Algorithmic Trading and Direct Market Access

Fernando Ripolles

, Director UBS Investment Bank

Introduction

 Electronic trading is dominating institutional trading and this trend is set to continue — Compliance, operational risk, real time updates….

 Direct Market Access has become a permanent feature of a buy-side dealer’s toolbox — Already well established in the US and will become more established in Europe  Algorithmic trading is the “new kid on the block” — Quantitative models are extensively used by the sell-side – and not only by the prop desks!

— Buy-side dealers on both sides of the pond are steadily increasing usage of broker models

Terminology



Worked order flow

— — Sending electronic orders to your usual sales-trader for manual acceptance.

Traditional trading process similar to telephoned orders.



Direct Market Access

— — The ability of a buy-side trading desk to route orders directly to an execution venue without intervention by a sell-side trader The sell-side provides memberships, technology, trade support and credit 

Algorithmic Trading

— — — Placing an order of a defined quantity into a quantitative model that automatically generates the timing and size of market orders Typically constrained to trade to a benchmark, price or time In-house or vendor provided models or broker provided models 

Smart Order Routing

— Algorithmic model for managing multiple liquidity sources — Can be applied to both DMA and Algorithmic Trading

The business case for technology

 For “plain” order routing, FIX enhances the business process and is a complement to the phone.

 But for products and services such as….

— Direct Market Access — — — Algorithmic Trading Efficient Crossing and Internalisation Smart Order routing  FIX is a prerequisite as these services cannot be accessed or carried out manually!

Buy-Side Order Flow by Execution Service 2004

100% 80% 60% 40% 20% 7% 33% 60% 15% 11% 74% 0% US

Source: Tower Group, Edhec Risk Advisory

Europe Algorithmic DMA Discretionary

Buy-Side Order Flow by Execution Service 2006

100% 80% 21% 19% 60% 38% 46% 40% 20% 41% 35% 0% US

Source: Tower Group, Edhec Risk Advisory

Europe Algorithmic DMA Discretionary

UBS Dealing conference – Question 3

W hat % your Equity trading will be done using DMA in 18 months time?

1. None at all 2. Less than 10% 3. Between 11% and 25% 4. Between 26% and 50% 8% 5. More than 50% 0% 28% 28% 36%

UBS Dealing conference - Question 4

W hat % of your Equity trading will be done using Algorithmic Trading in 18 months time?

1. None at all 2. Less than 10% 3. Between 11% and 25% 4. Between 26% and 50% 6% 5. More than 50% 0% 19% 36% 39%

E-Orders and E-Turnover 2004 - 2006

100% 60.0% 80% 60% eOrders 40% 20% 50.0% 40.0% 30.0% eTurnover 20.0% 10.0% 0% Q1 '04 Q2 '04 Q3 '04 Q4'04 Q1'05 Q2'05 Q3'05 Q4'05 eOrders eTurnover

Source: UBS

0.0%

 Electronic trading currently represents some 80% of orders and nearly 40% of value in the European Cash Equities business  Four years ago the corresponding numbers were 15% and 5% respectively

Electronic Trading by Client Nationality Q4/05

90% 80% 70% 60% eOrders 50% 40% 30% 20% 10% 0% BeNeLux

Source: UBS

Ger European Equities UK eOrders France Italy eTurnover Iberia Nordic 50.0% 45.0% 40.0% 35.0% 30.0% 25.0% eTurnover 20.0% 15.0% 10.0% 5.0% 0.0%

 But, numbers vary significantly from country to country  Regional differences in software suppliers  Regional differences in composition of client base

Latest statistics from UBS- February 2006

 Up to 80% of all orders in European Equity markets entered the Bank electronically  More than 38% of the value of all orders in European Equity markets enter the Bank electronically  More than ¾ of the Bank’s largest customers trade Equities electronically  The total number of clients connected to the Bank for trading Equities is higher than 2,500 globally  A majority of connected clients subscribe to multiple services e.g. single orders, lists, DMA.

UBS Execution Services - Before

Client UBS Equity Trader OMS VENDOR

Orders / Fills / Allocations

FIX engine Sales Trading Portfolio Trading Manual Execution Risk Teams Markets

UBS Execution Services - After

Client UBS Equity Trader OMS VENDOR

Orders / Fills / Allocations

FIX engine Direct Execution Services.

