By Vaibhav Sagar, Senior Technology Consultant, Open System Tech
Higher buy-side expectations and the rapidity of technological advances means a shift to low touch trading will continue.
Back in the day, most market making and client order execution was carried out by human traders. So-called high touch trading was often an opaque process, vulnerable to latency and susceptible to front-running. Since there was no way for buy-side clients to monitor how the broker desks dealt with their orders, there was always an element of mistrust and misjudgment.
A typical high touch order flow involved buy-side orders being sent to sell-side dealers with a limit price range to work on. The sell-side trader would first try and cross an order with other client flow and then maybe cross it with their own book positions. If these approaches failed, the broker would try their best to slice-and-dice the order in the open market.
This process had the advantages and disadvantages of using a trader’s judgement, networks and biases. Manual trading also carried the risk of higher slippage and market impact. Moreover, there wasn’t a smart way to conduct transaction cost analysis or measure market impact.
Arguably, high touch trading often made good sense for illiquid stocks. On the other hand, for liquid, high turnover stocks it was inefficient.
As a result, many buy-side clients started preferring direct market access (DMA) orders where they used brokers’ exchange connectivity pipes to reach their exchange of choice and route orders accordingly. This helped solve the trust and front-running issues, but failed to tackle the problems associated with smart trading and market impact. DMA orders could be used to send orders to target exchanges, but that does not necessarily mean they target the high liquidity exchanges.
Many large quant and high volume shops also insisted on liquidity seeking executions that had minimum market impact and successfully managed market risks. Since the buy-side firms’ primary concern was the investment decision, they allowed trading intelligence to be handled by sell-side broker dealers.
Now, of course, with the advancement in computing power, data storage and data analytics, more and more trading is automated. Algorithms are designed to target venues with maximum liquidity and are also adaptive to changing market conditions to reduce market impact. They are configurable and can be tuned to behave in a passive, neutral or aggressive manner depending upon trade and market conditions. Algorithms also incorporate historical execution data and analytics to make better trade routing decisions.
All major broker dealers have algorithm suites for different investment styles and which are adapted for diverse geographical regions, while specialist technology companies provide trading algorithms that cater to smaller broker dealers and buy-side firms. Regulatory demands, greater buy-side expectations and the sheer speed of technological developments means that more and more trade flows will migrate from high touch to low touch. That’s great news for people with technology skills.
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