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September 28, 2006

Comparing Broker Algorithms

By Melanie Wold

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  • Comparing Broker Algorithms

Brokers and vendors are seemingly offering clients more algorithmic products than Kellogg's has cornflakes. An exaggeration? Of course, but you get the idea. The buyside, however, might just feel that way, as some providers expand their algorithmic offerings, while others are still getting into the game. With a multitude of offerings on its doorstep, the buyside may have entered a frazzled state of mind perhaps best described as "algo fatigue."

Still, the buyside trader does see value in algorithms. They've become a necessity for a number of reasons. Those range from protecting anonymity, to minimizing market impact, to lowering commissions. Besides broker and vendor offerings, the buyside can develop their own algorithms, though most don't.

But how is a buyside firm supposed to know which broker's algorithms work best? Are they all the same? Is one better than another?

Transaction cost analysis (TCA) might be one way to find out. TCA analysis firms such as Quantitative Services Group (QSG), ITG's Plexus Group, Abel/Noser Corp. and Elkins/ McSherry are beginning to test the quality of various brokers' algorithms, so that buyside users can compare and contrast strategies.

EdgeTrade is one of the few broker-dealers to offer up its algos for comparison with those of its peers. The small agency brokerage contracted with Elkins/McSherry to do TCA on its VWAP algorithm.

VWAP Analysis

"When it comes to best execution and analyzing trade data, it is not easy to get your arms around it. We wanted an independent party to verify how we are doing," Kyle Zasky, president of EdgeTrade, says.

Elkins/McSherry's analysis showed that EdgeTrade's VWAP outperformed 93 percent of a universe of large institutions including asset managers and funds during 2005. Zasky believes TCA will grow in importance in the near future: "There is me too' and catchup going on now because of the pressure to justify where you are sending your order flow. You don't want any fingers pointed at you by customers. We are pretty bullish on the TCA idea."

TCA for algorithms is not a one-size-fits-all solution, its critics maintain, and is still in its infancy. TCA itself has been around for years, and is an integral part of the trading process. And it is the industry's acceptance of this post-trade critique that is helping lead to the concept of measuring the effectiveness of algorithms.

Costs associated with a transaction go well beyond the explicit-such as commissions, markups and fees-to implicit costs, which are also critical. Market impact, in particular, is becoming the one cost the buyside is paying closer attention to when analyzing algorithmic strategies.

Susquehanna Financial Group (SFG) was another broker-dealer to look to a measurement firm for feedback on its algos.

Susquehanna asked Quantitative Services Group (QSG) to test its algorithmic strategies against its peers, using SFG's data from one quarter. QSG found that SFG beat competitors by a total of 18.5 basis points in terms of total execution cost, largely because of its ability to minimize market impact.