Goodbye BNY ESI. Hello BNY Securities. After spending the last five years building up its agency brokerage services, the Bank of New York is launching the finished product. The newly-christened BNY Securities Group boasts twelve divisions and 925 employees servicing money managers, plan sponsors and broker dealers around the world.
The BNY ESI moniker is scrapped. The decision to jettison the venerable ESI brand reflects the dramatic transformation of ESI & Co. since the bank bought it in 1997. From its roots as a 135-employee small-order electronic routing shop, ESI has blossomed into a full-service global player.
BNY Securities is now the country's fourth largest agency broker based on reported trades of listed securities. It trails only ITG, Bridge Trading and Instinet. BNY ranks 26th when matched up against all brokers, having traded 175 million shares in June, according to AutEx/BlockDATA.
The Game Plan
The new game plan is simple: Capture as many orders as possible by offering every type of agency execution possible. That means blocks and baskets — both domestic and foreign. Soft dollars. Commission recapture. Transition management. Electronic order routing. Direct access to a New York Stock Exchange floor broker. Direct access to Nasdaq through its partnership with Bloomberg TradeBook. Electronic matching of Nasdaq and listed stocks, also through Bloomberg. Clearing.
All its competitors offer some of these services. None offers all of them. Instinet comes closest, but lacks an independent floor broker. ITG is famous for its portfolio trades and electronic matching, but does not service plan sponsors. Bridge Trading is known for connectivity and blocks, but lacks plan sponsor capabilities and international trading.
Joe Velli, head of BNY Securities and a senior executive vice president of the bank, said "breadth" is what distinguishes BNY from the pack. "Our intention is to offer all the different models," he said. "So no matter how an asset manager trades we can accommodate him."
Velli cites the recent purchase of Big Board direct access broker Francis P. Maglio as evidence of the strategy. "I don't want to trade with an upstairs desk," he said, echoing the words of a hypothetical buyside trader. "I don't want to trade electronically. I don't want soft dollars. I want to go right down to the floor of the New York Stock Exchange and talk to a trader."
The idea of a one-stop shop was first bounced around the Bank of New York's boardroom about seven years ago. At the time, the bank was already a major supplier to Wall Street of such backoffice services as custody, stock loan and fixed income clearing. The progression up the food chain of securities processing was considered a natural extension of those lines.
The bank, considered a "fee-based" bank by analysts, is grouped with such institutions as State Street, Mellon and Northern Trust. All derive the bulk of the revenues from fees for servicing Wall Street's backoffice needs. Interest income plays a lesser role. The Bank of New York has $80 billion in assets, making it the 16th largest U.S. bank.
Bank of New York management would not disclose how much it has invested in its brokerage group over the years nor the division's revenues. ESI's numbers are buried in the $1.75 billion of "securities servicing fees" the bank booked last year. Velli claims BNY Securities is larger than ITG, however, which grossed about $375 million last year.
Twin Foundations
The twin foundations of BNY Securities – trading and clearing – were laid in 1997 and 1998 when the bank bought ESI & Co. and Everen Clearing, respectively. Over the next few years it bought a slew of clearing firms and small, specialized trading shops. This year the bank has reached for its wallet three times. It bought rival agency brokerage Autranet, the international basket trading firm G-Trade Services and Francis P. Maglio.
All told, Velli and his No. 2, Ralph Mastrangelo, deputy head of BNY Securities and an EVP at the bank, have overseen the acquisitions of 11 trading firms. They have also made five high-profile hires during the past five years.
Carey Pack was one of those hires. Pack joined BNY ESI in 1999 from Salomon Smith Barney after building the big broker's clearing division. He ran sales for two years before replacing ESI founder Steve Shloss as president. Shloss became chairman.
Pack heads up the largest unit within BNY Securities, BNY Brokerage. He oversees five divisions including the firm's core trading operation, Institutional Trading Services. Beefed up considerably by the merger with Autranet, ITS boasts 60 traders including a handful trading Nasdaq stocks.
The acquisition of Autranet clearly marked a turning point for BNY and was a large factor in the decision to rebrand. While both brokers were mid-sized, ranking in the mid-40s of the AutEx/BlockDATA hierarchy, they were perceived differently by the market.
BNY ESI was considered a small-order router. It had built up considerable block trading capacity in recent years, but was best known for the connectivity business it pioneered in the 1970s.
