Derivatives traders replaced with machines

Market Share

Dealers are “definitely fighting for market share,” Davis said in a telephone interview. “Once you get plugged, it just becomes operationally easy to trade, so that’s what the rush is to get all these algos out. It’s kind of a race to say who has the best plug-and-play-model right now to gain market share. I don’t think there’s a clear winner or loser at this point.”

Clearing and margin required by Dodd-Frank will also change the cost structure of trading, and algorithms may be one area where traders will be required to post less capital relative to other types of transactions, she said.

Algorithms may also get a boost if CDX futures get traction, Davis and Tchir said.

“You’ll see more people do it, and as these products become more easy for people to trade electronically there will be more participants” from firms such as Citadel LLC, Susquehanna International Group LLP, or Knight Capital Group Inc., Tchir said. “They’ll be able to add their algos to it once it becomes more mainstream.”

Like Stocks

The increasing popularity of algorithms is an example of how credit markets are becoming more like stocks, Tchir said, citing so-called E-mini S&P 500 futures, with a contract value of $70,513 as of yesterday and trading volume of as much as $200 billion a day with no real market maker, he said.

Banks will probably be successful in block trading or in systems resembling so-called dark pools where large orders are traded without identifying the brokers and institutions that buy and sell, he said. There will be “fewer market makers, but those that remain will provide very large-size block trades,” he said.

Computer-driven transactions and high-frequency trading have come under increased scrutiny after the so-called flash crash in May 2010, when a 20-minute plunge in stock prices temporarily erased some $862 billion of market value. A report by the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission pinned the decline partly on an algorithm employed by one firm trading stock futures.

“They have a bad rap on the street as driving the ’87 crash and they’re not considered by Main Street as friendly vehicles, but at the same time, they are liquidity providers and that’s the biggest change with Dodd-Frank,” AllianceBernstein’s Davis said. “Having more algos in the market in these products will help because it will give market makers a way to have more liquidity so when you call a dealer up they’ll have another outlet.”

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