Algorithmic Trading: Brave New World

for the Capital Markets?

Prepared for: Walter Distaso
Tanaka Business School
Final Project
December 2007
Dan Showering - WEMBA 2006
Algorithmic Trading
Executive Summary
Algorithmic trading can be defined as the use of autonomous software agents for both the
determination and eecution of trades within the ca!ital mar"ets# $heir usage in the e%uit&
mar"ets stretches bac" to the mid-'()0s where their dubious claim to fame was
accreditation for the stoc" !rice colla!se of *ctober '(th '()7# Des!ite !ublic setbac"s such
as this and the colla!se of +ong $erm ,a!ital Management in '(()- their ado!tion has
continued to grow# Algorithmic trading tools ha.e become ubi%uitous for the tactical
im!lementation of trading strategies and the& are gaining traction as a .iable strategic
source of in.estment ad.ice# *ngoing de.elo!ment in this field combined with enthusiastic
ado!tion b& mar"et !artici!ants has enabled the creation of /blac" bo0 trading !latforms
which are designed to re!licate man& of the traditional functions of human agents# $hese
!latforms are also "nown as /no-touch0 in.estment .ehicles 1 a useful moni"er to illustrate
the degree of autonom& the& are designed to !ossess#
$he first 2and most ubi%uitous3 usage of algorithmic trading has been in the tactical
im!lementation of trading decisions# M& research indicates that these tools ha.e become so
!er.asi.e that their usage has become the norm for institutional e%uit& trades# Section 4 of
this re!ort outlines the mechanics of their o!eration in some detail- but in outline the& are
designed to answer and e!edite the following three %uestions5
6ow much will 7 ha.e to !a& to bu& x thousand shares of AB, 8+, in the net half
hour9
6ow much will 7 ha.e to !a& if 7 wait for the remainder of the trading da&9
6ow much can 7 sell of AB, ,or! in one hour "ee!ing the mar"et im!act to z !ence9
$he algorithmic agents em!lo&ed b& bro"ers and other !artici!ants see" to minimise the
endogenous ris" of a transaction - i#e# the ris" of ad.erse !rice mo.ements caused b& the
.olume of a s!ecific transaction# $his .olume can be either real or inferred 1 the !ublic
realisation that a large trader is in the mar"et can create ad.erse mo.ements inde!endent of
the actual .olume traded to date# $he mechanics b& which this is achie.ed co.ers a broad
s!ectrum of algorithmic strategies outlined in $able ' of Section 4#: as well as their direct
connecti.it& with the /dar" !ools0 of li%uidit& described in Section 4#4# $here is considerable
e.idence that these tools achie.e both greater trading efficienc& 2i#e# a reduction in mar"et
im!act through anon&mit& and .olume slicing3 and a corollar& increase in the !roducti.it& of
human traders#
$he usage of algorithmic trading for the determination of strategic in.estment decisions is
relati.el& new but seems to be becoming more wides!read# ;uantitati.e strategies such as
Statistical Arbitrage or high fre%uenc& intra-da& momentum trading lend themsel.es well to
com!lete automation# 7n.estment criteria for funds o!erating in this area are s&stematic and
thus relati.el& eas& to re!licate within software# 7ndeed- there is e.idence that these tools
can be used to generate /!ure0 al!ha returns 1 s!ecificall& from funds categorised as E%uit&
Mar"et <eutral# $here is a ris"- howe.er- that the continued e!ansion of funds in this area
together with the commonalit& of their in.estment criteria is ha.ing a dis!ro!ortionate effect
on their .olatilit&# $he e.ents of the first wee" of August 2007 demonstrate that the ris" of
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Algorithmic Trading
financial contagion has become .er& real# Whilst these funds ma& be /Beta neutral0 .is-a-.is
the broader stoc" mar"et- their historicall& low .olatilit& should not be assumed to be a
reliable indicator of forward ris"#
$he future de.elo!ment of algorithmic tools ma& a!!ear to belong more to the genre of
science fiction than commercial realit&# /=enetic0 algorithms that ehibit learning beha.iour-
!redator& algorithms designed to e!loit the wea"nesses of their widel& de!lo&ed fist-
generation !eers 1 the industr& is set to witness a .eritable arms race of algorithmic
strategies# $he future ma& well be /red in tooth and claw0 for !artici!ants of the sector#
$here are strong indications that algorithmic tools together with related ad.ances in the
so!histication of technical infrastructures are ha.ing a !rofound effect on the financial
ser.ices sector# >irms in this sector ha.e long en?o&ed abo.e a.erage returns in com!arison
with their !eers in the broader mar"et# According to the 7BM 7nstitute for Business @alue this
ad.antage is manifest in an a.erage Aeturn on E%uit& that is almost double that seen in the
wider mar"et o.er the last decade 2'BC .s# )#7C3# $his ad.antage has translated into
substantial im!ro.ements in mar"et ca!italisation 1 the D#S# >inancial Ser.ices sector now
accounts for a!!roimatel& 2(C of total mar"et ca!#
$he s!eed and trans!arenc& of information flow together with the massi.e increases of
ca!ital de!lo&ed in alternati.e in.estment .ehicles such as hedge funds 2a tenfold increase
o.er the last decade 1 total funds in.ested now eceed E' trillion3 is beginning to inhibit the
!rofitabilit& of the sector# >igure 2' of A!!endi 2 of this re!ort !ro.ides a global !ers!ecti.e
on this trend together with an etra!olation of the conse%uences until 20'B# 7t is clear that
the continued bifurcation of in.estment returns into Beta 2returns dri.en b& the broader
mar"et3 and Al!ha 2out!erformance 1 or returns in ecess of Beta3 will ha.e far reaching
conse%uences for the E20 trillion global mutual fund industr&# Algorithmic technolog& has the
!otential to re!licate both com!onents of this return at a lower marginal cost of !ro.ision# M&
contention in this re!ort is that mar"et !artici!ants will be dri.en to one of two etremes5
,ommoditisation - stri.ing to become the lowest-cost !ro.ider of Beta
Differentiation 1 attem!ting to differentiate offerings b& the de!endable generation of
Al!ha
Algorithmic trading has not &et reached the le.el of so!histication re%uired to be the arbiter
of choice for s&stematic in.estment decisions- but its0 !otential is clear# 7t re!resents a
disru!ti.e technolog& for the financial ser.ices industr& 1 much li"e the 7nternet has been for
the tra.el and music industries# Differential success for firms in this industr& will almost
certainl& lie in their degree of understanding of these changes and the im!lementation of
these new tools in !ursuit of their strategic im!erati.es#
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Contents
Eecuti.e Summar&################################################################################################################ 2
,ontents################################################################################################################################# :
'#Bac"ground to the 8ro?ect################################################################################################### B
2#6istorical ,ontet################################################################################################################ B
4#$he e%uit& mar"ets 1 an e.olution in !ers!ecti.e################################################################6
4#' ,ontet######################################################################################################################### 6
4#2 =uerrillas and 7cebergs################################################################################################# )
4#4 Dar" 8ools#################################################################################################################### (
4#: Algorithmic eecution strategies##################################################################################''
4#:#' $he trading schedule############################################################################################ '2
4#B Arbitrage##################################################################################################################### ':
4#B#' Ais"less Arbitrage################################################################################################# 'B
4#B#2 8airs trading######################################################################################################### 'B
4#B#4 Statistical Arbitrage############################################################################################### '7
4#6 $he end of mutual funds9########################################################################################### ')
4#6#' 6edge >und re!lication######################################################################################## ')
4#6#2 8ortable Al!ha###################################################################################################### 20
4#7 *utloo" for the future################################################################################################## 2'
:# @olatilit& 1 do algorithms threaten to destabilise the financial mar"ets9############################22
:#' $he algorithmic sca!egoat########################################################################################## 22
:#2 August 2007 1 algorithmic nemesis9##########################################################################2B
B# Algorithms in the >oreign Echange Mar"ets###################################################################2)
B#' 6istorical contet######################################################################################################### 2)
B#2 6edge >unds change the nature of the mar"et###########################################################2(
B#4 8rinci!al algorithmic trading solutions#########################################################################40
B#4#' DMA F electronic connecti.it&##############################################################################40
B#4#2 $he aggregation of !ricing####################################################################################4'
B#4#4 Multi-asset trading !latforms#################################################################################42
B#4#: A.ailabilit& of historical !rice and .olume information###########################################42
B#: *utloo" for the future################################################################################################## 42
6 Bonds F Deri.ati.es########################################################################################################## 44
6#' $he bond mar"et######################################################################################################### 44
6#2 Deri.ati.es################################################################################################################## 4:
7 8roof of efficac&################################################################################################################# 4B
) An o.er.iew of the mar"et!lace for algorithmic tools#########################################################4)
A!!endi ' 1 !rinci!al mar"et !artici!ants###########################################################################4)
A!!endi 2 - $ables############################################################################################################## :6
Aeferences########################################################################################################################### :7
Ac"nowledgments################################################################################################################ :7
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Algorithmic Trading
1. Background to the Project
$he decision for me to tac"le this sub?ect was borne both out of a genuine interest in the
sub?ect and a firm belief that algorithmic tools are set to re.olutionise ca!ital mar"ets across
the globe#
8rocuring rele.ant information has been a challenge at times# $he fact that this !ro?ect will
be !ublicall& disseminated ob.iousl& limits m& abilit& to access granular %uantitati.e data on
both the s!ecifics of the algorithmic tools currentl& in wides!read use and detailed
!erformance metrics for the %uant funds that em!lo& them# Des!ite this- 7 ha.e been
!leasantl& sur!rised b& the degree of co-o!eration gi.en to me b& industr& !artici!ants in
both the D#S# and E#D# $hese tools ha.e been in acti.e use for o.er a decade and &et it
seems the industr& is still .er& much at its0 nascent stage 1 !erha!s this is a factor in the
genuine enthusiasm for the sub?ect that 7 ha.e seen#
As a MBA !ro?ect that has no sco!e for confidentialit&- 7 was forced to tac"le the central
%uestion through !ublished sources- inferences from mar"et de.elo!ments and inter.iews
with "e& !la&ers in this industr&# Whilst 7 would ha.e a!!reciated the o!!ortunit& to del.e into
more %uantitati.e detail- 7 do not belie.e that m& inabilit& to do so in.alidates the central
argument of the thesis# $he inferences 7 ha.e drawn are difficult to refute gi.en the wa& the
mar"et for these tools has accelerated 1 !rimaril& dri.en b& the ten-fold increase in hedge
fund ca!ital seen o.er the last decade# E' trillion of funds- a fair !ro!ortion of which are
dedicated to wholl& %uantitati.e strategies- cannot fail to dri.e technological de.elo!ment in
algorithmic technolog&#
7 am indebted to the man& industr& !artici!ants who chose to s!end their .aluable time
enlightening me# 7 sincerel& ho!e that this !ro?ect can go some wa& to increasing the
e!osure for these fascinating new de.elo!ments#
2. Historical Context
$he mo.e towards order flow com!uterisation was begun on Wall Street with the
introduction of the Gdesignated order turnaroundH s&stem 2D*$- and later Su!erD*$3 in the
<ew Ior" Stoc" Echange# $his routed orders electronicall& to the correct trading
destination to be eecuted manuall&# $his was followed b& the Jo!ening automated re!orting
s&stemJ 2*AAS3 which aided bro"ers in determining the mar"et clearing o!ening !rice#
$he seminal moment in the histor& of algorithmic trading was the !ublication of the Blac" K
Scholes *!tion 8ricing Model in '(74# $his model established a %uantitati.el& rigorous
method for !ricing o!tions contracts b& t&ing their .alue to that of the underl&ing e%uit&
securit&# $his established clear-cut arbitrage o!!ortunities deri.ing from minor discre!ancies
in the !ricing of related instruments#
E%uit& traders on Wall Street began to a!!l& similar %uantitati.e techni%ues to inde and
statistical arbitrage in the earl& '()0s# $he concurrent establishment of full& electronic order
eecution together with the mo.e to decimalisation on Wall Street fuelled this trend and
throughout the '()0s and '((0s !rogram trading des"s became a ubi%uitous feature of Wall
Street in.estment ban"s#
$here ha.e been some setbac"s in the de.elo!ment of algorithmic trading tools# $he most
notable being '()7 stoc" mar"et crash- the blame for which was !artiall& attributed to these
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Algorithmic Trading
%uantitati.e trading tools acting in concert to eacerbate .olatilit&# $he '(() colla!se of +ong
$erm ,a!ital Management was also !rimaril& attributed to mis?udged !rogram trading#
Des!ite this- the im!ortance and !re.alence of these tools grew throughout the '((0s#
$he !rinci!al enabling technolog& for algorithmic trading has been the stead& !rogression of
automation in the asset management and bro"erage industries5
8ortfolio and order management s&stems ha.e automated the handling of !a!er
order tic"ets#
$he wides!read ado!tion of the >7L 2>inancial 7nformation Echange3
communication !rotocol has automated the !hone call#
,om!uter s&stems ha.e automated the clearance and settlement !rocesses#
Electronic ,ommunication <etwor"s 2E,<s3 ha.e automated the role of the
echange#
$he ser.ers that run the ma?or E,<s for global stoc" mar"ets ha.e de.elo!ed the
ca!acit& to handle the high order K cancel traffic t&!icall& generated b& algorithmic
trading with low latenc&#
<etwor" ca!acit& has e!anded to handle the growing .olumes of mar"et data such
as com!lete order boo" information disseminated b& the ma?or echanges#
Data storage and !rocessing costs ha.e continued to decline substantiall&- meaning
that mar"et data 2which can run to tens or e.en hundreds of gigab&tes dail&3 can be
stored and anal&sed ine!ensi.el&#
