered a series of qualitative and quantitative questions about the brokers they use and their businesses in the U.S. cash equity space. 3% 4% U.S. Equity Traders 8% 22% 62% Banks Pensions and Endowments Mutual funds Hedge funds Investment managers U.S. Equity Portfolio Managers 3% 5% 9% 27% 56% Tipped Scales, No Growth There is no doubt that equity e-trading tools have found a home in buy-side traders workflows, and the breadth of strategies, order types and transaction analysis available has never been greater. Likewise, distribution across order and execution management systems has been streamlined and fairly standardized. As a result, since 2012 nearly 90% of Greenwich Associates study participants regularly use low-touch channels to execute their institutional orders. Even as this level of popularity continues, growth in e-trading volume lacks momentum. Over that same time period, usage of algorithms and smart-order routers remained flat, with only a third of a buy-side trader s flow executing via low-touch strategies. Although the variety of products has grown and barriers to accessing to these tools have lowered, the buy side is no more enthusiastic about electronic trading then they were five years ago. Use of U.S. Equity Algorithmic/Smart-Order Routing Trading Total Institutions 89% 90% 31% 91% 90% Currently use Algo/SOR trading Flow as proportion of overall trading volume among users Note: Includes dark pool sourcing algos and smart-order routing. Based on 291 institutions in 2012, 284 in 2013, 303 in, and 292 in. GREENWICH ASSOCIATES GREENWICH REPORT

2 Stationary Desks One might think that lack of e-trading volumes may be driven by resource constraints on the buy side. If buy-side desks are understaffed, this may reduce the amount of time traders could have their eyes on the screen and inhibit the use of low-touch channels: I am pressed for time, so I pick up the phone. A counter argument is that staffing limitations should encourage e-trading, assuming e-trading is more economical than calling a broker: There is too much to do, so I click on the algo, push send and go. According to our Trading Desk Optimization study, however, neither scenario holds true, as the number of traders per buy-side desk has been flat since Even through the boom-bust-boom in equity markets, the typical buy-side desk still averages slightly under four traders. Such resilience can be taken as a sign that institutional desks are well calibrated: both traders daily tasks and extended responsibilities are formalized, organized and apportioned. That s not to say that these roles are static. In contrast, buy-side traders are proven multitaskers. As a result, they are more likely to gravitate toward processes and technologies that increase their efficiency and resourcefulness. So while desk size is flat, volatility and volume are down, e-trading options are up, and counterparty transparency is becoming an industry standard, institutional traders refuse to change their habits. One has to wonder if market structure complexities and confusion are contributing to this inertia. Confusion and Dilution These market structure challenges come in many forms. As always, the persistent battle in Washington for the hearts and minds of regulators by the largest market participants has fatigued traders. With debates about pilot programs and surrounding proposals seeking modifications and modernizations to the orderhandling rules, even buy-side traders with sea legs are experiencing bouts of nausea. On top of structural insecurity, the waves of e-trading product offerings from smaller brokers and an influx of new indistinct matching engines have begun to dilute the overall e-trading business and reduce clarity. The buy side finds it tough to distinguish an innovative platform from one that is partially or wholly repackaged. Algorithmic product managers will be the first to attest that excess in choice often leads to decision paralysis. Most have mediated heated strategy sessions between developers, wanting to offer a dynamic algorithm that makes multiple, tactical decisions with a dozen or so parameters, which sales then ask to cut down to a pragmatic three. On average, there are 75 different types of iced teas at your grocery store. How many have you tried? Perhaps e-trading falls into the decision tree of what psychologists call good enough. More choices give you more freedom only if the advantages can be clearly seen. As market structure gets murkier and brokers offerings more opaque, buy-side traders are understandably less enthusiastic about diving into muddy waters. Average Buy-Side Staffing Levels Traders per Desk Note: Based on 252 institutions in 2005, 267 in 2006, 263 in 2007, 248 in 2008, 270 in 2009, 273 in 2010, 293 in 2011, 286 in 2012, 231 in 2013, 107 in, and 113 in. This question was asked of a select population in and. GREENWICH REPORT 2

3 Number of Brokers Used for U.S. Equity Trading Note: Based on 271 institutions in 2007, 272 in 2008, 287 in 2009, 285 in 2010, 217 in 2011, 278 in 2012, 276 in 2013, 283 in, and 278 in. Frugal Flow Although adoption of e-trading technology in general is high, the buy side has been more parsimonious in isolating their flow to a select group of brokers. In the past, buy-side desks have been adept at spreading their equity order flow across a diverse broker list to pay for a variety of services including research, corporate access, sales trading, commission recapture, and capital commitment. Today, institutional equity desks interact with around 40 brokers annually a level that's shrunk less in the last four years than in years prior. Of those relationships, an institution s top two brokers usually garner about a quarter of their overall equity business. In contrast, e-trading flow is much more highly concentrated, with the lead and second broker capturing more than two-thirds of a buy-side desk s business. With third place capturing another 15%, this leaves a small amount of an institution s electronic volumes to be dispersed among the rest of the Street. Greenwich Associates study data shows that the majority of buy-side firms actively use around five electronic brokers offerings, so chances of getting a bite from the table scraps is limited. In effect, the fewer times a broker can reach the podium in the medal ceremony, the less likely they are building a viable low-touch business. So what are the values the buy side wants most from their e-trading broker? Rainbows and Race Cars Running an e-trading business is not a cheap proposition. Beyond the initial startup costs to build out the platform, monthly connectivity and market data fees, as well as continual expenditures to keep pace with regulatory requirements and infrastructure enhancements, can eat a deep hole into the bank account while sales struggle to build credible market share. Short cuts, such as Concentration of Business Lead broker Second broker Other brokers Algorithmic/Smart-order routing business 1 46% 23% 31% Most important firm 2nd most important firm Other firms Overall equity trading business 2 17% 11% 72% Note: 1 Based on 187 institutions in. 2 Based on 246 institutions in. GREENWICH REPORT 3

