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B u i l d i n g B e t t e r P e r f o r m a n c e

C O M M E N TA RY 8 1 AUGUST 2004
The role of the buyside trader has changed dramatically over the last decade.
Buyside traders now have an arsenal of execution tools at their fingertips and
are taking greater control of their orders. Delegating the responsibilities for
order execution to a broker is now supplanted by electronic trading.

Can Systems Make a Good Trader? was the subject of As trades shift away from a central market to scattered
the January 2003 Plexus Commentary1, which focused venues, soliciting liquidity became difficult. Without
on the use of Order Management Systems and Straight intermediation, both buyer and seller must show up
Through Processing (STP) through
FIX connectivity. We questioned
whether the fast connections of Markets fragment because traders have
electronic trading were getting
traders where they needed to go.
different needs and trading problems.
Just a few quarters later, a proliferation of providers is independently. While traders do not want sellside
exploiting network connectivity to provide better, faster intermediation on every trade, they need access to deep
and less expensive service in areas such as liquidity liquidity pools. Thus isolated ”buyside only” pools
aggregation and algorithmic trading. In this Commentary needed to reconsolidate in order to raise the rate of
we review recent market structural changes and discuss successful matching.
how these changes motivate and empower the buyside
traders to better control their orders. The changes mandated by the 1997 SEC Equity Order-
Handling Rules combined with technological
improvements such as OMS systems and FIX protocols
How Much Have Things Changed?
to accelerate the development of electronic
communication networks (ECNs). Very quickly, the ECNs
In “Consolidation, Fragmentation, Segmentation and saw that connectivity could improve liquidity, and began
Regulation 2,” Larry Harris discussed the reasons why inter-connecting with each other and with NASDAQ.
markets fragment, the forces leading to re-consolidation, Growing popularity and volume begat more popularity
and a subsequent situation that Harris defines as a and volume.
segmented market. Quite presciently, what has
happened is very close to what Harris describes. The 1997 Order-Handling Rules also mandated
decimalization, which impacted markets in three ways:
Markets fragment because traders have different needs • As the increase in the number of price points thinned
and trading problems. Pre-1990 market structures were out liquidity at any given price, it became difficult for
floor-centric, with broker/dealers intermediating most buyside traders to find size. Traders were forced to
trades. A ”fourth market” emerged in the 1970’s as a break orders into small pieces to access thinned-out
private phone-based crossing network among buyside liquidity.
traders to fulfill the budding demand for direct buyside to • “Pennying,” jumping in front of bids/offers by penny
buyside crossing. In the 1980’s the fourth market went increments to force better prices or faster execution,
electronic via Instinet, followed by both the Crossing became a significant deterrent to buyside traders for
Network and ITG’s POSIT. Even so, the demand 1
Available on
continued for more alternatives to inviting broker 2 Consolidation,
Fragmentation, Segmentation and Regulation
Harris, Lawrence, Financial Markets, Institutions & Instruments v. 2, no. 5,
intermediation into the process. December 1993, 1-28.
posting limit orders to attract hidden liquidity. The book traded has fallen 18%.
became even thinner. • Interestingly, the number of manager clients requesting
• The reduction of spreads make it difficult for brokers to evaluation of individual traders is up 67%. Individual
profit from their traditional market-making business. trader skills are increasingly under scrutiny.
This forced them away from the market-maker
wholesaling business model toward an agency-based
OMS Systems And Connectivity
trading service model. This shift positions
brokers/dealers as facilitators for both their clients and
Order Management Systems (OMS) are the keystones of
the facilities offered by ECNs.
the buyside’s ability to manage workflow. These systems
collect orders from portfolio managers, aggregate them
Meanwhile, low returns expectations and increasing
into trading blocks, manage executions, collect fills and
surveillance caused buyside firms and fiduciaries to
perform allocations. Nearly all of Plexus’s manager
focus on the costs of portfolio turnover. The increased
clients use an OMS system, although there are big
sensitivity motivated them to monitor transaction costs
differences in system capabilities.
and adjust behavior where appropriate.

