Brokers have for many years supplied trading tools and services to fund managers but is such an arrangement always in the best interests of the fund managers and their end investors? Nicholas Pratt investigates
As the year comes to a close, various industry award shows hover into view, including this magazine’s own glittering soiree. But before the lounge suits and ballgowns are slipped on and the magnums of champagne are poured out, a panel of judges has had to pore over the numerous entries that vied for industry recognition.
As a judge for this magazine’s technology and trading awards, one of the most noticeable trends that has developed over the years is the increasingly inextricable link between brokerage services and technology products. This link is especially evident in the trading and execution space with a number of brokers now offering execution management systems, smart order routers and other related tools and services.
For example, a fund manager looking to select an execution management system (EMS) or a smart order router (SOR) has traditionally had three different categories of provider to choose from – an independent software provider with no broker link, an agency-only broker with its own range of technology and trading tools that is broker neutral when it comes to order flow, or a principal broker where there is a more conspicuous link to an investment bank.
The technology market has almost developed full circle now though. It is not just brokers buying up software vendors but, as in the case of Orc Software’s acquisition of NeoNet, we are seeing technology firms buying up brokers (albeit agency brokers). According to Jesper Alfredsson, vice president of product management at Orc Software, it makes sense for fund managers to select their execution technology from brokers rather than directly from software companies and it has largely worked well. However, there is increasing pressure from some buy-side firms for trading software to be broker neutral.
Whether a buy-side firm is broker-led or technology-led when it comes to choosing trading tools, it comes down to the complexity of their operations, says Alfredsson. “The standard, long-only fund manager does not have a high level of complexity – they execute large orders and could almost do it by phone. But then there are the high-frequency trading firms that will build their own technology or go to a vendor directly and they are the ones that are pushing for broker neutrality,” says Alfredsson.
Retaining the independence of the independent software providers is also of particular importance for Alfredsson, in order to ensure that the technology remains their priority. “In certain areas, the technology people are driving the research and development and raising the bar in development. We rarely see that from the brokers where technology is more of a support function.”
A greater concern, however, is the possibility that fund managers using trading tools and services provided by brokers are putting the broker relationship before the technology capability. Certain people in the industry believe that there is an unhealthy quid pro quo at work where, for example, some brokers are providing an EMS to fund managers on a complementary basis on the understanding that the manager will then direct a healthy proportion of their order flow to the broker. “We hear about this all the time,” says one industry insider.
In this post-MiFID period where transparency and best execution are supposed to be guiding principles, fund managers should be more discerning than ever in selecting both their brokers and the trading tools and services that they install. And given the market’s compressed state at present, one would think that a more competitive environment would exist and fund managers could be even more demanding of their brokers. But, perversely, the opposite appears to be true.
For example, Richard Balarkas, chief executive and president of Instinet Europe, an agency-only broker that also offers a range of trading services, points out that buy-side dealing heads are not always able to select a broker based solely on the quality of their execution. “Dealing desks are being pressured by their fund managers to put their flow through certain brokers in order to pay for the research they have bought over the last year but not yet paid for. The managers are worried that unless they direct flow to the brokers, they will not get a call the next time there is a big IPO.”
It may be a practice that has gone for years, and maybe serves to emphasise that the investment industry is still principally about relationships rather than automated trading engines and efficient algorithms but, says Balarkas, the way that fund managers choose to spend their broker fees and commissions should still be addressed. “It is not their money, it is the investors’ money. And while execution can be measured, the majority of commission is spent on non-tangible aspects like research, which is not subjected to any kind of analysis.”
There is also the harm that this practice does to the quality of the technology used for execution. If a dealing desk is simply using whatever system their broker of choice provides them with, what motivation is there for providers to strive for improved technology? “If execution services are provided by brokers as loss leaders it makes the area non-competitive,” says an industry insider. “This is not good for the buy side and it is not good for the end investors. If fund managers are getting execution services thrown at them, they have to realise that they are not getting them for free. There are other factors involved and they are paying for them in one way or another.”
Balarkas says there needs to be a structural overhaul to address the cross-subsidies that exist in investment banking services and there also needs to be more accountability upon the fund managers when it comes to commission payments. “I do believe you need to encourage, or force, fund managers to justify their spend on execution and research services because, ultimately, it is not their money that they are spending.”
According to Duncan Higgins, head of electronic sales at ITG, brokers have traditionally supplied their fund manager clients with ways to make trading easier and connecting to their broker easier. “For many years brokers have provided direct phone lines for their clients and a single broker EMS could fall into the same category.”
However, Higgins believes that fund managers are choosing an EMS based on the merits of the technology and not solely broker relationship. “A start-up hedge fund may be reliant on a prime broker for much of its technology in its formative stages but as they grow bigger, the majority of them will then look for a broker-neutral EMS. And for any fund manager or hedge fund, the EMS selection process is very thorough and very intensive.”
This intensity provides the pressure for EMS providers to continue to innovate, says Higgins, particularly those providers that come from an independent software background or are broker neutral. “There may be less pressure on the investment bank-based brokers to innovate because the EMS may be bundled up with other services and the overall relationship they have with fund managers,” says Higgins.
Conflict of interest
The potential conflict of interest around trading tools supplied by brokers that are also after order flow has been particularly evident in the provision of smart order routers and execution algorithms. According to Tim Bevan, director of global electronic trading at Russia-based securities broker Otkrite, managers have to be especially careful when using these broker-supplied services. “They say they will be providing best execution and on paper they do, but what exactly is happening to their orders?
“With all the liquidity pools (dark and lit), will the orders be going to them all one by one? Which one is it going to first? And how long is it sitting there? Unless you pull apart the algo, you won’t really understand what is happening to your order. I think a lot of managers are not doing this. But increasingly hedge funds and other firms are aware that any degradation of execution could cost them significantly.”
There is also a growing recognition among trading firms that some SORs are smart and others are dumb, says Bevan. “The debate is coming to the fore but managers are still primarily concerned with the investment decision. Any fund manager can bring things in-house and develop their own technology, SORs, algorithms and EMSs but it is difficult and expensive. Ultimately, the onus is on the fund manager to ask the right questions of the brokers providing these tools.”
Perhaps the onus in all of this is for the end investor to ask the right questions of their fund managers. If, as some suspect, fund managers are going to great lengths to ensure that they do not upset their broker relationships by enforcing best-execution rules and are happily using the tools their broker supplies in return for order flow, then change is unlikely to occur from within in the immediate future. And one could argue that preserving relationships remains a fundamental part of the investment industry. Ultimately, it is the end investor that loses out from inefficient execution and unaccountable commission payments, then the onus lies on them to correct what may be the unacceptable yet almost imperceptible face of fund management operations.
©2010 funds europe