Rob Daly: Taming the Algorithms

The role of the sell-side trader has been changing and is on the verge of making its next evolutionary step. In order to maintain their relationships with their active and advanced buy-side clients, sell-side firms have been slowly ceding their historical role as gatekeeper to liquidity to their clients over the past few years.

First came direct market access (DMA), which gave buy-side traders the ability to decide when to pull the trigger on their trades. Then came broker-developed execution management systems (EMSs), which helped clients decide where to execute their trades. Finally, with the introduction of trading algorithms, the sell side provided the buy side with the necessary automated tools to decide how to execute their trades.

With the basic repeal of naked sponsored access, the role of the broker-dealers has become one of a risk manager for their clients and the market overall.

Now, however, the sell side has a new opportunity to take on a role of execution consultant. With the continued growth of automated trading, buy-side firms are finding themselves drowning in available trading algorithms. Even the smallest boutique brokers have put together their own versions of the basic vanilla trading algorithms like volume-weighted average price (VWAP), time-weighted average price (TWAP) and arrival price. Toss in the adoption of FIX Algorithmic Trading Definition Language (FIXatdl), which makes it much easier to integrate third-party trading algorithms into EMS platforms, and the buy side is battling to deal with the veritable deluge trading algos.

Separation Anxiety
Many buy-side traders admit that they are not quite sure what separates one broker’s VWAP from another, or which aggressive liquidity-seeking algorithm works best. Considering that most of the algorithms are updated on a daily, weekly and monthly basis—depending on market conditions—it is safe to say that many buy-side traders do not use the same algorithm twice.

This is where the sell side can step up and act as an execution sommelier suggesting which of the available algorithmic strategies would best fit the client’s overall trading goal.

The challenge for the sell side is to not surrender this relatively new role to automation, like it has done in the past. However, it might already be too late—a number of EMS providers are already openly discussing the advent of the algorithm management system (AMS) that will provide buy-side users the ability to design their execution strategies and track their performance.

So far, most EMS providers are discussing this as a feature of the next generation of EMS platforms. But similar arguments had been made about the execution capabilities of the next generation of order management systems (OMSs) and now firms are working hard to integrate standalone EMS and OMS platforms.

One potential bright note for the sell side is that in all likelihood, AMS capabilities will not lend themselves to independent third-party platforms. To get the performance measurement and real-time transparency throughout the trade lifecycle that the buy side is currently requesting, a level of access to the broker-dealer’s systems is required that few would be willing to grant third parties.

Early AMS capabilities most likely will be rolled out to single-dealer platforms first, providing users with more granular understanding of the individual broker’s suite of algorithms. Yet apples-to-apples comparisons between algorithm performance from a variety of brokers is still quite a while away. For the next few years, the pendulum is definitely swinging back toward single-dealer platforms.