A key trading cost will rise next year, but securities industry officials fear that in 2012 the business will be hit with a much bigger one.
The Section 31 securities transaction tax is now scheduled to rise next year from the current $16.90 per million dollars to $19.20 per million, according to the Securities and Exchange Commission. It relies on the fee to pay for the costs of regulating the trading industry.
The 13.6 percent increase in Section 31 fees will go into effect 30 days after the SEC’s 2011 budget is adopted. Still, there is a larger issue looming, says a trading industry official.
"In 2012, it is quite unclear how things are going to be handled," according to David Franasiak, a lobbyist for the Security Traders Association. He warns that, potentially, the Section 31 fees could "double or triple" in 2012, as the SEC takes on more duties and more staff.
"If these costs go up enough, it is inevitable that some of them will have to be passed on to the investor," said one trading executive who declined to be identified.
An SEC official declined comment.
The Section 31 rate is based on market volume under the Investor and Capital Markets Fee Relief Act of 2002. That’s legislation the trading industry lobbied for to keep these fees from becoming excessive and a profit center for the government. Before the Fee Relief Act, the Section 31 fee was as high as $33 per million dollars of trades and was generating profits for the government.
The fee rate is set twice a year. Since the Fee Relief Act became law, the rate has been dropped nine times and raised seven times, including the projected rate for early next year.
The Act, in re-directing how the transaction fee would be set, called on regulators to "consider the economic benefits flowing to investors from fee reductions to include such factors as market efficiency, expansion of investment opportunities, and enhanced liquidity and capital formation." The 2002 legislation also said the SEC would now be "self-funded."
That’s the way it has worked over the last eight years. So when trading volumes are strong, the fee could be dropped. When they decline, the fee must be raised. Market volume has been down for most of this year, noted another STA official, so a rate increase was expected in 2011.
"Many of our members had been expecting that," said John Giesea, president and CEO of the STA. However, the system of limiting fee increases could radically change after next year, according to Franasiak, the lobbyist.
Given the new SEC’s numerous new responsibilities as a result of the massive financial industry regulatory reforms brought by Dodd-Frank, Franasiak warns that Section 31 fees could rise much more in 2012.
"With all these increased costs, they’re going to go to the same pool of contributors, who are people who invest in the equity markets. I think it’s unfair," according to Franasiak. If current trends continue, he says a Section 31 rate of $33 per million is possible in the next few years.
Jamil Nazarali, senior managing director and global head of the electronic trading group at Knight, spoke with Traders Magazine recently about several issues affecting equity trading. Among the topics discussed were the "flash crash," transparency in order routing and the role of market makers.
Traders Magazine: What trends have you seen in the area of algorithmic trading since the May 6 flash crash? Jamil Nazarali: One development [we’re seeing] in algorithms is the incorporation of risk protections. This would be to help prevent another May 6, where something that in most situations performs fairly well could perform poorly in extreme situations. No one wants his algorithm to be the next algo that causes a market disruption. Everyone should have in place on their algorithms either a price limit or, under severe market situations, some kind of pause mechanism to kick the algo back to the sender.
This is related to the Securities and Exchange Commission recently passing the sponsored-access rules-you can’t send an order straight to floor using someone else’s MPID-which was considered "naked access." It seems to me, if you are allowing a firm to use your algos to access the market, then just like the sponsored-access firm that now has to incorporate risk checks, you should also be responsible for the risk checks. Whether they are using your algos or your lines, it’s really the same-you’ll have to be responsible for putting in risk-check mechanisms.
TM: And away from risk controls? Nazarali: More algorithms are encompassing other asset classes beyond cash and options, and in a more seamless way. They’ve also improved their global capabilities, simultaneously executing trades in both the U.S. and in foreign markets. For example, [you can use] one algorithm to buy a technology stock in the U.S. and sell a U.K. banking stock. But there are still a host of different clearing and custody issues to contend with.
TM: Do you feel market makers should have stricter market-making obligations? Nazarali: We think the current regulatory framework in the U.S is very comprehensive. However, if the SEC believes additional regulations are required, then we support the proposed market-maker obligations. I think market makers provide an important intermediary function in the marketplace. But over the last five to 10 years, high-frequency traders and other players in the market who don’t have the same requirements and obligations have taken a much more prominent role in the market.
Right now, there are a lot of people who call themselves market makers, and they don’t really do anything other than put out a two-sided quote, which anyone can do. But at the same time, they’re able to get affirmative determination, which means they don’t have to locate a stock before they short it. What we’re advocating or saying is, "Look, it should mean something to be a market maker." It should mean something more than putting out a two-sided quote, which until recently, meant you could put something in at a penny by 10,000. Now, at least, it means something more.
TM: What would you like to see as criteria for market makers? Nazarali: We put out a letter to the SEC that talks about requirements like percentage of time at the inside and depth within the national best bid and offer. We think these things would be helpful to the marketplace. But at the same time, market makers should get some relief to allow us to perform our duties a little bit better.
For example, there are many situations where there is retail-buying interest in a stock on the Reg SHO list. Unfortunately, because we can’t short the stock, the buy must be sent to the market-and that hurts the retail investor because he ends up buying at a higher price. Were we able to provide an intermediary function, then we could short the stock, sell them the shares and then have some time to cover that short.
