The Buy Side Buys In

Why It's Important: Algorithmic trading offers a tremendous advantage to buy-side firms, enabling efficient, cost-effective and anonymous trading. It also allows investment managers to bypass interaction with sell-side trading desks, cutting down on trading times as well as conflicts of interest that arise when the sell side may have its own trading portfolio in mind.

Where the Industry Is Now: On the buy side, hedge funds still make up the largest segment of algorithmic users; however, to the surprise of many, traditional asset managers are adopting the practice in large numbers, particularly if they trade in index funds that measure their results against benchmarks. Currently, there is wide adoption of algorithms using basic techniques such as VWAP (volume weighted average price), TWAP (time weighted average price) and Implementation shortfall -- techniques that most, if not all, algorithmic suppliers can offer. But many buy-side firms are seeking algorithms that target more-specific and more-complex trading strategies.

Focus in 2006: Since nearly every provider offers some form of algorithmic trading, buy-side traders are seeking more-advanced techniques, such as algorithms that account for spread of liquidity. Extension of coverage beyond equities also is important as buy-side traders find themselves juggling multiple asset classes.

In addition, although transaction cost analysis (TCA) is nearly ubiquitous on buy-side desks, standards have yet to be established for how to determine what algorithms yield the best results. Most important, though, the buy side wants to integrate algorithmic trading with other technologies, such as order management systems and crossing networks.

Industry Leaders: Hedge funds and quantitative traders currently are the most active in algorithmic trading on the buy side. But Celent Communications projects that traditional buy-side firms will make up the largest segment of growth over the next two years, with compound annual growth of nearly 30 percent. Traditional asset managers, such as Barclays Global Investors and Ohio Public Employees Retirement System (OPERS), have acknowledged their active growth in this space. In fact, OPERS notes that algorithmic trading accounted for half of its business in 2005.

Technology Providers: Algorithm providers range from bulge-bracket firms to agency brokers to third-party service providers. Leaders on the sell side, many of which have invested in technology companies to bolster their order-flow offerings, include Credit Suisse, Goldman Sachs, JPMorgan, Lehman Brothers, Morgan Stanley and Merrill Lynch. Agency brokers in the algorithmic game include BNY Brokerage, Flextrade and EdgeTrade. Third-party service providers also offer products that range from data-management to transaction cost analysis.

The Price Tag: Aite Group predicts buy-side firms will spend $13 million on algorithmic trading technology in 2006, accounting for about 5 percent of the overall algorithmic trading technology market. The initial outlay for algorithmic trading implementation may be the most significant expense, but buy-side firms should take into account other costs, such as consulting and contracting fees, as well as the potential need for hardware upgrades to support new trading technologies, before attempting to implement an algorithmic trading platform. <<<