AT_Digital_Issue_2011_03

PLUS:Laptop Killer: Hedge Funds Want Their iPads An Algo That Avoids a Crisis High-Frequency Trading’s No. 1 Critic Speaks Out The Electronic Revolution:HFT’s Rise to Dominance Larry Tabb Offers an Algo Seal of Approval DESIGNER ALGOSINTELLIGENCE FOR THE ELECTRONIC MARKETS MARCH 2011Today’s buy-side trader wouldn’t be caught dead with an off-the-rack algorithm. Made-to-order strategies are all the rage on the Street. p.9<< PreviousExperience the power ofnext-generation routing.COVER STORYMade-to-Order AlgosToday’s buy-side traderswouldn’t be caught deadwith off-the-rack algorithms.Now that equity algos havebecome commonplace,custom algos are all the rageon the Street.FEATURE 13The Rise of the MachinesHigh-frequency trading’s riseto dominance started inequities, but it already hasinfiltrated options and futures.It seems as if only theregulators can stop it now.4MARKET INTELLIGENCELaptop Killer Apple’s iPad tablet is transforming theway hedge fund managers get market intelligenceand threatening the laptop’s dominance.Crisis-Crushing Algo A new metric may hold the keyto averting future flash crashes.7ONE ON ONEHFT’s Harshest Critic As a U.S. senator, Ted Kaufmanoften spoke out against high-frequency trading.Today, he’s still slamming the Street.15STREET CREDGrading Algo Testing Putting a ‘Seal of Approval’ onalgos is a legitimate idea, acknowledges contributingeditor Larry Tabb. But it’s not practical, he says.3 FROM THE EDITOR16 EDITORIAL AND BUSINESS CONTACTS9March 2011This is the first of fiveall-digital issues thatAdvanced Tradingwill be producing in 2011.<< Previous NY +1.212.449.6090 | Chicago +1.866.202.5908 | Europe +44.20.799.52838 Japan +813.6225.8398 | Asia +852.2161.7550 relationship.Next >>trading insider let me in on a secret recently. I asked about high-frequency traders and how they operate.He stopped me short and said only people on the “outside” call it “high-frequency trading.” “Everyonein the industry just calls it ‘trading,’” he told me.We still cling to the idea that trading means brokers shouting into a telephone or waving tickets on a trading floor. While it makes for a great scene on TV or in the movies, the real action takes place in data centers, where Wall Street powerhouses keep their servers and their black-box trading strategies. (In fact, thehead of equity trading at a major global firm whispered in my ear that the New York Stock Exchange tells its employees to mill about the trading floor when CNBC does its live remote spots — the exchange wants people to think the floor is still buzzing.)In this special digital edition of Advanced Trading , we examine algorithms’ rise to dom-inance and their ongoing evolution. In her cover story, “Designer Algos,” editor-at-large Ivy Schmerken looks into the growing demand for bespoke trading formulas on the buy side (page 9). Not only do hedge funds want custom algos, they want unique algos for each trader. And what the buy side wants from its brokers, the buy side usually gets.Meanwhile, HFT remains in the hot seat. As associate editor Justin Grant discovered,although one former U.S. senator no longer roams the halls of Congress, he still doesn’t have anything nice to say about HFT (page 7), and his former colleagues are examining the issue closely. Justin also reports on an algo that sniffs out order toxicity (page 4)and the latest must-have accessory for today’s trader: the Apple iPad (page 5). Finally, I explore high-speed trading in non-equity asset classes — unless you’re talking about bonds, today it’s traded in microseconds.Just don’t call it “high-frequency trading.”AHFT: The New Blackeditor’s letterPhil Albinus, Editor-in-Chief@philalbinuskeep a closer eye on risk and exposure, says TabbGroup analyst Kevin McPartland. “It’s about moreeasily keeping in touch with the market,” he says.“The ability to just flip it on, look, and then con-tinue about your day is a huge advantage.”Nine out of 10 participants in the Agio surveysaid the iPad made them more efficient, and 70percent said they are pushing their firms to pro-vide iPads alongside other mobile devices.