Program trading on institutional desks has become popular at a time when markets are volatile and trading margins depressed.
"Program trading desks are a necessity these days," said Michael Mook, co-director of program trading at Weeden & Co. "At large firms, at bulge bracket firms, they all must have program desks."
Mook estimated that program trading accounts for 30 percent of the business of an average desk at a big sellside trading firm. In the late 1990s, he said it was about five percent.
Mook predicted that, in five years, program trading would cover about 45 percent of the institutional business. Big firms have no choice, trading executives stressed.
"This is a question of where necessity has become the mother of invention. We could have done this many years ago and saved a lot of money. But when we were in a bull market, no one wanted to challenge cultures at that time," said one trading executive, who didn't want to be quoted by name.
Unprecedented
A 40 percent drop in most stock market indexes over three years will do a lot to change cultures in a hurry. So will unprecedented volatility. For example, back in the mid-1990s, the S&P 500 index could go some two years without rising or falling two percent in a single day.
Last year, that kind of thing happened at the S&P about once a week and on the Nasdaq about twice a week. That has taken program trading from an exotic strategy used by quant houses and tech nerds to the mainstream of the trading world.
Indeed, on a recent week on the New York Stock Exchange, some 10 percent of the program trades involved stock index arbitrage. Program trading overall accounted for an average of 487 million shares daily, or some 40 percent of the Big Board total.
Some of the largest growth in this program trading is from institutional investors buying and selling portfolios of stocks. This kind of institutional program business is called portfolio, or basket trading. And it is becoming big business.
But what exactly is program trading?
"Program trading," the Wall Street Journal states in a definition many trading executives endorse, "is the simultaneous purchase or sale of at least 15 different stocks with a total value of $1 million or more." The biggest players are Morgan Stanley, UBS, Goldman Sachs Group, RBC Dominion, Deutsche Bank Securities and Credit Suisse First Boston.
"Program trading is the trading of large numbers of stocks, large numbers of orders in some coordinated way at the behest of a client," said Larry Leibowitz, executive vice president of equities at Schwab Capital Markets. It began with index arbitrage and machine generated orders, but trading executives say its application has spread tremendously over the past decade.
"In addition to lowering costs, program trading has become an essential risk management tool," said Alan Rubenfeld, a director in Deutsche Bank's global portfolio trading group.
"For a firm to become an effective portfolio management player, it must have worldwide capabilities and offer both principal and agency options," added Sean McFarland, another director in this group.
Average buyside traders – many without technical computer expertise – now look favorably at portfolio trading. "Program trading offers efficiency to the buyside in terms of managing risk and routing orders," said Enrico Gaglioti, head of global program trading at Goldman Sachs. "Now, more than ever, transaction costs and execution are being more closely looked at with regards to performance," said Greg Tusar, who runs the TradeFactory, Spear Leeds' front-end trading operation. (Spear Leeds is an affiliate of Goldman Sachs.)
Buyside Desks
Program trading is seen as cost effective by buyside desks. The typical commission charged to institutional accounts by sellside firms for a program trade is around 1.5 to 2 pennies a share at the largest firms. That's compared with 4.5 cents to 5 cents a share at many large desks executing a block stock order.
"In today's marketplace, where the use of large block trading is dropping, buyside desks have really been forced to piece their orders into the marketplace a lot slower and in smaller increments," said Mook.
Factors driving this move toward portfolio trading include the trend of smaller trades, which are less efficient and more expensive for firms than executing entire portfolios. For example, Nasdaq's average trade size has dropped from 1,712 back in 1997 to just under 600 shares recently, according to Birinyi Associates. The same has been happening at the Big Board. The average trade size has gone from about 1,800 to some 500 in the same period, Birinyi reports. Smaller trades mean desks – like it or not – must find a way to become more efficient, trading executives say.
Critical Weapon
Indeed, portfolio trading has become a critical weapon for margin squeezed desks battling for decent profits in a bear market.
Program trading, which is enormous on the listed markets, is also on the rise on Nasdaq. "If you're doing a lot of S&P 500 index, large cap names, then you're doing portfolio trades on listed exchanges," Mook said. "If you're using a lot of small caps, then it's Nasdaq."
