A Roadmap for the Future

New trading rules, evolving market structure, better technology, more asset classes. All of these developments are conspiring to make the lives of traders more complex and difficult. A trader, like never before, needs to be on his or her toes and aware of what lies ahead. Toward that effort, Traders Magazine asked a handful of consultants to offer our readership a roadmap of the future. What can equity traders expect their marketplace, and maybe more importantly, their jobs, to look like, say, a year from now? Read on and hopefully some of your questions will be answered.

Q: What do you expect to be the impact of Regulation National Market System (Reg NMS)?

Gavin Little-Gill

Research Group Director, Securities & Investments

TowerGroup

Reg NMS in the United States and the Markets in Financial Instruments Directive (MiFID) in Europe are regulatory initiatives that are pushing best execution. The direct impact of these regulations is felt in the exchanges/execution venues and at the institutional brokers; the trickle-down effect to the asset management industry is on measuring brokers’ effectiveness relative to their compliance with those regulations.

The direct impact moves best execution from a client relationship and client-facing regulatory requirement (remember that BestEx has its roots in Employee Retirement Income Security Act of 1974, or ERISA, laws) to the trading floor. The more significant impact of these regulations is in the brokers’ subsequent strategic responses.

The sudden increase in broker crossing networks, the movement of brokers into the market data business, and the creation of broker consortiums creates new venues and new trading paradigms, and it promises an explosion in market data. Smart orders have to become even smarter, and the subsequent movement of trades across liquidity venues promises an explosion in volumes and volatility. Brokers are responding largely by building out low-latency platform solutions.

The question asset management firms need to be asking is not whether Reg NMS will impact the buyside but rather what asset management firms need to do to manage their broker relationships and leverage the infrastructures and solutions those brokers are building.

James T. Leman

Principal, Head of Capital Markets

Westwater Corp.

As Regulation NMS (Reg NMS) goes live in stages in 2007, the primary impact will fall upon the exchanges and ECNs as they must observe the trade-through rule among others and the implications for regulatory oversight and examination that come with new securities regulation adoption. They as well as brokers will live in a much more transparent world where alternative routing actions by order originators will gauge performance in milliseconds and where exchange and ECN costs are a telling component of trade distribution decisions.

Block trading will undergo a dramatic transformation where the various liquidity pools, ATS entities, combined with exchanges and ECNs will provide price and liquidity discovery. Brokers, acting as market makers, besides acting at speeds achievable only with sophisticated auto execution software will strive to deliver price improvement and liquidity to match the fastest exchange or ECNs. ATSs will focus on periodic or negotiated crossing to achieve the Holy Grail of minimal market impact, minimal information leakage and cost savings in an extremely timely way for institutions.

Continuous crossing ATSs will also attract flow as every alternative to uncover liquidity is used since blinding transaction speed can be achieve if enough technology dollars are applied. Brokers will need to choose not only which marketplace to direct orders to, based on top of book quotes, but will also need to select which ATSs to route to, in what order and how many, in a sweep or concurrently submitted method. DMA solutions will need modifications as will algorithmic strategies to cope with these new options. All of this will be watched by brokerage management, internal compliance, regulators and institutional clients with not all questions being answered in a timely fashion but with the potential for hindsight to be applied.

Brad Bailey

Senior Analyst

Aite Group

Reg NMS, after several years of discussion, and several delays, is now becoming a reality. In short order, all the discussions (nature of regulation), technology challenges (routing, data storage, compliance), and concerns (locked markets) will be forgotten, and all that will be left will be a new US equity market structure. Certain people will look back to the bucolic pre-Reg NMS days, with a sense of nostalgia, but for most, thoughts of “how did we ever trade before Reg NMS?” will be more likely.

This might be in several years, however.

In the meantime, the run up to Reg NMS has created a fascinating and complicated U.S. equity market landscape: a landscape that includes approximately 15 percent of that liquidity being unquoted, or as it is lovingly known, “dark”; a landscape that includes new ECN entrants that are quickly gaining market share; a landscape where regional and new stock exchanges are seeing increasing volumes; a landscape that most importantly is built on an incredibly rapidly growing web of electronic connectivity.

Of course, testing Reg NMS in a period of multi-year highs in volatility is its own challenge. One thing that I find interesting from the vantage point of several years hence, is whether the late-February, early-March volume spike will be blamed on the introduction of Reg NMS?