TM: Should HFTs be required to register as market makers? Nazarali: I do not think they should be required to register. But I do think if they do register as market makers, they should be bound by the same requirements, and if they do not register, they should locate stock before they borrow it, as only market makers are exempt from this requirement. I think it should mean something to be a market maker. But again, there is no reason they should be required.
TM: Why? Nazarali: High-frequency is just a different business model. If they just want to be in the marketplace and trade, they shouldn’t be restricted from doing just that. I think they provide a valuable function to the market-like providing liquidity-and I think that is good. I think if they are not going to avail themselves to any of the benefits of being a market maker, then they shouldn’t have to become market makers.
The marketplace is really competitive, and we’re not looking to reduce the competition or innovation at all and force people into certain buckets. However, we do think there is a role to be played by market makers, and the SEC is considering that.
TM: Then what is the real role of the market maker? Nazarali: The real role of the market maker is to primarily facilitate trading, make orderly markets and provide liquidity in the marketplace to the best of its ability. On May 6, there was no one who had enough liquidity to be buying from every seller. And so I don’t think you can mandate someone to be there all the time. However, I think you can provide incentives to be in the market more. Incentives could be in rebate form, or relief around short sales.
TM: Can you give an example? Nazarali: I think one example is the NYSE’s DMM and SLP program-where they said, "We’ll provide economic incentives to be at the inside. And if you are a supplemental liquidity provider and come on our platform at the inside at ‘x’ percentage of the time, we’ll give you an enhanced rebate." And guess what happened? Lots of people came on their platform, and they started adding a lot of liquidity, and that resulted in an increase in NYSE market share. If you provide those types of incentives, people will respond to them and the market will be better off.
TM: The SEC has voiced concern over dark pool trading and internalization. How do you view their concern? Opponents say internalization hurts public price discovery. Do you agree? Nazarali: The short answer is no. But it’s right to ask that question. Are we at a place where the amount of trading off exchanges has impeded the price-discovery process? But some of these questions are being raised by certain business models worried about losing market share. It’s a very competitive market, and investors have benefited from that competition. In the U.S., there is a lot more stock traded off exchange than any other market.
Yet the last five years, when dark liquidity and dark trading developed, has been a period of extraordinary robustness in the marketplace. Whether you’re looking at things like tighter average spread, higher volume at the inside, lower explicit commissions for retail and institutional trading, lower average market impact-by almost any measure you use, investors are trading better, faster and cheaper now than they were five years ago. The data support the fact that competition has been good. I’m concerned certain players, whose business models have been hurt by competition, could use the regulatory process to stymie that competition.
TM: Do you see internalization growing in 2011 from the current level of 30 percent? Or what about growth in dark pools’ share of that percentage? It is now around 12 percent. Nazarali: I see them growing a little, yes. I don’t see the explosive growth we’ve seen over the last few years, though. Broadly, I think the overall rate could grow to 33 percent from 30 percent, and that’s assuming no major regulatory burdens or changes. The dark pool percentage will drive most of that growth, moving within the 12 to 15 percent range.
TM: How do you address the buyside’s concerns about transparency on how their orders are being routed? Nazarali: The buyside should certainly have the ability to understand better how their orders are being routed by their sellside brokers. They should be able to say both, "Tell me where you are sending my order," and at the same time, "Don’t publish to others what’s being done with my order."
TM: What do think about the amount of message traffic going through the system? What should be done about it? The SEC has floated a minimum quote time idea. Or do you think there should there be a fee for excess cancellations? Nazarali: It seems that a handful of firms are generating a large amount of message traffic, and all firms are incurring the cost of parsing this traffic. So, you have this breakdown in economic efficiency because you’re creating costs others have to bear.
TM: So what do you do? Nazarali: There are a few things you can do. If this is a cost issue, then you can try and internalize those costs, so that when you develop a new strategy you take these costs into account. However, you should be careful to charge only what the "true" costs are to the system. You also have to make sure you credit the firm for the "benefit" to the system of the additional quote, since the quote adds liquidity and therefore benefits everyone in the market.
You could also charge for cancels. You can charge for excess message traffic. But, it’s very risky to put something like caps on message traffic and cancellation rates, or implement minimum quote duration. These things, I think, will lead to a number of unintended consequences. It’s also risky to charge more than the cost you create for the entire market. Rather, regulators can continue to go after firms that engaged in illicit activities, such as quote stuffing. I think that’s something they should do. You could do things like in options, where you don’t update quotes at the inside as often. You could only update if the price changes, not the size. However, I do think a lot of this is a smoke screen for people looking to go after high-frequency trading.
TM: BATS’s new exchange is going to reward liquidity takers (3 cents per 100 shares). Would that encourage you to send order flow to BATS, or send more? Nazarali: We’ll do whatever is in the best interest of our clients and shareholders. If there is a very attractive rebate out there, then we prioritize accordingly.
Incoming House Majority Leader Eric Cantor stirred up a fair amount of controversy lately by speaking in favor of, or at least not dismissing out of hand, a plan by the Virginia legislature to amend the U.S. Constitution to provide that a two-thirds vote of the states could overturn any duly enacted federal law. Virginia’s proposal is reminiscent of the “nullification doctrine” advanced by Senator John C.Calhoun of South Carolina in the 1820s.