“They’re using it primarily for ... the consumptionof news, for accessing their computers at workor at home, and for more of the traditional e-mailand web surfing,” says Agio’s McDonough.Such functions traditionally were the domain of laptops, but McDonough contendsthat their days are numbered at hedge funds. “A couple of people actually said thatspecifically in the results,” he relates. “They tried to use it as a laptop and were successful.”According to Agio, 90 percent of the hedge fund managers surveyed said the iPad wasdriving them to lean more heavily on mobile devices since it enables them to remotelyaccess order management systems or internal research.The laptop’s one saving grace, however, may be its ability to support trading functionality.While it is possible for a trader to make deals on the iPad, even for hedge funds that aren’tusing latency-sensitive strategies, it’s not the most effective way to execute Array SHARE trades, Tabb’s McPartland argues. “There are more efficient ways for an insti-tutional trader than to sit there and tap away,” he insists. “If you are reallygoing to be actively trading, I still think you would open up your laptop.”Souring on the BlackBerry?Meanwhile,Agio’s research suggests that the iPad may spell doom forResearch In Motion’s BlackBerry devices, as well. Although the BlackBerry’sextinction is a long way off, many hedge fund managers are beginning toclamor for iPhones and complete emersion in the Apple operating envi-a market-based solution to liquidity shortages like the May 6, 2010, event. In a paper released this past fall, Tudor’s Marcos Lopez de Prado and Cornell’s David Easley and Maureen O’Hara outline a new metric — Volume Synchronized Probability of Informed Trading, or VPIN — that detects when orders are becoming toxic for market makers. High order toxicity can set off a chain of events that prompts electronic market makers to stop supplying liquidity in order to stave off severe losses, which in turn can fuel a liq-uidity crisis and spark a crash like the one that played out so dramatically this past May.Order flow is considered toxic when it is initiated by counterparties armed with surefire information on the direction the market is heading. This can lead to a trade imbalance that can trigger significant losses for market makers if they don’t unload their positions.“In the case of May 6, the market makers were buying stocks and it became very hard for them to turn the portfolio around to sell,” Lopez de Prado explains. “They accumulated losses and at some point had to shut their portfolios down and vanish from the market.The crash occurred because there was no liquidity.”High-Frequency CrashesExperts note that in the current marketplace such scenarios are playing out with alarm-ing frequency, albeit on a much smaller scale. In February, for example, Apple saw its market capitalization briefly plummet about $10 billion in a matter of minutes before recovering. And this past fall, shares of Progress Energy were soaring along at $44.57each before crashing to $4.57 in a matter of seconds. Shares of the Washington Post Co.and Citigroup also experienced similar drops in 2010.Such plunges can be damaging for high-fre-quency market makers since they’re operatingwith far less capital than traditional marketmakers and are saddled with more leverage.But these mini-flash crashes have become a common occurrence since market makers are forced to withdraw from the market muchmore often than they once did.“In the old days on the New York Stockronment since the smartphone’s apps are similar to the iPad’s, Agio’s McDonough says.“If you coupled this study with our real-world experience in managing hedge funds’mobile devices, it’s not looking good for BlackBerry.”But as momentum for the iPad and iPhone builds on Wall Street, the pressure on IT departments has never been greater. They simply are managing more mobile devices than ever before, p l acing an unprecedented burden on security and compliance, Tabb’s McPartland notes. “Think about how many devices you had five years ago — we each probably had a computer that connected to our wireless network at home,” he says. “Now you probably have seven or eight devices in your house between cellphones, laptops,iPads and the desktop computer. Firms are dealing with that on a much bigger scale.” Ian a simple mathematical formula prevent another Flash Crash? A pair of Cornell professors and a hedge fund trader say they have found the key toavoiding another market plunge.As regulators mull market-making obligations for high-frequency traders,two Cornell University professors and the head of high-frequency futures trading at hedge fund Tudor Investments claim to have developed a new metric that can pave the way forCBy Justin Grant@JPaulGrantAn Algo That Prevents CrashesA new metric may hold the key to