Trade processing costs press the need for buy-side aggregation tools

Greater trading efficiencies via direct market access, algorithms and other tools across multiple venues have benefited buy-side front-office operations significantly in recent years. But as Stewart Eisenhart reports, these tools have also exposed managers to higher back-office processing costs as volumes have increased

According to a new Tabb Group study, Buy-side clearing: Driving efficiency through aggregation, the proliferation of trading venues available to investment managers has driven up the number of settlements that buy-side organisations and their custodians must process. As such, back-office efficiencies and manageable clearing costs have become more challenging to maintain.

Robert Iati, partner at Tabb Group and report author, writes that certain larger-tier managers trading bigger volumes incur the greatest processing costs - the biggest firms process more than 40,000 allocations daily, at an estimated average cost per allocation of $15.65 ($626,000 per day).

Annually, the largest managers spend more than $170 million on trade processing, according to Iati, necessitating better tools to aggregate and lower their trade allocations to control these costs.

The advent of electronic trading has proven empowering for buy-side front-office desks, but expanded use of algorithms, DMA (direct market access), and dark pools of liquidity has complicated back offices.

Iati writes that as liquidity sources become more and more fragmented and buy-side orders are sliced and diced across multiple brokers to get fills, custodial transactions likewise increase - along with ticket charges.

The report finds particular challenges for managers employing algorithms and accessing dark pools; if a trader cannot execute a full block within one dark venue, an alternative venue or broker must be found to fill what remains of that block. Clearing costs are thus doubled, at least

In addition, use of algorithms can also drive up processing costs, writes Iati. When a buy-side trader utilises algorithmic suites from multiple brokers to source internal liquidity or compare sell-side performance, multiple ticket sets are created, which in turn create multiple clearing charges for the manager.

The report explains that buy-side settlement costs contain several distinct components, each of which affects firms' total institutional charges.

Key expenditures include central trade matching and allocation fees to Omgeo, safekeeping and other custodial fees, and internal management and staffing costs. Managers can also incur penalty, failed trade and late-fee charges.

According to Tabb Group and Omgeo estimates, buy-side firms typically incur an approximate charge of $15.65 to process a single trade ticket (see graph 2).

Custodial fees, the bulk of managers' typical processing costs per allocation, comprise both charges based on clients' assets under management and clearance fees on a per-ticket basis for each receipt or delivery into or out of clients' accounts.

Managers must also pay their share of the fees assessed by Omgeo for managing notifications and processing services between the buy-side, sell-side and custodian firms involved in each trade.

Despite efficiencies gained through electronic trading, Iati notes that trade failure rates have begun rising again now that the number of broker settlement counterparties has grown. Managers can incur interest and penalty charges due to late trade deliveries, bad settlement instructions or mismatched commissions.

The report further points out that processing costs do not differentiate between small and large tickets - meaning that billion-dollar managers and million-dollar managers pursuing similar execution strategies will pay similar ticket charges, regardless of their respective sizes.

Best execution presents another factor exacerbating buy-side clearing and settlement challenges, according to the report. More often than not, instances most conducive to best execution are also most challenging for complete order execution, and also incur the highest clearing costs.

In other words, partial executions of orders in various dark pools may cross best execution thresholds, but additional costs of multiple ticket clearing can quickly offset that benefit.

Iati lays out three preventative options for buy-side traders:

- Take no action and let clients absorb these additional costs

- Absorb costs internally through client rebates

- Or "seek a solution".

The author argues that aggregation tools present buy-side traders the most effective method of achieving best execution and then matching and allocating trades through a single clearing entity.

The Tabb Group specifically contends that central clearing aggregation will prove increasingly necessary not only to reduce managers' clearing costs, but also enable them to enhance their liquidity and best execution strategies.

The central clearing model involves a single counterparty acting as what Iati calls a "broker's broker", consolidating tickets for each security across each particular venue in order to create a single ticket per security, both for the buy-side and the sell-side counterparties.

For buy-side traders, the central counterparty would aggregate multiple fills into a single ticket, incurring substantially less clearing fees.

But adoption has hardly been widespread. The central clearing model faces significant challenges in terms of familiar but significant buy-side operational issues, including:

- Quality of managers' trade support systems

- Mitigation of custodial risk

- Access to multiple algorithms and venues through a single provider

- Integration challenges with current OMS technology. >