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Of Bright Lights, Measurement and the Future of Trading…

Of Bright Lights, Measurement and the Future of Trading…. Implications of Best Execution Standards and Exchange Linkage. Harold S. Bradley Senior Vice President American Century Investment Management March 25, 2003. Brief Historical Perspective.

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Of Bright Lights, Measurement and the Future of Trading…

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  1. Of Bright Lights, Measurement and the Future of Trading… Implications of Best Execution Standards and Exchange Linkage Harold S. Bradley Senior Vice President American Century Investment Management March 25, 2003

  2. Brief Historical Perspective • Market 2000 Response (11/18/92)-- when asked whether Instinet was fragmenting, segmenting or balkanizing the national securities markets …(letter from John Dingel to the SEC) • IRC strongly advocates and utilizes many of the non-traditional trading systems under consideration by the Commission in this study. Such systems provide access to liquidity at very low costs to the shareholders of the Twentieth Century funds. • Furthermore, the analysis of IRC trading cost data by industry consultant SEI Corporation shows that trading of OTC stocks on non-traditional systems yields far lower costs (commissions and market impact) than trading done with traditional NASDAQ market makers who deal on a principal basis. The implicit additional savings to shareholders far exceeds the explicit savings attached to the discounted commission rate per share.

  3. Market 2000 Continued… • Additional Musings Way Back Then: • Market 2000 appears to be a direct response to the evolution of "exchanges" with specific physical locations, where intermediated transactions may be negotiated to a "concept" of a central order driven marketplace, where buyers and sellers can discover price efficiently and anonymously. IRC urges the SEC to affirm this move to markets where investors have instant access to low cost, transparent transaction systems. • Transparency implies far more than a timely report of a trade to the tape. Transparency implies markets with open access, clear views of indications from buyers and sellers and a central limit order book preference where aggressive pricing and time of order entry may be rewarded.

  4. As Harry Truman said: • “The only thing new in the world is the history you don’t know…” • Once in Golconda, A True Drama of Wall St. 1920 • Weeden & Co., the New York Stock Exchange and the Struggle Over a National Securities Market • 1969…”The central marketplace today is no longer a geographical concept. It is a communications concept.” • ”The increase in the institutional block business has drastically reduced the effectiveness of the specialist…he has found it impossible to obtain direct exposure to the full sweep of institutional inquiry.” • “We pointed out that Rule 394(b) continued the separation of our market from that of the NYSE and was the principal reason for what the NYSE referred to as “fragmentation.” • “But keep in mind our firm does not enjoy a monopoly franchise in which there is a continuous conflict between our role as an agent for public orders on our book and our activity as a dealer for our own account.”

  5. Characteristics of an Investor’s Trading System Don’t Yes No Know N.A. Total Yes Order Anonymity 43 0 0 1 44 98% Maximum Order Confluence 38 1 0 5 44 86% Decimal Prices 33 10 0 1 44 75% Time Priority of entered orders within price 38 2 4 0 44 86% Single price auction at opening 31 8 2 3 44 70% Full, but anonymous, disclosure of supply/demand schedule 40 1 0 3 44 91% Free entry and exit by those offering microliquidity 37 5 2 0 44 84% Multilateral price negotiation capability 39 1 1 3 44 89% Integration of price discovery, execution and transaction reporting 43 0 0 1 44 98% Source: Trader Forum, February 2, 1995, JuniusPoake, Universityof Northern Colorado.

  6. The New Definition • “In placing a trade, the trading desk will seek to find a broker-dealer or alternative trading system that will execute a trade in a way that the trader believes will realize the maximum value of the investment decision.” • Gene Gohlke, associate director of SEC Office of Compliance Inspections and Examinations, Dec. 2000 ICI Securities Law Development Conference • As amended by the AIMR Trade Management Guidelines: • “Best execution (is)…the trading process Firms apply that seeks to maximize the value of a client’s portfolio within the client’s stated investment objectives and constraints.” • “…processes, disclosure, and documentation which together, form a systematic, repeatable, and demonstrable approach to seeking Best Execution in the aggregate.”

  7. Say What? • The hiring of a consultant to measure execution quality is not sufficient proof that a manager is “in compliance” • Adequacy of order handling systems, trade error experience, and timeliness of execution reports will be reviewed • Allotment of IPO shares against requested allocations will be assessed • The use of ECNs as venues with liquidity, price improvement and lower commission rates will be evaluated

  8. Impediments to Best Execution… • Given four choices, traders responded: • 37% said directed orders and soft dollar obligations • 25.9% said information dissemination and lack of anonymity about trading intentions • 25.9% said lack of depth on exchanges “Defining Best Execution Summit,” Liquidnet, November 2002

  9. Commission 5 ¢ (17 bp) Impact 10¢ (34bp) Delay 23 ¢ (77 bp) Missed Trades 9 ¢ (29 bp) Source: Plexus Group, 2002 The Iceberg of Transaction Cost * Missed Trade cost on average 130 bp on 8% of the portfolio, and are expressed in terms of portfolio effect

