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The Future of Trading

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Buyside Traders: Not Taking Orders Any More

November 4, 2010
By Chris Kentouris

Regulatory pressures are mounting. The number of alternative trading venues is on the rise. Algorithmic and statistical trading is commonplace. So traders at investment firms are quickly embracing new technological tools, to keep up.

The goal: To not only gain an edge over their competitors, but clout over portfolio managers and broker-dealers. Buy-side traders can no longer afford to be order takers and rely on their portfolio managers and broker-dealers to dictate appropriate strategies.

The reason: “The buy-side trader has to prove his or her value as firms reduce trading personnel in favor of low- or no-touch strategies,” says Matt Simon, senior analyst for Tabb Group, a New York based research firm. Meaning: more automation.

While buy-side traders may not be quant analysts, they are certainly coming close in their required skill sets. “Buy-side traders are taking responsibility for order execution from the sell-side, using direct market access, smart-order routing and algorithmic trading strategies,” of their own, says Mark Schlarbaum, managing director and portfolio manager for PalliserBay in Radnor, Pa. “They have to be one step ahead in understanding all of the electronic ways to execute orders and the ability to interpret the results.’’

That understanding, says Schlarbaum, also means requires knowing the merits and pitfalls of each executing venue; there are dozens of lit, semi-lit and dark pools of liquidity. There are also, the Securities and Exchange Commission estimates, roughly 200 broker-dealers who maintain internal pools of buyers and sellers through which they try to run trades. And there are algorithms specializing in each trading venue and in anti-gaming – preventing high-frequency trading firms from gaining the upper hand.

PREDICTING COST

If the buy-side is now more technically about handle a portion of its order flow, the question then becomes how well is it doing. Before placing an order, buy-side traders needs to predict just how much it should cost and where to send it. They also need to examine how well that strategy was implemented by comparing the end results to various benchmarks.

That’s just the tip of the iceberg. While the goal of nearly all order execution algorithms is to minimize information leakage and find liquidity they do vary in their effectiveness to reduce implicit costs. That means buy-side traders must become a lot savvier in understanding what inputs are being used by the broker-dealer and how much of the implicit cost is being affected by the type of algorithm used, the investment style of the fund manager and the trader itself.

Doing so will enable the buy-side trader to not only measure his or her own performance but offer the portfolio manager some guidance on the best way the order should be executed. That means how quickly it should be filled and over what time period.

“It’s become an extremely quantitative function,” says Chris Amorello, managing director of sales and trading for ITG, an agency brokerage and provider of cost analysis software in New York. “The buy-side trader can no longer only rely on volume-weighted or implementation shortfall. He or she needs to ask a lot more questions of their broker dealers.”

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