A call to action.
Summary paragraph: Greater regulatory scrutiny and the pursuit of alpha have given rise to a new generation of decision support tools aimed at helping institutional investors perfect the investment process.
Greater regulatory scrutiny and the pursuit of alpha have given rise to a new generation of decision support tools aimed at helping institutional investors perfect the investment process.
A number of factors have supported the intensity of institutional investors' focus on quality of execution in recent years. For many, the overriding one is higher levels of scrutiny of buy-side trading practices - by regulators and senior managers and clients - in a post-crisis environment characterised by scandal, suspicion, and more than the occasional technology glitch. The US flash crash of 2010 increased pre-trade risk management requirements and now regulators the world over are taking measures to ensure algorithms are in safe, qualified hands. Meanwhile, the deception deployed by US dark pool Pipeline - it claimed to match client blocks against each other when it was really running a prop desk - led to greater board- and client-level interest in how buy-side trading desks executed stock trades. Alongside these high-profile reality shocks, the tactics deployed by trading venues to attract high-frequency flow - including, but not restricted to, the maker-taker pricing model - has gradually stepped up pressure from the buy-side for substantially greater transparency from brokers about how their orders are being executed.
The other key feature of the new post-Lehman landscape - slow, uncertain recovery accompanied by low volumes and frequent panics (witness the response to the possible withdrawal of quantitative easing earlier this year) - has also heightened the importance of execution excellence. At one level, having fewer trades on the blotter makes it more important to make the big ones count. At another, alpha has been scarcer, placing a premium on any scheme, technique or insight that can wring a few more basis points out of the deal.
A third element is maturity and expertise in the field. Yes, most algorithms perform to pretty high standard these days, but so do the people who deploy them (or alternatively forego the electronic route because high-touch methods are more productive when, for example, building a position in the Turkish construction sector). Combined advances in trading technology and best practice mean 'noise' trades can be safely automated, with human brain power focused on more complex challenges, be they working with a PM to execute a block trade, opportunistically, but stealthily, in an unpredictable market, or applying electronic techniques in other asset classes to increase the capacity of the trading desk without growing headcount. In a tough economic climate, the trading desk must always be looking for ways to support better client outcomes, lest the appeal of increasingly sophisticated outsoucing options attract the attention of senior management.
As for the trading tools themselves, one of the most significant developments in the past five years has been in speed, not so much in terms of latency, but in the ability to respond to changing circumstances. Volatile post-crisis markets in 2009 saw algorithms junk historical trading patterns for real-time market data and pressure built continuously for more immediate and more detailed transaction cost analysis (TCA) to analyse execution performance. Just as social media has transformed the news cycle - both accelerating distribution and amplifying feedback - so modern trading technology allows the buy-side trading desk to take in a wider range of inputs into a trading decision, whilst also making it easier to adjust that decision should new insights and information demand it. And while the traceability of electronically enabled communications might cause qualms in the personal and political spheres, in the profession of trading a new era of transparency, clear audit trails and detailed decision support are largely to be welcomed.
Multiple, flexible, immediate
Some things don't change of course. As Palak Patel, global head of equity trading product development at Bloomberg LP, points out, "'when to trade' is the fundamental, critical decision, followed by 'how to trade'," he says.
Bloomberg's EMSX platform provides the trader with additional input into the latter question by supplying real-time data on trading patterns across the 50+ venues that make up the fragmented US equity market. Bloomberg EMSX's venue analysis enables the trader to compare an individual venue's activity for a specific order in a particular stock with volume levels elsewhere in the market in real time, enabling him to switch to a pool or broker that is seeing more flow in that name. Similarly, it can show the buy-side trader where his broker sources liquidity in a stock and compare wider patterns in that stock's volumes across the market, potentially identifying routing anomalies or inefficiencies. "More actionable post-trade data makes for more effective execution," says Patel, noting that traders have been using stock-specific historical volume patterns to evaluate and implement optimal trading strategies for some time.
The scope to incorporate a wider range of inputs into the timing and 'in-trade' tactics of a trade are continually expanding. Patel says that peaks in social media activity relating to a particular stock are already changing price levels and even direction. But the spectrum of inputs is far wider than Twitter. "Any news, pending event, speech, corporate action or available short sale data can be incorporated into the trading environment," he says. In the evolving field of predictive analytics, complex event processing capabilities are being incorporated into execution management systems (EMSs) to help traders identify short-term momentum and volume opportunities. Correctly identifying a reversion or other trend that may play out over ten minutes or less could make a big difference to a trader's search for liquidity in a particular stock. "People want a flexible environment that lets them use different building blocks that are suited to specific strategies and stocks," says Patel.
