The New Sell-Side Trader
Brokers are morphing into execution consultants to advise the buy side on selecting algorithms and measuring performance.
Editor's note: This is part 2 in a two-part series on electronic stock trading and how the relationship between the buy and sell sides is at a turning point. As the buy side takes greater control of its trades, the sell side is looking for new ways to add value. Last week (E-Tools Energize Buy-Side Trading), we looked at the buy side's perspective; this week, we look at the sell side's.
After unleashing a multitude of algorithms into the buy-side trading community--which empowered buy-side clients to take control of their own trading but often left them confused about which algorithms to use--the sell side is fine-tuning its quantitative tools and retraining its sales traders to offer continued value to buy-side clients. Many bulge-bracket firms--the major brokerage houses that underwrite and distribute securities as well as produce research--are taking on a consulting role, helping buy-side customers choose algorithms. Brokers say they'll advise buy-side firms on which electronic strategies to apply for particular trading styles and develop customized algorithms, as well as pre- and post-trade analysis tools, for clients.
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Algorithms enhance the sales trader's ability to provide market color, says Andrew Silverman, head of U.S. algorithmic trading at Goldman Sachs.
The brokerage firm uses the Cube to advise buy-side clients on "how to segment their flows scientifically, based on characteristics of stocks," says Jana Hale, managing director and head of global algorithmic trading at Goldman Sachs. Some of the standard advice can be automated and incorporated into order-management systems. Other times, it's provided by a broker, Hale says.
Sell-side traders are touching less order flow these days, as users gravitate toward algorithms and other low-cost trading venues.
Streetwide estimates suggest that 50% of total buy- and sell-side order flow is passing through electronic channels--a combination of program trading, direct market access, algorithms, and crossing networks. Where the high-touch broker can add value is on the remaining 50%, although that portion "is going to decrease as more users go on board with algorithms," Hale says.
The increase in model-driven trading appears to be forcing brokers to retrain their traders and sales traders. While predicting that algorithmic trading wouldn't replace human traders, Sang Lee, managing partner at Aite Group, wrote in a March report, "We are witnessing the birth of a new type of trader: the Execution Consultant who is part [quantitative]/execution expert capable of providing high-touch services to maximize the potential benefits that can be gained through electronic trading."
The recognition by brokers that the buy side isn't adopting algorithmic trading as quickly as brokers expected may help drive the consultative trend. A buy-side algorithmic trading study conducted by Financial Insights and released in May found that only 5% of total buy-side order flow is being pushed through algorithms. The study surveyed 60 of the top 477 investment managers, including hedge funds. While large firms and quantitative firms are the heaviest users of algorithms, Financial Insights contends that actual usage among most firms is quite modest. (Editor's note: A recent Tabb Group study reported that 11% of buy-side order flow is captured by algorithms. Financial Insights used median calculations, which reduce the impact of outlying firms, the small number of firms that use algorithms substantially more than everyone else. Tabb Group used average figures.)
"Algorithmic trading is everywhere on the Street now, but the problem is, it's undifferentiated. It's hard to know one provider's VWAP [volume-weighted average price] from another's," says Randy Grossman, research manager of institutional trading and investment management at Financial Insights. "The fact that there are so many providers pushing their algorithms and their product has led to confusion about what algorithmic trading is about and what it can provide."
So far, the buy side mainly is using basic algorithms, such as volume-weighted average price and time slicing, predominantly on large-cap stocks, Grossman says. "They haven't ventured too far in the realm of creating their own algorithms or customizing algorithms, even though those services exist at most major brokers," he says. Also, the buy side is focused on the productivity gains and the anonymity as benefits but hasn't looked at algorithms as a tool for performance improvement, Grossman notes.
"It's probably the early stages of the art of algorithms," says James Leman, head of execution trading for the Americas at HSBC Securities (USA). "As the use expands, the buy side will want the brokers to counsel them more and probably provide more innovative uses of algorithms."
But if the buy side is relying more on algorithms and direct market access to execute orders, what's the broker's value proposition going forward, and how is the interaction with the buy side going to change? And what does the future hold for the sales trader?
"The broker's value proposition is as technology provider," says Robert Iati, a Tabb Group partner. In 2004, large brokers went on a direct-market-access buying spree: Banc of America Securities bought Direct Access Financial; Citigroup acquired Lava Trading; Bank of New York purchased Sonic Financial Software; and Piper Jaffray acquired Vie Systems. Additionally, in 2000, Goldman Sachs obtained REDIPlus through its acquisition of market maker Spear, Leeds & Kellogg. Within three years, direct-market-access technology has become a commodity at a faster rate than ever before, Iati says. As a result, the sell side still is searching for the value proposition for the next generation of its business, he adds.