The best laid plans oc-casionally go awry because of good fortune rather than for negative reasons, as seems to be the case for Canada’s institutional investors over the past year.
New research by Connecticut-based Greenwich Associates shows that institutional investors didn’t follow through on many of their intentions for the year. They didn’t rush into electronic trading, do all their own research or abandon the use of “soft dollars.”
Although firms’ plans are often thwarted by lifeless markets or competitive pressures that force them to batten down the hatches, it appears that very strong and active markets were behind the recent shift in agenda.
Indeed, Greenwich reports that assets under management for the Canadian firms it surveyed were up about 42% year-over-year. Similarly, the trading commissions paid by the buy side rose by 41% to an estimated $790 million. The numbers are more or less in line with the latest data from the Investment Industry Association of Canada. It reported that equity trading revenue for securities firms rose by 46.5% in 2006 over the previous year and, through the first half of the year, equity trading revenue rose by a further 6.3%.
Greenwich consultant Lea Hansen says it makes sense for firms to shelve any major strategic plans in the current market, which is not only robust from a business standpoint but also appears to be in the midst of ongoing evolution.
The competitive landscape for trading is in flux because of the long-awaited emergence of alternative trading systems. The development is still in its early stages, and how it plays out remains uncertain. Although some market-watchers believe that Canada’s market is big enough to support only a few ATSes, a number of hopefuls have recently launched or plan to do so shortly. Others are still in the works.
It’s far from clear who the winners and losers will be, but the emergence of fierce competition can only be a positive development for institutional investors, as it should lead to better service and/or lower prices for them.
Moreover, the industry is facing the prospect of changes in the regulatory environment, including efforts to integrate the ATSes, establish trade-through rules, implement a national rule on the use of soft dollars and broaden the definition of “best execution.” The final details of the rules may go a long way in determining how the trading landscape evolves. In the meantime, investors need not hurry to alter their businesses radically.
The fact that the rules have yet to be adopted may not in itself be considered a good thing, but poor rules, hastily implemented, would certainly be bad. So, the time the regulators take to get it right is certainly better than the alternative. The continued uncertainty about the content and timing of the essential rules is just one more reason for institutional investors to bide their time.
“Stepping back to watch how market dynamics and regulation play out, both domestically and in the U.S. and other countries, may in the end prove a very sound strategy,” Hansen wrote in the report.
Indeed, many of the same critical factors that are influencing the development of the Canadian market are also still shifting in the U.S. and Europe. Given the influence that the foreign and domestic industries and regulators have on one another as they try to sort out the same kinds of competitive issues, it makes sense for Canadian firms not to rush to alter their businesses in any fundamental way.
The firms’ use of soft dollars is perhaps the clearest example of this. Just a few years ago, firms were swearing off the use of soft dollars, fearing regulators might ban them or severely restrict their use. The share of trading commissions allocated to soft dollar arrangements by Canadian firms dropped to 8% in 2006 from 11% in 2005, Greenwich reported.
However, some of the regulatory pressure to clamp down on the use of soft dollars seems to have eased recently, particularly in the U.S., so the move away from soft dollars seems to have abated as well. Greenwich found that, in 2007, Canadian firms’ use of soft dollars slipped a little, to 7% of commissions, and investors expect to keep it at that level for the time being.
@page_break@The apparent holding pattern in the use of soft dollars mimics that of Canadian regulators, whose rule on the use of soft dollars has been in limbo for a year, ever since the comment period closed in October 2006. Their other proposals, for changes to market structure rules and best execution obligations, closed in July.
Although the industry seems to be waiting to see how regulators rule on such critical issues, the Greenwich survey asked portfolio managers how their businesses might change if the Canadian Securities Administrators’ proposals on soft dollars were adopted. Most don’t anticipate a great change, with 76% saying that it won’t affect their use of full-service brokerage research, 46% saying it won’t impact the use of third-party research and 58% saying it won’t affect their use of other third-party products and services.
In all three areas, however, more institutional investors expect their usage to decline rather than increase. For example, 16% indicate their use of broker research would decline after the rules take effect, whereas 8% say it would increase.
Another area that could be affected by the proposed soft dollar rules is electronic trading. The survey also found that — contrary to expectations — 42% of institutions say their use of electronic trading would decrease, or decrease significantly, if the proposed soft dollar rules were adopted. The rest of the industry expects its usage to stay the same; no one expects it to increase.
Greenwich notes that this is exactly the opposite of what is expected to happen in Britain, where restrictions on soft dollars are predicted to boost the use of electronic trading. Of course, the soft dollar issue is not the only factor that is likely to affect the popularity of electronic trading in Canada. The regulators’ decisions on best execution and market structure rules will also weigh heavily on the development of that emerging segment.
As it is, Canadian firms continue to lag their U.S. counterparts in the adoption of electronic trading. Greenwich reports that, in 2007, electronic and portfolio trading still accounts for less than a quarter of institutional investors’ equity trading volume, which is more or less unchanged from the previous year. By contrast, U.S. investors are executing about 37% of their trades electronically.
Electronic trading probably hasn’t taken off in Canada as it has in the U.S. for a variety of reasons. For one, the shallower penetration of electronic equity trading in Canada reflects less use of algorithmic trading by domestic firms. Greenwich’s report shows that the popularity of direct-market access trading is about equal on both sides of the border, but there is a notable difference in the use of algorithmic trading.
Just 42% of firms say they use algorithmic trading in Canada, compared with around 75% in the U.S. It accounts for 13% of volume here, compared with 19% in the U.S.
One reason algorithmic trading has lagged in Canada is the lack of trading technology to facilitate such an activity. However, that is changing with the advent of a number of ATSes that are targeting algorithmic traders, a development that has been matched by the dominant equity market, TSX Group Inc. , upgrading its existing capabilities and launching new services designed to serve the niche.
It remains to be seen how the various competitors in the evolving trading game fare but, for now, buy-side investors don’t appear to be anticipating a huge shift in their behaviour. Greenwich finds that Canadian firms expect the market share for algorithmic trading to grow to only 17% of volume, and overall electronic equity trading to rise to about 37% of trading volume, within the next three years.
If institutions follow through on their plans, it would put the Canadian market where the U.S. is today, in terms of reliance on electronic trading. The goalposts are moving, however, as the use of electronic trading is still growing in the U.S., where investors can expect electronic trading to grow to account for about 50% of equity volume, Greenwich reports. IE
Institutional investors given an unexpected boost
Many big Canadian investors shelved their strategic plans over the past year because of markets’ surprising strength and activity
- By: James Langton
- October 15, 2007 October 15, 2007
- 13:18