? Isn’t it true that the problem is not the electronic systems inplace, but the regulations and the rules?GUPTA: The New York Stock Exchange has its version, as I saidearlier, of institutional trades in the crowd versus more retail type trades inthe book, but they want to limit any other types of choices. They choose67
Robert Wood is Distinguished Professor of Finance at The University of Memphis.
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SCOREX was the acronym for Securities Communication Order Routing and ExecutionSystem, which was introduced by the Pacific Stock Exchange. It was active in the early90s. Specialists used early systems like this to execute orders from member firm, to updatetheir markets and to transmit and accept quotes from SIAC.
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what works in the best interests of their business model. Even Europeanexchanges have iceberg trading similar to reserve order trading. Nothinglike that exists in the New York Stock Exchange market where, for example,you could post 49,000 shares on the exchange and only show 1,000. Youreserve the other 49,000. On the New York the specialist would see all ofthat order. We have not seen a whole lot of innovation. We have seen smallamounts of responses to criticisms from pennying and other areas.CORMACK: The question is, can New York survive with incrementalchanges over the next couple of years? Is the business model of having afloor unsustainable? What has happened to spread compression with theinflux of ECNs and Nasdaq over the past five years, is only beginning tohappen in the listed markets.By rolling out an ECN or an electronic exchange, you in essence lowerthe barriers of entry to market making. That makes everyone better off. Itcompresses spreads. The guys on the floor in New York have to competewith tighter spreads. Great, if they can do so. If not, somebody else wins.But the bigger question is whether those business models operated by thespecialists are sustainable. We all have our opinions about that.MALITZIS: It is important to note that, prior to SuperMontage, wehad proposed to establish a book. As early as 1990, we had a book in SOES.It was not fully integrated. My point is that we were not just pushed towardscreating SuperMontage by the competition and the innovation that the ECNsbrought to the market. Prior to that, we had been looking to create book-likefunctionality in Nasdaq. This is the nature of Nasdaq’s open architecture.That is why ECNs exist in our market. We invited them in. We wantedthem in our market.RUSSELL MONAHAN69 [From the Floor]: You mentioned that ITSis a major barrier for the ECNs to come into the listed markets. But Islanddoes not abide by ITS rules. So, how come they are not a player in tradingIBM?GUPTA: That is the debate that rages. Obviously, the American StockExchange is showing considerable concern that Island is not abiding by theITS rules. However, we have now reached a problem that the regulators arenot addressing. It is that people are reading different things into the fact thatIsland is not being told to stop. We do not know whether or not there will benew regulation that makes them effectively in compliance. Suddenly, wenow have a new market center that is not complying, and that market centerhas a huge market share in a very important security (the Qs).
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Russell Monahan is Director of Strategic Research at the American Stock Exchange.
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We are going to see something. In the current state, we have regulationson the books that are not necessarily working or being abided by. But anattempt was made to take action, and the regulators said, ‘Don’t take action,we are aware of the situation and are working on it.’ This suggests that weprobably will see something soon.CORMACK: Island submitted an exchange application in mid-1999and nothing has thus far happened with it. We went through the process ofgetting the exchange application submitted. Part of the battle is gettingthrough the issues in DC. I can tell you that there is a lot of pain to be hadon ITS committees, UTP committees, etc.John mentioned getting SuperMontage up for listed securities and havingan ITS amendment for that. That is not easy. Basically, any regionalexchange can veto any change. How progressive is that? That is theenvironment we live in. We may all choose to go down different paths onhow we are going to trade listed securities, or any securities for that matter.But it is not easy to get into the ITS club.SCHENKMAN: Fix the governance structure, and you can fix a lot ofthe problems in ITS. But we all make choices. We choose to participate inITS or not. Some of us choose to go the exchange route. Some of us choosenot to go down the exchange route and therefore trade within ITS or outsideof ITS. Our choice is based on our customers’ needs and what they want tosee from us, on the services that we provide. The issue is more one for theexchanges – how do they get out of the ITS regulation?REDFEARN: I would put a slightly different spin on this. Whathappened with the ETFs gets back to the way that ETFs are priced. ETFprice discovery is based upon futures, based upon NAVs, based uponbaskets, of underlying stocks. People who are trading in programs or othermarkets can price these without being on the floor, so it is easier to takethem off the floor. In our equities and the rest of the equities on the Amex,we still have somewhere around an 80% market share in our equity volume.This is similar to what you see on the New York Stock Exchange. The ITSargument doesn’t hold up so much as the key barrier to ECNs getting intothe listed market, given that it is not enforced. It is not abided by at all byIsland. It is not a relevant rule right now. I would say that as long as youhave a degree of concentration of order flow of that magnitude (80%), and aslong as you have other typical equities where pricing is based upon supplyand demand (and where the buying interest and the selling interest areconcentrated on the floor), so long as you have all of the above, that therestill is a gravity that pulls orders down to the floor. The existingconcentration has itself helped to keep the order flow there. There never wasthis same sort of concentration in the dealer market, simply because of theway the dealer market is structured.
