Dark Trading Pools

In the April 2013 issue of ai-CIO, there is an article about the growth of dark trading pools.  These are private exchanges where investors trade anonymously.  Their nicknames include non-displayed markets, private markets, off-exchange trading or upstairs trading.  In 2008, they made up 6.5% of the total trading volume in US Equities.  In 2012, they have grown to take up more than 13%.

The main advantage of the dark pools is privacy.  An institutional investor getting into or out of a large position would not move the stock price much.  On the exchanges, a large order would be noticed and the price would move against the investor.  To hide their order, it would have to be split into many smaller orders by a sell-side salestrader.  Dark pools are not foolproof.  The stocks are usually limited to those with the highest trading volumes.  The operator of the dark pool could use the information to trade ahead of the investor or sell it to another trader.

Since 2007, investment banks have created dark pools such as Credit Suisse's Crossfinder and Goldman Sachs' Sigma X.  To generate additional revenue, they have given access to algorithmic traders in the quest to find discrepancies in security prices among exchanges.  If dark pool trading volume in more numerous trading venues grows, then the prices on public exchanges may no longer be accurate.  More pools means that investors would have search harder to find the other side of the trade.  It seems that the solution for one issue has created others.

Allocating Shares for an Initial Public Offering

In the last article, we went through the IPO process.  There are two major parties on the sellside that handle the deal:  equity sales and capital markets.  In the days leading up to the IPO effective date, salestraders are entering their indications of interest;  that is, the number of shares that their buyside clients want and any additional color that may help their clients get a larger allocation.  For a hot deal, buyside firms know that they will not get their number so they overbid i.e. I really want 100,000 shares but I'll order 200,000 to get it.  After the orders are placed, sales and capital markets management start allocating the IPO shares.  They will initially speak with the issuer company on some broad outlines.  The CEO may instruct the bankers to give minimal amounts of shares to hedge funds.  He may be afraid that they will "flip" the shares on the first day.  By "flipping", the fund makes a quick profit by selling the shares - providing that the IPO appreciates.  Or make sure that this fund gets a good allocation as they are a "friend of the firm".

Management will look at the following criteria (in no particular order) for the allocations:

• Amount of secondary commissions done with the bank
• For the last 3 months in the IPO's market (for example, for Netscape's IPO, management would look at US commissions)
• For the last 6 months in the IPO's market
• For the last year compared to the prior year in the IPO's market
• For the last year compared to the prior year global equity markets
• For the last year for derivative and convertible securities
• Amount of primary commissions done with the bank for the year compared to the prior year
• Amount of total commissions done with the bank (secondary and primary) for the year compared to the prior year
• Ranks for each of the commission categories above
• The fund promises to buy aftermarket shares
• The fund is a notorious flipper
• The fund's strategy is buy and hold

Primary commissions are equivalent to the selling concession from a deal.  Secondary commissions are from everyday trading of previously issued securities.  Note that the broker vote does not seem to hold much weight.

Studies in Client Profitability

We have reviewed the broker vote and the main factors that contribute to it.  The next logical step is to analyze them and determine if the investment bank is receiving a good return on its allocation in resources.  It's a simple revenues versus expenses calculation.  The art is in determining what the expenses are and how to weight them.  What services are the most important and bring the most value to the buy side?  How much does each service cost?

Within the financial services industry, the most expensive costs are people's time.  For the main roles that interact with the buy side, banks would measure:

Research Analyst - 1x1 meetings, group meetings, field trips, projects/special reports, 1x1 calls, conference calls, entertainment
Research Sales - calls/time spent on client, entertainment
Salestrader - calls/time spent on client, entertainment

For Corporate Access, the statistics would include 1x1 meetings, 2x1/3x1 meetings, group meetings, field trips, presentations, conference calls, special events and entertainment.

In addition to the basic profit/loss analysis, there are scenarios run to estimate revenues if the resource allocation changes.  If a fund is given more meetings, what is the upside in revenue?  What is the downside in revenue if resources are cut?  How should we approach a client who is not giving the firm enough revenues to merit the resources that are given to them?  Here is where senior management needs to make hard decisions.  This is usually the province of a relationship manager for large accounts and sales management for others.  We will discuss the role of the relationship manager at a later time.

A Qualitative Survey of Sell Side Brokers

Greenwich Associates is a third party research company that advises sell side firms on how they are currently serving their clients and how they can improve.  A review of the www.greenwich.com website lists a wider mission statement that includes both sell and buy side firms.  In this article, we will concentrate on the sell side survey.

The survey starts when Greenwich sends out a list of the buy side firms that will contribute.  The usual suspects are on the list:  Fidelity, Capital Group, Wellington Management, etc.  For these firms, the sell side nominates the contact who will receive the survey.  Also, the sell side is encouraged to add new firms to the list.  This helps Greenwich give the sell side more robust results and add new customers.  The contact for any given buy side firm is by majority vote.  So if 6 firms have John Smith as the contact and 5 firms have Pete Jones, then John Smith will be listed as the official contact.  This is called "ballot stuffing".  Obviously, if John Smith receives the survey, then the 5 firms that speak primarily with Pete Jones will be at a disadvantage.

