NEW YORK Asset managers responsible for getting the best price for large positions, however volatile the market, could soon use a new trade simulation tool to address the elusive best-execution problem.
Robert Schwartz and his partners from the worlds of academia, trading and technology are developing a trade simulation program, called TraderEx. An early version of the program already is used in several courses at Baruch College in New York.
Ever since Congress enacted the Securities Acts Amendments of 1975, best execution has been an important objective in the U.S. equity markets, said Mr. Schwartz, the Marvin M. Speiser Professor of Finance at the Zicklin School of Business at Baruch. But, if you think that demonstrating that you have met a best-execution obligation is difficult, you are right. TraderEx is the tool we developed with best execution in mind.
The TraderEx simulated trading software gives users the ability to test order execution in four types of trading venues: a call auction at the open and the close, similar to the Nasdaq open and closing cross; a limit order book as found on electronic communications networks or electronic exchanges; a block-trading platform without displayed quote or dark pool; and a quote-driven dealers upstairs market.
TraderEx simulates direct market access to those venues and includes variables that allow a trader to test execution in different market situations, including high volatility, volume spikes and illiquid stocks.
TraderEx is in beta testing. We are very close to launching, Mr. Schwartz said. Well provide access to people in academia who need trade simulation for their teaching and to asset managers who want to get a better sense of the strategies and venues that best serve the execution of a given order at a given time. For a large brokerage firm, this could be a tool to tell whether someone has an aptitude for trading and to train young traders.
The TraderEx simulation requires the user to make strategic decisions on his choice of execution, with the four trading possibilities offering different benefits.
In the call auction, orders are batched together and execution made at the price where most buy and sell orders can find a match. The benefit is minimal exposure or friction, while the risk is that working the order throughout the day may lead to a better price.
ECNs and open markets provide transparency and often liquidity, but orders are exposed to the public, which bears the risk of market impact. Dark pools address this issue, but may lack the deep liquidity needed to quickly move a block at the best price.
Best execution raises a lot of questions. Should you trade in the call, or in the continuous environment, or both? Should you break your orders into smaller pieces for sequential submission, or enter the block trading facility, or both? Should you enter market orders, or limit orders, or both? Mr. Schwartz said, listing some of the questions that institutional traders have to deal with on a regular basis.
These strategic decisions are made in the face of considerable uncertainty: for instance, if you start the trading day as a patient buyer, will the price really be better in the afternoon? he asked. If you look at how the Dow Jones industrial average traded on Jan. 23, down 300 points, up 300 points, simulation is a tool that can prepare you for an extremely volatile market.
On that day, U.S. equity markets reacted poorly to the Federal Reserves three-quarters point cut in the fed funds rate announced on Jan. 22, just one week before its scheduled policy-setting meeting. The first inter-meeting rate cut since January 2001 and the largest such move since 1984 conveyed the sense among investors that the central bank saw signs of a rapidly deteriorating economy, driving the Dow sharply lower. But news later in the day that banks and regulators were working on a package to back troubled bond insurers brought relief to the market, sending the Dow to a strong finish.
Best execution varies according to many parameters, such as market conditions, order types or liquidity, Mr. Schwartz said.
Best execution can also be assessed against a benchmark for which TraderEx offers several choices, such as beating the volume weighted average price or implementation shortfall.
Unfortunately, VWAP has some problems because your own actions affect VWAP and it can be gamed. Implementation shortfall involves transaction cost analysis, which has strong assumptions whose interpretation can be problematic, Mr. Schwartz added. The bottom line is that no really good benchmark exists against which to assess a trade or a sequence of trades.
Preliminary evidence with TraderEx simulation shows that aggregating liquidity by simultaneously tapping various liquidity pools and using different strategies combines the benefits of each market but is no guarantee of achieving best execution all the time, Mr. Schwartz said. The reality is that best execution shares something in common with liquidity. Both are hard to define and measure, but you sure know them when you see them, he concluded.