$he effect of these changes has been that algorithmic trading strategies ha.e begun to
automate both tactical and strategic order routing decisions# Both the bu&-side and the sell-
side ha.e successfull& im!lemented automation strategies to im!ro.e trading !erformance
and increase !roducti.it& whilst lowering costs#
$he basic ad.antages offered b& algorithmic tools o.er their human counter!arts are
twofold# >irstl&- the s!eed of eecution is significantl& faster than human reaction time# 7n this
era of electronic DMA 2Direct Mar"et Access3 trading !latforms the most significant cause of
latenc& is human reaction time# 7t ta"es a human e&e a!!roimatel& half a second to
become aware of a !iece of information !resented to them on a screen F se.eral seconds to
formulate a res!onse F act on it# ,om!uters0- on the other hand- ha.e reaction times in the
milliseconds and can !lace trades significantl& faster# Secondl&- there is an u!!er limit on
the amount of information human traders can realisticall& absorb# According to Aichard
Balar"as- global head of ad.anced eecution ser.ices at ,redit Suisse- studies ha.e shown
that !rofessionals ma"e their trading decisions onl& after considering three or four .ariables#
,om!uters- on the other hand- can !rocess hundreds of .ariables simultaneousl& and refer
bac" to &ears of historical data at near-instantaneous s!eed# $his !roduces manifold
ad.antages in fast mo.ing and data intensi.e trading en.ironments# 7n a 200' stud& b& 7BM
Meffre& Ne!hart com!ared the !erformance of human commodit& traders with autonomous
trading agents# 6e found that the software agents !roduced returns 7C higher than humans#
3. he e!uity markets " an evolution in #ers#ective
3.1 Context
D!ta"e of algorithmic trading for transactional eecution in the e%uit& mar"ets has been
ra!id owing to the structure of these mar"ets# E%uit& trading is centralised 2i#e# echange
based3 as o!!osed to the *$, 2*.er the ,ounter3 based mar"ets for >L- >ied 7ncome F
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Algorithmic Trading
Mone&# $his has meant that electronic integration has necessaril& been smoother and more
cost-effecti.e as the ma?or echanges ha.e mo.ed to full& electronic settlement and
!rocessing#
$he e.olution of automated trading began with .endors such as Aeuters F Bloomberg# 7n the
beginnings of their terminal ser.ice the& offered indicati.e !rices that were not tradable#
With the wides!read ado!tion of terminals within the in.estment ban"ing communit& came
the !ro.ision of full& tradable !rices and the o!ening-u! of their software infrastructure to
allow full& automated trading from within a ban"s0 internal 7$ !latform# Aecentl&- these
ser.ices ha.e been etended to encom!ass automated trading across all underl&ing
instruments 2e%uities- bonds- >L F mone& mar"ets3#
Standardisation of message formats has also had a !rofound effect on the growth of
automated trading# >iL 2for the e%uit& mar"ets3 and >!M+ 2for the foreign echange mar"ets3
ha.e !rogressed from !ro.iding standards for bac"-office communications to !resentl&
encom!assing the %uotation and eecution of instruments#
$he gra!hic below illustrates de.elo!ment stages5
Figure 1: Development stages of equit trading
As the sur.e& below from the $ABB =rou! demonstrates- the industr& is !redicting further
significant mo.es awa& from !hone-based trading in the short to medium term# Most of this
trading .olume is e!ected to be re!laced b& !ro!rietar& algorithms#
Figure !: Projected "hange in #rder Flo$ %outing
$here are two different contets that algorithms can be used 1 the automation of trading
2what to trade3 and the automation of eecution decisions 2how to trade3# While the first one
deals !rimaril& with in.estment decisions- the second one focuses on their im!lementation#
7n this cha!ter we will see the e.olution of algorithmic strategies from those dealing wholl&
with im!lementation to those designed to identif& in.estment o!!ortunities for the
maimisation of al!ha# 7n this re!ort 7 will differentiate between these two areas b& calling
im!lementation strategies /eecution algorithms0 and more acti.e decisions on what to trade
/s&stematic algorithms0#
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Algorithmic Trading
3.2 Guerrillas and Icebergs
$he genesis of algorithmic trading strategies 2and still the most !re.alent use3 was in
increasing the efficienc& of order eecution and allowing the mar"et !artici!ant to recei.e the
most fa.ourable @WA8 2@olume Weighted A.erage 8rice3 for their trade#
$he gra!h below is a sim!listic illustration of the mechanics of the mar"et# Bids F offers are
submitted to the mar"et F eecution is !erformed at the intersection 2/matching03# DMA
2Direct Mar"et Access3 information emanating from the echanges has grown in recent
&ears to include not onl& details on .olume F matching !rices but also a detailed !icture of
the siOe F !rice of all the bids and offers !resent at an& one !oint in time# $he mandator&
!ublication of this bid F offer data has- somewhat ironicall&- caused a reduction in li%uidit& as
mar"et !artici!ants are unwilling to !ublicise their trading intentions to the rest of the mar"et#
Figure &: The 'id ( offer spread
Source: Soft$are %ealit
7n the !ast- traders who wished to trade large bloc"s of stoc" o.er a short time horiOon
would- b& necessit&- cause the mar"et !rice to mo.e unfa.ourabl& 2i#e# a trader !lacing a
large bloc" of stoc" to sell would cause the !rice of their traded instrument to decline as all
the bids !resent on the mar"et were absorbed3# $his would negati.el& im!act their @WA8
and decrease 2or eliminate3 the !rofitabilit& of their trade#
$wo automated strategies ha.e been de.elo!ed F widel& im!lemented to counter this effect5
Iceberging is an earl& strateg& that s!lit large trades u! into manageable chun"s that
could be absorbed b& the mar"et without affecting the !rice# $his strateg& is also
"nown as /Wa.e $rading0 since wa.es of orders are sent to the mar"et for eecution#
$hese orders can ha.e more com!le customisation !resent 1 ado!ting more
aggressi.e order siOes if the mar"et !rice is good and K or randomising order
se%uencing and siOe in order to disguise the !resence of the mar"et !artici!ant#
Guerrilla is an algorithm de.elo!ed b& ,redit Suisse which attem!ts to determine in
real time which !ublicall& dis!la&ed bids or offers can be ta"en without affecting the
mar"et !rice# $hus !ositions can be built u! or li%uidated at the most fa.ourable
@WA8 achie.able#
$he use of these tools has begun to change the com!etiti.e en.ironment for intermediaries
in the e%uit& mar"ets# *ne such eam!le can be seen in late <o.ember 2006 when ,redit
Suisse began offering its0 clients cut-!rice commissions for trades on the 7$= 8ostit bloc"-
trading networ"# ,redit Suisse used =uerrilla to interface directl& with the 8ostit mar"et and
eecute trades at fa.ourable mar"et !rices# $he commissions the& charged for these trades
Page 8
Algorithmic Trading
were half those of their ri.als at 2c !er share for eecuted trades# $he reason behind this
was to !romote the efficac& of their =uerrilla algorithm and to discourage their clients from
going to direct to 8ostit# 7$= subse%uentl& bloc"ed the use of =uerrilla on 8ostit which still
remains# $he two com!anies ha.e since begun tal"s aimed at allowing ,redit Suisse
customers to once again trade with 8ostit orders#
Dis!utes such as these are becoming !re.alent as mar"et !artici!ants fight for a share of a
ra!idl& diminishing commission base# $otal annual D#S# e%uit& commissions shran" from
E'4#:bn in 2002 to E'0#)bn in 2006- according to consulting firm =reenwich Associates# $he
$abb =rou! 2a !ri.atel& held research firm s!ecialising in this area3 is !redicting total
commission re.enue is set to decline a further E'#7bn b& the end of 200)#
G$hese changes are massi.eH sa&s =regor& $uscarm head of electronic trading at =oldman-
Sachs F ,o# G$here is a tremendous amount of .er& large structural transformation going on
in the mar"et!laceH#
3.3 Dark Pools
$he increasing trans!arenc& afforded b& DMA access ser.ices !ro.ided b& the echanges
has had the corollar& effect of reducing !ublicised li%uidit& 2i#e# the number and .olume of
!ublished bids F offers3# $his is !rimaril& due to mar"et !artici!ants being unwilling to share
their trading intentions with other mar"et !artici!ants and the high eecution !rices le.ied b&
echanges#
$he consolidation of echanges seen in recent &ears has done little to consolidate trading
.olume# 7ndeed- it would seem that .olume is becoming increasing fragmented as more
in.estment ban"s and other intermediaries launch /crossing networ"s0 which match orders
outside of the t&!ical echange-dri.en transaction# $hese crossing networ"s ha.e been used
for some time b& in.estment ban"s for matching orders generated in-house# Aecentl&- the&
ha.e begun to !roliferate and around :0 such networ"s are now a.ailable# $he ma?or
!artici!ants from the in.estment ban"ing communit& com!rise5
Bank of New York VortEx
+aunched in A!ril of 2007- this !latform has alread& !ro.en !o!ular with institutional
in.estors# $he s&stem monitors non-dis!la&ed li%uidit&- eecuting orders when li%uidit& is
found# When the entire order cannot be filled the outstanding balance of the order is
cancelled and returned to the client# What differentiates this !latform is the !rocess when no
!art of an order can be filled 1 the order is then transmitted to other 4
rd
!art& !ools-
maimising the li%uidit& a.ailable on the !latform# =areth Mones- managing director of B<I
,on.ergE Euro!e sa&s G@ortE uses inno.ati.e technolog& to minimise information lea"age
and latenc& b& interacting with onl& those li%uidit& !ro.iders that are read& to tradeH
Morgan Stanley MS Pool
Morgan Stanle& was first to mar"et with a !latform in '((( 1 /$ra?ector& ,ross0# $heir second
s&stem was launched in Se!tember 2006 F has grown to an order .olume of around '4Bm
shares !er da& 2according to research firm Aite3# MS 8ool offers com!letel& anon&mous
matching F combines li%uidit& stemming from retail- institutional- algorithmic trading and
Morgan Stanle&0s internal order flow# Morgan Stanle& !ro.ides no !ost-trade information in
order to ensure com!lete anon&mit&#
Goldan Sac!s Siga "
$his !latform was launched in the D#S# in Mul& 200B and will shortl& be a.ailable in Euro!e#
According to mar"et research firm Aite- it has the biggest mar"et share with 26C of all dar"
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Algorithmic Trading
!ool trades emanating from this s&stem# 7n A!ril of 2007 usage of this !latform increased
dramaticall& when =oldman Sachs allowed clients to anon&mousl& lea.e orders within the
s&stem# Since then trading .olume has increased from :0m shares !er da& to around 200m#
=reg $uscar- head of electronic trading at =oldman Sachs sa&s G*ur strateg& ensures
clients ha.e the greatest access to li%uidit& b& interacting with =oldman Sachs0 !rogramme
and bloc" trading des"s- as well as li%uidit& from our clientsH#
#redit S$isse #ross%inder
$his is one of the onl& ban"-s!onsored !latforms that is a.ailable in Euro!e# 7t su!!orts
continuous and !eriodic crossing and enables clients to use algorithms both for eecuting
orders through the dar" !ool and through the mar"et# Aichard Balar"as- managing director
at ,redit Suisse sa&s the s&stem is differentiated on the basis of a.ailable li%uidit&
G,ross>inder is blind to !artici!ants- minimising mar"et im!act# $he li%uidit& of the s&stem
deri.es from ha.ing a broader range of names- ensuring that some clients ne.er ha.e to go
to mar"etH#
Pro&ect '$r($oise
$his s&stem was e!ected to go li.e in <o.ember of 2007 but the launch has now been
!ushed bac" to the first %uarter of 2007- it is bac"ed b& se.en of the world0s largest
in.estment ban"s $he trading s&stem will be a h&brid !ublic order 2to com!ete directl& with
Euro!ean echanges3 K dar" !ool s&stem# A s!o"esman for $ur%uoise has been %uoted as
sa&ing that the s&stem will be an aggregator of dar" !ools and will !otentiall& cross these
trades against the !ublic boo"# $his would enable the twin aims of li%uidit& and anon&mit& to
be met#
$his is a threat to the echange as the traditional hub of li%uidit&H sa&s Bill ,line from
Accenture# G$hese dar" !ools are an alternati.e mechanism to the traditional echange-
absent man& of the fees and costs of an echangeH#
$he echanges are fighting bac" against the li%uidit& drain caused b& these ri.als# Dnder
new !ro!osals from the Aegulations <ational Mar"et S&stem- an& trading .enue that
accumulates more than BC of D#S# e%uit& .olume must !ro.ide o!en %uotes to the broad
mar"et# Des!ite these measures- the mar"et share of echanges is !redicted to decline
further# Aite =rou!- an inde!endent research firm based in Boston- !redicted in a re!ort
!ublished in Se!tember 2007 that the ma?or D#S# echanges0 mar"et share will decline from
the current 7BC to 62C in 20''#
$he !roliferation of these trading !latforms and their subse%uent com!etition for li%uidit& has
had the effect of both reducing commissions and increasing the range and .ariet& of
electronic ser.ices on offer# $his de.elo!ment has done much to s!ur the growth in
algorithmic trading with a number of !ro!rietar& tools de.elo!ed to ta"e ad.antage of these
hidden sources of li%uidit&#
Ban" America Securities 2BA,S3 has recentl& launched a !ro!rietar& model called /Ambush0#
As Bill 6arts- managing director and head of strateg& for BA,S sa&s- G$here is a lot of
li%uidit& out there that is not .isible to the mar"et- either because it is in a reser.e order or a
hidden order# $he Ambush algorithm is designed to sniff out the sort of li%uidit& that0s not
ordinaril& .isibleH#
,itigrou! also has two !ro!rietar& tools designed to wor" within this new mar"et landsca!e#
/Dagger0- launched in August 2006- is an aggressi.e strateg& that is designed to ca!ture a
high !ercentage of echange li%uidit& for a s!ecific instrument while using a limit order# As
$imoth& Aeill&- managing director of D#S# electronic eecution sales for ,iti sa&s G$he
measure of Dagger0s success is how much of the a.ailable li%uidit& within that limit !rice a
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Algorithmic Trading
trader actuall& ca!tures as a userH# /Scout0- also launched in August 2006- is an algorithm
designed to see" li%uidit& 1 where.er it ma& be found# 7t automaticall& !olls for li%uidit& at
both ma?or Dar" 8ools and the echanges 1 enabling their clients to find the best source of
li%uidit& at an& one !oint in time# Aeill& describes it thus5 GWhat the Scout algorithm will do is
route more flow to whate.er outlet is !ro.iding more li%uidit&H#
A number of other !ublicised algorithms are acti.e in this area# 7nstinet launched one called
/<ighthaw"0 on Mune 2) 2006 which is designed as a li%uidit& aggregator# 7t simultaneousl&
!olls the ma?or sources of dar" li%uidit& in order to disco.er the most effecti.e !latform to
ma"e a trade#
$he iron& of this fragmentation of li%uidit& 2itself caused !rimaril& b& the u!ta"e of algorithmic
trading3 is that it is !ro.ing to be another "e& moti.ator in the ado!tion of algorithms b& the
bu&-side# As the sur.e& below demonstrates- concerns o.er li%uidit& became far F awa& the
!rimar& trading difficult& for bu&-side !artici!ants in 200B#
Figure ): Difficulties of Trading Toda*s +arket: , T$o-.ear "omparison
Source: TABB Group Institutional Equity Trading in 2005: A Buy-Side erspecti!e"
3.4 Algorithmic execution strategies
Algorithms designed to maimise the efficienc& of a transaction can be s!lit into two different
classifications b& wa& of their interactions with the trader5
Enhanced DMA strategies are relati.el& eas& to understand and do not re%uire the
trader to delegate an& real decision ma"ing to the algorithm#
Algorithms which re%uire trader in!ut are generall& designed to minimise eecution
ris" against a s!ecific benchmar"# $hese are generall& more %uantitati.e in nature-
ta"ing into account models of mar"et microstructure#
$he table below summarises the !rinci!al strategies a.ailable to traders from both of these
classification#
Ta'le 1: Principal algorithmic e/ecution strategies
Enhanced DMA
Strategies
Iceberging Large orders are split into smaller components
so as to minimise execution risk disguise t!e identit" o# t!e trader$

