The Gateway to Algorithmic and Automated Trading

The buyside trader - empowered or extinct?

Published in Automated Trader Magazine Issue 02 July 2006

The introduction of Reg NMS next year will further compound other changes, such as decimalisation, that have transformed the equity market in recent years. Joe Wald, CEO of EdgeTrade Inc., explains how traders need to evolve and respond to meet this challenge if they are to remain relevant in the new environment.

The introduction of the SEC's Order Handling Rules in January 1997 represented a watershed for the US equity market. The rules required market makers to display client limit orders (or place them into a qualified ECN) that were not immediately executed and were priced at or better than the market makers' own current quotes. This was one of the factors that drove the emergence of direct market access (DMA). Since then, other developments have changed the way buyside traders operate. Reg NMS will shift the pace of this change into a higher gear (among other things it will drive the re-emergence of DMA - see Figure 1) and those traders who do not evolve and adapt in response are effectively running the risk of extinction.

Heed the call of change

Already, we can see a very distinct division emerging between those traders who realise that this is a challenge to face up to if they are to survive, and those who don't. Those who don't, fall into two sub-groups. One sub-group assumes that algorithmic trading and DMA will stall and therefore they need do nothing. The other sub-group believes that while algorithmic trading and DMA may take off there is no onus on them to do anything about it - their life will just become easier, as the technology does all the work.

Both these sub-groups are heading for a rude awakening. To all intents and purposes, when Reg NMS is aggregated with all the other recent market changes, the result will be a marketplace where it is effectively mandated that electronic systems must be used for trade execution. In terms of how traders use those electronic systems, the competitive bar will also be rising. Therefore, those traders with the skills to leverage electronic systems to the maximum will have the advantage.

Education and effort

To gain that advantage requires an education process. Traders need to immerse themselves in the technology to develop a strong understanding of direct market access and how it interacts with the new market structure. At the same time, they need a firm grasp of algorithms and how best to use them in facilitating the trading process. Finally, they need to evaluate transaction cost analysis to appreciate the impact their trading has on the marketplace. To do this, they will also need to analyse their trading venues and the implications of using various trading partners.

This is a challenge, but it isn't an insuperable one. For example, in the case of algorithms, traders do not need to understand the quantitative details or the nuances of FIX connectivity. Instead they can focus on the practicalities, such as how the algorithms operate in the market and react to various situations or types of events.

Some traders may feel tempted to take it easy, and assume that their pre-trade analytics will make the decisions for them: this is a mistake. Pre-trade analytics are an effective tool in some ways and misleading in others. They are valuable in terms of highlighting the trades in a list that might be problematic and therefore require greater attention from the trader. However, they cannot predict the future or replace human judgement. Ultimately, pre-trade analytics are a decision support, not a decision replacement, tool.

Figure 1

Integration and collaboration

Only when traders have a solid understanding of the technologies, markets and trading partners at their disposal can they start to think about how to integrate all these into a homogenous and effective trading style. Algorithms and technology cannot replicate all a human trader's skills - they may be highly appropriate for some trades and not remotely suitable for others. Therefore, one of the new skills that the empowered trader needs to develop is the ability to understand which parts of his/her traditional role to hand off to the technology and which to retain. That isn't a static process - markets are dynamic and the way in which an algorithm performed yesterday isn't necessarily the way it will perform today, so trades originally passed to algorithms may have to be taken back for manual execution, and vice versa.

The understanding gained from these learning and integration processes also allow the empowered trader to collaborate more effectively in the design of new algorithms that will assist them in their role. We have found that those traders who already have a good understanding of how existing algorithms interact with the market are highly effective participants in this sort of creative development. On the one hand they can express their requirements very clearly. On the other, they are an invaluable source of wellinformed feedback. The most conducive backdrop for this collaboration between a trader and his algorithmic provider is an agency-only firm that poses no conflict of interests such as proprietary trading, market making and data mining. By contrast, where there is a potential conflict of interest, the benefits of any collaboration will obviously be impaired by confidentiality concerns.

Figure 2

Choose your partners

Apart from understanding and choosing the appropriate technologies, the empowered trader will have a further challenge as Reg NMS approaches - picking the right trading partners. The last two years have seen a lot of broker activity, such as buying stakes in execution venues and building internalisation engines. The snag is that many traders wrongly assume that because they cannot be traded through, post Reg NMS, these developments will not affect them.

Not so. In order to be competitive, traders will need the best possible order routing and direct market access tools. The trader who wishes to be empowered will be asking questions like, "If my broker owns an execution venue, will it be as quick in routing my order to a venue where it can trade at a better price as my own independent DMA/routing tools?"

Final thoughts

Those buyside traders who still think sitting on their hands is the best response to the future might care to consider the numbers. They prove beyond question the increasing predominance of technology in equity order execution.

TABB Group's 2005 Institutional Equity Trading Report (see Figure 2) shows phone broking dropping from 48% of volume traded in 2004 to 31% in 2005, and with a projection of 20% for 2007. Both algorithms and ECN/DMA rise inexorably over the same period.

In the light of that alone, masterly inactivity is clearly not a great career move - but this is only one of the most obvious examples of how the market place is changing.

Responding to this change will require traders to make an effort on several fronts: learning about DMA/algorithmic technology, understanding how to integrate that to best effect with their trading style, and re-evaluating their trading relationships to identify conflicts of interest. Only those traders prepared to take these steps will be empowered - those who bury their heads in the sand risk extinction. .