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Honey, I Shrank the Brokers

Brokers - Algorithmic Trading
Published on Mar 17, 2016

Is Algorithmic Trading really killing the brokers in India? Every morning, when I switch on the TV set, I hear ghastly stories of more brokers shutting down shops in India, because ‘Algos‘ are killing them. Is that really the case? Read on…

When I was with Credit Suisse, a major portion of their brokerage revenue was being generated through Algorithmic Trading. They would provide superior execution, helping clients by being offside Volume Weighted Average Price (VWAP) by a small margin on 2-5 BP and make a killing on the performance generated. When I was with Merrill Lynch, it was the same story.

Why then are brokers in India blaming partially Algorithmic Trading for their business being less profitable? A part of the reason is that high-frequency arbitrageurs and traders, who made a killing profit during the 2002-2007 equity Bull Run, have just stopped making any money at all. The reason is twofold:

The bigger one is the securities transaction tax (STT), which stands at a whopping 2.3 BP in Index/Equity futures in India. With such a cost, any high frequency (HF) opportunity gets washed out, given that HF traders survive on wafer-thin margins of a couple of basis points. The second reason is that now because of more computer programs, any pure arbitrage/easy spread money is gone. The co-located servers and HFT programs make sure that any small spread/pure arbitrage opportunity is completely cannibalized with no room for screen traders at all.

The entire confusion about Algorithmic Trading, helping some brokers while killing some other brokers, is a result of the difference between Prop and Agency side of Algorithmic Trading business. In Prop, because the client is trying to make money using an Algorithmic Trading of (or HFT) mechanism like market making, scalping, etc, they have to make money in absolute terms. In Agency side of Algorithmic Trading, because brokers have to only execute orders on a client’s behalf using a VWAP, TWAP, in-line, etc strategy, they are more bothered about being less off-side w.r.t the VWAP of the day. They really are not interested in making money on these Algorithmic Trades.

Most brokers in India, still focus on Algorithmic Trading from Prop side of the business. The agency side of the business requires good investment in infrastructure, IT team, etc, but the pay-off is more certain and definitely more stable in the long run. Imagine doing a volume of Rs 1,000 cr using Algorithmic Trading and client willing to pay 0.5 BP on it, you have revenue of Rs 500,000 per day!

Internationally, most large brokers like GS, JPM, MS, DB, CS, UBS, and HSBC focus on Agency, as their core business in Algorithmic Trading. Prop – well, GS is the leader, but then it is a cannibalized game – is best left to hedge funds and smart money managers. Not a game for brokers, whose expertise lays in execution rather moneymaking.

In the long run, brokers in India have to evolve and give superior execution capabilities to their clients, then try and make money on Algorithmic Trading platforms. Tomorrow’s leaders in brokerage business will need to think about clients – NOT Prop – from the Algorithmic Trading perspective.