stopping future Flash Crashes.PG "EWBODFE 5SBEJOH -JRVJEJUZ "MHPT )'5 &.4 0.4 'JOBODJBM 3FGPSN 5$" BOE NPSF5IF CFTU PG UIF CFTU "5 OFXTEFMJWFSFE UP ZPVS JOCPY Y QFS XFFLExclusive Digital IssuesAdvanced Trading Dailyuring his two-year run in the U.S. Senate,Delaware’s Ted Kaufman(D) was one of the loud-est critics of high-frequency trading. (He didn’trun for re-election in 2010 and was succeeded byDemocrat Chris Coons.) Kaufman often fought to rein in HFT,arguing that it left retail investors at a stark disadvantage, whileleaving the public markets exposed to manipulation. With thenation’s regulators now preoccupied with drafting rules toenforce the Dodd-Frank Wall Street Reform and ConsumerProtection Act, Kaufman contends they won’t be able to effec-tively police a market they didn’t fully grasp to begin with. Inan exclusive interview with Advanced Trading associate editor Justin Grant(follow @JPaulGrant), Kaufman, who served as chairman of the Congressional Oversight Panel for the Troubled Asset Relief Program, explains why marketwide circuit breakers won’t work, how Dodd-Frank complicates matters and why the market’s structure must change.to regulate with. It’s dangerous. My approach allalong has been that we don’t know enough.I’m concerned about the credibility of ourmarkets, and we’ve taken a couple of big hitswith the dot-com crash and with the financialmeltdown. And high-frequency trading wasnot responsible for either of those, but we’ve got a lot of work to do.Doesn’t high-frequency trading make the markets more efficient while supplying more liquidity?Kaufman: I’ve said this a hundred times on television, radio and in meet-ings — no one has ever contradicted what I’ve said: I’m for liquidity.Liquidity is very important. But fairness and transparency trump liquidityin my opinion every single time. The thing is, we don’t know if it’s fairbecause it’s not transparent.There are all kinds of allegations that during the Flash Crash — thetime when you most need liquidity — high-frequency traders pulled theplug. There is no obligation [for high-frequency traders] to maintain anorderly market.How would potential budget cuts at the Securities and Exchange Commission impact its ability to monitor HFT effectively?Kaufman: I can’t believe they’re actually going to do that. I really can’t. Theproblem is, when we passed Dodd-Frank we didn’t put enough in the lawlike we did with Glass-Steagal back in the 1930s — we pushed all the impor-tant decisions on the regulators. So here are the regulators struggling withall these other things, and then you’re given all this to regulate?That’s not even talking about the budget cut. They’ve got hundreds of regulations they have to come out with. I sent the SEC a letter calling fora market structure study, which SEC chairman Mary Schapiro said theyare going to do. We still don’t have that. How are they going to do thatSHAREwhen they have all these other different regulations they’re going to have to pound out? So it’s a real concern. Meanwhile high-frequency trading just keeps growing and growing.Was the SEC’s ban on ‘naked access’ to public markets a good first step toward reining in systemic risk?Kaufman:The fact that they were allowing it is amazing. It’s a great step.But it’s a little like saying I’m going to run a five-mile race and I’m a mile away from the starting gate. We have a long way to go and we’ve got to do the easy things first. The easy thing is banning naked access.You’ve been critical in the past of the high-frequency trading com-munity for not cooperating enough with the government to curb sys-temic risks and prevent market manipulation. Have you seen any improvement in that area?Kaufman: None as I can see. They say there’s no problem: “We’re providing efficiency and liquidity. There’s no problem here. We didn’t cause the financial meltdown. Go do something else.” What I’m asking them to do is come forward and do something about this before we have somethingmuch worse than the Flash Crash.Will marketwide circuit breakers be enough to prevent another Flash Crash?Kaufman: Not in my opinion. It’s like saying my arm is falling off and treating it with a Band-Aid.We need structural change. The markets have changed dramatically in a relatively short period of time. And we have to do exactly what the SEC and the Commodity Futures TradingCommission said they were going to do, which was to study the market structure and see how they would deal with all the changes.But they just haven’t done it yet. We need a market structure study,and we need it now. The new realities are, we’ve got so many market centers now. This isn’t just the high-frequency traders. We’ve also got all these new market centers. We’ve got the dark pools. Anywhere there’s a market you can do high-frequency trading.IKaufman’s High-Frequency BarbsFormer Sen. Ted Kaufman has been an outspoken critic of high-frequency trading. Below are some of his most pointed comments on HFT and the state of the capital markets.