The goal of Reg NMS was to create a fair and transparent equity market to the advantage of the individual investor. It is doubtful whether many individuals are even aware of this regulation, or for that matter, ever will be. But one thing is clear: the web of connectivity that has been built will create a powerful and redundant network. It will create an effective electronic market that will strengthen the U.S. equity market in many ways.

David Easthope

Senior Analyst

Celent LLC

As a result of Reg NMS, Celent believes ECNs will be able to more deeply penetrate exchange-listed trading, well outside their traditional dominance in OTC securities trading. The order protection rule allows ECNs, through their automated quotes, to more easily compete for listed order flow, though ECNs will face caps on rebating for liquidity, a prior strategic advantage for attracting order flow.

The regional exchanges have also been dealt an excellent hand due to Reg NMS. With strategic partners such as the large broker-dealers, regional exchanges are investing heavily in technology to automate trading. Through their dedicated partners, who will have an incentive to send trading flow to the Boston Equities Exchange(BeX), as an example, for execution, the regionals will play a larger role.

Q. What interesting developments do you expect to see in the securities industry over the next year?

Gavin Little-Gill

One of the biggest changes and challenges for the buy side has been in brokers’ efforts to acquire execution management system (EMS) platforms or order management system (OMS) technology. Examples are ITG’s 2006 acquisition of Macgregor and the integration of Bank of New York (BNY) Securities Group and Eze Castle Software to form the new BNY ConvergEx group. In a similar fashion, the transaction cost analysis (TCA) market is dominated by brokers, many of which have made a major effort to expand their pre- and post-trade TCA capabilities.

The impact is best illustrated by a hypothetical trader trying to get an order filled at the best price. The trader pushes a trade through a broker’s EMS, into a broker algorithm. That algorithm executes through a dozen venues, including the broker’s own crossing network. The next day, the asset manager gets a best-execution report from that broker explaining how the trade performed. Many asset management firms are starting to ask whether they can meet their fiduciary and regulatory responsibilities when they use their brokers’ TCA reports to tell them how well they traded against a trade placed through a broker’s technology and services and against their liquidity. In 2007, these issues, bundled with the better interpretations of commission sharing agreements (CSAs), will drive a much stronger focus by asset management firms to use technology to manage broker relationships.

James T. Leman

Aside from adapting to the new processes that Reg NMS brings, the proliferation of ATS venues is an unfolding story that will bear watching. With so many to choose from with diverse methodologies, negotiating the maze will require ongoing analysis and examination of order flow characteristics by clients and their brokers. Seeing how many will survive and what combinations or alliances form will be attracting investors and users’ interest. Multi-asset class interest in the electronic trading space will also grow as hedge funds and others seek more novel and rewarding strategies. Current algorithms will continue in use with modifications and tuning as well as client specific strategies. The extension of algorithmic trading to European and Asian markets will also continue with MiFID going live in late 2007. With mounting technology costs facing anyone operating trading desks at brokerage firms, the specter of commission sharing arrangements (CSAs) will be evident as more arrangements are put in place in 2007. Pre trade, during trade, post trade and periodic assessment of execution performance will be taken to a new level in 2007. The mix of execution methods, be they DMA, algorithmic, program or market making/block trading, will see more analysis occurring as the resources needed are assessed for cost effectiveness, the real focus in 2007.

Brad Bailey

Unlike the universe, which just keeps expanding, the U.S. equity market goes through expansions and contractions. We have been experiencing an expanding market, not from the perspective of the Dow, S&P, or Nasdaq rising, but from the perspective of greater numbers of venues, greater connectivity, and greater use of technology. This expansion has awakened certain regional exchanges and has given them a chance for new life in the new market data environment.

The technology challenges that today’s market faces are vast, and present one of the greatest difficulties in the emerging exchange landscapes. This is particularly true in the area of message traffic creation and data output.

Many of these challenges will, perhaps, be addressed by the still young and emerging logic of programming and software architecture called event processing (EP). Of course, the capital markets are a natural place for a technology that is, fundamentally, based around the idea of processing data and relating that data in a logical, temporal, and ultra-fast way. Many of the first-generation EP solutions have centered around algorithmic and strategy trading, but Aite Group expects EP to play a more significant role in several areas. Over the course of 2007, expect EP to play a greater role in such areas as real-time trade compliance for Reg NMS, order routing and trade cost analysis.

EP will play a more dominant role in the capital markets, where potential applications are wide-spread. EP has the ability to cope with ever-increasing data creation and output, along with an agnostic approach to where that data comes from. Those two features, combined with a large savings in resources, indicate that EP is destined to play an ever-expanding and increasingly pivotal role across the capital markets.

