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A Journey From Active Day Traders to Institutions
Transaction costs, speed, anonymity and order control-no, I'm not talking about the benefits of using the Internet to distribute bootleg movies. Rather, these are the factors most often cited by America's next-generation stock traders when they explain the evolution and growth of so-called direct-access technology.
Direct-access software, which allows stock traders to electronically and expeditiously route orders to multiple execution destinations, without any assistance from an intermediary, has been around, in various iterations, since the mid-1990s. But the technology really started to pick up steam in 1997, following the launch of SEC-mandated order-handling rules that were intended to level the playing field for smaller U.S.-equity investors.
The implementation of the rules gave rise to a plethora of electronic-communications networks (ECNs) - equity trade-matching engines that electronically crossed customers' buy and sell orders. After the emergence of ECNs, which quickly snatched up significant market share in Nasdaq stocks, investors needed a fast and cheap electronic mechanism for routing orders to these matching engines. Subsequently, direct-access vendors started to spring up across the country. And today, there are more than 20 providers of the latest craze in stock-trading technology.
Most of the current direct-access suppliers cater mainly to active day traders - rapid-fire investors that routinely jump in and out of stocks several times per day. However, though direct-access trading has experienced most of its growth in the day-trading community, buy-side institutions - particularly smaller hedge funds - have developed an appetite for the technology over the past 12 months.
Interest from the buy side, supplemented by the launch of aggressive institutional strategies by a plethora of direct-access vendors, has helped the technology sustain its growth. Indeed, at a time when many investors in the U.S. stock market have been hurt by the recent economic downturn, the number of transactions executed by direct-access traders has steadily risen. Moreover, Celent Communications, a research and consulting firm specializing in financial services, recently predicted in a study that the total number of direct-access transactions will rise from 155 million in 2001 to 247 million in 2004 (see chart).
Day Traders Catch On First
While it is true that market factors such as the launch of the order-handling rules and the rise of ECNs contributed to the emergence of direct access, day traders must also be given credit for leveraging the technology and contributing to its growth.
“What they figured out was that if they could go ahead and get a trade executed within microseconds, they could take advantage of movement, whether it be up or down, in a stock. And in order to do that, they needed a platform to take advantage of that scenario,” explains T. Gene Gillman, chairman and co-founder of the direct-access vendor TradeTek.
Robert Russel, a managing director at Investment Technology Group - a hybrid broker/software vendor that markets its own direct-access front end exclusively to buy-side institutions - says that transaction cost savings was the factor that initially lured day traders to direct access. Since these traders were actively buying and selling stocks throughout the course of a day, they needed an inexpensive mechanism for entering and routing orders. “That's why you are seeing people now executing trades for $10 a trade,” he says. “Not too many years ago, it was $200 a trade. A I don't think you'd see a lot of people executing 40 trades a day at $200 per trade.”
Noting Wall Street has a “bloated cost structure,” Thomas Peterffy, chairman of Interactive Brokers Group (IB), agrees that the reduction in transaction costs which direct access provides is the most appealing benefit for individual investors. Citing a recent industry study, he says that, in some cases, direct access allows individual investors to slice their transaction costs by 25 and 30 basis points. “That's an immense amount of money ... (and) this all boils down to costs,” he says.
However, Aleke Msumba, a product manager at TradeTek, says other factors - including order control and speed - have contributed significantly to the rise of direct access. Using a direct-access system, he notes, an investor can control which execution destination thier order gets routed to. For example, says Msumba, if an investor has a favorite market maker or ECN they like to trade with, they can route orders exclusively to that liquidity pool.
Perhaps even more significantly for rapid-fire investors, direct access provides end users with the capability to speedily route orders and receive fills. “Using direct access, I've seen people just route out a 50,000 share order for Cisco's stock and get filled on the Archipelago (ECN) inside of 15 seconds,” says Msumba.
IB's Peterffy retorts that speed and order control, in the case of active day traders, are just additional direct-access mechanisms investors use to slash costs. “If you get a quicker execution, it doesn't matter if you don't financially benefit from the faster execution,” he says. “Similarly, control of orders gives you the ability to ultimately achieve a better execution price, which is again related to transaction costs.”
Buy Side Coming On Strong
IB, which owns and operates market-making firm Timber Hill, is one of a few suppliers of direct-access technology that actually got its start on the buy side. Initially, in fact, IB built its so-called Trader's Workstation direct-access platform in support of its own market makers. Eventually, however, IB made its direct-access system available to a wider audience, and now the Trader's Workstation universe of users is comprised of 50 percent institutional investors and 50 percent individual investors, says Peterffy.
ITG, like IB, cut its direct-access teeth in the buy-side community. However, ITG has marketed its Quantex front end exclusively to institutional investors. ITG's Russel says one of the reasons the buy side's usage of direct-access software has increased is because the number of trades institutional traders have to execute on a given day has increased “massively” over the last decade. As ECNs began to rise, he notes, the number of small orders executed in the Nasdaq market also began to increase.
Subsequently, since there were fewer large buy and sell orders to be had, institutional traders trying to complete big block orders had to execute more trades. Consequently, since they needed an efficient and fast electronic mechanism for performing more “mini-executions,” institutional traders began to warm up to direct access, says Russel.
Buy-side traders, he notes, are less concerned about best price than active day traders because they have to execute a certain amount of large block orders in a given day and can't necessarily afford to wait for a stock to move two ticks in their direction. That's why, initially, many firms in the buy-side community were reluctant to embrace direct access. But as they gained more knowledge about the cost and efficiency benefits tied to the technology, says Russel, the buy side started to leverage direct access. “They want a system that allows them to participate in multiple pools of liquidity, on an equal basis ... (so) that they can make sure they get the whole customer trade done, at a fair price, in a systematic way,” he says.
Celent's McCormick agrees that institutions started to warm up to direct access as they gained more knowledge of the technology, but also says software upgrades performed by direct-access vendors contributed to its growing popularity on the buy side. Today's direct-access technology, he says, is much more flexible than trading software developed a couple of years ago, allowing institutions to perform more sophisticated transactions - such as basket trading and program trading. McCormick say that direct access has also given buy-side firms the power to either supplement or replace their legacy-trader order management and portfolio-management systems.
Undoubtedly, there is now a lot of room for direct-access growth on the buy side. McCormick says that, in the future, large buy-side firms will probably use direct-access technology to supplement their existing relationships with broker/dealers. “Large institutional money-management firms are not going to terminate their relationship with the sell side, but direct access will likely play a supporting role,” he predicts. |
