Crossing the Line? Business Innovation Powered By Technology. March-April 2006

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1 March-April 2006 Business Innovation Powered By Technology Crossing the Line? Brokers are opening up their internal crossing networks to the buy side, even going so far as to register them as ATSs. But buy-side firms, such as Pioneer Investments, say they aren t interested if proprietary trading desks are involved. The No. 1 concern with using a sell-side firm s crossing networks is the involvement of its proprietary trading desk, according to Robert Gauvain (left), Director of U.S. Trading, and John Myles, VP and Senior Domestic Trader, Pioneer Investments. We would have to have some guarantee that there d be anonymity, says Gauvain.

2 CROSSING OVER Brokers are transforming their internal crossing networks into alternative trading systems to boost their match rates and earn market data revenues. BY IVY SCHMERKEN PHOTO BY MARK OSTOW LARGE BROKERAGE FIRMS that have huge amounts of natural liquidity from customers flowing through their trading desks are offering buy-side traders the ability to cross their trades internally. In some cases, brokers are registering their internal crossing networks as alternative trading systems (ATSs) to make these networks more attractive to the buy side by bringing in regulatory oversight and opening them up to external sources of liquidity. Really, what they re doing is crossing natural flow, observes Robert Gauvain, director of U.S. trading at Pioneer Investments. They re putting together at a midpoint [price] buyers and sellers. Natural flow is the stream of buy and sell orders that institutional and/or retail customers route through the sell-side trading desks, DMA platforms or algorithmic strategies. Internal crossing enables brokers to potentially match both sides of trades within their own shops. So far, Credit Suisse and Goldman Sachs Execution and Clearing Services (GSEC) have registered ATSs. Morgan Stanley also is building a new crossing network and intends to file as an ATS. And there is speculation that more brokers will enter the ATS game. The big players all have [crossing networks] already, says Alex Ramistella, an analyst in TowerGroup s securities and capital markets practice. [Ed. Note: Ramistella left the company at press time.] It s a matter of how they are going to use them and if they are going to externalize it. WCrossing Comes Naturally to UBS HILE MANY Wall Street firms are expanding their crossing capabilities, the trail was blazed by UBS, which operates the largest internal network for crossing institutional and retail order flow on the Street. UBS acquired internal crossing technology from Charles Schwab s SoundView Capital Markets division in UBS internalizes a huge volume of retail order flow on a daily basis, writes Josh Galper, managing principal at Vodia Group, in a recent report. This is a very natural thing for a broker to do, comments Will Sterling, managing director of equities at UBS Securities. As part of its role as the largest market maker in Nasdaq stocks, UBS does a lot of natural crossing every day, he explains. UBS client business in the U.S. Morgan Stanley, for example, is developing an internal crossing network to augment the crossing that it currently does with algorithmic orders. The goal is to create an internal crossing network for all order flow, relates Brian Fagen, the firm s managing director, institutional equities division. Right now, they just cross algorithmic orders internally and electronically, he comments. But the firm is considering expanding its crossing activities to factor in smart order routing, direct market access (DMA) and orders that are being routed to the New York Stock Exchange s DOT (designated order turnaround) system. Why couldn t these [orders] all be internally crossed? suggests Fagen. Sell-side firms say the advantage of these internal crossing networks is that they obtain the best price and incur less market impact than if orders were routed externally to exchanges and ECNs. They may be buying at the bid or meeting in the middle when they re crossing, says Larry Leibowitz, managing director and COO of UBS Equities Americas, which manages more than 350 million shares a day of institutional and retail flow. They re typically not going to be paying the spread. Beyond the obvious spread savings, the liquidity provided by sell-side crossing networks offers the buy side a lowerimpact way of trading, because these orders have the opportunity to trade with other natural liquidity directly in addition to participating actively in the market, Leibowitz adds. Unlike exchanges and ECNs, which display their quotes, crossing networks quotes are not displayed and, therefore, offer anonymity, so there is less chance of information leakage. Because the crossing networks are not displaying a quote executes about 400 million shares a day from institutions, hedge funds and broker-dealer clients, including small, retail-oriented flow, and the majority of that is available for crossing, notes Sterling. The biggest differentiator [from other crossing networks] is the sheer scale, says Sterling. We ve built the technology to integrate everything from our retail business, our block trading and algorithms, he says, noting that Other firms may have done it in one pocket or another. According to Joan Stack, trading manager at the Ohio Public Employees Retirement System, Schwab was early with its Passive Indication Network, where institutional orders could go swimming in the retail pool. I never had a lot of success finding the other side of the pool, she admits. But, UBS has more ability to support the product, Stack adds. I.S.

