Executive Summary
The increase of order flow to electronic venues outside the broker’s traditional sales-trader route demonstrates that many clients value execution quality and anonymity above relationships and is leading the brokerage community into a struggle to find ways in which they can remain a significant player in the trading process.
The rapid rise of order volume that flows to electronic communication networks (ECNs) and crossing systems such as LiquidNet has come at the expense of the traditional sales trading and market making desks. The drain on order flow has eroded commission and market making revenues for the sell side. These alternative trading systems (ATSs) offered lower costs, reduced information leakage, and provided better, faster execution for the buy side, but they have also fragmented liquidity.
Endeavoring to retain flow, brokers have added value by providing customers with low-cost, no-touch advanced trading tools such as direct market access (DMA) and algorithmic trading. However, as high-commission flow is replaced by low-commission flow and these no- or low-touch tools break up larger orders into smaller trades, brokers become overwhelmed processing far more orders while collecting fewer commission dollars.
The major question is: Can brokers leverage these trades to reduce execution costs (implicit and/or explicit) for customers and increase profits for brokers?” The development of the internal market is one of the solutions being pursued to answer this question. The internal market is the marriage of internalization with the gathering and crossing of orders from each of the trading desks throughout the firm.
A successful internal market leverages a brokerage’s order flow to offer clients better pricing than the current National Best Bid and Offer (NBBO) with greater anonymity and less market impact, which, in turn should attract more buy-side order flow.
Buy-side clients have historically been wary of internalization. They fear proprietary trading desks may view their order flows and “pick off” the best orders or adjust the internal trading style to the client’s disadvantage. However, as the size of trades continues to decrease and decimalization makes it more difficult to find large liquidity, the attributes that have attracted institutional and hedge fund flows to the external crossing networks—ready liquidity, potential price improvement, and controlled information leakage—are now attracting the buy side to broker’s internal markets. Brokers and institutions both acknowledge the historic negative connotation of internalization but express a willingness to find workable assurances to deal with the issue.
As pricing pressure increases, institutional investors are clearly looking for execution at a price better than the NBBO as a requirement to allow their orders to sit in, or be delayed by, an internal system. Meanwhile, brokers m are convinced that offering fast, anonymous execution while occasionally improving on price will be sufficient to attract additional flow.
TABB Group believes that brokers who consistently demonstrate clear price improvement will flourish. Brokers who do not aggressively offer improved execution will fail to attract additional order flow and ultimately will be unsuccessful in their efforts to create an internal market due to lack of participation. Further, brokers who emphasize and capitalize on their ability to match orders and cross at the mid-point will be more successful than those who emphasize ”black box” internalization models.
No broker claims to have completed development of an internal market system. The main commonality among the brokers who have developed or are in the planning stages is that they view internal markets as an evolutionary process. Development will proceed on an opportunistic basis with consideration to factors such as potential cross volume, technical readiness of the firms’ existing OMSs, development of profitable execution pricing models, and the climate of client demand or resistance.
The biggest challenge that brokers face is the readiness/availability of their current technology and a business architecture to leverage an internal market. Recognizing that incorporating flow from all desks is critical to achieving critical mass, and that brokers traditionally have technical difficulties interfacing with the disparate systems used on these desks, the TABB Group believes that this creates a defined opportunity for the vendor community to produce a product to fulfill this need.
TABB Group believes that the development of a robust internal market strategy is essential to retaining order flow and will help brokers reclaim some of the volume lost to alternate execution venues, which will soon be exacerbated by the rollout of the NYSE’s Hybrid Market. As the role of the sales trader continues to decline for routine execution business, brokers must respond with products like the internal market, which capitalizes on every potential trading opportunity.
While the trend toward internal markets is significant, it is critical how firms implement this technology and how it is marketed to their clients. Buy-side firms want price improvement and lower execution costs, but are also concerned about order flow manipulation and transparency into internal market black boxes. These issues must be addressed and overcome if the broker expects to leverage this technology to its fullest while managing client relationships, the regulators, and best execution requirements.
About TABB Group
TABB Group is the data-driven research and advisory firm that provides strategic insight for market leaders in the financial industry. Based in Westborough, Massachusetts with offices in New York, TABB Group was founded in June 2003 by Larry Tabb, the 25-year financial markets veteran and former vice president, securities and investments at TowerGroup.