Speculation about Instinet Group's future has heated up again recently. Equities trading has not been an easy business to make money in during the past three years as investors looked for ways to cut their costs. Independent specialist brokers such as Instinet found it particularly tough.
But 2004 was a decent year for the firm. A reorganization, which involved the creation of two separate divisions, appears to have come off smoothly. One division, Instinet, is the institutional broker; the other, INET, is the alternative electronic trading system, which combines Instinet's old ECN with Island ECN, which the firm bought in 2002.
The reorganization has enabled each of the two businesses to concentrate more fully on its own clients and business development, and has come at a time when the equities trading business has picked up across the Street. As a result the company has managed to cut costs and to improve profits this year.
Reuters prepares to sell
But there are two things hanging over the group's head causing the speculation. First, conventional wisdom has it that independent brokers cannot, or should not, survive for long. Costs are supposed to be too high and profit margins are getting smaller. Equities crossing network ITG has been the target of sale rumours for the same reason, although that has not been reflected in its stock price.
Second, Instinet Group's largest shareholder, Reuters, which owns 62% having spun off the rest in a stock sale three years ago, does not intend to retain its substantial stake. Reuters executives have given no indication of timing, but have been stating all year that Instinet is a strategic investment that they expect to unwind at some point.
Thus the rumours have been swirling, to the point at the end of November that Reuters felt obliged to issue a statement declaring that it had not reached an agreement with anyone to sell the equities broker but was looking at all options.
A slight drop in its November trading volumes and in the average price it charged per share had tongues wagging again last month. What has gone almost unnoticed, though, is just how well the company fares against its peers when it comes to the nuts and bolts of the job: execution.
In a study by Plexus Group, which analyzes transaction costs, Instinet, the institutional brokerage, ranked top out of 883 brokerages, including the bulge-bracket firms, in delivering what Plexus dubs ?value-added execution? for trades of 2,000 shares or fewer.
That might not sound that impressive: it's the big orders that count, surely. But increasingly the buy side is breaking up its big orders into smaller and smaller pieces. In recent years, as technology has improved and as asset management firms concentrate much more on costs, the buy-side traders have become much more hands-on in the way they execute their trades, rather than simply handing them over to their preferred brokers to do. And one of their chief goals in a big trade is to avoid the cost of market impact, when sufficient information can leak out about the trade to move the price against you. Breaking up that order into smaller components is one of the main ways of trying to avoid that.
To come up with the data Plexus compared the price of stocks when released to the brokers with the price the traders got. Having worked out what the price change should have been Plexus set that as the benchmark and measured all the brokers against it.
Algorithmic trading
This is the hot part of the equities trading world right now: using computers to break up orders and send them to the best destination to meet the buy side's targets is central to the catchphrase of the moment in equities, algorithmic trading. Most of brokers are falling over themselves to show that they can do it well.
Judging who's best, though, is a difficult task: the systems are new, traditional buy-side firms have only started using them on a regular basis in the past year, and little independent analysis exists as yet. The Plexus study is not an explicit survey of algorithmic trading, but serves as a useful proxy.
For those still hooked on the big trades, Instinet does well there too. It has ranked top in Plexus's survey of block trades involving between 10,000 and 50,000 shares for the past three quarters.Daniel Goldberg, brokerage analyst for Bear Stearns, thinks this is just the start of a growth phase for Instinet. ?The firm's total US exchange listed market share remains very near the highest level in its history, 4.1%, and we continue to believe that operating leverage will come into play in the coming quarters,? he says. ?We believe pending market structure changes could drive this number up.?
If there is a buyer lurking out there, it might make sense to strike sooner rather than later.