Speed Shakes Up Trading
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By Jeff Kearns, Whitney Kisling and Nina Mehta
Jan. 29 (Bloomberg) -- The near darkness behind the bulletproof doors of a windowless Secaucus, New Jersey, warehouse is humming with tens of thousands of computers as U.S. exchanges open on a December Friday.
Brokerages and trading firms, battling for the fastest access to capital markets, buy or lease space at this Equinix Inc. center and others to place their machines as close as possible to stock exchange computers. The practice, known as co- location, is one way firms are vying to win fractions of a second -- the difference between getting a trade and missing it.
Speed is shaking up the brokerage industry -- and drawing scrutiny from the U.S. Securities and Exchange Commission, Bloomberg Markets magazine reported in its March issue, in which it ranked brokers worldwide.
On Jan. 13, the SEC took a first step toward reviewing the effect of trading strategies in which computers may buy or sell shares as many as 1,000 times a second. The commission asked traders, exchanges and the public to weigh in on high-speed trading, which has soared since 2005 to account for as much as 61 percent of U.S. stock market activity and 70 percent of individual trades, financial services consultant Tabb Group LLC says.
‘Their A Game’
Against this frenetic backdrop, brokerages are adding technology and services to help them execute large orders for customers.
“What you needed this past year versus 2007 and early 2008 was lots of tools, technology and the use of gray matter,” says Peter Weiler, executive vice president of global sales at Abel/Noser Corp., a New York-based broker that also analyzes trading costs. “Brokers needed to bring their A game.”
Goldman Sachs Group Inc. ousted JPMorgan Chase & Co. as the firm that got the best prices for its institutional clients during Bloomberg’s 12-month ranking period from July 1, 2008, to June 30, 2009, according to data compiled by Ancerno Ltd.
During that time, stock volatility quadrupled from its 20- year average and the Dow Jones Industrial Average swung by more than 40 percent.
Goldman was the worldwide winner among brokers that handled at least $25 billion in trades in getting an average price closest to the stock level when the order was received, according to Ancerno, a spinoff of Abel/Noser that audits costs for $7.5 trillion of trades by 500 money managers in more than 70 countries every year.
JPMorgan, the top broker during the 12-month ranking period that ended on March 31, 2008, fell to No. 4 worldwide in the recent ranking.
Goldman Sweeps
New York-based Goldman also swept the competition in the three regional categories: Asia, Europe and North America. Last time, Goldman placed sixth worldwide and second in Europe; it was a no-show in the top five in North America.
“They have the most developed and advanced electronic systems,” says Roger Freeman, an analyst who covers brokerages and exchanges at Barclays Plc in New York. “They can get some of the fastest execution times on trades, thereby minimizing some potential costs.”
Goldman is also able to match buy and sell interest under its own roof because it receives orders from a mix of mutual funds, asset managers and other institutional clients. That makes it less likely that hints about trading intentions will leak out to the market, says Paul Russo, Goldman’s head of U.S. equities trading and co-head of global equity derivatives.
“Any time a client trades with us, we try to match them off against our natural internal flows,” he says. “That way we can minimize the trading footprint we leave in the marketplace.”
Working Together
Goldman’s technology and its access to a large pool of potential buyers and sellers help it to search for -- and find -- liquidity at the best price for customers.
“The winning brokers coordinated across trading desks within their company,” says Kevin McPartland, a senior analyst at New York-based Tabb Group. “Their software-development and server technology teams worked together efficiently.”
Charlotte, North Carolina-based Bank of America Corp., which acquired Merrill Lynch & Co. for $29 billion in January 2009, shot to second place from fifth in the recent global ranking. Merrill, the world’s biggest brokerage at the time of the purchase, had placed seventh previously.
“We stayed incredibly focused on clients and the quality of our trading products that came out of the merger,” says Mike Stewart, co-head of global equities at Bank of America.
Tumultuous Time
Morgan Stanley finished third, and Barclays tied for fourth with JPMorgan.
“The liquidity we’re able to find leads to significant opportunities to match customers’ orders against each other,” says Jason Crosby, Morgan Stanley’s head of Americas portfolio distribution in New York.
In a year of tumult on Wall Street, investors didn’t avoid brokers that took money from the U.S. Treasury’s Troubled Asset Relief Program. The top three -- Goldman, Bank of America and Morgan Stanley -- along with JPMorgan, which tied for fourth, all received TARP funds from the government, which allocated $700 billion to purchase assets from financial institutions. No. 9 Citigroup Inc. also took U.S. bailout money. Barclays, Citigroup and JPMorgan declined to comment on the ranking.
Cratering Stock Prices
“The stock prices of many brokers were cratering, and many received government bailouts,” Weiler says. “But the perception was that they were OK, rather than teetering, because institutions continued to do business with them.”
