the changing role of the buyside trader

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9rorrltuilding Belter Perf orrneinaeCOMMENTARY 81 AUGUST 2OO4

THE CHANGING ROLE OF THE BUYSIDE TRADERThe role of the buyside trader has changed dramatically over the last decade.Buyside traders now have an arsenal of execution tools at their fingertips andare taking greater control of their orders. Delegating the responsibilities fororder execution to a broker is now supplanted by electronic trading.

-r, '.' ' ',s MaNe a Good-lrader? was tne subject ofthe January 2003 P exus Commentaryl which focusedo^ the use of Orde' Varage-ent Systems and StraightThrougl^ Processir^g (STP) trrougrFIX connectivity. We questronedwhether the fast connections ofelectronic trading were gettingtraders where they needed to go.Just a few quarters later, a proliferation of providers isexploiting network connectivity to provide better, fasterand less expensive service in areas such as liquidityaggregation and algorithmic trading. In this Commentarywe review recent market structural changes and discusshow these changes motivate and empower the buysidetraders to better control their orders.How Much Have Things Changed?

In'Consolidation, Fragmentation, Segmentation andRerr-;laf;^n2 " | "rry Haliis discusseri th= re:scns wh;,markets fragment, the forces leading to re-consolidation,and, a srrhqenrent sit;ation that Harris def nes as asenmnntcd merkct Clrrite nrescientlv What haShappened is very close to what Harris describes.Markets fragment because traders have different needsand trading problems. Pre-1990 market structures werefloor-centric, with broker/dealers intermediating mosttrades. A "fourth market" emerged in the 1970's as aprivate phone-based crossing network among buyside.traders to fulfill the budding demand for direct buyside tobuyside crossing. In the 1980's the fourth market wentelectronic via Instinet, followed by both the CrossingNetwork and ITG's POSIT. Even so, the demandcontinued for more alternatives to invitino brokerintermediation into the orocess.

Hs irades shift away from avenues, soliciting liquidityintermediation, both buyercentral market io scatteredbecame difficult. Withoutand seller must show up

independently. While traders do not want sellsideintermediation on every trade, thev need access to deepliquidity pools. Thus isolated "buyside only" poolsneeded to reconsolidate in order to raise the rate ofsuccessful matching.The changes mandated by the '1997 SEC Equity Order-Handling Rules combined with technologicalimprovements such as OMS systems and FIX protocolsto accelerate the development of electroniccommunication networks (ECNs). Very quickly, the ECNssaw thai connectivity could improve liquidity, and beganinier-connecting with each other and wrth NASDAO.Growing popularity and volume begat more popularityano vorume.The 1997 Order-Handling Rules also mandateddecimalization, which impacted markets in three ways:. As the increase in the number of price points thinnedout liquidity at any given price, it became difficult for

buyside traders to find size. Traders were forced tobreak orders into small pieces to access thinned-outliquidity.. "Pennying," jumping in front of bids/offers by pennyincrements to force better prices or faster execution,became a significant deterrent to buyside traders for

I Available on www.plexusgroup.com'!Consolidation, Fragmentation, Segmentation and RegulationHarrs, Lawrence, Financial l\y'arkets, Institutions & Instfuments v. 2, no. 5,December 1993, 1-28.


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posting limit orders to attract hidden liquidity. The bookbecame even thinner.. The reduction of spreads make it difficult for brokers toprofit from their traditional market-making business.This forced them away from the market-makerwholesaling business model toward an agency-basedtrading service model. This shift positionsbrokers/dealers as facilitators for both their clients andthe facilities offered bv ECNs.

