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January 1, 2005

Volumes Grow as Firms Open: The Black Box

By Peter Chapman

"The key to the whole electronic trading platform," Cloyd says, "is to handle every aspect of that business as efficiently as possible without introducing any latency into the process."

Just down the road from Wedbush in Segundo near the Los Angeles airport is one of the pioneers of black box hosting, MB Trading. The nine-year old brokerage entered the black box space in 2000 at the behest of its European clients.

They were trading in Nasdaq 100 names in Germany and sometimes needed to hedge those positions in the U.S. overnight. MB's customers automated their trading systems to trade concurrently with the U.S. MB developed facilities to allow them to do that.

"That just lent itself naturally into more people using us for automated algorithmic trading," explains MB chief executive Ross Ditlove.

MB Trading was established as a broker for daytraders. The shop still services the guys with the baseball caps, but among its black box customers it counts banks, funds (hedge and otherwise) and the so-called "semi-pro" traders.

The semi-pros are licensed, trade strictly for their own accounts, are self-funded or else trade for a group which provides the funding. The banks are European clearing firms similar to the U.S.'s broker dealer clearers. Their customers are brokers that either trade proprietarily or handle retail orders.

About half MB's customers are black boxers and half are keyboard traders. MB trades over 14 million shares per day, according to Ditlove; half is black box, half keyboard.

At Lime Brokerage, in New York, a shop that was started specifically to handle black box traders, the number of transactions exceeds 10 million per day, according to CEO Richter.

Serving Community

Lime was formed in 2001 because "the black box community was not being well-served," Richter says. "For most of the brokers, their level of service was not what I would call industrial grade." Lime now has 15 employees.

Richter says black box trading is of two types. Some traders use computers to predict price movements, which informs their decisions about when and how to place the orders. Then there are those who monitor the quotes in the market to make those decisions.

Driving black box trading, according to Richter, is the fact that increased computing power has enabled traders to link the decision of what to trade to the decision of how to trade. Whereas in the old days, a strategy might be traded once a month. Today, it can be traded several times per day.

For example, assume a trader wishes to execute a long/short strategy whereby he goes long the best stocks in the S&P's industry groups and short the worst. The strategy is not novel, but may contain hundreds of symbols. Trading manually could take days.

With black box technology the portfolio can be kept in balance more frequently. Rather than rebalance the portfolio once a month, the trader can rebalance once an hour. That way he keeps the weightings of his portfolio in line with his strategy.

Lee Maschler, president of Trillium Trading, part of daytrading giant Schonfeld Group, agrees the increased popularity of black box trading is due to the way it enhances the value of a trader's strategy.