%imple time slicing &!e order is #ragmented sent to t!e market at regular time inter'als
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Algorithmic Trading


%mart order routing
Li(uidit" #rom man" di##erent sources is polled t!e
order is

sent to t!e destination)s* o##ering t!e best price or
li(uidit"

+egging ,n order is sent out at t!e best a'ailable bid )ask* i# bu"ing )selling*
price mo'ements generate modi#ications in t!e order$

%imple -arket on .lose
)-/.*
&!e order is sent into a closing
auction$


Quantitative Algorithms
01,+ 2esigned to maximise per#ormance 3!ilst minimising tracker error
3it! respect to t!e 0olume 1eig!ted ,'erage +rice

&1,+ %imilar to simple time slicing4 but in addition attempts to track

t!e &ime 1eig!ted ,'erage +rice to minimise bot! spread and impact
costs

+articipate
2esigned to capture a user5speci#ied proportion o# t!e total 'olume
traded$

,lso kno3n as +/04 Inline4 6ollo3 1it!
0olume

-/. -ore sop!isticated -arket on .lose strateg" 3it! optimisation

measures 3!ic! includes commencing trading be#ore t!e closing
auction

Implementation %!ort#all )I%* ,utomates t!e trade o## bet3een impact risk b" executing as
close as possible to t!e mid5point$
Much li"e e.er& other in.estment !rocess- the choice of eecution strateg& lies in the trade-
off between ris" and reward# Algorithms see" to maimise !erformance for a gi.en le.el of
trac"ing error against a chosen benchmar"# $herefore the standard de.iation of the trac"ing
error is as im!ortant as the a.erage when auditing the !erformance of a gi.en algorithm#
Different in.esting st&les will- b& necessit&- em!lo& different strategies# 6igh-fre%uenc&
traders such as hedge funds will acce!t higher le.el of ris"s for each indi.idual trade in the
!ursuit of enhanced !erformance whereas institutional funds with longer time horiOons F
more infre%uent trades will tolerate less ris"# Successful algorithms will attem!t to maimise
!erformance for a gi.en ris" K reward intersection#
3.4.1 The trading schedule
$he central com!onent of an& algorithmic eecution strateg& is the method b& which orders
are bro"en down into sub-com!onents and sent to the mar"et# $he wa& this is done is
dictated b& the strateg& em!lo&ed 1 for eam!le @WA8 algorithms will eecute .olume
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Algorithmic Trading
according to historical .olume !rofilesP 8artici!ate will trend eecutions according to current
.olumeP 7m!lementation Shortfall will in.ol.e some im!act K ris" modification#
8artici!ate is !erha!s the most .olume-de!endant of all the strategies outlined abo.e# 7f
trading .olume is light F the !arameters for the !ercentage of .olume to be ca!tured are
aggressi.e then mar"et im!act is li"el& to be large# <ot onl& would this im!act on the
a.erage !rice !aid- it ma& also allow other traders or algorithms to recognise the !resence of
the strateg& F front-run it#
$he gra!h below illustrates the wa& two different strategies will t&!icall& s!lit orders u! o.er
the course of a trading da&#
Figure 0: Time slicing of order volume ' strateg
Source: T#e Trade $e%s & Algorit#'ic Trading( A buy-side #andboo)
As we can see- @WA8 and 7m!lementation Shortfall strategies ha.e .er& different trading
schedules# Both ha.e their !lace in the management of the im!act K !erformance trade-off
for differing le.els of acce!table ris"
Decisions re.ol.ing around the actual eecution of the trades are of !aramount im!ortance#
Sim!listic algorithms ma& sim!l& send orders to the mar"et e.er& time it wants to ma"e a
trade# Whilst this would be ha.e a low trac"ing error against target .olume 2i#e# there would
be Oero !ortabilit& of not filling the order3- it is li"el& that it would be inefficient in so far as no
consideration is made of the current bid K offer s!read# When deciding whether to eecute a
trade the algorithm faces a decision tree with three se!arate !arameters5
'# 8a& the offer F fill the trade
2# Wait on the bid side of the order boo"
4# Wait outside the order boo" for a tighter s!read
Both o!tions 2 F 4 increase the ris" of raising the trac"ing error against target .olume whilst
!otentiall& increasing the rewards from decreased s!read and im!act costs# $hus the
!ertinent .ariables in the formation of the decision matri will be s!read- .olatilit& and
li%uidit&#
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Algorithmic Trading
$he choice of im!lementation strateg& must ha.e reference to the characteristics of the t&!e
of securit& being traded# We can sim!listicall& brea" these down into three different
categories as shown in the table below5
Ta'le !: Development stages of equit trading
Source: T#e Trade $e%s & Algorit#'ic Trading( A buy-side #andboo)
1igh tick si2e(volatilit3 high median spread(volatilit
Although stoc"s in this categor& are reasonabl& .olatile- short-term eecution is ad.ersel&
affected b& .er& large tic" siOes# Stoc"s such as these t&!icall& ha.e large amounts of
li%uidit& at the best bid F as" !rices relati.e to a.erage dail& .olume#
$he best strateg& to em!lo& for these t&!es of stoc"s would be to use fewer trades at larger
.olumes when the s!read narrows# $he large amounts of li%uidit& !resent on the best bid F
offer !rices means that larger .olumes should ha.e little negati.e !rice im!act#
Algorithmic eecution strategies add a great deal of .alue to trades for these t&!es of stoc"s
since the& can constantl& monitor the rele.ant !arameters in order to ?udge the most
o!!ortune time to !lace a trade# $he& can ?udge imbalances of su!!l& F demand in the
order boo" to gauge the !otential for ad.erse !rice mo.ements in which case the& would
!a& the s!read immediatel&# *therwise the& can wait for a shortening of the s!read to occur
F then !lace their eecution order#
4o$ tick si2e(volatilit3 high median spread(volatilit
$he .olatilit& ehibited b& stoc"s in this categor& does ma"e them less amenable to
algorithmic strategies# *n the other hand- stoc"s such as these are t&!icall& .er& sensiti.e to
information lea"age - if the identit& of large traders is re.ealed ad.erse !rice mo.ements are
sure to follow#
$he most efficient strateg& is to trade smaller bloc"s at faster time inter.als when the !rice
has a fa.ourable s!read# +arger order .olumes are li"el& to result in wider s!reads being
%uoted F thus ad.ersel& affect efficienc&#
4o$ tick si2e(volatilit3 high median spread(volatilit
$hese stoc"s are generall& highl& li%uid blue-chi! issues that are relati.el& eas& to trade#
*rder .olume is unli"el& to ha.e an& im!act on s!reads so more sim!listic strategies ma& be
em!lo&ed such as sim!le time slicing#
<ow that we ha.e e!lored the basics of algorithmic trading with reference to !ure eecution
strategies- we will go on to eamine their e.olution into more com!le multifaceted trading
strategies#
3.5 Arbitrage
$he mechanics of an arbitrage trade lend themsel.es .er& effecti.el& to an algorithmic
trading strateg&# $he !arameters for the trade are easil& %uantified and the "e& determinant
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Algorithmic Trading
for successful eecution is s!eed 1 both the time needed to disco.er the o!!ortunit& and the
time re%uired to eecute the trade#
Arbitrage o!!ortunities can be classified into a three different categories of increasing
com!leit&#
3.5.1 Riskless Arbitrage
$his trade in.ol.es the !urchase F sale of t!e sae asset which generates a !rofitable trade
2after the deduction of trading costs3# 7n the e%uit& mar"ets these trades are limited to
securities which are %uoted in multi!le mar"ets such as a ma?or multinational# >or eam!le a
trader could theoreticall& simultaneousl& !urchase a stoc" listed on the <ISE 2where the
!rice is lower3 F sell it where the !rice is higher 2the +SE3# $he !rofitabilit& of this trade
would ob.iousl& de!end on both foreign echange differentials and eecution costs#
Whilst trades in this categor& do !eriodicall& eist- the ease b& which the& can be identified
and e!loited ma"es them rare and transient in nature#
,ross-asset ris"less arbitrage o!!ortunities are also !ossible between different mar"ets - for
eam!le the e!loitation of !ricing differentials between deri.ati.es and securities mar"ets
for a !articular stoc"#
Whilst algorithmic strategies would ha.e clear ad.antages in this area o.er their human
counter!arts- the cost of im!lementing the strateg& is li"el& to outweigh the e!ected gains#
$his can be attributed to the fact that these !ricing anomalies are both rare and transient#
When the& occur ri.al traders will also mo.e to e!loit them 1 dri.ing down the !rofitabilit& of
the trade almost immediatel&#
3.5.2 Pairs trading
$his strateg& differs from that outlined abo.e in so much as it does in.ol.e a degree of ris"#
$he conce!t remains- howe.er- disarmingl& sim!le# $he trader finds two securities which
ha.e highl& correlated historic !rice mo.ements and then shorts one whilst going long on the
other when their !rices go be&ond a set number of standard de.iations 2or /Bollinger Bands03
from the obser.ed norm# $he strateg& has the ad.antage of being /mar"et neutral0 in so
much as the trader is not e!osed to underl&ing mar"et ris"#
$he gra!h below illustrates the conce!t b& gra!hing two highl& correlated stoc"s5
Figure 5: Simple price correlation 'et$een ,67 8 94:
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Algorithmic Trading
A cursor& glance at the !re.ious '2 months of !rice data re.eals that the stoc"s mo.e in
concert with occasional di.ergences#
$o get a better .iew of the data we can loo" at the !rice-relati.e indicator# $his !lots the
!rice of AstraQeneca di.ided b& the !rice of =SN# B& including the mean together with u!!er
and lower bounds mar"ed b& two standard de.iations we can more accuratel& gauge the
best time to ma"e a trade in order to !rofit from e!ected re.ersion to the mean#
Figure ;: %eversion to the mean: price correlation ' standard deviation
Source: contracts-*or-di**erence+co'
$he strateg& has a long histor& of successful im!lementation in the e%uit& mar"ets# $he first
ac"nowledged !ro!onent was Morgan Stanle& in the mid '()0s who set-u! a trading
di.ision based u!on the wor" of <unOio $artaglia and his team of mathematicians- !h&sicists
and com!uter scientists#
A seminal wor" in this area was !ublished b& the Iale School of Management 2authored b&
=ate.- =oetOmann F Aouwenhorst3 in '((7# $he title of the !a!er was /8airs trading5
!erformance of a relati.e .alue arbitrage rule0# 7n the !a!er the contributors eamined stoc"
!rice mo.ements in the DS e%uit& mar"ets between '(62 to '((7 in order to identif& highl&
correlated !airs of securities# *nce these !airs were identified a trading strateg& was bac"
tested on the same data to determine the o.erall .iabilit& of !airs trading# $he !a!er found
that a strateg& of !airs trading using an unle.eraged !ortfolio ehibited annual ecess
returns o.er the mar"et of '2C for the !eriod under eamination#
$he .iabilit& of this strateg& does run counter to the conce!t of efficient mar"ets# Ais"-
ad?usted returns for the strateg& should not- in theor&- be !ositi.e# $he fact that that seems
to not be the case is attributed in the Iale !a!er to a two main factors5
Sentiment or /herding beha.iour0 1 in.estors are more li"el& to bu& stoc"s when the&
are going u! F sell them when the& are going down# $his beha.iour ser.es to
eacerbate !ricing differentials between two highl& correlated stoc"s#
+ac" of li%uidit& 1 in theor& these !ricing anomalies should not eist if there is
sufficient ca!ital em!lo&ed to e!loit them# $he !a!er !osits that onl& low-cost
trading o!erations are in a !osition to trade this strateg& !rofitabl&# $he strateg& is
not !rofitable enough to sustain large amounts of in.estor ca!ital#
$he use of algorithms to conduct !airs trading is well established and a number of ban"s
and 4
rd
!art& su!!liers are using customised software tools to detect and e!loit trading
o!!ortunities# Mar"et commentators 2such as Ste!hane +ero& 1 global head of sales for
;uant 6ouse3 !osit that the .ast ma?orit& of !airs-trading strategies are now algorithm
dri.en#
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Algorithmic Trading
$he screenshot below is ta"en from 8rogress A!ama Algorithmic $rading 8latform software#
Figure <: Screenshot of ,pama ,lgorithmic Trading Platform
Source: ,r ,obb-s .ournal
Whilst the detection of these trading o!!ortunities has been handled b& com!uters for some
time through Ecel or other !ro!rietar& anal&tics software- onl& recentl& has the entire
!rocess been automated from end-to-end# Solutions such as that shown from A!ama abo.e
enables the identification- bac" testing and eecution of !airs trades from within a single
!latform#
$he com!etiti.e ad.antage conferred b& the s!eed and efficienc& of these solutions has
dri.en their wides!read ado!tion in the e%uit& mar"ets# $his /mainstreaming0 of !airs trading
has resulted in dramaticall& lower !rofitabilit& for the strateg& in recent &ears# <ewer- more
so!histicated techni%ues were needed in order to enable the consistent generation of al!ha#
3.5.3 Statistical Arbitrage
Statistical arbitrage or /StatArb0 was a term coined in the mid '((0s to define the new
%uantitati.e trading !rocedures based around the conce!t of re.ersion to the mean# 7ts0
!rinci!al earl& ado!ter and main !ro!onent was the emerging hedge funds in the '((0s#
StatArb le.erages the e!onential growth in com!uter !ower- storage ca!acit& and the
corollar& reduction in networ" latenc& to broaden the search for !rofitable trades be&ond
sim!le !airs# $he strateg& can encom!ass multi!le instruments- sometimes s!anning across
different asset classes 2such as commodities F o!tions3# +e.erage is also routinel& used to
trade both sides of the mean re.ersion 1 i#e# long K short !ositions at !rofitable entr& !oints
with corollar& short K long !ositions ta"en once re.ersion to the mean has occurred#
8arameters used to match and trade !airs ha.e also broadened be&ond sim!le !rice metrics
1 for eam!le .olatilit& correlation can be a source of !rofitable trades#
$he techni%ues em!lo&ed b& hedge funds in this area are relati.el& new and therefore highl&
commerciall& sensiti.e# $hus eact details of the inner wor"ings of such trading !latforms
are !resentl& im!ossible to .erif&#
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Algorithmic Trading
What is clear is that the changes in mar"et microstructure caused b& wides!read !airs
trading and algorithmic ado!tion could itself un.eil new sources of mean re.ersion
beha.iour# $he algorithmic arms race amongst hedge funds and ma?or in.estment ban"s is
dri.ing their so!histication forward at a ra!id !ace#
3. !he end o" mutual "unds#
According to the 7n.estment ,om!an& 7nstitute worldwide mutual fund assets are currentl& in
the .icinit& of E20 trillion# At !resent there is no sign of the growth of these in.estment
.ehicles abating- o.er the last ten &ears assets under management ha.e increased tenfold#
6owe.er- according to a large and growing grou! of researchers and in.estment managers
there are storms on the horiOon for the mutual fund industr&#
$he returns en?o&ed b& !artici!ants in a mutual fund can be bro"en down into two
categories5
Beta 1 $hese are returns accruing from the mar"et itself- inde!endent of the actions
of a mutual fund manager# >or eam!le- the Beta for a di.ersified stoc" fund of large
ca!s in the DS would be e!ressed b& the mo.ement of the SF8 B00 7nde#
Al!ha 1 $hese are the returns accruing to the fund in excess of that ehibited b& the
mar"et# $his is !rimaril& seen as the com!etiti.e differentiator of a fund who will li"el&
widel& tout mar"et-beating results in their literature#
$here alread& eists relati.el& commoditised wa&s to generate Beta in the form of Echange
$raded >unds 2E$>s3# >ees charged b& funds of this t&!e are significantl& less than those
seen for t&!ical acti.el& managed mutual funds 1 in some cases E$>s are a factor of three
chea!er# Aecent &ears ha.e seen a !roliferation of E$>s 1 gi.ing the in.estor a di.erse
choice of Beta returns- from large indees such as the SF8 B00 to bas"ets of emerging
mar"ets# Within the last '2 months E$>s ha.e e.en been launched to mirror Beta returns
from certain s&stematic trading strategies such as /.alue0 or /growth0 strategies#
3.6.1 Hedge Fund replicatin
6edge funds- the !rinci!al mar"et-neutral al!ha generation .ehicles ha.e grown significantl&
o.er the last decade 1 from E'00bn under management in mid '((6 to nearl& E' trillion in
mid 2006 2according to $remont ,a!ital Management3# Whilst the growth of their funds
under management has grown significantl&- the& are still mainl& be&ond the reach of all but
the largest in.estors# $heir fee structures- whilst largel& tied to !erformance- remain
!rohibiti.e in the contet of the wider fund management industr&#
,om!etition in the s!ace has intensified in recent &ears and- as a natural corollar&-
!erformance has degraded# $his can be clearl& seen from the gra!h below from a !a!er
from >ung and 6sieh in A!ril 2007#
Figure =: %eduction in returns for hedge funds over the last decade
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Algorithmic Trading
Source: /edge 0und replication strategies: i'plications *or in!estors and regulators
According to >ung and 6sieh between :0C - 7BC of a hedge fund !erformance can be
re!licated b& s&stematic strategies# $his is done b& classif&ing a hedge fund into one of the
following four categories5
$rend following
@alue
=lobal K macro
Distressed securities
*nce a fund has been classified in this manner !erformance re!lication is !ossible b&
means of s&stematic in.estment criteria generated and eecuted b& algorithms#
$he table below shows the relati.e efficienc& of re!lication for the ma?or hedge fund
strategies#
Ta'le &: >ffectiveness of replication strategies ' su'-sector
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Algorithmic Trading
Source: /edge 0und replication strategies: i'plications *or in!estors and regulators
*nce this re!lication !erformance has become widel& acce!ted in the financial communit& it
is li"el& that some degree of commoditisation will occur much as it has in the E$> industr&#
$his will be fuelled b& the use of low-cost s&stematic algorithmic strategies b& industr&
!artici!ants# 7t is entirel& !ossible that %uoted in.estment .ehicles will arise which attem!t to
mimic s!ecific hedge fund strategies at a significantl& lower cost#
Al!ha generation is on course to become significantl& chea!er and more accessible#
3.6.2 Prtable Alpha
$he new conce!t of /!ortable al!ha0 is mo.ing to the mainstream of financial academia#
8ortable al!ha is defined in a !a!er b& ,oates and Baumgartner as G#### a financial
engineering methodolog& that see"s to add low correlation sources of return 2al!ha3 to a
