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How Algorithmic Trading on the Sell Side Works

How Algorithmic Trading on the Sell Side Works

2015-08-31 02:54:00
David Rodriguez, Head of Product
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Why might sell-side firms need algorithmic trading, and why does it matter? We examine a number of key topics relevant to the individual trader.

Put in broad terms, the sell side provides market access and tools to the buy side, and in order to do so pursues algorithmic trading systems.

In order to attract and retain clients, the sell-side firm also offers algorithmic trading tools, analysis, and in some cases strategies. We’ll explore a number of worthwhile themes.

First, some definitions:

Sell-side: In the broadest sense, a sell-side firm is one who sells its services to the buy side. Clear examples include brokerage firms who provide market access and services to asset managers but do not principally take on significant market positions themselves.

Buy-side: The buy-side firm is the consumer of the sell-side’s services. Typically this will include asset managers of all stripes. Unlike the sell-side, the buy-side will look to establish market positions of their own and benefit from asset price moves.

Key differences: The sell-side generates profits by collecting market access fees, while buy-siders generate profits by largely taking directional risks. Often these lines are blurred as many firms have historically offered sell-side services while maintaining proprietary trading operations. Yet changes in market regulations has made this far less common, and we’ll treat the buy-side and sell-side as wholly separate.

Algorithmic Trading on the Sell Side

Sell-side firms provide access to trading, and in order to do so they must develop technology systems to direct order flow and manage risks. If the firm acts as a market maker, it will also often develop its own market-making algorithms in order to collect the bid/ask spread while minimizing its own position risk. The level of technology and market access necessary for this activity makes it inaccessible to most, however, and it is beyond the scope of our discussion.

Sell-side companies must also compete for and attract clientele, and this very often means providing useful research and tools to the buy side. This is of great interest for a number of reasons:

  1. The sell-side firm will most often have greater access to important market data. e.g. trading volumes, client positions.
  2. The sell-side firm may have strong algorithmic tools, strategies, and analytics but may be prohibited from proprietary trading. It can use these to provide meaningful guidance to its client base.
  3. The scale of many larger sell-side firms allow them to produce trading tools/analytics that would be cost-prohibitive for the smaller buy-side firm to produce internally.
  4. Sell-side firms will look to retain and attract clients by providing these tools at low or no additional cost to those who use its services.

Ultimately this is of real interest to an individual trader and/or firm looking to take their own positions in the market. Access to advanced market data and trading tools can help the buy-side trader gain an edge they would otherwise not have. Of course we must keep a number of limitations in mind.

  1. The sell-side algorithmic trader/analyst is unlikely to be compensated directly for their buy-side customer’s success.
  2. Though tools and strategies may be provided, the end-user must likely do considerable work on their own to make use of the sell-side tools and strategies.
  3. The sell-side firm may provide tools and strategies with the intent of generating further trading activity and provide little to no benefit for the buy-sider.

It is critical for any algorithmic trader to do their own work and due diligence before putting any trading technique and strategy into play. And indeed this may especially be the case if the strategy is offered by someone whose interests may not align.

Yet it remains worth noting that many sell-side firms have access to analytics, brainpower, and data that can be of real use to the proprietary trader. There are many legitimate reasons for why a sell-sider can’t take full advantage of these assets.

Before a trader uses the sell-sider’s tools, however, they should ask themselves two key questions: Are interests aligned? And is this tool/strategy guided towards further trading activity with little end benefit? The second question is especially difficult to answer. But in general terms, one might expect firms with greater reputational risks and greater profile to tread more carefully in this field.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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