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Page last updated
February 15, 2003




The future of trading is electronic


The investment industry is currently on the threshold of an electronic revolution. The impact on financial institutions will be even greater than the repercussions of the Industrial Revolution on manufacturing. As in the eighteenth century, the underlying driver is efficiency and profit maximisation. But like the Luddites, many market professionals will find it hard to respond to change. The message is clear: adapt and thrive.

Over the last 10 years there has been a dramatic transformation in global investment styles from active to passive management, i.e. from portfolios invested according to individual stock selections along value lines, towards those that are created to follow a benchmark index. Actively managed funds require relatively greater analysis and management than passive funds and, as a result, investment houses charge higher fees to cover these costs and the perceived added value they offer. Active fund performance is mixed and historically, given the higher trading and management costs, has tended to underperform benchmark indices. Conversely, the investment decisions for index funds are less resource intensive and, therefore, cost less to manage. In addition the low volatility of returns relative to the benchmark makes them more attractive to the investor. In recent times we have seen an explosion in the volume of passive investment while active managers search for new ways to maintain their position. The result is that both types of fund managers are continually looking for efficient trading mechanisms that can help them reduce their transaction costs. These costs are made up of four major components: delay opportunity cost, market impact, bid/offer spreads and commission.

It is the quest to control these transaction costs that has been the catalyst for the development of Alternative Trading Systems (ATSs). John C. Bogle, Sr., Chairman of The Vanguard Group, Inc. sums up the need to lower costs:" The shortest route to the top quartile in performance is to be in the bottom quartile of expenses". ATSs cover a wide variety of electronic products and companies ranging from the Electronic Communication Networks (ECNs) such as Instinet, Indication of Interest (IOI) products such as Autex and Crossing Networks such as POSIT.®

In the US during the 1980s, Instinet, a subsidiary of Reuters, was the first to create an ECN. However, it took a considerable length of time for the concept to be embraced. Most ECNs offer a trading extension to the exchange market place, incorporating order book functionality with automatic order delivery and receipt. Their success is dependent on adding functionality and efficiency over and above that which is prevalent in the underlying exchanges' trading mechanism. Failure to add significant benefits will soon make a system redundant. However, the rapid growth of ECNs in the US over the last three years has shown that these systems are supplying investors with significant transaction cost control features.

Many would argue that concepts that work well in the US would also be a success in Europe. However, in Europe, the inefficiencies that have allowed ECNs to flourish in the US are not as prevalent. European exchanges have recently been proactive in adopting electronic and order driven systems. This will undoubtedly make the role of European ECNs more challenging.

The last few years has also seen a rise in the use of IOIs. These products allow investors to advertise business without commitment to trade. Investors can select those who can see these advertisements and thereby show "interest" in individual stocks, markets or indices. IOIs also perform post trade publishing, allowing clients to publicly report trades in order to encourage further business to come forward. Whilst we have seen considerable growth in IOI products, there has also been criticism of the legitimacy of what they actually do as there is no check on the authenticity of the business.

The last group of ATSs are the crossing networks. In the US, ITG Inc. has been running the world's largest intra day crossing network, POSIT® (Portfolio System for Institutional Traders), for thirteen years. However, the last six years in particular have witnessed huge growth in the popularity of the product as investors have increasingly sought to drive down transaction costs.

POSIT® matches US equities eight times a day providing a massive and anonymous source of liquidity for investors to trade at the mid-point of the bid-offer spread with zero market impact. ITG Australia runs three POSIT® matches for Australian shares and ITG Europe introduced POSIT® for UK equities in November 1998 and now runs four daily matches across eight European countries.

POSIT® is a simple concept. Buyers and sellers transmit individual stock or portfolio orders anonymously to a central host computer system. Any equal and opposite orders are matched randomly within a seven minute window at the predetermined times. The execution price is the mid point of the bid-offer spread at the exact time of execution. The results of the match are reported immediately back to the user; therefore, the time of entering orders into POSIT® is reduced to a matter of minutes. The dealing spread savings of using POSIT® make significant reductions to transaction costs, but the zero market impact achieved through the anonymous nature of the orders delivers even greater benefits to the user. For example, commission for UK POSIT® is charged at 0.1 per cent on executed business only, but mid point pricing and the reduction of market impact often saves users well over 1 per cent.

Prior to the advent of anonymous trading systems, institutions wanting to buy or sell shares would have had to open their hands to the market. This inherently led to price impact before the order was completed, if indeed it ever was. Price movements in the UK equity market of 10% on a poorly managed order were, and in some cases still are, not uncommon. With systems such as POSIT® , the investor opens his hand to a black box. No other market participant is aware of the existence of the order and only after an execution will a trade report occur on the market at the mid price. There is no awareness of overhang of supply or demand. If there is no execution, no one is the wiser and the market has not been spoiled. Evidence from the US suggests that crossing networks release latent liquidity in illiquid stocks - that is, the sight of activity in certain stock lines on the trade tape gives rise to more orders being released in that stock. This is conducive to a deeper and more transparent market.

ATSs, however, are not the answer to the requirements of all investors. Where sensitivity to price is of greatest importance, they play a vital part. Where guaranteed execution is required, the investor will still pay for the immediacy of execution and the cost of capital that the liquidity provider is undertaking, which adds to the overall transaction costs. Nevertheless, most successful investors today are not short-termist - they are more interested in medium to longer-term performance and so are turning increasingly to using various ATSs.

It is sometimes argued that ECNs and ATSs fragment the market. Historically, there has been only one place to go for price information and trade execution - the floor of the stock exchange. This meant that the Exchange was the market. However, the market of the future will not only consist of the exchange mechanism of trading, but also an array of ATSs working in parallel, each with its own specific added value. Equity dealers may currently have to search more widely for price quotes, but the benefit will be a reduction in the cost of trading. The electronic revolution we are witnessing is systematically replacing the single trading mechanism with a group of products that together provide greater liquidity, a more effecient method of trading and ultimately higher profits.

Investment Technology Group Limited is an agency only stockbroker and member of the London Stock Exchange. The company was formed as a joint venture between ITG Inc. and Société Générale.

Alistair Haynes
ITG Europe


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