Routing Orders
Execution Services, Inc. was founded in 1976 to enable the buyside to electronically process small "nuisance" trades. The broker began by routing orders to the New York Stock Exchange and expanded as the number of electronic sources and endpoints grew. Today, its electronically routed orders average between 5,000 and 10,000 shares.
Autranet was known for blocks. It was one of the pioneering agency brokers in soft dollars, a trading service that allows the buyside to finance its purchases of independent research and market data.
Despite the fact both Autranet and ESI reported trading one billion shares last year, Pack maintains ESI was the bigger of the two. "At the time of the merger, [ESI's] trading business was larger than Autranet's," he said. "And yet many customers still perceived ESI as small orders. Ten years ago that was probably true. But the scope of ESI has changed so much."
Pack adds that Autranet was only one-third the size of BNY ESI, but its soft dollar business was larger. "ESI had a broader mix of business, both execution-only and soft dollars," he said. "Nowadays we are probably the dominant soft dollar provider." Most of ESI's block trading was done purely for execution. Any soft dollar trades were related to the electronic business.
"[Autranet's] focus was to be a soft dollar broker and our focus was to be an agency broker that provided soft dollar services," explained Jeanne Murtaugh, a strategic adviser to the bank and a long-time ESI executive. "However subtle, that was clearly the difference."
Most agency brokers are players in soft dollars because they typically don't offer in-house research. They are execution-only shops. They can "offer" third-party research though. A money manager investing on the basis of an independent report can trade through the agency broker. The broker will then rebate a portion of the commission to the research vendor. That portion is considered "soft."
Typically, brokers and their buyside customers work out in advance how much trading must be done to finance the purchase of the research or market data. The total amount of the commission is based on some percentage of the cost of the service. Current ratios average about 1.4-to-1. That means a buyside desk will do $700,000 in commissions with a particular broker to pay for $500,000 worth of research or market data. The broker pays the vendor's bill and books the $200,000 difference as revenue.
Trading for soft dollars, originally the province of agency brokers, has become very competitive in the past few years and the service is now considered a commodity. Most of the major full service brokerages now offer the service. Even Goldman Sachs and Morgan Stanley trade for soft dollars. The pair refused the business for many years, complaining loudly in Washington that the practice was corrupting the system.
Budge Bracket
The entree of the bulge bracket into soft dollars has put considerable downward pressure on ratios. From between 1.6-to-1 and 2-to-1 only three years ago, ratios have dropped to about 1.4-to-1. The declines mean institutions are able to save, in effect, thousands of dollars in commissions.
In light of these economics, observers say the decision by Autranet to partner with BNY is a smart one. "Goldman and Morgan are not out there aggressively marketing themselves as soft dollar providers," said Dave Brooks, head trader at Boston Company Asset Management. "But people are beginning to utilize them. Firms like ESI and Autranet need more critical mass to compete."
Brooks adds he is consolidating more of his soft dollar business with the bigger brokers because of the flexibility they offer. He can start a trade for soft dollars, for example, then change his mind if market conditions warrant and request capital. He cannot do that with a soft dollar-providing agency broker because it will not risk capital.
Morgan Stanley's about-face had further repercussions for BNY. When the holdout started in soft dollars last year it poached top BNY ESI executive and long-time soft dollar expert Glenn Firestone to run the business.
BNY's response to this incursion by the big boys onto agency turf is to hedge its bets. Last year, it bought Westminster Research Associates, a broker dealer that offers administrative services to buyside desks trading soft dollars with full-service brokers. So now, when it can't beat 'em, it'll join 'em.
Westminster effectively replaces the vendor in the soft dollar equation. Instead of asking Merrill to pay Bloomberg, for example, the buyside trader instructs Merrill to pay Westminster. Westminster pays Bloomberg.
This arrangement is intended to help the buyside in two ways. Firstly, it reduces their administrative burden. Buyside desks typically use several different brokers often to pay hundreds of different vendors. That's a lot of paperwork.
Secondly, it eliminates the broker-vendor relationship. That frees the buyside trader to conduct his soft dollar trades anywhere. Rather than trade with Merrill to pay for a Bloomberg terminal, for example, and Goldman to pay for an Eze Castle order management system and Lehman to pay for its Lebhar-Friedman research, the trader can do all of these trades with Credit Suisse First Boston.
Best Execution
"This is really important from a best execution standpoint," said John Meserve, president of Westminster.