Adding value upstream
Post-crisis rationalisation means that the sell-side has fewer resources on offer and the buy-side lower commissions with which to pay for them. The outcome of this chicken-and-egg situation is that buy-side trading desks are being a lot more selective about what trading resources they rely on the sell-side for and what they must generate from elsewhere.
"At a time when coverage models on the sell-side are converging, buy-side desks are looking to add more value upstream to PMs," says Patel.
Traditionally, much of the input provided by the sell-side into buy-side investment decisions has come in the form of research. In the prolonged boom to 2007, research production expanded vastly, with the largest banks attempting to provide blanket coverage across multiple companies, geographies, asset classes, themes and time horizons. The well-connected PM could not possibly read all research pertinent to his portfolio, leading many to dismiss broker research as vanity publishing.
Despite an increasingly nuanced approach to the supply of research since the 2007 crisis, with brokers also monitoring moves by regulators to improve price transparency, Colin Berthoud, founding partner of research platform operator TIM Group, rejects the accusation of systemic over-supply. "There may be less ability to pay for research at present, but the investible universe is larger than it used to be and mandates are not shrinking. The buy-side still needs a broad range of research." TIM Group currently supplies research from 320 firms, an increase of 20 from 12 months ago, which includes a larger number of new providers which more than offsets post-crisis casualties.
As with decision-support tools on the execution side, buy-side firms are looking for streamlined and measurable sell-side input from a content perspective. TIM Group filters sell-side research based on its understanding of its buy-side clients' specific needs. Initially serving predominantly quant-based hedge funds, the firm increasingly supplies long-only PMs looking for longer-term investment ideas as well as their trading desks, seeking opportunities to add alpha or identify bubbles of liquidity at shorter horizons. Based on a research provider's record, a PM might block short-term 'spam', or request access to a firm's telco reports, minus the market-leader for which the analyst has a blindspot. According to Berthoud, TIM Group not only filters research, making it more consumable, but also improves transparency, helping the buy-side identify more accurately which research is worth rewarding in the broker vote. He also believes the last five years have witnessed a marked change in appetites.
"There is a lot more interest in top-down investment themes and sector-based research. Macro-economic issues are playing a greater role in investment strategies, with more PMs looking to apply a tactical overlay, for example adding a derivatives exposure to effect an underweight position in a particular region," says Berthold. Reflecting in part the shift of the sell-side to meet this demand, TIM Group already offers an FX-focused research product and most recently expanded into derivatives. Moreover, the firm is increasingly working with buy-side clients to provide tailored research dashboards.
While firms such as TIM Group are responding to the need for different kinds of input into the investment decision, so others are developing technology-based solutions that offer the trading desk a wider range of inputs into the execution strategy.
Financial data provider Markit will launch a 'trader dashboard' in the first half of next year to provide buy-side traders with streaming 'in-trade' decision support aimed at improving execution performance.
Targeted at long-only investment institutions, hedge funds and some sell-side clients, the new tool will provide users with various triggers and data inputs to inform trading strategy and monitor execution performance, including streaming transaction cost analysis.
The dashboard builds on both existing Markit financial data services and acquired capabilities including trading analytics specialist QSG, securities lending information provider Data Explorers and financial website developer Wall Street On Demand, purchased in 2010 and rebranded to Markit On Demand, which has created a commission management solution and broker voting service which allows buy-side firms to evaluate and vote on sell-side services, and allocate research commissions.
"From Q2, we will be delivering our analytics and metrics on a streaming, intraday basis to our existing clients. By integrating multiple signals on a single dashboard, we will provide the decision support that will help clients answer critical trading questions about how they trade and the footprint they leave in the market," says Tim Sargent, co-head of equities at Markit. In due course, the dashboard will integrate real-time TCA, commission management and broker voting capabilities to help traders to allocate business to brokers based on both execution performance and commission levels.
While the provision of such market intelligence to the buy-side trading desk might look like disintermediation of the broker, Sargent sees the development as another step in the evolution of the services supplied by the street and the independence of the buy-side. "At a time when they face competition from high-frequency flow, buy-side firms realise they can't rely on anyone else to fight their battles. But we see healthy collaboration between the buy-side and the sell-side. Some relationships are still grounded in the traditional one-on-one call, backed by technology, while others are sharing information via portals etc. Ultimately, the challenge is about getting market-moving information to the client," he explains.
UK agency broker Olivetree Financial Group created a new business unit - OTAS Technology - to house its technology offerings, which are designed to provide traders with decision support analytics and other tools to improve execution performance.
Charlotte Wall, head of sales and marketing at Olivetree, says demand is being driven both by the need of the trading desk to add greater value to the investment process and the necessity for a detailed audit trail that can be used to explain why specific trading decisions were made.