OMS systems are becoming the technological backbone

While it appears that we still have fragmented markets
of the buyside firm 3. Automating the clerical part of the
today, the reality is quite different. Rather than being
job is not enough; firms demand integration of portfolio
consolidated at the destination, institutional markets are
management functions such as optimization models and
now de-fragmented at the source, the buyside trade
risk and compliance modules.
desks. New trading systems allow buysiders to efficiently
scan all market fragments for liquidity. Larry Harris’
The key advance for OMS systems in the last five years
“segmented market” seems close to today’s reality.
has been enhanced connectivity to brokers, trading
venues, direct market access brokers and algorithmic
The Buyside Traders Workload trading systems. The Tabb Group found that the buyside
now handles 52% of its order flow electronically and only
In addition to allowing buyside traders to take control of 48% manually by phoning a broker. The larger the
their trading, the technological advancements of the last manager, the lower the level of manual order handling.
decade facilitated large increases in productivity on the
trade desks. Aggregation Technology: Creating A
Segmented Market Place
Back-of-the-envelope calculations, using lists of clients
for whom Plexus evaluates individual traders, show Reconsolidation, the natural evolution of fragmentation,
interesting trends: has been accomplished via aggregation technology.
Both buyside and sellside now see
one consolidated montage of the
OMS systems are becoming the tech- markets. Aggregation technology
gathers data from the various
nological backbone of the buyside firm. electronic marketplaces, thus
integrating otherwise isolated pools
of liquidity. These systems also provide execution
• The number of orders per trader processed by Plexus’s facilities that can trade seamlessly across all trading
manager clients is up 20% since 2000. This is probably venues.
the best indicator of the increase in trader workload.
• Despite increased workload, half of the desks have the ECNs were early providers of aggregation across
same number of traders today as they did in 2000. NASDAQ dealers. Clients would use Bloomberg or
• The number of managers reducing trader population on Archipelago to access multiple liquidity sources. Even if
their desks exceeds the number of managers the ECN did not have the other side, it still got a piece of
increasing desk population by a factor of 2:1. Individual the action as the point of market entry. The result was
desk population data indicates that the trader dramatically improved liquidity and quick user
population has decreased 8% since the turn of the acceptance. But the trading was labor intensive; the
millennium. electronic markets still required manual interfaces. Users
• While workload is up in terms of number of orders, the
shares per order has dropped 24% and the total dollars
3See Commentary #74, January 2003. Also see the report by the Tabb Group. Both are
available on
spent a lot of time punching keyboards to work the buyside trading desks are fairly new, but penetration has
systems. been broad. Both the Tabb Group and the Plexus survey
found that 60% of the desks use algorithmic trading
Smart order routing technology represents the latest systems, with the percentage soaring for large firms to
advances in aggregation systems. The technology 80%.
analyzes order flow for particular patterns of size and
liquidity, identifies attractive venues and automatically The basic strategy of these systems is still crude: “slice
routes orders for execution. By re-combining liquidity and dice” the orders down to the size being shown in the
pools and allowing the user to set custom trading rules, order books. The widespread use of automated trading
aggregation providers hope to pre-empt the need to link stratagems such as probe trades and other devices to
to four or five competing vendors. Advanced aggregation test the tenor of the market still lies in the future.
systems can simulate sophisticated order types across
market venues even though some ECNs may not support Modeling trading strategies, even a basic VWAP strategy,
them. is not an easy task. The best algorithmic trading systems
have developed much broader capabilities than a basic
Smart order routing is still in its infancy; according to the VWAP model, but the vast majority of users still use only
leading providers of this technology, few trade desks the basic model. The main use of these systems is for the
have made use of anything beyond simple VWAP trading. fairly liquid, easy to trade orders where little value can be
added by more human attention.
Broker-provided aggregation systems are the most
widely used by buyside firms, followed by independent As was the case for aggregator systems, broker provided
providers such as Lava and FlexTrade. FlexTrade is also algorithmic systems dominate the market place. CSFB,
offered through some brokers. Smaller aggregators are Goldman Sachs and ITG are the current leaders. CSFB
also aggressive competitors, and together command a has a big presence among the large and medium size
larger market share than FlexTrade. firms and ITG mainly among medium size firms.
Proprietary models and FlexTrade were the non-broker
Drilling down on firm size shows a different picture. Large systems with the largest percentage of users.
firms mainly rely on the Lava aggregation system,
followed by FlexTrade. Small buyside firms, on the other The goal of traders using these systems is to either
hand, rely heavily on brokers to provide this technology. reduce costs or improve efficiency. A few have started to
analyze the results from their algorithmic system and are
According to the Tabb Group, breadth of functionality – often not pleased with the results. Plexus has evaluated
and cost – separates the aggregation system from each the results of naïve VWAP engines versus PAEG/L and
other. Although sub-second speed – the time it takes to also found poorer than expected results.
get your order to the point of liquidity – was considered
critical, most buyside desks felt that most systems were
competitive on speed. Conclusions

