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By Tony Huston, Executive Vice President and Principal at Internet Financial Services, Inc

By Tony Huston, Executive Vice President and Principal at Internet Financial Services, Inc., New York, a leader in providing real-time electronic trading and execution technology for hedge funds and institutional money managers and Andre Urbanski, Vice President for UltimateTrader Institutional Sales at A.B. Watley, Inc., the broker/dealer subsidiary of IFSI. This article appeared in the February 1998 issue of Hedge Fund News┐.

Massive advances in information and trading technologies are bringing major improvements to the way hedge fund managers do business. A new breed of technologically innovative trading systems are now available which are cheaper, faster and easy to integrate into the entire investment decision process. These systems can allow professional trading desks to control how and when orders are delivered to the markets, particularly the electronic exchanges where NASDAQ and OTC securities trade and to participate directly in the electronic exchanges.

Broker/dealers have recently introduced Proprietary Trading Systems (PTS), designed to run on the PC and tailored directly to the middle market institutional trader and their data and trade execution needs. Through powerful desktop software, hedge funds, especially those with under $100 million in assets, are able to obtain better pricing by trading between the spread and achieve significant cost savings. When commissions are reduced, overall trading costs decrease even further. The PC of today performs most of the same functions on the trading desk that were previously reserved for cumbersome workstations consisting of dedicated hardware and leased lines. Portability and choice are realities with PC based systems, allowing traders to conduct business when traveling or on holiday. All that is required is a laptop with a modem, and a standard phone line port.

The Proprietary Trading System

A PTS is software that combines a real-time data feed with order entry capability tied directly to the exchanges. Many of these PTS are designed to run in a Windows95 environment and are fully customizable in terms of how the manager would like the data to appear on the screen. Execution alternatives available to the user usually include all the methods for the electronic, negotiated markets, including SelectNet (Nasdaq's order routing system), and SOES (Nasdaq's Small Order Execution System), along with access to the private Electronic Communication Networks (ECN), such as Island, TerraNova, Bloomberg, and Instinet. For the floor exchange auction markets, execution is usually achieved through a Designated Order Turnaround (DOT) feature that allows for direct electronic order routing to floor specialists for listed securities and options. The best PTS will deliver orders to these various exchanges in one second or less.

Flexible data feed delivery systems with proven records of delivering real-time, institutional quality data, such as PC Quote and S&P Comstock, provide the market data for these PTS. There are now services that offer the consolidation of separate data feeds as well, offering connections to a variety of institutional quality real-time news feeds delivered through the program. The windows environment allows for the traders to configure this data in the fashion most conducive to their portfolio monitoring or trading style, a significant improvement over the rigid, pre-determined data formats that many traditional, off-the-shelf data providers offer. Traders not only receive their data in real-time, but can also configure their own screens in order to see the direction of the market. The data can be formatted to appear in running tickers, extensive charts that change with price movements, time and sales windows, and color-coded NASDAQ Level II market maker screens. Continuously updated portfolio position windows are also a part of the display options. The setup of these windows is achieved with the ease of simple windows formatting commands and a short amount of time spent reviewing manuals or interactive CD-ROMs.

It is the execution side of the PTS, however, that makes these systems such a viable alternative for conducting trade transactions, particularly in the OTC area. Transactions are completed with a click of a mouse button on the bid or ask price of the selected stock. To execute a trade, another button is clicked and the trade is routed to the desired exchange or ECN. When a trader places a bid through the system, that bid actually becomes part of that market. The executing broker which provides the PTS does not get involved in the transaction between the trader and the exchanges, but rather is extending its trading facilities to the portfolio manager via the PTS. The executing broker then reconciles trades with the prime broker for the various hedge fund accounts, unless it is already acting in a prime broker capacity. This true agency role of the executing broker differentiates the transaction significantly from executing through a market maker.

Order Entry

Reliability, speed and integration are central to the order entry component of the best PTS. The SEC Order Handling Rules adopted by NASDAQ in August 1996 have been a driving force in making the PTS a viable trading alternative for hedge funds and institutional investors. These rule changes, designed to provide market participants with greater limit order protection and improved access to market information, have liberated all market participants in the area of price transparency. ECN, such as Instinet and Bloomberg, are now required to post the inside market on their books on Level II for all market participants to see, and can be preferenced for trade execution.

