Buy Side: The Next Direct Access Frontier

Life on earth, Charles Darwin once theorized, is the result of eons of adaptations. Throughout the course of history, Darwin hypothesized, constantly changing environments spurred the evolution of new species. Species that adjusted to their environments survived, while those less fit were phased out of existence. Similarly, in the U.S. brokerage industry, the changing needs of customers have periodically fueled the rise of new entities that have not only created new efficiencies but cast doubts on the viability of traditional brokerage players.

Most recently, for example, institutional-investment firms, spurred by client pressure to increase trade efficiency while slashing costs, have begun adopting direct-access technology -- front-end trading systems that enable end-users to electronically link to multiple stock- execution destinations without any assistance from a brokerage intermediary.

The evolutionary trend towards buy-side adoption of direct access is significant for a variety of reasons. Institutions that are now getting better trade executions via direct-access technology have been forced to re-evaluate their relationships with long-time trading partners -- large broker/dealers. Broker/dealers, in turn, have had to ponder what steps they can take to avoid being cut out of the buy-side picture by direct-access brokers.
Since this phenomenon is so new, there is no real mechanism for calculating exactly how deeply direct-access technology has penetrated the buy side, and it's hard to say with any certainty which direct-access brokers have achieved the most institutional success. To date, in fact, there have been no detailed reports or studies released about direct access' march into the buy side. However, there is no question that a handful of vendors have already carved out some buy-side niches, particularly in the smaller hedge fund and registered investment advisor segments of that market. Moreover, there is certainly room for growth in the mid-to-large-size segments, because direct access is truly just at the tip of its evolutionary curve.

Up until last year, direct-access technology was not even on the radar screen of the institutional-investor community. Indeed, from its beginnings in 1997, direct access has steadily built a reputation as the exclusive playground of day traders -- active online stock traders who often rapidly jump in and out of positions. Portrayed in a negative light in many media circles, these intra-day traders were linked hand-in-hand with direct access, making the technology a tough sell in the professional buy-side arena.

Some institutions were scared off by the bad press tied to direct access' main target audience, while others simply felt that their standard practice of telephone-based trading with broker/dealers worked just fine. But over the last year to year-and-a-half, as they have become more educated about the speed, choice and cost benefits of direct access, buy-side firms have gradually started rolling out the technology. Moreover, during that same period, many direct-access vendors -- recognizing that they needed to find new streams of revenue in a down economy that has been unkind to many in the day-trading community -- have for the first time begun actively pursuing institutional investors.

"Previously, there was not a lot of (buy side) knowledge about (direct access) technology itself. It was really couched inside the day-trading community, which frankly had not had the greatest reputation," explains Fritz McCormick, an analyst covering institutional e-brokerage at research and consulting firm Celent Communications. "There was also not a lot of pressure on these smaller buy-side firms to become more efficient, in terms of trade operations and cost savings. But (institutional) clients are now clamoring for increased efficiency, price transparency and lower trade costs. And one of the ways they think they can achieve this is through direct-access technology."

Anonymity and ECNs
Cost savings, speed and execution breadth are certainly three of the primary benefits buy-side firms are deriving from direct access. But Ross Ditlove, chief executive officer of the direct-access broker MBTrading, says there is also one other benefit that sometimes gets overlooked: anonymity. "One of the reasons buy-side firms wanted to control their orders was because of the additional anonymity they get from not using a market maker or calling a trade desk," he says.

In terms of execution breadth, one feature that most direct-access systems offer is electronic interfaces to all of the major ECNs -- equity trade-matching engines that now account for more than one-third of Nasdaq's average daily volume. ECNs really started to emerge back in 1997, following the Securities and Exchange Commission's launch of the so-caller order handling rules. Those regulations were intended to help level the stock playing field for individual investors, but those investors also needed a front-end application through which they could tap into multiple ECNs.
Subsequently, direct-access brokers emerged to fill that void. And though they now offer a wider array of features and services, the ability to route orders to multiple ECNs via a single front-end is now one of the selling points direct-access brokers use in an effort to recruit institutions. "Institutions, like everyone else, are looking to get the best executions possible. So they want more complete access to the ECN marketplace; otherwise, they would be short-changing themselves," says Ralph Cruz, co-CEO of the direct-access broker the TradeStation Group.

