Source: Bank of America
According to a recent survey conducted by Financial Insights, an IDC company, and sponsored by Bank of America (NYSE: BAC), algorithmic trading has become a standard practice within the securities industry with 72% of investment managers responding that they use algorithms, up from 67% in 2005.
Among hedge funds, who emerged as early and avid adopters of algorithmic technology, the figures are virtually unchanged, with 93% of respondents reporting experience with algorithms. While these figures suggest the market has reached maturity, there remains significant growth potential as trading technologies become personalized and more sophisticated. 63% of participants, for example, stated that their usage of algorithms had increased in 2006, and unlike the year before, no respondents reported a decrease.
The survey, entitled "Marching up the Learning Curve: The Second Buy-Side Algorithmic Trading Survey," was administered to head traders at 60 top buy- side institutions. It follows a similar survey conducted in 2005 by Financial Insights and Bank of America, which aimed to gauge buy-side trading habits, such as adoption and usage of algorithms, direct market access (DMA) platforms, and electronic communication networks (ECNs). The 2006 survey focused on measuring how execution and order management practices have evolved since the previous appraisal and weighing the future landscape of electronic trading.
"We've come to a point where the market largely understands the benefits of program trading and the survey shows that the industry has accepted equity algorithms as an effective means of reducing transaction costs, optimizing trade execution, and maximizing overall workflow efficiency and profitability, but this is just the beginning," said Bill Harts, Head of Strategy for Equities at Bank of America. "As we have witnessed with our clients, increased demand for more sophisticated, market-adaptive algorithms has driven innovation beyond what anyone thought possible, and we are only now starting to realize the full potential of these powerful tools."
"The 2006 survey results show that buy-side firms, regardless of size, continue to actively manage their own trades," said David Cox, Chief Research Officer at Financial Insights. "A greater emphasis on returns has forced firms to look at transaction costs more closely and focus increasingly on best execution practices. As transactions grow in complexity, incorporating multiple strategies and asset classes, algorithms that can minimize costs while providing anonymity and ease of use will be in high demand."
Among the key findings of the survey:
Electronic Trading Now Common Practice
Overall, electronic trading achieved a greater level of buy-side penetration in 2006, compared with the year before. Newer forms of automated execution, such as algorithms (95%) and DMA platforms (90%), remained a regular practice for the vast majority of respondents. Moreover, the number of respondents who executed more than 10% of their total order flow algorithmically jumped to 33% versus 25% in the 2005 survey. Orders filled through DMA also increased dramatically, with more than half of respondents (51%) now managing more than 10% of order flow in this fashion, up from 21% in 2005. Older technologies such as ECNs and crossing networks, saw similar increases in frequency of use.
Future Value Lies in Ability to Innovate, Customize
Increasingly, the buy-side is moving past simpler algorithms and calling for tools that can help them manage more complex trades. In 2005, VWAP (volume-weighted average price) was by far the most commonly used algorithmic program among those surveyed. In 2006, however, only 40% of respondents regularly used VWAP and/or TWAP (time-weighted average price), down from 75% the year before. Conversely, the percentage of participants using more advanced proprietary strategies jumped significantly, especially among hedge funds, with 57% relying on in-house algorithms versus 33% in 2005. One implication of this is that vendors lacking the resources to keep up with the brisk pace of innovation could be replaced by a cadre of providers able to supply a package of highly sophisticated quantitative trading strategies designed to suit a client's individual trading style. To some extent, this is already happening, as buy-side firms begin to consolidate their brokerage relationships and concentrate their business with providers perceived to add the most value. In 2005, for example, 50% of hedge funds surveyed used four or more algorithmic providers. This figure dropped to 28% in 2006.
Dark Pools Increasingly Important
Clearly, the prevalence of easy electronic access to financial markets has resulted in some overcrowding, making it difficult to obtain price improvement on published quotes. The sell-side has responded by offering access to private, unpublished liquidity, or dark pools, to help match buyers and sellers away from public markets. According to the survey, more firms are realizing the benefits of hidden liquidity and seeing value in electronic tools that can help them reach it. 60% of respondents said that they used algorithms to access dark pools, compared with only 32.5% in 2005. Notably, the increased popularity of dark pools has prompted greater fragmentation in the marketplace, with more volume being drawn away from the big exchanges. For example the average transaction size at NASDAQ decreased from 65% in 2005 to 38% in 2006 and from 32% to 13% at the NYSE.
Education Still Critical
Last year's survey showed that rapid adoption of new technologies had created some confusion. One important conclusion was that brokers and other technology providers had to do a better job of educating their customers on how best to implement and utilize algorithms and other sophisticated tools. The 2006 survey shows clear evidence that the buy-side is becoming more comfortable relying on trading technology, but there is still room for improvement. In 2005, nearly 23% of respondents listed lack of understanding as a main impediment to using algorithms, whereas none of those surveyed cited that as a problem in the 2006 survey.
The survey was administered by phone to a random sample of head equity traders from 60 of the top 500 U.S. buy-side firms. These included investment managers, pension funds, and hedge funds with managed assets totaling up to $71 billion. Respondents were asked a series of 54 questions, largely unchanged from 2005, on firm positioning and issues relating to electronic trading practices within the firm.