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By Scott Kurland and David Sher, New York. Mr. Scher is a veteran of the hedge fund industry having founded and managed Lafayette Capital Partners, LLC, a quantitative hedge fund, as well as Elephant eXpress, an institutional brokerage company. Mr. Kurland was a pioneer of direct access and ECN routing technology in the early 1990's, when he co-founded Equity Traders, LLC. He has since worked with Mr. Sher to develop listed routing technology, electronic trading systems and proprietary trading strategies through Elephant eXpress, and most recently through Double Alpha Holdings, LLC in New York. This article appeared in the August 2002 issue of Hedge Fund News┐.

Today, many fund managers running quantitative, black box strategies in the momentum, market-neutral and statistical arbitrage space alike are finding that a major key to success lies in the ability to reduce or eliminate the slippage associated with act

Today, many fund managers running quantitative, black box strategies in the momentum, market-neutral and statistical arbitrage space alike are finding that a major key to success lies in the ability to reduce or eliminate the slippage associated with actually executing the strategy. This is a particular problem in the listed market, where there are much fewer tools to provide portfolio managers with control over their orders and trading strategies. In the Nasdaq environment, tools like SOES, Island, SelectNet Preference, and Instinet provide greater speed, more information, better anonymity and more flexibility to work orders and develop successful proprietary strategies. The reason for this is that NASDAQ is a "WYSIWYG" market, where WHAT YOU SEE IS WHAT YOU GET: a quote is immediately accessible to anyone who wants it for the size quoted. The listed market is not a WYSIWYG market. The NYSE, for instance, often shows liquidity at a certain price, but it is not WYSIWYG; it may not even reflect the current true price since the NYSE Specialist has up to 90 seconds to update his quote. He is not even obligated to fill you at the quoted size he shows, and therein lies the problem. In the listed market, the Specialists on the NYSE and the other exchanges are just like your competitors on Nasdaq. And yet every time you send an order through DOT to a Specialist, you forfeit speed, anonymity and trading flexibility. In essence, you give up control of your order to the very person who is competing with you in that stock! And you pay a commission or "floor charge" to do this.

As any fund manager can tell you, there are many strategies that look great on paper. Yet the key to success is being able to actually execute them in virtually all market conditions, which is why in today’s market environment, managing slippage is more critical than ever. In this article, we would like to give some of our thoughts as to why slippage occurs and how we built an Electronic Specialist and Alternative Trading System to help solve this problem.

Models, Market Data, and Trade-Throughs

Models are built based upon market data. Because of rules regarding when a Specialist must print the trade, the data may be very misleading. A transaction that printed on the tape at 12:05 for example, may actually have occurred 90 seconds before. This delay is a major cause of problems for anyone wishing to model transactional data. The secondary problem associated with this issue is that a trader may seem to miss a price that does occur, in spite of seeming to be the best price in the market at that time. This problem is often referred to as the trade-through problem.

A trade-through in the listed market occurs when another market center -a regional exchange, the NYSE, or a Computer Assisted Execution System (CAES) Member, for instance, seemingly executes a trade outside the national best bid or offer (NBBO). For the most part, a trade-through occurs when one exchange is showing a bid/offer and another exchange prints an execution at a price that is not as good as the price being offered on the other exchange. For example, say your order represents the best bid in the market for 2000 shares of IBM at 125.10, represented through another system or ECN’s Quoted Bid, and while your order is still open, a NYSE Specialist executes a 500-share trade at 125.05. In this case, technically the NYSE has "traded through" you.

Why do these trade-throughs occur in the first place? One reason stems from the fact that there are multiple systems involved in the Consolidated Quotation System (CQS) and that, with the exception of the Cincinnati Stock Exchange, the NYSE and the other regional exchanges connected to the InterMarket Trading System (ITS) are primarily manual operations with human operators. While these Specialists are busy evaluating incoming order flow and posting executions, they may fail to notice that another exchange has a better bid/offer at that exact moment. Or, it may be that the Specialist is anticipating a move in the price of the stock, making them unwilling to take the other side of the trade. While there are SEC rules which specifically prohibit trade-throughs, the reality is that the volume of trade-throughs that do occur is very high and growing every day, as trading volume increases and liquidity becomes more fragmented across the various market centers and execution venues.