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NATAN TIEFENBRUN70 [From the Floor]: I have heard a lot ofanecdotal evidence that the New York Stock Exchange itself does not reallyabide by ITS. One reason why the ECNs that participate in ITS have failedto get very far is that, as a buy-side client, you might post your quote, gobest bid in a stock, and then see it printing in New York straight throughyour quote. Would anyone want to comment on that?SCHENKMAN: Our ECN participates on ITS. We see anywherefrom 1200 to 1800 trade- throughs a day from New York.MERRIN: We all keep talking about why it is not necessary to changethe rules. But nobody seems to like the rules. The exchanges are not goingto be hurt by the competition. Just allow it.SCHENKMAN: If it is not going to be enforced, get rid of it. Orenforce it and let’s deal with it. We have spent enough on technologyresources to comply with the trade-through rule. It should be either enforcedor removed.BARRY SMALL71 [From the Floor]: Seth, are your customersconcerned with information leakage? Also, is their behavior modified as aresult of seeing information in your system, by being able to trade awayfrom that information, by not being obligated to trade, and by the invitationof hedge funds into your system?MERRIN: I think that you just about hit on all of them (laughter).Some people have the perception that they are giving up information bysimply being in the system. I say it is a perception because I do not believeit. I guess if perception is reality, we have to deal with it. But in our system,what we tell people is that you have two contras with orders in Liquidnet.This is in contrast with what goes on every single day with every singleorder on your desk.This is the way the market structure works. You pick up the phone andcall a broker. You hang up the phone and have lost all control over wherethat information goes. The broker is obviously incented to try and find theother side. The broker makes phone calls and sends stuff to AutoEx. Hemight also send FIX indications of interest to pretty much anybody whowould accept them. As a result, with most of the orders that you give totraditional brokers, a lot of information runs away from you.In Liquidnet, by contrast, if there is one buyer and one seller, there areonly two people in the entire world who know that there is something to bedone. And you are one of them. Further, the information that is being70
Natan Tiefenbrun is Senior Vice President at Instinet Corporation.
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Barry Small is Chief Executive Officer at Weeden & Company.
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disseminated is limited. Regarding the counter party, you have no idea whathis size is, or who he is. You ask (and we have done our data analysis onthis one) whether orders in our system move any markets. Of course, theanswer is no – because they are our studies (laugher). Kidding aside, wefound that there is no market movement.Regarding hedge funds, we have been very selective about which hedgefunds we have let into the system. Because of that, we have probablyexcluded 95% of the hedge funds from participating. The major reason foran exclusion is whether they are involved in any day trading whatsoever. Ifthe traders have any discretion over what symbols they trade, they cannotcome onto the system.72 In addition, every participant in Liquidnet that sodesires has the ability to exclude trading with a hedge fund. I think we haveten hedge funds to begin with, and they are actually excellent members.FREUND: We have just a couple of minutes left. I would like to pull afast one on all of you. Can you identify just one major change in thearchitecture of the securities markets that you expect will occur over the nextyear or two?SCHENKMAN: The fundamental change that will occur is themorphing of roles of all of the players that provide a liquidity function to themarket. This will force the industry as well as the regulators to differentiatethe players by their function rather than by designation such as exchange,broker and ATS.The core competency and primary function of dealers in the marketplaceis the creation of liquidity through the use of their capital. The corecompetency of an exchange is the aggregation of liquidity and thedissemination of information about that liquidity on the tape. The corecompetency of an agency broker or an ATS is the search for liquidity. Thefundamental change that I foresee as the morphing continues is that therewill be less regulation by designation, and more regulation by function. Thiswill free the players, brokers, dealers, exchanges, and ATSs to produce amore robust set of choices.REDFEARN: I see a gradual evolution towards a much more integratedmarketplace. An integration that includes equities, options, derivativestrading, and single stock futures. When single stock futures start trading, a72
Liquidnet said it does not admit customers whose traders make the decisions to buy or sellstock for a portfolio because that could invite traders who ‘fish around,’ In thisenvironment these traders could, for example, put in orders to find out what interest isavailable, then use that sensitive information to force a stock price down or up on an ECN.‘Our members are people who have a serious problem: filling orders that the portfoliomanagers give us,’ Merrin said after the conference. ‘All of our members would be greatlydisadvantaged by having these day trading firms allowed on our system.’
