2000-2009: The decade of electronic trading

Whatever else its legacy might be, the noughties was a decade that revolutionised how the buy-side executed trades in the global equity markets. To put the scale and nature of the shift from voice-broked to electronic trading into context, theTRADEnews.com asked six influential industry figures to chart the milestones reached and the benefits achieved, as well as the challenges to come.

The buy-side trader

Steve Wood, global head of trading, Schroder Investment Management

How did 2000–2009 change trading for the buy-side?

For Steve Wood, the past decade has seen a “radical” change in the working practices and the skill sets of the buy-side trading desk. At the beginning of the decade, it was still possible to hand off a trade to a broker and spend lunchtime down the pub until fills were reported back in the afternoon. Today, the buy-side trader exercises considerably more control and judgment.

In 2000, Wood was head of trading for J.P. Morgan Asset Management in London and also had responsibility for the firm’s Asian trading operations. The firm had already adopted FIX to communicate with brokers and Wood sees widespread use of the protocol as one of the key milestones of electronic trading. “FIX allowed us to seamlessly launch program trades from our order management system (OMS) direct to the brokers’ trading tools and then receive execution data back. This was also a great leap forward from faxing over a list of stocks to the broker for risk programs, not least because they used to build into the spread the potential cost of the delay incurred in that process,” says Wood.

Wood also identifies the introduction of broker-neutral and multi-broker trading systems for the buy-side around five years ago as a “quantum leap” that increased the choice at the trader’s disposal. “Whereas you might have had access to ten algos from two providers, of which maybe three algos were in regular use, a multi-broker execution management system offered access to a wealth of riches,” he says. “It was not viable to have multiple front-ends on the trading desk, from either the user’s and provider’s perspective, but now the trader has to be able to choose from up to a hundred algos from a whole range of brokers.”

Electronic trading had initially helped buy-side traders to improve the execution quality they could achieve in trading baskets of stocks, observes Wood, but this has been supplemented by increased single-stock capabilities in the past three years.

What has electronic trading brought the buy-side so far?

Wood views the benefits of electronic trading in terms of choice, control and reduced market impact. “Rather than relying on the broker’s expertise on how best to interact with a primary exchange, now our traders have the skills to execute in a much more fragmented market,” he says. “High-touch services from brokers are still highly valued; they can often access liquidity that we are unable to reach ourselves. But a broker is just one venue now. We can access the venues, the multilateral trading facilities (MTFs) and dark pools ourselves and our visibility in the market is our responsibility.”

There is no doubt in Wood’s mind that electronic trading has helped the buy-side to reduce transaction costs to the benefit of the end-investor. “A substantial amount of our trading is done in low-touch arenas now,” he says. “That reduces commission costs of course, but the more important factor to reducing overall transaction costs is the ability to control order flow.”

What can it help the buy-side achieve in 2010 and beyond?

While great improvements in the cost-effectiveness of buy-side trading may have been achieved in the past decade, traders like Wood are discerning purchasers that continually expect more from their sell-side counterparts. And as fragmentation increases, that means demanding greater transparency and execution quality from smart order routers (SORs). “We ask brokers how exactly their SORs interact with the market,” explains Wood. “Do they reach all the right venues in the right sequence or are they missing out on some, either because those venues don’t have the necessary volume or because it’s not cost-effective for the broker? Does the SOR preference a market that is cheaper for the broker to deal on or does it go for liquidity?” A better understanding of how SORs will lead directly to a further reduction on transaction costs, suggests Wood. “We want to see what percentage of a transaction is executed on each venue so that we can evaluate the transaction cost per exchange and then direct more flow the cheaper venue,” he says.

The broker

Richard Balarkas, CEO, Instinet Europe

How did 2000–2009 change trading for the buy-side?

"Most senior managers at banks didn't see any upside or revenue potential in electronic trading. But they were worried that they would lose clients if they couldn't take orders by FIX." This was the situation facing Richard Balarkas as newly appointed global head of electronic trading at Credit Suisse at the turn of the century. Credit Suisse had bought BZW from Barclays and wanted to replicate the UK firm’s success in automating equity trading for the retail investor at the institutional level. The way to achieve this was unclear until Balarkas was introduced to one of Credit Suisse’s New York-based prop traders, Dan Matheson. Matheson was using rules-based programs or algorithms to execute his trading strategies more efficiently.

The meeting led directly to Credit Suisse developing its Advanced Execution Services business as the first major brokerage to offer algorithms directly to the buy-side. It took a matter of months for some fairly rudimentary algos to be developed for internal traders to test, and before long firms such as Putnam Investments were demonstrating the benefits to rivals and competitors. "If we'd have only allowed access via sales traders or just provided DMA there wouldn't have been the same kind of growth,” asserts Balarkas. “It was a huge cultural shift for a bank to provide that kind of service. There were real fears about cannibalising revenues."

