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Trading

Order management costs coming out of the dark

Factors converging to show how providers will get paid for access

Spencer Mindlin said recent acquisitions indicate that trading technology providers don’t want to be left out after any shakeup.

The cost of order management system connections for securities trades, often unknown to money managers and others on the buy side, is coming out of the shadows, sources said.

That's due to several factors, including reduced commissions to brokers that were paying for these connections themselves; the potential for brokers to pass on these costs to the buy side; and the disclosure of trading execution costs under MiFID II that could lead to transparency on connectivity.

Those factors could alter the landscape of how providers of order management systems, which execute securities trades, are paid for access to their systems. Those payments traditionally are done through non-disclosure agreements between brokers and providers that have been in place, in many cases, for more than a decade, sources said.

"There's a larger narrative taking place in asset management," said Spencer Mindlin, capital markets technology analyst at Aite Group LLC, Boston. "There's a convergence of disclosure, a sell-side revenue crunch, changes in how (order management systems) will be used in the future and how those changes will affect OMS business. OMS providers will have to adjust or go out of business."

What has spurred that money management narrative has been regulatory requirements under the European Union's Markets in Financial Instruments Directive II, which mandates unbundling and disclosure of research and trade-execution costs. And while MiFID II doesn't specifically require connectivity cost disclosure, some money managers are asking, "why not?"

Order management system "providers are unwilling to negotiate with the sell side on costs, which are in the range of 7-10 mils (.0007 to .001 cent) per share traded and/or a flat monthly connectivity fee," said Nanette Buziak, managing director, head of equity trading at Voya Investment Management, New York. "Put this in context of our current environment where commission costs have continued to drop dramatically as compared to where they were in the 2003-2005 time period when these (non-disclosure agreements) were established." Average commission rates in 2005 were 4 cents to 5 cents per share; the current average is 2 cents per share, Ms. Buziak said.

Factor in acquisitions

The issue of connectivity cost transparency could be one element behind last month's two major acquisitions of connection system providers. State Street Corp. (STT) announced plans on July 20 to acquire Charles River Development Ltd. for $2.6 billion. On July 31, SS&C Technologies Holdings Inc. announced a deal to buy trade management software provider Eze Software Group LLC from private equity firm TPG Capital for $1.45 billion. Both are cash deals expected to close later this year.

The Charles River and Eze Software deals "speak to where we are at in this, as regulatory changes have brought about a secular change to this part of our business that until recently had been unbeknownst to most buy-side firms due in part to the (non-disclosure agreements) that were put in place with the sell side over a decade ago," Ms. Buziak said. "It is effectively 'game over' for the OMS providers that charge the brokers such ... fees in this new regulatory environment that we have today."

Aite Group's Mr. Mindlin said the acquisitions point to a broader trend among trading technology providers "to have a seat when the music stops. These vendors have been around a long time. Their DNA is in the traditional equity space. That's not a growth space for money managers. You're starting to see consolidation because of the nature of the business."

The transparency issue could be exacerbated as brokers strapped by reduced commissions cut their own costs — possibly, said Mr. Mindlin, by disclosing and passing on connectivity costs to investors.

In a June report, "Order Management Systems in Focus: The Light and Dark Sides of FIX and Client Connectivity," Aite Group estimated brokers paid more than $1.2 billion in 2017 globally to vendors and connectivity providers that deliver the software and solutions to money managers. In contrast, the report said, stock exchanges in 2017 paid brokers $3.5 billion in access-fee rebates in a practice under scrutiny by the Securities and Exchange Commission through a proposed maker-taker access-fee pilot.

If those rebates ultimately are banned, "at some point, the brokers have to push back," said Linda Giordano, CEO at transaction cost analysis firm Babelfish Analytics Inc., New York. "It's possible" that brokers could pass on connectivity costs to money managers and others on the buy side, she added. "The way economics for brokers has become, they have to make money somehow. Maker-taker fees are a part of how they make money. Then things like commission compression and paying OMS fees. They have to find other ways to rein those things in."

'Even more consolidation'

If managers end up paying OMS fees, Mr. Mindlin said, "you'd see even more consolidation" among order management system providers. "You're seeing managers making decisions on what technology to use at a more strategic level, in the front office, picking only the ones that can have front-to-back and straight-through processing capabilities," he added. The system providers' "traditional costs are no longer tolerable. Vendors will need to adjust; those that don't will have to find another path."

However, there's a risk for brokers who do pass on those connectivity costs. That could lead managers already trimming their broker rosters because of research unbundling to whittle their lists further to those that will take on connectivity fees, said Jason Valdez, managing director and global head of equity trading at Penserra Securities LLC, Orinda, Calif. "It could create more reasons for managers not to do business with brokers," Mr. Valdez said. "They could say, 'We already have too many broker-dealers, sorry.' Now they're getting a free ride. What's it to them if they need to cut a few brokers because those brokers are now charging for this?"

Steven Glass, Bethesda, Md.-based principal and head of Zeno AN Solutions, agreed with that assessment. "As managers go to execution-only commission rates, they might have previously had OMS with 70 brokers connected, but as commissions went down and MiFID II required unbundling, the connections have dropped a lot, to like 15 to 20 brokers connected," Mr. Glass said. "If I'm a broker still paying for OMS software and connectivity, if I'm not getting the commissions I once did, do I still want to pay for that? So now the costs for connectivity will get pushed back to managers. And that brings up the same question as unbundling did — are they comfortable paying that cost themselves or will they pass it in to the end user? It's part and parcel with MiFID II and the cost of research. Can they live with that additional cost? And will there be an effect on investment performance with less connectivity?"

Mr. Glass, whose firm provides trading consulting and cost analysis to asset owners, said pension funds and other asset owners should ask their managers about connectivity costs, much as they had raised questions in the past year on the impact of MiFID II requirements. "From an asset owner perspective, this goes hand in hand with the need for conversations with managers on the impact of research cuts," he said.

Not in the short term

While some said the transfer of connectivity costs to the buy side is inevitable, David Margulies, head of electronic products group at brokerage Weeden & Co. LP, Greenwich, Conn., doesn't see that happening in the short term. "It's the elephant in the room," Mr. Margulies said. "No one wants to get into that too deeply." He also said that even if non-disclosure agreements over OMS fees are eliminated, "this is all still very opaque. It's not something that comes up in a normal discussion. In a typical case, the buy side will ask broadly for costs, but the discussion won't turn to paying X mils for receiving order flow."

Still, Mr. Margulies added: "There's nothing wrong with full disclosure on what these fees are. Regulators are focused on transparency. There's wind behind the push for more transparency and for what's actually going on. I don't see this kind of transparency happening in the short term, but it's only a benefit to everyone once it happens."