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Spotlight-blackInnovations in Trading and Technology (more stories)

25 April 2011

The Buy Side's Embarrassment of Algo Riches

Daley looks at the proliferation of algorithms for the buy side, how brokers are trying to distinguish themselves and how winners might be found.

Broker-dealers are grappling with the conflicting needs of the buy-side in an algorithmic trading market that grows more complex by the minute.

Buy-side firms have an embarrassment of riches when it comes to algorithmic trading. Gone are the days when buy-side clients would be satisfied by a broker’s ability to provide an algorithm that would govern the buying and selling of a set amount of shares at a price that follows the volume weighted average price (VWAP) or the time-weighted average price (TWAP) benchmarks.

Brokers are competing for the buy-side’s attention with algorithms based on a seemingly infinite number of benchmarks such as target price, market close, percentage of volume, arrival price and so on. TWAP, VWAP and Market on Close and Market on Open algorithms - the alphabet soup of acronyms for algorithms is a sign of how much algorithmic trading has shaken the value chain of securities trading, driving up trading volumes, adding to volatility and forever changing the dynamics between buy-side and sell-side firms.

Some broker-dealers, in a rush to distinguish themselves, have flooded the market with suites of algorithms and services that overwhelm the buy-side with too much choice. This is quickly leading to algo overload and fatigue.

The buy-side has reacted by asking brokers to somehow reconcile conflicting desires — give them everything they want, streamline the offerings and yet keep the intelligence and complexity that distinguishes them. Some buy-side firms have even taken matters into their own hands and have attempted to mitigate their own algo fatigue.

What can buy-side firms do to get what they want?

Conduct a beauty contest among algorithmic suppliers. Many buy-side firms have determined that they do not want their algorithms from one vendor and have embarked upon a best-of-breed strategy to develop a roster of algorithms. The winners of the beauty contest will have their algos exploited for very specific purposes, thus bringing some order to the chaos.

Taking it a step further, some buy-side firms, after applying a Transaction Cost Analysis to their algos, can write an ‘algorithm of algorithms’ intended to match the right algo to the right transaction. Firms can take the next logical step and remove the decision-making process from the individual traders. In this instance, the trader submits transactions to the ‘algo of algos’ and it makes a variety of determinations in order to select from an array of broker algorithms the one that will provide the best execution.

How to identify a contest winner?

Find a winner in a true partner. Rather than add another layer of complexity and abstraction, broker-dealers can be true partners for their buy-side clients by using human ingenuity and applying a high-touch approach to a low-touch business. By relying on human intelligence, broker-dealers can be certain they’ve done what they can to spot something outside of the norm, such as trading patterns that contradict what their client had in mind.

Broker-dealers can offer a series of algorithms that can be highly customized even down to the individual trader level within the firm. They can apply customization to algorithms to give each firm an individual edge.

Last, they can assign a sales trader to every account. The sales trader can monitor the buy-side client’s trades, understand the trading goals of the account and can contact the account to report any aberrations. Sales traders should adjust his or her understanding of what their client is trying to do and ask: Should the firm be using a different set of algos? Or should the firm be adjusting the algos to achieve a different set of goals?

This is the basis for a real partnership and to satisfy the conflicting requirements of buy-side clients — maintain the intelligence and complexity of the algorithms, streamline the decision-making process and give them the best of everything they want.

Spotlight-white-trans For more stories in the Innovations in Trading and Technology Spotlight Series click here.

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