Wedbush Morgan Securities is not usually associated with the powerhouses of trading, but that could change.
The small retail brokerage and clearing firm has joined heavyweights such as Knight Trading and Charles Schwab on Nasdaq's weekly list of top liquidity providers. In fact, Wedbush ranked second for the week ended December 6.
In Thomson's AutEx/BlockDATA share volume rankings, however, the firm has placed no higher than 50 in recent years. So why is Wedbush making the Nasdaq list? How did it come to rub shoulders with some of the most active trading houses on the Street? The answer is black boxes.
"Black boxes produce a tremendous amount of volume," says Harvey Cloyd, in charge of Wedbush's professional trading group. "It's become a significant portion of our business."
Wedbush is one of a growing number of brokers catering to the expanding universe of black box traders. Black box, or auto-, traders, as individuals or in groups, program computers to execute trading strategies impossible to do manually.
Market Conditions
Black box trades can involve the simultaneous and/or periodic execution of hundreds or even thousands of orders. The trades are based on strategies that range from the aggressive price predictive momentum variety to more conservative arbitrage schemes. Executions are triggered by current market conditions or short-term forecasts.
The practice, driven by faster and cheaper technology, can be seen as a democratization of the "program" trading conducted by bulge bracket firms since the 1980s.
Former daytraders, PhDs, and others now have the ability to devise and run their own strategies across multiple asset classes. If they have already developed a successful strategy with five stocks they can automate and apply it to 100 or 200. If they want to trade thousands of pairs at one time, they can.
Traders typically work with software developers to build customized boxes based on their ideas. Many of the custom houses are obscure outfits operating with a handful of programmers such as New York's Radial Systems and Austin, Texas' WatchCat. Other traders may opt for off-the-shelf products from vendors such as Neovest or 4th Story [See Q&A].
It is estimated that most black box trading strategies – perhaps as many as nine in 10 – fail. "They are very successful on paper," says Amit Livnat, a principal at Radial Systems, "but lose money in the market."
The designers are inexperienced, Livnat adds. They often fail, for example, to properly account for slippage, or the difference between the expected price and the actual fill price.
John Paul DeVito, president of Bon Trade Solutions, a three-year-old connectivity provider, has also seen black boxes come and go. "We have run through so many of them," DeVito says. "In three years, we've seen only a few that were consistently profitable."
Automated trading is occurring at all levels of Wall Street, but the term "black box" trading generally refers to the activities of professional individuals, investment partnerships and small hedge funds. It is the low end of the professional market, but increasingly accounts for considerable share volume.
There are no statistics available on the number of shares, orders or participants in black box trading. But the scope of the business can be gleaned from information provided by some of the players. One of the larger brokers in this space, for instance, claims to be doing seven million black box shares per day.
At a proprietary trading brokerage, between 15 percent and 20 percent of its 500-member roster has the technology, says a spokesperson. None use it all the time though. A smaller prop trading house with 150 members counts 30 black box users. The rest trade manually.
One brokerage with a staff of 15, catering strictly to black boxes, claims to handle 10 million orders per day. Another source believes no more than 10 percent of the nation's approximately 8,000 hedge funds delegate their trades to computers.
Almost all players point to the growing percentage of program trades reported to the New York Stock Exchange as a proxy for the growth of black box trading. That said, the trading of Nasdaq symbols appears to predominate.
One proprietary brokerage says 70 percent of its black box order flow is in Nasdaq names. Another agrees, noting the NYSE's specialist system works against quick in-and-out trades. "It's hard for a black box to operate when you have a 30-second pause between orders," says Lime Brokerage chief executive Michael Richter, referring to the specialist's right to hold orders for up to 30 seconds.
Brokers servicing the black boxes are not large. Besides Wedbush, they include such shops as Lime Brokerage, MB Trading, Trinix, Trillium/Schonfeld, Echo Trading and TradeStation. Connectivity providers such as New Jersey's Bon Trade also target black boxes' access needs with APIs.
These service providers typically compete on the speed and efficiency of their direct access trading infrastructure and the quality of ancillary services. They may provide the algorithms, but more often do not. Black box traders mostly want speedy market data feeds and equally speedy connections to market centers.
Wedbush got into the game in 2002 after the flagging retail market forced it to look elsewhere for growth. Already a clearer of long-standing, the regional house decided to target fast-on-the-trigger hedge funds and broker dealers.
The broker dealers aren't too different from the hedge funds, Cloyd says. Many are engaged in proprietary trading using their own money. They're just set up as broker dealers. "We look at what they do," says Cloyd, "as opposed to how they are structured."
Like most of the brokers serving black boxes, Wedbush also services manual-entry keyboard traders. For them, Wedbush offers a proprietary front-end trading platform called Maximus for direct access.
For the black boxes, Wedbush does not provide strategies or trading algorithms. It prefers instead to focus on connectivity and clearing. To keep latency to a minimum, Wedbush last summer installed a risk management platform built by vendor FTEN. Orders pass through this checkpoint before traveling to trading venues.