Westminster profits from two sources: a piece of the commission and a fee from the buyside. The broker dealer was established in 1993 by a pair of ex-Lehman execs and has a staff of 13. It maintains a network of all the top full-service brokerages and conducts business with all of the largest buyside firms, according to Meserve. There are no agency brokers in the network.
Annual Budget
Soft dollar trading is based on the premise that the buyside doesn't have the cold cash to pay for all the services it needs. It must rely on its annual budget of commission dollars to obtain independent research and market data. Soft dollar trading allows the buyside to fund its purchases of independent research and market data with commissions rather than pay for them outright. Brokers keen on grabbing as much of that budget as possible must be willing to split some of the dollars with third parties. If not, the trade will go elsewhere.
The story is the same with commission recapture, a trading service BNY is targeting. Commission recapture involves rebating a portion of the commission back to the money manager's client, the plan sponsor. A pension plan, for example, will instruct its money manager to conduct certain trades with certain brokers. The brokers then split the commissions with the plan.
Prominent commission recapture brokers include the Lynch, Jones & Ryan unit of of Instinet, BIS, Donaldson & Co., Citation, SEI Investments, Abel Noser and Frank Russell Securities. BNY entered the fray with its acquisitions of two small brokers, Alpha Management and Institutional Securities Trading, in 1998 and 1999, respectively. Both were divisions of pension consultants.
Adding commission recapture was all part of BNY's strategy to capture the trade regardless of the institution's commission restrictions. "That's how we want to position ourselves," Pack said. "We tell the managers: we can handle all of your commission requirements – execution-only, soft dollars, commission recapture. We can solve all of these.'"
In addition to the rebate processing duties required of commission recapture, a broker must also manage a trading network. It must give plan sponsors a choice of where to execute. It cannot expect to handle 100 percent of the business. BNY manages a network of 14 broker dealers.
Still, it expects to handle most trades itself. "We don't want to constrain the manager," Pack said. "But, we think, because he has an existing relationship with us, he'll want to do the business with us. And that has been the pattern."
Pack says BNY's trading desk executes about half of the trades facilitated through BNY Plan Services, the division that works with plan sponsors.
Plan Sponsors
BNY isn't stopping at commission recapture as far as plan sponsors are concerned. It has also thrown its hat into the transition management ring. As with commission recapture, Alpha Management was the vehicle.
A transition is said to occur when a plan sponsor liquidates one portfolio and builds another with a different money manager. The often complex process is increasingly handled by an intermediary. By hiring a professional, the plan expects to save on both explicit and implicit trading costs.
Traditionally, a plan switching money managers instructs the old manager to close out all positions and transfer cash to a custodian. The custodian then moves the money to the new manager. The new manager then builds a new portfolio. The plan pays commissions (explicit costs) at both ends and risks market impact (implicit costs) at both ends.
In the past few years, a group of "transition managers" has stepped into the middle of this process pledging to smooth it out. Prominent among them are Deutsche Bank, Barclays Global Investors, State Street Global Markets, Frank Russell Securities and Morgan Stanley.
All five are colossal program traders. BGI and State Street are the world's largest managers of index funds. Morgan Stanley and Deutsche Bank are two of the biggest program traders at the NYSE.
Basket Trades
Their modus operandi is to cross as much of a plan sponsor's outgoing and incoming portfolios in-house against their basket trades. That way they avoid taking the trade to the market. Commissions are small and market impact is zilch. Plan sponsors have been known to save millions of dollars on large transitions.
BNY is not a colossal program trader, but does process baskets on an agency basis. At the time BNY purchased Alpha in 1998 it was also building up its portfolio trading capabilities. It had hired well-regarded buyside quant Fred Graboyes to establish the practice.
Three years later, in October 2001, Graboyes was picked to run BNY Global Transition Management which was being spun out from the quant desk. Simultaneously, Alpha's San Francisco operation was being shut down and moved to New York.
The assignment was short-lived. Graboyes left BNY this January to run a start-up agency brokerage. He was replaced by Lisa Manuele, the former president of Global Execution Network Associates (GENA), a non-dollar basket trading shop acquired by BNY in 2000.
Despite the shaky start, Pack says transition management is on track. "We realize we're relatively new," he said. "But we're trying to build it in terms of market presence and capability as fast as we can. We want to be one of the leaders in this business."
That could be difficult considering the strengths of BNY's competitors. Pack counters that BNY does have a healthy stream of order flow crossing its desk with which to cross against.