  10. Non-Intermediated Markets Eliminate Costs • Fifteen years of ACIM data indicate structural removal of trading costs when using non-intermediated, electronic, linked venues relying on price and time priority • We trade our most difficult business on these systems; highest measured price volatility, lowest market capitalization, lower prices over time • Our costs average between .3% and 1% cheaper than in traditional venues • Last year, NASDAQ trading as a percent of overall business slipped to less than 20% of total but the percent of business done on electronic venues was steady • In the second half of 2002, trade cost measurement service CRA said: • ACIM experienced trading costs of .54% of principal traded with traditional brokers on traditional exchanges • We traded $825 mm of listed securities on an electronic exchange at -.37% of principal ($7.5 mm in our investors’ pockets) • We traded $1.9 bb of listed securities on a competing platform at -.43% of principal ($18.4 mm in our investors’ pockets)

  11. Studies • “The key motives for trading on these systems are reduced market impact, lower spreads, better liquidity and anonymity… • Economides and Schwartz, “Assessing Asset Managers’ Demand for Immediacy: Equity Trading Practices and Market Structure” • “An examination of total trading costs, inclusive of commissions, reveals electronic trading to be superior to traditional brokerage by any measure of trade difficulty for buy trades and to be comparable for sells.” • Domowitz and Steil, “Automation, Trading Costs, and the Structure of the Securities Trading Industry,” (1999)

  12. Why your traders say they can’t use ECNs (and what Bollen/Busse and “Common Cents?”) Missed… • Just look at these screens…all the orders are for 1,000 shares…you just can’t trade size! Since decimals, there’s just no depth of book!!!! • Hidden limit orders • Reserve orders • The culture of blame transfer and what it costs -- I’ve been working on this idea for three weeks and I want it done “now!”

  13. New Order Types on Electronic Exchanges… • Archipelago Exchange Order Types: • Inside Limit • Random Reserve • Passive Discretionary • Limit Reserve • Sweep Reserve • Limit on Close

  14. Followed by New Broker Order Services • CSFB Advanced Execution Services: • VWAP: tries to match VWAP from start to end time with maximum percentage of volume limits • In-Line: trades with the volume until complete when in-line; slows down pace of execution as prices trades away • Tex: works order as fast as possible while trying to prevent showing any size in the market • Float: displays specified size in patient (bid side buy), normal (in the middle) or aggressive (offer side buy) styles • TWAP: time weighted average price

  15. Exchange Response • NASDAQ and NYSE Falling Behind: • Super Montage not gaining market share • Limited functionality and no order routing • Trader optimism over ARCA Exchange listed trading functions • “If the universe is infinite, all points are at the center.” • Old Instinet marketing slogan…is technology so lowering the barriers to entry that liquidity truly is becoming portable? Turns theory based on physical points of liquidity on its head.

  16. NYSE Competitive Response • Traders asked which exchange do you believe gives you best execution? • 28% NYSE • 68% NASDAQ • 4% AMEX “Defining Best Execution Summit,” Liquidnet, November 2002

  17. Life Cycle of an Order Broker Sales Trader Broker “Upstairs” Trader Broker’s NYSE Floor Broker Investor (Buyer) Institutional Trader Specialist Floor Broker Institutional Trader Investor (Seller) Sales Trader “Upstairs” Trader

  18. Can You Trade Big on ECNs? • Orders Traded No. of Blocks % of Total Block Equivalents Per Trading Day • All Trades > 50,000 867 13.3 • 50,000 - 100,000 397 46% 6.1 • 101,000 - 250,000 283 33% 4.4 • 251,000 - 500,000 105 12% 1.6 • 501,000 - 750,000 37 4% 0.6 • 751,000 - 1,000,000 19 2% 0.3 • 1,000,000 and up 22 3% 0.3 American Century Investment Management Jun 1, 01 - Aug 31, 01 -- A.K.A. Summer Doldrums

  19. ECN Listed Share Block-Sized Orders Orders exceeding 250,000 shares in listed stocks, June 2001, AmCen

  20. Specialists Make 3 – 4 Cents Per SharePer $100 Traded, Good Times and Bad

  21. The First Surprises This Quarter…why?

  22. What Our Traders Say… • ICI has represented our interests at NYSE with little forward progress: • Limit orders enjoy no protection; NYSE offers price improvement on market orders • 52 Institutional Express trades in 18 months • Has been only one vendor of “Expressable” quotes • AutoEx of small orders only at 30 second intervals “with a stopwatch” • Proprietary pipes distributing new “Liquidity Quotes” to vendors • “We have to pay $5,000/month to see our own orders” • User not subscribing will not see it – reminds me of I-only on Instinet prior to Order Handling Rules

  23. Implications of the Changes • Broker Cannibalization • Brokers Merge NASDAQ and Listed Trading Desks • Pulse, White Cap, execution only brokers • Less Transparent Markets • Optimark-like Features • Call Market Only Logical Outcome • Traders report dozens of quote changes based on a single exposed 100-lot in small stocks based on all the hidden algorithms. • New trade term – chiseling – trading in hundredths of a penny • Anchoring – traders upset about a stock moving 4c in price – an $84 ETF.

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