The Dumbing Down of the Buy-side By David K.

Donovan The Regulation NMS (or Reg NMS) market infrastructure rules that were consolidated in 2005 to promote the national market system have instead paved the way for an unforeseen and unfortunate result -- the rise in machine trading and the move away from the more traditional capital facilitation trading of the past. Prior to 2005, buy-side firms invested in quality execution by hiring experienced traders that were as adept and knowledgeable of trading as their sell-side counterparts. Firms set up their trading desks in sectors to mirror sell-side trading desks. Traders processed information on a daily basis in their sectors and became experts based on their trading experience and the research/trading flow they received both from brokers and internally from their own in-house analysts and portfolio managers. Buy-side traders in the pre-Reg NMS era were extensions of their fund managers and were able to react effectively and opportunistically to changing market conditions. They traded their orders based on tactical perspectives and their personal experience by using multiple trading strategies. They were measured on their ability to execute at the highest level with the long-term goals of the funds traded taken into account. From 2000-2005, some of the best trade execution costs in the market leveraged the streets capital to trade aggressively based on both the long- and short-term goals of the firm. The focus on volume weighted average price (VWAP) was not as prominent because traders naturally beat this measure by trading on instinct. In 2005, Reg NMS changed all this by revamping the market structure and promoting the rise of machine trading. Orders were now executed mostly through electronic markets, and the human intervention for pricing discovery of trade execution was de-emphasized. Algorithms that mirrored the VWAP became the dominant strategy to execute orders, and buy-side traders were using these algorithms to execute orders. Instead of traders trading order flow, they became traders who managed order flow through the machines. Traders no longer looked to be opportunistic and trade aggressively during times of price displacement. Instead, they would go along and work orders over the day through the machines and then would simply settle for their average price execution I call this the dumbing down effect. The Rise of the Machines Today, almost all equity order flow goes through some type of machine. The result is that the U.S market went from handful of exchanges with onsite regulators that required balanced markets into 40-50 trading venues with both dark and light markets that are crossed owned and that favor high-frequency trading firms (HFTs) or flash traders. These new trading venues are co-owned by HFTs and sell-side brokerage firms that both have large financial stakes in these new exchanges. Technology now dominates the equity market for execution. HFTs co-locate by placing large server farms right next to

exchanges so they can get faster data feeds with the sole goal of scalping the buy-side order flow. Mutual fund companies that represent the public through 401k, pensions accounts and saving plans dont have co-location facilities and their orders are preyed upon by HFTs, which represents 70% of all of the equity trading volume being executed on exchanges. So what are HFTs? In simple terms, they are computerized trading programs. They make money basically in two ways. First, they offer bids and offers in such a way that they make tiny amounts of money per share from rebates provided by the multiple trading exchanges. Second, and more importantly, they make tiny long/short profits on billions of shares per day by front running institutional orders they detect in the market place. Reg NMS was passed to create more liquidity and transparency to the equity markets so that institutions could transact in a more efficient way. Instead, it has had the opposite effect -- markets are now much more fragmented and markets are less transparent. The U.S. equity market is now mostly a for profit enterprise of dark pools, electronic communications networks and alternative trading systems that are connected by low latency high-speed technology. There is no actionable or visible liquidity on which institutions can see or act. Now every order is hidden in an algorithm and sliced and diced over the day. Exchanges need to make up for the lost profits they used to receive from new stock listings. The financial crisis and the dot com bust have reduced new IPOs and listing fees by 50% since 2000. To compensate, exchanges have started selling advanced market data that caters to HFTs at the expense of the buy-side. HFTs can use that data plus other technology tools like actionable indications of interest to pick off orders in algorithms and dark pools. As a result of the rise in machine trading, VWAP and time weighted average price as a means of measuring trade execution, mutual funds started looking for ways to cut costs. Mutual fund complexes and fund managers started accepting VWAP as a way of execution, and the need for experienced trading professionals who could add alpha by their trading expertise became reduced. When the financial crisis of 2008 hit, asset managers needed to cut costs. They decided to start using less professional traders and swapped experience trading professionals for order clerks or less experienced traders who could just manage the trading flow into the machines. Instead of a better understanding and an emphasizing of opportunity cost as a way of measuring trades, mutual funds focused on cents per share trading and commission rebates as a way of satisfying shareholders that they were sensitive to transaction costs. With trading commissions compressing and rebates eating into any profit opportunity, the sell-side responded by investing more in technology and less in capital facilitation as a way to execute trades. As a result, there was more volatility and less quality liquidity in

