The speedy adoption of algorithmic trading – which places more power in the hands of buyers and sellers – has altered equity markets to such an extent that some are even predicting the demise of sell-side trading firms altogether. Natasha de Terán explores.

Algorithmic trading – trades generated electronically based on a set of pre-determined rules, such as small movements in share prices – has long been seen as the catalyst for the surging volumes in the equity markets. In 2005, the Aite Group estimated that algorithmic trading accounted for approximately 28% of all equities trading. The same firm estimates that at the end of 2006 the share of algorithmic trading approached 33% of the total equities volume.

Brad Bailey, a consultant at Aite, believes the trend is set to become even more prevalent. Both buy- and sell-side firms, he says, will increasingly use algorithms to differentiate themselves and get an edge. By the end of 2010, he estimates that some 53% of all equities trading will be executed using algorithms.

It is rare that the derivatives markets lag their cash market equivalents, but they have done so where algorithmic trading techniques are concerned. While reams of studies have been published on the impact of algorithmic trading in the cash equity markets, no such studies have been published for the futures markets. Most believe that the adoption of the complex techniques is still very much in the early stages – accounting for less than 10% of derivative volumes and about the same in the foreign exchange markets. But comments from senior futures business figures over the past 12 months paint a clear picture: algorithmic trading is hitting the derivatives markets – and it is hitting them hard.

At the Futures and Options Association conference in London, the Swiss Futures and Options Association meeting in Bürgenstock and at the Futures Industry Association (FIA) meeting in Chicago, algorithmic trading came up time and time again. Indeed, at the FIA Chicago meeting in November 2006, the gathered exchange heads concluded that futures volumes would grow by at least a factor of 10 over the coming 10 years; a trend, they agreed, that would largely be driven by algorithmic trading.

The topic of algorithmic trading also came up in the Chicago Mercantile Exchange’s (CME) third-quarter results presentations, when Robin Ross, managing director in charge of interest rate products, said that algorithmic trading had “been a big contributor” to the growth in eurodollar futures at his exchange over the past year. Chief executive Craig Donohue said he expected the CME’s new FXMarketSpace product to hold particular appeal for algorithmic traders. At the announcement of interdealer broker Icap’s interim results, CEO Michael Spencer said continued growth in his business will be strongly assisted by the expansion of algorithmic trading.

Some dedicated futures and options trading firms have already adopted the techniques quite widely. The London-based Kyte Group, which is the number one broker of futures contracts on Liffe, the European derivatives exchange, executes half of its trades through such systems.

Peter Green, chief executive of the firm, believes uptake has also been quite large outside his firm: “As computer power has improved, hardware costs have reduced and bandwidth has increased so there has been a massive increase in the number of hedge funds and banks using high frequency trading systems to take advantage of anomalies across the futures markets. It is already becoming harder for the typical old-style traders to compete – those that haven’t adapted their methodologies and ways of looking at the market will need to change fast.”

Encouraging algorithmic trading

In response to the growing interest in algorithmic execution, Liffe and Eurex have upgraded their platforms this year; both have done so in such a way as to specifically accommodate (and encourage) increasing volumes from algorithmic traders. And when Eurex finally relented to customer pressure on fees and announced a price reduction programme in mid-December, it did so by targeting algorithmic traders: rather than offering headline fee reductions, the exchange introduced an incentive programme designed to benefit, and thus encourage, algorithmic trading.

The impact of the growth of algorithmic trading for the exchange groups is clear. So long as they are able to meet the low-latency, high-bandwidth demands of their customers, volumes will surge. Investment in technology will be considerable and ongoing, but rising volumes will likely more than offset this. Moreover, and with proximity of location being of paramount importance for algorithmic traders, the exchanges could stand to win economically on another front: by renting out space for member’s servers at their data centres.

Mr Green says: “You need to be as near to exchange matching engines as possible to achieve optimal results, so as this phenomenon develops, geography will become an increasingly important success factor. The exchanges could capitalise on this by leasing out data servers to market users, thereby gaining an additional revenue stream.”

But for traders – and particularly for sell-side traders – the advent of the algorithm is going to be much more of a mixed blessing.

An IBM study has predicted that the traditional outsourcing of execution from buy- to sell-side will likely wane as algorithmic trading proliferates: more buy-side clients will seize back control of execution, and sell-side firms will lose out on flow and fees. The study’s authors, Keith Bear and Zohar Hod, even went so far as to suggest that today’s “buy-side” and “sell-side” terminology may soon start to lose relevance. In future it suggested that these would simply be classified as either “advisers” or “principals”, or as “risk assumers” or “risk mitigators”.

The sell-side has, of course, been developing its own algorithms and successfully offering them to clients – announcements of its imminent demise are thus probably premature. However, it is fast becoming equally clear that some of the profitable territories that sell-siders traditionally assumed to be their own will no longer be sacrosanct to them, thanks to the algorithm.

Eurex’s new incentive programme is perhaps the clearest illustration of how the game is beginning to change in the futures markets. The exchange’s new pricing programme was announced in December after several years of bank-led badgering over the exchange’s fees. The Swiss-German exchange worked long and hard to devise a pricing scheme that would not impact on its revenues while accommodate the calls for lower prices. However, to maintain or boost its bottom line at the same time, it would need to simultaneously encourage higher levels of trading. The result? The exchange designed a pricing programme that would encourage more proprietary, algorithmic and hedge fund traders not only to use the exchange’s products – but to trade on the exchange directly. In other words, the exchange has given in to the banks’ call for lower prices – but it is also effectively disintermediating them.

The trader profile

Another recent IBM study, entitled “The trader is dead, long live the trader!’’, determined that for every 40 traders active today, there would be only four left at their desks by 2015. “The four traders will be the stars that assume risk, achieve true client insight and, of course, consistently beat the market,” the study concluded.

Headline grabbing stuff, but not everyone is convinced that trading floors will be the empty places that the IBM commentator is suggesting. Mr Green instead believes that it will be the trader profiles that will change.

“There is a fear that these systems will eliminate the human role in the trading process, but that is not the case as the brains behind the systems are of paramount importance,” he says. “What will likely happen is that traders’ profiles will change: the trader landscape will be dominated by electronic engineering wizards, instead of being populated by economic wizards as it is today.”

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