!ortfolio while maintaining the total !ortfolio0s desired s&stematic 2beta3 e!osuresH# $his
conce!t is well illustrated b& the following gra!h from the abo.e mentioned !a!er5
Figure 1?: Porta'le ,lpha @ an overvie$
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Algorithmic Trading
Source: ortable Alp#a: A practitioner-s guide
$he benefits of this methodolog& are numerous5
+ower fees 1 6igher management charges are !aid onl& to those managers adding
al!ha to a !ortfolio
Efficient ris" allocation 1 Since the source of Beta and Al!ha are se!arated so too
can be their e!ected ris" !rofile 1 enabling a more granular control o.er ris"
e!osure
More asset class o!tions 1 the source of al!ha can come from asset classes different
from that used for Beta- enabling a wider uni.erse of .ehicles to be added to a
!ortfolio#
7ncreased !erformance 1 the decision of which .ehicle to use for al!ha generation is
made inde!endent of the beta source gi.ing in.estors access to a wider uni.erse of
2!otentiall&3 more efficient al!ha sources#
$he se!aration of the beta and al!ha com!onents of a !ortfolio is certain to dee!en the
/mar"et0 for al!ha# Beta sources are alread& a!!roaching commoditisation as E$>s
!roliferate be&ond traditional stoc" inde funds into tailored strateg& re!lication and e.en into
alternati.e asset classes such as commodities# +ow-cost hedge fund re!lication strategies
are certain to ha.e a !rominent !lace in this e!anded mar"et for al!ha#
7t is clear to see how these two de.elo!ments !ose a clear threat to the mutual fund
industr&# Both com!onents of their total return 2Beta and Al!ha3 can be re!licated b& lower
cost !latforms# 6ow can the& continue to ?ustif& their fee !remiums when the& no longer
!ossess an& meaningful .alue-add9
7t is far from certain that algorithms will be able to com!letel& re!licate the traditional fund
manager o.er the net decade but it is almost certain that agenc& !rofits in the financial
ser.ices industr& will continue to decline# $he u!shot of this margin s%ueeOe will- in all
!robabilit&- be an increased reliance on the most cost-effecti.e source of s&stematic trading
strategies 1 algorithmic !latforms#
3.$ %utlook "or the "uture
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Algorithmic Trading
Without the benefit of a cr&stal ball it is im!ossible to tell how !er.asi.e s&stematic
algorithmic trading will become in the medium to long-term# What is certain is that
algorithmic eecution strategies ha.e become .er& much mainstream !ractice for the bul" of
e%uit& mar"et !artici!ants on both the bu& F sell side# 6ow far this trend continues into
s&stematic trading will be a function of technological im!ro.ements- in.estor sentiment and
the de!th of the antici!ated margin s%ueeOe for intermediaries in the mar"et#
$he increased ado!tion of algorithmic strategies will dri.e inno.ation in the mar"et!lace as
in.estment ban"s- hedge funds and 4
rd
!art& solutions !ro.iders see" to differentiate their
offerings# 7t is certain that the algorithm em!lo&ed b& mar"et !artici!ants will continue to be
.iewed as a ma?or source of /.alue-add0 for their offering# $his will lead to both a significant
fragmentation of the t&!es of strategies being em!lo&ed and a boost to the so!histication of
the technolog&#
De.elo!ments in artificial intelligence and neural networ"s will feed into this e.olution of the
industr&# *ne !articular de.elo!ment that is alread& been widel& de!lo&ed is the conce!t of
a /learning algorithm0 1 this introduces e.olutionar& !rinci!als into the selection of algorithms
on the fl&# $he bac"-testing of s!ecific strategies will co-eist will real-time monitoring of their
!erformance and algorithms dis!la&ing com!etiti.e ad.antage will be /selected0 o.er their
!eers and !ut into !ractice immediatel&#
$he e!onential ad.ances in s!eed and efficienc& offered b& algorithms will ma"e it harder
for their human counter!arts to com!ete on a le.el !la&ing field# 7t is li"el& that the role of
human traders will mo.e towards relationshi! management and awa& from non-%uantitati.e
stoc" selection#
Whate.er the future sha!e of the e%uit& fund management industr& there is no doubt that
algorithms will continue to change the com!etiti.e landsca!e in !rofound and far-reaching
wa&s#
$. %olatility " do algorithms threaten to desta&ilise the 'inancial markets(
4.1 !he algorithmic sca&egoat
$he !o!ular !ress li"es nothing better than an easil& identifiable sca!egoat to deride when
things go wrong in the financial mar"ets# $echnical trading has been im!licated in all the
most recent eam!les of etreme mar"et .olatilit& 1 from com!uterised sell orders causing
the rout on *ctober '(- '()7 to the fall of +ong $erm ,a!ital Management in '(()- to the
etreme losses suffered b& hedge funds in August 2007# What all of these instances ha.e in
common is the conce!t of /financial contagion0# $his is characterised b& a chain reaction of
e.ents leading to etreme .olatilit&- the root cause of which is the commonalit& of strategies
em!lo&ed b& mar"et !artici!ants#
$he blame for the '()7 stoc" mar"et crash was !ut s%uarel& at the feet of the !redecessor
of algorithmic trading 1 !rogram trading# Automated sell orders did certainl& com!rise a
large !ro!ortion of the .olume on Wall Street on Blac" Monda& but the crash was largel&
sentiment dri.en rather than a technical glitch# $he crash began in 6ong Nong- s!read west
to Euro!e and hit the DS onl& after the other mar"ets had alread& declined significantl&# $he
fact that !rogram trading was almost wholl& confined to the DS e%uit& mar"ets at the time
does lend credence to the theor& that !rogram trading was not the root cause- but merel&
the mechanic behind the huge surge in sell orders# $he fact that DS financial mar"ets were
forced to sus!end trading during the crash was- howe.er- directl& attributable to !rogram
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Algorithmic Trading
trading# $he surge in electronic order .olume o.erwhelmed the technical ca!acit& of the
echanges F a tem!orar& sus!ension was re%uired in order to catch u! with order fulfilment#
+ong $erm ,a!ital Management 2+$,M3 was the first /%uant0 fund to e!erience significant
2and .er& !ublic3 losses in '(()# $otal losses stemming from this once highl& !rofitable fund
amounted to E:#6bn# Much em!hasis at the time was !laced on the reliance of the fund on
!urel& %uantitati.e- com!uter-dri.en trading strategies# $he realit& of the situation was more
com!le F in no wa& wholl& attributable to the models em!lo&ed b& +$,M# $he firm0s
!rimar& business was arbitrage in the e%uit&- deri.ati.e and debt mar"ets# 7t em!lo&ed
significant le.erage 1 in '(() it had e%uit& of E:#72bn with borrowings of E'2:#Bbn# 7t also
had off balance sheet deri.ati.e !ositions amounting to E'#2B trillion# $he Aussian bond
default of '(() tem!oraril& in.alidated the trading strateg& based around re.ersion to the
mean and set-off a series of margin calls for +$,M resulting in their e.entual demise in earl&
2000# Des!ite this e.ent being a statistical aberration- the le.erage of +$,M0s !ortfolio
meant it was unable to /ride out the storm0# As Mohn Ma&nard Ne&nes is re!orted to ha.e
said Gthe mar"et can sta& irrational longer than &ou can sta& sol.entH# $he efficac& of
statistical arbitrage strategies was onl& tem!oraril& affected b& this e.ent but the bac"lash
against %uantitati.e trading lasted far longer#
So des!ite these s!ecific incidents does an& e.idence eist that algorithmic trading
increases .olatilit& in the ca!ital mar"ets9 7n theor& at least the o!!osite should be the case#
Algorithms ha.e done much to mo.e trading awa& from the ma?or echanges F into intra-
ban" transactions and /dar" !ools0 as we ha.e seen earlier in this !a!er# $he following
illustrations from the boo" /Statistical Arbitrage0 b& Andrew 8ole ser.es to demonstrate this
fact5
Figure 11: The a the market $as
Source: Statistical Arbitrage by Andre% ole
Figure 1!: , deflated market model
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Algorithmic Trading
Source: Statistical Arbitrage by Andre% ole
$hus we can see that the o!eration of these electronic agents should ser.e to reduce rather
than increase .olatilit&# $he echange no longer holds the transactional mono!ol& and off-
echange transactions ma& soon become a more significant source of li%uidit& than the
echanges themsel.es# But has this !ro.en to be the case in actualit&9
$o in.estigate this we can loo" at the ,hicago Board *!tions Echange0s 2,B*E3 @olatilit&
7nde or @7L# $his inde was de.elo!ed b& the ,B*E in '((4 and at ince!tion it !ro.ided a
measure to gauge stoc" mar"et .olatilit& b& ta"ing the weighted a.erage of im!lied .olatilit&
for the Standard F 8oor0s '00 7nde calls F !uts# 7n 2004 this 7nde was re.ised to co.er the
entire SF8 B00 7nde#
As we can see in the gra!h below from Iahoo >inance- the .olatilit& of the SF8B00 declined
mar"edl& between 2004 and 2007 1 reaching an all time low in Manuar& of 2007#
Figure 1&: Price histor for AB:
Source: 1a#oo 0inance
$his was at a time of increased reliance on algorithmic trading for all mar"et !artici!ants 1
es!eciall& the hedge fund sector# ,ould off-echange transactions and statistical arbitrage
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Algorithmic Trading
be ser.ing to decrease o.erall stoc" mar"et .olatilit&9 ,ertainl&- the o!eration of statistical
arbitrage must ha.e !la&ed a !art in this 1 substantial increases in the amount of ca!ital
de.oted to !rofiting from /re.ersion to the mean0 must act to reduce .olatilit& for target !airs#
4.2 August 2''$ ( algorithmic nemesis#
7n order to answer the %uestion com!letel& we must go some wa& towards e!laining the
ra!id .olatilit& increases seen in mid-to-late 2007# $he fact that this increase has occurred at
a time of record losses for /%uant0 funds ma& indicate that the trend has been bro"en and
!resage further instabilit& in the financial mar"ets#
August 2007 mar"ed the end of a tumultuous summer for the financial mar"ets 1 the D#S#
sub-!rime mar"et began to be seen as a ma?or source of economic wea"ness# $wo credit
strategies funds o!erated b& Bear Stearns were forced to close in Mune of 2007 after
e!eriencing catastro!hic lossesP Sowood ,a!ital0s had to sell their entire !ortfolio to ,itadel
after e!eriencing losses eceeding B0C in Mul& and rumours of balance sheet wea"ness for
ma?or international ban"s with e!osure to the American sub-!rime sector were widel&
re!orted#
What ha!!ened in the wee" commencing the 6
th
August was .er& different howe.er# A
number of funds em!lo&ing statistical arbitrage strategies began to e!erience hea.& losses#
$his was unusual for two reasons 1 it did not !recede an& immediate mo.ements in the
e%uit& or debt mar"ets and the strategies themsel.es were su!!osed to be Beta neutral# $he
)
th
August saw a 4C decline in the SF8 B00 with further significant losses for %uant funds#
B& the end of the wee" losses from -BC to -40C were re!orted for some of the most
consistentl& !rofitable hedge funds# As Da.id @inia- ,>* of =oldman Sachs said at the time-
GWe were seeing things that were 2B standard de.iation mo.es- se.eral da&s in a row####
$here ha.e been issues in some of the other %uantitati.e s!aces# But nothing li"e what we
saw last wee"H# $he Wall Street Mournal re!orted on August ':
th
that the =oldman Sachs
=lobal E%uit& *!!ortunities >und had lost more than 40C of its .alue the !re.ious wee"#
$he Wall Street Mournal re!orted the etent of the losses on August '0- 20075
)*fter t!e close of trading+ ,enaissance 'ec!nology #or-.+ a !edge/f$nd co-any wit! one
of t!e 0est records of recent years+ told in1estors t!at a key f$nd !as lost 2.34 so far in
*$g$st and is down 3.54 in 6773. *not!er 0ig f$nd co-any+ 8ig!0ridge #a-ital
Manageent+ told in1estors t!at its 8ig!0ridge Statistical 9--ort$nities %$nd was down
:24 as of t!e 2
t!
of t!e ont!+ and was down :;4 for t!e year. '!e <:.20n -$0lically
traded 8ig!0ridge Statistical Market Ne$tral %$nd was down =.64 for t!e ont! as of
>ednesday.... 'yk!e #a-ital+ ??# a New York 0ased ($antitati1e+ or co-$ter/dri1en+
!edge/f$nd t!at anages a0o$t <:.20n !as s$ffered losses of a0o$t 674 in its largest
!edge f$nd so far t!is ont!....@
7n loo"ing for definiti.e e!lanations for these mar"et mo.ements we are faced with a cou!le
of insurmountable obstacles5
$he e.ents are .er& recent F therefore minimal academic research has so far been
!ublished#
$he s!ecific strategies em!lo&ed b& hedge-funds are highl& commerciall& sensiti.e F
.er& unli"el& to be made !ublic#
<e.ertheless- we can ma"e a number of inferences based on obser.able mar"et data# 7t
must be said- howe.er- that these will remain as inferences until sufficient !eer-re.iewed
!a!ers ha.e been !ublished b& the academic communit&#
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25
Algorithmic Trading
$he first factor we can infer is the amount of le.erage em!lo&ed b& !artici!ants in the
StatArb s!ace# As >igure ( on !age :::: shows- the returns en?o&ed b& hedge funds has
been declining for the last 7 &ears# $he ten-fold increase of assets under management for
this sector o.er the last decade- from E'00bn to E' trillion- is the most li"el& cul!rit for this
!erformance degradation# $he increase in ca!ital chasing mar"et-neutral al!ha must clearl&
ha.e had the effect of decreasing absolute returns for all mar"et !artici!ants#
=i.en this reduction in returns- the onl& method a.ailable for hedge funds to achie.e their
e!ected return on ca!ital em!lo&ed is to increase le.erage# A !arallel de.elo!ment has
been the increase of the so called /'40K400 e%uit& funds# $hese funds maintain both long and
short !ositions in two sets of securities# >or eam!le- a E'00m fund ma& ha.e E'40m of
long !ositions on one set of securities and E40m of short !ositions in another set# $his is
currentl& the fastest growing area in the institutional mone& management business# Due to
the fact that !ortfolio construction for this t&!e of fund is more technical than for traditional
long !ortfolios- the& tend to be almost wholl& the !reser.e of %uant o!erators#
$his o.erall le.erage increase has come at a time when the correlation between returns of
different hedge funds strategies has increased mar"edl&# $he figure below is from a !a!er
from Nhandani and +o from M7$ and shows the degree of correlation for two different !eriods
1 '((: to 2000 F 200' to 2007# $hic"er lines re!resent absolute correlations greater than
B0C- thinner lines re!resent absolute correlations between 2BC and B0C- and no
connecting lines corres!ond to correlations less than 2BC#
Figure 1): "orrelation amongst 1& different "S ( 7e$mont hedge-fund inde/es over t$o su'-periods
Ce: ",: "onverti'le ,r'itrage3 DSB: Dedicated Short Bias3 >+: >merging +arkets3 >+7: >quit +arket
7eutral3 >D: >vent Driven3 FB,: Fi/ed Bncome ,r'itrage3 9+: 9lo'al +acro3 4S>1: 4ong(Short >quit
1edge3 +F: +anaged Futures3 >D+S: >vent Driven +ulti-Strateg3 DB: Distressed Bnde/3 %,: %isk
,r'itrage3 +S: +ulti-Strateg
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Algorithmic Trading
Source: 2#andani 3 4o 56IT7 & 89#at #appened to t#e quants in August 200:;- & $o!e'ber 0<( 200:
As we can see- ecluding the tumultuous e.ents e!erienced b& +$,M and others in the
industr& in August '(()- the degree of correlation of returns has increased mar"edl& o.er
the last decade# >rom this we can infer that certain strategies ha.e become homogenous
and widel& du!licated within the industr&# >urther !roof of this fact can be seen in Section
4#6#' of this document where the effecti.eness of s&stematic hedge fund re!lication
strategies is demonstrated# 7f re!lication is !ossible for the ma?orit& of funds it must follow
that the& are mostl& following the same strateg&#
$hus we ha.e a highl& le.eraged industr& that is !ursuing mostl& homogenous strategies#
What then could cause the significant losses sustained in the second wee" of August 20079
$he fact that the losses were wholl& contained within the StatArb categor& does gi.e us an
indication of the source of the mo.ement# $he ma?or e%uit& mar"ets were mostl& u! on the
da&s ehibiting the worst of the losses for the %uant funds so the origin of the mo.e must
ha.e come from within the industr& itself# 7n the M7$ !a!er from Nhandani F +o the& argue
that the most li"el& source of the mo.e was a ra!id /unwinding0 of one or more %uantitati.e
e%uit& mar"et-neutral !ortfolios# $he& contend that the magnitude of the !rice im!act im!lies
that the unwind was the result of a sudden li%uidation of a fund 1 !erha!s in an effort to
rebalance ris" in light of the sub-!rime meltdown- a margin call resulting from a deteriorating
credit !ortfolio or a com!lete change in business lines#
$his sudden mar"et mo.e would ha.e set-off a contagion amongst other funds with broadl&
similar e!osures# $heir sales to rebalance le.erage F reduce mar"et e!osure would ha.e
caused a .icious circle of selling that sent the whole categor& into freefall#
Does this re.ersal in fortunes for the StatArb sector mar" a !ermanent re.ersal in fortunes
for %uant funds9 *r can it be classified as a /Blac" Swan0 e.ent as defined b& Mr $aleb in his
boo" of the same name9 7t certainl& a!!ears as if %uant funds ha.e been mis!ricing the ris"
of their strategies to date# 7n such a crowded and highl& intra-correlated mar"et s!ace
sudden mar"et mo.ements are li"el& to be magnified into full blown meltdown# $here no
doubt eists a real and !resent danger of financial contagion for the whole sector#
Mames Montier obser.es in his !a!er from Se!tember 2007 that ris" has become
/endogenous0 in certain mar"ets 1 !articularl& those which ha.e e!erience large ca!ital
inflows# $he basics of his contention is that if a !articular !ortfolio strateg& becomes so
!o!ular that its li%uidation can affect the ris"s that it faces- then basic ris" models such as
/@alue-at-Ais"0 and normal distributions no longer hold# Eogenous ris" is usuall& the onl&
one to be modelled with endogenous ris" being ignored or discounted#
7n m& o!inion- des!ite the current mis!ricing of ris" there is no reason to discount the .alue
of %uant funds for in.estors# $he& sim!l& fall into a categor& of in.estments with relati.el&
stable a.erage !a&offs and a small !robabilit& of a large loss 1 much li"e the mar"et for
names on the +lo&ds insurance mar"et# $here is no reason to !re-su!!ose that this t&!e of
ris" !rofile is not desirable for in.estors# >or eam!le- consider the following in.estments 1
which would be the most desirable9
Bnvestment 1
*utcome ' - R7B-000 !a&off with !robabilit& of B0C
*utcome 2 - R2B-00 !a&off with !robabilit& of B0C
Bnvestment !
*utcome ' - R'00-000 !a&off with !robabilit& ()C
