Report: Buy Side Bearish on Algo Trading?

NEW YORK—Algorithmic trading exploded in 2006, but while its use shows no signs of slowing down, there are signs that the buy side is losing patience with it, according to a recent white paper.

Overall satisfaction levels increased, but on a scale of one to five, with five being the most satisfied, those who reported being "highly satisfied" fell slightly, the report says. Only 53 percent of respondents say their satisfaction levels are at a four or five, compared with 73 percent of those who answered the 2005 survey.

The report, written by industry analyst firm Financial Insights and sponsored by Bank of America, is the result of interviews with the heads of equity trading at 60 major buy-side firms. Each participant was asked 54 questions regarding their use and practices relating to electronic trading, with an emphasis on algorithmic trades.

There are two possible reasons for this trend, says Bill Harts, head of strategy for equities at Bank of America.

In the last several years, "we have started to see small shops pop up and start offering algo products and the amount of investment that's required to properly build, develop and support a suite of algo tools is very high," he says.

"A small shop may not have adequate investment dollars to spend on these products," which can produce a sub-par result, he says.

In addition, "as the product grows and more and more people use it, generally you'll have people who are newer to it, and sometimes there is a learning curve for people to get used to it," Harts says.

That could also mean that the sell side has an educational opportunity with the buy side that has not yet been explored, Harts says.

Financial Insights' David Cox, group vice president and head of research for banking, insurance and capital markets; and Jin-Chul Kim, consulting manager with custom research and consulting, the report's authors, suggest that the results could provide the sell side with a chance to provide more guidance to the buy side on the broader opportunities for algorithmic trading.

Those opportunities could include additional asset classes. Although algorithmic trading is largely used in cash equities, respondents also expressed an interest in algorithms for options, foreign exchange, futures and fixed income, the report says. They would likely be delivered by the same mechanisms in use for equity algorithmic products, like order management systems (OMSes), trading systems and FIX pipes, Hart says.

There was also a sharp decline in the number of firms that did not understand how to manipulate algorithms. "The number of clients who don't understand algos has dropped tremendously, and that indicates that brokers are doing a better job of explaining" how they work, Harts says.