Private investors are set to enjoy cheaper equity trading as increasing numbers of stockbrokers offer a direct route straight to the order book of the London Stock Exchange.
Direct market access – where trades bypass the traditional third- party marketmakers – was until fairly recently the preserve of institutional dealers and highly experienced individuals. Now the door is opening to more mainstream traders.
TD Waterhouse, an online stockbroker, has recently started to offer direct access to clients trading by telephone. Barclays Stockbrokers plans to launch direct trading early next year. Meanwhile, iDealing, which already allows clients to make electronic trades on the order book, is seeing rapid growth in demand.
The main advantage to direct trading is, quite simply, a better price. Traditionally when a trade is placed it goes from a stockbroker to one or a number of marketmakers. These groups set prices for the bid/offer spread. If multiple marketmakers are involved, the broker will typically offer clients an average price. Marketmakers take the opposing position to you – they sell what you buy and vice versa. The difference between the buy and sell price is taken as commission.
By going directly to the stock exchange you eliminate the marketmaker and so typically get a tighter spread. The way it works is that you submit an order to buy or sell a specific amount of stock at a specific price. This order is sent to a central “marketplace” – or order book – where buyers and sellers are paired up directly. Unlike trading through a marketmaker, trades made on the order book are conducted directly between buyer and seller at one price. The outcome is that you can generally sell stock for a little more and buy it a little cheaper than you would have done via a standard trade with your broker.
Michael Foulkes, chief executive of TD Waterhouse’s European division, says: “Direct market access is the purest form of trading in the market. We are in the early stages of offering it to UK retail investors but expect it to really start to take off within a year.”
The barriers to offering direct market access are currently quite high – technology is expensive and brokers have to vet clients to make sure they have sufficient knowledge to trade in this way.
Amy Nauiokas, head of Barclays Stockbrokers, says brokers often charge higher commission for direct market access trading than they would for standard trades. For example, iDealing charges £9.90 per standard trade. Direct market access trades cost £10 up to £10,000 and after this 0.1 per cent of the trade. Also, each direct trade made incurs a clearing fee of £2.25. Killick does not charge extra for direct trades. But its clients can only place these over the telephone via the broker – they cannot place them straight on to the order book themselves.
“Presently clients have to trade huge volumes very frequently to gain the benefits of direct access, otherwise they could end up paying the same or even slightly more for their trades,” says Nauiokas.
But she does not expect it to stay this way. Barclays is exploring ways to make direct access available for less active, but increasingly shrewd investors. One option is Barclays trading directly on the order book and passing back cost savings by setting narrower spreads for clients.
Foulkes says only a handful of the most “attentive and knowledgeable” clients are trading directly. “But the steady march of technology is making this cheaper and more accessible,” he says.
IDealing started to offer electronic direct market access to clients last year. Gary Duckworth, business development manager, says demand has grown rapidly. “We have had a lot of interest from clients, especially those trading within a Sipp or Isa.”
Direct access is currently available for all stocks in the FTSE All Share and around 90 additional stocks listed on the Alternative Investment Market (Aim). In early 2007, all remaining quoted stocks will be able to be traded on the open book four times per day.
“Clients have become increasingly aware that the cost of trading is not just the broker’s commission but also the effect of the bid/offer spread,” says Duckworth.
Investors may find the best savings on smaller, more niche companies, which might be considered more volatile and therefore are likely to have wider spreads. But brokers say direct access offers cheaper trading even on the most liquid FTSE 100 stocks.
By trading direct on the order book, you can actually influence the price of the spread. You are effectively trading as the marketmaker so you can submit any price you wish to buy or sell at.
For example, a recent bid/offer spread for Dana Petroleum was £12.36-£12.40. The best price put forward by a potential buyer becomes the selling price listed on the LSE – in this case £12.36. This reflects the fact that a seller will want to trade with the buyer offering the highest price. Similarly the lowest selling price submitted to the order book becomes the buy price on the quoted spread – £12.40. If in this case you submitted a buy order within the spread – for example £12.38 – this automatically becomes the most attractive price to a seller and so narrows the spread to £12.38-£12.40.
“This gives fantastic control to the trader,” says Duckworth.
Direct market access is also more transparent than using marketmaker spreads as you can see exactly what price someone is willing to pay. Another advantage is that you can trade in “auction periods” – that is the 10 minutes before the market officially opens and 15 minutes after it closes.
If you want direct market access, you will have to prove to a broker that you have sufficient knowledge of the market and trading experience to cope with this type of trading. Once your account is set up, the broker will add the London Stock Exchange to your list of accessible markets.