*utcome 2 - -R'-000-000 loss with !robabilit& 2C
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Algorithmic Trading
$he correct answer is that in terms of e!ected !a&off the two o!tions are the same 1 the
ris" sentiment of the in.estor will determine which o!tion is the most desirable#
$he other factor that 7 would contend adds weight to the .iabilit& of algorithmic-dri.en %uant
funds is the changes we can e!ect to see in the mar"et!lace as it matures# As more
institutions ado!t %uantitati.e trading strategies their "e& .alue add will be differentiation not
!oogenisation. 7n an era of declining margins for the mone& management sector there
remain onl& two .iable !rofit-see"ing strategies5
,ommoditisation 1 see" to become the !ro.ider with the lowest marginal cost
through the use of algorithmic re!lication strategies# $his will be a"in to an e!ansion
of the E$> sector into the domain of acti.el& managed funds 1 the !ro.ider with the
lowest marginal cost of !ro.ision will ha.e a differential ad.antage o.er their
com!etitors#
Differentiation 1 retain the best talent a.ailable in order to de.ise strategies that
maimise al!ha# $his will most li"el& be through the de.elo!ment of !ro!rietar&
s&stematic algorithmic trading tools that ha.e a demonstrable !erformance
ad.antage o.er their !eers# 7t will allow the maintenance of fee margins through the
!ro.ision of better than a.erage al!ha generation#
7f sufficient numbers of mar"et !artici!ants choose to differentiate their offerings from the
com!etition 2as we can reasonabl& assume the& will3 then the ris" of financial contagion will
necessaril& fall# $he amount intra-correlation between different strategies will fall and with it
the endogenous ris" contained within their !ortfolios#
). *lgorithms in the +oreign Exchange ,arkets
$he ado!tion of algorithmic trading in the foreign echange mar"ets offers a counter!oint to
that witnessed in the e%uit& mar"ets# $he u!ta"e of these tools is .er& recent but the growth
in their im!ortance is e!onentiall& faster#
5.1 )istorical context
>oreign echange 2>L3 mar"ets differ from their e%uit& !eers in so much as the& ha.e ne.er
witnessed the formation of a formalised echange to !ro.ide trans!arenc& for eecution and
settlement# $he mar"et has hitherto e.ol.ed in line with mar"et d&namics with Ban"s being
the sole !ur.e&ors of !ricing and settlement ser.ices# $hese were offered- in the main- to
cor!orate and non-financial ser.ices com!anies who re!resented the bul" of demand for
currenc& echange ser.ices# $he& are "nown as /real mone&0 clients in >L for which
currenc& trading is a necessar& !art of their commercial acti.ities# $hese clients re!resent a
com!lete s!ectrum of com!anies in.ol.ed in cross-border trade - from shi!!ing com!anies
to multinationals#
Dntil .er& recentl& all >L trading was conducted b& tele!hone and !ricing was determined b&
the one-to-one relationshi! between the client and the dealer# $his began to change when
ma?or .endors such as Aeuters and EBS began to offer inter-dealer !ricing !latforms where
the dealing ban"s could trade directl& with each other 1 thereb& enabling the !ricing and
distribution of ris" between mar"et !artici!ants# 7n res!onse to com!etiti.e !ressure trading
ban"s e.entuall& offered full .isibilit& of their !ro!rietar& trading !latforms direct to their
clients# $his did offer some means of more efficient !rice disco.er& and a measure of
electronic trading but the structure of the industr& remained .er& much the same# Ban"s
continued to act as !rice setters and full trans!arenc& was not enabled 1 differential s!read
!ricing was widel& used b& dealing ban"s whereb& fa.oured customers were offered better
!rices than those who traded smaller .olumes or less fre%uentl&#
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Algorithmic Trading
5.2 )edge *unds change the nature o" the market
$he enormous growth of hedge funds o.er the last decade has fuelled their e!ansion
be&ond their traditional domain of long K short e%uit& and deri.ati.es trading and into the >L
mar"et# >or the first time the mar"et witnessed .er& large ca!ital inflows which differed
substantiall& from the historic em!hasis on transactional acti.ities 1 this ca!ital was !urel& in
search of al!ha# $he rise in trading .olumes brought about b& the entr& of hedge funds has
been dramatic and is forecast to continue rising# $he Ban" for 7nternational Settlements
estimates that a.erage dail& >L trading .olume 2including s!ot- forwards and swa!s3 grew
from E'#2 trillion in mid 200' to E'#( trillion in mid 200: 1 a B7C increase o.er onl& three
&ears# $ABB =rou! estimates that this growth will continue in the short to medium term
dri.en b& a number of "e& trends5
=lobalisation and outsourcing within the ser.ice and manufacturing industries is
forecasted to continue its0 s!ectacular growth# $his will continue to e!and the need
for !a&ments made in multi!le currencies and concurrentl& the growth in the .olume
of /real mone&0 in the mar"et#
+ow global interest rates has internationalised sources of in.estment ca!ital 1
leading record numbers of in.estors to new mar"ets and new currenc& e!osures#
$he flow of mone& into hedge funds is !redicted to continue F with it will come a
need for mar"et !artici!ants to di.ersif& their focus into new sources of al!ha
generation#
$he enormous growth in credit and financial deri.ati.es 2dri.en largel& b& hedge
funds3 has created a resulting e!ansion in the need to manage >L e!osures#
$he ad.ent of ,ontinuous +in"ed Settlement 2,+S3 in the >L mar"ets has resulted in
the com!lete elimination of /6erstatt Settlement Ais"0 2the ris" generated b& different
legs of a transaction settling in different time Oones3# $his ris" has historicall& acted
as an inhibitor for broad acce!tance of >L as an asset class#
>igure 'B below illustrates the growth in trading .olumes- both historic and forecast
Figure 10
Source: TABB Group & 80= Algorit#'s: Bringing best e>ecution to t#e 0= 'ar)ets
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Algorithmic Trading
6edge funds built !ro!rietar& %uantitati.e models to !ursue strategies such as statistical
arbitrage and momentum-based in.estment !la&s# $he siOe of their !ortfolios meant that
ban"s were forced to offer them direct access to their electronic >L !ortals# >or the first time
trading ban"s were faced with com!eting information-based !la&ers on their own networ"s#
$he& ra!idl& mo.ed be&ond the status of clients and became !rice-setters within the >L
s!ace#
Dnli"e in the e%uit& mar"et s!ace- >L transactions are almost ne.er inhibited b& a lac" of
li%uidit&# +arge bloc"s of currencies are fre%uentl& traded and s!reads in the most traded
currencies are tight# So wh& ha.e algorithmic tools !roliferated to such an etent des!ite the
fact that the& are bereft one of their most cogent ad.antages 1 the abilit& to manage mar"et
im!act9
$he answer lies in the information as&mmetr& between the bu& F sell side# Without a
centralised echange- no normalised !ricing data and with access to !rice dri.en b& ban"ing
relationshi!s bu&-side traders are at a distinct informational disad.antage to their sell-side
!eers# Bu&-side traders are without the means to disco.er the 0est !rice at an& one !oint in
time since onl& the largest ban"ing clients are %uoted the /inside s!read0# <otwithstanding
this difficult&- the bu&-side also has little means to disguise their intentions from their sell-
side !eers# >L trades are often highl& time-critical since the& ma&- for eam!le- be hedging
transactions for trades alread& com!leted in other mar"ets# $his means that sell-side traders
can safel& offer uncom!etiti.e s!reads- safe in the "nowledge that the& must be acce!ted
due to time constraints#
Much li"e the corres!onding de.elo!ment of /dar" !ools0 in the e%uit& s!ace- >L A$Ss
began to !roliferate in the mar"et s!ace# $hese offered anon&mit&- more efficient !ricing
trans!arenc& and an o!!ortunit& to interact with alternati.e sources of li%uidit&# $his
de.elo!ment fragmented the >L mar"et and dro.e the de.elo!ment of e.er more
so!histicated DMA !latforms and algorithmic eecution strategies#
5.3 Princi&al algorithmic trading solutions
=i.en this demonstrable need for algorithmic solutions in the >L mar"et- what are the
!rimar& de.elo!ments for the bu&-side trader9
5.3.1 !"A # electrnic cnnecti$it%
$he foundation of algorithmic eecution is the !resence of electronic connecti.it& and direct
mar"et access !latforms# $he formation of these !latforms came in the late '((0s with the
entr& of third !art& !ro.iders such as ,urrene and ,>*Web# Since then electronicall&
traded >L has continued to grow as a !ercentage of total order .olume# $ABB grou!
estimates that in 2000 less than a third of >L .olume was traded electronicall&- b& 2006 this
had grown to 62C and is forecast to reach )0C b& 20'0# >igure '6 below illustrates the
ra!id u!ta"e of electronic eecution#
Figure 15
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Algorithmic Trading
Source: TABB Group & 80= Algorit#'s: Bringing best e>ecution to t#e 0= 'ar)ets
$his u!ta"e comes des!ite considerable technical hurdles in the >L mar"et# Dnli"e the
e%uit& mar"ets where the >inancial 7nformation Echange 2>7L3 ra!idl& became the
standardised as a communication !rotocol- the >L mar"et has no standardisation
whatsoe.er and connecti.it& is !ro.ided o.er man& !ro!rietar& lin"s# $his has meant that
de!lo&ment s!end for algorithmic tools is necessaril& higher than seen in the e%uit& mar"ets#
As we ha.e alread& seen- the growth of A$Ss in the >L s!ace has been ra!id in recent
&ears# $his has been distinctl& beneficial for bu&-side traders who were afforded more
effecti.e methods of !rice disco.er& and the !ossibilit& of anon&mising their trades# $his
de.elo!ment has also fuelled the im!lementation of algorithmic eecution strategies that are
able to !oll multi!le li%uidit& sources in the search for the best eecution !rice for a trade#
$he ma?or A$Ss that ha.e been formed to date include5
EBS which has traditionall& dominated mar"et share for the Euro- Ien and Swiss
franc
Aeuters which has been historicall& strong for the Sterling mar"et
+a.a and >LA77 both offer ad.anced order t&!es tailored to the use of algorithms and
ha.e attracted a significant !ro!ortion of %uant fund .olume
6otS!ot is differentiated b& its0 high s!eed- low latenc& connections which a!!eals to
hedge funds with time-sensiti.e trades
,urrene has de.elo!ed su!!ort for multi-ban" access and trade allocations which
are designed to a!!eal to the /real mone&0 cor!orate !la&ers
Bloomberg has recentl& launched $radeboo" >L which is designed as a com!etiti.e
offering to Aeuters F EBS
5.3.2 The aggregatin & pricing
As we ha.e alread& seen- the >L mar"et is becoming highl& fragmented with the shift of
li%uidit& from trading ban"s to A$Ss# $his fragmentation has dri.en the need for s!ecialised
tools that aggregate !ricing and .olume data for multi!le li%uidit& !latforms# Algorithms are
being em!lo&ed to deal with this challenge and !ro.ide the bu&-side with !rice trans!arenc&#
$hese tools act as feed handlers that se%uence and aggregate !rices from dis!arate
sources 1 this allows the order boo" to be constructed in real-time for the benefit of the
trader with both !rice and a.ailable li%uidit& being dis!la&ed# $his re!resents a ma?or shift in
the informational dis!arit& between the bu& and sell side# >or the first time bu&-side traders
Page
31
Algorithmic Trading
can direct their trades to the most efficient .enues 1 allowing a ste! change in the efficienc&
of their transactions#
5.3.3 "ulti'asset trading plat&r(s
$he encroachment of hedge funds into the >L mar"et has had the ob.ious corollar& of the
etension of their !ro!rietar& electronic order management s&stems to include >L# $his
allows them to !lace immediate matching trades 1 for eam!le the& ma& !urchase a Euro
denominated e%uit& and immediatel& hedge their Euro e!osure with a connected
transaction# $hird !art& !ro.iders such as ,harles Ai.er and Mac=regor ha.e recognised
this im!erati.e and ha.e de!lo&ed >L integration into their *MSs# Algorithmic !latform
!ro.iders ha.e also begun to add >L trading to their software suites# 8rogress software has
recentl& launched />L Mar"et Aggregation Accelerator0 whereb& clients can %uic"l&
customise algorithmic strategies using aggregated streaming !rices from a wide range of
sources#
>igure '7 demonstrates the ra!id u!ta"e in >L functionalit& as forecast b& $ABB grou!#
Figure 1;: D of >+Ss $hich support F: e/ecutions
Source: TABB Group & 80= Algorit#'s: Bringing best e>ecution to t#e 0= 'ar)ets
5.3.4 A$ailabilit% & histrical price and $lu(e in&r(atin
Dnli"e e%uit& echanges- trading ban"s in the >L s!ace ha.e alwa&s been reluctant to share
their historic !rice K .olume databases# $raditionall&- the& ha.e used this information for
trading on their own boo"s# $he mo.ement of li%uidit& towards A$Ss has considerabl&
im!ro.ed this situation for the bu&-side traders# Dnli"e ban"s- A$Ss see their !ricing histor&
databases as differential com!etiti.e offerings for their clients F thus ha.e begun to ma"e
them readil& a.ailable# >or eam!le- >LA77 recentl& launched /Accelor0 which is database
com!rising full de!th-of-boo"- com!leted trade data and historic !rices# $his has enabled the
bac"-testing and de!lo&ment of s&stematic algorithmic strategies to trade >L#
5.4 %utlook "or the "uture
$he de.elo!ment of algorithmic trading in the >L has come later than witnessed in the e%uit&
mar"ets# Des!ite this- it would seem that ado!tion is altogether more ra!id# $his can be
attributed both to the a.ailabilit& of tools and techni%ues from the e%uit& mar"ets and to the
cogenc& of the re%uirements of the bu&-side#
Page
32
Algorithmic Trading
$he technolog& !ro.iders generating the most mar"et im!act are the same as those we saw
dri.ing algorithmic ado!tion in the e%uit& mar"ets# ,redit Suisse has le.eraged their suite of
tools designed for e%uit& eecution into the >L mar"et# /=uerrilla0 is hea.il& used to find
li%uidit& and minimise mar"et im!act# />loat0 is a deri.ation of a !artici!ate strateg& designed
to com!lete a >L order within a s!ecified time frame# Barcla&s released new functionalit& for
its multi-asset BAA s&stem 2Barcla&s Automated Aeal-$ime Eecution S&stem3 allowing >L
trades to be !laced with @WA8 or $WA8 algorithms#
7t is certain 2albeit un!ublished3 that hedge funds are also leading the wa& in the
de.elo!ment of s&stematic algorithms for >L trading# $he li%uidit& of the mar"et offers them
considerable ad.antages in their !ursuit of al!ha# $he growth in the a.erage siOe of their
!ortfolios and com!etition with other funds in their sector has dri.en them to alternate trading
.enues where mar"et im!act can be minimised and !rofitabilit& maimised#
$he growth of multi-asset trading !latform such as BAA from Barcla&s is li"el& to lead to
further de.elo!ments in algorithmic trading# $he abilit& to !lace immediate cross-asset
trades will enable new forms of mar"et-neutral strategies which e!loit cross-asset
correlation# Algorithms will be instrumental in the de.elo!ment of these strategies with their
abilit& to concurrentl& trac" huge numbers of .ariables and find !atterns in historic !rice K
.olume data#
What is certain is that the structure of the >L mar"et has changed fore.er# <o longer will
trading ban"s ha.e the mono!ol& on the disco.er& and setting of !rices F s!reads#
7ncreased order flow from the bu&-side has changed the balance of !ower dramaticall& as
seen in figure ') below 1 in 2007 bu&-side .olume sur!assed that seen from inter-ban"
transactions F this trend is forecast to continue#
Figure 1<: D of dail e-F: trading volume
Source: TABB Group & 80= Algorit#'s: Bringing best e>ecution to t#e 0= 'ar)ets
- Bonds . /erivatives
.1 !he bond market
$here ha.e been a number of recent de.elo!ments in fied-income algorithmic trading with
!roduct releases b& the !rinci!al 4
rd
!art& .endors# Des!ite this- the mar"et remains nascent
Page
33
Algorithmic Trading
and .er& little !rogress has been made in the migration of trading to full& electronic
channels# $here are a number of structural im!ediments in the bond mar"et which !re.ent it
from su!!orting these new eecution models#
Mar"et !rice data is not widel& a.ailable in real-time electronic form# Whilst data on
go.ernment bonds for the ma?or economies are widel& a.ailable in real-time- the
same is not the case for cor!orate bonds where !rice data is u!dated !eriodicall& b&
bro"ers# $his lac" of !rice data is a serious im!ediment to the de.elo!ment of real-
time algorithmic eecution channels#
+i%uidit& !oses challenges for most fied-income instruments outside of the most
acti.el& traded go.ernment issues# $his is due to the fact that the mar"et is
considerabl& broader than that seen in e%uities or >L 1 there are a!!roimatel&
6-000 e%uities listed on the <ISE F <ASDA; com!ared with more than 2#7 million
fied-income instruments in the DS alone# >inding an actionable bid K offer can be
etremel& challenging and would be close to im!ossible for full& electronic eecution#
Bonds are non-fungible and often difficult to .alue# Differences in credit ratings-
maturit& dates- issue dates F !a&ment structures ma"e it near im!ossible for
s&stematic algorithmic .aluation metrics to be em!lo&ed#
Much li"e the >L mar"et from a few &ears ago- fied-income instruments are traded
in an o.er-the-counter mar"et dominated b& a select grou! of dealers# Dealers trade
with other dealers through inter-dealer !latforms such as $radeWeb or Mar"etAess
whereas clients can deal onl& through dealers who are members of these !latforms#
<o alternate sources of li%uidit& eist and thus anon&mit& is im!ossible to achie.e#
Des!ite these challenges there is no reason wh& algorithms can0t ha.e .alid a!!lications in
the fied income mar"et# $he form of interaction is unli"el& to be in the form of /blac" bo0 or
full& automated trading s&stems- but there ma& be other .iable %uantitati.e anal&sis
a!!lications# $hese could !ro.ide more com!le .aluation insights- automated ris"
strategies and s&nthetic securities arbitrage# 6owe.er the !hone is li"el& to remain as the
onl& .iable eecution !latform for the foreseeable future#
.2 Deri+ati+es
Mar"et !artici!ants in the futures and o!tions mar"et widel& em!lo& algorithmic tools but
the& differ mar"edl& from that seen in the e%uit& and >L s!ace# $here is a cogent need for
%uantitati.e tools when trading instruments of such com!leit&- but electronic mar"et access
is !atch& and li%uidit& remains a challenge# >igure '( below is sourced from a March 2007
sur.e& of e%uit& deri.ati.e traders which ran"ed their ma?or issues of concern#
Figure 1=: Biggest challenges faced ' equit derivatives traders
Page
34
Algorithmic Trading

