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Continuous improvements in electronic trading systems make them suitable to address important trading issues faced by hedge fund managers By Andre Urbanski of Bloomberg Tradebook, LLC, a leading institutional ECN providing equity trade execution to hedge funds and institutional money managers worldwide.

Continuous improvements in electronic trading systems make them suitable to address important trading issues faced by hedge fund managers. This article examines recent developments in trading systems as they relate to "Best Execution" and international trading.

As the structure of the U.S. equity market undergoes rapid change, market participants are becoming increasingly concerned about execution quality. The term "Best Execution" is receiving a great deal of attention, with some market participants even calling on the SEC to define it. Outgoing SEC Chairman Arthur Levitt, while dismissing the need for rulemaking on execution quality, has placed Best Execution at the heart of the debate on market structure and has asked market participants to think carefully about ways to realize the promise of Best Execution.

There is no one way to define Best Execution. Best for one customer or order might be the purchase of sale or stock in seconds with low sensitivity to price, while for another it might be anonymous accumulation of stock all day at favourable prices. In order to achieve the specific objectives of an order or client, an electronic trading system must provide three key components: transparency, linkages and innovative trading tools.

Transparency refers to the ability of market participants to see or become aware of other market participants' orders. Linkage refers to the ability of market participants to trade with the quotes they see, or to execute trades at those prices in a timely manner. Linkage and transparency go hand in hand because market transparency without electronic linkages makes it impossible to execute against the visible liquidity.

Transparency requires an unbiased, integrated display of orders from participants, market-makers and other electronic communication networks (ECNs). The system must not focus on internalising order flow as some do. Instead, an open architecture system ensures that orders execute against the best prices in the National Market. Some ECNs present displays showing their orders in one format, with non-participant orders or quotes in a separate location with separate access - such displays do not provide the transparency needed to quickly see and trade against the best prices (which may or may not be in the internal book of orders). Transparency requires a decentralized, open and competitive marketplace where all orders freely interact with each other.

The next key component is linkage. Seeing prices and not being able to trade against them doesn't get you very far in search for Best Execution. A trading system should offer the ability to trade with any and all participants in the Nasdaq quote and go out to all other market-makers and ECNs to directly access the liquidity needed to execute orders. As such, the system should have dedicated high-speed links to access other market-makers through Nasdaq's SelectNet system and the major ECNs (Bloomberg Tradebook, Archapelago, RediBook, Instinet and Island).

Once transparency and linkage have been established, the trader needs a set of sophisticated trading tools that help efficiently access all points of liquidity. Institutional size orders need to be transformed into orders that can safely interact with all of the varied layers of liquidity that exist in Nasdaq - be they from retail customers, day traders, proprietary traders, derivatives desks, market-makers, program traders, and other institutions. In totality this liquidity is enormous - accessing it efficiently requires sophisticated algorithms that "slice and dice" large institutional orders into a wave of smaller orders that tap this liquidity without overwhelming it.

To quickly access available liquidity the first thing needed is immediate representation of a trader's orders in the quote. While this may sound trivial, a recent study conducted by the SEC revealed that this is far from certain when utilizing more traditional order routing to market-makers. The SEC investigated whether market-makers were abiding by rules enacted in 1996 that require the display of customer limit orders that improve the prevailing market price within 30 seconds of having received them. At three of the large Nasdaq trading firms that were sampled, the SEC found violations of limit-order display rules in 46%, 58% and 92% of trades sampled. An order should be represented electronically the moment the trader hits the enter key for his/her order.

Beyond immediate representation in the quote, the trading system should provide a sophisticated suite of trading tools that help achieve the trader's own Best Execution for all orders. This suite should include the following:

1. Complete Anonymity - minimize information leakage and market impact.

2. Reserve - provides the ability to show only a specified portion of the order while placing the remainder in a reserve that, while not visible to others, remains positioned for execution. Once again, this helps to minimize market impact.

3. Bang - ability to directly access liquidity from NMS participants: take offers, hit bids, sweep through multiple levels, send immediate or cancel orders, send orders to specific market makers and ECNS and much more.

