Climbing the Algorithmic Learning Curve
Major brokerage houses offer the algorithmic-trading strategies, which in most cases have been designed by their quantitative analysts and financial engineers. According to The Tabb Group's survey, the major suppliers are Credit Suisse First Boston (CSFB), Goldman Sachs and Morgan Stanley. Additionally, Investment Technology Group has been offering algorithmic trading since the '90s. But a slew of other marquee names are currently jumping on the bandwagon, including Banc of America Securities, BNY Brokerage, Citigroup and Lehman Brothers, among others. Other sources include buy-side quantitative analysts that create their own algorithms and third-party vendors like FlexTrade Systems and Portware, which offer canned algorithms and tools to develop customized algorithms.
"The advantage of a platform like Portware is that we can write our own algorithms for effective trading tactics," says Michel Debiche, president and CEO of Quantia Capital Management in Princeton, N.J., which runs an equity statistical arbitrage fund that does automated trading.
Despite the hype over algorithmic trading, for many buy-side traders, it is not the only electronic tool they utilize. When First Quadrant's Bui evaluates her order flow, she still negotiates big orders through crossing networks and floor brokers who give her market looks - prices from the floor. She uses the VWAP strategy from Instinet, the institutional agency broker, for her "clean-up orders" - the residual that is left over from bigger trades. "They're more like passive orders," Bui explains. Other brokers have offered her VWAP strategies, but Bui has declined because she believes VWAP strategies and crossing networks do basically the same thing.
With brokers offering so many algorithmic strategies, one concern is that buy-side institutions lack the tools to understand which algorithm to use for a particular stock. There are two hurdles that must be overcome for algorithmic trading capability to be adopted by the buy side, contends Robert Hegarty, vice president, securities and investment practice at TowerGroup. "First, there's the buy side's ability to digest it - their ability to make use of the algorithmic models. They need a certain level of sophistication and understanding to use it," Hegarty says.
The second issue is "the willingness of the sell-side firms to give up control over the models," Hegarty continues. "They are doing a tug of war: 'Do I turn it over to [the buy side], or do I use it as a lever to get other types of business?'" If the brokers keep the models in-house, Hegarty says, they can still get buy-side customers on the phone and sell them other things. "That's sort of the dilemma that's out there right now."
Rob Flatley, managing director of electronic trading services at Banc of America Securities, agrees that buy-side firms are having a hard time evaluating when to use a particular algorithm. For example, if a portfolio manager tells a trader to sell a mid-cap, semi-illiquid stock within five hours - because the manager has to raise cash - the trader may be confused about which algorithm is the best solution given the constraints on liquidity and time, Flatley says.
But, brokers say their sales consultants and financial engineers will give the buy side advice on how the models work. "There's a huge amount of opportunity to do a better job to educate our clients when to use an algorithm and what type of order a particular algorithm is appropriate for," says Jeffrey Wecker, managing director and head of global connectivity at Lehman Brothers.
Meanwhile brokerage houses - many of which created the models over the past few years for their proprietary trading desks - are scrambling to offer the tools directly to their customers via traditional buy-side order-management systems (OMS) and other front-end trading systems. "We've built these kinds of tools for our own traders to use over the last several years," Wecker says. "What's new is the ability to provide direct access to these tools for our clients."
At a base level, firms are connecting to the algorithms via the Financial Information Exchange (FIX) protocol, though brokers may also offer their own portals or propriety trading systems that integrate direct-access trading. At the same time, brokers are working with third-party vendors, such as Charles River, Macgregor and Bloomberg, to embed access to their algorithms in the OMS or use a customized FIX order ticket so that the buy side can configure the strategy.
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