June 18, 2013

The last year's market deterioration made things difficult for brokers, who are seeing tighter spreads, fragmented flow, smaller trade sizes, and compressed commissions. Brokers now face the most difficult operating environment in recent memory, with decreased market liquidity, increased message traffic and lower order volumes from clients.

Brokers also find themselves in an adverse situation, having over-invested in a number of areas, including their trading infrastructure, their capability to generate algorithms and their ability to process trades. Most broker's capabilities vastly surpass the current needs of their clients.

From Bad To Worse
And just when you thought that things could not get any worse for brokers, they are now increasingly subject to regulation seeking to promote transparency. Brokers also have to deal with plan sponsors who need to justify more effectiveness in trade handling, and, more generally a buy side that wants to clear up the inherent conflict of interest of broker-sponsored platforms.

As broker-sponsored platforms face an uncertain future, sophisticated buy-side firms have to answer difficult questions about how they manage the associated risks of trading on these platforms ... and whether those risks are worth taking at all.

Although broker-sponsored platforms can be conceptually acceptable, investors need to protect themselves against the risks that these systems could potentially generate, such as significant market impact, limitation of transparency and higher, undisclosed, transaction costs.

Top 10 Buy Side Concerns
Here are the the top 10 issues every buy-side trader needs to be mindful of to ensure efficient and effective trading on their broker-sponsored platforms:

1. Control Information: In the financial markets, information IS money. To avoid leaking information (and money) every buy-side firm should maintain a clear policy on its data flow, especially in markets with tight liquidity, like corporate bonds or blocks. Using single-dealer platforms or even multi-dealer RFQ platforms in some cases could be similar to advertising positions to the entire market place. The buy side should assume that information is public as soon as it reaches a broker operated single- or multi-dealer platform and check that its business objectives are compatible with this disclosure. (For example, iceberg and registered orders could be read and used by pricing servers.)

2. Use Multiple Platforms: Do you want to show all your order flow to one broker by accessing only their execution management system (EMS)? This can be a risky strategy. If you need to access single-broker platforms, it is best to have a few of them, so you can avoid giving one counterparty too much control over your execution quality. To be sure, to make it worth executing on a single-dealer platform, the capability to tap internal crossing capabilities should be, at the minimum, flawless. Don't think that consortia platforms are better in that respect -- they just distribute the information to more people.

[For more on how the buy side is evaluating EMS systems, read: Market Structure Drives the Buy Side to Seek New OMS/EMS Systems].