Why I Left the Bulge Bracket Behind


The following is a guest article by Dan Sanders, who joined Olivetree Financial last month as Head of US Execution Services after a sixteen-year bulge bracket career, most recently as Head of Americas Cash Equities Execution at Citi.

Four main thoughts, as outlined by Peter Diamandis, regarding the profound evolution of all industry including the global capital markets:

  1. Acknowledge the only constant is change, and the rate of change is increasing. To pretend otherwise is reckless.
  2. You either disrupt yourself and your company or someone else will. Either way, standing still = death.
  3. Your potentially disruptive competition probably isn’t even in your industry. They’ll come from the outside in the form of “exponentially empowered entrepreneurs”.
  4. Think about how Amazon has disrupted other industries. Or Uber. Or Tesla. Mindset matters… a LOT. Now more than ever.

People ask me why I left the bulge bracket behind to join a specialist firm and the simple answer is that the bulge bracket cash equities model is flawed.  Let me explain.

Does this sound like a good business model to you??

Before I moved to cash equities, I had traded mortgages at PaineWebber from 1995 to 2000, which was a straightforward process.  I would buy undervalued inventory, hedge it, market it internally to PW’s sales force and then externally to clients.

When I moved to equities (at the time Salomon Smith Barney), what a difference there was in the anatomy of a trade. An equities trade started with a research analyst and/or research salesperson giving calls, analysis, models, and so on to a portfolio manager, then HOPEFULLY the PM would tell the fund’s trader that we were instrumental in their investment thesis, resulting in the buy-side trader giving an order to our sales trader, who then would give the order to our trader, who then routed the order to the best liquidity source, then provided intra-order feedback to the sales trader, who then gave feedback to buy-side trader, who then justified best-ex to the PM, and so the loop continued.  Small wonder cash equities is unprofitable.

The problem is compounded by the fact that no one knows what really triggers the trade.  Why does an order come in the door in the first place?

  1. Is it our Algo suite and best-ex capabilities? (The Algo team has limited awareness of what the client is consuming by way of resourcing and assumes they get an order due to their commoditized products.)
  2. Is it our Trader’s IOI attracting the other side of the trade?
  3. Is it our Sector Specialist’s commentary and content that was distributed to the buy-side trader?
  4. Is it our Sales Trader’s relationship, market nuances, and/or morning research call?
  5. Is it our Analyst’s direct dialogue with the PM at the fund (and prays that the PM tells his trader where to trade)?
  6. Is it our Research Salesman’s relationship or resourcing of the client?
  7. Is it our Equity Capital Markets relationship?
  8. Is it due to our Senior Management who might have a relationship with the client but certainly influences our resourcing?

Phew – that is eight different factions with hands in the cookie jar that has a whopping $0.01~$0.03 commission (at best) when all is said and done IF (big if) the client keeps all of the gross commissions with us without asking for principal on the order, extracting a portion as CSA eligible after the fact, and so on.

Clients arb the system…because the Sell-Side is enabling it

As the market evolved I realized that the larger clients were exploiting the cash equities process because of its inefficiencies.  They would consume resources (corporate access, research and otherwise), feel they were entitled to the services, and would inform us after-the-fact what they thought it was worth. [Note: I could never get used to pay-later system. As a sports fan I bought tickets to a game and had to present the ticket as I went through then turnstile.  Unfortunately, I wasn’t able to “put” the price back if I was dissatisfied with the performance of the team and, as a NY Jets fan, man I wished I could.]

Here’s how the clients benefited from inefficiencies in the process. As an example, if we had a corporate access event, say a bus tour for rig counts in Houston:

  1. PM in a sleeve/vertical (i.e. Energy) at a major client insists that he NEEDS a seat.
  2. He is one PM amidst 250 that works at the client that in aggregate pays our firm a good deal of revenues and he is demanding a seat even though his particular wallet is de minimus. (The vast majority of the revenues from his firm comes in the form of prime brokerage and Delta 1 in Pan Asia; which is actually a resource unto itself since the client is consuming our balance sheet.)
  3. We provide one of only 15 seats to the insistent client even though our internal profitability analysis confirms client consumes more resources than he pays in revenues.
  4. The PM sends us orders in form of payment for $xx and everyone high fives.
  5. Three months go by and the client takes 75% of the gross commissions out from the CSA eligible bucket to pay third party vendors.
  6. Six months go by and the client belatedly sends us the results of their broker vote where the PM says:
    • YES, I know I demanded that seat and I knew you had finite supply and 2x covered the amount of demand BUT I went to JPM’s, Barcap’s and DB’s events after yours and got far more value.
    • SO, the $$ I earmarked to pay you I am now extracting from the piggy bank (aka CSA pool) that you hold as custodian on my behalf to pay the other brokers.

This is why some of the largest client wallets are inherently unprofitable as the cash equities game has been played.

A new game

Now the game is changing.   Each time the market has evolved, it has not been forced by cash equities clients. Market regulation (for example Reg NMS, Decimalization and the unintended market fragmentation result) and the sell-side itself (offering lower cost solutions) have been responsible for the change.  Client wallets continue to be robust but what the client is willing to pay for is now changing.