In Balarkas’ view, the availability of electronic tools such as execution algorithms helped to usher in a new era of professionalism on the buy-side trading desk. "It signalled the death of the dealer that just outsourced all risk and responsibility for the trade to the broker and heralded the arrival of the buy-side trader that could take full control of the trade and be a more discerning buyer of sell-side services," he notes.

What can electronic trading help the buy-side achieve in 2010 and beyond?

The revolution in buy-side trading capabilities that electronic trading has supported is far from complete, according to Balarkas. For every firm that has invested in technology to enable traders to reduce transaction costs, there are plenty that believe that investment is unwarranted, or at least of secondary importance. "A lot of buy-side desks are not proficient in execution and are not autonomous because their portfolio managers do not realise the impact execution can have on portfolio performance,” says Balarkas. “Those funds are missing a trick."

The trading venue operator

Peter Randall, CEO, Equiduct

How did 2000–2009 change trading for the buy-side?

Peter Randall has been at the heart of a number of the key developments that made 2000-2009 the decade of electronic trading. After a period as executive director of FIX Protocol Ltd, he took on the role of director of business development at Instinet Europe, the agency brokerage that gave birth to the first successful pan-European trading venue in early 2007. Randall became CEO of Chi-X Europe in December 2007 and oversaw a rapid expansion of the venue’s market share before stepping down in the first quarter of 2009. In 2000, however, he was looking at electronic trading from a slightly different angle. “I was working in Hong Kong helping to quantify the size and dynamics of the Asian retail market for an established stockbroker looking to provide an online service for retail investors,” Randall remembers.

He believes that the development, adoption and effective implementation of the FIX protocol has been the most significant driver of electronic trading over the decade, but says that the changes wrought during that period have gone well beyond financial messaging. “Electronic trading has delivered significant liquidity advantages to the buy-side,” he asserts. “It has also helped to systematise the entire dealing, settlement and accounting process – issues that represent so much of the buy-side's cost base.”

What can electronic trading help the buy-side achieve in 2010 and beyond?

With many of the building blocks of electronic trading now firmly in place, the next decade should in Randall’s view be one in which the gains of 2000-2009 are truly exploited to the advantage of end-investors. “Much remains to be done,” he acknowledges. “However, now that essential standards for market data, trading, clearing, settlement, fund accounting and modeling have been established, I expect to see a blossoming of innovation and product development over the next 10 years.” And with faster innovation comes ever fiercer competition. “There will be an ever increasing focus on the quality, the market infrastructure and the costs of the services that the sell-side provides to the buy-side,” says Randall. “As with all other products, excellent quality at a competitive price coupled with great service and innovation will set the standard.”

The all-rounder

Marcus Hooper, executive director, Pipeline Financial Group

How did 2000–2009 change trading for the buy-side?

As head of trading for AXA Investment Managers in 2000, Marcus Hooper could already see that electronic trading would have “a huge future”. In the late 1990s, he had been the first member of the Tradepoint Exchange, which offered the first practical direct exchange membership to the buy-side community. “Tradepoint didn’t succeed, but it definitely helped to change the market,” recalls Hooper. “The London Stock Exchange wouldn’t have adopted electronic trading so quickly without Tradepoint’s appearance.” 

Ten years ago, says Hooper, much of the buy-side community was struggling to introduce technologies and processes considered fundamental today, such as electronic order and execution management systems.  “Almost everyone was looking to deploy a new OMS and the choice was very limited. Also the functionality of most systems was often quite poor with very little connectivity,” he says.

In more recent years, he identifies MiFID as a key milestone because it put Europe on a common regulatory basis, thus enabling new electronic systems to come to the market. “I think we’ll see more consolidation in the electronic trading space,” Hooper notes, “but without MiFID we wouldn’t have had the opportunity for these systems to enter the market and compete in the first place.” 

What has electronic trading brought the buy-side so far?

Growing buy-side side empowerment over the decade has given traders greater freedom of choice and increased anonymity which, says Hooper, has had a significant impact in reducing trading costs. 

But he suggests that electronic trading has delivered a significant benefit that many may have forgotten about: a massive reduction in trading errors. “Before electronic trading systems, most traders always had a fear in the back of their minds that a giant trading error was waiting in the shadows! The good news is that these events just don’t seem to happen anymore – no trading the wrong stock, no buys instead of sells,” says Hooper.

What can it help the buy-side achieve in 2010 and beyond?

But it hasn’t all been upside. Electronic trading has introduced problems as well, according to Hooper, such as the reduction of order size in the visible markets. “Trading large block orders is increasingly difficult because the visible markets really don’t support price discovery anymore. The prices that are discovered are all ‘at the margin’ in tiny quantities that don’t represent anything like the full market supply and demand,” he explains. “Large block orders take place away from the visible markets even though they often rely upon reference prices from those markets.” The result is that supply and demand from block orders neither interacts with nor contributes to the price discovery process and Hooper suggests that technology “can definitely play a part” in the resolution of this problem. 