Source: TABB Group & 8Equity ,eri!ati!es ?esearc# & 6arc# 200:-
$he reason for the lac" of li%uidit& once again falls to the breadth of the mar"et 1 deri.ati.e
contracts s!an a wide range of maturities- stri"e !rices and contract structures# *nl& the
most acti.el& traded instruments ha.e sufficient li%uidit& to enable full& electronic eecution#
$he lac" of electronic interfaces a.ailable is !rimaril& due to the fact that most of the
deri.ati.es echanges ha.e onl& recentl& mo.ed awa& from eclusi.el& o!en-outcr& mar"ets
2man& still remain3#
7n s!ite of the challenges facing algorithmic trading in the deri.ati.es mar"ets- man& industr&
obser.ers are !redicting ra!id u!ta"e of full& electronic eecution o.er the net few &ears#
$ABB grou! !redicts that more than (0C of all futures contracts will be traded electronicall&
b& 20'0# ,orollar& increases in traded .olume are also forecast 1a 40C com!ound annual
rate o.er the net three &ears to o.er B#(bn futures contracts traded in 20'0# $his increased
li%uidit& along with better de.elo!ed electronic eecution channels could s!ur considerable
de.elo!ment in algorithmic tools 1 much li"e that seen within the >L mar"et o.er the last few
&ears#
0 Proo' o' e''icacy
$o set about demonstrating the efficac& of algorithmic tools is be&ond the sco!e of this
!a!er# 7n order to ha.e some measure of !erformance we would need access not onl& to the
!ro!rietar& algorithmic models em!lo&ed b& mar"et !artici!ants- but also granular data on
their trading histor&# $his information remains far too commerciall& sensiti.e to be addressed
in an&thing other than a confidential internal !a!er# <e.ertheless- we can ma"e some
inferences on the .iabilit& of these tools both from their rate of ado!tion and the
amalgamated !erformance of in.estment sub-sectors which are "nown to be hea.il& reliant
on s&stematic algorithmic strategies#
>rom con.ersations with industr& !artici!ants such as Ste!hane +ero& 2head of global sales
for 4
rd
!art& software !ro.ider ;uanthouse3 it is a!!arent that the ado!tion of algorithmic
eecution strategies is now nearl& uni.ersal for both the bu& and sell-side# $he efficac& of
these tools is in no doubt for industr& !artici!ants 1 whether the& are using im!act-reduction
strategies such as =uerrilla or @WA8 or .olume ca!turing tools such as 8artici!ate# $here is
a widel& held o!inion in the financial communit& that algorithmic eecution not onl& im!ro.es
trading efficienc& and lowers im!act cost- but it also greatl& im!ro.es the !roducti.it& of
traders who are able to s!end more of their time on more com!le trades where the& can
add more .alue# $he considerable in.estment made in the de.elo!ment of these tools is
Page
35
Algorithmic Trading
!roof enough of their efficac& 1 it is hard to concei.e of wh& in.estment ban"s would ma"e
these commitments without the e!ectation of a !ositi.e return#
Establishing %uantitati.e metrics for the efficac& of s&stematic algorithmic strategies is
altogether more difficult# Anecdotal e.idence of the !rofitabilit& of these strategies is
a.ailable 2for eam!le the =lobal Al!ha fund from =oldman Sachs is re!orted to ha.e
achie.ed returns in ecess of '00C for a number of &ears following its0 ince!tion3 but
detailed metrics are not# Bac"-testing s!ecific im!lementations of /blac" bo0 trading
strategies is clearl& im!ossible 1 the detailed wor"ings of such tools is highl& confidential#
Well "nown funds that are "nown to use algorithmic tools such as =lobal Al!ha do not
!ublicall& di.ulge !erformance data so cannot be directl& used as a !ro&# 6ow then can we
deri.e some measure of !erformance for these s&stematic strategies9
Some measure of !erformance can be deri.ed from the best "nown inde for hedge funds 1
,redit Suisse K $remont 6edge >und 7nde# Whilst the aggregated !erformance data of the
entire inde offers little in the wa& of e!lanator& !ower 2since not all of the funds trac"ed are
using s&stematic algorithmic strategies3- loo"ing at sub-sectors does !ro.ide some useful
data#
Ta'le !: +onthl Performance #vervie$ of "redit Suisse ( Tremont 1edge Fund Bnde/
Data as of #ct &13 !??;
Bnde/ ( Su'
Strategies "urrenc Aalue #ct ?; .TD 1 .ear
,vg
,nnl
E
Std Dev
EE
Sharpe
EEE
,redit
SuisseK$remont
6edge >und
7nde
DSD :47#0) 4#'6C '4#:'C '7#))C ''#2BC 7#B2C 0#(6
,on.ertible
Arbitrage
DSD 440#'7 2#')C 7#')C (#(2C (#02C :#B7C '#'0
Dedicated
Short Bias
DSD 70#'B -2#:(C -4#(4C -)#60C -2#B4C '6#67C -0#4(
Emerging
Mar"ets
DSD 4)2#2' B#:)C 20#(:C 2)#40C '0#')C 'B#64C 0#:0
E%uit& Mar"et
<eutral
DSD 474#)7 '#B0C )#':C '0#'BC '0#00C 2#):C 2#'2
E.ent Dri.en DSD :)7#:7 2#('C ':#77C '(#02C '2#'4C B#B0C '#:)
Distressed DSD B7B#7) '#:'C (#72C '4#44C '4#:(C 6#'4C '#BB
Multi-
Strateg&
DSD ::(#B' 4#):C ')#B:C 24#2(C ''#:)C B#()C '#2B
Ais"
Arbitrage
DSD 2('#'B 2#'4C '0#4:C ':#22C )#04C :#'4C 0#()
>ied 7ncome
Arbitrage
DSD 24:#:' '#'BC 4#)7C B#):C 6#4BC 4#66C 0#6:
=lobal Macro DSD 602#)( 2#72C 'B#)2C '(#0)C '4#)7C '0#:)C 0#(:
+ongKShort
E%uit&
DSD B07#B7 4#74C 'B#'BC 20#6'C '2#:6C (#):C 0#)6
Managed
>utures
DSD 2:'#6( :#06C 6#6(C '4#:7C 6#B(C ''#()C 0#22
Multi-Strateg& DSD 466#47 4#02C ''#7'C '6#26C '0#04C :#40C '#:0
Source: %%%+#edgeinde>+co'
*f all the '4 sub-sectors co.ered b& the ,S K $remont 7nde 7 would contend that E%uit&
Mar"et <eutral is the best !ro& for algorithmic strategies# >unds in this sector are "nown to
concentrate on Statistical Arbitrage and other %uantitati.e strategies based around .olatilit&
arbitrage and stochastic oscillation#
Page
36
Algorithmic Trading
$he E%uit& Mar"et <eutral sub-sector does show desirable ris"-ad?usted returns# $he
Shar!e Aatio 2as defined below3 is 2#'2 1 the highest of all sub-sectors of the 7nde and
considerabl& better than seen for the bul" of mutual funds# $he ,S K $remont 7nde
calculates the Ais" >ree rate from the rolling (0 da& $reasur& Bill rate#
$he Shar!e ratio is a reward-to-.ariabilit& ratio which measures the ecess return !er unit of
ris" for an in.estment or !ortfolio# S is the standard de.iation of the ecess return- , is the
return on the asset- ,f is the ris"-free rate of return F ET, U ,fV is the e!ected .alue of the
asset return o.er the ris"-free rate# $he formula is gi.en below5
-
$he standard de.iation of returns 2monthl& standard de.iation annualised3 is also the lowest
for the 7nde at onl& 2#):C#
Difficulties arise- howe.er- when benchmar"ing absolute returns# A common strateg& would
be to use broad stoc" indees such as the SF8 B00 as a !erformance benchmar" but the
correlation of returns should not 2in theor&3 be high because the strateg& is designed to
eliminate Beta ris" altogether#
Figure !?: >quit +arket 7eutral Strateg 'enchmarking
Source: %%%+#edgeinde>+co'
6ow then can we assess the ris" K reward trade-off for strategies dri.en b& s&stematic
algorithms9 Ael&ing on historic .olatilit& as a measure of ris" is clearl& dangerous in light of
the e.ents of August 2007 as discussed in Section :#2# Strategies such as these
e!erienced considerable losses o.er a .er& short !eriod 1 an e.ent not seen to date in the
short histor& of their usage# 6istoric !erformance data suggests a desirable ris" K reward
trade-off with .er& low .olatilit& of returns# 7 would !osit that what we are seeing is the ris" for
this categor& being confined to the tail of a 8areto distribution# $his would be characterised
b& a high !robabilit& of reasonable returns with low .olatilit& F a small ris" of significant
.olatilit& with accom!an&ing losses# *nce these funds ha.e been acti.e for sufficient time to
build u! a com!lete historical !icture we will be more certain of their ris" !rofile# Dntil then it
would seem as if the ris" contained within these %uant funds is being mis!riced#
Page
37
Algorithmic Trading
$o date it would seem most %uantitati.e funds in the StatArb s!ace ha.e been following
broadl& similar in.estment criteria as demonstrated b& the uniformit& of losses suffered b&
funds in this area in August of 2007# $he resulting ris" of financial contagion 2discussed in
Section :#23 is the most li"el& cul!rit for the sudden and une!ected .olatilit& increases
witnessed o.er recent months# $he sector has attracted a great deal of ca!ital and mar"et
mo.ements are necessaril& eacerbated b& the uniformit& of their trading decisions# 7t is
!ossible that this ris" will be ameliorated as com!eting funds loo" to differentiate themsel.es
from their !eers# ,ertainl&- there is am!le sco!e for a wide range of !rofitable e%uit& mar"et
neutral strategies to co-eist without ha.ing to resort to the re!lication of strategies# Should
this differentiation occur in the future then we can be certain that the inherent ris" of the
sector will decline#
1 *n overvie2 o' the market#lace 'or algorithmic tools
$he mar"et for algorithmic tools is highl& fragmented- as can be e!ected for such a new
industr&# $he mi of hedge funds- in.estment ban"s- bro"ers and 4
rd
!art& software su!!liers
!ro.ide a di.erse range of tools ranging from highl& s!ecialised a!!lications to com!lete
software !latforms# >rom m& discussions with 4
rd
!art& software su!!liers it would a!!ear
that the& .iew their customers as re!resenting the !rimar& com!etiti.e threat# 7n-house
de.elo!ment of algorithmic tools remains .er& much the norm due to understandable
concerns o.er confidentialit& and com!etiti.e .alue-add# $he /bulge brac"et0 in.estment
ban"s !urchase little 2if an&3 software ser.ices from 4
rd
!arties# Smaller !la&ers within the
hedge fund and in.estment ban" industries remain the !rimar& consumers of such ser.ices#
7t is credible that this situation ma& change in the medium to long term# Antici!ated margin
declines for intermediaries within the in.estment ban" sector o.er the net few &ears will
im!el them to see" reductions in their o!erating e!enses# *ne li"el& candidate for cost
sa.ings would be the considerable budgets consumed b& in-house algorithmic de.elo!ment#
Aeliance on 4
rd
!art& software !latforms would enable them to com!ete technologicall&
whilst still retaining their .alue-add in the form of !ro!rietar& algorithmic models for eecution
and s&stematic trading strategies# 7 would !osit that an e!ansion in the mar"et for these 4
rd

