US Institutional Equity Trading: Crisis, Crossing and Competition Executive Summary The credit crisis in 2008 set off a bear market characterized by an explosion in daily trading volumes and unprecedented intraday volatility.  Not an asset class or a geographical marketplace got away unscathed.  The bear devoured long-revered investment banks and sent others running into the protective arms of the Federal Government bailout machine.

The financial services landscape as we’ve known it has been altered.  Credit derivatives and collateralized debt have devastated the balance sheets of the banks and brokers.  Capital is being reallocated and risk is being redefined.  Volatility and concerns about counterparty solvency are changing the way traders behave.  And liquidity reigns as king.

Volatility has remained in nosebleed territory, resulting in dearth of liquidity.  When prices move in inexplicable ways with great speed, traders are reluctant to trade in any size.  They are increasingly fearful of telegraphing any information about their orders to the marketplace, and they’re unwilling to show a bid or an offer.  Trading in blocks is rare, and using broker capital to do it is expensive.  Using electronic crossing networks maintains anonymity, but the fear of being wrong on price can make a trader hesitant to commit.  Trading dark pools is appealing, and using algorithms to sneak in and out of liquidity pools is one way to hide intent.  This is the way to trade in an information vacuum.

For the first time in our lifetimes, equity traders and asset management firms have a concern about counterparty risk.  With the fall of Bear Stearns and Lehman brothers, the heretofore unthinkable was now a real possibility.  Many of these buy-side firms use swaps and over-the-counter options or run 120/20 leveraged funds.  When compiling a view of the firm’s overall exposure to any individual broker, compliance and risk managers now want to see how many outstanding stock trades and CSA cash balances are sitting on each broker’s books.  They want to know what buy-side equity traders are hearing, the rumors, what the hedge funds are doing, where the liquidations are coming from.

Behavior begins to change.  Suddenly the idea of broker consolidation takes on a whole different meaning.  Concentrating order flow with a handful of core investment banks is a way to optimize commissions.  With the increase in electronic trading and the commensurate drop in overall rates, directing an increased amount of order flow to a smaller number of sell-side firms allows the buy-side trader to obtain desired resources.  Connectivity, algorithms, access to internalized dark pools, desktop execution platforms, and sales trader coverage – if a buy-side trader wants all of the toys, he is going to have to pay for them.  Commission sharing arrangements make concentration of trading even more attractive.  A buy-side trader can execute with firms offering superior best execution services while paying the portfolio manager’s research bills by check.

Today that paradigm is tossed by the wayside.  Some of those core brokers don’t exist anymore.  Others have yet to complete their restructuring and reveal what they’re going to look like.  Traders are gone, trading desks are gone.  The risk of failure is still in the air, and there’s a void where firms once stood. 

Where there is chaos, there is opportunity.  In a volatile, illiquid market, the door is open for a broker with flow to capture increased market share.  In an information vacuum, a sales trader with insight and expertise is a welcome partner to the buy-side trader.  Mid-tier and niche broker dealers with access to unique liquidity sources and a presence in certain types of order flow have an opportunity to capture market share that is essentially up for grabs.  The practice of eliminating execution relationships has come to an end.  The desire to grow new ones is high.

The TABB Group Study on US Institutional Equity Trading:
Crisis, Crossing and Competition

For this year’s buy-side trading study, TABB Group spoke with 61 head traders of US institutional equity management firms.  The discussions covered the ways in which they are directing their order flow across multiple execution venues; the impact of volatility on the use of crossing networks, algorithms, and block trading; the impact of electronic IOIs on the use of dark pools; the impact of the credit crisis on availability and pricing of broker capital; trends in concentration of order flow; broker selection criteria; adoption rates of CSAs and their impact on the number of broker relationships; trends in commission rates; the re-emergence of high-touch sales trading; and the impact of investment bank failures and mergers on the opportunity to build market share.