Meanwhile, low returns expectations and increasingsurveillance caused buyside firms and fiduciaries tofocus on the costs of portfolio turnover. The increasedsensitivity motivated them to monitor transaction costsand adjust behavior where appropriate.While it appears that we still have fragmented marketstoday, the reality is quite different. Rather than beingconsolidated at the destination, institutional markets arenow de-fragmented at the source, the buyside tradedesks. New trading systems allow buysiders to efficientlyscan all market fragments for liquidity. Larry Harris'"segmented market" seems close to today's reality.The Buyside Traders Workload

In addition to allowing buyside traders to take control oftheir trading, the technological advancements of the lastdecade facilitated large increases in productivity on thetrade desks.Back-of-the-envelope calculations, using lists of clientsfor whom Plexus evaluates individual traders. showinteresting trends:

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. The number of orders per trader processed by Plexus'smanager clients is up 20% since 2000. This is probablythe best indicator of the increase in trader workload.. Despite increased workload, half of the desks have thesame number of traders today as they did in 2000.. The number of managers reducing trader population ontheir desks exceeds the number of managers.increasing desk population by a factor of 2:1.Individualdesk population data indicates that the traderpopulation has decreased B% since the turn of themillennium.' While workload is up in terms of number of orders, theshares per order has dropped 24o/o and the total dollars

traded has fallen 1B%.. Interestingly, the number of manager clients requestingevaluation of individual traders is up 67% Individualtrader skills are increasingly under scrutin,.OMS Sysfems And Connectivity

Order Management Systems (OMS) are the keystones ofthe buyside's ability to manage workflow. These systemscollect orders from portfolio managers, aggregate theminto trading blocks, manage executions, collect fills andperform allocations. Nearly all of Plexus's managerclients use an OMS system, although there are bigdifferences in system capabilities.OMS systems are becoming the technological backboneof the buyside firm 3, Automating the 1!z,.rinal oart of thejob is not enough; firms demand integration of portfoliomanagement functions such as optimization models andrisk and compliance modules.The key advance for OMS systems in the last five yearshas been enhanced connectivity to brokers, tradingvenues, direct market access brokers and algorithmictrading systems. The Tabb Group found that the buysidenow handles 52% of its order flow electronically and only49o/o manually by phoning a broker. The larger themanaqer. the lower the level of manual order handlino.Aggregation Tech nology : Creati ng ASegmented Market Place

Reconsolidation, the natural evolution of fragmentation,has been accomplished via aggregation technology.Both buyside and sellside now seeone consolidated montage of themarkets. Aggregation technologygathers data f rom the variouselectronic marketplaces, thusintegrating otherwise isolated poolsof liquidity. These systems also provide executionfacilities that can trade seamlessly across all trading

venues.ECNs were early providers of aggregation acrossNASDAQ dealers. Clients would use Bloomberg orArchipelago to access multiple liquidity sources. Even ifthe ECN did not have the other side, it still got a piece ofthe action as the point of market entry. The result wasdramatically improved liquidity and quick useracceptance. But the trading was labor intensive; theelectronic markets still required manual intefaces. Users3 See Commentary #74, Januaty 2003. Also see the repod by the Tabb Group. Both afeavailable on www.plexusgroup.com.


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spent a lot of time punching keyboards to work thesystems.Smart order routing technology represents the latestadvances in aggregation systems. The technologyanalyzes order flow for particular patterns of size andliquidity, ident!ir:s attractive venues and automaticallyroutes orders for execution. By re-combining liquiditypools and allowing the user to set custom trading rules,aggregation providers hope to pre-empt the need to linkto four or five competing vendors. Advanced aggregationsystems can simulate sophisticated order types acrossmarket venues even though some ECNs may not supportthem.Sn'an o'der rout'rg is still in its infancy: according to theleading providers of this technology, few trade deskshave made use of anything beyond simple VWAP trading.Broker-provlcied aggregation systems are the mostrnridelv rrco.i h r hrrrici.lo firme fnllniriod hri inrlononrionioroviders such as Lava and FlexTrade, FlexTrade is alsooffered through some broKers, Smaller aggregators arealso aggressive competitors, and together command alarger market share than FlexTrade.Drilling down on firm size shows a different picture. Largefirms main y rely on the Lava aggregation system,followed by FlexTrade. Small buyside firms, on the otherhand, rely heavily on brokers to provide this technology.According to the Tabb Group, breadth of functionality -^hA ^^^+ ^^^^,^+^^. ru uurL - rEpdro,vr the aggregation sysiem from eachother. Although sub-second speed - the time it takes toget your order to the pornt of liquidrty - was consideredcritrcal, most buyside desks felt that most systems werecomoetitive on soeed.A growing number of brr,l:ers sell their expertise in usinoECNs and aggregation systems to provide buysidetraders agency executions without invoking "shopping" ofthe order Brrvside desks use these firms to becomeactive users of aggregation and access technologywithout investing time and money. Firms like PulseTrading, White Cap Trading, Firefly, UNX and others haveexperienced good volume growth in the Plexus BrokerUniverse over the last few years. Other firms in this spaceare EGS, Electronic Specialist, EquityStation, Terra Novalnstitutional. Vie Financial and Paravane Partners.Algorithmic Trading

