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Want an Algorithm With That?

Major brokerage houses are franchising their algorithmic trading strategies to smaller firms that are feeling pressure to offer the service.

With a nod to the Golden Arches, large broker-dealers that have built algorithmic trading infrastructures have begun to franchise their quantitative trading strategies to small and midsize sell-side firms. Major sell-side firms, including Banc of America Securities (BAS) and Credit Suisse First Boston (CSFB), are reselling their algorithmic tools, giving other sell-side firms the right to use the algorithms on behalf of their institutional customers.

Small and midsize broker-dealers that lack the resources and time to invest in developing volume weighted average price (VWAP) engines and other quantitative strategies can offer the proprietary benchmark trading strategies to their buy-side customers who are demanding them. In return, the source firms are paid a few mils - short for milicents, or thousandths of a cent - per share based on the volume that's pumped through their models.

"We give you the french-fry grill, the Big Macs and everything," says Rob Flatley, managing director of BAS' electronic trading services group. Since February, the bank has been "prefabricating" its infrastructure to prepare to sell to smaller brokers - bundling connectivity, order-entry screens and access to algorithmic trading servers and direct-market access order-routing technology. In October, it launched its Algo-Connect initiative, designed to give other sell-side firms the ability to offer sophisticated trading strategies to their buy-side customers.

Banc of America Securities even lets the brokerage firms treat the algorithms as a private label product. The reseller's brand name is put in front of the customer for a particular strategy. Still, even if the franchisee broker puts its own name on the algorithmic strategy, the execution occurs on Banc of America Securities' side, virtually invisible to the institutional firm. "That's really the intellectual capital of these firms; it's really the algorithms themselves," says Gavin Little-Gill, senior analyst in the investment management research service at Needham, Mass.-based TowerGroup. "You're not going to see these firms giving up the source code, so to speak."

When it's time to execute an order, a broker-dealer that is utilizing BAS' algorithms would also utilize BAS' direct-market access service to route the order to either an exchange or an ECN. BAS' Flatley says the originating broker-dealer gets credit for the volume, it represents the order at the exchange or ECN, and it still preserves the execution and clearing relationship with the buy-side client.

But, why are buy-side firms trading through the smaller brokerages, rather than trading through BAS directly? TowerGroup's Little-Gill suggests that the motivation is tied to the smaller brokerages' research offerings. The buy-side firms likely have research bills with those smaller brokerages; to pay those bills, a buy-side firm directs a portion of its trades to the small brokerage house that provided the research. (This is often referred to as a soft-dollar arrangement.)

What's Mine Is Yours

To connect with the sell-side, BAS has integrated access to its advanced algorithmic strategies with sell-side order-management systems - namely Bloomberg Professional, Portware Professional, Royalblue Fidessa and SunGard Trading Systems' BRASS OMS, UMA and Broker DirectU2. Integrating with sell-side order management systems isn't novel, says Ian Domowitz, managing director of analytical products and research at Investment Technology Group (ITG). Big brokers have already done this with OMSs on the buy-side, including those from Macgregor and Charles River.

What is new is the idea of letting sell-side firms use various services that ordinarily would be held closely by the proprietary trading desk on the sell side, or given out exclusively to buy-side institutional investors, Domowitz says. ITG is discussing this possibility with certain broker-dealers as part of its broader strategy of providing value-added layers on top of algorithmic trading and direct-access, he says.

Technically, it is easy enough to do that, and other large broker dealers are likely to follow, according to TowerGroup's Little-Gill. "All you need is a custom order-entry screen and the ability to translate the details into a FIX message," he says. Large broker-dealers have already been doing this with buy-side customers and hedge funds.

Banc of America Securities' Flatley says, however, that not all brokerage firms are prepared to process transactions for other brokers who they may regard as competitors, even if their technology infrastructures are up to the task. "Politically, it's a difficult thing to get over," he says. Avoiding hide-bound thinking, he notes, BAS rebuilt its business with an eye on leveraging its technology platform to external customers. "We might as well add value in the transaction chains," he says.

There appears to be a market among small and midsize broker-dealers. Though they lack the resources to develop their own algorithmic trading servers, or the years required to test the models, build the databases and master the reporting, they have the buy-side customer relationships to leverage the trading strategies of the larger players.

"In this day and age, everyone is talking about consolidation and offering a full suite of services in order to survive, and algorithmic trading is essential," says Gene Choe, vice president of Broker Dealer + (BD+) at CSFB.

Buy-side customers are asking for the algorithms, and so the smaller brokers have to find a way to offer them, or risk losing the business. "Algorithmic trading has become a self-fulfilling prophecy," says Bill Cronin, president of Direct Trading, a Dallas-based direct-access broker that began running BAS' algorithms about nine months ago after switching from Schwab Soundview Capital Markets (which was recently sold to UBS Financial Services). Cronin offers a front-end technology directly to buy-side institutions. "The reason to have the algorithmic order types out there in conjunction with the standard limit order markets and ECN discretion is from customer demand," Cronin explains.

CSFB is also targeting the broker-dealers, such as research boutiques, where trading may not be a core competency, Choe says. CSFB began looking at the broker-dealer community last spring. The company's first move was to integrate the buy-side order management systems, a step it has completed. This year, it focused on the sell-side systems, according to Choe, who estimates that 95 percent of the sell-side systems now have CSFB's algorithms. "Basically, our approach is to tell the sell-side customer, 'You can have a pipe to our BD+ strategy servers and leverage it to maximize your firm's strategy,'" he says.

Some of these sell-side firms are looking to outsource their trading desks to pure agency shops; others are looking to handle larger orders and increase their capacity to handle more volume. "Just by adding BD+ on the sell-side desk, it allows them to scale capacity and increase productivity," Choe says. Brokers often use the tools on their program trading desks.

The Bottom Line

There are a number of reasons buy-side firms are demanding algorithmic trading. BAS' Flatley says the economics of the buy-side and sell-side relationship are propelling smaller sell-side firms in the direction of electronic trading. A steady drop in transaction rates is forcing sell-side firms to become more efficient in how they process trades and to lean on automation and computer power more than ever before to cut costs.

Meanwhile, buy-side firms aren't willing to compromise on the quality - or cost - of execution. "The buy side is being more closely monitored and scrutinized for its execution quality," Flatley notes. Algorithmic trading offers the buy side a less expensive option to full-service brokers, while providing a way to complete a complex order type.

Yet small broker-dealers like Direct Trading say access to big brokers' algorithms is far from cheap. Still, the ability to offer algorithmic trading is quickly becoming a competitive necessity. "It's far more expensive than traditional execution venues," Direct Trading's Cronin says. "But, if a customer feels that he's getting a better execution, it's incumbent on us to provide it."

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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