DMA/DSA/ DCA Sales Trading Portfolio Trading DMA Strategy Centre Manual Execution

Crossing Engines

Markets Risk Teams

Questions to ask of yourself

 Investment style?

 Goals and benchmark?

 Discretion / room for judgement ?

 Orderflow profile?

 DMA, DSA or/and DCA ?  Remember only 4 ways to trade: — Orders to humans — Orders to market yourself — — Orders to a computer / robot Orders to a book

Questions to ask about others

 Which providers ?

— Relationship / Trust — — New or existing Silo or open  Other services ?

— Technology skills — — Business skills Credibility  Direct execution services ?

— DMA v DMA — VWAP v VWAP — — — Pre and post TCA tools Business process around the technology Reporting

Direct Execution: the connectivity problem

 Buy side Order Management Systems – Lack sophistication – Suffer version lag – Broker facing not market facing  Execution management systems – – Struggle with buy side backend integration Don’t get access to all the broker secrets  Broker tools – Contain the broker secrets – Generally access only one broker – Struggle with buy side backend integration

Direct Execution: what can FIX offer?

 The buy-side is increasingly adopting direct market access and algorithmic trading – making the case for

co-ordination

and

standardisation

.

 Instead of using proprietary interfaces to each broker, apply a

standardised FIX format

to communicate algorithmic orders!

 The human capital behind the algorithm is proprietary, but the format of communication

does not have to be secret

. Insist on the

exchange of ‘Rules of Engagement’

documents amongst buy-sides, vendors and brokers.



The FPL working group

is working to ensure that the interface requirements between buy side trading applications and sell side algorithmic servers are covered by the FIX protocol to avoid fragmentation.

Direct Execution: how can I go live…

 Enhance proprietary OMS to support Algorithmic trading, DMA — There are different ways to achieve this….

 Check if you OMS provider has already certified with the broker  Integrate your OMS with a broker tool — Execution services AND functionality  Use a stand alone application  Connectivity going forward — No longer 3 simple models — Hybrid model is likely to prevail

Conclusion

 Robo-trading

Execution services and platforms

— — — — Broad range of relevant offerings in the market.

Market facing vs broker facing.

Tighter control of execution process.

Increasing demands on transparency  The Human Factor

Training and skills

— — — — Stock, Sector and Market Expertise Market funnies Broker services and funnies Useage plan and creativity  Trading desks must step up to benefit !!

Appendices

Appendices

 DMA — Checklist — Costs and Benefits  DSA — Checklist — Costs and Benefits  EMS — Checklist — Costs and Benefits

(True) Direct Market Access check list

 Direct insertion of the order onto the exchange.

 Full control of order by client without broker intervention  High performance / Capacity / Reliability  Breadth ( markets ) / depth ( functionality )  Broker must own the exchange links  Segregated pipes  Safety (Fat finger protection / custom client checks )  Anonymity

DMA – Costs and Benefits

 Costs — Time ~ resourcing — Ownership of Execution risk — — Expertise Infrastructure  Benefits — Speed to market — — — Ownership of Execution risk Price Anonymity

Direct Strategy Access (DSA) check list

 Performance  Range of Strategies offered  Business process ( eg Strategy risk managers )  Access to all liquidity within the firm (IXT)  Rocket scientist quotient (brain power)  Market knowledge  Ownership of pipes  Reliability / stability / ease of implementation

DSA Costs and Benefits

 Costs — Applicability of strategy — Intellectual property — Non human execution (Unexpected events)  Benefits — Outsourcing of execution risk — — — — — Non human execution (Pub/Sun factor) Consistency of execution Price Impresses the regulator and the boss (Buy side) Scale (Sell side)

Execution Management Systems (EMS)

 OMS were typically designed in a world where the broker owned execution process. ( Buys side handed out orders ).

 Buy side now require sell side like systems.

 EMS = a staging post between the OMS/PMS and broker/market  How ?

— Enhancement of the Order Management Systems — — Single broker applications Multibroker applications

EMS Check list

 Range of markets supported  Integration with OMS  Parent / Child functionality  Real time market data  Mousetrading – Order manipulation from depth screen  Watch lists and Customisable blotters etc.

 Remote trading triggers  Men on motorbikes and Training courses

Contact details

Fernando Ripolles Direct Execution Services [email protected]

+44207 568 6015 UBS Investment Bank, 1 Finsbury Avenue London, EC2M 2PP