The technologist

Kevin Houstoun, chairman of Rapid Addition; co-chair of the global technical committee of FIX Protocol Ltd.

How did 2000–2009 change trading for the buy-side?

The difference in client expectations since the start of the decade is evidence of the distance buy-side trading has travelled in 10 years. Kevin Houston was running the European equity electronic trading team at Salomon Brothers in 2000, a market leader since developing FIX to communicate with Fidelity Investments in 1992. “We could deliver orders to many markets on a single platform and identified early on the great potential for electronic trading to expand globally. Now, not only is this expected functionality for any large broker, but people care how many milliseconds, or increasingly microseconds, it will take. A decade ago, people wanted global coverage; now they want high-speed global coverage,” notes Houston.

Although it had made its debut eight years previously, FIX was far from a ubiquitous communication protocol in 2000, but Houston says that’s just one of many step changes across the decade. “Algorithmic trading techniques were being used by some specialist funds and proprietary trading desks to make money; now they have been extended to also become productivity tools used by the buy-side to place orders into the markets. Initially they were premium services which justified near full-service commission levels and now they have become just another discount commission channel that the larger brokers are expected to have,” he says.  

What has electronic trading brought the buy-side so far?

The benefits of the growth in electronic trading can be seen in the reduction in commissions and spreads, says Houston, who asserts that the trend is inexorably downwards despite glitches caused by lower liquidity levels after the credit crunch and – potentially – by regulators’ increased interest on high-frequency trading. “This is probably the biggest direct benefit to the buy-side,” Houston comments, “but there are many others as well, such as: reduction in errors; better risk systems; and algorithmic trading tools as productivity tools that allow the buy-side to focus on the larger / more difficult trades where they can add more value.”

What can electronic trading help the buy-side achieve in 2010 and beyond?

Houston observes that competition and innovation in the trading technology space has been harmed recently by consolidation, notably among providers of FIX engines, but he expects strong demand for software as a service and hosted FIX services. He also forecasts that regulators will have a bigger role to play in how firms trade, not least by demanding more risk controls for those currently enjoying naked access. “Risk and regulation is going to be the next big thing that we look back at in a few years; there are currently around a dozen and a half or more pieces of legislation going through the US legislative process alone that could have an impact on our business,” he says. “Looking back at say 2005 from 2015 I guess we'll be saying "Wow, were we lightly regulated then!"’

The Consultant

Frederic Ponzo, managing director, Greyspark

How did 2000–2009 change trading for the buy-side?

On 10 February, 2000, Frederic Ponzo was taking the Eurostar train from London to Paris to establish the UK business of Net2S. For most of the next decade, Ponzo was overwhelmingly engaged in helping sell-side and latterly buy-side firms develop their electronic trading capabilities, in London and beyond. In the early part of the decade, he was focused on implementing direct exchange connectivity for banks as Europe’s exchanges first automated then consolidated. By 2004, electronic trading was beginning to be seen beyond cash equities and listed derivatives, and soon platforms such as BrokerTec and Tradeweb were automating the request-for-quote process in the fixed income market. “Around five years ago, spreads began to tighten a lot, especially for smaller order sizes, as electronic trading in fixed income increased competition between brokers,” says Ponzo. One reaction to this increased transparency was the complexity of products offered by the sell-side that resulted in credit derivatives that became all but impossible to price. Back in equities, MiFID revived innovation in electronic trading, according Ponzo as the pace of fragmentation and the growth of dark pools surprised many. “The story of MiFID is not finished yet – no one is sure which of the MTFs will survive,” Ponzo asserts. “Moreover, SOR was introduced on the promise of reduced trading costs, but it has not delivered yet.”

What has electronic trading brought the buy-side so far?

“With notable exceptions, the buy-side trader’s use of technology extended little beyond emails and excel spreadsheets 10 years ago,” observes Ponzo, who believes a shift in power between the buy-and the sell-side has been effected over the past decade. “The growth of electronic trading on the buy-side has demystified the business of brokerage,” he claims. “Empowering the buy-side to take responsibility for their own trades has had at least three far-reaching consequences: they have demanded better value-for-money from the sell-side; they have taken ownership of their own technology; and they are achieving greater transparency on price formation.”

What can electronic trading help the buy-side achieve in 2010 and beyond?

Given the progress that has been made in individual asset classes in recent years, Ponzo believes that multi-asset trading will be a lasting theme at the beginning of the next decade. “Rather than the complexity and opacity that we saw a couple of years ago, we will see increased interest in the ability to trade different asset classes in a consolidated way, i.e. on a single platform. An emphasis on simplicity will also improve transparency, add more pressure to brokers and reduce operational risk. Wherever you can, do it yourself.”