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whole new item will be introduced in the markets. The SEC has alreadyallowed the same specialist firm to trade the equity in one market and theoption on that equity in another market. I foresee the evolution continuing inthat direction – especially in Nasdaq, where it has become more difficult forpeople to find ways to provide liquidity. Complex trading strategies,centralized risk management, and the ability to hedge will all be instrumentalin bringing more liquidity to the table.FREUND: And when that happens, it will be to the great advantage ofthe Amex.REDFEARN: And fortunately, we have an options, ETFs and equitiesbusiness already on the floor of the exchange (laughter).MERRIN: I do not see any major regulatory changes coming any timesoon. What interests me is what ECNs have shown to be the portability oforder flow. Until five years ago, if you had a Nasdaq order you went toNasdaq, if you had a New York order you went to New York. Now theECNs have shown that order flow can be transacted anywhere. We have notyet seen this so much on the listed end, but the trend is the interesting parthere. You do not necessarily have to deal with an exchange. You have todeal with what may be construed as best execution, wherever that is.MALITZIS: This is sort of esoteric, but I think the following. You aregoing to see the SEC looking at tape revenue and tape revenue sharingamong exchanges. In connection with that you will see the SEC looking atthe question of inter-market linkages. I cannot tell you what they are goingto do, but that is a front burner issue for them.GUPTA: Hopefully, some time this year, you will see approval of theADF.73 Then, as I pointed out earlier, I think they are going to allow fornon-ITS participation, which is an easy way to kill ITS. You do not evenhave to put it to sleep. It will automatically go to sleep when the choice toparticipate becomes voluntary. At that point, you will see a changinglandscape in the listed marketplace. I would suspect that, once you allowcompetitive forces in, you will see appropriate market share gains by thepeople who offer innovative solutions, whomever they may be.CORMACK: The monopoly on listed trading will be broken (laughter).
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As noted, the ADF is approved for trading in OTC stocks. Regulatory approval for tradingin listed stocks was still pending as of early 2003.
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FREUND: Well, I am sure we could use another hour. I also knowthat the same questions will be covered in the next panel. But, of course,they will change the answers. Thank you very much.
CHAPTER 6: DOES BEST EXECUTION MAKESENSE?Moderator – Ananth Madhavan, Global Head of Trading Research,Barclays Global Investors74Theodore Aronson, Managing Principal, Aronson+Johnson+OrtizMinder Cheng, Global Head of Equity and Currency Trading, Barclays Global InvestorsNatan Tiefenbrun, Senior Vice President, Instinet CorporationWayne Wagner, Chairman, Plexus Group
ANANTH MADHAVAN: This panel, the last of the day, is on ‘bestexecution.’ The topic is important, it is charged, and it is highlycontroversial.Let me begin by putting it in perspective. The topic is now at the centerof debates on market structure. Anthony Neuberger, in his remarks thismorning, mentioned one of the factors that is driving this interest in bestexecution on his side of the Atlantic – the Myners report. The Myners reporthas shaken up the U. K securities industry and raised awareness of bestexecution. It has emphasized the importance of non-commissioned costs,which is something that Wayne Wagner has been talking about for a longtime.Wayne is the person who popularized the concept of the ‘iceberg ofcosts.’75 That notion has now gained widespread acceptance. The Myners
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At the time of the conference, Ananth was Managing Director of Research at ITG, Inc.