A growing number of brokers sell their expertise in using The relationship between buyside trade desks and
ECNs and aggregation systems to provide buyside brokerage firms is in the process of redefinition. Indeed,
traders agency executions without invoking “shopping” of today’s markets operate radically different than they did
the order. Buyside desks use these firms to become three or four years ago.
active users of aggregation and access technology
without investing time and money. Firms like Pulse The idea of “relationships” being the gravitational force
Trading, White Cap Trading, Firefly, UNX and others have holding together buyside trader and broker is weakening.
experienced good volume growth in the Plexus Broker Changes in market structure and order-handling rules
Universe over the last few years. Other firms in this space allow the buyside desks to take more control of their
are EGS, Electronic Specialist, EquityStation, Terra Nova orders. The days when brokers controlled market access
Institutional, Vie Financial and Paravane Partners. and market information appear gone forever.

This will not be good news for brokers who rely on little
Algorithmic Trading more than relationships for the securing of order flow.
With more trading being done electronically or through
Algorithmic trading systems model the trading rules and direct floor access, the remainder of the pie is getting
logic of different trading strategies and implement the thinner. We predict that many brokerage firms will seek
models via FIX connectivity. The systems offered to the
to merge or be acquired to beef up their value Algorithmic trading systems model the trading rules and
proposition. logic of trader tactics and apply communication
technology to implement the model. All current models
For a while, we worried that the 1997 Equity Order- use VWAP as a basis for their execution strategy, with
Handling Rules would fragment the market and make the best systems offering broader models. Clients are
trading more difficult. No longer; recent developments in still struggling with how best to use the systems.
trading system technology now provides buyside traders
with the ability to efficiently scan all fragments of the In the future, we can expect advances in modeling
market place for liquidity. technology to result in more sophisticated automated
order handling. Increasingly, the models will add value
Aggregation systems are re-consolidating the directly by reducing trading costs or indirectly through
fragmented market for the buyside desk. These systems improvements in efficiency. The role of the trader will
provide one consolidated
montage across all market
fragments, and now incorporate
The days when brokers controlled market
smart order routing technology access and market information are gone
to automatically route orders to
specific venues for execution.
evolve more towards trading strategy as a component of
Algorithmic trading systems provide the buyside desk investment strategy, and away from the clerical roles of
with more advanced methods of handling small orders. phone handler, commission cashier, and lion tamer.

Plexus News
We are pleased to announce that Bill Bennett has joined the Plexus sales team in New York. Bill comes from
JPMorgan Investor Services and brings a deep background in investment management processes.

Put this on your calendar! The Plexus Group 9th Client Conference is scheduled for September 18 - 20, 2005 at the
Fairmont Turnberry Isle Resort & Club (

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