Throughout the steady evolution of the way US brokers manage their market access, one priority has remained constant: the need to achieve best execution. Whether dealing with a hedge fund, an institutional money manager, a retail investor or another broker-dealer, best execution is the common demand from all clients. Brokers that are not able to deliver - and prove that they are - will be left behind.
The market access evolution has also seen changes in the role technology plays. Always central to a broker's market access decision-making, the era of fragmentation brought with it new liquidity pools and a demand for smart order routing (SOR) tools that could handle simultaneous access to multiple venues. While SOR technology enabled brokers to achieve optimal execution, it also allowed them to leverage their own memberships to advertise share volumes and increase market share.
The passage of Reg NMS leveled the playing field for all 'protected' venues, moved compliance into the spotlight and accelerated the growth of high-frequency trading (HFT). Brokers needed the ability to fulfill their trade-through obligations and interact with EVERY exchange and its unique SOR capabilities, while also seeking out best execution. The advent of HFT further complicated the search for best execution. As the notion of 'sponsorship' became common currency, brokers had to make a decision: to establish and maintain memberships and connections with all protected venues, or 'piggy back' and leverage another broker's memberships or an exchange's routing.
This radically changed the way that sell-sides viewed each other. Competitors could also be seen as potential providers of market access, whether through an SOR infrastructure or algorithmic trading. Firms with their own smart order router can leverage their exchange memberships and offer their pipes to other broker-dealers, adding considerable dimension to the trading ecosystem.
With best execution as the stated goal of market access arrangements, brokers must also consider the related issue of performance. Certain trading methods, like HFT and co-location, as well as the race to support sub-microsecond processing times have elevated performance and latency concerns. Add Reg NMS into the mix, and brokers must now consider the costs and challenges of building and maintaining an elaborate and compliant infrastructure.
Finally, flexibility has become a defining feature of successful market access. The introduction of new high frequency strategies and algorithms is a constant worry for all participants. Simultaneous rather than sequential access, accompanied by the ability to exclude certain venues on the fly, can help to counter the possibility of HFT players gaming other market participants.
These developments in technology, sponsorship, performance and flexibility have created a spectrum of market access options, ranging from total outsourcing to complete in-house management. Brokers today face a choice of where to position themselves on this scale.
Typically, boutique-sized firms choose to outsource all aspects of their market access, including SOR, exchange connectivity and membership, direct market access (DMA) and algorithmic strategies, to fellow brokers. This reduces complexity and allows them to achieve best execution and compliance at minimal cost; however, they must also focus on finding and analyzing the best available algorithms, not just achieving the best price. These advantages must be balanced with the fact that outsourcing an order to a third party also requires handing over responsibility for that order. This means it may be shown to the aggregator's own dark pool, algo engine, or other preferred entity before it is sent out to the market.
At the other end of the spectrum are the large tier-one firms that can afford to build and maintain their own market access infrastructure via proprietary technology and exchange memberships. With the appropriate technology, developers and infrastructure, these tier-one firms can offer out their memberships and proprietary technology to other brokers and act as liquidity aggregators. These brokers often provide the market access and execution services that are used by the boutique firms - an example of 'coopetition' in action.
The Outsourcing Option
It is relatively easy to identify the brokers that occupy the extreme ends of the spectrum. But it is the middle section where the requirements - and the solutions - are more complex and more interesting. Firms here essentially require, and must be able to support, a combination of different market-access solutions taken from any point on the outsourcing spectrum.
For example, these mid-tier brokers may wish to leverage a number of strategically important direct exchange memberships while outsourcing access to venues they consider less critical. Alternatively, they may be looking to create and market their own suite of execution services - algo trading, smart order routing, DMA - by deploying a vendor's technology, possibly in conjunction with memberships and services from another broker. They may wish to focus on monitoring market access costs in real-time, and modifying trading decisions based on that information, and so require the flexibility to introduce new strategies and services (and reconfigure existing ones) in real-time. Or they may wish to focus on retaining control over their flow to enable them to promote their ability to minimize information leakage and maintain anonymity as a value-add to clients.
The middle of the spectrum is where we see the intersection of all the key aspects of a broker's market access decision: best execution, cost, flexibility and control. Any broker positioned between the extremes of the spectrum will need a set of tools to manage and support a unique market-access solution that has been tailored to its client base, expertise and business model.
There is a growing incidence of mid-tier firms working with third-party vendors to develop truly broker-neutral solutions that distill the company's expertise into a unique solution as a means of providing competitive differentiation. It also furthers the classic buy vs. build dilemma: by working with a vendor, the broker-dealer can create its own execution strategies that combine its ideas and workflow with the vendor's technology and pipes.
Whatever a firm's chosen recipe is for market access or proving best execution, it must make sure the solutions it chooses are nimble and flexible and can accommodate the continuous fluctuations in the marketplace. For ambitious mid-tier firms, the formula for success is particularly delicate. They must choose their outsourced solutions carefully, ensuring they can be integrated easily, be resold down the line or offered as white labeled services, if necessary.
The advantage, as always, is that rather than dedicating resources to software development and maintenance, firms are able to remain flexible and operate nimbly in the face of new liquidity and changing regulations without being encumbered by the high cost and infrastructure that come with maintaining in-house systems.
Justin Llewellyn-Jones is CCO for the US for Fidessa.