Whereas business once came to them, exchanges now have to work for it.

One manifestation of this dynamic is in exchanges’ relationship with the coveted demographic of institutional investors. A decade ago, an incumbent such as the New York Stock Exchange didn’t have to lift a finger to have buy-side orders routed its way; since massive regulatory and technological changes have given rise to dozens of exchange and alternative-trading-system competitors, the Big Board now goes out and hustles to win new business as well as retain existing customers.

“We have a direct buy-side outreach program, which takes the form of one-on-one meetings with the buy side — from head traders from hedge funds, to fund managers and index firms,” said Christine Sandler, executive vice president of global sales for NYSE Euronext. “We have tailored our buy-side outreach program to highlight products that are designed for different segments of the buy side.”

An exchange can be likened to an ecosystem, in which all market participants come together and interact. Whereas exchanges value high-frequency traders for their liquidity and transaction volume, buy-side order flow is prized for its depth and constancy; in line with the ecosystem motif, neither high-frequency traders nor buy-side institutions would be as valuable without the other party.

“We have recently partnered with our [Designated Market Maker] firms and floor brokers to better position our community as an ecosystem for trading and information, capital raising, and a complete portfolio of technology solutions,” Sandler told Markets Media.

According to Sandler, NYSE Euronext products geared toward the buy side include New York Block Exchange, a joint venture with Bids Trading that allows traders to access block liquidity; a parity model that allows competing orders at the same price point to share execution; floor-broker algorithms; and an enhanced data feed that parses the market’s critical open and close.

As one might expect in a competitive marketplace, the buy side views exchanges as viable business partners, but they also keep their options open. If they can achieve best execution at an obscure ATS, they’ll go there rather than route to a big name such as NYSE or Nasdaq.

Buy-Side View

“As a buy-side trader, I need to get to market to trade,” said Steve Hedger, managing director of trading and investment operations at Fifth Third Asset Management, which manages about $18 billion. “Buy-side traders are looking for best price and best liquidity. It’s kind of like driving down the street and looking down every cul-de-sac for liquidity.”

“Exchanges still have value, but it’s a competitive space,” Hedger added.

Hedger is not alone in acknowledging the value proposition of exchanges in the new era of market fragmentation. “Exchanges are not dinosaurs,” said Arun Kaul, managing principal and chief investment officer of Olympian Capital Management, a Florida-based hedge fund.

Kaul noted that the best-lit exchange and the darkest dark pool have the same core mission statement: to provide a venue for market participants to gather and trade. Both exchanges and ATSs are “legitimate disciplines,” Kaul said.

Some market participants have said that exchanges have improved significantly since the days when their monopolistic or duopolistic status essentially guaranteed them order flow. That long-held incumbent status started to come unglued in the U.S. as far back as the 1990s, when improvements in electronic communication set the stage for new, commercially viable trade-matching businesses. The movement gained steam in the 2000s when new rules such as Regulation National Market Structure promoted competition among trading venues.

With 13 U.S. equity exchanges and upwards of 30 to 40 dark pools to compete with, exchanges are long past the days of giving short shrift to customer service.
“We really take into account customer feedback,” said NYSE Euronext’s Sandler. “We want to provide products and solutions that meet the needs of our entire ecosystem as it continues to evolve.”

Exchanges such as NYSE Euronext are not optimal venues for every buy-side order. Evidence of this is in the rise of competitors such as Bids Trading and Liquidnet, buyside-focused alternative trading systems that have proven to be sustainable businesses; broker-dealers Credit Suisse and Goldman Sachs also operate their own dark pools. But the New York Stock Exchange remains the biggest trading venue, which is an advantage in itself. “In some ways, liquidity can be more important than price for institutions,” said Hedger of Fifth Third.

“Our competitive edge is our overall liquidity,” Sandler said. “It is among the richest and broadest liquidity pools for listed stocks.”

