Brokers are morphing into execution consultants to advise the buy side on selecting algorithms and measuring performance. But how will the sell side reinvent the institutional sales trader?
After unleashing a multitude of algorithms into the buy-side trading community - which both empowered buy-side clients to take control of their own trading and 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 are taking on a consultative role, helping buy-side customers choose algorithms. Brokers say they will 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.
In February, Goldman Sachs began providing a framework - known as the order execution "Cube" - to help buy-side customers classify their orders and segment their flow by methodology and venue. "The Cube maps orders into different execution strategies based on order size, liquidity and trade urgency," according to Andrew Silverman, head of U.S. algorithmic trading at Goldman Sachs, who explained the concept in April at a trading technology conference.
The brokerage firm uses the Cube to advise buy-side clients on "how to segment their flows scientifically based on characteristics of stocks," relates Jana Hale, managing director and head of global algorithmic trading at Goldman Sachs, in an interview with WS&T. Some of the cookie-cutter advice can be automated and incorporated into order management systems. Other times, it's provided by a high-touch broker, explains Hale.
"Future sales traders are going be the ones to re-classify the orders and channel the execution to the proper venue and commission structure," Silverman explained to conference attendees. "Small orders in large-cap stocks with low urgency should use DMA and orders that are in the one-cent [per share] range," he continued. "Large orders in small-cap stocks with high urgency need broker capital and you should be paying four to five cents a share."
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But sell-side traders are touching less order flow these days, as users gravitate toward algorithms and other anonymous, low-cost trading venues. "Now, the buy-side trader has the same execution venues as the sell-side trader," Silverman asserted at the conference. "This has changed our relationship because the buy-side trader is no longer as dependent on the sell side for executing their order flow," he continued.
Streetwide estimates suggest that 50 percent 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 percent, though that portion "is going to decrease as more users go on board with algorithms," says Hale.
The increase in model-driven trading appears to be forcing brokers to retrain their traders and sales traders. While predicting that algorithmic trading would not replace human traders, Sang Lee, managing partner at Aite Group, writes in a March report, "We are witnessing the birth of a new type of trader: the Execution Consultant who is part quant/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 is not adopting algorithmic trading as quickly as brokers expected may help drive the consultative trend. A buy-side algorithmic trading study conducted by Framingham, Mass.-based Financial Insights and released in May found that only 5 percent 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 percent 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, 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," he adds.
So far, the buy side mainly is using basic algorithms, such as VWAP and time slicing, predominantly on large-cap stocks, asserts Grossman. "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), who is based in New York. "As the use expands, the buy side will want the brokers to counsel them more and probably provide more innovative uses of algorithms," says Leman.
But if the buy side is relying more on algorithms and DMA to execute orders, what is 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?