The New Toll Collectors

Cha-ching! Every time a buy-side firm sends an order to a broker or an alternative trading system (ATS), you almost can hear the sound of a cash register ringing. That's because the order management industry is moving toward a transaction model. Several software companies that provide order management systems catering to buy-side firms are collecting a connectivity fee from brokers that want to receive order flow from buy-side institutions. Yes, software companies have found another way to cash in on the electronic trading wave.

This is not necessarily a bad thing. After all, the OMS vendors that originally provided investment managers with portfolio management and compliance tools need to fund research and development to keep up with new trading functionality demanded by their clients. At least 20 brokers supply algorithmic trading strategies and some offer pre-trade analysis tools - OMS providers need to recoup the costs of integrating these tools with their offerings.

But should a value-added software provider want to become a toll collector? That certainly will change the relationship with its institutional clients and brokers.

The problem is that large buy-side clients already are paying hundreds of thousands of dollars a year - some are paying up to $1 million - in software licensing and maintenance fees. Therefore, they expect the vendors to integrate broker algorithms and evolve their products as part of the cost of staying in business.

By layering on connectivity fees, OMS vendors could rub their customers the wrong way. Buy-side institutions are under tremendous pressure to lower their trading costs. They have been able to negotiate one-cent- and two-cents-a-share commissions with the sell side for low-touch direct market access (DMA) and algorithmic trades. Brokers already are paying transaction fees so that their buy-side customers can use direct-access-trading players, such as Lava Trading, or portfolio program trading systems, such as FlexTrade. If the OMS providers charge brokers connectivity fees, the sell side may not be willing to offer lower commissions to the buy side. One ATS operator calls the piling up of fees a "train wreck waiting to happen."

From their perspective, OMS vendors are charging a connectivity fee for routing orders. With the exception of Macgregor, which built its own FIX network, the OMS providers have linked to extranet providers. Charles River Development has linked to Radianz; Linedata Systems linked to Transaction Network Services (TNS); and Eze Castle gives its customers a choice of REDINet, TNS, NYFIX or Thomson AutEx, among others. Buy siders say the value provided by OMS vendors is that they test and support the FIX connections to brokers and certify that the brokers' algorithmic trading strategies actually work.

Interestingly, brokers that are paying the OMS vendors for connectivity are starting to worry that the platforms are losing neutrality. Isn't it possible that an OMS will show favoritism toward a particular broker that is generating larger transaction revenues than another broker?

This sounds like pay-to-play and has been likened to payola - radio stations accepting payments from record companies to play their songs. Here, brokers want "air time" for their algorithms, and paying connectivity fees may be the way to get it.

I'm not saying that OMS vendors are not entitled to reinvent their business models in order to remain financially viable. They probably have to adapt to survive in this new age of automated trading. But are there too many toll collectors taking a piece of the commission pie?

Perhaps OMS vendors need to strike a balance. One idea would be to charge a fixed monthly fee to the brokers for order routing - like the phone company charges a flat fee for calling within a certain region - and then layer on specific fees for features like call waiting or, in this case, access to algorithms and other advanced tools.

Buy-side firms seem open to discussing different pricing structures - even they don't want to gouge the sell side.

Ivy Schmerken is a 20-year WS&T veteran. As Editor at Large, she covers trading for both Wall Street & Technology and Advanced Trading. [email protected]