I have not seen the questionaire but it is qualitative in nature.  These answers are compiled into a rating score on a scale of 1 to 1000.  A total result is given for the entire universe of accounts.  Then ratings are given by each role within equities:  research, research sales and salestrading.  They can be further sliced and diced by account coverage.  For any result to be statistically significant, a minimum of 5 firms have to fill out the survey.  Greenwich also provides account profiles that contain feedback from the buy side firms.  The contents are confidential to sales management.  The salespeople and salestraders covering the account are not to be informed.  However, I always wondered about it.  If the buy side tells sales management of the investment banks on how to improve client service, how would management broach the subject to their staff without giving away the source?  Especially after the Greenwich survey has been published.

A Day in the Life of a Salestrader

Like a research salesperson, a salestrader's day starts early. They receive the morning call's research via email or in hardcopy and have a separate trading meeting at 7:30. Talk about early. The people that distribute the research are there long before 7:30. There is a review of the yesterday's activities: how many shares were traded, what stocks were particularly active and any other market color. Then the position traders will inform them of any large blocks of stock in the firm's inventory that can be traded. They will be notified of any IPO's coming up.

Salestraders are a firm's filter for their research ideas but the focus is on short term trading. The buy side uses these ideas in hopes of making a quick profit. After the daily call, the salestraders hit the phones with their clients; putting in orders before the market opens. When it opens, there is a frenzy of activity as these orders are executed. 9:30 - 10:30 is the busiest hour of the day. When the investment bank is the lead bookrunner of an IPO, the entire first day is busy as the firm has to make a market in the new security. At other specific times, there will be a burst of trading such as after any Federal Reserve Board meetings or unemployment reports. The last 30 minutes of the trading day are also hectic.

During the day, the salestraders will be in constant contact with his clients - on the phone, through email or instant messages. They will be executing their client's trades at the best price possible. Most of the time the buy side initiates them. At this point there may be conflicts with the position traders. In order to get the best price for their clients, the position traders' p/l statement will be hit. They and management will also approve or deny requests for capital commitment on their client's trades.

After the market closes, there are client reviews and team meetings to attend. Salestraders may have a client dinner or event after the end of the work day. Again, their purpose is to build relationships with their buy side counterparts.

Serving the Buy Side

Research, Sales and Trading

The main elements of the broker vote revolve around research and best execution. To better understand this dynamic, look at the traditional roles on the sell and buy sides and their lines of communication. On the sell side, there are four main actors: research analysts, research salespeople, salestraders and position traders. Their counterparts at the buy side are research analysts, portfolio managers (PMs) and salestraders.

Sell side research analysts are the idea generators for an investment bank. They follow a sector or industry and get to know the companies intimately through analyzing financial statements, talking to the company's officers, following industry news and speaking to suppliers, clients and competitors of the firm. They compile all this information into opinions about the prospects for the company's business and stock price. This is known as the "Mosaic Theory". The analysts interface with the buy side's research analysts and PMs; giving them their talking points about different companies. Their recommendation is often boiled down to a buy, hold or sell in the press. The buy side is NOT solely interested in that. They are interested in the thinking process behind an analyst's stock recommendations.

Research salespeople are advocates for their buy side clients. It is their job to obtain the resources needed by them from within the investment bank. This may be a meeting with a sell side analyst or getting them into an industry conference. They market the bank's research capabilities by acting as filters - passing on the most impactful research to a client. For example, if a client has a large position in Microsoft, the salesperson will relay any important research reports regarding that stock to them. A better salesperson may relay news regarding Dell and Hewlett Packard as their sales affect the volume of Windows packages are sold.

Sell side salestraders communicate with the PMs and buy side salestraders. They execute trades and are trying to minimize the transaction prices for the buy side. The calculation of any investment return is dependent on the price of the security when bought. They also act as filters of the investment bank's research. Their ideas are more geared to day trading than any long term investing. Most of the orders are originated by the buy side. At times, they will ask the sell side to facilitate a trade by committing capital. This is something only the largest institutional clients are able to ask for and get.

Position traders interact with the exchanges and salestraders. They have a trading book which has a profit and loss (p/l) statement that is measured constantly. When an order comes from the buy side, the broker/dealer's salestrader will execute the trade through the position trader. Ideally, it will be in the book's current inventory. This is where some friction will appear between the sales and position traders. If the salestrader executes the trade at a good price, the customer will be happy and be more willing to allocate trades to the firm. However, a good price adversely affects the trading book and the p/l statement.

All four roles are large contributors to the broker vote. Whether research or trading is more important is firm specific although each side thinks that they contribute more to the vote than the other. Beyond the client service aspect, there are other items that influence commission allocation such as:

1. Is there is a prime broker relationship?
2. Corporate access
3. Does the investment bank sell the buy side firm's funds?

We will explore these factors later.