How Do Execution Algos Add Value to Each Link of the Chain?
It’s clear that computerized algorithms are finding their way into nearly every sector of our modern lives, from what shows we watch to what route we take to work, to what goods are suggested for us to get delivered right to our doors. The investment and trading world is no exception. Over the past decade, algos have become increasingly essential for traders of all shapes and sizes. And now the key is not just the use of algos in trading, but to choosing the best ones to use.
When speaking about trading algos, it is important to distinguish between the two primary use cases: alpha or trade signal generating algos and trade execution algos. The differentiating factor lies in when the algo is deployed and the function it serves. Alpha algos look at any number of factors, be they technical or fundamental, to help an investor determine what (and how much) to invest in based on their predetermined risk factors and specialized settings. On the other hand, an execution algo facilitates the next step in the process, where the trader has already decided what to trade and in what direction, but not necessarily how or when to trade it. These execution algorithms decide how and when the predetermined trades should be placed in order to minimize slippage and market impact. A simplistic example is an alpha generating algo crunching price data to generate a signal to buy 500 contracts of crude oil futures at the current market price, while the execution algo will crunch bid and offer data to do 200 contracts now, then 50 a few microseconds later, then 70, then 180 over the next minute to get as close to the desired price as possible.
The most recent area for opportunity with execution algos is clear – the futures markets. While equity markets have been using such quantitative techniques for quite some time, the futures markets have taken a little longer to get on board. For decades futures markets have been dominated by players in energy, agricultural, and large asset management firms – hedging their physical positions and trades in the open market with other large counter parts. But a new rising player has been changing the game, throwing off the traditional market dynamic as we’ve known it – quant traders. These smaller but very technically focused prop firms and hedge funds focus on the speed and microstructure of markets, using those technologies to exploit the inefficiencies of futures market execution – either because of order latency or indifference by some to crossing the spread and receiving worse fills. As a result, execution algos have become essential for anyone and everyone looking to invest in futures markets, be they grown in the ground commodities or financial futures such as E-minis or bond futures. Execution algos offer an increase in upside potential for investors by leveling the playing field (some execution algos do this better than others). But what’s harder to see is how these algos strengthen every link in a now stronger and more efficient chain, and thus have begun to create a more efficient and heightened economy.
Here’s how execution algos are improving customer results for industry players throughout the value chain:
Independent Software Vendors (ISVs): These vendors represent the channels or pipelines that bring trades to the exchange. We’re talking the software or online trading platforms showing market quotes, depth of book, and a bevy of advanced tools and indicators to support traders in futures markets. Whether on a screen or through an API, adding execution algos to the ISVs give their customers more choices than ever before. An example would be to think of these ISVs as Netflix or Hulu, both of which deliver content to the users of their platforms. Now if you add execution algos to the ISVs platform, it’s like adding a whole new set of content and movies available to stream. By embedding execution algos inside of their platforms, ISVs can offer a trader money savings options on each trade.
Exchanges: The benefits for exchanges to facilitate and offer execution algos are just as clear, as they garner a large percentage of revenues from the large trading firms and CTAs which trade big volume in large blocks. In helping their largest clients cut down on possible inefficient trading by using execution algos to reduce slippage, it creates new opportunity for those clients to reinvest their savings back into the market – back into the exchange. The more the exchange can keep up with the quant revolution and expand their services in relation to the needs of these largest clients, the better off they will be.
Banks/FCMs: These players are a little bit more complicated, as there is a divide between those who have their own in-house algos and those who do not. But regardless of owning proprietary versions or not, there’s opportunity for the use of dedicated execution algos from third parties.
a. If they don’t already have algos: They typically already have trading desks that simply don’t have the programmers, capabilities or software to create their own execution algos. It can be tough for those desks to win business or retain existing business when competing against firms that do have the capability of building execution technology in-house. Without an affordable algo option, they may quickly notice a loss in market share to the competition. Utilizing third party execution algos will allow these players to not only stay in the game, but compete and win business from some of the larger players with deeper pockets. It’s like using Salesforce versus building your own CRM.
b. Even if they do already have some of their own execution algos: Banks and FCMs can still outsource this portion of the business to teams that are dedicated to continue optimizing and improving existing algos, and creating new ones. Without continuing to put resources towards constantly monitoring and modernizing their execution algos, gaps quickly appear in trading performance. For those groups to thrive longer term and continue to win business it makes sense to explore outside options, so that they can continue to use quality execution algorithms as a value add to their desks.
Traders: Traders are probably the most obvious group that benefits from the use of execution algos. In addition to the obvious things like improvements in returns, lessened slippage and market impact – when using execution algos, traders spend less time focusing on the physical execution, and more on R&D, other desk tasks, or improvements to the alpha of their strategy. Where traders may be currently placing 10 – 100 lot orders to buy over the next hour, they can now place 1 – 1000 lot algo order. This all equals time savings and more money either for the firm (if prop trading) or the firm’s clients (if managing outside money).
All of these pieces together makes the final output – the trillions of dollars in exchange traded futures changing hands – that much stronger and more linked than ever before. And as the world continues to become interconnected and globalized by computerized algorithms, execution algos become increasingly necessary as it offers opportunity for each link in the above chain to increase their value to the overall picture. I’m excited to be a part of the growth of a firm dedicated to execution algorithms (RCM-X) and be able to work across the value chain – from ISVs to exchanges to banks/fcms and finally the traders – to bridge the gap from past methods to a revolutionized future. With the glow of execution algos shining into each segment of the market – the future of the futures markets has never been so bright.