No Touching: Algo Trading Leaps Forward

The way that institutional buy-side traders are managing their order flow is rapidly changing. Gone are the days when buy-side traders just delegated their order flow to their favorite broker. Today, the world is moving toward no-touch trading - quickly. Up from 23 percent just last year, no-touch trading (which includes, ECN, DMA, algorithmic trading and crossing) has increased to 31 percent of order flow and is anticipated to increase to 43 percent by 2007, according to Tabb Group's second annual study on institutional equity trading. If you look at hedge funds, no-touch trading is projected to grow from 47 percent of order flow in 2005 to a whopping 57 percent in 2007.

While we knew that buy-side firms were shifting their trading patterns away from the phone, we didn't realize that they also are reducing their use of FIX to access sell-side block desks. While firms predicted only a 1 percent overall decline in FIX use from 2005 to 2007, analyzing the data weighted by assets under management (large funds being more heavily weighted than small ones), buy-side firms predicted a 12 percent drop in FIX usage, indicating that no-touch trading is not only being used as a way to automate, but also as a more effective way to trade blocks.

Firms' sophistication in algorithm use has increased over the past year. Money managers are using a greater selection of models and buy-side traders are using less guesswork in their model implementation - 18 percent of funds noted that their models were deployed on the basis of their traders' or portfolio managers' discretion; 16 percent said they were employed based upon transaction cost analysis; 15 percent noted they were deployed predicated upon order objectives; and 13 percent said models' use was dictated by the stock. This is in contrast to last year's survey, in which 57 percent of respondents stated that they were still in the experimental mode - an answer unheard this year.

What does this rapid adoption say for both the firms in the market as well as those behind the curve? If you've already entered the game, you had better ratchet up your level of play. The leaders in the no-touch market are significantly ahead. They have the resources to push the technology out into the market and the support teams to train, customize and drive adoption (while at the same time, buy-side firms are reducing their broker ranks).

Newer players need to either embrace the trend or ignore it. If your firm wants to embrace the trend, you'd better get moving. To get your firm started, there are several vendors that can assist in defining and developing models that can be white-labeled or provide the infrastructure for firms to create models themselves. But this is a difficult road. The market is getting crowded; embracing no-touch tools easily can cause sales-channel conflict as perceived higher-price order flow may be sacrificed for lower-priced flow; and moving the firm up the education curve is not as easy as hiring a motivational speaker.

The other option is to ignore the trend. While no-touch trading isn't going away, buy-side firms need more than pipes and algorithms. Focusing on research, origination and traditional idea generation are important competitive differentiators for brokers, as those are the facets of the broker relationship with which buy-side traders find fault. While bypassing the no-touch trend may not be the ultimate goal, in the long run, many of these models will commoditize, allowing them to be developed or white-labeled more efficiently.

So the right no-touch brokerage model may in itself be no-touch. For small firms, letting the larger brokers build the models, educate the market, commoditize the technology and lower the barriers to entry, while concentrating on adding research, support and services, may not be a bad idea. But be warned: Playing catch up is not easy.

Larry Tabb is founder and CEO of Westborough, Mass.-based The Tabb Group, a financial-markets strategic-advisory firm. [email protected]