January 13, 2010

With traditional Wall Street research analysts focusing on long-term trends, sell-side sales forces are filling the void for short-term trade ideas -- including both buy and sell recommendations. To communicate these ideas and prove their value to institutional clients, sales desks are sending their trade ideas through so-called "alpha capture systems," which enable sell-side traders to efficiently communicate with buy-side firms in an electronic format and put performance metrics around their ideas.

"These trade ideas are coming not only from traditional sources, such as research analysts, but now trade ideas are originating on sales desks," comments Paul Rowady, senior analyst at TABB Group.

According to industry experts, salespeople at the investment banks increasingly are leveraging alpha capture systems such as youDevise's Trade Information Monitor (TIM), Thomson Reuters' StarMine and First Coverage's Community to share trade ideas with the buy side. An alpha capture system -- first used by U.K. quantitative hedge fund Marshall Wace in 2001 to capture profits from short-term trade ideas -- allows buy-side clients to manage and filter information while quantifying the value of trade ideas.

Stuart Fraser, head of alpha capture at U.K. institutional broker Collins Stewart, conveys trade ideas to institutional clients through youDevise's TIM. The Web-based system disseminates -- in real time -- trading ideas on more than 13,000 equities and ETFs generated by as many as 350 sell-side companies. Buy-side clients can filter which salespeople they wish to follow, as long as they have an existing relationship with those sell-side firms.

TIM tracks the performance of the trade ideas based on their timeframe and market value, according to youDevise, which is based in London and New York. "It gives the clients a bit more confidence that the salespeople can sift through ideas and reject bad ideas," says Fraser.

When the salesperson inputs the trade idea, TIM pulls the latest price for that stock or a volume-weighted price, depending on the fund manager's request, relates Colin Berthoud, a director with youDevise in London. The system updates the market prices from the moment the author decides to take profits or close the idea. "While the system monitors the trade ideas," Berthoud explains, "it will generate stop/loss alerts if it passes a certain threshold, and the fund manager can increase or reduce his exposure."

According to Berthoud, quant funds and asset managers feed the equity trading ideas, along with research notes, directly into their internal systems. But the buy side is not necessarily trading off of the information, asserts Collins Stewart's Fraser.

Most buy-side clients, Fraser says, are "assimilating the information" along with other research reports and market information. "The buy side has to have a lot more data points to be confident in the information," he explains.

YouDevise's Berthoud concedes that rather than trade based exclusively on the sell-side ideas offered in TIM, it's more likely that buy-side firms are using the ideas as additional support for current strategies. The buy side, he notes, typically follows a universe of stocks and already has an idea of whether a stock is undervalued or overvalued. "This is more to help the buy side time their moves," Berthoud says.

More Than a Buy or Sell Recommendation

TIM also can help buy-side firms gauge the performance of individual sales professionals, Berthoud adds. For example, if eight of the 10 trade ideas entered by a salesperson during a quarter are profitable, the buy-side client could see that his shorts outperformed his longs or that he is better at picking gold stocks in China than oil stocks in North America.

Perhaps more important, TIM can be used for compliance purposes, Berthoud points out. The trade-idea information could be used in a buy-side broker vote system to justify why a firm rewarded a broker with trading commissions, he says. "It's a really good quantitative way of seeing what value a broker has added -- it's there in black and white," Berthoud says, adding that TIM provides a complete audit trail of what was routed and to whom. Further, TIM stores all of the information on the platform forever, so a buy-side firm can provide to regulators the precise broker information on which routing decisions were based.

Though youDevise has not had any direct interaction with regulators, Berthoud says, the U.K.'s Financial Services Authority (FSA) has paid close attention to alpha capture systems in general. When the FSA reviewed alpha capture systems in 2006, it examined the controls necessary to ensure that ideas disseminated on the platforms do not include insider information or other relevant data not generally available. Because these systems have a complete audit trail, however, the FSA acknowledged that the risk of conveying trade ideas over alpha capture systems might be lower than traditional communication methods, though it noted that some risk still might exist.

According to Berthoud, youDevise has strong relationships with the compliance departments at large brokerage houses, which monitor the trade ideas submitted by their salespeople. "We provide them with real-time access to all of the ideas [originating] within their company," he relates. Since brokerage firms have restricted lists of stocks for which they are privy to insider information in some way, the salespeople are prohibited from commenting on certain stocks, Berthoud explains, adding that some brokerage firms have built an authorization loop so that trade ideas are not released until the compliance department reviews them.

youDevise to build the back-end platform that now serves as an industry utility known as the Repository and Distribution Centre (RDC). TABB's Rowady explains that, "You need an intermediary to build this once because for a buy-side player to build the same system, you'd have to convince all your brokers to use your [alpha capture] systems exclusively."