“While speed and efficiency can produce certain benefits, they have also created a micro-arms race that is being waged in our public market p lace by high-frequency traders and others.”—In a letter to SEC Chairman Mary Schapiro, Aug. 5, 2010“The technological advances and mathematical algorithms that have allowed computers to trade stocks in millionths of a second in and of themselves are neither good nor bad. But technology cannot operate in a vacuum nor should it dictate how our markets function.”—In his final U.S. Senate floor speech, on market structure issues, Sept. 28, 2010“There is a real perceptual risk that retail investors will no longer believe that the markets are operating fairly, that there is simply not a level playing field. If investors don’t believe the markets are fair, they won’t invest in them.”—Speech on market structure issues, Sept. 28, 2010“We need a market structure study, and we need it now.”“Basic strategies aren’t cutting it any-more — all the bro-kers offer the same strategies,” saysTabb senior analystCheyenne Morgan.“It’s the level of customization and sophistication that is prob-ably the next step in terms of competition [among brokers].”According to Morgan, long-only asset managers are work-ing with their brokers and algo developers to figure out which strategies work best for their portfolio objectives and build those strategies into their algorithms. Buy-side firms,she says, “are working very closely with their brokers to cus-tomize their algos and learn about high-frequency trading and how they could use that to their advantage.”After rolling out its own colocated direct-market-access (DMA) platform in December, Wedbush Securities in Los Angeles assembled a team of pro-grammers and Ph.D.s to work on custom algos. “We can go into an institution and ask, ‘How do you want to trade?’” says Kevin Beadles, director of trading at the brokerage and investment management firm.Then Wedbush developers code and simulate the algo and show the trader the results prior to putting it into effect,he explains, adding that by taking a more scientific and quantitative approach, a trading firm can replay a trading day to see if the custom algo decreased or increased a trader’s performance. “We can go back and test it versus the Flash Crash day or versus any other time frame,” Beadles indicates. And in the aftermath of the May 6, 2010, Flash Crash, suchoday’s buy-side traders wouldn’t be caught dead with off-the-rack trading algorithms.Now that algorithmic trading strategies for U.S. equities have become commoditized,custom algos are all the rage on buy-side trading desks. Buy-side traders know exactly what they want, and they aren’t shy about demanding it from the sell side and independent algo developers. Fifty-two percent of head traders on U.S. equity trading desks see no differences in current algorith-mic offerings, according to a recent Tabb Group sur-vey. In fact, some traders who participated in the survey pointed to a once-unthinkable thought: that all algos are the same. “Although this may be partially true,” the study noted, measuring those differences is difficult and expensive, Tabb Group reports.TBy Ivy Schmerken@ischmerkenOff-the-rack algos are so last season, darling.Today’s buy-side trader needs made-to-order formulas for pursuing alpha, and the algo designers are scurrying to meet the demand.Designer AlgosIn This IssueHedge Funds Want Their iPads p.4An Algo That Prevents Crashes p.5Q&A With HFT’s No. 1 Critic p.7HFT Spreads Beyond Equities p.13Larry Tabb Grades Algo Testing p.15Table of Contents p.2back testing of algorithm performance has become an increasing priority for the buy side. Regulators’ indication that a plain vanilla algo used by mutual fund company Waddell & Reed sparked the Flash Crash, for example, have alarmed the buy side. While it’s commonly thought that the basic strategy performed as it was supposed to, some market participants are concerned that brokers are not testing off-the-shelf algorithms for outlier events.