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June 30, 2003

The Sudden Success of Program Trading: Does a new trend mean the demise of block trading?

By Gregory Bresiger

Nevertheless, Goldman Sachs' Gaglioti, who believes that the use of program trading will inevitably rise, said that even computerized strategies will also always need "some level of human intervention."

But, adds Mook, "a computer decision is instantaneous. With a human there is also a delay." And that means, several trading executives explained, that desks using program trading have the chance to beat benchmarks.

"I think you have seen costs versus VWAP drop significantly on program trading desks," said a trading executive who didn't want to be quoted by name. He said that several studies have shown that the average cost versus VWAP is about a penny and a half less. "That's a very significant cost savings," he noted.

The Downside

The disadvantage of program trading? Mook said it can divide firms.

"One of the things bigger firms have difficulty with is that their program desks and their block desks have a tough time integrating," he said. "So if you have a block desk on one side of the floor and a program desk on the other end, they cannot talk to each other and they ultimately don't want to because each department's profits are measured individually."

But there is another benefit of program trading, trading executives say. It is in the quality of the execution.

"What computers do is increase the consistency of your executions. So on the one hand, you may avoid once in a while doing really, really well, but you will also avoid doing really, really bad," said Schwab's Leibowitz. He noted that portfolio trading was appropriate because "today clients are just more sensitive to the negative impact of the downturn."

The lessening of violatility - especially just after a three year period in which most markets were down more than 20 percent a year - is a critical factor today for many clients, he adds.

But then so are the costs of highly compensated, highly-skilled traders. Human skills are almost always the biggest bill in any financial services firm. Before the massive layoffs at Schwab, which makes a market in thousands of Nasdaq stocks, it would have needed about 250 traders, Schwab officials say. Today, using its electronic trading strategies, the number is about 45.

"And what's even better about this is that those 45 traders now will be paid very well," Leibowitz said.

Nevertheless, several trading executives argue that, because it has become more successful, individual traders will become more involved with the strategy.

"Today program trading desks have gone from being desks that just execute baskets of securities, to desks that have really focused much more on enhanced execution strategies," Mook said.

Major Players

Several trading executives said that program trading originally made sense for index arbitrage. But "now every single vanilla account is looking at program trading because of the need to lower costs." One trading executive added that portfolio trading has gone from a specialty of "quant players" to a technique used by all the major players including the big investment companies such as Fidelity, Alliance Capital and Putnam.

What could stop the march of computers and the popularity of portfolio trading?

In the short term, trading executives say they only see it growing because of penny trading. However, let's say the Securities and Exchange Commission were to accept the trading industry's request to impose the minimum nickel tick? Then, these executives agree, if that happened, the growth of program trading would slow and the use of block trading would start to rise. And some trading executives also say that, for now, regulators tend to look benevolently on the use of program business because of its cost savings and transparency.

So trading executives predict that program trading strategies, for the foreseeable future, will continue to rise. Regardless of regulators or the return of the bull market, the growth of program trading is going to continue.