However, that said, while just about every direct-access broker now has a strategy in place to pursue at least one segment of the buy side, most players had very little interest in the institutional space throughout the economic boom of the late 1990s, when they seemingly had a bottomless reservoir of day traders to tap into. While a few players, such as TradeStation Group and Burbank, Calif.-based UNX, initially developed their offerings for institutional investors, most direct-access brokers -- including the recently merged tandems of Ameritrade/TradeCast and ProTrader/Instinet -- are now trying to adapt their retail-oriented systems to the buy side.

"The marketplace for the day trader is sort of drying up," says UNX chief technology officer Randy Abernethy. "The days when everything was going up and everybody was a great stock picker are over. So, with the field evaporating, these (direct access) firms that have a pretty significant investment in technology are now searching for a place where there's still a market that's viable for them." UNX, unlike many of its direct-access counterparts, designed its technology explicitly to meet the needs of hedge funds and institutions. What's more, says Abernethy, UNX now counts a few "billion-dollar-plus" institutions among its stable of roughly 100 buy-side accounts.

Conversely, organizations like Ameritrade/TradeCast have made their marks in the retail investor world, and only recently began marketing their direct-access technology to the buy side. "The majority of our volume still comes from the active day-trader space," says TradeCast Chief Operating Officer Ken Jones, who also holds a vice president's title at Ameritrade. "Heretofore, the primary Ameritrade market has been the individual small investor, who doesn't trade that often, and (TradeCast's) market has been the active individual investor who does trade often. But now we're going to aggressively go after the hedge-fund market, proprietary-trading firms and institutional-trading desks."

Old Habits Die Hard
Bobby Earthman, president of TradeCast and a vice president at Ameritrade, says that part of the reason TradeCast is just now jumping into the buy-side arena is because it lacked the motivation to proactively target that market in the past. During the "first few years" of its existence, Earthman says, TradeCast received so much demand from the "active-trader space" that it saw no need to dive into another market. But, he says that while building a niche in a new market is no easy task, wiping out the old-school mentality of some institutional investors may prove to be the real challenge.
Most buy-side adopters of direct-access technology previously executed transactions through "phone-based discussions with broker/dealers," says Celent's McCormick. And convincing institutional traders to give up their old way of doing things, some direct-access sources say, is often akin to pulling teeth. "Good traders are certainly habitual about what they do. They don't want to change, and it's not because they are superstitious. They are just comfortable and feel that they don't need to fix what's not broken," says John Hopkins, senior vice president in charge of institutional trading at Terra Nova Trading.

Terra Nova, a direct-access broker that uses Townsend Analytics' RealTick system, recently launched a separate institutional division in an effort to persuade hedge funds and investment advisers to give RealTick a try. The problem, says Hopkins, is that a lot of hedge fund managers have brokerage backgrounds -- meaning they have long-standing relationships with the brokers Terra Nova is trying to replace. "And the larger the institution, the more difficult it is to change, because the infrastructure is set," he says. Still, even in light of such obstacles, Terra Nova's institutional clients now account for 15 to 20 percent of the firm's overall business -- a figure that represents, says Hopkins, a 100 percent increase from six months ago. Down the line, as it further educates the buy side on important RealTick features -- like basket trading and currency hedging -- Terra Nova expects to expand its institutional reach.

Like Terra Nova, ProTrader, now operating as the direct-access brokerage subsidiary of Instinet, has only recently put together a sales team to go after the buy-side market. But despite the fact that its buy-side strategy is still in early stages, ProTrader is very confident that it can build a niche in its primary institutional target audience: small hedge funds. "We think the (electronic trading) penetration rate at these small hedge funds -- (firms) with below $100 million in assets -- is probably less than 15 percent," says ProTrader Chief Executive Officer Jay McEntire. "So we see a huge opportunity there, and that's where we're focusing all of our (buy-side) attention." McEntire says that the dwindling significance of traditional broker/dealer value-added services, such as research and IPO allocations, is part of the reason ProTrader likes its chances in the hedge fund arena. "Today, with the IPO pipeline gone, effectively, the value of paying a whole lot of money to brokers to just stay in that pipeline has all but vanished," he says, adding that, through vendors like Multex, more and more institutions are getting their research from alternative sources.

Through its ties to Instinet, the large global-agency brokerage firm that owns and operates its own ECN, ProTrader could conceivably be granted access to some of the world's biggest institutional-investment firms. Instinet's client list includes such buy-side giants as Fidelity Investments. But ProTrader currently has no plan to chase after the larger firms on the buy side. Instinet will handle those customers, while ProTrader will aggressively pursue both hedge funds and active individual traders. "Larger mutual fund money managers that are covered by Instinet already use some type of FIX connectivity to the ECNs," says McEntire. "But if you drop down below that level, and look at the people who are just actively managing stocks for a portfolio, this (direct-access) technology is very applicable."