According to Wayne Wagner, ‘Trading costs are like an iceberg. The real danger comesfrom the portion that cannot be seen. Commissions are easily observed but represent onlythe tip of an iceberg. The remaining costs are far more significant, but cannot easily beobserved.’
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report spends a lot of time talking about the non-commissioned costelements of trading.On our side of the Atlantic, best execution has most recently beendriven by the Association for Investment Management and Research(AIMR) initiatives and by the Securities and Exchange Commission.76 TheAIMR has issued its trade management guidelines. Ted Aronson, is thechairman of the committee on trade management guidelines (otherwiseknown as the AIMR Best Execution Committee). These are voluntaryguidelines, but they will lead how we think about best execution in thiscountry in the future.It would be useful to set the stage for our discussion by giving you asense of what the AIMR thinks best execution is. As we all know, it is verydifficult to define best execution, but let me read from the AIMR report. Itdefines best execution as follows:In summary, best execution refers to well-informed trade executiondecisions, made with the intention of maximizing the value of clientportfolios under the particular circumstances at the time. This definitionrecognizes that best execution is, intrinsically tied to the portfolio decisionvalue and cannot be evaluated independently, is a prospective, statisticalconcept that cannot be known with certainty ex ante, has aspects that may bemeasured and analyzed over time on an ex post basis, is integrally woveninto complicated and repetitive practices and relationships.The bottom line is, the AIMR guidelines do not prescribe a universalstandard for how firms should measure best execution. Instead, they focuson the procedures in which firms check that client portfolios are properlyhandled. It is not a trade-by-trade process. The proposed guidelines, asoriginally unveiled by the AIMR, seek to establish more than 20 bestpractices in trading in three broad areas: trade practices and policies,disclosure and record keeping. The AIMR is looking for managers, traders,and brokers to put into place a set of processes that will ensure thatconsiderations involving trading are carefully looked at during day-to-dayoperations.The AIMR report is one element that is driving interest in the topic. Asecond element is equally important. Many more companies’ investmentmanagers, along with brokers at large trading desks, on their own, are nowlooking at trade measurement in a systematic and fundamental way. Theyare doing it in a way that looks a lot like what the AIMR report describes.76
On November 16, 2001, the Best Execution Committee of the Association for InvestmentManagement and Research released proposed ‘Trade Management Guidelines,’ calling oninvestment firms to execute trades and manage the trading function in a way that is alwaysin the best interest of clients.
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Part of this is driven by a growing awareness that implicit trading costs aremuch larger than commission costs. This awareness has taken a while toseep in, but people are now looking at the trading room and traders as if theyare of some value, as if they do help to control execution costs.People recognize that trading costs, especially the market impact costsand opportunity costs, are very large relative to net alpha.77 This isespecially true in the post bubble environment that we are currently in.Today, net alphas are lower, and transaction costs are a significant portion ofthem. Consequently, good control over transaction costs can add meaningfulvalue to the portfolio manager and to the trading desk.Now let’s turn to the panel for further discussion. We will begin withMinder Cheng.MINDER CHENG: Thanks, Ananth. The essence of best execution isour trading strategy and we must be sure that we design that in the best waypossible. We must make sure that the way that we allocate trades is in linewith the minimization of our transaction costs. On the buy-side, we have anatural incentive to achieve this goal. The sell-side’s interest to do so is notas clear, although there has been quite a lot of discussion. At the end of theday, if a broker dealer cannot fulfill his responsibility for best execution,who will suffer? The broker dealer’s clients. However, the sell-sidebasically can just pass any impact on to the clients. I have the impressionthat it could be self-motivated on the sell-side, but they may also need somehelp from the regulators.The buy-side should be financially aligned with our obligations toachieve best execution, since failing to do so impacts our investmentperformance directly. I think for stock exchanges, some of the things thatwe heard earlier, say Boston having a better quote than the NYSE, what doyou do? Per the Intermarket Trading System (ITS), the NYSE specialist hasto route the order to another market which has a better price. This principledoes not apply so much to the sell-side, and certainly not apply to the buyside, because we tend to trade with the brokers not with the stock exchangesdirectly. We don’t have control over where the orders are going to berouted. Having said that, it would be helpful to go through the methodologythat we have been using. It is similar to what some other buy-side firms maybe doing to control their transaction costs.77
Net Alpha was introduced by Ananth Madhavan to signify the difference between theexpected Alpha – which is a measure of performance over an established benchmark – andwhat is actually realized. Net Alpha, in this context, is calculated by subtracting tradingcosts from the expected Alpha. The term was also used by Minder Cheng, who stressedhowever in a later review of his remarks, that he used it interchangeably with the term,Alpha.
