Taming the Wolverine: How To Control the Costs of Modern Trading

As the new normal of fragmented, globalized, multi-asset trading takes hold, the costs of simply staying in the game continue to rise. Clearing, venue membership, market gateways and connectivity are becoming major cost centers, and even 'entry-level' technology requires a significant investment.

At the same time, trading is relatively flat and commissions are under pressure. Buy-sides are getting closer to the trade and cutting sell-sides out of traditional profit-generating functions. With their own technology investments, they are better equipped to analyze performance and make informed broker selections than ever before. If high frequency trading continues to grow in the Canadian markets as it already has in the US, the pressure on the traditional sell-sides will continue to increase.

Given this complex environment, it is not surprising that many brokers believe that meeting the ever-changing functionality and compliance requirements is draining resources from the revenue-generating business of developing and supporting competitive strategies. But this is not the complete picture. The latest technologies also offer plenty of options to lower the total cost of ownership. There are tools available to measure and quantify the performance of clients, desks, strategies and even individuals so that brokers can better understand the cost and revenue dynamics of their activity.

It is surprising that some of the brokers under the most pressure have been reluctant to explore new ways to keep costs on the trading desk under control while maximizing returns. The more forward-thinking brokers – the ones who have come to terms with a multi-market trading environment – are building their futures, not by throwing money at the problem or adding indiscriminately to their tool box, but by being smarter about the technology they select and the way they deploy it.

These are the key lessons to be learned from brokerage firms that are facing down their cost-pressures and turning the current challenges into their advantage.

Consolidating platforms in the front office

The traditional IT set up is a series of vertical platforms that are functionally complete but separate. Multiple applications may consume the same data and have inbound or outbound gateways for the same customers and venues, but the invariable result is duplicated effort, multiple vendor bills, complex upgrades and updates, and greater incidence of errors. It is inefficient and inflexible.

In contrast, firms should be concentrating on minimizing redundancies across systems to help lower their costs. For example, implementing a single horizontal platform that distributes all the necessary compliance checks, analytics, risk controls and position monitoring services to individual desks from a central installation is far more cost-effective and reduces the pressure on internal resources.

Cost savings can also be delivered through a consolidated but customizable feed of normalized data drawn from all required sources: not only does it keep the capital costs of managing the data deluge under control, it improves decision-making processes. At the same time, internal and external connectivity can be handled through a centralized but flexible system that allows users to control and monitor all connectivity points across multiple trading applications and destinations.

Embracing trade compression in the back office

Many firms have yet to embrace the opportunity to reduce back-office costs through cross-market compression and amended reconciliation processes, either through Level 2 or Level 3 compressions. Level 2 uses market level trade compression to aggregate trades based on side, symbol, inventory and marketplace of execution. It is used by the majority of sell-side firms in Canada, however many of these firms have yet to realize the full benefits of this model, as they still separate client inventories for internal reconciliation processes. For example, if a firm trades 200 RIM on TSX in client inventory A, and 200 RIM on TSX in client inventory B, that would result in two trades to the back office, so two ticket charges.

Only a few sell-side firms in Canada use multi-market level (or Level 3) compression, which aggregates trades based on side, symbol and inventory. As noted above, not all firms have ‘streamlined` their use of client inventories to maximize efficiency. One reason why they have been hesitant to move to this level of compression is that it requires a change to their market side reconciliation processes, even though the cost savings could be significant. For example, RIM traded into a single inventory on five markets (five ticket charges) could be reduced to one ticket charge.

Understanding service costs vs. benefits

Firms have also yet to fully weigh the service costs from paying premium rates to 3rd party brokers versus the benefits of using ‘in-house’ advanced trading tools for standard strategies, such as POV, TWAP, VWAP algorithms and pairs trading. When clients use 3rd party algorithmic services, they typically pay a cost per share to the broker providing the service, with the charge schedule depending on the volume that is traded. However, more often than not, firms can save on these costs by executing these algorithms directly without needing to pay a cost per share. By using ‘in-house’ strategies, not only will firms benefit from using their own broker number but they will also gain full access to any rebates resulting from the trading activity.

Additionally, the standard algorithms (i.e. POV, TWAP, VWAP), which are the ones that most clients request, are no longer regarded as specialist strategies and are easily executed in-house. This means that firms will only need to pay the external service costs for 'specialised' strategies, which typically account for a small percentage of the overall algorithmic flow, thus making it much more cost-effective to execute as much as possible in-house.

Monitor and minimize execution costs

The next piece of the puzzle is to reduce execution costs. By leveraging tools that increase visibility, brokers are able to take advantage of current pricing models and maker-taker arrangements, allowing them to look at the costs of each execution decision. Coupled with truly intelligent routing that selects a trading destination based on costs and preferred outcome, rather than position in the sequence, cost analysis tools enable sell-side firms to boost performance while keeping costs under control. Post-trade analytics enable them to identify things like whether or not aggressing the market has delivered real advantage, which traders are consistently beating the benchmark, or what strategies are delivering the best returns to investors. These analytics also provide empirical evidence of performance and skill that can be used to woo new clients as well.

Maximize internal crossing opportunities

Being able to understand and analyze trading performance can help brokers identify and leverage trading opportunities by providing better and timelier information to clients. Furthermore, it helps brokers by analyzing client information held across various points in the organization. Brokers who are able to develop a comprehensive, dynamic and easily accessible profile of each client can match potential counterparties according to their preferred trading patterns, industry sectors, market approach or order size, among other criteria. If orders are crossed internally, brokers can avoid the costs associated with trading on external lit or dark pools.

With the global marketplace continuing to fragment and become more complex, and new cost centers cropping up everywhere, it is essential that brokers employ the right tools, not just the latest tools. They must be able to measure and quantify everything from the performance of clients, trading desks and algorithms through to individuals, so they can track the cost and revenue dynamics of their trading activity and improve their bottom line.

Bringing as much trading activity as possible in-house and intelligently sourcing the rest, puts brokers much closer to each trade, which is the best way for them to control costs and gain competitive edge.

Martin Hakker is CEO of Fidessa Canada.