A big problem with tracking or complaining on trade-thoughs, however, has to do with "Out of Sequence" prints. These often occur under highly volatile market conditions (such as when a change of momentum occurs) and another Specialist may be trying to fill multiple orders at that same moment. In these situations, the Specialist can immediately fill the orders, but has up to 90 seconds to print (report) them to the Tape, after they have actually occurred. This is called in industry parlance "Stock Ahead", and is a direct consequence of dealing with a manual system. Therefore in essence, a large number of what appear to be trade-throughs actually aren’t. Another instance of legal trade-throughs include special way trades, such as trades with a different specified settlement date. These types of trades are supposed to be marked in the last sale quote, but are not necessarily seen in all quote displays.

Once a trade-through occurs there is a complaint mechanism that exists, which is traditional through a manual phone-call to the exchange or market-center where the order was originally routed. Unfortunately, while the complaint must be filed in a timely manner (usually within 5 minutes), the offending exchange may take more time to come back with a resolution, at which point market conditions may have changed such that you no longer want the original execution you were supposed to get at the time, even if you are the "winner" of the complaint.

Trade-throughs in the listed market are not the problem per se. In fact, NASDAQ is an all-electronic dealer market where trade-throughs are actually allowed and occur all the time. In certain securities on Nasdaq, trade-thoughs are so blatant that prints can occur more than 10 cents away from the quoted inside market and often do. Rather, trade-throughs in the listed market are a symptom of a larger issue which one has to deal with in order to better execute one’s strategy. That larger issue stems from the fact that the NYSE Specialist, traditionally the primary liquidity provider, is not an impartial referee. He is a businessman/trader attempting to maximize his profits by using the inherent advantage his position affords him to make money off of his customers.

Working Towards a Solution

In 1885, a group of Cincinnati businessmen came together to auction the shares of a handful of local companies, just as their counterparts in Philadelphia and Boston had. The Cincinnati Stock Exchange was the first auction exchange to replace its central physical trading floor with electronic trading in 1976 and to introduce a competing specialist system (akin to the NASDAQ’s Market-Maker system) where multiple Specialists put up their own bids and offers in any given security.

Over the past year, we have assembled a team of technologists and portfolio managers with years of experience trading quantitative, black-box fund strategies in order to create a completely electronic Specialist and Market-Making system through the Cincinnati Stock Exchange. Our open system operates on the principle that there should be no differentiation between exchange members and non-members, thereby extending the same information and privileges afforded to Specialists on the trading floor directly to fund traders and portfolio managers. We designed the system to provide our clients and their traders with equal market access, control, and flexibility as other Specialists have (such as immediate cancels, complete anonymity, and direct quote representation in the Consolidated Tape), but in a completely electronic manner, with the ability to instantly execute against any other quote or order in the system’s internal book or the Cincinnati Stock Exchange book (just like Nasdaq’s ECNs). Furthermore, our system allows a trader to send a large block order, but only display a limited quantity, to be automatically refreshed from the "hidden reserve" upon each execution until the entire order is filled, or to cancel or replace part or all of the reserve order at any time. The system automatically executes against Cincinnati or other client orders residing in the system, for the entire share size quoted. In addition, unlike other "closed" ECNs, our system displays any unmatched limit orders in the National Market through the Consolidated Quotation System as Cincinnati bids or offers, which are always firm for the size quoted, and which in turn can be executed by any other regional exchange, the NYSE, or CAES Market-Maker. This ensures that all client orders always get the maximum visibility in the marketplace, without relinquishing control to a potentially competing party such as another Specialist. Finally, the system internalizes prop/agency orders with no risk of breaks by sending Symbol, Quantity & Price in a single FIX "cross" message. These crosses then immediately print to the Consolidated Tape through the system’s electronic interface with the Cincinnati.

The Cincinnati Stock Exchange is now the third largest and fastest growing exchange in terms of volume, executing over 100 million shares daily from a combination of institutions which include hedge funds, broker/dealers, program trading desks, market makers, and buy/sell side firms. We believe that as Cincinnati’s volume continues to grow in the coming months, the opportunities for our clients to auto-execute their trading strategies through our system will also increase, thereby reducing slippage and trade-throughs.

Over the longer-term, we think the combination of narrower spreads, higher daily volumes, and more competing market centers with electronic execution capabilities will drive the listed market to look more like NASDAQ’s "WYSIWYG", where immediate auto-execution for the size shown is more and more of a reality. In addition, as Market Makers look to expand their presence in the listed space, we should see more "real" liquidity that further reduces slippage and allows fund managers to actually execute the strategies they have modeled. Until then, however, the best advice we can give to fund managers looking to curb slippage in the near-term, is to make best use of electronic execution venues, such as the one we have designed, that today offer immediate "auto-ex" and access to multiple pools of liquidity and require as little competing human intervention as possible.u

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