The Challenge: As hedge funds soar, winning their order flow has become more vital than ever. To compete for that business, brokers and other providers need to offer hedge fund managers wider access to markets and trading products, and break down silos to improve integration.
Preparing for its 2003 launch, New York-based Thunderbay Capital Management tire-kicked a number of prime brokers in search of services that suited the hedge fund's trading style. "We needed a prime broker that could handle a rapid-fire order flow and clear it without any problems," says Dean Barr, Thunderbay's CEO and managing partner.
As hedge funds become a bigger part of the investment industry, attracting order flow from people such as Barr is becoming an increasingly important part of the business for everyone from prime brokers to broker-dealers and clearing firms. To win his business, Barr had a shopping list of what Thunderbay wanted in a prime broker:
- Financing, leverage and accounting services.
- Exceptional trading services, including competitive rates, direct market access and access to varied liquidity pools and a range of financial instruments.
- Access to more trading algorithms.
- A willingness to open some doors to help Thunderbay grow.
Though the firm created its own trading algorithms, Barr didn't want to run systems that required a big in-house IT department. "When you run a hedge fund, you want an efficient operation," he says. "You are looking to outsource as much as you can. All [maintaining systems] does is add costs to your firm."
Thunderbay ultimately selected Goldman Sachs' trading technology and services. "We are engaged in a battle for the desktop real estate," says Greg Tusar, managing director, execution product development, at Goldman Sachs. The key to winning is providing a "tool that has all the functionality a trader needs on a given day," he adds. That means providing a service through which hedge fund traders can access different markets and trading products, from equities to options, futures, fixed income and foreign exchange.
Looking for a One-Stop Shop
Barr says that Wall Street firms are no longer willing to contribute their own capital to hedge funds, so typically it's not a default decision to give order flow to a big investor. Instead, the real differentiator among firms lies in their execution abilities, he says.
That means prime brokers or agency brokers looking to service hedge funds are busy building out their systems to provide a full menu of services for hedge funds. It also means that they need to examine their internal systems and enhance everything from their auto-quoting and auto-trading applications to their risk management and credit systems.
While commissions for handling hedge fund order flow are only fractions of a penny, the huge volume of trades at hedge funds make them an attractive client, says Dushyant Shahrawat, an analyst at Needham, Mass.-based TowerGroup. An estimated 7,000 hedge funds in the U.S. manage more than $870 billion in assets. Estimates of the share of the daily equity volume that they account for run as high as 20 percent.
In July, SEC Chairman William Donaldson testified before the U.S. Senate Committee on Banking, Housing and Urban Affairs that 20 percent of corporate and public pension plans used hedge funds in 2002. A Bank of New York study estimates that U.S. institutional investors will increase the capital committed to hedge funds by 450 percent over the next five years, hitting $300 billion by 2008. The study predicts institutional capital will soon account for half of the money flowing into hedge fund coffers.
"As hedge funds continue to attract more investment dollars, they become a larger force," says Carey Pack, president of BNY Brokerage, part of the Bank of New York. So, while billions of dollars flow into hedge funds, and the SEC prepares to regulate them, the battle shapes up among prime and agency brokerages on how best to attract this order flow.
One way that firms servicing hedge funds are doing that is through technology. "These [hedge fund managers] are cowboys," TowerGroup's Shahrawat says. "They don't have the time and patience for buying technology."
Hedge funds are forcing investment banks to break down barriers inside their firms. "Historically, firms have looked at the business in a very siloed fashion," Goldman Sachs' Tusar says. Traditionally, investment firms often broke up their businesses along product lines, such as equities, foreign exchange and fixed income, with different technology platforms and databases servicing each silo. But the key to servicing the hedge fund market is providing "seamless processing of trades" from the pre-trade to post-trade process, Tusar says.
That's why Goldman has focused on integrating systems, including REDIPlus, the direct market access online trading platform from New York-based Spear, Leeds & Kellogg that's part of the Goldman Sachs Group. It provides market access to liquidity for U.S. equities, options and electronic futures, plus access to European equities in more than 20 markets and the electronic futures markets, including quotes, news, charts and order and position management. Goldman embedded REDIPlus into EZE Castle Software's (New York) trade order management system, which is popular with hedge funds, to provide order management, smart-order routing, direct-market access and real-time market data in one place.
BNY Brokerage's Pack says hedge funds are also on his firm's radar. "We have got to build better relationships with hedge funds," he says. "That's why it's important for us as an institution to have multiple touch points," including asset servicing and execution, and back-office and administrative functions. BNY recently launched DEx, its direct execution trading services platform. "It gives us a real state-of-the-art platform that we can put up against anybody in the business," Pack says. The platform features a suite of trading tools and services, including SonicSmart and SonicPort, direct-market access and smart order routing tools that BNY acquired when it recently purchased direct-market-access provider Sonic Financial Technologies.
"The Sonic acquisition enabled us to really have a more competitive offering for hedge funds," Pack continues. "We tried to be smart when we built out DEx. We wanted to make it very easy for hedge funds to use." BNY also links DEx to a range of trade order management systems, such as LongView from Linedata Services, EZE Castle and Macgregor.
But it's not just the big firms competing for a piece of the hedge fund business. "As a smaller boutique, we've always had to find ways to compete and be different from the bulge-bracket firms," says Joe Gawronski, COO at Rosenblatt Securities, a New York-based agency-only execution firm. "We definitely had to add product arrows to our quiver."
For example, the firm now distributes independent research from Birinyi Associates in Westport, Conn. And it beefed up its execution platform, adopting FlexTRADER, an equity trade and order management system from FlexTRADE Systems (Great Neck, N.Y.) that features pre-defined trading strategies and tactics for single stocks or baskets of stock and can be customized to suit a firm's trading needs.
The Great Equalizer
Gawronski believes technology is allowing boutique firms to compete against bigger players for hedge fund business. "Small firms don't have unlimited technology resources," he says. "It doesn't make sense for us to build the entire robust platforms that our clients trade on." Instead, by teaming up with vendors like FlexTRADE, Gawronski contends that his firm can deliver the trading services that hedge funds need.
Rosenblatt also provides support services for hedge funds that border on strategy consulting. It's helping hedge fund managers evaluate the technology choices for direct market access and deal with the changing regulatory and trading environment. "We're helping them with the rapidly changing market structure," he says. "They need to know how to adjust to the new markets and how trading will change."
Goldman's Tusar agrees that attracting hedge fund order flow is more than simply providing stellar execution services. "In the early phases, we do a lot of consultation with hedge funds," he says, everything from assessing their technology needs to helping them find office space. As hedge funds take on more assets and expand their offerings, in some cases moving from providing single-trading strategy funds to adopting multiple trading strategies, they're becoming much more demanding customers, Tusar adds. "They're much more sophisticated about operations and infrastructure than they have been in the past."