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December 19, 2007

2007 Review: More Tools & Fragmentation

The Year in Trading

By James Ramage

Do-it-yourself electronic trading continued to grow this year as the development of new tools gave the buyside more ways to handle orders than ever before.

At the same time, market fragmentation made trading more challenging. The good news is that buyside traders are gaining expertise in handling orders in that fragmented marketplace, as they do more trades themselves and send fewer orders to sales tradersÑthough that trend appears to be slowing.

A November TABB Group study on institutional equity trading says the percent of buyside share volume sent to medium- and low-touch channels--classified as DMA, program trading, algos and crossing networks/dark pools--should continue to grow. It jumped from 53 percent in 2005 to 63 percent in 2007. TABB did not predict electronic trading growth for 2008, but it predicts electronic trading will constitute 68 percent of all shares traded in 2009.

GE Asset Management exemplifies this trend. The firm has been embracing low- and no-touch electronic trading for the past five years. And the percentage of trades it handled with algos, DMA or crossing networks leapt from 5 percent in 2002 to about 30 percent today, according to Damian Maroun, GE's head of trading.

TABB says the marketplace volatility will affect the amount of orders that sales traders see. But the drop-off in high touch--dramatic since 2004--appears to have started to stabilize this year. TABB estimates the buyside will direct 32 percent of its order flow to full-service sales traders in 2009, just slightly lower than the 37 percent in 2007, but a huge decrease from the 79 percent of business sales traders saw in 2004.

Mark Schlarbaum has witnessed this from his desk as director of equity trading at Conshohocken, Pa.-based firm Global Capital Management. While trading small caps over the past 15 years, he's seen his job change with the advent and evolution of electronic trading. "You have a lot more electronic tools than you used to have, and it seems like relationships are less important," Schlarbaum says. "Now I end up talking to the guy that programs algorithms, as opposed to a sales trader. That's partially a joke, but partially true."

Schlarbaum's strategy for trading small caps is almost entirely low- and no-touch. He'll use algos and have orders exposed to dark pools constantly. And Schlarbaum says he'll work chunks of the larger orders himself, because he's small-cap savvy and knows how to find the better prices for them. Still, his preferred strategies don't involve a sales trader.

TABB says that the increase in self-directed electronic trading on the buyside's part will continue to bring down commission rates, which have fallen from 2.53 cents a share in 2006 to 1.97 cents in 2007 on a blended basis. But as long as the market volatility perpetuates instability, the report notes, blended commission rates should climb with the continued shift in low- to high-touch order handling.

For 2008, industry watchers expect more buyside traders to use electronic tools--such as DMA, algorithms, dark pools and other crossing networks--to complete trades. But they also see a great need for high-touch handling as many still contend with volatility fallout.