Both the buyside and sellside are benefiting from program trading.
"We are seeing more and more sellside firms looking to open program trading desks," said Vijay Kedia, a former Bear Stearns official who set up FlexTrade Systems, a seller of program trading software. Kedia, in a recent interview with Traders Magazine, said that previously program trading was a strategy only used by elite desks. But now even the regional brokers, the second tier brokerages, consider setting up these desks.
"Everyone is looking at program trading. Which speaks to demand on the buyside to send programs to the sellside," Kedia said.
That's because, in some cases, program trading is a necessity for desks that are trying to survive declining revenues.
"Commissions look so meager or fragile," said Jay Bennett, an analyst with Greenwich Associates, "that they are worried about making any money whatever happens to markets – and they certainly can't make any with an overly specialized sales force."
Trading executives say that, although the computer will never completely replace the human element, program trading is going to be increasingly used by desks even when the bear market is over. On the buyside, the execution is usually handled by the trader, though at some firms portfolio managers take command of this process.
"I do think that program trading is really the only way to trade these days because of the penny markets we're facing," said Leibowitz. And this is also true in listed as well as unlisted markets. Portfolio trading, back in 1992, made up less than 5 percent of the Big Board's volume. By the end of last year, that number was 32 percent, according to New York Stock Exchange numbers.
The appeal of program trading – of bigger, more cost effective trades – is undeniable in a bear market in which savings must be found.
That's because broker equity revenues some 30 percent over the past three years, according to the Securities Industry Association. Effective relative spreads on the Nasdaq market were a little above 1.60 percent in 1992. A decade later they had shrunk by close to 90 percent. By the end of last year, they were below 0.20 percent, according to Nasdaqtrader.com.
Margins
Both the buy and sell sides of the institutional business are facing declining margins. Since the bear market has been squeezing them on the revenue side, that only leaves creative new expense reduction strategies, in the short term, as the path to profitability. And that also means more efficient ways of trading, say market observers.
"They are," according to a pair of recent Greenwich Associates reports referring to institutional traders, "reducing sellside receipts by cutting basic commission rates, shifting brokerage business into portfolio trading and electronic systems, and increasing their use of soft-dollar and commission recapture programs."
Schwab recently eliminated hundreds of traders, hoping to find huge cost savings through the greater use of electronic trading in Schwab's Liquidity Network. In fact, Schwab's Capital Markets President, Lon Gorman, has made big promises about the benefits of using more computerized operations.
"We fully expect the Schwab Liquidity Network to advance the art of market making in a way that ECNs did in the last decade," Gorman said.
"The more automated you are. The more leveraged you are. The better the product you're going to be able to offer," Leibowitz added.
Program trading, or portfolio trading, has become enormously popular with many desks over the last few difficult years. And one of the more popular elements of the program trade has become the principal/risk program trade. The amount of such trades increased from 21 percent in 2001 to 37 percent in 2002, Greenwich Associates said.
Greenwich Associates also reported that the economic motive is stark. Electronic brokerage systems and portfolio trading have "commission rates which are around one-third less than those of normal agency transactions at 12-15 basis points." Those two strategies, the report said, have become increasingly used in the trading of European equities as well as domestic stocks.
"For instance," Greenwich Associates noted, "around two-thirds of most active U.S. institutional investors (those generating over $20 million in U.S. equity commissions) are now doing portfolio trading in domestic shares, and these institutions are doing 14 percent of their total trading this way." The report also says that huge amounts of Asia/Pacific and European shares change hands through portfolio trading.
Greenwich Associates' studies list as these key reasons for the success of the principal program trade: There is cost certainty. These transactions are efficient. A trade can usually be completed in one day.
Benchmarks
The growth of program trading will, without doubt, continue over the next few years, trading professionals predict. But they also say that program trading's more frequent use stems from the quality of executions as well as the endless hope of firms to attain the Holy Grail – which is to beat benchmarks.
"Portfolio trading is a way to beat the VWAP," said one trading executive who didn't want to be quoted by name. "Many of our clients only trade with us on an agency basis and we use the VWAP as a benchmark and the deviation from VWAP has become closer and closer recently. Therefore, missing VWAP has happened less and less," he said. As portfolio trading moves closer to benchmark standards, it also is trumping a trading standard.
