Technology, TCA and Traders: Can the buy-side get the balance right?
By Bill Stephenson, Greg Lee
How do you find that “just right” point between too much technology and not enough; between tracking your traders every move and going with your gut instinct? How do you know when to invest in developing technology in-house, and when to bring in outside expertise? And, importantly, how does the buy-side rate the sell-side?
Bill Stephenson, Franklin Templeton Investments’ Senior Vice-President and Director of Global Trading Strategy, spoke to Greg Lee, Head of Autobahn Equity Asia, Deutsche Bank about the tipping point between sensible and opportunistic.
Greg Lee: While many buy-side firms balk at committing more resource to trading technologies, Franklin Templeton has continued to invest in this area. What has been your rationale behind this approach?
Bill Stephenson: Our general philosophy on technology has been to be opportunistic, but sensible. We need to stay ahead of the curve on technology because we realise that, besides our people, technology is the key differentiator on a trading desk. So, maintaining a competitive system with minimal fragmentation and all the requisite functionality was the key.
Certainly, over the past two years we have been very engaged in investing resources into our OMS, EMS, TCA, and internal collaborative technology.
The end result we’re aiming for is best execution. We believe that global integration is achievable and has strong benefits. We’ve adopted an open architecture that allows partners and suppliers from around the world to better understand our platform.
One practical approach we’ve taken is to put our programmers alongside our traders. By doing so, our programmers gain a much clearer understanding of the business, and our traders can rapidly shape our programmes and processes. It’s a collaborative relationship.
Greg Lee: Many firms prefer to buy rather than build, whereas your focus is on developing in-house. What, in your opinion, are the challenges or limitations to outsourcing technology?
Bill Stephenson: We have had a bias towards building our own technology solutions, particularly when it comes to our OMS, but we are not averse to buying as long as we have the ability to work with a vendor to create custom add-ons. We did consider building our EMS into the OMS, but eventually decided to keep it separate, but connectable. To do this, we needed FIX. FIX was the key link.
We now have an EMS that we feel brings together the best off-the-shelf solution with a customisation that took over a year to get right. We had to find a vendor who would work with us to develop customer solutions on a global level. We do believe that a global solution is possible, which is what we have implemented with our OMS and EMS. Granted, there will be nuances for each market that need to be addressed, but generally, one solution can be leveraged globally.
Greg Lee: At Franklin Templeton you see Transaction Cost Analysis (TCA) as being an effective tool. What has been your experience in integrating TCA into the trading process?
Bill Stephenson: Yes, we certainly see TCA as an extremely valuable and value-added tool. Our philosophy is that if you can measure performance – whether its trader performance or algorithm performance –then you can improve it.
Integrating TCA into the process isn’t always easy, but ultimately, it’s part of the best execution process and should be a staple in a trading desk’s daily routine.
What we do encourage is that traders pitch ideas, such as opportunistic algos – and we can bring these online on a probationary basis. It’s all part of the rolling evaluation process, where TCA helps play a part in deciding which execution destinations are adding value to our execution process and which are not.
When we look at TCA each day, we get reports that essentially identify our risks and where we are making our biggest stock specific directional calls. For example, is a trader using a lot of discretion that could theoretically create a $100 million short position (i.e. selling more or buying less than the benchmark target) in the name? This daily reporting helps create a dialogue and allows the trader to better evaluate their strategy and ensure the risks are aligned with the potential rewards.
Greg Lee: You talk about building TCA into the culture of the trading desk. Have you seen much resistance?
Bill Stephenson: Sure, there is some resistance, because the system is not and never will be, perfect. This is especially true with the complexities of our order flow. No rule will work for all scenarios, but we do believe in the law of large numbers. We know that with over billions of dollars and hundreds of thousands of transactions, performance will be statistically significant and trends will emerge.
The process has now been in operation for over ten years within Franklin Templeton, but developing trader buy-in has been a gradual process, and it takes time to embed this workflow into the trading desk culture. We explain the benefits, we work on educating brokers, the end-client and traders, and we also make it clear that this is now part of the trader’s job.
Greg Lee: What about the future of TCA? How do you think the industry can better optimise this process?