the equity markets. For example, in the past, the sell-side would provide quality liquidity in mid- and small-cap stocks by using their balance sheet to commit capital to facilitate trades. Today, with the market fragmented, liquidity in those names is nonexistent. As a result of asset managers not getting quality liquidity in mid- and small-cap names, they have instead turned to investing in exchange-traded funds and broader market indexes at the expense of single stock names to get market exposure to this group. Price Slippage The sell-side has also decided to invest and better align itself with the HFTs, which has created a conflict of interest for the buy-side. Now when a buy-side order is entered in a brokerage electronic trading system, the buy-side electronic algorithmic order is being routed to the cheapest venue and not to the venue that provides the best liquidity and execution. These cheaper venues contain HFT predators that can take advantage of robotic order flow based on VWAP algorithms, resulting in price slippage. Price slippage, for example, occurs when a buy-side trader pays $26.50 for an execution, which is $.02 better than VWAP, instead of paying $26.40 for the same stock but lost by $.02 to VWAP because the machines forced liquidity at higher prices, thus manipulating VWAP. Ironically, the buy-side trader accepts this because he or she looks better under the VWAP way of measuring trades. WVAP can be manipulated by the HFTs once they identify the algorithm. They use lighting fast technology to front run and profit against the VWAP orders. Another way that HFTs profit against the buy-side is through flash trading. The HFTs get proprietary or flash orders and use this data to give them the edge to make huge profits, which is known as latency arbitrage. The latency being arbitraged is the speed of data sent to computer terminals. This is why you see HFTs co-locating their servers next to exchanges. Both HFTs and brokerage firms are spending lots of money on advanced technology and software upgrades to reduce latency. By using cutting edge technology and co-location with exchanges, along with purchasing raw data feeds which are faster than the consolidated tape -- the HFTs are able to create their own best bid and offer (NBBO) quotes ahead of what is available to the public. This gives HFTs the advantage of knowing the market direction microseconds ahead of the public -- information that is extremely valuable when youre trading thousands of stocks thousands of times a day. In a past release on market structure, the U.S. Securities and Exchange Commission (SEC) itself acknowledges the advantage: Some proprietary firms strategies may exploit structural vulnerabilities in the market or in certain market participants. For example, by obtaining the fastest delivery of market data through co-location arrangements and individual trading center data feeds, proprietary firms theoretically could profit by identifying market participants who are offering execution at stale prices.

What this means is that exchanges are providing HFTs with the ability to out institutional orders. This in turn makes the exchanges complicit in disadvantaging the asset managers, institutions and brokers that have a fiduciary responsibility to their clients. Buy-side traders must protect their firms orders by adjusting and changing their methods of trading to avoid HFTs. By constantly relying on the same VWAP algorithms to execute trades, they are setting themselves up for the HFTs predatory activities through price slippage and front running. HFTs profit every day because theyre playing poker and can see everyone elses hands. David K. Donovan is Vice President of Sapient Global Markets, a business and technology services provider to the capital and commodity markets. Previously, David Donovan was the preeminent trader at Fidelity Management & Research (FMR), where his vision and grasp of the intricacies of the global market enabled him to make key decisions across Fidelitys major funds. Disclaimer: The views and opinions expressed here do not necessarily reflect the views and opinions of Sapient Global Markets or any other company. For more information, visit www.davidkdonovan.com. ###