Most lawyers, and I am no exception, are fascinated by Constitutional law issues. Unfortunately, the issues raised by the nullification doctrine were not resolved in court. South Carolina did, in fact, vote to “nullify” the Tariff Act of 1828, eventually causing Congress in 1832 to authorize President Jackson to take military action against the State. Cooler heads prevailed before bullets started to fly, rendering military action at that time unnecessary. However, the doctrine remained popular in Southern circles and was only finally put to rest by the Civil War. The unfortunate reality is that, rather than providing an opportunity for interesting legal employment, fundamental Constitutional issues have a nasty way of being resolved by bloodshed.
The thrust of the nullification doctrine, in either its ancient or its latest regurgitated form, is to grant more power to the States, as compared to the federal government. In recent years, federal securities laws have tended to move in the opposite direction. The trend has been to put more responsibility for fighting fraudulent practices involving securities in the hands of the states. Interestingly, the states don’t seem eager to have this power.
Most recently, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) removes from Securities and Exchange Commission (SEC) registration any investment adviser that manages less than $100 million in assets, provided that the adviser is regulated by its home State. This move continues the trend that began with The National Securities Markets Improvements Act of 1996 (NSMIA), which removed investment advisers of less than $25 million in assets completely from the SEC registration scheme. On November 19, 2010, the SEC proposed new rules that would implement the investment adviser registration division of labor enacted by Dodd-Frank.
Under the new rules, (1) if an investment adviser has assets under management between $25 million and $100 million and (2) the State in which the investment adviser maintains its principal office and place of business requires it to register and (3) the adviser is subject to examination by the state securities commissioner (or similar official), then the adviser must register with the State and is prohibited from registering with the SEC. Unless all three elements are satisfied, the investment adviser is required to register with the SEC.
It is worth noting that Dodd-Frank differs from NSMIA in the way it deals with the dividing line between Federal and State authority. Under NSMIA, investment advisers managing less than $25 million in assets are exempt from SEC registration, whether or not their home State actually chooses to regulate them. As it happens, every State except Wyoming has a registration scheme for investment advisers.
However, state registration laws also contain many exemptions; so many registered advisers with assets under $25 million are completely exempt from registration anywhere. Advisers with assets greater than $25 million may also be exempt under State registration statutes, but Dodd-Frank would then require them to register with the SEC. Most States have adopted some version of the Uniform State Securities Act (1956), which exempts from registration investment advisers whose clients are limited to institutional clients or employee benefit plans with assets greater than one million dollars. Some states define institutional clients quite broadly. Advisers who qualify for one of those state exemptions would have to register with the SEC.
In addition, to qualify for federal exemption, Dodd-Frank requires not only that a State register an investment adviser, but also that the investment adviser be subject to an examination program. According to a comment submitted by the North American Securities Administrators Association (NAASA), 47 states maintain an examination program for investment advisers that includes routine examinations. 89 percent of routine examinations are performed on a one-to six-year exam schedule.
However, there are some notable absences when it comes to investment adviser examinations. New York, for example, does not have an examination program, so unless it establishes a new program, New York advisers with assets between $25 and $100 million will remain subject to SEC registration. New Mexico has one person who is responsible for all things investment adviser, and doesn’t welcome the addition of a substantial number of new customers. Connecticut has loudly objected to the new rules, on the grounds that increasing its regulatory responsibility would impose a significant burden on its already stretched resources. State programs are being abolished and curtailed everywhere due to budgetary concerns. Notwithstanding NAASA’s optimistic comment to the SEC, taking responsibility for a large number of investment advisers is unlikely to be met with applause by any State’s legislators, including Virginia’s.
The SEC, for its part, does not intend to determine whether any State’s investment adviser examination program is adequate or effective. Instead, the SEC will simply ask the State in writing whether or not it has an examination program that would satisfy Dodd-Frank. If it responds affirmatively, the case is closed. Offloading a substantial number of registrants into inadequately funded or ineffectual state programs seems like a recipe for fraud; but any state that objects to the influx of new registrants need only eliminate its examination program! That will keep out the new state registrants, but will allow the under-$25-million advisers to remain free from examination oversight.
The SEC’s new rules do provide a helpful uniform way to calculate the amount of assets under management.
U.S. securities laws have always been a shared responsibility of Federal and State governments. The reason for this is primarily historical. The States were plagued with episodes of securities fraud in the 1920s and enacted “blue sky” laws to protect their citizens. These laws became the basis of the Securities Act of 1933. The only exception, and a very important one, is the Securities Exchange Act of 1934, which is exclusively a matter of Federal jurisdiction. The markets belong entirely to the SEC.
Dodd-Frank’s division of authority dovetails nicely with European regulation. The recent Alternative Investment Fund Manager Directive generally would provide European-wide regulation for investment advisers who manage more than 100 million euros in assets, while leaving all others in the hands of national regulation.
The fact is that national and state governments are happy to collect registration fees from investment advisers. Examination programs, on the other hand, are expensive. Smaller advisers present particularly difficult examination issues because they often lack the resources to employ dedicated compliance personnel and maintain expensive compliance programs. This lack of resources renders the work of State examiners tedious, time-consuming and frustrating. For the same reason, it is difficult to assess industry fees sufficient to maintain examination programs for this sector. State Securities Commissions suffer chronic underfunding issues.
It is also difficult to argue that Dodd-Frank’s division of labor is a devolution of local issues to local authorities. The Investment Advisers Act already contains an exemption for advisers whose clients are located only in one State. The fact is that in this era of globalization, many investment advisers with offices in say, Connecticut, largely serve investors in other states. Visits from clients are rare events. As a result, decisions about where to locate an investment advisory office tend to be dictated by the convenience of an adviser’s portfolio managers, rather than the location of its clients. This means that a State’s scarce investor protection resources will often be allocated to protecting another State’s investors.