Bill Stephenson: We use TCA to evaluate our investment process, our traders and our brokers. It is a constant evolution and we appreciate that it isn’t always easy to isolate the performance of any one contributor to the investment implementation process. Understandably there can be a lot of overlap in performance attribution, but we still believe that we’re close enough to make it a valuable exercise.
And TCA will continue to evolve. I don’t think there’ll ever be a standard benchmark, but that is ok.
Our process of investment management and trading is different than some of our competitors, so we expect our benchmark could be different. But we do believe that our methodology aligns closely to the portfolio manager’s objectives for the client, so therefore our benchmark is appropriate. As for optimisation, the best way to see the true value of TCA is to have a culture of acceptance where it becomes a part of the daily process. Only then can it be used to guide strategy.
Greg Lee: How important is pre-trade analysis?
Bill Stephenson: Pre-trade analysis is a helpful guide, but certainly shouldn’t completely drive decisions. This is especially true if you’re using a model-based trade cost estimate for an order greater than 50 percent of ADV. The risk is that these models do break down and might skew your decision making process.
For smaller orders it can be a more useful guide for traders. Having pre-trade tools built into the EMS or OMS are the most efficient ways of using this process so that the trader’s process is not slowed down.
Greg Lee: What do you consider are the main dilemmas facing buy-side firms today in relation to selecting an OMS or/and EMS?
Bill Stephenson: When selecting an EMS, cost is obviously a factor. Equally you need to look at broker neutrality and the willingness of brokers to join the platform. You also need to look at the vendor firm’s commitment to building custom functionality and their willingness to work with, and invest in the brokers to integrate the most recent destination specs.
The OMS and EMS are two separate and distinct tools, and you need to consider that one vendor may not be able to meet the needs of the manager, especially if they require specific functionality.
Greg Lee: How would you visualize the ideal trading platform?
Bill Stephenson: The ideal platform would fully integrate a broad range of pre, during and post-trade processes and content: pre-trade, real time, post trade TCA tools, portfolio attribution, broker voting, external and internal research, collaboration tools and market data. You want it to be modular so that components can generally plug and play, and you want to keep your vendors and partners diversified, which will keep them incentivised to stay cutting edge.
Ideally, a straight-through efficient process, starting from order origination through settlement with all the pertinent decision making tools at your fingertips would be the trading platform we strive to achieve.
However, I’m not sure one platform could offer best-of-breed across all these areas, but ideally these processes should all be inter-operable so that a trader’s workflow can be optimized.
Greg Lee: Relationships are changing rapidly in the trading environment. How do you feel the buy-side is evaluating the sellside in the current climate?
Bill Stephenson: As the saying goes, you’re only as good as your last trade. I think this still holds true when buy-side traders evaluate sell-side performance, but that can be too short-sighted. That’s where TCA can be helpful such that the evaluation encompasses a much broader set of trades over time. However, measurement of actual performance from a TCA perspective isn’t always easy, and there are subjective aspects of the performance to be taken into consideration that are just as important.
We look at aggregated performance and also a series of subjective measures twice a year where our traders evaluate broker performance in eight best execution categories, which are typically standard across all regions, globally.
Under these categories we include questions at the sales trader and firm level that we think are important services that tie into best execution. For example, we will ask our traders to rate a sales trader on the quality of the order flow and trading information, such as market color.
Greg Lee: What do you see as the future for automated trading? Will technology triumph over people?
Bill Stephenson: No, technology will not triumph over people. But the traders who embrace change, who understand market structure and who have solid technology and analytical skills will bring the best value to their clients.
No system can make judgements, so we need real people who understand the markets. The markets are based on individual people’s ideas of value at any given point in time and how they react to changing market prices. Parts of the process can probably be systematised – such as broker or venue selection and opportunistic strategy shifting – but the markets are too dynamic to have one rule set that will always apply. So we do need our traders to be making the decisions, especially around the macro strategy of large orders relative to ADV. We also see sales traders as being resurgent in this low liquidity environment. In low liquidity or higher volatility times, we need high touch order expertise. It’s about finding the right people for the right times and giving them the support and processes to make the right judgement.