He adds, though, that there are other costs to consider besides market impact. Opportunity costs, for example, can't be eliminated by crossing. "We stress our trading and our administrative expertise," he said.
Pack concedes though that BNY will seek out a blind principal bid on an anonymous basis if warranted. That means trading with a big shop such as Deutsche Bank or Morgan Stanley, of course. Such blind bidding' is not uncommon in the portfolio-trading world. An institution seeking to avoid market impact will often pay up to a broker such as Deutsche bank to take a portfolio off its hands.
BNY Securities does have one natural advantage, according to Pack, that most of its competitors do not. The Bank of New York is one of the largest custodians on the Street. It may be holding a plan's securities already. "We think the bank's custody base is a natural source of business for us," Pack said.
The value of that franchise is somewhat questionable, though, as Deutsche Bank is shopping its U.S. custody business. The likely buyer? State Street. State Street would become the largest custodian in the U.S.
Although the competitive landscape of transition management appears daunting, not jumping into the game could prove much riskier-at least in the long run. The more plan sponsors opt to use transition managers, the fewer orders their agents, the money managers, will have to direct to the everyday' basket traders. If BNY doesn't solicit transition trades, it will lose them.
A similar dynamic is beginning to play itself out with direct access. As transition managers grab order flow once destined for plain vanilla portfolio desks, Big Board floor brokers are reaching out for trades once destined for the block desk.
Officially designated direct access brokers such as Richard A. Rosenblatt, Institutional Direct, Francis P. Maglio and others are calling on buyside desks almost daily. Once fearful of alienating their traditional sellside customers, former two-dollar brokers now boldly advertise their trading expertise direct to the buyside.
Ustairs Desk
BNY bought Maglio lest it allow those trades to slip away. "I can see a shift in volume," Velli said. "Some of that which now goes to our upstairs desk is going to the floor." Velli tells of a Midwest fund manager that has boosted its trading with independents from 10 percent to 30 percent.
Still, the move by BNY is almost unprecedented. Very few brokerages with upstairs trading operations own independent floor brokers. They simply aren't eager to cannibalize their upstairs business. Among the exceptions are Jefferies & Co., Bear Stearns and SunGard Institutional Brokerage
The newly-christened BNY Direct Execution will operate independently from BNY Brokerage's upstairs desk. There will be no contact between the traders of the two operations. There will be no sharing of information. The profits remain in the BNY family, of course, but the new service is likely to eat into a portion of BNY's upstairs business. The issue is a sensitive one. Bonuses on the desk could end up smaller next year.
Chinese Wall
BNY's pledge to build a Chinese wall between the two groups notwithstanding, buyside traders are naturally suspicious of such arrangements. Using an independent floor broker is a way for them to minimize the leakage of information inherent in their large trades. They don't want to find out that their so-called "independent floor broker" is actually passing trade details upstairs to a sister desk.
That actually happened a few years ago. A bulge bracket outfit bought a floor broker and claimed it was independent. Traders soon realized though that information imparted to the floor was quickly going upstairs.
Pack says that scenario is not plausible at BNY. "With the full-service brokers, the whole bias is to run everything through the upstairs. That's how they glean their information," he explained. "We are an agent. We don't have a whole lot of use for that information."
Maybe. But in a study released earlier this year on trading costs authors Robert Schwartz, a professor of finance at Baruch's Zicklin School of Business, and Benn Steil, a senior fellow at the Council on Foreign Relations, stated that agency brokers frequently alert one client to the trading activities of another in order to win their business.
Whatever the case, BNY executives stress that direct access will likely remain a small portion of the firm's overall activities. The buyside typically does not push a lot of its order flow through direct access brokers and BNY does not plan to over promote the service.
Mastrangelo notes the orders are usually large ones that need special attention. "You're not going to do 300 orders with that broker that day," Mastrangelo said. "You're going to have a couple of orders that really count."
Trading Conditions
BNY bought Maglio just five months ago, its fifteenth acquisition of a broker dealer in the past five years. Given the dismal trading conditions some have questioned its appetite for more Wall Street exposure. Investors have slammed its stock as well as those of its Street-reliant peers. BONY is now trading at $27, half its high for the year.
One analyst is comfortable with the bank's buying spree though. "By positioning itself now in this awful market," said RBC Capital Markets bank analyst Girard Cassidy, "it will reap the rewards of the investment when the market turns around. This bear market will end. It's just a question of when."