3 CROSSING NETWORKS in the public market, they may not have as much impact as they would if the order was routed to an exchange or ECN, industry participants say. Further, internal crossing networks allow brokers to find matches without paying fees to exchanges and ECNs. Economic Incentives Internalization or internal crossing is nothing new, according to Sang Lee, managing partner at Aite Group, a Bostonbased research and advisory firm. Really, what s interesting now is all these brokers trying to establish their own ATSs. Lee explains that brokers that operate crossing networks as We re actively finding external liquidity while offering our customers the advantage of internal liquidity. Will Sterling, Managing Director of Equities, UBS Securities ATSs could be entitled to earn market data fees under Regulation NMS. They do see opportunities in the marketplace driven by Reg NMS, he says. It may be attractive to have an ATS because they could now get a share of market data revenue. If firms match trades internally, they are required to print the trades on an exchange. The exchanges then sell the market data and allocate a portion of the revenues back to their participants. Many of the same firms that are registering ATSs also have taken stakes in regional exchanges. If a firm starts an ATS, it potentially can print the trade on an exchange in which it has an investment and qualify for a share of the market data revenues. It may not be $100 million in revenue, but, nevertheless, it s another revenue source, Lee says. I think we re going to see more firms doing this. In the end, I think all the bulge-bracket firms will be going into internalization networks, he predicts. And the proliferation of sell-side crossing networks seems to be a key component in a rapidly evolving equity market structure driven by Reg NMS, Lee continues. The brokers that are internalizing order flow are telling the NYSE and Nasdaq, if you re fees get too high, we do have other options, he says. It s also a nice way to hedge. As they become involved in developing the market structure, they have more say in how the marketplace shapes up. The trend also is being driven by Wall Street s desire to cut costs in a world of compressed spreads and shrinking commissions. With equity commissions paid to brokers declining from 4 cents or 5 cents per share for traditional block trades to 1 cent or 2 cents a share for algorithmic trades and even fractions of a penny for DMA trades there is an economic incentive to cross orders internally before routing outbound. I call it the silo effect of internalization and algorithmic trading, says David Mortimer, head of product development, Piper Jaffray Algorithmic & Program Trading Group (APT). Basically, everybody is trying to internalize to keep as much of the order flow that passes through their computers internal to themselves. Some of that is for economic reasons, he relates. If you cross it internally at these low commission rates, there s an economic incentive. Sources also see the emergence of internal crossing networks as a way for the sell side to retain the order flow it is losing to ATSs such as Liquidnet, Pipeline Trading Systems, ITG POSIT and NYFIX Millennium. Part of the brokers moves is a response to the ATSs they see volume occurring away from them, says Joan Stack, trading manager at the $60 billion Ohio Public Employees Retirement System (OPERS), who cites Pipeline and Liquidnet as examples of ATSs that are garnering block orders from the buy side. They re trying to capture some of that business for themselves. Obviously, this benefits the brokers economically. They would keep both sides of the trades, explains Stack. They would make a commission on both sides of it. With so much economic opportunity, however, sell-side firms are likely to face stiff competition, including competition from exchanges. In fact, Nasdaq is due to launch Nasdaq Cross, a low-cost, intraday crossing network, by the end of the first quarter. Attracting Customers In today s electronic trading environment, brokers also recognize the opportunity to capture more business by registering their crossing networks as ATSs. While the concept of internalization via automated execution was invented by the Madoffs in the 1970s, according to analysts and trading executives, until recently, most of this sell-side crossing activity was conducted by voice brokers. With the growth of algorithmic trading, through which institutions are slicing and dicing their block orders and routing them electronically, however, brokers are automating the process to match up the orders internally. And now that sell-side