Entire libraries have been devoted to the concepts of federalism and the related nullification and States’ rights theories that underpin our Constitutional system. I doubt very much that anyone thinks a valid reason for the system is to skim the cream into the Federal system and relegate the expensive small problems to State authorities.
In principle, authority should be a triumvirate with obligations and funding. So would the State of Virginia, in a delightful twist of irony, “nullify” that portion of Dodd-Frank that expands the authority of the States to regulate investment advisers?
Stephen J. Nelson is a principal of The Nelson Law Firm in White Plains, N.Y. Nelson is a weekly contributor and columnist to Traders Magazine’s online edition. He can be reached at sjnelson@nelsonlf.com
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on thiscolumn and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com
Two more suppliers of order routing services for broker-dealers and exchanges have shut their doors.
Order Execution Service Holdings and Selero, the last of a dwindling band of old-line connectivity providers, are no more. Both firms have disbanded in the past few months.
OES, a broker-dealer with at least 150 customers, based in Newark, N.J., collapsed owing creditors nearly $2 million. The firm was created in 2002 when management bought out the OES division of Herzog Heine Geduld, then a division of Merrill Lynch.
OES offered order routing and brokerage representation to both exchanges and broker-dealers, operating a network that spanned the marketplace.
The firm, which cleared through Merrill Lynch, made a name for itself with the onset of Regulation NMS. It won contracts with almost every exchange to act as their outbound routing provider, a necessity given the decommissioning of the Intermarket Trading System.
OES’s downfall came as a result of the financial meltdown of 2008. The subsequent slump in volume and prices cut into OES’s revenues, sources say. As a broker servicing other brokers, OES made about one mil, or one-thousandth of a penny, per share before the market collapsed. With the cutthroat competition that followed, that rate dropped to as low as half a mil.
Unlike many execution-only brokers that have dealt with the slump this year by investing in value-added services such as research, OES stuck to its knitting. Because the brokerage was narrowly focused on barebones trade executions for brokers, it could not compete with such value-added players as clearing firms, sources contend.
OES made a last ditch effort to sell itself earlier this year. In March, it brought in former Lava Trading topper Rich Korhammer as interim chief executive officer and chairman. At one time, Lava was both a competitor and customer of OES, operating an order routing network of its own. Korhammer spent a few months at OES, working with long-time OES CEO David Scheckel, but to no avail.
According to documents filed with the Financial Industry Regulatory Authority, OES Brokerage Services, one of three broker-dealer subsidiaries, and the former Archipelago Brokerage Services, owes an unnamed brokerage firm $1.9 million. Source speculate the firm could be Merrill or Penson.
In better days, in its quest for the outbound routing business of exchanges under Reg NMS, OES occasionally butted heads with both Lava and Selero. NYFIX was also a major competitor. Lava, now part of Citi, informs Traders Magazine that it is still in that business. Selero however has shut its doors.
Behind the demise of Denver-based vendor Selero, sources say, was a reluctance by brokers to contract for its Reg NMS smart routing services. “We were on the leading edge as far as smart routing, but demand wasn’t there during the Reg NMS process,” a former employee said. Rather, firms took a wait-and-see attitude that nullified any first mover advantage Selero held. The decision by a couple of large customers to balk at renewing their contracts with Selero also hurt.
Selero had its successes, including a win at NYSE Euronext in early 2009. Through its Nunami broker-dealer unit, Selero acted as a back-up for the exchange operator’s own outbound routing service. In that win, Nunami/Selero displaced OES, the executive noted.
The collapse of OES and Selero brings to at least four the number of old-line connectivity providers that have vanished in the past year or so. NYSE Euronext bought NYFIX in November 2009, while order management vendor SS&C bought Tradeware in January.
While the reasons for the firms’ demise vary, the forces impacting their core businesses are similar. Connectivity, including co-located hosting, has become cheap, sources say. That has made a commodity business even more commoditized.
Knight Capital Group, the Jersey City, N.J.-based brokerage firm, went from trading house to publishing house last week when it released a book of essays on market structure from 12 different contributors.
The book is entitled, "Current Perspectives of Modern Equity Markets: A Collection of Essays by Financial Industry Experts." The 130-page soft cover features essays from a wide range of contributing writers–from academics to industry insiders.
"Our goal in creating this book was to provide a body of work that outlines how U.S. markets were shaped, how they currently work, and where they may go in the future," wrote Thomas M. Joyce, Knight’s chairman and chief executive, in the book’s preface. "At Knight Capital Group, we welcome the opportunity to engage in a dialogue about our rapidly changing equity markets."
The book project had already started before this year’s May 6 "flash crash," and began roughly a year ago, according to Knight officials. Debate about high-frequency trading, flash orders and other questions about rules and market structure was in full swing when the book was commissioned. Discussion surrounding market structure only intensified following May 6.
At an event last week celebrating the book’s release, Joyce told Traders Magazine that the project was designed for both Main Street and Wall Street. He said he hoped retail investors, regulators and elected officials would read the book to gain a better understanding of today’s marketplace, as well as how far–despite its imperfections–it has come in offering greater efficiency and lower trading costs for investors.
