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Market volatility forcing US equity traders to change execution strategies, says Tabb report

Market volatility that has reached unimaginable levels and shows no sign of settling back down to pre-crisis levels is changing the way US equity traders behave, including the way they use capital, transact trades in blocks, embrace algorithms and crossing networks and view their relationships with brokers, says a new report.

Buy-side traders are altering their execution strategies, resulting in a realignment of market share and a reevaluation of broker relationships, according to U.S. Institutional Equity Trading: Crisis, Crossing and Competition, an annual benchmark study conducted by research and advisory firm Tabb Group.

As a result, the report says, sell-side brokers' sales traders have increased their share of order flow for the first time in years, capturing 44 per cent of total buy-side flow, up from 37 per cent last year. Although the equity sales trader has enjoyed a comeback amid this year's extreme volatility, the question remains whether the change is temporary.

Tabb Group interviewed 61 head traders at traditional long-only institutional asset management firms representing an aggregate USD12.9trn in assets under management, conducted during the period when the US government has taking over Fannie Mae and Freddie Mac and when Lehman Brothers was tottering on the brink of bankruptcy.

Confirming that buy-side traders fear moving large blocks in highly volatile markets, 51 per cent of respondents said their block executions had decreased year-on-year in 2008. 'The percentage of volume executed on crossing networks has dropped for the first time since Tabb began tracking it in 2004, in line with the overall drop in block-sized transactions,' says Laurie Berke, a Tabb Group senior consultant and the study's author. Nearly 90 per cent of the study's participants increased or are maintaining the amount of their order flow executed using algorithms compared with 2007.

Berke, who joined Tabb Group in May 2006, has more than 20 years' experience in equity and derivatives trading and technology, having spent 10 years in global execution services product management as a director at ITG, following five years as a senior vice-president at Merrill Lynch. She began her career in 1979 in options sales and trading at Paine Webber, where she launched the stock index arbitrage trading desk in 1983, and from 1985 to 1990 she led the equity sales and trading team for Kidder Peabody's portfolio trading and financial futures division.

As bulge-bracket firms undergo restructuring, risk capital has become scarce and, according to Berke, a majority of buy-side firms say that the cost of capital has risen while the number of brokers willing to commit capital has dropped.

Asked what they need their brokers for most, more than 30 per cent said liquidity reigns supreme. This year just 13 core brokers are receiving 72 per cent of the buy-side flow, compared 64 per cent enjoyed by more than 15 core brokers in 2006.

However, Tabb Group argues that the trend toward ever-increasing broker consolidation has come to a halt as buy-side firms diversify their trading and commission-sharing agreement relationships, opening new opportunities for mid-tier and niche brokerage firms. 'The next five brokers outside the core group will grow market share by as much as 20 per cent by 2010,' Berke says.

She concludes: 'The core broker list has stopped shrinking, and while the loss of several bulge-bracket players required re-allocation of existing flow, the stage is set to encourage and reward that next tier list of sell-side firms.

'If liquidity really is king, buy-side traders will pay tribute with incremental commissions. Whether it comes over the phone, via IM, via IOI or in an electronic liquidity pool, brokers can build market share through coverage and persistence.'

'In some ways, just as the banks will have to go back to taking deposits to loan out money, brokers will have to go back to offering insight, expertise and a partnership to keep the orders flowing in,' adds Adam Sussman, director of research at Tabb Group.

Founded in 2003 and based in New York and London, Tabb Group uses an interview-based research methodology developed by founder Larry Tabb to analyse and quantify the investing value chain linking the fiduciary, investment manager, broker, exchange and custodian.

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