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The High Cost of Best Execution
U.S., European regulatory demands causing uncertainty, rising IT expenses
February 18, 2008
Market-structure-altering regulations in the U.S. and Europe are driving broker-dealers to adopt new technology or find ways to boost the performance of existing systems. But some firms may be avoiding the issue altogether.
The U.S. Regulation National Market System (NMS) became effective for market centers in March and for brokers in August, yet there still appears to be confusion--and in some cases apathy--about the compliance demands.
"In terms of broker-dealers, we haven't seen too many that have even been concerned about it--there's no sense of urgency," said Joelle Smith, assistant VP of banking, financial services and insurance at AppLabs, a Philadelphia-based consultancy that tests systems performance for firms.
Reg NMS and the European Union's Markets in Financial Instruments Directive (MiFID), which took effect in November, both require that brokerages find the best execution for customers. However, MiFID may be causing more angst, partly because the market structure changes it is causing are more sudden and profound. Brokerages are "really in the eighth or ninth inning complying with Reg NMS, whereas they're in the first with MiFID," said David Easthope, senior analyst at Boston-based Celent.
One of the biggest remaining problems with Reg NMS, noted Easthope, will be the ongoing technology costs. He cites a broker-dealer with less than 100 employees who says 51 percent of its post-Reg NMS trading technology costs are connectivity related fees, 46 percent order management system charges and the remainder for market data.
The connectivity expense isn't going away, Easthope said, since firms must scan any new displayed venue for best price and, for competitive reasons, will likely link to numerous dark-liquidity destinations, though that's not a requirement.
Large firms will have to spend more on technology to handle their higher volumes, but their costs are a lesser percentage of their revenues than smaller competitors'. "If you are a mid-tier or smaller brokerage, and you can't demonstrate that you're getting competitive or better prices than a Goldman Sachs or Bear Stearns, then institutions are going to have a tough time sending you their order flow," Easthope said. One consequence may be the concentration of flow in fewer hands.
Vendors such as Citigroup's Lava Trading and Princeton, N.J.-based OES Market Group can help by providing both the pipes and the order routing services. Customers can use their own trading platforms or opt for the vendors' systems. Some market centers, including the International Securities Exchange and Philadelphia Stock Exchange, use OES technology to satisfy their routing requirements.
OES charges its brokerage clients--approximately 160 firms of varying size--on a per-share basis, according to Michael Barth, the company's EVP of strategic initiatives. "We also provide a database and data-mining tools to see the order-routing trails and the quote information related to those trails, and customers can customize reports or use canned reports" for compliance purposes.
Some brokers develop their own connectivity to liquidity points; others seek to ensure their vendors remain NMS-compliant. New York-based consultancy Jordan & Jordan promotes a "preventive maintenance" approach. Michael O'Conor, management-consulting director of the firm, said that regulators will be comparing brokers' trade-related data to network data--quotes and trades across the industry. Jordan & Jordan provides tools for firms to do that on their own.
"Any protected quotes that are better than where you executed your trade, at the time you executed your trade, could indicate a trade-through situation," O'Conor said.
