TORA is a cloud-based front-to-back office technology provider for the buy-side.
After driving a sea change in how brokers charge for their investment research, the next target for regulators seeking to stamp out potential inducements could be the sophisticated technology that powers fund managers’ share trading desks.
With the introduction in January of the revised Markets in Financial Instruments Directive, or Mifid II, regulators stamped out the practice of bundling the costs of research and trade execution together. Their view was that the research represented an inducement to trade whereas they wanted to encourage asset managers to pay separately for research and choose their brokers based on their skill.
Some industry insiders argue the same level of scrutiny should be applied to the cost of the trading technology portfolio managers need to buy and sell shares and who pays for it.
The practice of brokers paying for trading software is widespread, and although these arrangements vary across firms, insiders say there is little transparency about who pays for what.
Asset managers, for example, may not know how much brokers pay to third-party providers on their behalf. The money to pay technology vendors is believed to come out of the commissions that asset managers pay brokers to trade. Some vendors of the trading technology even charge brokers a percentage of the commission or a fee of the notional value traded.
Opponents of brokers paying say that if asset managers paid the costs of these systems directly, they would be tougher on negotiating down the costs charged by tech providers. One broker said: “We have clients for whom we pay vendors $500 per month to connect, and others on a different [system] where the fee could be $15,000 a month. That more expensive [system] enhances the [fund] managers’ ability to execute” a trade.
Octavio Marenzi, co-founder and CEO of Opimas, a consultancy, said: “There is a bit of a conflict here. Broker-dealers have to pay the fees, otherwise they can’t get the business, which sounds to me like an inducement.”
Regulators so far have not taken action to declare that the status quo arrangement constitutes an inducement. In some aspects of the system, they have approved it.
One specific area that is the subject of debate is how much brokers pay for so-called FIX connections that allow fund managers to send orders instructing their brokers to buy or sell shares. The Financial Conduct Authority’s guidance has been interpreted so far as indicating that connections used for transmitting orders are part of the service of executing trades.
Despite the FCA’s guidance, two people said they knew of a fund manager that had decided to take the cost of their 100 or so FIX connections back from brokers, but balked at the price and reduced its total number to around 10.
Others fear that some brokers are paying more than they need to for FIX connections in order to quietly subsidise the costs of the other technology used by asset managers. There is concern that the industry risks drawing regulatory scrutiny if the charges paid by brokers exceed the real cost of these connections.
People familiar with the matter say that the FCA has communicated to individual firms that two other technologies comprised within the overall system, the Order Management System (OMS) and the Execution Management System (EMS) would generally have to be paid for separately by asset managers.
Fund managers argue that they are already struggling to cope with heightened regulatory scrutiny, pressure on the fees they can charge and the need to cut costs in order to keep up with the rise of passive managers that mimic stock market returns.
However, one trading technologist, who declined to be named because of the sensitivity of the issue, said that fund managers ultimately pay for the connectivity and technology through higher trading commissions than are necessary.
The fog of fees
In theory, overall trading costs for fund managers would come down if these technology-related costs were paid directly by fund managers. In that scenario, technology providers would compete directly for fund managers’ business the way research providers are doing now — along with the attendant pressures on unsuccessful providers to improve or go bust. But it is hard to determine what the effect of unbundling would be in practice. To many, the root problem is the opaque nature of the arrangements themselves.
Oren Blonstein, a managing director at Tora, a provider of order and execution management systems, said it was “tricky to say this is absolutely an inducement”.
He admitted, however, that “there has always been a lack of transparency” around these matters. Blonstein said Tora is still a relatively new entrant in some markets, such as Europe, and that the existing practices present barriers to the growth of his business.
A November 2017 report by research firm Aite Group, commissioned by Tora, found that some investment managers are “unaware of or significantly underestimate” how much brokers pay to tech providers they use to trade on their behalf. The report, which made no reference to inducements, found that most of the hedge funds surveyed reported using “only 20% to 30%” of these systems’ functions, all of which they pay for.
The study, which was based on 15 in-depth interviews with senior executives at global hedge funds in the second and third quarters of last year, said that the cost of the technology can be “hidden and indirect”.
Andy Mahoney, head of sales at software provider Flextrade, said that asset managers pay for the Flextrade software itself, covering customisation cost, automation and analysis, whereas brokers and brokers pay to get their algorithms and other services in front of asset managers.
However, he added: “I definitely think there is more to be done across the industry to ensure price transparency – many vendors hide behind [brokers’] fees, or consultancy rates without ever fully disclosing the total cost of ownership to [fund managers].”
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