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I will highlight one number that is important to a firm like BarclaysGlobal Investors (BGI). BGI trades with more than 100 parties globally.The question is, even if you want me to use a random number generatorwhen I have a list of orders to trade, from out of the 100 brokers, whom am Igoing to pick for this trade? This highlights the need for us to have in placea methodology to quantify how we allocate our trades and to make itconsistent with our performance objective, which is lower transaction costs.There are two questions that I will not try to answer now. I will leavethem to the panel. One is, do I think that broker allocation should somehowbe tied into best execution and, if so, how? The answer depends on whomyou talk to. It could be something that you can quantify. It could be that Ijust went out for a nice dinner with a broker, so tomorrow I am going toallocate some trades to the broker. It will not always be one way or theother; most of the buy-side firms are probably some where in between.This brings me to the second question – can execution quality bequantified? I am sure that, if I turn to Wayne Wagner, he will say ‘yes.’ Ialso believe that the answer is ‘yes.’ But that answer applies only to theportion of execution quality that can be captured in price. There are otherfactors that impact trading quality. As we heard on previous panels, speedmatters. Suppose you can get the same price, but that there are two differentways of trading – one is slower and one is faster. How are we going tocapture that?Something else that is often talked about among buy-side players isinfrastructure. For example, suppose I want to process a large basket orderinvolving, say, 40 countries. I could place that huge basket with a singlecounterparty, or maybe a few. How efficient can these counterparties be ingetting the fills back to us? Should I instead hit a button and send an orderto a broker, and then have to wait for hours or days to get everything cleanedup? My choice between these two alternatives makes a difference. But thequality of the result, again, cannot be captured by prices alone.Nevertheless, it feeds into our considerations. If you do not get your fillsback in time, then you cannot re-optimize your position for the next trade.So, while it is not price related, it does feed into overall trading quality.Exhibit 23 presents an equation for a broker score that we assign to allof the counter parties whom we trade with.
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Exhibit 23
The score is a value-weighted measure. In this particular score, there is atotal of (capital) I trades included in the analysis. The first term in thenumerator on the right hand side is,the total value of a trade. It is alsothe weight associated with the trading quality that we are trying to quantify.The second term in the numerator,divided by the expectation of cantell you a lot. It is a large part of the iceberg and quantitatively describes thequality of the trade. We calleither total transaction costs, orimplementation shortfall. It is what we think, from the time we decide totrade (from the moment that we cut the list) to the time the entire order getscompleted. It could be one day or multiple days. Wayne Wagner couldundoubtedly provide more color on this. We have our own in-housemethodology to capture this for our own trading strategies.On the bottom of the fraction,is expected transaction costs. It isnot enough to measure the actual transaction cost of every individual trade.We also have to keep in mind that there are easy trades, and there aredifficult trades. It is not fair to compare a trade that cost us 10 basis pointswith a trade that cost us 100 basis points, and conclude that the broker thatgave us the 100 basis points trade failed. To make the comparison fair, we
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have to adjust for trade difficulty. That is where the expected transactioncosts enter. If, on expectation, it will cost us 100 basis points to trade andthe trade comes in at 80, the formula gives us a 20% improvement.We think about trading quality in this context. By going through thisprocess to choose a broker, we provide something above and beyond whatwe would expect to pay for completing the trade. In the case I justdescribed, it would be 20% of value added.Here is a different case. Suppose the expected transaction cost is 50basis points and that it came in at 60. Although 60 was lower than theprevious trade, in this case it is considered a 20% takeaway from the valuethat we should have captured.We weigh these various trading qualities by the value of each trade. Atthe end of the day, we have one trading score assigned to every broker thatwe have used. We do that over multiple days as well.In Exhibit 24, we traded with seventeen brokers over a two to threemonth period using the strategy that I just explained.