!art& !latforms would lead to some degree of standardisation and consolidation for the
industr&# $he well "nown !hrase /&ou ne.er get fired for bu&ing 7BM0 must hold true for such
mission critical tools#
7n the D#S# mar"et it would a!!ear that the leading 4
rd
!art& software su!!lier is 8rogress
Software# 7n the Euro!ean mar"et ;uant6ouse 2a recent s!in-off from a hedge fund3 has
had considerable success#
$he list of !artici!ants contained in the A!!endi below re!resents those that 7 ha.e
encountered during the course of m& research and is b& no means ehausti.e# 7nformation
for the list comes both from the director& at ad.ancedtrading#com and from !rimar&
inter.iews conducted b& m&self#
*##endix 1 " #rinci#al market #artici#ants
,egis Soft$are
A
rd
-arty software s$--lier
Product
Page
38
Algorithmic Trading
*t!ena'rader is a software !latform which su!!orts e%uities- futures- o!tions and foreign
echange# Su!!orts a wide range of algorithmic strategies for both the bu& and sell side#
,lgorithms Supported
,lose- S!read 28airs3 $rading- ,rossing- Slicer- ,a!K>loor 8rice- Discretion- 8egging- Delta
6edge- =amma 6edge- Small *rder- 8ercent of @olume- +ongKShort- Ais" Arbitrage-
Statistical Arbitrage- 7nde Arbitrage- Arri.al 8rice- *rder Staging Model- Sensiti.it&- $@*+-
$WA8- @WA8
D+, interfaces supported
Athena =atewa& Ser.er- D<L Electronic Agenc& Bro"erage- $radeStation- $ownsend
Anal&tics Aeal$ic"- Sungard $radingKBro"er Direct D2- AED78lus- Ao&alblue >idessa-
8ortware- <e$rend- <eo.est- MB$ 7nstitutional- +ime Eecution 8latform- +a.a $rading
>loor- +a.a ,olorBoo"- 7$= $riton- 7$= Aadical- 7nstinet Direct Mar"et Access- >leDMA-
Edge$rade EMS- DE
"lient overvie$
B0C hedge funds- 20C mutual funds F 40C sell side
Plans for future features
8ost-trade re!orting- customised algorithms- multi-echange connecti.it& F !ortfolio
o!timisation
Bank of ,merica
Broker
Product
Electronic 'rading Ser1ices offers multi!le /dar" !ool0 connections as well as so!histicated
algorithmic su!!ort to o!timise trading !erformance
,lgorithms supported
Small *rder- Arri.al 8rice- *rder Staging Model- Sensiti.it&- $@*+- $WA8- @WA8
D+, interfaces
<KA 2bro"er3
"lient #vervie$
)0C hedge funds F 20C other
Plans for future features
8ro!rietar& algorithmic de.elo!ment and international echange connecti.it&#
Barclas "apital
Broker
Product
B*," offers multi!le asset class trading 2including fied income3 using so!histicated
algorithmic strategies#
,lgorithms supported
S!read 28airs3 $rading- Slicer- ,a!K>loor 8rice- 8egging- $WA8- @WA8
D+, interfaces
8ortware- ,harles Ai.er- Bloomberg
Page
39
Algorithmic Trading
"lient #vervie$
60C hedge funds- 20C mutual funds F 20C other
Plans for future features
8ost-trade !erformance metrics 2transaction cost anal&sis3 F international echange
connecti.it&#
Bear Stearns
Broker
Product
E.*.S.'. is an eecution !latform that allows the usage of com!le algorithmic strategies to
o!timise trading !erformance- maintain anon&mit& and connect with multi!le li%uidit&
sources#
,lgorithms supported
S!read 28airs3 $rading- Slicer- ,a!K>loor 8rice- 8egging- 8ercent of @olume- +ongKShort-
Ais" Arbitrage- Statistical Arbitrage- 7nde Arbitrage- Arri.al 8rice- *rder Staging Model-
$@*+- $WA8- @WA8
D+, interfaces
All orders are eecuted through Bear Stearns DMA
"lient #vervie$
<KA
Plans for future features
*ngoing algorithmic de.elo!ment- connecti.it& to international echanges F multi-asset
class trading
Bloom'erg Trade'ook
'ec!nology -ro1ider B 0rokerage
Product
*l-!aPro is a suite of algorithmic strategies designed to o!timise the eecution !erformance
of trades going through the Bloomberg !latform#