4. Pegging - moves an order up or down as the National Best Bid and Offer (NBBO) changes. This allows an order to remain continuously positioned to buy or sell based on specified parameters.

5. Discretion - ability to display passively while responding aggressively to certain bids or offers within a pre-specified range without revealing openly one's willingness to trade at those levels.

6. Time Slicing - ability to slice an order into multiple pieces to be traded at specified time intervals over the whole trading day or a portion of the day.

7. List Management capabilities - ability to upload/download lists or baskets of stocks that need to be traded simultaneously and seamless connectivity from the PC into the trading system.

Whatever the execution needs, a combination of innovative tools can be used to tailor a custom solution. When combined with superior transparency and linkages, these tools can truly empower the trader to receive Best Execution.

International Trading: Bloomberg's Tradebook example

While the growing use of alternative trading systems has benefited traders of U.S. stocks in a number of ways - increased liquidity, new trading tools, and anonymous platforms to conduct business, those benefits have not always been available in foreign markets where traders have had fewer options and less flexibility. In addition, the less liquid nature of most overseas exchanges and the relative size of institutional business have combined to make market impact a central problem faced by many trading desks.

To help close the gap, Bloomberg's Tradebook platform has been extended to 65 countries, offering the same access to liquidity that institutions are embracing in the U.S. This functionality is linked with the global execution, settlement, and clearing capabilities of G-Trade Services, Tradebook's global executing and clearing partner. The combination offers a completely integrated front- and back-office solution for international equity trading.

Tradebook gives trading desks direct control over orders down to the floor of the exchange, as well as the opportunity to trade within Tradebook's own pool of liquidity. It also lets institutions safely display their orders in less liquid markets so as to minimize market impact. Trade automation enables traders to slice orders throughout the trading session, depending on available liquidity. All of this takes place within an anonymous electronic environment.

Tradebook's reserve feature allows traders to enter just a fraction of their total orders for display on the floor of the exchange. The remaining portion is kept in reserve. So, for example, a 500,000-share order for Sony Corp. can be transformed into a 490,000 in reserve. Once the 10,000-share order has been filled, another trade for 10,000 shares is sent down to the floor of the Tokyo Stock Exchange, and this process continues until the reserve is depleted. At the same time, order quantities greater than the amount displayed can be used to access reserves elsewhere in the system if there's a match. In this way, traders can access off-market liquidity and receive fills without openly tapping the exchange.

A pegging feature lets orders move with the bid or offer. When a trader is buying a volatile stock, pegging to the bid allows the order to move up and down with the best bid within a specified range. In this way, it is continuously positioned to buy stock at the bid. In the case of Tokyo, this also works for short orders, which can't enter the market at a limit price lower than the last traded price for the equity. The trader can peg the order at this price, moving the offer side to the last transacted price.

Innovative solutions also exist for traders who link their buying performance to volume-weighted average price (VWAP). Aside from the ability to enter an end-of-day VWAP (VWAP for the entire day's trading session) or a point-of-day VWAP (the VWAP form the point the trade is entered to the end of the trading day), traders can have their trades sent to the exchange floor in equal parts throughout the remainder of the day. This can be pegged to either the bid, the offer, or the market. This feature gives traders an automated way in which to access markets throughout the trading session and in a fully anonymous way while minimizing market impact.

In addition, all execution information is available online and is fully automated down to the level of the exchange. Fills and balances are reported as soon as they are received from the exchange, and traders can interact with the market as close to real time as an exchange allows. Tradebook offers a fully automated back-office solution to clear and settle international trades. G-Trade Services is the executing broker for all of Tradebook's international business. It maintains a trading desk with specialist dealers in 65 international markets. All international trades are settled through G-Trade's central back office, which operates 24 hours a day, six days a week, from a single location. This site maintains real-time information about all market trading. Settlement messaging can be fully automated to a back office through industry standard protocols such as FIX, Swift, and Global Oasis. The risks and problems associated with international clearing and settlement have also been minimized through centralization of these functions in a specialist organization focused solely on the needs of the international trading community. u

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