The Art of Trading; The Science of Best Ex

Updated: April 14, 2020

By: Bill Stephenson As a former global head of trading, achieving ‘best execution’ was something I always viewed as part art and part science. My trader colleagues understood the art of trading, but the hard part was actually the science; the quantitative measurement AND interpretation of trading outcomes. In the mid-1990’s, I became passionate about transaction cost analysis (TCA) and how we can improve our decision making and prove the execution value in the investment process.

We embraced measurement, the creation of unique benchmarks, and a mindset that aligned decision making with the long-term goals of the portfolios. Sounds easy, but it wasn’t. Traders are often measured trade-by-trade while portfolio managers and analysts are measured in months or years. It takes time to find balance, form a true meeting-of-the-minds, and ultimately create a benchmark aligning these three constituents--which I call the “Alpha Triangle.”

Though the process was not without its challenges, our firm was largely successful in training our focus on best execution within the context of the long-term investment strategy. Our process became well documented and scrutinized in regular reviews at our Global Best Execution Committee meetings.

The mid-2000’s saw a dramatic increase in electronic trading, growing reliance on algorithms and the overall proliferation of dark pools and exchanges. Trading had become increasingly complex; performance measurement increasingly difficult. Miscues by dark pools, broker-dealers, and exchanges only compounded this difficulty. Firms intent on maintaining high best execution standards felt the growing need for traders with a better understanding of market structure and the nuances of how various markets actually work.  The game was changing quickly. Buyside traders faced a call for greater accountability. It was increasingly incumbent upon them to understand how their orders were handled, where they were being executed, and how these factors impacted trading costs.

For me, the tipping point came in late 2011, when one ‘dark pool’ settled charges with the SEC regarding false and misleading claims about trading with ‘natural liquidity.’ The good news from my firm’s perspective was that our executions in that venue, as we measured them, were adding value. It just wasn’t disclosed that they were principal transactions.

These events prompted us to ask an array of internal questions about the due diligence process when onboarding a new broker or new ATS. Even though the broker or venue provided value, were there reputational risks in trading with firms who don’t do what they say they do? Of course!

Besides our effort to collect the primarily private Form ATS filings from all the alternative trading systems, we began a deeper dive into evaluating all our counterparties; a huge undertaking. Collecting these filings proved to be just the beginning as we tried to unravel potential conflicts of interest among market participants and the overall complexities of the market.

By 2012, a buyside trader from another firm began to build a web-based system to engage broker-dealers as part of his firm’s due diligence and onboarding processes. That system was known as Plia and, in 2014, became a product for other asset managers. I viewed this as a much-needed system for central management of information that investment managers could acquire from their counterparties; brokers, trading systems, or even exchanges. Over the years, the system’s functionality and capabilities have improved, but the market structure and brokerage operations have only grown more complex.

For some, Plia was used to help avoid venues and brokers who could not or would not fully disclose their operations in a way that aligned with an investment manager’s best execution processes or values. It can add both a qualitative and quantitative aspect to best execution that will help any head trader or head compliance officer feel more comfortable about the risk management component of their remit.

As the complexities of trading increase across all asset classes, it is becoming more important that leaders in the asset management community develop standards with their counterparties such that all market participants will have accountability to each other in a constructive way. I believe that technology-enabled solutions developed by the industry and for the industry will mitigate risks in the investment and best execution processes, but it takes broad acceptance of such practices to truly make a difference for all.

For more information on Plia, contact: support@plia.com