David Easthope

Reg NMS creates a limited set of new opportunities for US market participants, including the ability for market makers to charge the 0.3 cent per share access fee currently levied by ECNs. In addition, market centers will be in a position to sell their depth-of-book information without any price controls. Certainly, European exchanges have been free to sell their depth-of-book information for some time now, and that experience would suggest that this is an opportunity, but not an overwhelming one.

An interesting new opportunity is an area that we have dubbed algorithmic quoting. Since Reg NMS distributes market data based not only on trade volume, but also on how much of the time a particular market center is posting the best quote, there are built-in incentives to post quotes without any real intention of trading. Several firms are currently developing these kinds of algorithmic quotation systems that are designed to capture market data revenues. Since the formula in Reg NMS distributes a greater share of market data to less liquid stocks, we can expect to see some odd behavior in the quotes for those shares.

Q. What is the next big issue you expect equity traders to face?

Gavin Little-Gill

We have seen article after article prognosticating the death of the equity trader because of black box trading. TowerGroup has never bought into those arguments, but 2007 may herald the death of the “long equity only” trader.

When we look at the evolution of products and customers’ demands, we’re seeing a migration away from traditional long-only actively managed products toward alternative strategies like portable alpha strategies or 130/30. This migration is related to increased acceptance by institutional clients of the use of derivatives. Traders are finding it harder to take positions fast enough to capture the alpha portfolio that managers are identifying in their decision processes. Likewise, trading platforms are getting better at managing multiple asset classes. Electronic trading of exchange traded derivatives and foreign exchange is exploding, and the brokers themselves finally are beginning to integrate multiple asset classes into their solutions. As we end up with algorithms that trade equities and their derivatives or potentially settle with a derivative, the rules begin to change.

The scenario I’ve presented here is one in which client demand, technology, and liquidity are aligning such that they will require the “equity trader” to support multiple asset classes in ways that promise to make a complicated job even more so.

James T. Leman

Sales traders and traders roles have been in flux in recent years as clients have adopted technologies and taken more control of their trades. The blurring of the lines between the two roles is being addressed differently at most organizations. Facing a client base comprised of classic long-only managers and astute hedge funds, the sales traders are being asked to broaden their product knowledge, assume more direct control over order distribution and to work even more closely with their traders. Together they need to meet complicated trading demands, capital intensive trades and to react more quickly to market changes-while keeping their clients’ styles of trading in mind.

Juggling clients’ demands, adapting to the speed and transparency the market calls for, while reflecting on derivative product influences and quantitative models, buyside traders pit sales traders and traders against a new cast of characters with new skills. Their greatest challenge is to adapt to markets and clients while continuing to deliver outstanding client service. One dimension of this shifting role is that brokers need to school themselves, and in turn clients, in understanding how to wield all of the execution tools at their disposal. To do that, sales traders need to master the use of these tools to achieve clients’ objectives. Beyond that, their clients, as they assume more control of orders, need to develop their skills in using these tools.

Acting as a coach to the “buyside,” brokers and outside parties will begin to deliver “liquidity-consulting” advice on the range of execution venues available and the algorithms, routing techniques and strategies available to meet execution objectives. Of course collaboration within multi-product units is mandatory and awareness of client-by-client focus and how clients choose to pay for services goes along with this more complex world and brings its own challenges.

Brad Bailey

In many ways, 2007 is an important hallmark in the history of the U.S. equity markets, if for no other reason than we are exactly one decade from 1997, when the order handling rules were put in place and the framework was put in place for the equity market of today. Since 1997, the changes have been so profound that an equity trader placed in suspended animation in 1997 and awoken today would only understand the basic tenets of trading, such as: buy low, sell high; or, bulls buy, bears sell; and pigs get slaughtered.

In addition the speed in which change occurs is accelerating. It is nearly a full-time job to figure out, not only how to put an order into the market, but where. Combine this with the amount of time equity traders are now dedicating to compliance across the life-cycle of an equity trade, the increased responsibility for execution decisions that much of the buyside has undertaken, the on-going responsibilities for demonstrating best-execution in many situations (and more asset classes), analyses of trading performance and broker performance, and the difficulties associated with commission management and organization, it is a wonder that traders even have any time to think about the market! This array of additional responsibilities is most apparent to head traders and heads of desks.

2007 will set the tone for the U.S. equity market for many years to come. Given the global scale and the ventures into which exchanges are expanding, the impact will be felt around the world.