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February 1, 2005

The Trader in the Algo Era

By Peter Chapman

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Traders who make their reputations on relationships and negotiating skills are a dying breed. At least that's the conclusion of TowerGroup senior analyst Gavin Little-Gill, who recently tackled the complex subject of algorithmic trading. Little-Gill suggests that the trading desk of the future will prefer traders with the mathematical and programming skills to negotiate an increasingly electronic and quantitative marketplace.

Little-Gill expects the algorithmic trading of buyside order flow to double through 2006. Defined roughly as computer-managed trading that tracks a benchmark, algorithmic trading will grow 20 percent in 2005 and by 27 percent next year, according to a TowerGroup report by Little-Gill.

Most algorithmic trading is handled by brokers for clients, but an increasing amount is expected to be controlled by the buyside trader. The top three brokers in this area, as measured by share volume, are Credit Suisse First Boston, Morgan Stanley and Goldman Sachs, according to the report.

Commissions on algorithmic trades are roughly two cents per share, according to the report, about the same as for program (basket) trades. Those numbers compare to one cent for direct market access trades.

Little-Gill joined TowerGroup in 2001. The analyst spent nine years at money management house Scudder Stevens, where he built and supported the company's communications infrastructure. Little-Gill briefed Traders Magazine Technology Editor Peter Chapman on some of his findings.

Traders: Your report includes a pie chart outlining brokers' market shares, but you don't supply any numbers.

Little-Gill: That was deliberate. I have quite a bit of volume information. But it is all under non-disclosure agreements. I think I was actually the first person to be able to put out the volumes on a relative basis.

Traders: Isn't CSFB the leader?

Little-Gill: Everyone talks about CSFB being the leader. But there isn't much difference between them and Goldman and Morgan Stanley. There's a reason for that. The perception of CSFB as market leader has to do with its penetration of total trading desks. They are absolutely the leader on that count. Hands down. I don't think any broker dealer on that list would question that. They did a wonderful job in pairing up with Bloomberg very early on in the game.

Traders: But as far as share volume...

Little-Gill: The prime brokerage businesses - their hedge fund clients - of both Morgan Stanley and Goldman drive a tremendous amount of transaction volume. So it's a smaller client base, but...

Traders: Hedge funds trade more.

Little-Gill: Exactly. They have a higher propensity to use these algorithms than your standard long-only buyside shop. They have higher turnover.

Traders: The hedge funds using algorithms are generally the long-only variety? Not the strategy traders?

Little-Gill: Right. I don't see much use of algorithms on the back of strategies. Pairs trading, for example. It's all if-then statements as opposed to trading to particular benchmarks.

Traders: Commissions on algorithmic and program trades are about the same? Two cents per share?

Little-Gill: Pretty much. It depends on what you negotiate with your broker.

Traders: Yet you expect that number to drop. How come?