internal crossing networks are integrated with their algorithms, firms logically are registering them as ATSs because as it becomes more difficult to commit capital, they re looking for ways to attract as many different liquidity sources as possible, according to Townsend Analytics CEO Jeff Wecker, who formerly was global head of electronic client services at Lehman Brothers. Going forward, the best mechanism to provide access to clients looking for the other side of a sell-side firm s inventory is electronic the most natural way to do that is through an ATS, because it opens up the system to external liquidity, explains Wecker. The sell side is recognizing that there s an expanded customer community they can provide value to and leverage value from, that they have not been able to access easily before. That customer community can help increase the cross rates that the sell-side firms are trying to achieve, Wecker adds. While internal broker crossing networks match orders utiliz-

4 ing both customer and principal flows, some of the new crossing networks that are classified as ATSs also are connecting to external liquidity sources, such as ATSs and block crossing networks. We connect to most of the [external ATS] systems as well as ECNs and exchanges, says Will Sterling, managing director of equities at UBS Securities. We re actively finding external liquidity while offering our customers the advantage of internal liquidity. For example, UBS offers a product called PIN with which customers can access our liquidity through our sales trading and block desks and through our program desk. It s also built into our algorithmic product, Sterling continues. So this liquidity pool is behind each of our execution streams. But boosting liquidity isn t the only reason to register as an ATS. Another reason brokers are registering their crossing networks as ATSs is because the sell-side crossing networks include both customer and principal flows, which makes some buy-side traders uneasy. By filing as an ATS, a sell-side crossing network invites regulatory oversight with the goal of making buy-side traders more comfortable with the service. For example, earlier this year, Credit Suisse filed CrossFinder, its internal crossing system, as an ATS with the Securities and Exchange Commission (SEC). We did that to improve transparency, explains Dan Mathisson, head of Advanced Execution Services (AES) at Credit Suisse. The purpose of CrossFinder is to catch all the 300- and 400-share orders that pass through Credit Suisse s algorithmic strategies and cross the opposite side of the trades, according to Mathisson. Because AES executes high volume about 150 million shares a day in January, with peak days above 200 million shares, while CrossFinder handles 30 million shares a day on average We thought it was important to put this thing out in the open and make it transparent, explains Mathisson. Part of the brokers moves is a response to the ATSs they see volume occurring away from them. They re trying to capture some of that business for themselves. Joan Stack, Trading Manager, Ohio Public Employees Retirement System One of the selling points [behind Credit Suisse s algorithms] is that AES flows are kept separate from the bank s other flows, he notes. The more transparent we are about how the crossing systems work, the better it is for our business. However, Mathisson says that Credit Suisse does not have plans to open up CrossFinder to the public. Registering as an ATS is a move to add a little transparency and to show clients that there s nothing behind the scenes going on it s public information, says Mathisson. It s not a precursor into turning into an ECN. While the inclusion of principal flows raises concerns on the buy side, brokers point out that proprietary flows add liquidity to the crossing networks. I think that the buy-side [trader] provided he could get comfortable that a firm s proprietary desk has the same fair access to the same internalization engine should view that proprietary flow as the source that could improve the quality of [his] order flow, says Townsend Analytics Wecker. While he suggests that having customer flow cross against proprietary trading flow would be beneficial, Wecker admits, Certainly, there are ways in which you should be concerned about information leakage. Not speaking for any particular broker, Wecker notes, How this actually works at each of the different firms is something that requires more investigation by the buy-side trader. Buy-Side Concerns While the incentives for the sell side to push crossing networks are clear, and while buy-side traders agree that