Confronting the agony of choice

For maximum efficiency, buy-side traders should look to a strategic marriage of electronic and voice trading, contends William F. Cronin, managing director, Knight Equity Markets.

The benefits that buy-side trading desks now derive from advanced trading tech-nologies are the result both of changes in domestic mar-ket structures and in global economic trends.

Regulation - or, rather, deregulation - over the past two decades has played a cru-cial role in expanding oppor-tunities for buy-side choice in trade execution. A first wave of regulatory reform in 1994 cul-minated, in the US, at least, in numerous competing ECNs where investors could directly execute their orders. Although consolidation ensued fairly rapidly with traditional exchanges remaining the dominant liquidity venues, the ECNs offered buy-side traders the opportunity to take control of their own order execution - an appetite that they have understandably retained since the dawn of the ECN.

A second wave of regula-tory reform, for which deci-malisation was the tipping point, has brought new trad-ing choices to the buy-side trading desk. Along with the rise of electronic trading, the regulatory framework had the effect of reducing the average trade size to below 275 shares as of April 2008. As a result, institutional investors have been keen to employ algorithmic and other order types such as dark pool crossing that offer speed, anonymity and reduced market impact, depending on the objective of the desk.

Global trends
Beyond these changes in the structure of the familiar domestic markets, financial engineering has introduced new security types, while global economic liberalisa-tion has greatly expanded the range of investable assets, particularly in emerging markets.

Faced with this broad array of options, buy-side head traders have set about growing their desks through the acquisition both of new systems and sell-side expertise - a pool of talent that has become increasingly accessible as sell-side firms have, through their own techno-logical innovation, sought to do more with less.

The criteria by which trading success is judged - best execution in the broadest sense - have, how-ever, not changed. Speed, anonymity or a desire for minimal market impact can each point the trader in a different direction for a specific order and will influence the way that suc-cess is determined. At the same time, the number of potential venues where liquidity may be found has multiplied, further affecting the strategic choices that a trader needs to make.

The trading continuum
At Knight, we would see electronic and voice access not as alternative choices, but as complementary parts of a unified solution to addressing the complexities of liquidity sourcing and execution optimisation. We see significant, synergistic opportunities from our hybrid market model.

The first point to stress is that a newly empowered buy-side desk should not regard reliance on a sales trader as somehow a ‘Plan B’. There are, of course, opportunistic as well as stra-tegic reasons for using a sales trader in a particular trading environment. A desk may wish to benefit from increased trade execution capacity in certain short-term situations, including periods of high volatility. Particular sell-side firms may also have recognised execution capability in spe-cific stocks; for example, the ability to interact algorith-mically with small-cap names in dark pools.

An EMS with all the ‘bells and whistles’ may be invalua-ble, but it does not by itself shield the buy-side trader from having to make deci-sions about how best to use the time and resources availa-ble to the desk. An effective buy-side trader will see direct market access and capital facilitation through voice trading as integrated pieces of a coherent execution strategy.

This is evident in the commission structure that brokers apply. DMA trades in blue chip names admit-tedly account for a signifi-cant chunk of daily volume, but they are still a minority of transactions, even in US markets. Algorithmic order types and crossing facilities will attract higher commis-sion, while voice brokering commissions are higher still based on the added value.

What might be called ‘full’ commission is more than a residual hangover from pre-electronic days. Voice brokers can play an important role in, for exam-ple, super-block-sized trades, block prints in small- and mid-cap securities, block options that often require capital, derivatives trades and emerging market trades.

The client’s call
Despite its reputation for its suite of automated products, Knight maintains more than 80 sales traders in eight offic-es worldwide. Clients will use them to search for additional liquidity for large-volume orders and to provide exper-tise and market insight in challenging market condi-tions. Voice traders also help minimise market and trade risks, as well as provide broad market colour.

A cutting-edge EMS does not simply present the trad-er with a screenful of undif-ferentiated choices to wade through. Access to a match-ing engine, for example, should not be seen as an alternative to DMA, but as part of the same functionali-ty. Similarly, a dark pool aggregator is not an alterna-tive to other algorithmic strategies, but a tool to be used when the trader deems it appropriate to his needs and the market environ-ment. Voice traders should be seen as part of the same strategic continuum. These voice traders will themselves be able to act effectively in the market with the same electronic tools. The buy-side trader will therefore still be deriving all the available benefits of automation with-out having to oversee every single execution. Experienced sales traders, while perhaps fewer in number, will remain impor-tant partners in the buy-side’s execution strategy.