In the recent past, buy-side investment firms across the world have been joining the trend towards the adoption of algorithmic trading solutions. The US has been leading the way for some time but both Europe and Asia are making good progress in catching up with their American counterparts.
“Let’s say it took five years for the US to embrace algo trading,” says Vijay Kedia, CEO at FlexTrade Systems. “It will take a much shorter time for Europe to do it because it’s all about the learning curve. It is all about familiarity and being comfortable.
“Also, a lot of the large asset managers are global and if they see the technology is working very well in the US, they will be very tempted, because it makes a lot of sense, to apply this to other countries.”
 | Robert Boardman, European head of algorithmic trading sales at ITG, agrees: “I think it’s fair to say that the US has led the way in terms of both the development and the deployment of algorithmic trading, certainly on the buy-side.In my opinion it is two or three years further down the track than Europe. |
“Algorithms are almost mandatory for someone who is trading in the US markets. Stocks move so quickly and the market structure is very fragmented. You can trade by yourself, but it’s like piloting an aircraft: it’s so much easier to let the autopilot take the strain.”
The demand for algo trading has been linked to the growth in the adoption of quantitative research tools by the fund management community and the increasing need to obtain competitive advantage by having access to the right technology.
Although positive growth figures can be seen across different sectors within the buy-side, some firms have been quicker than others in going down the algo trading route.
The demand for algo trading solutions has been high across firms operating in the traditional, long-only investment world. The interest has been particularly significant among those players whose organisational structure very much depends on their quantitative trading capabilities.
“In those firms, you see a lot more sophistication in terms of how the buy-side trading desks are being evaluated with regard to execution performance,” says Richard Hills, head of electronic services for Société Générale Corporate
& Investment Banking (SGCIB). “In order to do that those desks are building more and more analysis tools to see how can they get the best out of their various brokers’ algorithm products, and what we are beginning to see is that they are selecting brokers based on execution performance.
“At the other end of the spectrum, there are buy-side firms that don’t have that kind of culture and perhaps their trading desk is not evaluated in terms of execution performance at all. They are more traditionally dealing orders over the course of the day and it’s the portfolio managers are the ones looking at the execution performance when they get the orders back. That kind of culture is not so sophisticated in terms of their uptake of algo usage.”
Outside the long-only sector, many identify the long/short industry as another area where things are moving fast in terms of increased demand for algo trading solutions. According to Mark Palmer, general manager at algo trading platform provider Progress Apama, the demand from hedge funds has been particularly high over the past 12 to 18 months. “The driver has been generally the opening up of the markets to be more electronic and the ability of hedge funds to take advantage of this,” Mr Palmer says.
The growth of algo trading outside equities and into other types of investments is generating more demand for technology that can meet the specific requirements of different asset classes.
“FX is probably the best example of that where you’ve got multiple liquidity pools, all with different characteristics and different market depths,” says Mr Palmer. “They can concentrate on different parts of the foreign exchange market, they see they can get a better price on some exchange than on others. All that creates arbitrage opportunities. Those are the kind of things that buy-side firms feel they can get access to now because it is not that difficult to get electronic access to those liquidity pools.”
Mr Palmer explains that IT resources in the buy-side have traditionally been limited so clients are demanding pre-built solutions that can be customised.
“The sell-side tends to take a platform and build a lot from scratch,” he says. “The buy-side wants to have 80 or 90 per cent out of the box. The hedge fund guys tend to be smaller and therefore want the product to do a little bit more than the sell-side people want.”
Another sector where algo usage is still not common practice but presents potential for growth is private banking. Mr Hills says the demand from private banks for direct market access (DMA) solutions is already high.
“What we see there is that generally order size is too small to make algos worthwhile, but on the other hand they occasionally get big orders where an algo would fit in,” he says. “Depending on the profile of their clients, you can see that algo trading has a place in this sector, but at the moment private banks are mainly attracted to the benefits of DMA in terms of cost, speed of execution and real-time feedback.”
The current demand for algo trading solutions is resulting in increased competition among providers of algorithms and specialised trading platforms.
For a buy-side firm, choosing the right partner is quite a difficult task and during the selection process they tend to focus as much on the technology itself as on the company behind it.
“For a large buy-side firm the biggest factor is that the provider has a strong and large technology team with global presence to support them,” says Mr Kedia. “Obviously the technology itself is of paramount importance but for the large institutions the company behind the product is just as important as the product itself.”
When looking at algo providers, clients want to get good commission rates and low execution costs. “Although it is not the only driver for choosing a provider, they are looking for very competitive commission rates and I think that is restricting the number of brokers that can enter this market. If you don’t have the flows on certain exchanges you can’t be cheap enough to compete, “ says Mr Hills. “The second thing they are looking for is coverage. They want a one-stop shop, they don’t want to have to remember that broker X,Y or Z only covers Euronext and Madrid. They want to know that if they have a broker on the platform they can go to any market.”
He adds that performance is very important as well as the quality of the algos. “We have found that in order to sell we have to show execution performance on the various different algos.”
Because every trading house has a different trading style, Mr Hills believes they can add value by keeping an eye on algo performance from a service desk. “When we think an algo is not performing correctly, we can have a discussion with the client about whether we should change the parameters,” he says.
Also, they can identify stocks where algos don’t do so well and traders would benefit from dealing with them manually. “ What we are trying to do is to build a service around the algos which is more than just building the technology and giving you access to it. We are still going to monitor and manage your order flow,” he says.
Changes in regulation with the arrival of MiFID and its focus on best execution are also expected to have an impact on trading practices and any future developments in the electronic trading sector.
“MiFID has many implications for different markets. For equity markets, MiFID is going to be very positive for end users,” says Mr Boardman.
He believes that increasing competition among the different exchanges will be beneficial for the industry. “At the moment most of the liquidity in any one stock in European equities is concentrated in the home domestic listings,” he explains. “We think that competition among exchanges will lead to more innovation and a reduction in fees.”
He adds that with the arrival of MiFID the burden of proving best execution is subtly moving from brokers to institutions: “This will prove to be quite fundamental for investment firms because they will no longer be able to effectively outsource this obligation of best execution.”