“Brokers created these algos to capture customer business,” says Beadles. But, “I don’t think they went through the rigors of testing on a custom basis and said, ‘This is how it would have performed.’”Made to OrderMeanwhile, the big global brokers are diving into the customized algo business. “The buy side definitely wants more customized algorithms,” confirms Jose Marques, man-aging director and global head of electronic trading at Deutsche Bank in an interview in his downtown New York office.Since individual traders have different styles, Deutsche Bank focuses on customizing algos on a trader-by-trader basis, according to Marques. For instance, some traders sort orders by difficulty of trade, while others might stock an order into a VWAP or in-line algo. “Each trader has his own algo in his mind,” says Marques.“When you build an algo, there are hundreds of knobs we can turn,” he continues, noting that the features vary, for example, for high-cap versus low-cap securities. In terms of speed to market, it can take anywhere from two minutes to three months to build acustomized algo, says Marques, whose quantteam consists of a sizeable group of mathemati-cians and market microstructure specialists.Not to miss an opportunity, NomuraSecurities also is customizing algos for institu-tional clients. “We’ve done a number of customimplementations for accounts,” says MatthewWeitz, executive director, and head of U.S. elec-tronic sales and trading at Nomura SecuritiesInternational. “There’s a lot of consultative work in bringing the algorithms online for clients.”One important aspect of customization is the client’slevel of aggressiveness, which varies from firm to firm. “Weneed to make sure we build algos in a customized way tovary that level of aggressiveness,” says Weitz. He notes thatone trader’s medium level of aggressiveness can be anoth-er trader’s ultra-high aggressiveness.“All of this comes into play when accessing liquidity inthe marketplace,” Weitz says, adding that Nomura’s algosaccess both the firm’s liquidity via NX, Nomura’s dark pool,and external liquidity sources. “Having the ability to cus-tomize is definitely a differentiator.”While the widespread move to customized algorithms isa new trend, many equity traders already have experimentedwith algo customization. Two-thirds of the 68 head equitytraders sampled by Tabb Group said they use some type ofcustomized algorithm that they built with a broker. But it’snot clear how the buy side is defining “customization.”“In some cases, the buy side provided guidance andspecifications to build a very specific algorithm,” according to the Tabb Group report,“U.S. Equity Trading 2010/2011.” “In other cases, the customization has more to do with avoiding specific types of order flow, custom adjustments based on time, or ADV [average daily volume], etc.”For instance, buy-side firms are asking their brokers to profile which liquidity pools their algorithms access. Some institutions have a bias against dark pools that permit high-frequency traders’ participation, so brokers will customize an algo’s routing tables by eliminating those liquidity pools. “We have the ability from an electronic trading per-spective to customize the liquidity sources that client orders interact with,” says Nomura’s Weitz. Nomura is able to exclude certain liquidity sources from its own dark pool. “We are able to customize our algos to access particular types of liquidity within NX.”So while some buy-side trading desks may prefer to develop algorithms from scratch,“Whenyou buildan algo,there arehundreds ofknobs wecan turn.”—Jose Marques,Deutsche BankFor additional information, please contact Anthony Carraturo at 914.368.1083 or simply email acarraturo@. For other UBM mailing lists please visit .7ALL 3TREET 4ECHNOLOGY -AILING ,IST !VAILABLE 4ARGET !UDIENCE #ATEGORIES )NCLUDE Advanced Trading: Trading/Exchanges, TradingInfrastructure/Technology, OMS/EMS, Algorithmic Trading, Data Latency, Block Trading, ATS/ECN/Dark Pool, Transaction Cost Analysis (TCA), Derivatives, Market Data, Trading Regulations/Compliance, Cross Asset Trading.Capital Markets: Asset Management, Compliance, Data Latency, Data Management, Data Security, IT Infrastructure, Operations, Risk Management, Wealth Management.2EACH /UT 7ITH 4HE &OLLOWING 3ELECT #RITERIA s *OB &UNCTION )NCLUDING : Corporate Management, Business Mgmt and IT Mgmt.s 0RODUCT 3ERVICE )NTERESTS )NCLUDING