Prologue

In a research brief titled "Algorithmic Trading: Brokers Race to Mediocrity" that was published in Securities Industry News, October 2004 by analyst Randy Grossman (Financial Insights), he concludes that Algo trading has not yet lived to the hype of delivering transaction-cost savings to the buy-side desk. He further argues that this re-affirms the value of block trading specialists such as Liquidnet, Pipeline and Harborside+.

It's my opinion that the fundamental problem with Algo trading has to do with its synthesis from broker-performance-benchmarks to better-execution-mechanisms. VWAP or the poster child of algo trading began its life as a broker evaluation benchmark which was meant for aiding buy-side desks in their evaluation of their brokerage counterparts. Trade execution algorithms are a classic case of how the sell-side managed to adapt and quickly learned to benefit from the big stick of broker evaluation benchmarks. In essence, they took those same benchmarks that were designed to keep them in-check and ever so enterprisingly turned them into one of the better arbitrage opportunities of late.

By guaranteeing a performance pegged to a benchmark, not only did the sell-side appease the money manager, they also succeeded in creating valuable liquidity within their own pro trading books. To top it off, they also commanded beefy commissions for this premium service.

By demanding a pegged guarantee, the buy-side has succeeded in short-circuiting the agency relationship and placing their brokers on the same side of the market they were on. It is no wonder that traditional agency trading is taking a backseat to the more lucrative practice of principally trading institutional pegged inflows.

It won’t be long before the buy-side comes to the conclusion that if their brokers are making a tidy return selling execution guarantees, then they are most certainly not realizing their coveted “best execution.” Somewhere along the way, a healthy premium is being left behind..