Some traders bucked the big-broker dominance and sent their orders to specialized block trading firms. Such shops seek to buy or sell thousands or millions of shares at a time without substantially swaying the price.
“If I’m trading 100,000 shares a day of a stock that only trades 500,000 a day, then best execution can be harder to get,” says Clarence Woods Jr., chief equity trader at Baltimore-based MTB Investment Advisors Inc., which manages $12 billion.
Woods routes most of his stock orders to Westlake Village, California-based JonesTrading Institutional Services LLC. JonesTrading relies on discreet phone calls -- rather than massive computers -- to find people to take the other side of a trade, as is also done on block trading desks at many brokers that serve institutions. (JonesTrading didn’t meet the capital requirements for our ranking.) Bloomberg LP, the parent of Bloomberg News, owns Bloomberg Tradebook LLC, an electronic agency brokerage that lets customers route orders to exchanges in 38 countries.
North America
Sanford C. Bernstein & Co., the brokerage unit of AllianceBernstein Holding LP, was the sole “execution-only” shop among the North American top five. Such firms handle customer orders and do not use their own money to facilitate customers’ trades.
Trading and investments, along with a cut in its bonus pool, helped spark Goldman’s fourth-quarter 2009 earnings to a record. Net income soared to $4.95 billion, or $8.20 a share, from a loss of $2.12 billion, or $4.97 a share, a year earlier.
Goldman’s $13.4 billion in annual profit exceeded its prior record of $11.6 billion in 2007, which was the highest earnings ever by a Wall Street firm. Proprietary trading has accounted for about 10 percent of the firm’s revenue in most years, Goldman spokesman Ed Canaday says.
Goldman’s billions have some investors crying foul. In early January, an Illinois shareholder filed a so-called derivative suit on behalf of Goldman against its officers in New York state court. An Illinois pension fund and a Pennsylvania investor filed similar suits against the company, criticizing executive pay.
Goldman’s Compensation
The Illinois shareholder claimed that Goldman’s compensation payout plan is a waste of assets -- and a breach of duty and loyalty after the firm took the federal bailout. Goldman announced after the suit was filed that it cut its 2009 compensation to $16.2 billion from the $16.7 billion it set aside earlier in the year, limiting compensation to its lowest proportion of revenue in the firm’s 10 years as a public company. Canaday says the suit is “entirely without merit.”
Goldman’s customers aren’t likely to complain. Compared with other brokers in our ranking, Goldman got its clients prices that diverged the least from the prices they had sought on stock purchases and sales.
Goldman customers lost an average 0.275 percent, or 27.52 basis points, when they bought or sold through the bank, according to Ancerno’s world ranking. (A basis point is 0.01 percentage point.) For instance, a customer who placed an order to buy 50,000 shares at $10 each would get the shares for an average price of slightly less than $10.03. Bank of America’s customers lost 32.67 basis points, while Morgan Stanley’s lost 33.61.
The Big Guys
The biggest brokers -- with their math whizzes, algorithms and flexibility to commit their firms’ money -- had the advantage as the Standard & Poor’s 500 Index posted the biggest percentage decline since 1937 in 2008 and volatility soared. Trading volume climbed 12 percent from the third quarter of 2008 to the fourth and then 3.8 percent in the next quarter. On average, 10.4 billion shares a day changed hands on U.S. exchanges during the 12 months ended on June 30, 2009.
U.S. stocks had their most-violent swings in almost eight decades in 2008, pushing the Chicago Board Options Exchange Volatility Index, or VIX, to a record 80.86 in November of that year. The index, which measures the cost of using options as insurance against S&P 500 declines, is a gauge of investor uncertainty. It averaged 20.28 over its two-decade history and 38.91 in the first half of 2009.
Volatility Costs
Increased volatility makes it costlier for brokers to buy and sell the large blocks of stock that account for the biggest share of institutional orders.
In North America, costs roughly tripled for the top five brokers, causing customers to pay, on average, 25.42 to 34.10 basis points. Institutional investors around the world paid $28.2 billion in trading commissions in 2009, compared with $30.7 billion in 2008 and $26 billion in 2007, according to Greenwich Associates in Stamford, Connecticut.
With so much money at stake, the technology arms race that spawned millions of dollars’ worth of buzzing computers in Secaucus shows no sign of letting up.
“Equities is a technology business now,” Tabb Group’s McPartland says.
What the humans need to do is to make sure their firms have the best equipment, trading know-how and programmers.
To contact the reporters on this story: Jeff Kearns in New York at jkearns3@bloomberg.net; Whitney Kisling in New York at wkisling@bloomberg.net; Nina Mehta in New York at nmehta24@bloomberg.net.
Last Updated: January 29, 2010 00:00 EST |