"We thought the markets were getting a bad rap, so we wanted to get a cross-section of people intimately involved in the markets," Joyce said, "so they could comment, and we could get a broad spectrum of opinions." Each writer had editorial independence, he added.
"We think it is a great reference," Joyce said. "We hope people can use it and benefit from it." The book will be distributed to a number of key players in Washington, D.C. and to customers. It is available on Knight’s Web site.
Brett Mock, chairman of the Security Traders Association, co-authored a chapter in the book with John Giesea, the STA’s chief executive. The chapter was a joint effort by the STA board, according to Mock.
"They showed leadership in getting thought leaders with diverse opinions to discuss our equity marketplace in the 21st century," Mock said, adding that the STA essay discussed broad principles like investor protection, capital formation and balancing effective regulation with competition. "We have the most liquid markets in the world, but what often gets lost in the debate is that we need to make sure that our markets remain healthy … and that our small companies have access to capital."
Jamil Nazarali, who heads Knight’s electronic trading, said he thought that the book is a good step toward continuing "a rational debate" about how the U.S. markets should evolve. Last January, the Securities and Exchange Commission issued a Concept Release that asked the industry to comment on various aspects of the market. It is unclear if the Concept Release will lead to further rulemaking.
Nazarali said he doesn’t expect 100 percent agreement with the authors’ opinions. In fact, he said, there are differences of opinions among the authors themselves. The flash order debate is one example, he added.
That’s why, he said, it is a good idea to "get financial industry experts and discuss what is really good about the markets and what can be improved."
Industry contributors include Daniel Mathisson, managing director and head of Advanced Execution Services (AES) at Credit Suisse; Nazarali, a senior managing director and head of electronic trading at Knight; Fred Tomczyk, president and chief executive of TD Ameritrade; Paul Schott Stevens, president and chief executive officer of the Investment Company Institute; Mock and Giesea, chairman and chief executive, respectively, for the STA. Former SEC chairman Arthur Levitt also contributed a chapter in the book.
Exchange contributors include: Gary Katz, president and chief executive officer, International Securities Exchange; and Duncan L. Niederauer, chief executive officer, NYSE Euronext.
Academic contributors represented one-third of the book’s dozen essays. They include: James J. Angel, Georgetown University; Jennifer E. Bethel and Erik R. Sirri, both Babson College; Lawrence E. Harris, University of Southern California; and Chester S. Spatt, Carnegie Mellon.
ITG now has its trades in Canada cleared by Fidelity Investments’ clearing arm. ITG, which self-clears in the United States, says it plans to remain self-clearing in the U.S.
In Canada, ITG had been using a Canadian bank for its trade settlements. But it decided to move to Fidelity Clearing Canada because it offered a better service, according to ITG.
“We took Fidelity because its technology platform fits our business very well,” said Greg Davies, the chief financial officer of ITG Canada. Fidelity uses Broadridge’s Dataphile system, a real-time data system. “Many other systems are batch-oriented or somewhat overnight-process-oriented. But this is a system that was recently developed, not a legacy system,” Davies said.
In the United States, ITG went self-clearing about five years ago. It had used Jefferies & Co.’s clearing services, which Jefferies recently sold to Pershing. (ITG was originally a division of Jefferies, which spun out ITG in April of 1999.).
“[Self-clearing] has worked out very well for us, although there are places in the world where it makes sense for us not to self-clear,” said James Farley, an ITG spokesman.
In 2009, ITG Canada had revenues of $70.8 million, representing 11.2 percent of ITG’s $633 million in revenues. Through three quarters of 2010, ITG Canada has generated $57.3 million, representing 13.2 percent of its parent’s $432.4 million in revenues.
ITG officials also said the decision about self-clearing versus having someone else clear is based on economies of scale, compatibility of systems and the unique needs of clients in each country.
In Canada, for example, Davies said Fidelity’s clearing model is the best choice. He also says the ability to change systems easily was a factor in going with Fidelity Clearing Canada. He notes that ITG isn’t a full-service broker-dealer. Davies emphasized that Fidelity Clearing Canada’s system would be better for its record-keeping.
It lets ITG Canada keep all of its business in one place, Davies said. Record-keeping is an important issue for ITG, which has clients in the U.S., Asia and Europe. Most clients are institutional money managers.
Match rates on trades in Canada are now about 95 percent, Davies added. He noted that the minimum rate should be 90 percent. “And we want to be comfortably above that number,” he added.
That’s because, he said, the average client’s biggest need is “executions without any surprises. And the client also wants a trade settled the next day.”
In Hong Kong and Australia, ITG self-clears, Farley says. However, he added, “in Europe we have a consolidated arrangement with BNP Paribas, but we have our settlement books and records in house.”
Brokers’ electronic trading desks have been as busy as ever this year developing algorithms. Cases in point include Bloomberg with B-Dark, ConvergEx with Abraxas and Deutsche Bank with SuperX. SunGard even took a shortcut by purchasing Fox River to offer its algos.
But in 2010, the algos many brokers were developing were those tailored specifically to their buyside clients. For algorithms, it was the year of customization.
That’s certainly the case at Credit Suisse, said Eugene Choe, head of sales for Advanced Execution Services in the U.S. Clients often asked AES to design algos that make real-time adjustments based on the market conditions around a specific sector or an index in an environment that has been highly correlated for the last half of the year. The firm calls the algos "relative value" customizations.