Disintermediation: Wave of the Future?
The Instinet/ProTrader relationship raises a couple of key questions. Namely, will direct-access technology ever gain popularity among large institutions? And are broker/dealers in danger of being disintermediated as direct-access brokers creep further and further into the buy side?

Naturally, there are a variety of opinions on these topics. Celent's McCormick thinks that while large institutions may use direct access as a supplement to their existing trade execution strategies, they will never fully rely on the technology. "I have my reservations about whether the real large, high-end buy-side firms will ever really take up this technology in a truly meaningful way," he says. "I think you'll see (direct access) used as an ancillary system, or in conjunction with what will continue to be their most important form of execution: their relationship with their broker/dealer."

In contrast, John Forlines says that direct access has the potential to cause serious waves at large institutions in the near future. "What's going to happen eventually is that all of those larger firms are going to start committing trading dollars -- trade commission dollars -- to direct access," says Forlines, the recently-appointed chairman and CEO of direct-access trading firm Blackwood Inc. "Right now, quantitative hedge funds comprise the lion's share of our institutional clients. But (those firms) are also good harbingers of where the buy side is going to go. So I do believe very strongly that larger buy-side firms are going to be interested in direct access and smarter execution."

Of course, Forlines' strong belief in direct access is at least partially driven by the fact that Blackwood -- which typically trades between 15 and 30 million shares per day -- now derives between 80 and 90 percent of its volume from institutional clients. But even firms that still rely on active individual traders for the majority of their revenues think direct access has the potential to make a big splash at major institutions.

MBTrading's Ditlove, for instance, says that some value-added services broker/dealers have provided large institutions in the past -- such as research -- are not as important as they once were. Consequently, he says, the window has now opened a little wider for direct access. "A lot of these institutions have adopted methods for doing a lot of their own research. And if (institutions) can do their own research and execute their own trades, well then, (they can) save themselves a whole lot of money," Ditlove explains. ProTrader's McEntire agrees that value-added broker/dealer services, such as research, have become more commoditized, but does not believe broker/dealers should feel threatened about their livelihoods. There will always be a place, McEntire says, for brokers that can work and execute large block orders on behalf of big-time institutions. "If I'm real busy and I've got a 50,000 share block, I can receive real value-added if I call a buddy at Merrill Lynch ... who I (can) trust to work that order for me," he says. "But for small orders, when you can get access to multiple pools of liquidity for modest costs, (direct access) is kind of a no-brainer."

Direct access, Celent's McCormick concurs, definitely makes sense for small buy-side firms. However, he says that broker/dealers rely too heavily on revenues from large institutions to allow themselves to be usurped by direct access. The big sell-side players, he says, are "nervous" about the threat posed by this next-generation technology, and will therefore take the necessary steps to defend their turf. "They don't want to get booted out, so they are working hard or new value-added services, or anything that's going to keep their relationships with large buy-side firms intact," he says.

Acquisitions are one way in which broker/dealers can protect themselves from disintermediation. Over the past few years, the U.S. securities market has seen numerous broker/dealers hedge their bets for the future by acquiring equity stakes in multiple ECNs. Moreover, more recently, we have witnessed major online-discount brokers, like Ameritrade (via its deal for TradeCast) and Charles Schwab (via its purchase of CyBerCorp), throw their hats into the direct-access arena.

So it would come as no real surprise if, in the name of self-preservation, more traditional broker/dealers acquire some type of direct-access platform. "These direct-access systems bring a lot of value, and in this down market, you can pick them up for a lot cheaper than you could two years ago," says MBTrading's Ditlove.

McCormick retorts that whether more broker/dealers get involved in the direct-access acquisition game remains to be seen. But regardless of whether broker/dealers offer direct-access software to their institutional clients, he says, the trend towards the implementation of advanced technologies on the buy side will continue. "In a lot of ways what's happening is not only: are (smaller institutions) taking up some of the direct-access technology? -- but for the first time maybe they are looking at an order management system and a portfolio management system -- or some combination thereof," he says. "So I think this direct-access trend is part and parcel of a larger trend toward additional technology inside buy-side firms."