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May 16, 2007

Smart Gets Smarter

By Nina Mehta

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Algorithms themselves won't be turned upside down by Reg NMS changes. "Reg NMS will have a strong effect on the details of how orders are placed into the market. It's a huge technological challenge," says Robert Almgren, head of quantitative strategies for equities at Banc of America Securities and a managing director in the firm's electronic trading services group.

But Almgren doesn't expect algos themselves will need a top-down overhaul. "My gut feeling is that fundamentally Reg NMS won't change much above the order-placement level," Almgren says. "You're still trading with people [who make decisions]. Exchanges are the means to get there, so whatever the rules on exchanges, you're still waiting for when people are ready to take the other side."

Big Investment

To compete in the new Reg NMS environment, brokers need hefty technological resources. They must establish connectivity to all trading centers, develop sophisticated smart routing technology and invest significant sums of money to expand and bolster their market data infrastructures.

These infrastructures must capture tick, quote and trade data. Continuously tracking and processing information about where liquidity resides permits smart routers to make split-second decisions about how to place and take liquidity.

Algorithmic providers will be judged over the next year by how well they succeed at this new task of intelligently placing orders into the market and extracting liquidity from a marketplace that is becoming more fragmented. As a result of incresed electronic trading of listed stocks and the quote-protection rule, liquidity already has begun to disperse across market centers.

A recent TABB Group report noted that brokers will spend $91 million between this year and next for applications that help them comply with Reg NMS. Most of that will be spent by bulge-bracket firms.

Eighty to 90 percent of the outlay will be for low-latency connectivity to markets, order routing and market data aggregation. These areas constitute the "core technology underpinning the trading infrastructure that brokers need to compete" in a Reg NMS environment, according to the report.

Credit Suisse, long considered a leading firm on the algo front, has had four people working full time for a year to study and understand the order-routing logic at various exchanges and electronic communications networks. This effort, which is separate from the firm's algorithmic effort, got under way even before the New York Stock Exchange introduced its hybrid trading model and Reg NMS began its phase-in.

Sorting out the myriad execution rules and order types at market centers-and their impact on how liquidity is distributed across venues-is no walk in the park. But it's critical for algos. Dan Mathisson, head of Advanced Execution Services, Credit Suisse's suite of algorithmic products, notes that there are 10 exchanges, five ECNs and anywhere from 10 to 30 alternative trading systems, depending on how they're counted. "That's 25 to 45 destinations, if you count the private networks," he says. "You must figure out all the order types they support, how they route out and under what circumstances you will use which types of orders."

Rick Holway, CEO at execution management system vendor Firefly Capital, also stresses the complexity and hazards of operating in a landscape occupied by rapidly changing order types and execution rules.