"There are a lot of clients who require specific customizations," Choe said. "Over the last two years, really all we’ve been doing is customized strategies. One size does not fit all."
Algorithm use by money managers hasn’t reached a plateau, as it continued to rise in 2010. And it should only become more widespread. According to an industry study of electronic trading trends by Tabb Group, the buyside used algorithms to execute 29 percent of its flow. The number is estimated to rise to 35 percent in 2011-putting it neck and neck with high-touch volume.
As algorithms have evolved, the buyside has been getting more comfortable using them and, in turn, has been expecting more out of them, industry execs say. Accordingly, the buyside has been letting brokers access information on their inner workings to build them better and more customized algos.
Firms such as Goldman Sachs, Citi and Pipeline Trading Systems said their customers want tools that will help them trade based on data from their own past trading decisions. The brokers are working more closely with buyside traders and even portfolio managers to construct the algos that suit their trading and investment strategies. It’s the next level of customization, said Greg Tusar, head of Goldman Sachs Electronic Trading in the Americas.
"Many clients have asked for help in making the algorithm selection process more scientific, mainly by working together to profile by a variety of characteristics: urgency, size, market cap, etc.," Tusar said. "In working together to do that, we in effect customize an algo which may reflect orders from different funds, PMs, traders, etc."
Ultimately, buyside traders wanted algos that suited the different objectives of their many portfolio managers. As an example, Pipeline introduced a service it developed alongside J.P. Morgan Asset Management and AllianceBernstein that claims to do this by bringing execution tools one step closer to portfolio managers and their traders. (J.P. Morgan Asset also worked with trade-cost analysis provider Abel/Noser to help it develop algos tailored to portfolio managers’ investment and trading styles.)
The service helps traders develop and deploy custom trading strategies, said Fred Federspiel, Pipeline’s chief executive. The technology starts by analyzing up to hundreds of thousands of trades an institution has executed, to build a profile of its desk. Then, after Pipeline receives an order from a trader’s order management system, the technology takes the instructions and current trading conditions and compares them to the institution’s profiles of historical trading activity to identify analogous conditions.
It predicts the order’s intraday alpha during those conditions. Then Pipeline devises custom strategies that maximize the institution’s alpha capture, based on those analogous trading conditions.
For its part, Citi is also creating an algo that maximizes alpha to specific asset managers. The technology starts by creating profiles of an institution’s PMs, using two years of trade data. It then uses that to map out the "alpha expression" for each PM, said Dan Keegan, co-head of Citi’s electronic trading division. But then the algo will build the institution a "rules engine, which will then guide a lot of the order placement, and micro-strategy order placement to all of their internal orders," he said.
Traders still use the core algorithms, as well, Credit Suisse’s Choe added. But customized algos are popular because they’ve given the buyside more say in the creation of the very tools it will soon be using to trade.
NYSE Amex Options, which earlier this year instituted an electronic specialist program, has seen a near doubling in the number of contracts traded electronically.
The old-line floor-based exchange is now trading three-quarters of its volume electronically. That compares to two-thirds a year ago.
In October, for example, Amex traded nearly 1.6 million contracts per day electronically, on average, up from 900,000 contracts in October 2009.
While the growth is not entirely attributable to Amex’s 10 e-specialists, a substantial chunk of it is. "Our volume has been up overall, and most of that growth has been on the electronic side," Amex chief executive Steve Crutchfield said. "The major contributing factor is the launch of the e-specialist program."
In February, five firms became e-specialists, including Barclays Capital, Goldman Sachs, UBS, Citadel Investments and Citigroup. All five are also among a group of seven firms negotiating to take a 50 percent stake in Amex Options. In July, five more brokers joined the program: Morgan Stanley, Timber Hill, Integral Derivatives, Wolverine Trading and Susquehanna Securities.
More are on the way. Crutchfield said the exchange is in talks with a number of other firms that wish to join the e-specialist program.
The year just passed actually wasn’t atypical. Electronic trading has gradually overtaken floor trading at Amex Options since NYSE Euronext bought the American Stock Exchange in October 2008. At that time, two-thirds of all volume was still being traded on the floor.
There are five open-outcry specialists at Amex Options, but their ranks have dwindled. At least seven floor-based specialists, including Goldman Sachs and LaBranche Structured Products, have closed shop in the past year or so.
Still, the names they traded have been passed to the remaining five, and now just about every one of the options traded at Amex is handled by both a specialist and an e-specialist.
The five remaining traditional specialists are Barclays, Integral Derivatives, Taylor Executions, Susquehanna and Trinity Derivatives. Floor-based specialists are permitted to trade both on-floor and electronically. E-specialists can only trade electronically.
Floor-based volume continues to grow, Crutchfield said, albeit at a slower pace than electronic trading.
Rob Nonna, ConvergEx Group; Peter Maltese, Anthony Porcelli, both Raymond C. Forbes, all New York.
John Tsamasfyros, Merriman, Curhan, Ford; Jason Rempel, Janney Montgomery Scott, both San Francisco; Tom Defazio, Aqua Equities, New York.
Tyler McCullough, McAdams, Wright, Regan, Cari Miller, Liquidnet; Tim Carkin, Ferguson Wellman Capital Management, all Portland.
Jens Soerenson, UBS, San Francisco; Cindy and Blaine Dickason, Quest Investment Mnanagement.
Betsy Miller, Isaac Baimer, both D.A. Davidson, Portland.
