High-frequency tools are key to liquidity: Report

NEW YORK & LONDON, December 9, 2010 – As the pace of change in the US equity markets accelerates, finding liquidity will become a greater challenge, says TABB Group in a new research report. As the buy side continues to struggle in accessing hidden order flow and extracting maximum liquidity at minimum cost from the public markets, they are in need of algorithms that can match the level of sophistication being employed by other market participants.

According to Cheyenne Morgan, TABB analyst and author of the new report, “Next-Generation Algorithms: High Frequency for Long Only,” the key to navigating today’s market lies in utilizing lessons learned from high-frequency trading (HFT). “More to the point,” she adds, “the buy side should look to algorithmic providers that mimic high frequency traders’ approach to measuring and minimizing transaction costs, technology infrastructure and reacting to risk limits. As such, a new breed of algorithms is entering the market, adopting the techniques of trading outfits that endeavor to profit from the market microstructure, rather than treat it as an automatic loss. As a result of this practice, the execution landscape is now becoming a level playing field, rather than a minefield for long-only institutions.”

Thereare three critical ways that algorithms are being upgraded to leverage existing opportunities within US market structure. This new breed of algorithms is being developed to look at a broad range of market data feeds and other essential information sources to optimize buy-side traders’ strategies. Morgan cautions, however, that “receiving or generating market data is only the first step toward next-generation algos, followed by development of robust testing processes ensuring that signals are strong. This is in contrast to the ‘trial and error’ process found in traditional algorithm development.”

The core architecture that algorithms runon also needs to move to the latest low-latency technologies.She continues, “Today’s algorithms should be able to execute with the very same vigor under the most extreme circumstances. While the limitations of some algorithms were uncovered as the markets tumbled rapidly and precipitously during the May 6 flash crash, an opportunity was also discovered to correct these shortcomings.”

The role of the broker in the adoption of next-generation algorithms is essential, Morgan points out. “The greatest toolbox in the world is worthless unless you know how to use each tool, which is why brokers should be actively educating their buy-side clients in how to effectively implement the trading solutions they provide. Their consulting service requires collaboration on both asides where the buy side articulates their needs and the sell side describes how their solutions can best address those needs.”

The 23-page report with 6 exhibits gives a detailed description of today’s challenging trading environment and the natural dispersion of high frequency trading techniques has changed the way algorithms are being designed. It also analyzes why the next generation of algorithms can be utilized by long only institutions and describes how sell-side algorithmic providers should be continuously adjusting and updating strategies to help buy-side clients take advantage of changes in market structure and how its participants interact.

“High frequency traders have passed along a skill set that allows firms to invigorate their trading techniques, intraday strategies, performance reaction and the way they employ the buy-side trader,” adds Adam Sussman, TABB Group’s director of research. “Algorithms were at the beginning of the trading progression. Now as we enter a new age of trading, the innovation of these tools can be crucial to buy-side traders in maintaining a competitive edge.”

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