NYSE Euronext’s buy-side outreach has included joining forces with other companies.
“We developed the New York Block Exchange as a means of addressing the needs of the buy side,” Sandler said. “We link liquidity…We’ve also enhanced our communication around sourcing liquidity among floor brokers in an effort to foster block trading.” Additionally, NYSE has formed a suite of non-displayed order types on all of its equity platforms.

NYSE is not the only exchange being more proactive with the buy side. In March 2010, Nasdaq OMX hired Mary McDermott-Holland to manage relationships with institutional investors. McDermott-Holland had been director and trading manager at Mellon Capital Management.

Buy-side market participants like the choice and innovation market-venue fragmentation has brought – up to a point. “I’m not sure we need so much fragmentation because you then end up with unnecessary complexity and cumbersome rules that attempt to reconnect all venues back into one entity,” said Kaul of Olympian. “This structure is inefficient and now engenders more conflicts of interest across the various participants.”

Fewer Blocks
One challenge for buy-side equity traders – and by extension the broker-dealers who route their order, and the exchanges that host their trades – is the decrease in average order size over the past few years, which is at least partly largely a function of high-frequency trading.

“Block trading has been a good tool to help keep large orders discreet and extract liquidity,” said Hedger. “It’s unfortunate that traditional block trading over the years has been evaporating. I hope it can make a comeback, because it was a great way to extract liquidity from the market.”

Sandler said NYSE works with the institutional investors to buy and sell large share quantities. For example, the exchange builds tools for floor brokers to leverage discreet communication around block transactions. NYSE Euronext is also active in industry groups.

“Our relationship managers work with the Investment Company Institute and the Managed Funds Association, both of which have representatives on our Institutional Trader’s Advisory Committee,” Sandler said. “We interface with many advocacy groups to ensure we are interfacing with a broad base of key institutions. Through this interaction we can reach those we might not interact with on a regular basis.”

NYSE’s parity model, which is used on the NYSE and NYSE Amex venues, enables orders from multiple floor brokers, DMMs, and orders at the top of the electronic book to trade together. “Our parity model is a differentiator,” Sandler said. “We endeavor to communicate the benefits of parity to all members of our trading community.”

The parity model came about through NYSE’s customer feedback and information about the model is disseminated via the exchange’s buy-side outreach, she added.

Since exchanges typically work with buy-side participants only indirectly through broker-dealers, keeping buy-side initiatives general and focused on the overall breadth of available liquidity is key. “While we often don’t directly know the end users, as the buy side is sponsored by our member firms, we do tailor our offering to a wide variety of users,” for example index providers, Sandler said. “An effective focus on liquidity benefits all flavors of buy-side clients,” she cited.

One recent development in the buy side-exchange relationship is a more informed buy side. “In recent times, the buy side has become more aware of how their order is handled,” Sandler said. “They’re more involved in the execution process and as a result, they get more granular with tools, and the platforms we offer.”

Sandler said another NYSE product geared for the buy side is an alert feed that is available to all users via order management system (OMS) and execution management system (EMS) vendors. This is meant to address “the buy side wanting to get more transparency around the open and close as single points of liquidity,” according to Sandler.

High-frequency traders can pose a dilemma for exchanges, as the high-speed, short-term market participants bring volume and liquidity, but they sometimes irk buy-side managers, who say HFTs can be predatory and raise the risk of a systemic disruption.

Sandler noted that the NYSE welcomes high-frequency traders, and having them on board can be helpful for buy-side execution.

“We benefit from the richness of our order book and the diversity of participants, both long-term and short-term oriented,” Sandler said. “Despite the differences in models, it’s all quality, as diverse order flow leads to a better experience for all participants.”

“There continues to be a misperception about high-frequency trading,” Sandler continued. “When we approach the buy side, we position liquidity providers as a critical piece of the community…There is a need for HFT — they’re important for a venue, provided the venue has established meaningful thresholds for liquidity providers.”