The Financial Services Industry Increases Its Demand for Transparency
The demand for transparency has spread across the financial services industry, extending to the micro level of electronic trading, as buy-side traders increasingly seek additional information on - and control over - the broker algorithms they use.
Certainly, a principal goal of algorithms is to automate aspects of trading. But as algorithms become more advanced and traders more proficient in using them, benefits could accrue to those who can monitor their orders more closely throughout the trade life cycle - and, in some cases, adjust those orders to changing market conditions.
"When you're trading manually, you can get a feel for where things are going," says Nenad Yashruti, head trader at Seattle-based Freestone Capital Management, which manages about $1.8 billion in client assets. "Algorithms are great at sourcing pools of liquidity, being quick and dancing on different exchanges and venues - that function is absolutely necessary in today's market. But algorithms can't see and anticipate like a human," he explains. "When you're putting out an algorithm, you're really trusting the logic," Yashruti adds. "The best we can do as traders is understand that logic and see it in motion."
As the portfolio manager of a hedge fund at MKP Capital Management ($5 billion in assets under management) in New York, Michael Stivala helped develop the firm's trading algorithms, giving him a better understanding of the logic behind algorithms than most. His experience with a former employer, where he oversaw allocations to systematic trading strategies for one of the world's largest fund of funds, gives him an additional perspective on the benefits of trading transparency. "I can certainly appreciate the desire for managers to want to know how their trades are being executed," he says. "It's all about slippage. You want to monitor this, and the only way to do that is by understanding how your trades are being executed."
The Best-Laid Plans
Indeed, it's when things go awry that additional monitoring capabilities can be crucial.
"Most of the time, the current level of transparency of broker algorithms is sufficient for normal trading activities," according to Paul Netherwood, a partner at Beach Horizon, a London-based systematic trading firm focused on commodities and financial markets. "It's in particularly volatile conditions and for markets with fickle liquidity that you need the control, which you don't have with most external algorithms," he says.
"As it stands now, when you send out an [algorithmic] order, you not only lose sight of it, you also lose the ability to affect it in any meaningful way," Netherwood continues. "During the execution process, you don't gain any immediate feedback on the strength or weakness of a market that might enable you to make adjustments to your execution strategy. If, however, you can track an order throughout the process, you have the ability to pull it back, change execution instructions or even switch to another exchange or platform."
And transparency becomes even more important as a fund grows, Netherwood adds. "When you're dealing with larger size, that's when efficient execution algorithms become essential," he asserts. "As your asset size grows and the size of your trades increase, execution algorithms have to be within your control."