Exhibit 24
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The black bar is the execution score. You can see that, in this case,thirteen of the brokers were able to trade and provide value above andbeyond what we had expected to pay. There were four brokers, especiallynumber seventeen, who were way below our expectation. Ideally, you wantto see that the gray bar, – which is the allocation of the trade flow among thebrokers – roughly matches the black bar which represents each broker’sexecution score. In other words, more trades go to the top performers andfewer trades go to the bottom performers. That is what you want to see.Ananth, by the way, the gray bar has been scaled if you are wondering whythe numbers do not add up to a hundred percent. I want to make it easiervisually to compare the two bars. More trades go to the top performers andfewer trades go to the bottom performers.This highlights the difficulty of quantifying best execution. I do notthink that I can recall a single time (unless maybe by chance) that I havegotten what I showed you on the Exhibit 24. Instead what I often see isrepresented in Exhibit 25.
Exhibit 25
This is the same slide with the black bar, exactly as we had before, butlook at the distribution. You may ask, if broker 1 did such a good job, why
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didn’t we allocate more trades to broker number 1? Why did broker number6 get so much more? The question comes down to the fact that one size doesnot fit all. Especially given the trades that we do. There are large sizedtrades. There are small sized trades. There are listed trades, and OTCtrades. There are liquid names and illiquid names. Further, some of thebrokers are not actually brokers – they are ECNs. There are trades that wetend to, given the economic design of the trades and how they design theirtrading system, we just tend to send to them. For instance, B6 could be oneof those, or B1 could be one of those – it is an ECN trade. But we are notable to allocate more, given the nature of that trade and the reason we wantto trade it. We might be more patient and go through the upstairs market.This is one reason why it is so hard to line these two up.On that note, I will stop and hand the mike back to Ananth.MADHAVAN: Thank you, Minder. I will turn to our next buy-sidepanelist, Ted Aronson. Ted, do you use the same formula (laughter)?THEODORE ARONSON: Yes, but I have it memorized so I don’tneed any slides (laughter). Actually, we do use something similar. Like mycolleague Minder, we do attempt to score brokers on an annual basis. Andthere is a rotation. Those who do best move up in the rankings and get morebusiness. Those who don’t, eventually disappear.MADHAVAN: Let me ask you, Ted, to put on your other hat, that ofchairman of the AIMR Trade Management Guidelines Committee, BestExecution Task Force. Given your comments just now, and Minder’scomments, should we even be in the business, and should the SEC be in thebusiness, of mandating or prescribing any form of best execution obligation?It seems to me, when I look at Minder’s presentation, that a lot of thoughthas gone into getting best execution. There is a lot of measuring, a lot ofstructure already there. Perhaps these things go much beyond what theAIMR task force has recommended. Do we really need those guidelines?Do we need the government? Do we need AIMR to say anything about this?ARONSON: Wow, leave it to you to put a twist on a question. I havevery, very strong feelings about how transaction costs should be measured.But, as you know, when it came to the AIMR Trade ManagementGuidelines, the point of the effort was simply to try to measure what is goingon. It is very dangerous to make a sweeping statement in this auspiciouscrowd. But I will anyway. I believe in modern finance, the essence ofwhich is the quantitative measurement of what is going on. It is not perfect.It will never be perfect. But what the AIMR guidelines and the newstandards indicate is that there must be an effort to quantify the process.Why? Because the process seems to be taking a lot off the table for a lot ofinvestors.
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The guidelines do not specify how to measure transaction costs or how toquantify best execution. But, at least according to our sources at the SEC,they underscore that an effort had better be made.MADHAVAN: I want to follow-up quickly on that and then move on.Can you clarify for us. just where the SEC stands given the AIMR task forcerecommendations? Will the Commission’s recommendations be different?Will they second what has been done by the AIMR? Where do we stand onthat?ARONSON: It is my sense, and I suspect that most members of thetask force would agree, that this is a major focus of the SEC. Indeed, in thelast meeting of the task force, one of our members was undergoing an SECexamination when we were meeting. He was on the phone from his office.He could relate right from the front that notions and details of best executionwere one of the first lines of questioning that the SEC led with.MADHAVAN: Thanks, Ted.Natan, there seems to be a presumption among the panel (I will speak forWayne, I know him well) that best execution is something we can certainlyget a handle on measuring. How do you come down on that? Can we reallymeasure best execution, given the subtleties of the marketplace?Specifically, how do you measure best execution for stocks traded on theNYSE, given some of the debate that we have just had?