Here is one example of how program trading is a step up from block trading.
"Assume that a client wants to get the average price. Let's say he is shooting for the VWAP, which is his benchmark," said Doug Rivelli, who co-manages Weeden's program trading operations. "If he had 50 names he gave to a block desk, each trader would get five or six names to watch and those traders would be making active bets on where they thought those names would go throughout the day. The swings versus their benchmarks would be very high when they were right. But if they bought it and the stock dropped two dollars or so, then they would look horrible," Rivelli added.
Several traders have said that the losers in this move to portfolio trading will likely be the block traders.
"The faster trading becomes, the smaller orders become," commented Brian Pears, head trader at Victory Capital Management in a column for Traders Magazine's online service. He believes block trading, because of current market trends, is in decline.
"The smaller orders become, the more likely a large order is executed in algorithmic fashion. We all become VWAP-style traders, simply because the marketplace losses its ability to discover price in blocks," Pears noted.
With program trading, Mook said, traders take a more historical, liquidity, and statistical view of a stock. Traders look for short-term momentum indicators and they also try to find the tendencies of a stock over the course of a day instead of over a shorter period.
This will give the pro using program trading a chance to record better numbers than a traditional block trader because, in part, the computer can process 50 stocks in milloseconds. "A human can't do that," Mook said.
Nevertheless, Goldman Sachs' Gaglioti, who believes that the use of program trading will inevitably rise, said that even computerized strategies will also always need "some level of human intervention."
But, adds Mook, "a computer decision is instantaneous. With a human there is also a delay." And that means, several trading executives explained, that desks using program trading have the chance to beat benchmarks.
"I think you have seen costs versus VWAP drop significantly on program trading desks," said a trading executive who didn't want to be quoted by name. He said that several studies have shown that the average cost versus VWAP is about a penny and a half less. "That's a very significant cost savings," he noted.
The Downside
The disadvantage of program trading? Mook said it can divide firms.
"One of the things bigger firms have difficulty with is that their program desks and their block desks have a tough time integrating," he said. "So if you have a block desk on one side of the floor and a program desk on the other end, they cannot talk to each other and they ultimately don't want to because each department's profits are measured individually."
But there is another benefit of program trading, trading executives say. It is in the quality of the execution.
"What computers do is increase the consistency of your executions. So on the one hand, you may avoid once in a while doing really, really well, but you will also avoid doing really, really bad," said Schwab's Leibowitz. He noted that portfolio trading was appropriate because "today clients are just more sensitive to the negative impact of the downturn."
The lessening of violatility – especially just after a three year period in which most markets were down more than 20 percent a year – is a critical factor today for many clients, he adds.
But then so are the costs of highly compensated, highly-skilled traders. Human skills are almost always the biggest bill in any financial services firm. Before the massive layoffs at Schwab, which makes a market in thousands of Nasdaq stocks, it would have needed about 250 traders, Schwab officials say. Today, using its electronic trading strategies, the number is about 45.
"And what's even better about this is that those 45 traders now will be paid very well," Leibowitz said.
Nevertheless, several trading executives argue that, because it has become more successful, individual traders will become more involved with the strategy.
"Today program trading desks have gone from being desks that just execute baskets of securities, to desks that have really focused much more on enhanced execution strategies," Mook said.
Major Players
Several trading executives said that program trading originally made sense for index arbitrage. But "now every single vanilla account is looking at program trading because of the need to lower costs." One trading executive added that portfolio trading has gone from a specialty of "quant players" to a technique used by all the major players including the big investment companies such as Fidelity, Alliance Capital and Putnam.
What could stop the march of computers and the popularity of portfolio trading?
In the short term, trading executives say they only see it growing because of penny trading. However, let's say the Securities and Exchange Commission were to accept the trading industry's request to impose the minimum nickel tick? Then, these executives agree, if that happened, the growth of program trading would slow and the use of block trading would start to rise. And some trading executives also say that, for now, regulators tend to look benevolently on the use of program business because of its cost savings and transparency.
So trading executives predict that program trading strategies, for the foreseeable future, will continue to rise. Regardless of regulators or the return of the bull market, the growth of program trading is going to continue.