internal crossing networks can benefit them by lowering market impact, the buy side is raising questions about whether sell-side crossing systems are anonymous and whether the proprietary trading desks at these firms have access to the networks. We would have to have some guarantee that there d be anonymity, says Pioneer Investments Gauvain. That s the paramount concern if you re going to use any crossing network. Gauvain stresses that he would want to know who has access to his trading information. In particular, buy-side clients want to know if there is any potential for information leakage with proprietary desks. If the proprietary desk is getting hits in a crossing network, they can use that as information, explains Gauvain. If I knew that their proprietary desk could participate, it would not be of any interest to me to use a product like that, adds John Myles, vice president and senior domestic trader at Pioneer. When firms that operate internal crossing networks also do proprietary trading, It s a huge concern, confirms OPERS Stack. When we sign up for direct access with a broker, one of our first requirements is that flow does not cross a proprietary desk,

5 she says. In fact, many brokers are offering an audited statement that shows that the flow from the buy side through DMA does not pay a visit to the proprietary desk, Stack notes. Credit Suisse, Goldman Sachs and UBS all allow prinicipal flows to participate in their crossing mechanisms. To address the buy-side concerns, each firm says it allows customers to optout of crossing against principal flows, or to specify that they only want to cross against customer flows. According to Credit Suisse s Mathisson, CrossFinder clients have a choice between crossing only versus other clients, or trading versus all the available liquidity. Though the firm declines to characterize its offering as a crossing network, in July 2005, GSEC registered its own ATS, called Sigma-X, which customers can access through the REDIPlus trading platform. Sigma-X aggregates both external hidden liquidity and internal hidden liquidity from the Goldman Sachs & Co. franchise, according to the firm. The sources of liquidity for Sigma-X include order flows from customers, crossing networks and electronic market makers, as well as Goldman Sachs principal flow, a spokesman explains. In the 6.0 release of REDIPlus, clients can opt out of interacting with GS flow if they prefer, he says. Steve Swanson, CEO of Automated Trading Desk, an electronic market maker, relates that his firm and three other providers are putting liquidity into the Goldman ATS. They poll for that liquidity before they go outbound and hit the street, he says. However, Piper Jaffray s Mortimer contends that none of the crossing venues distinguish among order flow that is generated by a client of the firm versus their own proprietary book or liquidity from hedge funds, market makers or floor brokers using the broker s DMA platform. In addition, Joe Gawronski, COO of Rosenblatt Securities, an institutional agency broker, is concerned that brokers that do proprietary trading can aggregate all the data from the crosses to glean information about trading patterns that can then be used to customers disadvantage. If they say we don t look at your orders, that fact is likely true on an individual order basis, he says. However, Gawronski suggests that the next question that needs to be asked is whether they do in fact look at information on an aggregate basis. For instance, If they see there are 3 million shares to buy and 100 million shares for sale in their system, how do they deal with that? Gawronski asks. The big brokers are not making their profits on the agency trading they re making it on the proprietary trading, so tough questions are warranted, he says. Other questions are emerging regarding fragmentation caused by the emergence of multiple crossing networks. I don t think the trend is all that favorable for the buy side, says OPERS Stack. It fragments liquidity, she explains. Six or seven years ago, we had 14 ECNs they all consolidated down to a handful. Now, this is refragmenting the liquidity again. Though internal crossing networks are a source of liquidity, brokers still execute client orders in multiple venues, according to Credit Suisse s Mathisson. We re always probing all the ECNs and sources of liquidity, and CrossFinder is one of the potential sources of liquidity, unless a client asks to opt out of it. Stack says, It adds layers of complexity it s more destinations you have to connect to and ping. She also worries that when crosses occur, a lot of the ATSs don t print to