4 white-labeling a vendor s or other broker s technology, may soften the blow but also limit the robustness of the platform. The rainbow at the end of this stormy weather is that the buy side is not asking for more nuanced, sophisticated strategies. The top priority for institutions is similar to the demands of anyone who relies on technology to manage their business: They want simplicity, reliability and responsive support. Ease of system use still ranks as the most important criteria by more than three-quarters of study respondents. But in the current market environment, the need for quality trading consultancy (46%) now outweighs the desire for more evidence of execution quality (37%). Equity traders are like race car drivers their job runs from green to checkered flag each day. Between waves, they are both hyper-focused and continually distracted. Driving with precision, they expect their car to respond equally on every turn. A skilled pit crew is vital to return them to the track without losing time. E-trading offerings are the stock cars zooming around the modern markets today. The likely reason traders use so few platforms is that they only have the capacity to be fully proficient in a select few. In some cases, this expertise may be limited on a strategy-by-strategy basis. As markets increase in complexity, the buy side is becoming more reliant on a higher level of support from trading consultants who marry market structure Most Important Selection Criteria for Algorithmic or Smart-Order Routing Trading Ease of system use, reliability and quality of technical support Quality of algorithmic trading consultancy Proven execution quality of algorithms Fast trade execution/ low latency 16% 26% 34% 37% 46% 44% Note: Based on 96 institutions in and 93 in. 73% 77% 0% 40% 80% and execution expertise to guide traders through the increasingly subtle challenges of balancing order exposure and aggression in these high-speed markets. Given the intense focus and scrutiny on order-routing speeds as it pertains to information leakage and impact, it s not surprising to see the quality of algorithms temporarily take a back seat to latency and the immediacy of an execution. As the buy side is removed from order-handling practices at brokers and exchanges, it s more likely this Flash Boys effect will fade, and focus will return to performance. Finally, although e-trading salesmen would like to believe that institutional traders spend their days glued to brokers trading screens, the buy side s attention is far from captive. Adding to their daily responsibilities, traders have to balance access to liquidity, research obligations and directed flow. More than half of all institutions still require capital commitment from their brokers and execute 1 in every 10 trades through guaranteed facilitation. Likewise, 78% of firms employ commission-management programs, with 34% of commissions being paid through the facility. And a third of firms are directing order flow to emerging brokers, although disproportionally more for mutual funds than hedge funds. Buy-side trading desks may be stationary, but their chairs are always swiveling. Looking Forward: Self-Driving Cars or Chauffeurs? Although e-trading usage struggles to better its current plateau, there is optimism that more volume will be executed through broker algorithmic and smart-routing platforms. With TCA adoption at all-time highs and intra-trade performance measurement by venue increasingly available, institutional traders ability to control and calibrate their order flow will increase. In the same vein, as brokers start to allocate resources to enable traders to manage multiple orders more efficiently, the alignment of e-trading adaptation and usage will be more rational. The challenge is that regulations related to system compliance and proposed rule amendments raise the probability of higher costs. E-trading tools fronted by a sales trader, as opposed to an OMS drop-down window, garner higher commission rates. So while buy-side traders struggle to increase their usage, brokers struggle to see why they should demand it. In the end, Google cars and Uber cabs can harmoniously share the roads, and based on traffic, traders will always be able to choose the best way to get there. n GREENWICH REPORT 4

5 Methodology Greenwich Associates conducted in-person and telephone interviews regarding U.S. equity investing with 243 U.S. equity portfolio managers and 321 U.S. equity traders between November and February. Respondents answered a series of qualitative and quantitative questions about the brokers they use and their businesses in the U.S. cash equity space. The data reported in this document reflect solely the views reported to Greenwich Associates by the research participants. Interviewees may be asked about their use of and demand for financial products and services and about investment practices in relevant financial markets. Greenwich Associates compiles the data received, conducts statistical analysis and reviews for presentation purposes in order to produce the final results. Unless otherwise indicated, any opinions or market observations made are strictly our own. Greenwich Associates, LLC. Javelin Strategy & Research is a division of Greenwich Associates. All rights reserved. No portion of these materials may be copied, reproduced, distributed or transmitted, electronically or otherwise, to external parties or publicly without the permission of Greenwich Associates, LLC. Greenwich Associates, Competitive Challenges, Greenwich Quality Index, Greenwich ACCESS, Greenwich AIM and Greenwich Reports are registered marks of Greenwich Associates, LLC. Greenwich Associates may also have rights in certain other marks used in these materials. GREENWICH ASSOCIATES 6 High Ridge Park Stamford CT USA Ph / ContactUs@greenwich.com