Eli Robinson Pacific Crest; Greg Harrison, Sandler O´Neill, San Francisco; Alex Richards, D. A. Davidson, Portland.
Michael McDougall, Pacific Ridge Capital; Jens Soerenson, UBS, San Francisco.
Joseph Pernstein, Piper Jaffray, San Francisco; Mike Viteri, Oregon State Treasury, Salem.
Kevin McEneaney, JMP Securities, San Francisco; John Tsamasfyros Merriman, Curhan, Ford; Sarah Ospina, Piper Jaffray, Jason Rempel, Janney Montgomery Scott, both San Francisco
Alex Richardson, D. A. Davidson, Portland; David Myers, Credit Suisse, New York.
Mark Verlangeri, Realtick, New York; Alex Richardson, D. A. Davidson; John Giesea, STA, New York; Todd Giesea, SunGard, San Francisco; Michael McDougall, Pacific Ridge Capital, Portland.
Tim Carkin, Ferguson Wellman Capital Management, Portland; Brett Mock, BTIG, San Francisco; Nenad Yashruti, Freestone Capital Management, Seattle.
Jonathan Blum, Cantor Fitzgerald, San Francisco; Bill Kitchens, Morgan Keegan, Memphis; Eileen Angelo, Dahlman Rose, San Francisco; Tim Kelly, Jefferies, Los Angeles; Tom Defazio, Aqua Equities, New York.
Sue Lyall, Citadel, Chicago; Jaylynn Jury, Wells Fargo, St Louis; Val Sanchez, UBS, New York.
Andrew Howell BIDS Trading; Erik Johnson, Knight, both San Francisco.
Charles and Ariane Zewe, Brian Sander, both Ticonderoga Securities, San Francisco; Stephanie Libien, Jefferies, San Francisco; Eli Robinson Pacific Crest, Portland; John Tsamasfyros, Merriman, Curhan, Ford, San Francisco; Ben Thistlethwaite, Pacific Crest, Portland.
Denise and Chris Hannan, Tradeweb, San Francisco; Reynolds Ospina, WJB Capital Group; John Murphy, Thomson Reuters, Portland.
Isaac Baimer, D.A. Davidson, Portland; Robin Kaukonen, Matthew Dill, both ITG, San Francisco.
Nicole Tuttle, Pipeline, San Francisco; Molly Whitlock, Fox River, New York; Ariene Zewe, guest.
Zabi Fazal, UNX, Los Angeles, Michael McDougall, Pacific Ridge Capital, Portland.
Rich and Jan Fong, Wells Fargo; Terry Brown, Becker Capital Management, both Portland; John Giesea, STA, New York.
Blaine Dickason, Quest Investment Management; Portland; John Tsamasfyros, Merriman Curhan Ford, San Francisco; Mark Verlangeri, Realtick, New York; Andrew Howell BIDS Trading, San Francisco.
Paul Darin, JonesTrading, Los Angeles; Stephanie Lipman, D.A. Davidson, Portland; Howard Lindsay, Goldman Sachs, San Francisco; Scott Ray, ConvergEx Group, San Francisco
Rich Mettler, Columbia Management, Portland; Kevin McEneaney, JMP Securities, San Francisco; Neil Driscoll, Instinet, Los Angeles; Paul Weisbruch Street One, King of Prussia.
Brady Muir, Robert W. Baird, San Francisco; Jonathan Blum, Cantor Fitzgerald, Los Angeles, Brett Mock, BTIG, San Francisco.
Knut Grevle, Brian Dunderdale, both B Riley, Los Angeles; Don Daniel, Keefe Bruyette & Woods, San Francisco; Eli Robinson, Pacific Crest, Portland.
Tim Hughes, Strategas; Tom Defazio, Aqua Equities, both New York; Rick Br
Commentary: States’ Rights Embodied in the Securities Laws
Incoming House Majority Leader Eric Cantor stirred up a fair amount of controversy lately by speaking in favor of, or at least not dismissing out of hand, a plan by the Virginia legislature to amend the U.S. Constitution to provide that a two-thirds vote of the states could overturn any duly enacted federal law. Virginia’s proposal is reminiscent of the “nullification doctrine” advanced by Senator John C.Calhoun of South Carolina in the 1820s.
Most lawyers, and I am no exception, are fascinated by Constitutional law issues. Unfortunately, the issues raised by the nullification doctrine were not resolved in court. South Carolina did, in fact, vote to “nullify” the Tariff Act of 1828, eventually causing Congress in 1832 to authorize President Jackson to take military action against the State. Cooler heads prevailed before bullets started to fly, rendering military action at that time unnecessary. However, the doctrine remained popular in Southern circles and was only finally put to rest by the Civil War. The unfortunate reality is that, rather than providing an opportunity for interesting legal employment, fundamental Constitutional issues have a nasty way of being resolved by bloodshed.
The thrust of the nullification doctrine, in either its ancient or its latest regurgitated form, is to grant more power to the States, as compared to the federal government. In recent years, federal securities laws have tended to move in the opposite direction. The trend has been to put more responsibility for fighting fraudulent practices involving securities in the hands of the states. Interestingly, the states don’t seem eager to have this power.
