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January 1, 2003

A Market Making Alternative

By Peter Chapman

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Leaving It to the 'Expert System'

Is the market maker of the future a computer? Automated Trading Desk, a proprietary shop in which computers do most of the trading, is betting it can make a buck as a wholesaler. The Charleston, S.C.-based broker dealer bought a flagging Chicago Stock Exchange specialist last year and is now running many of its trades through its system.

That system is a so-called "expert system," which uses artificial intelligence to mimic the thought process of a market maker or sales trader. By posting limit orders on ECNs and the New York Stock Exchange's DOT system the machine trades about 80 million shares per day in 2,000 Nasdaq and listed securities.

ATD was co-founded by Rutgers University Professor of Finance Emeritus David Whitcomb in the late 1980s. It was designed to apply his pioneering work in market microstructure to the trading of stocks. Market microstructure looks at how a market's rules affect the price formation process. Whitcomb is chairman of ATD. Steve Swanson is president and chief executive. The firm has about 75 employees.

Last July, ATD bought Chicago Securities Group, the third largest specialist on the CHX by number of securities traded, as part of a strategy to diversify its sources of order flow. In addition to the largely retail flow it expects to get from CSG's broker dealer customers, it has also begun tapping into the institutional market with a "guaranteed VWAP" execution program.

ATD has integrated its expert system into the order management systems of the Chicago Securities Group. Thinking and acting like a human trader, the system is charged with laying off CSG positions and representing customer orders.

"We're taking a conventional market making business and making it unconventional by using technology," said Whitcomb. "We think we can give better order execution than firms now give and make money as well."

"Making money" is not a phrase uttered by many wholesalers these days. ATD bought CSG at a time when many long-time players are getting out of the business altogether. NDB Capital Markets and Fleet Trading, for instance, shut down last year. Knight Trading, the biggest wholesaler, and Schwab Capital Markets are scrambling to replace lost retail order flow with more institutional flow.

Chicago Stock Exchange specialists have been hit hard as well. Top market maker Dempsey & Co. sold out to E*Trade last year. SG Cowen exited the business last month. Chicago Securities Group itself was losing steam when it was acquired by ATD. In 2000, CSG traded about 500 Nasdaq and listed names with a staff of about 50. Last year, it was down to just 200 or 300 stocks and 25 employees.

Diminished profitability is behind the retreat. Decimalization and the bear market are behind the diminished profitability.

Decimalization reduced the minimum trading increment from 6.25 cents to a penny. Dealer competition then compressed quoted spreads on the most active stocks to one cent. That made it impossible for dealers to profit on the difference between the price they gave their customers and the price they got when laying off the position.

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