By Jack Miller
What does the perfect trade look like in 2019?
Two hundred years ago, it might have been two guys under the proverbial buttonwood tree, calling out bids and offers and exchanging hand-written pieces of paper. Today trades take place in the blink of an eye (faster, really), and mostly on a server in a data center in a New Jersey swamp.
But in spite of all this progress, surveys consistently show that a significant percentage of the buyside is unhappy with the electronic trading tools, venues and routing options that are available to them. Algorithmically-driven automation would seem to offer a way to streamline and simplify trading, but comes with its own set of complications. Algos can process more information faster than a human ever could, but are only as good as the instructions they are given. They may emphasize urgency or caution; act carefully or aggressively; attack liquidity or avoid impact; be opportunistic or stick to the schedule – all appropriate behaviors depending on the situation, and all factors which impact the outcome of a trade. They don’t act in a vacuum, they don’t by themselves guarantee best execution, and they don’t always provide the level of accountability demanded by the buyside where control and detailed transparency in order routing are paramount concerns.
A “one size fits all” approach to the use of algos has taken hold in some areas of the market, reflected in the tendency to plug the parameters of a trade in and let it run. This rarely leads to an optimal outcome. Market conditions can change quickly, and no single algo can account for all the potential variables. You need another algorithm to decide which algorithm to use – or input from a human being.
To that end, a 2013 survey showed a keen interest on the part of the buyside in combining high and low touch approaches. Six years later the interest is still there, but there is recognition that the implementation has often been imperfect. The question of how and when a human trader should intervene continues to be debated, while in some shops technical and human expertise remains effectively siloed making interaction difficult.
The reality is that too many options are leading to a kind of paralysis. As electronic trading and market structure become more complex and advanced technologies allow for more detailed customization, it’s increasingly challenging for a desk from both a level of understanding and a workflow perspective. The problems the industry is trying to solve end up manifesting themselves again due to information overload – the paradox of choice. In practical terms, traders end up using the wrong strategy for the current trading situation. Best execution remains out of reach.
The “perfect” trade is still out there to be had, however. When it’s achieved, it will look something like this: A trader knows the stock being traded and the prevailing market conditions of that trading day. There is a deep knowledge of the tools at their disposal and a deep understanding of the client’s trading intentions. The trader selects the configuration that best fits the situation at hand. The trader has the instrument panel needed to monitor his progress in real time – and the dials and knobs needed to course correct in real time if the objectives aren’t being met. The trader is in constant dialog with the client and is providing color on what is being seen – how are we performing, where are we finding liquidity? An algo does the heavy lifting, but the trader sets the course. The trader isn’t replaced with technology but is empowered by it.
Predatory traders, leakage, adverse selection, conflicts of interest, fragmentation and the emerging impact of Artificial Intelligence (AI) will continue to cause challenges for traders. There are a lot of options, and more on the way, but this does not necessarily bring with it understanding of how to use the available resources. The irony around electronic trading is that it’s only with the addition of human insight and expertise that the technology can truly produce the best outcome on a consistent basis for clients. Somewhere in that balance is where you’ll find the perfect trade.
Jack Miller is Head of Trading at Baird. He oversees the execution function within Baird’s Institutional Equities group and is responsible for driving Baird’s strategic priorities in electronic execution services and related technologies.