The Fund trader, by using SelectNet, can select market makers directly at their posted prices on Level II, or broadcast an order between the spread to all market makers, as if it were a dealer to dealer transaction. Market makers, however, remain blind to the real counterparty because they are trading with the four-letter symbol of the executing brokerage firm that offers the PTS. This is an important distinction in affording the hedge fund some protection from the release of sensitive information about the positions being taken or traded out of.

Connections to ECN such as Island allow traders to bid or offer the spread, with the price appearing on Level II, making the trader a defacto market maker. (Unlike a true market maker, however, the portfolio manager does not have to enter both a bid and an offer). By using the Island ECN, bids and offers may be posted outside the inside market spread as well. These bids appear directly on the Level II screens of market makers and all other market participants with direct lines into these ECN. Orders are consistently sent to both the market makers and ECN in less than one second, and on-screen confirmation of trade execution is returned to the trader's screen in an average of 2 to 5 seconds, depending on market conditions. The other side of the trade, or contra to the trade, is identified as part of this confirmation. The risks in using this electronic trading medium are actually less than traditional avenues that rely on voice relay, as there is less potential for miscommunication. A paper audit trail is the immediate result of these electronic confirmations, also lowering the risk of potential trade failure or DK's.

Depending on the broker/dealer offering the PTS, a button that routes the order to a professional trading desk is also available. Access to these traders is a valuable resource for large blocks of shares that need to be executed all at once, or to conduct difficult trades on illiquid stocks. This alternative is especially useful should the hedge fund wish to conduct business either before or after market hours for trading on the Instinet system, or when Nasdaq's systems are down.

Proper management of PTS server capacity by the broker/dealer should eliminate concern about the volume of trades that the PTS can handle. System designs allow for up to 100,000 shares to be traded simultaneously, but the responsibility is with the trader to determine how many shares to trade at once in order to guard against market movement. Use of crossing services may still be necessary to move large blocks of shares all at once, and the most innovative broker/dealers are beginning to offer these services though the PTS. Looking into the future, it is conceivable that order flow may allow for separate ECN created by executing brokers that have institutional order flow, providing minimized market impact and greater liquidity.

PTS systems are not comparable to what is often misnamed as on-line trading services. Browser based technology, utilized by E*Trade, Ameritrade and the like, is well below newer Java applications. The PTS, designed in the C++ programming language, is a great step up from Java. Supporting complete, interactive live data and trading is almost exclusively the domain of this higher level programming language. In terms of the PTS as an alternative to Instinet, the lower costs of using PC based software and lower commission prices are innate advantages, along with the wider variety of execution mediums. Total control over negotiations and trades is an identical feature of both, along with the feature of complete anonymity. Maximum liquidity, in terms of an alternative to using the floor specialists for listed or SelectNet for electronic exchanges, may still require the use of an ECN such as Instinet, even though the best bid and ask on that exchange are required to be displayed on Level II.

This facility to participate directly in electronic execution means that funds no longer need to rely on brokers to execute smaller orders, as the decision to go to market with an order is now in the hands of the trader at the fund. Most PTS revolve around this theme of control of order entry and immediate market access, and the trader decides what execution method to use to deliver the order to the market. This allows for much more control over pricing (the savings of eighths and quarters on large blocks of stocks) and a lower commission structure (typically in the neighborhood of $.025 per share), than traditional institutional trading typically provides.


Hedge funds and small to medium sized money managers now have intelligent alternatives not only to improve their OTC order execution, but also to avoid acquiring expensive and cumbersome data feeds and lease line arrangements. The PTS should not be viewed as a replacement for existing value added brokerage relationships. Rather, fund managers should use the low cost, institutional quality data that these PTS provide to gain important knowledge of the inside market on stocks in which they may have an interest. This will provide more informed decisions when dealing with brokers that the manager may continue to use to execute orders.

The lower cost of these systems also makes them an excellent back up data alternative for the fund manager, to go along with the benefit of execution capability. These new PTS may not be a complete replacement for current data and trade execution systems, but they do provide reliable access to the markets and much improved pricing power in OTC trade execution. By providing control over how and when orders are delivered to the exchanges, all at very low monthly cost basis, these systems have found a place on the trading desks of hedge funds and the small to mid-sized institutional money manager. u

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