,lgorithms supported
Dser customiOed algorithms- ,rossing- Slicer- ,a!K>loor 8rice- Discretion- 8egging- Scaling-
Small *rder- 8ercent of @olume- Arri.al 8rice- *rder Staging Model- Sensiti.it&- $@*+-
$WA8- @WA8
D+, interfaces
Bloomberg $radeboo"
"lient #vervie$
<KA
Plans for future features
<KA
"iti9roup
Broker B dealer
Product
Page
40
Algorithmic Trading
Electronic exec$tion is offered to all institutional clients which is combined with !ro!rietar&
algorithmic strategies# /Dar" !ool0 access is built-in#
,lgorithms supported
,lose- ,rossing- Slicer- 8egging- Small *rder- 8ercent of @olume- Arri.al 8rice- $@*+-
$WA8- @WA8
D+, interfaces
+a.a $rading >loor- +a.a ,olorBoo"
"lient #vervie$
40C hedge funds- 70C mutual funds
Plans for future features
Multi-asset class trading- ongoing algorithmic de.elo!ment F international echange
connecti.it&
"redit Suisse
Broker B dealer
Product
*d1anced Exec$tion Ser1ices C*ESD is the !rinci!al !latform used b& the ban" for
international securities trading#
,lgorithms supported
Signal Aeduction Strategies- ,lose- S!read 28airs3 $rading- ,rossing- Slicer- 8egging- Delta
6edge- =amma 6edge- Scaling- Small *rder- 8ercent of @olume- Arri.al 8rice- $WA8-
@WA8
D+, interfaces
<KA 2bro"er3
"lient #vervie$
:0C hedge funds- :0C mutual funds F 20C other#
Plans for future features
Multi-echange connecti.it&- ongoing algorithmic de.elo!ment F !ost-trade !erformance
monitoring
Deustche Bank
Broker B dealer
Product
*$to0a!n E($ity is a suite of algorithmic tools designed to maimise eecution !erformance
for both Deutche Ban" !ro!rietar& trading and institutional clients#
,lgorithms supported
8ercent of @olume- Arri.al 8rice- @WA8
D+, interfaces
<KA 2bro"er3
"lient #vervie$
<KA
Page
41
Algorithmic Trading
Plans for future features
E!ansion of algorithmic suite to all traded mar"ets
>6:
A
rd
-arty software s$--lier
Product
iSer1er is a !lug-in module designed to accom!an& a firms0 eisting algorithmic
infrastructure# 7t can be used for .arious StatArb strategies as well as eecution algorithms
such as @WA8
,lgorithms supported
,ustom Designed 2!ro!rietar& client algorithms3#- S!read 28airs3 $rading- Slicer- +ongKShort-
Statistical Arbitrage- $@*+- $WA8- @WA8
D+, interfaces
+ime Eecution 8latform F most DMAs through the >7L !rotocol
"lient #vervie$
60C hedge funds- 20C mutual funds- 20C other
Plans for future features
$ransaction cost anal&sis- integration with other 4
rd
!art& tools F multi-asset class trading
Fle/Trade Sstems
A
rd
-arty software s$--lier
Product
>le$rade Exec$tion Manageent Syste !ro.ides users with a suite of tools enabling both
algorithmic eecution and s&stematic strategies# $he !roduct co.ers multi!le asset classes
and DMA interfaces
,lgorithms supported
Auto >L 6edging- ,lose- S!read 28airs3 $rading- ,rossing- Slicer- ,a!K>loor 8rice-
Discretion- 8egging- Delta 6edge- =amma 6edge- Scaling- Small *rder- 8ercent of @olume-
+ongKShort- Ais" Arbitrage- Statistical Arbitrage- 7nde Arbitrage- Arri.al 8rice- *rder Staging
Model- Sensiti.it&- $@*+- $WA8- @WA8
D+, interfaces
>leDMA 2!ro!rietar&3
"lient #vervie$
20C hedge funds- :0C mutual funds F :0C sell-side
Plans for future features
8erformance monitoring- international echange connecti.it&
)
th
Stor
A
rd
-arty software s$--lier
Product
E1erglades is a !latform designed to o!timise algorithmic eecution strategies# 7t includes
real-time !erformance monitoring and considerable sco!e for client customisation#
,lgorithms supported
Page
42
Algorithmic Trading
,ustom Designed b& firms 2!ro!rietar& client algorithms3- S!read 28airs3 $rading- Slicer-
+ongKShort- Statistical Arbitrage- $WA8- @WA8
D+, interfaces
<KA
"lient #vervie$
70C hedge funds- 40C other
Plans for future features
Su!!ort for multi!le asset classes- !re-trade cost anal&sis F the de.elo!ment of customised
algorithms
Bnstinet
Broker
Product
Enstinet *lgorit!ic trading is a.ailable both through the 7nstinet $rading 8ortal and 4
rd
!art&
s&stems through >7L# Designed to le.erage the li%uidit& and international reach offered b&
7nstinet with ad.anced algorithmic eecution strategies
,lgorithms supported
S!read 28airs3 $rading- ,rossing- Slicer- Discretion- 8egging- Small *rder- 8ercent of
@olume- Ais" Arbitrage- Arri.al 8rice- $@*+- $WA8- @WA8
D+, interfaces
7nstinet Direct Mar"et Access 2and others through >7L3
"lient #vervie$
70C hedge funds- 40C mutual funds
Plans for future features
8ortfolio o!timisation- !re-trade cost anal&sis
4ehman Brothers
Broker B dealer
Product
?e!an Brot!ers Exec$tion C?M"D is an algorithmic eecution suite a.ailable in '(
countries# *ffers both off-the-shelf and customised algorithmic models#
,lgorithms supported
Ad.anced Strateg& $ool"it 2algorithm customiOation framewor"3- ,lose- S!read 28airs3
$rading- ,rossing- Slicer- ,a!K>loor 8rice- Discretion- 8egging- Delta 6edge- Scaling- Small
*rder- 8ercent of @olume- Ais" Arbitrage- Statistical Arbitrage- Arri.al 8rice- *rder Staging
Model- Sensiti.it&- $@*+- $WA8- @WA8
D+, interfaces
$ownsend Anal&tics Aeal$ic"
"lient #vervie$
B0C hedge funds- B0C institutional
Plans for future features
8ortfolio o!timisation- ongoing algorithmic de.elo!ment F multi-asset class trading
Page
43
Algorithmic Trading
+errill 4nch
Broker B dealer
Product
Glo0al Electronic 'rading encom!asses a full suite of trading tools from high to no touch#
,lgorithms supported
,lose- ,rossing- Slicer- ,a!K>loor 8rice- Discretion- 8egging- Scaling- Small *rder- 8ercent
of @olume- Arri.al 8rice- *rder Staging Model- Sensiti.it&- $@*+- $WA8- @WA8
D+, interfaces
$ownsend Anal&tics Aeal$ic"- AED78lus- Ao&alblue >idessa- 8ortware- <eo.est- +a.a
$rading >loor- +a.a ,olorBoo"- 7$= $riton- 7$= Aadical- 7nstinet Direct Mar"et Access-
>leDMA
"lient #vervie$
<KA
Plans for future features
8ortfolio o!timisation will shortl& be released
+organ Stanle
Broker B dealer
Product
Electronic 'rading Ser1ices is a suite of algorithmic tools offered in the D#S#- E#D# and Asia#
7ncludes trading ca!abilit& for e%uities- o!tions and futures
,lgorithms supported
,lose- S!read 28airs3 $rading- ,rossing- Slicer- Discretion- 8egging- =amma 6edge-
Scaling- Small *rder- 8ercent of @olume- +ongKShort- Arri.al 8rice- *rder Staging Model-
Sensiti.it&- $@*+- $WA8- @WA8
D+, interfaces
<KA
"lient #vervie$
70C hedge funds- 40C mutual funds
Plans for future features
,ross-echange connecti.it& F ongoing de.elo!ment of algorithmic tools
Port$are
A
rd
-arty software s$--lier
Product
Portware Professional+ Portware Enter-rise and Portware Strategy Ser1er com!rise a
centralised software !latform for cross-asset- international algorithmic eecution# $he
!roduct is su!!lied with standardised algorithms and offers the ca!abilit& for the creation of
customised algorithmic strategies
,lgorithms supported
,lose- S!read 28airs3 $rading- ,rossing- Slicer- ,a!K>loor 8rice- Discretion- 8egging- Delta
6edge- =amma 6edge- Scaling- Small *rder- 8ercent of @olume- +ongKShort- Ais"
Page
44
Algorithmic Trading
Arbitrage- Statistical Arbitrage- 7nde Arbitrage- Arri.al 8rice- *rder Staging Model-
Sensiti.it&- $@*+- $WA8- @WA8
D+, interfaces
Multi!le connecti.it& a.ailable through >7L
"lient #vervie$
60C hedge funds# '0C mutual funds F 40C sell-side firms
Plans for future features
>urther integration with bro"er !latforms F !ortfolio o!timisation
Progress Soft$are
A
rd
-arty software s$--lier
Product
Progress *-aa is a highl& customisable software !latform that enables both the bu& and
sell-side to le.erage their algorithmic trading strategies into customised a!!lications# $he
software comes with a gra!hical de.elo!ment en.ironment enabling eas& customisation and
de!lo&ment of !ro!rietar& strategies
,lgorithms supported
8ro!rietar& algorithms 2through user customisation3- ,lose- S!read 28airs3 $rading-
,rossing- Slicer- ,a!K>loor 8rice- Discretion- 8egging- Delta 6edge- =amma 6edge-
Scaling- Small *rder- 8ercent of @olume- +ongKShort- Ais" Arbitrage- Statistical Arbitrage-
7nde Arbitrage- Arri.al 8rice- *rder Staging Model- Sensiti.it&- $@*+- $WA8- @WA8
D+, interfaces
D<L Electronic Agenc& Bro"erage- $radeStation- $ownsend Anal&tics Aeal$ic"- Sungard
$radingKBro"er Direct D2- AED78lus- Ao&alblue >idessa- 8ortware- <e$rend- <eo.est-
MB$ 7nstitutional- +ime Eecution 8latform- +a.a $rading >loor- +a.a ,olorBoo"- 7$= $riton-
7$= Aadical- 7nstinet Direct Mar"et Access- >leDMA- Edge$rade EMS- DE
"lient #vervie$
:0C 6edge >unds- '0C Mutual >unds- B0C Sell-Side >irms# ,lient list includes ma?or
bro"erages such as M8 Morgan and Deutsche Ban"
Plans for future features
De.elo!ment of /genetic0 algorithms enabling continual fine-tuning of strategies
Fuant1ouse
A
rd
-arty software s$--lier
Product
F$ant%actory offers a full suite of tools to enable algorithmic trading# >rom F$antEngine 1 a
no-touch eecution !latform for customised algorithmic strategies to F$antGe1elo-er 1 a
framewor" and 7DE for the de.elo!ment of trading strategies# 7nfrastructure ser.ices are also
offered to ma"e the ,om!an& a one-sto!-sho! for the de!lo&ment and customisation of an
algorithmic trading !latform
,lgorithms supported
,lose- S!read 28airs3 $rading- ,rossing- Slicer- ,a!K>loor 8rice- Discretion- 8egging- Delta
6edge- =amma 6edge- Scaling- Small *rder- 8ercent of @olume- +ongKShort- Ais"
Arbitrage- Statistical Arbitrage- 7nde Arbitrage- Arri.al 8rice- *rder Staging Model-
Sensiti.it&- $@*+- $WA8- @WA8
Page
45
Algorithmic Trading
D+, interfaces
<KA
"lient #vervie$
70C hedge funds# 40C bu&-side firms
Plans for future features
<KA
GBS
Broker B dealer
Product
Girect Strategy *ccess CGS*D le.erages the li%uidit& of the DBS +i%uidit& <etwor" to enable
crossing orders to ta"e !lace efficientl&# A full& featured algorithmic suite allows institutional
clients to eecute a number of !o!ular algorithmic eecution tools
,lgorithms supported
87< ,om!lete- ,lose- S!read 28airs3 $rading- ,rossing- Slicer- ,a!K>loor 8rice- Discretion-
8egging- Delta 6edge- =amma 6edge- Scaling- Small *rder- 8ercent of @olume-
+ongKShort- Ais" Arbitrage- Statistical Arbitrage- 7nde Arbitrage- Arri.al 8rice- *rder Staging
Model- Sensiti.it&- $@*+- $WA8- @WA8
D+, interfaces
$rading Screens- DBS E%uit& $rader- $eth&s $echnologies- D<L Electronic Agenc&
Bro"erage- $ownsend Anal&tics Aeal$ic"- Ao&alblue >idessa- 8ortware- <eo.est- +a.a
$rading >loor- >leDMA
"lient #vervie$
<KA
Plans for future features
>urther international integration- !ortfolio o!timisation and further de.elo!ment of !ro!rietar&
algorithms
*##endix 2 3 a&les
Figure !1: 9lo'al return on equit trendline for financial services industries 1==) - !?10
Page
46
Algorithmic Trading
Source: IB6 Global Business Ser!ices & 8 T#e trader is dead( long li!e t#e trader-
4e'erences
,dvanced Trading 1 /,itigrou! targets hidden li%uidit&0 1 Se-te0er 6;+ 677;
,dvancedtradingHcom 1 Algorithmic trading director&
,ndre$ Pole 1 Statistical Arbitrage- Algorithmic $rading 7nsights and $echni%ues - 6773
Bloom'ergHcom 1 /Does Al!ha-Beta S!ell W$he EndX for Mutual >unds90 1 Gece0er :H+ 677;
Business Week @ /Big traders di.e into dar" !ools0 1 9cto0er A+ 6773
"oates 8 Baumgartner I+organ StanleJ 1 /8ortable Al!ha5 A !ractitioner0s guide0 - 6773
"redit Suisse ( Tremont 1edge Bnde/ 1 www#hedgeinde#com
Dr Do''*s Kournal 1 /Algorithmic $rading0 1 Marc! 7H+ 6773
Financial 7e$s #nline 1 /Dar" !ools of li%uidit& come into the light0 1 9cto0er 7:+ 6773
Financial 7e$s #nline @ /Dar" !ools thrust into the limelight as com!etition increases0 1 Se-te0er
:7+ 6773
Financial Times @ /Ban"s begin to di! into /dar" !ools0 1 9cto0er :2+ 677;
Fung 8 1sieh 1 /6edge >und re!lication strategies5 im!lications for in.estors and regulators0 1 *-ril
6773
BB+ 9lo'al Business Services 1 /$he trader is dead- long li.e the traderY0 1 *-ril+ 677;
Kames +ontier 1 /$he m&th of eogenous ris" and the recent %uant !roblems0 1 Se-te0er+ 6773
Chandani 8 4o I+BTJ 1 /What ha!!ened to the %uants in August 200790 1 No1e0er 75+ 6773
4ord Tennson 1 /7n Memoriam A#6#60
7assim 7icholas Tale' 1 /$he Blac" Swan5 $he 7m!act of the 6ighl& 7m!robable0 1 May 7A+ 6773
T,BB 9roup 1 /Bonds ain0t stoc"s0 1 9cto0er 677=
T,BB 9roup 1 />L Algorithms5 Bringing best eecution to the >L Mar"ets0 1 Se-te0er+ 6773
T,BB 9roup 1 /*utloo" on Algorithms5 <ew de.elo!ments in electronic trading0 1 %e0r$ary+ 677;
T,BB 9roup 1 /Who0s afraid of the big bad#######Algorithm90 1 Se-te0er 7:+ 677=
The >conomist @ /$he march of the robo-traders0 1 Se-te0er :=+ 677=
The Trade 1 /Algorithmic $rading- a bu&-side handboo"0 1 Se!tember- 200B
Traders +aga2ine @ /Dar"ness at high noon0 1 Ian$ary A:+ 6773
Wall Street Kournal - /7m!act of mortgage crisis s!eadsP Dow tumbles 2#)C as fallout intensifiesP
Mo.es b& central ban"s0 1 *$g$st :7+ 6773
Walters +aga2ine @ /Dar" !ools- clear results0 1 Se-te0er 7:+ 677;
Wikipedia 1 /0Shar!e Aatio0
Wikipedia 1 /Blac" Monda&0
Wikipedia @ /+ong $erm ,a!ital Management0
.ale School of +anagement 1 /8airs trading5 !erformance of a relati.e .alue arbitrage rule0 1
%e0r$ary 63+ :HH3
*ckno2ledgments
Ste!hane +ero& 1 ;uant 6ouse
Mar& Waggoner 1 atdes"
Michael Aoss 1 $ABB =rou!
>rancesca +oo 1 $ABB =rou!
Ste.e Smith 1 :
th
Stor&
Edouard AIS$ 1 D+ <et
Page
47
Algorithmic Trading
Michael 6ammond 1 ,it& ,a!ital
Marc Aobbert-Aasmussen 1 ,it& ,a!ital
8aul =leeson 1 ,it& ,a!ital
Page
48