Algorithmic trading: Mathematical and magical

By YAEL GRUNTMAN / GLOBES
February 27, 2011 04:33

Since algo trading takes place in large quantities, a mistake can cost a lot, so there is a need to consider risk management seriously.




Trader watches the stocks

Trader watches the stocks 311. (photo credit: AP)

Algorithmic trading is like a magic word whispered among capital-market professionals in recent years. The term refers to automated systems based on mathematical algorithms, which send tremendous quantities of buy and sell orders to world markets and carry them out in thousandths of a second, taking advantage of market distortions or opportunities at current securities prices. The systems generate phenomenal profits for their owners.

The systems are used by the most professional players in the market: leading investment houses, hedge funds, nostro players, mutual funds and exchange-traded funds, and also private investors who prefer to remain behind the scenes, though they control operations that would not embarrass any investment institution.

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The development of this trading method has resulted in the situation where today, about 2 percent of the world market players are responsible for 75% of its transactions – a number that can’t be ignored.

Assuming that you, too, want to take a part of the seemingly inevitable future of the capital markets, and you have in hand the method, the knowledge and the required algorithms, all that remains is to see how to bring the concept from potential to reality – and to find someone who can provide you with the supporting services.

Newedge, a subsidiary of French banks Societe Generale and Credit Agricole CIB, is the leading player in this sector in the world today. Recently, the company signed a cooperation agreement with Israeli investment house Camalia Capital Market, and with that opened an additional path for local players looking to take part in these operations.

Newedge professional trading group (PTG) senior executives Will Davies and Andrew Chart spoke with Globes recently.

“The Israeli market always interested us, but in the past we didn’t think it was right to enter, on our own, a market that is so competitive and saturated, so we preferred to collaborate with Camalia,” Davies said. “In our opinion, this is an opportunity that can be a real springboard for investors in Israel.”

In 2010, Newedge cleared 2.2 billion contracts, and its operations were carried out on 80 of the world’s leading exchanges. Last year, it reached a 13% share of all global clearing operations.

Until now, anyone who wanted to operate in the field in Israel had to turn to one of the world’s leading banks to serve as a prime broker (by offering packages of services to investors, including instruction and the clearing), such as Goldman Sachs and JP Morgan, and not to a local entity with a dedicated platform.

Accordingly, the customer had to begin a process of opening an account, which could take up to a year, and required a minimum initial deposit of $2 million to $5m., with minimum fees of about $25,000 per month and expensive use of information systems.

Now, Camalia and Newedge offer procedures to open an account much quicker, with an initial deposit of only about NIS 1m., minimum fees of about $5,000 to $10,000 per month, depending on the type of transactions, and proximity to Newedge’s server farms, which are connected to leading exchanges – with the advantage of cutting the time of connection to the exchange and of increasing trading volume.

Chart and Davies were surprised by the quality of the human capital in Israel’s capital market.

“The education level in Israel’s financial market is high, and the combination of entrepreneurship and Israeli brains with the technical and mathematical prowess of the Russian immigrants, together with the financial sophistication of immigrants from France, creates fertile ground for success in the field,” Chart said. “Despite the fact that Israel is a small market with many geopolitical problems, we were pleasantly surprised by the high level demonstrated by Israeli customers and from the quality of technological infrastructures.”

Most of the collaborative efforts between Newedge and Camalia are in developing prime brokerage services for Israeli players in foreign markets. Today, it provides brokerage services on a small scale in the shekel-dollar and Tel Aviv 25 Index derivatives market, and it is likely that these activities will be expanded in the future and that others will be launched.

“In recent years, the market has become more intelligent, the technologies are developing all the time, and they allow the transfer of a greater quantity of information in a much shorter time period, and much more safely,” Chart said. “This has led to a considerable drop in costs, and it allows the entrance of sophisticated customers, even if they don’t have a lot of money in the beginning.”

Globes: In your opinion, is there an ethical problem in the situation caused by algo trading, in which a small number of players have an advantage over others in the market?

Chart: “There is no ethical problem here. Algo-trading players supply liquidity in the markets, and help cut the spreads and create a more sophisticated market. For example, the interest rate has barely changed in the past year, but in interest-rate and interestrate- derivatives markets there is a lot of activity, as people operate through the interest rate in order to hedge other activities.

“Algo players do not operate against long-term investors. For most of them, market trends are not at all important, only shortterm distortions and mathematical failures created in the markets. They seek to reduce exposure to the trend. The bigger problem today is the hedge funds, which operate in much bigger amounts and affect the direction of the market through leveraged activities.”

Since algo trading takes place in large quantities, a mistake can cost a lot, so there is a need to consider risk management very seriously.

“The responsibility is everyone’s beginning with the customer, through the broker and the exchanges, but the latter always succeed in passing the responsibility onward,” Chart said. “They are like a road which has cars traveling on it that are recommended by brokers, and traders are driving them. If there is an accident, the damage is to the cars, not the road, but the managers of the road have the responsibility to maintain it. The risk rises a great deal when we put on the road the best and fastest car and allow customers to drive it. Therefore, regulation must be tightened.”


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