"Increasingly, firms want to get ahead of what the regulators might want to know about their trading operations. The acceleration from traditional TCA to 'in-trade' decision support is driven by a need to be on the front foot as both regulators and clients look for more detailed explanations of trading decisions. In many cases, firms are also moving away from in-house order and execution management systems to ensure they have a robust audit trail and associated controls in place," she says.
Olivetree's OTAS platform aims to improve trade and investment decisions, and in particular trade timing, by providing relevant input and analysis on director dealings and short interest activity, as well as trends in other relevant instruments such as options and credit default swaps. In addition, the firm's Tradeshaper tool helps the trader identify the most effective strategy for an order and provides alerts as market circumstances evolve.
In many respects, says Wall, today's generation of decision-support tools are focused on improving efficiency. Clients see the benefit of being able to see a large range of information at a sector, index and single stock level that is statistically relevant to their investment process.
"Many portfolio managers are more willing to take input from the trading desk these days but are often on the road rather than at their desk. Improving the flow of information between the two ticks a lot boxes," she says.
For EMS vendor Portware's CEO, Alfred Eskandar, technology must facilitate collaboration to be of value to today's trader. "The EMS cannot just be a screen and connectivity tool: It has to take static data and make it actionable," he says.
The need for greater collaboration on the buy-side trading desk stems in part from the need of traders to add value at scale. Eskandar estimates a ratio of 10:1 PMs to traders at some firms, an imbalance which can only be rectified by technology. "If the technology can help the trader decide with execution tools to use, explain that rationale to the PM, and monitor and adjust the strategy throughout the trade, then the order-giver and the order-taker can become an investment team," he says.
Portware's Alpha Vision tool - available with the firm's EMS or as a standalone tool - does the thinking that the buy-side trader rarely has time for. Available in Europe from Q1 2014, the tool automates order analysis, strategy selection, algo implementation and trade monitoring so that the trader can focus on added value tasks.
Described by Portware as an algorithmic optimisation solution, Alpha Vision automatically selects the perfect algorithm for any order based on variables including the order's parameters and factors impacting market conditions. Alpha Vision also provides the user with a bullet-pointed justification for choosing a particular algorithm. During the life of the order, Alpha Vision will then review execution performance throughout the lifetime of the trade and switch algorithms if it calculates that a different strategy would be more appropriate, for instance if market conditions change or if a new approach is required to finish off an order. While a human trader would switch algorithms around four times per trade, Alpha Vision changes strategies 40-50 times before the order is filled. "Alpha Vision continually re-evaluates its hypothesis," says Eskandar.
The pursuit of alpha through up-to-the-minute data is driving innovation in a number of ways. Trading technology provider InfoReach offers a decision-support tool that helps investors pinpoint moment-to-moment market opportunities to capture short-term alpha. As well as pre- and post-trade analytics, 'Second Opinion' factors in real-time trade and market variables - volume, volatility and market trends - during the progress of a trader's intended order execution. Based on market conditions, Second Opinion re-estimates all projections and updates the trader of any changes in pre-trade assessments every 15 minutes.
For example, initial pre-trade analysis might suggest that a certain trade will be 10% of the projected day's volume. But, Second Opinion At-Trade can flag that the remainder of the trade might be 20% of the projected remaining day's volume (based on both actual market volume being lower and the progress of execution being slower than expected). According to InfoReach CEO, Allen Zaydlin, these alert capabilities means users can identify opportunities to create riskless alpha as they arise, thereby improving overall investment performance. "Traders are looking to take greater control of their orders and to explain the performance they achieved," he says.
Another way in which technology can give more power to the trader's elbow is by helping to establish an institutional memory. A combination of more comprehensive TCA and the advancing functionality of today's EMSs is allowing traders to trawl through their trading desk's collective experience for certain sizes or types of transaction. Thus, a trader might go to a specific broker for a certain type of trade based on what he thinks is gut feel or instinct, but his EMS can prove to both the trader - and, perhaps more importantly, his investment committee - that he went to broker X because they have the narrowest spreads historically for a particular FX pair, for example.
The feedback loop is completed if the trader can check accurately the actual performance of the trade against the outcome forecast by the EMS's predictive models. Eskandar believes we are now in the era of ever-smarter, self-learning trading platforms that recommend and deliver better executions the more they trade, taking lessons for the future from how even the smallest outlier affected a previous deal.
But this is not EMS as Terminator, the machine that develops a consciousness and trades for itself without human supervision. "Just like you'll never fly across the Atlantic in an airliner with no pilot, you'll never have a desk with no traders. But what you will have is traders sitting in on more earnings calls, talking to brokers, helping the firm to keep costs low while growing the asset base. The trader becomes more valuable, not less, through automation."