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E-Tools Energize Buy-Side Trading

With brokers pushing more electronic execution tools, the buy side is being forced to raise the bar on its skill set
This leaves the sell side in a quandary: How does it reinvent itself to continue to capture volume through electronic channels while adding value through customized tools such as algorithms and pre-trade analytics? "Their goal is to become the execution consultant of choice," Aite Group's Lee says of sell-side firms. "It's no longer about providing execution--it's providing advice, adding market color, sharing idea generation of what types of stocks they should be trading."

For example, Trusco's Stewart says, brokers could tell the buy side, "In a situation like this, you may want to try this algorithm, or in a situation like this, you may want to call their program desk."

But buy-side firms are concerned about information leakage and execution quality and may be reluctant to share details of their trading strategies with the sell side. The most significant complaints about brokers revolve around information leakage and execution quality, as well as client service and market color, according to the Tabb Group report.

As far as whether brokers should act as consultants, "I don't think they have a choice," AXA's Coleman says. "Either that or we go straight to the [liquidity] source. Because there are a lot of me-too products, our job is to separate the also-rans from the unique products.

"It's very important that [brokers], more than anyone, know the limitations of these systems for their clients," Coleman says, adding that brokers should be able to tell a client whether a particular algorithmic strategy is good for the way they usually trade and when it's not going to work.

That's where the consultative relationship could work. "These algorithms have limitations," Coleman says. "I need the brokers to be a filter for us. ... We want them to come to clients with the most relevant tools."

As institutional traders experiment with algorithms to lower transaction costs, the buy side acknowledges that the sell side could provide advice on execution strategies. "That's the value proposition that the sell side does offer. It's no longer direct human interaction--it's quantitative trading tools," Vanguard's Sauter says. "The sell side has had to reinvent itself in many ways by providing the electronic communication platforms and also providing these algorithmic tools."

Vanguard continues to use brokers--both through human and electronic interaction--particularly on large or less-liquid trades. "There can certainly be a value proposition with the brokers on less-liquid trades if you end up using their capital," Sauter says.

Even so, Vanguard favors crossing systems such as Liquidnet and Posit because they lower transaction costs. "A fantastic technology," Sauter says of Liquidnet, noting that it provides a way for natural orders of buyers and sellers to meet, without the need for a broker or a market maker in the middle of the trade.

However, not everyone believes that the buy-side/sell-side relationship will survive the low-cost, low-touch trading trend. "I see us being moved on a less-personal relationship with the sell side. The high-tech, low-touch offer seems to be destroying the relationship with the sell side," said Peter Driscoll, VP and senior equity trader at Northern Trust Co., speaking at the TradeTech conference.

"The dialogue is changing from 'I need you to work this 100,000 share order' to 'Our FIX [Financial Information Exchange] system is down, I need you to check on the FIX connection,'" Driscoll said. "It's a huge difference that's going to change the structure of this industry."

So will the buy-side/sell-side relationship last? "The sell side still adds value," says Richard Tsai, head of electronic trading at Barclays Global Investors. "We're always very open-minded to where the sell side is going," he says, noting that with algorithmic trad- ing, "they were at the forefront in providing tools for the buy side to use."

Even with all the electronic tools at its disposal, Tsai says, Barclays isn't going to attempt to trade everything. "There are instances where seeking block liquidity with a sell-side firm is definitely the way to go," he says.

Buy-side traders say that information flow still is a key part of the relationship with the sell side. Speaking at the Tabb Group Forum, Jeffrey Alexander, a director of trading at Credit Suisse Asset Management, urged brokers to understand "that an algorithm isn't substituting for the relationship." In defining what he expects from a sell-side relationship, Alexander said, "It's committing capital when appropriate and doing it willingly without a fight. It's being a concierge to people in your firm."

But the relationship is changing, AXA's Coleman says. Right now, the buy side still needs the sell side to provide market color on how stocks are trading, since there still is merchandise trading upstairs through brokers' institutional block trading desks. "As time goes by, there will be less of them giving market color and working trades upstairs and more of them either monitoring or updating us on tools their particular firm provides," Coleman says. Even then, however, the buy side may prefer to talk with the quantitative analysts, rather than sales traders, he says, because they may understand the tools better.

Graphic by Gerald Bustamante/Veer