Intraday RiskXposure was built especially for Wedbush, but is now being marketed to others. FTEN says the product gives brokers a comprehensive view of all of their clients' trades, thereby mitigating risk and enabling them to take on riskier clients. The vendor says the product introduces zero latency into an execution.
"The key to the whole electronic trading platform," Cloyd says, "is to handle every aspect of that business as efficiently as possible without introducing any latency into the process."
Just down the road from Wedbush in Segundo near the Los Angeles airport is one of the pioneers of black box hosting, MB Trading. The nine-year old brokerage entered the black box space in 2000 at the behest of its European clients.
They were trading in Nasdaq 100 names in Germany and sometimes needed to hedge those positions in the U.S. overnight. MB's customers automated their trading systems to trade concurrently with the U.S. MB developed facilities to allow them to do that.
"That just lent itself naturally into more people using us for automated algorithmic trading," explains MB chief executive Ross Ditlove.
MB Trading was established as a broker for daytraders. The shop still services the guys with the baseball caps, but among its black box customers it counts banks, funds (hedge and otherwise) and the so-called "semi-pro" traders.
The semi-pros are licensed, trade strictly for their own accounts, are self-funded or else trade for a group which provides the funding. The banks are European clearing firms similar to the U.S.'s broker dealer clearers. Their customers are brokers that either trade proprietarily or handle retail orders.
About half MB's customers are black boxers and half are keyboard traders. MB trades over 14 million shares per day, according to Ditlove; half is black box, half keyboard.
At Lime Brokerage, in New York, a shop that was started specifically to handle black box traders, the number of transactions exceeds 10 million per day, according to CEO Richter.
Serving Community
Lime was formed in 2001 because "the black box community was not being well-served," Richter says. "For most of the brokers, their level of service was not what I would call industrial grade." Lime now has 15 employees.
Richter says black box trading is of two types. Some traders use computers to predict price movements, which informs their decisions about when and how to place the orders. Then there are those who monitor the quotes in the market to make those decisions.
Driving black box trading, according to Richter, is the fact that increased computing power has enabled traders to link the decision of what to trade to the decision of how to trade. Whereas in the old days, a strategy might be traded once a month. Today, it can be traded several times per day.
For example, assume a trader wishes to execute a long/short strategy whereby he goes long the best stocks in the S&P's industry groups and short the worst. The strategy is not novel, but may contain hundreds of symbols. Trading manually could take days.
With black box technology the portfolio can be kept in balance more frequently. Rather than rebalance the portfolio once a month, the trader can rebalance once an hour. That way he keeps the weightings of his portfolio in line with his strategy.
Lee Maschler, president of Trillium Trading, part of daytrading giant Schonfeld Group, agrees the increased popularity of black box trading is due to the way it enhances the value of a trader's strategy.
Much computational power goes into the development of a strategy. But, previously, when it came time to execute, "you called it in to your broker," Maschler says, "and he worked it." Now, the PhD who devised the overarching trading strategy can also develop an execution strategy to micromanage the order. That maximizes his return, notes Maschler.
Trillium, which was known as Heartland Securities before being acquired by Schonfeld in 2003, is promoting a home made messaging protocol to attract the black box trader. Known as HUBB, for Heartland Unmanned Black Box, the technology was built for speed, says Maschler.
Because it was purpose-built it contrasts with the industry standard FIX language. FIX must please a varied group of users and is weighed down with many often superfluous components, Trillium execs say.
"FIX is not designed to transmit mission critical market data and orders between the user and the end exchange," Maschler says. "It does not translate well to program trading that requires sub-millisecond performance."
Trillium's HUBB gateway processes four streams of data. It takes in market data and trade reports from execution points, passing them back to the trader's black box. And it accepts traders' orders and cancellations, passes them through risk and compliance checkpoints before sending them out to trading venues.
Most of Trillium's customers-which include both individuals and small investment partnerships-access its infrastructure from off-site. But they often locate their black boxes in Trillium's data center. That data center also happens to be next to INET's data center. The proximity reduces latency, Trillium execs maintain.
Trillium's relationship with INET is longstanding. Before it was called Heartland, the firm was known as Datek Online. The daytrading pioneer, run by Maschler's father and brother, created the Island ECN. Island would later merge with Instinet to create INET.
Trillium doesn't provide algorithmic trading strategies, but its competitor EchoTrade does. In 2003, EchoTrade, a unit of Pax Clearing, began promoting its Predator Pro automation software to its 500 members. Between 15 percent and 20 percent use the software – although not all the time – to trade more stocks than they can manually.
"It's for the experienced trader who already has a strategy that is working," says EchoTrade exec Rob Keller, "and who wants to take it to the next level."
The Trader
EchoTrade charges users either $199 or $249 per month for the software. Most users are trading single stocks though some trade baskets. Keller notes the trading program is only as good as the trader. "Automation isn't going to make a trader successful unless he already has a successful strategy or formula," Keller says. "All it is doing is what the trader would normally do, but it is taking the emotion out of it."
