The drive to integrate direct access trading technologies into institutional markets is heating up, but software developers are finding themselves fighting battles on two fronts.
On one side, firms like Sonic Trading, UNX, and Blackwood Trading must convince hedge funds and other institutional traders that direct access tools can work effectively on buyside trading desks. They must convince institutional clients that these tools will help them as much as they have day traders and other retail clients. Then there's the bigger problem: Convincing institutional traders that direct access vendors have their best interests at heart. Can these vendors change their stripes after working with day traders, the nemesis of the institutional community?
"It's like convincing the lion to lie down with the zebra, after the zebra's been stealing the lion's food for a long time,"said Randy Abernethy, chief executive of UNX, a Burbank, Calif.-based broker dealer that has created its own direct access trading platform for institutional markets. "It's a big challenge for the direct access companies."
So what's the big deal? Direct access vendors have made inroads into the institutional community and are not shy of marketing. True, but the early results are mixed.
"I'm hearing reports from traders that the systems are crashing. The technology is not robust enough to handle the institutional order flow," said one Wall Street insider. That does not surprise everyone.
"All the systems crash from time to time," agreed J. Mark Enriquez, president of Boston-based PulseTrading, a trading firm that specializes in routing and executing orders across the spectrum of Nasdaq market centers. "Archipelago went down this morning. Yesterday it was RediBook. Tomorrow it could be another system."
At issue, is the increasing spotlight on "direct access" trading, a term which refers to the bypassing of intermediaries on both the Nasdaq and listed markets.
On Nasdaq, it means hitting bids and lifting offers via ECNs and with the help of outfits such as quote aggregator' Lava Trading (its ColorBook' system shows all the limit orders and all the quotes on most large ECNs and Nasdaq), as well as smart routing' vendors. On the listed markets, it means bypassing the upstairs trading rooms, sending orders electronically to $2 brokers, or to the specialists. The technology means DOT' boxes used by traders to route their orders to the NYSE floor.
Direct access also means systems such as Harborside and Liquidnet, each in their own distinct way bringing buyside customers together on both sides of a trade.
Direct access vendors have much at stake. Since decimals were introduced, direct access vendors – seeing their profits squeezed – have had to cultivate new business among institutional accounts.
The campaign has critics. "The hype of direct access trading hasn't met the realities of the institutional trader," said Fritz McCormick, an analyst who studies direct access technology at Boston-based Celent Communications. "Sure, the technology enables you to execute trades, but for the institutions, is that enough?" The answer, says McCormick, is no. "The systems we're seeing aren't really fully functioning, and often don't include things market makers want, like reserve orders and advance pegging technologies. So traders view them as inefficient from a technology standpoint," he said.
Vendors Confess
Even the direct access vendors admit there are problems moving from the retail side to the institutional side. "We're also hearing that institutions are not too happy about the direct access offerings they're seeing," said Joseph Cammarata, founder of New York-based direct access vendor Sonic Trading. "This all started with day trading firms that accommodated the guy who did 100 small trades a day, which is fine. Once these firms started to see day traders disappearing they went to the institutions – but the institutions weren't buying it."
Cammarata adds that institutional traders won't tolerate some of the problems day traders may accept, like delays, lags and software bugs. "They won't touch the stuff," he said. "They read the newspapers and see the Schwabs' and E*Trades' crashing." Even if the institution will test the waters, Cammarata adds that it's a big investment – and maybe a bigger risk. "Traders want compliance, Web reporting, backoffice integration and risk management built into a direct access trading package. But traders think direct access vendors can't dependably provide these features."
Still, the technology is impressive enough to encourage some institutional traders to consider it. "We are hearing some positive things," said John Wally' Sullivan, managing director at Pulse Trading "You do see direct access firms like Lava and Blackwood Trading making headway. There is a lot to swallow for the buyside guys, but the more familiar the buyside becomes with the technology, the more amenable it will become in using the technology."
It's hard to make a case that direct access doesn't have some kind of a future with institutions. With 40 percent of all order flow – both listed and Nasdaq – handled electronically today, it could rise to as much as 75 percent in two years, according to Celent. In fact, 35 percent of trades executed on Nasdaq in 2000 were through direct access systems, mostly placed by self-directed and active traders.
In a report, "Direct Access: Taking Center Stage," Celent's McCormick writes that, "increasingly, direct-access technology is finding its way into the hands of asset managers, hedge funds and others looking to cut transactions and operational costs and keep a high level of control in their portfolio."
Obtaining lower costs and more control means a direct access vendor must think like an institutional trader. "We're a broker dealer first and I think that helps," said UNX's Abernethy. "Institutions have complicated service needs. They often need someone who does more than just deliver technology." Abernethy says his firm is called upon to step in and help execute orders when trading clients are overloaded. "We're often asked to handle allocation and pricing, too. Most direct access vendors aren't equipped to do that."
Bad Feelings
A big concern for direct access companies is the lion and the zebra issue.' For years direct access was designed to help day traders, the large asset manager's arch enemy, Abernethy said. "They make their living taking advantage of moves made by large asset managers. When someone sees a manager running one million shares you know the day trader is right behind and will skim profits off the top. And there's nothing asset managers can do."
That creates bad feelings with institutions. "Some traders want nothing to do with the people who helped the day traders," Abernethy added.
Still, what institution would reject better controls over prices and executions? "As long as direct access trading includes those elements," Cammarata said, "along with some other services like fast order execution, risk management, direct connectivity to each ECN, and compliance, people are going to have to consider the technology."
Cammarata said Sonic is introducing those features. In February, it unveiled a direct access trading package geared toward institutions that includes everything but the kitchen sink.
The platform combines basket trading, smart order routing, built-in risk management tools, Web-based trade data reporting, a FIX API connection and trade desk support in one platform. It also includes index arbitrage and pairs trading, hot-keys, point and click execution, order management, average buy and sell price calculations, order status, ECN outbound routing, and multiple account trade allocation.
To ease institution's concerns that direct access front ends may have problems integrating with a big trading firm's middle- and backends, Sonic designed the software to completely integrate existing buy- and sell-side order management solutions.
With the company's FIX API, clients can integrate front-end technology with Sonic's backend. Sonic also provides a service bureau offering. That allows clients to access the exchanges through Sonic's high-speed connections without requiring additional hardware and equipment purchases.
Liquidity Sources
The direct access vendor is also providing customers with a direct connection to all liquidity sources, including most of the ECNs, enabling traders to simultaneously view activity from multiple ECNs and market makers. "And we'll base it all on a customer's needs," Cammarata added.
Perhaps that kind of comprehensive approach will win the confidence of the big firms. "There is a lot of skepticism out there," said McCormick at Celent, "but the direct access technology has great potential."
with staff reports
