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5 Trends Shaping the Buy-Side Trading Desk

Among the top trends on the buy-side trading desk in 2011, the biggest development is likely to be the increased reliance on transaction cost analysis to entice institutional investors and ensure best execution.

As 2010 draws to a close, a chastened Wall Street has emerged. Financial services firms have been reined in by the strictest regulatory environment since the FDR administration, an uncertain macroeconomic landscape and choppy trading conditions.

Even as the global financial crisis continues its arduous slog into the rearview mirror, industry insiders say the buy side will remain cost-sensitive in 2011, with an eye on boosting assets under management while paying less for trading tools and executions. Meanwhile, as regulators sort out how the landmark Dodd-Frank Wall Street and Consumer Protection Act will function, experts predict buy-side firms will lobby hard in the nation's capital to ensure that they get a favorable interpretation of the new rules.

1. Growing Reliance on TCA

But with fund managers increasingly challenged to generate alpha -- a measure of a manager's ability to outpace general U.S. stock market returns -- the biggest buy-side trend next year will be firms' heavy reliance on transaction cost analysis specifically to entice investors, contends Fred Federspiel, founder and CEO of Pipeline Trading Systems, the New York-based operator of the Pipeline ATS, which specializes in block executions. "In the upcoming year we will see a real revolution in transaction cost analysis as firms deploy TCA that is completely focused on increasing assets under management," Federspiel predicts. "We are finally at the point where we can move beyond VWAP [volume-weighted average price] benchmarks, beyond noisy implementation shortfall benchmarks, into TCA that helps traders make decisions that increase alpha capture by the trading desk."

Federspiel says the controversy surrounding high-frequency trading in the aftermath of the May 6 Flash Crash has been a blessing in disguise of sorts for institutional investors because it raised their awareness of adverse selection costs, which essentially push the execution of trades beyond the best possible price. Typically, he explains, institutional investors such as pension plans have relied on the volume-weighted average price, which is calculated by dividing the total cost of every trade in a given security for the day by the total number of shares traded.

But many market participants observe that high-frequency traders, whose black boxes are colocated at the exchanges, are able to outmaneuver slower-moving investors, forcing institutions to pay more for buys or to sell stocks for less than they could have -- discrepencies that are hidden from VWAP analysis. Federspiel argues that innovation in how TCA is used will level the playing field.

"In the last several months we've had intense scrutiny placed onto the question of high-frequency trading, its value and its negative impact on the institutional trading community," Federspiel says. "That scrutiny has led to a blossoming of our understanding of adverse selection costs. And we now have TCA methods that measure the adverse selection costs involved with different trading techniques, and we can identify -- and traders can now use -- those TCA techniques to minimize their losses to high-frequency trading operations."

As high-frequency traders continue to usurp the role traditionally played by market makers and specialists, TCA will help institutional investors source liquidity without paying exorbitantly for it, Federspiel explains. "You can't hide in dark pools -- [high-frequency traders] are in every market and in every dark pool, so the key is to properly identify trading techniques that minimize these losses in different market conditions," he advises. "The main goal is collecting sufficient liquidity but doing so without incurring excessive losses due to high-frequency trading operations."

In a difficult market where alpha has proven to be elusive, the buy side will take a more critical look at the TCA tools it gets from providers, adds Ethan Levinson, president of agency broker SJ Levinson & Sons. "From a TCA standpoint, how useful are the numbers?" he poses. "People are starting to evaluate the cost of doing business across the board."

Levinson, whose firm provides institutional clients with quantitative analytics along with global equity and derivatives strategies, contends that in today's volatile markets, static reports won't be enough to satisfy buy-side desks. Rather, buy-side traders will demand real-time service. "As volumes are down and people are a little bit more skittish on the market in general, [traders] need to go to a place where they feel they can trust the person on the other end of the phone," Levinson says. As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio

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