Most recently, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) removes from Securities and Exchange Commission (SEC) registration any investment adviser that manages less than $100 million in assets, provided that the adviser is regulated by its home State. This move continues the trend that began with The National Securities Markets Improvements Act of 1996 (NSMIA), which removed investment advisers of less than $25 million in assets completely from the SEC registration scheme. On November 19, 2010, the SEC proposed new rules that would implement the investment adviser registration division of labor enacted by Dodd-Frank.
Under the new rules, (1) if an investment adviser has assets under management between $25 million and $100 million and (2) the State in which the investment adviser maintains its principal office and place of business requires it to register and (3) the adviser is subject to examination by the state securities commissioner (or similar official), then the adviser must register with the State and is prohibited from registering with the SEC. Unless all three elements are satisfied, the investment adviser is required to register with the SEC.
It is worth noting that Dodd-Frank differs from NSMIA in the way it deals with the dividing line between Federal and State authority. Under NSMIA, investment advisers managing less than $25 million in assets are exempt from SEC registration, whether or not their home State actually chooses to regulate them. As it happens, every State except Wyoming has a registration scheme for investment advisers.
However, state registration laws also contain many exemptions; so many registered advisers with assets under $25 million are completely exempt from registration anywhere. Advisers with assets greater than $25 million may also be exempt under State registration statutes, but Dodd-Frank would then require them to register with the SEC. Most States have adopted some version of the Uniform State Securities Act (1956), which exempts from registration investment advisers whose clients are limited to institutional clients or employee benefit plans with assets greater than one million dollars. Some states define institutional clients quite broadly. Advisers who qualify for one of those state exemptions would have to register with the SEC.
In addition, to qualify for federal exemption, Dodd-Frank requires not only that a State register an investment adviser, but also that the investment adviser be subject to an examination program. According to a comment submitted by the North American Securities Administrators Association (NAASA), 47 states maintain an examination program for investment advisers that includes routine examinations. 89 percent of routine examinations are performed on a one-to six-year exam schedule.
However, there are some notable absences when it comes to investment adviser examinations. New York, for example, does not have an examination program, so unless it establishes a new program, New York advisers with assets between $25 and $100 million will remain subject to SEC registration. New Mexico has one person who is responsible for all things investment adviser, and doesn’t welcome the addition of a substantial number of new customers. Connecticut has loudly objected to the new rules, on the grounds that increasing its regulatory responsibility would impose a significant burden on its already stretched resources. State programs are being abolished and curtailed everywhere due to budgetary concerns. Notwithstanding NAASA’s optimistic comment to the SEC, taking responsibility for a large number of investment advisers is unlikely to be met with applause by any State’s legislators, including Virginia’s.
The SEC, for its part, does not intend to determine whether any State’s investment adviser examination program is adequate or effective. Instead, the SEC will simply ask the State in writing whether or not it has an examination program that would satisfy Dodd-Frank. If it responds affirmatively, the case is closed. Offloading a substantial number of registrants into inadequately funded or ineffectual state programs seems like a recipe for fraud; but any state that objects to the influx of new registrants need only eliminate its examination program! That will keep out the new state registrants, but will allow the under-$25-million advisers to remain free from examination oversight.
The SEC’s new rules do provide a helpful uniform way to calculate the amount of assets under management.
U.S. securities laws have always been a shared responsibility of Federal and State governments. The reason for this is primarily historical. The States were plagued with episodes of securities fraud in the 1920s and enacted “blue sky” laws to protect their citizens. These laws became the basis of the Securities Act of 1933. The only exception, and a very important one, is the Securities Exchange Act of 1934, which is exclusively a matter of Federal jurisdiction. The markets belong entirely to the SEC.
Dodd-Frank’s division of authority dovetails nicely with European regulation. The recent Alternative Investment Fund Manager Directive generally would provide European-wide regulation for investment advisers who manage more than 100 million euros in assets, while leaving all others in the hands of national regulation.
The fact is that national and state governments are happy to collect registration fees from investment advisers. Examination programs, on the other hand, are expensive. Smaller advisers present particularly difficult examination issues because they often lack the resources to employ dedicated compliance personnel and maintain expensive compliance programs. This lack of resources renders the work of State examiners tedious, time-consuming and frustrating. For the same reason, it is difficult to assess industry fees sufficient to maintain examination programs for this sector. State Securities Commissions suffer chronic underfunding issues.
It is also difficult to argue that Dodd-Frank’s division of labor is a devolution of local issues to local authorities. The Investment Advisers Act already contains an exemption for advisers whose clients are located only in one State. The fact is that in this era of globalization, many investment advisers with offices in say, Connecticut, largely serve investors in other states. Visits from clients are rare events. As a result, decisions about where to locate an investment advisory office tend to be dictated by the convenience of an adviser’s portfolio managers, rather than the location of its clients. This means that a State’s scarce investor protection resources will often be allocated to protecting another State’s investors.
Entire libraries have been devoted to the concepts of federalism and the related nullification and States’ rights theories that underpin our Constitutional system. I doubt very much that anyone thinks a valid reason for the system is to skim the cream into the Federal system and relegate the expensive small problems to State authorities.
In principle, authority should be a triumvirate with obligations and funding. So would the State of Virginia, in a delightful twist of irony, “nullify” that portion of Dodd-Frank that expands the authority of the States to regulate investment advisers?
Stephen J. Nelson is a principal of The Nelson Law Firm in White Plains, N.Y. Nelson is a weekly contributor and columnist to Traders Magazine’s online edition. He can be reached at sjnelson@nelsonlf.com
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com