a tape Registering as an ATS is a move to add a little transparency and to show clients that there s nothing behind the scenes going on. Dan Mathisson, Head of Advanced Execution Services, Credit Suisse anywhere. You start to lose some sense of what the market is; what it s actually doing, she says. According to UBS Leibowitz, however, Any execution whether it s a customer cross or something that we traded we always print to the tape immediately. Typically, we print trades to Nasdaq to the Third Market through their ACT system, he says. Too Much Liquidity to Ignore While the buy side continues to weigh the benefits of sell-side crossing networks, Aite s Lee says the brokers have clout in the marketplace, and so traders cannot ignore another source of liquidity. Typically, liquidity goes to where there is existing liquidity. Certainly, for clients of these bulge-bracket firms, having liquidity actually helps, he says. There are good reasons why they might want to access these private networks, such as minimizing market impact or obtaining best price. We owe it to our people to be looking for liquidity, concedes Pioneer s Gauvain. If a trader knows a particular broker has been active in a particular name, it may behoove us to try his crossing network to see if there s anything in it that he may want to buy or sell. That s the job of a trader. In fact, Gauvain predicts that the sell-side crossing networks will be a destination off of OMSs. Similar to when you have different strategies within algorithms, you might have different destinations, he explains. You could route the order to a broker s crossing network with a guarantee of anonymity. However, with all the bulge-bracket firms working on internal crossing systems, buy-side traders don t expect them all to survive. Ultimately, the [broker] crossing networks that get traction, that are actually able to post and advertise and actually have success with liquidity, will survive, says Pioneer s Myles. Acknowledging that the majority of the brokers have their own internal crossing networks, TowerGroup s Ramistella says, It s going to be interesting to see if they re going to take the CSFB strategy and register as an ATS and keep it internal, or offer it to the outside. Many people believe that brokerage firms are going to make them available externally.

6 But OPERS Stack fears that there may be 10 firms offering an array of electronic crossing products to the buy side. I hope the shakeout doesn t take too long, she says. I hope they don t keep the weaker systems on life support it really makes my job a lot harder. The big brokers are not making their profits on the agency trading they re making it on the proprietary trading, so tough questions are warranted. Joe Gawronski, COO, Rosenblatt Securities CROSSING NETWORKS DIRECTORY Company Name Name of Service Contact Information System Launch Date And Technology Used Credit Suisse CrossFinder Manny Santayana CrossFinder was launched in 2004 and was built entirely in-house using proprietary technology. Instinet Instinet Crossing Bill Cody, First Vice President, Instinet Crossing william.cody@instinet.com It was developed using the C programming language and runs on the VMS operating system. Investment Technology Group POSIT Liquidnet Liquidnet Dan Wolff, ITG Marketing PROOF itg_marketing@itginc.com Director of Sales Operations dwolff@liquidnet.com POSIT Match was introduced in 1987 in the U.S. as a technologybased solution to the trade execution needs of quantitative and passive investment managers. Liquidnet was launched April 10, NYFIX Millennium Millennium ATS Millennium Sales info@nyfix.com Millennium was launched in 2001 and uses proprietary systems. NYFIX Transaction Services NYFIX Natural Transaction Sales info@nyfix.com NYFIX Natural was launched in 2005 and uses proprietary systems. Pipeline Trading Systems Pipeline Arthur Montuoro PIPE Arthur.Montuoro@PipelineTrading.com Pipeline launched in September UBS UBS PIN Timothy Gee Timothy.Gee@ubs.com The UBS liquidity pool was enhanced with the acquisition of Schwab Capital Markets in November We maintain a high-availability infrastructure, and our clients have access to smart-routing technology and execution tools that tap into UBS retail and institutional liquidity pool. This is not a comprehensive list of crossing networks. Advanced Trading invited other broker-dealers to participate, but they could not submit their information by press time. Service providers entered their own information in this directory. Copyright 2006 by CMP Media LLC, 600 Community Drive, Manhasset, NY Reprinted from WALLSTREET & TECHNOLOGY with permission. 6567