To that end, the FCA and ESMA came around and said that if the buy-side wants to consume research they will have to pay from their own wallet (or more clearly disclose the research cost to clients along with a bunch of other restrictions that most asset managers don’t want to bother with.)  Regulation is forcing the industry to evolve (yet again).  This time it’s in Europe via MiFID as they force the unbundling (RPAs at best and ZERO $ at worst).

So what happens?

  1. Trading desks become a much greater part of the investment thesis.
  2. The percent of the wallet that is paying for research goes down by 90% overnight.
  3. Traders no longer have to justify where they route order flow based on a broker vote (aka “RESEARCH vote”) because they are no longer handcuffed to where they can trade and HAVE to abide by best-ex.
  4. Clients will still use any reason to continue to shrink their broker lists.
  5. The list of clients that will pay for research from management fees will continue to grow and those that have stated they will not, will U-turn soon enough.
  6. HOWEVER, best-ex parameters and the most sophisticated independent consultants will force order flow to the most efficient desks.

In other words, the new game can make it easier to track who does what, who is delivering and who isn’t, what works and what doesn’t.

Trapped in the old system

Instead of jumping on the opportunities in the new game, the big sell-side firms are in denial about this next evolution of the markets.  Now that clients’ signatures will have to go on each check sent to pay for research, sell-side pricing of research is in disarray.  Internal profitability analysis teams should be examining what a research pricing menu will eventually look like instead of merely dividing corporate access costs by the number of access events attended and other attempts to maintain status quo.  The problem is that the answers are as obscure as the future of the cash equities platform itself.

It then dawned on me.  The big sell-side firms have an inordinately higher fixed infrastructure cost that they need to support but instead of trying to untangle the confusion, they will just keep reducing the research, trading and sales workforce into perpetuity. For most of them, their strategies are NOT aligned with the new realities.

Part of the problem is that the large sell-side firms are trying to garner market share to showcase a global footprint, yet they don’t have the capacity to truly monitor order flow at the point of execution.  To play the market share game, they have to continue to service the clients who have been most aggressively arbitraging the system.  If you want to have a cash equities market share north of 5~7% you are FORCED to do business with the top 25 client wallets, even though not all of their business is entirely profitable, and even though your relationships/skillsets might not align properly.

A case in point is that the buy-side wants small cap research and trading. Why? Because there is alpha in those names which then can increase performance and attract more AUM (the Active vs. Passive argument).  However, the sell-side cannot afford to offer such a service because even if they trade 50% ADV in a name that trades 2.5 million shares a day that does not generate enough revenue to turn the lights on.  Their fixed-costs are WAY too high.

Winners and Losers

That said, the bulge banks will still remain afloat, or at least some of them will.  Other equity products besides cash equities – such as prime brokerage and swaps – will generate flow and maintain market share.  But, will it be profitable? CTA exposure, systematic trading and quantitative clients trade on razor thin margins, delivering market share with limited revenues.

The winners will be the small, independent low fixed-cost specialists.  On the research side: the boutiques, where some of the best and brightest analysts have already gone to accept checks versus PRAYING that they get rewarded for their content via execution/trading commissions (where seven other people are taking the credit for the order.)  On the trading side, independent brokers focusing their attention specific to the point of execution.

I can’t put enough emphasis on how valuable it is to be objective and independent.  No research upgrades or downgrades based on anticipation of a banking deal. No re-scripting an ECM-related book run pricing based on the anticipation of the next deal if the current one goes well. Just fair value pricing and agnostic venue routing for trading (not forced to route 10% of the customers’ flow to an internal dark pool that represents 0.05% of the market’s volume).

So, what to do?  After a significant amount of time surveying the market landscape and feeling like a toll booth collector watching the rise of EZ Pass, I decided to go with an independent broker where we can concentrate on what we do best and get paid for it. If we focus at the point of execution and are unencumbered by market share objectives (in other words, we provide our resources to clients that pay us a fair price for our content and analysis), unbundled from traditional research and/or the high fixed costs of corporate access, our successes will be undeniable.

We have seen this train wreck coming for 7+ years already

Irrespective of the fact that it takes an Act of Congress to ban soft dollars, unbundling will be coming to the US.  Global asset managers have already stated that they intend to pay for research with their own $ for their European clients, and it is just a matter of time before they extend that to their US clients. (They would be crazy to tell a potential client that they intend to charge for something that they are supposed to produce themselves.)  However, the U.S. is under-prepared and has long sought to deny that MiFID was going to create unbundling needs.  Well, many are in for a rude awakening in the New Year.


About Author

Dan Sanders is Head of US execution services for Olivetree Financial, an independent agency broker which provides execution services founded upon the concept of Evidence Based Finance and upon the analysis of Event Driven situations. He was previously Head of Citi’s Execution Services in the Americas including Global sales trading, US electronic execution sales and US portfolio trading, capping a sixteen year career that began with Salomon Smith Barney. He started his career at PaineWebber trading Mortgage Backed Securities.

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