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July 31, 2003

Into the Algorithms

By Editorial Staff

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Decimalization has decimated displayed liquidity. Large bids and offers have virtually disappeared. Traders are too worried about getting pennied' to post size. Now many frustrated pros are clamoring for Washington to reverse course and institute a five-cent minimum trading increment.

But even while pros are calling for nickel ticks, most large trading desks are quietly adapting to the new reality. Strategies are emerging that help traders cloak their intentions and avoid unwelcome market impact.

Underpinning many of the new methodologies is the practice of breaking up large orders into tiny bits and pieces. The trend is underscored by the numbers: Since 2000, the average trade size on the New York Stock Exchange has fallen from about 1,200 shares to about 515 today. On the electronic Nasdaq market, the trend is less pronounced. The average trade size has declined from about 680 shares in 2000 to 610.

Slicing and dicing is not new, but the level of sophistication by which it is accomplished has grown. Using powerful computers and complex algorithms traders can feed huge orders into the market almost undetected, they say.

At the forefront of this algorithmic trading trend is Credit Suisse First Boston. The bulge bracket player first began testing various "order staging" strategies on its proprietary desk in early 2001, the year decimalization began. Later that year, CSFB expanded the use of its algorithms to customer orders. In 2002, its Advanced Execution Services (AES) group was born. It offered select clients direct access to its algorithms from their desktops.

Dan Mathisson is a CSFB managing director and head of AES. The exec joined the CSFB proprietary desk as a statistical arbitrage trader in 2000 after spending eight years with quant shop D.E. Shaw. Mathisson spent a year on CSFB's prop desk before transferring to the program desk and developing AES.

Mathisson has been involved with algorithmic trading in one form or the other for the past 11 years. He was interviewed by Traders Magazine Technology Editor Peter Chapman.

Traders Magazine: How did AES evolve? Why do this? Mathisson: We decided to roll it out because of decimalization. We saw a huge change in the way that the markets function and in the way people trade. The number of prints went up by about six times from what it had been in the fractional world. The average size showing went down by a factor of more than ten. In the fractional world, a typical market was, say, three-quarters to seven-eighths, 25,000 [shares] by 50,000. Today, it's 75 cents to 78 cents, 300 by 800. We've seen quoted size drop tremendously while the spread has gotten narrower. So, it has become a very difficult market to trade. You can't trade in big pieces the way you used to. Within this organization there was a need for a way of breaking up the orders and cutting them into little pieces. AES is an attempt to automate the trading process. To make it more efficient. And to cope with decimalization.