Algorithmic trading systems model the trading rules andlogic of different trading strategies and implement themodels via FIX connectivitv. The svstems offered to the

buyside trading desks are fairly new, but penetration hasbeen broad. Both the Tabb Group and the Plexus surveyfound that 60% of the desks use algorithmic tradingsystems, with the percentage soaring for large firms to80o/o.

The basic strategy of these systems is still crude: "sliceand dice" the orders down to the size being shown in theorder books. The widespread use of automated tradingstratagems such as probe trades and other devices totest the tenor of the market still lies in the future.Modeling trading strategies, even a basic VWAP strategy,is not an easy task. The best algorithmic trading systemshave developed much broader capabilities than a basicVWAP model, but the vast majority of users still use onlythe basic model. The main use of these systems is for thefairly liquid, easy to trade orders where little value can beadded by more human attention.As was the case for aggregator systems, broker providedalgorithmic systems dominate the market place. CSFB,Goldman Sachs and ITG are the current leaders. CSFBhas a big presence among the large and medium sizefirms and ITG mainly among medium size firms.Proprietary models and FlexTrade were the non-brokersystems with the largest percentage of users.The goal of traders using these systems is to eitherreduce costs or improve efficiency. A few have started toanalyze the results from their algorithmic system and areoften not pleased with the results. Plexus has evaluatedthe results of naive VWAP engines versus PAEG/L andalso found poorer than expected results.

ConclusionsThe relationship between buyside trade desks andbrokerage firms is in the process of redefinition. Indeed,today's markets operate radically different than they didthree or four years ago.The idea of "relationships" being the gravitational forceholding together buyside trader and broker is weakening.Changes in market structure and order-handling rulesallow the buyside desks to take more control of theirorders. The days when brokers controlled market accessand market information appear gone forever.This will not be good news for brokers who rely on littlemore than relationships for the securing of order flow.With more trading being done electronically or throughdirect floor access, the remainder of the pie is gettingthinner. We predict that many brokerage firms will seek


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to merge or be acquired to beef up their valueproposition.For a while, we worried that the '1997 Equity Order-Handling Rules would fragment the market and maketrading more difficult. No longer; recent developments intrading system technology now provides buyside traderswith the ability to efficiently scan all fragments of themarket place for liquidity.Aggregation systems are re-consolidating thefragmented market for the buyside desk. These systemsorovide one consolidated '-montage across all market i...|:;i:: ,,,i.:,.; ;,,:,,,r1,fragments, and now incorporatesmart order routing technology ,::,:'. 1.. ,:;.,to automatically route orders tosoecific venues for execution.Algorithmic trading systems provide the buyside deskwith more advanced methods of handlino small orders.

Algorithmic trading systems model the trading rules andlogic of trader tactics and apply communicationtechnology to implement the model. All current modelsuse VWAP as a basis for their execution strategy, withthe best systems offering broader models. Clients arestill struggling with how best to use the systems.In the future, we can expect advances in modelingtechnology to result in more sophisticated automatedorder handling. Increasingly, the models will add valuedirectly by reducing trading costs or indirectly throughimorovements in efficiencv. The role of the trader will

evolve more towards trading strategy as a component ofinvestment strategy, and away from the clerical roles ofphone handler, commission cashier, and lion tamer.

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the changing role of the buyside trader

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