Trading/Order Mgmt, Asset Mgmt, Risk Mgmt, Data Mgmt, Compliance, Security.s "USINESS INDUSTRY s %MPLOYEES )N /RGANIZATION s 'EOGRAPHY AND MUCH MOREOur Subscribers Are Your Customers.many find it easier to make tweaks to off-the-shelf strategies, changing parameters and setting dials to suit the stocks they are trading, according to the Tabb Group report. Further,some trading desks that spent a lot of time helping to build algorithms have had mixed results, often finding themselves left with quickly outdated tools, the report notes. Design It Yourself?Nonetheless, one technology firm argues that buy-side firms can develop their own algo-rithms without having a background in programming. In January 2010, TickIt Trading Systems launched Algo Design Lab (ADL), a visual programming language for developing trading algorithms. Trading Technologies acquired the firm in 2009 and is currently integrating ADLinto its XTrader platform for futures trading.“We designed a drag-and-drop system whereusers could create icons with logical steps thatcould control an order,” says TickIt cofounderMichael Unetich, who now is product managerat Trading Technologies. “Using these blocks, a trader can plug logic into a trading engine without any programming techniques” andbuild a black-box or grey-box strategy, adds Unetich, a former proprietary trader on the“Having the ability to cus-tomize [algos]is definitely a differentiator.”—Matthew Weitz, Nomura AmericasMay 17, 2011 Hilton New York/cloud2011REGISTER TODA Y!he industry’s top business technologists come together to discuss the realities, capabilities and expectations surrounding cloud-based applications and architectures and how they will drastically change the technology strategies for Wall Street firms.TData Portability: Breaking Vendor Lock-InHow can new standards and specifications help financial organizations gain flexibility and reap true benefits?Breakthrough Cloud Economics: Leveraging Cloud to Increase Innovation SpendingHear why firms that can break through the 80/20 tech spend will have a considerable advantage over rivals.Consumption-Based Cloud PricingFirst to Market: Cloud for Analytics and Data Management 2 Prerequisites for Cloud: Virtualization and Parallelized SoftwareHow are broker-dealers preparing for their 2011-2012 rollouts?Respected Speakers Peer-to-Peer Networking Quality, Focused ContentAGENDA HIGHLIGHTSWHO SHOULD ATTEND?Senior-Level IT ExecutivesInfrastructure & Architecture Experts Data Center SpecialistsMarket Data Managers floor of the Chicago Mercantile Exchange.While the product originally was designed for prop traders, Unetich says traditional asset managers and hedge funds also could use it to develop their own execution algorithms. Though he declines to reveal any specific companies, Unitech reports that Trading Technologies has received feelers from two buy-side firms in London and Chicago.“We’re basically offering a package of services for thousands that the prop trading firm start-up costs used to be millions,” adds Richard Lane,TickIt’s director of technology and founding partner.Ryan Carlson, an independent trader who trades Eurodollar futures onthe CME, was an early adopter of ADL. He says he uses the front end for algorithmic and point-and-click trading. “If you can design it, you can participate in the market using that strategy,” relates Carlson, who trades from all over the world via CME’s Globex system. Every day, Carlson notes, he’s able to adjust the algorithm’s variables. “One of the nice things about ADL is, I don’t have to rewrite the algo,” he says. “If I’m running 200lots, I can type over it and write 300.”In addition, once ADL is integrated into Trading Technologies’ network later this year, the platform will include a simulator with live market data, according to Carlson.“It’s a way to test things before you run it live,” he says.In the automated trading market, where a strategy only works for about six months,ADL can shorten the time to market and provide a safer trading environment, TickIt’sLane claims. “If you can shorten and normalize the development process, what a tool like thisdoes is afford the time to do the testing and toinclude these outlier situations,” he says. “A toollike this really shortens the life cycle of software.By shrinking the development cycle, you’re afforded a lot more opportunities for testing.”And faster testing means faster time to mar-ket and less time on the rack. Now algos may never go out of style. ISHARE。