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The Market Makers' Makeover

Decimal pricing and razor-thin profit margins are pushing wholesale market makers to overhaul their trading operations.

Wholesale market makers, hit hard by the economic downturn, narrower spreads from decimal pricing and demands for improving execution quality, are being forced to reinvent themselves.

For Schwab Capital Markets (SCM) L.P., a subsidiary of The Charles Schwab Corporation, the need to chart a new direction for the wholesale equity-market-making business became apparent a few years ago, and the economic downturn only accelerated it, says Larry Leibowitz, SCM's executive vice president, Equities.

"It became less and less viable to run a shop where you had 200 traders and assistants all running around and executing manually all these little orders," Leibowitz says. "Between that and decimalization, and all the execution-quality demands, all of those things combined to make it almost impossible for a shop of that many traders to make markets in (5,000) stocks anymore," he says.

About three years ago, SCM began developing The Schwab Liquidity Network (SLN) - a method of pooling order flow from the brokerage firm's vast client base of 8 million individual investors, 4,800 registered investment advisers, 250 broker/dealers and 400 institutional-investment firms.

The new approach - announced in February - combines automated electronic execution of retail orders and small institutional orders with up to 10,000 shares, with professional handling of large block orders of 10,000 shares or more.

Because of more automated trading, the firm operates with one quarter of the trading staff that it once maintained. "We've made major cuts from 120-plus traders and 120-plus assistants originally and we're now down to a total of 45. It's been completely reinvented," says Leibowitz.

Part of that reinvention is SCM's push into institutional brokerage for which it hired 40 institutional sales traders from other Wall Street firms and recruited another 12 sales traders in April to work large orders that require anonymity.

Leibowitz, who spearheaded the project, says, "The Liquidity Network is an outgrowth of a bunch of things that SCM has done." Without pointing to a single system, Leibowitz adds, "This is a concept, more than anything, of how do you put together all of these pieces."

One of the core pieces is SmartEx - an order-routing and automated-execution system for small orders (up to 10,000 shares) in which 91 percent of the trades are executed in 10 seconds or less.

Schwab previously had an auto-ex system - an automatic execution system that internalizes order flow - but the order-size limits were 2,000 shares.

In the past, if a retail investor were trying to sell 2,000 shares, the investor would get an automatic execution on 500 shares, and then 1,500 shares would be left. A trader would manually work the remainder and get back with the results a minute later.

"We don't have that happen," emphasizes Leibowitz. "SmartEx automatically executes most of these orders, so they don't get sent over to a trader to be worked," he says.

SCM also built a second system - called Automated Market Making - for risk management. At the same time SmartEx is pricing orders, Automated Market Making liquidates the residual position (in stocks) that the market maker has taken on.

Larry Tabb, founder of The Tabb Group, says the steps taken by Schwab are indicative of the harsh times facing wholesale market markers in Nasdaq stocks. Not only have several firms, such as Fleet Trading and Robertson Stephens left the business, but a major player like Herzog, Heine, Geduld - acquired by Merrill Lynch - has reduced the number of stocks it makes markets in from 10,000 to 2,400.

"There's a lot of pain in the over-the-counter business," comments Tabb.

According to a recent report by Celent Communications, the number of active Nasdaq market makers has decreased from roughly 490 firms in 1998 to 300 firms in 2002. OTC market-making revenues have declined from $3.5 billion in 1995 to $1.2 billion in 2002, notes the report, based on the Securities Industry Association's DataBank, a database of information on broker/dealers.

"At the same time, trading volumes have increased exponentially so that firms must increase their trading staff or utilize electronic methods to complete the bulk of their trading activity, thereby freeing traders to focus on larger block orders and to seek best execution," the report says.

One trend that SCM and other wholesale market makers have resorted to is internalization - Rather than expose orders to the marketplace first, they look for crosses among large blocks of stock.

"We have an internal book and we're aware of all the electronic orders that we have, so the system looks for crosses internally and, in addition, we try to make bigger (institutional) traders happy by using the salesmen," Leibowitz says.

However, even internalization is not a panacea for market makers. "Because of decimals, the profit margins are so slim that unless you do this properly, you're going to lose a lot of money internalizing," says Leibowitz. "There are a lot of costs to doing that," he says, adding, "We have to principal the orders, we have to pay ECN fees, spreads are very narrow, margins are razor thin, and that's why I don't believe the old model works."

Steps to a Makeover

Building Blocks of the Schwab Liquidity Network

  1. Replace auto-ex with SmartEx: Increase order size from 2,000 to 10,000 shares.
  2. Create automated market making for risk management.
  3. Reduce staff from 200-plus traders and assistants to 45 traders.
  4. Hire 40 institutional-sales traders plus an additional 12 sales traders.
Results - Makes markets in 5,000 to 7,900 Nasdaq stocks, including bulletin board and penny stocks. (Plans to build a similar product for listed stocks.)

Plans - Expand into institutional brokerage using FIX connectivity and other order-management systems.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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