Kevin McPartland, Senior Analyst, TABB group explains the metamorphosis of the Exchange today and how the very definition of an “Exchange” is being transformed.
High frequency traders are not the only ones trying to get faster. The last few years have seen exchanges enter an arms race for speed that rivals the most sophisticated trading shops in the world. The focus on reducing latency and increasing bandwidth is so extreme that we are watching the definition of“Exchange” transform right before our eyes. Not because physical trading floors in city centers have been replaced with massive data centers in out–of-the-way industrial areas, but because the exchange business model has fundamentally changed from one that is transaction-based to one that is technology-driven. The reasons why are quite simple. Execution fees have been driven down by competition largely brought on by field-leveling regulations (read Reg NMS and MiFID) enabling competition and in turn making technology, the real differentiator. The exchanges are desperate to both retain and attract more liquidity, but with execution fees often below zero and market monopolies consigned to history, only a serious investment in technology will ensure life throughout the next decade and certainly investments in technology are being made.
The most serious technology investments have been made by the world’s largest equity exchanges. NYSE Euronext purchased Wombat and NYFIX among others to create the newly branded NYSE Technologies, NASDAQ merged with OMX to create an exchange technology provider with global reach, the London Stock Exchange (LSE) recently purchased MillenniumIT to rebuild its matching engine and be its technology arm, and the Deutsche Boerse has long been a technology provider in its own right. Chi-X, the largest multi-lateral trading facility (MTF), has a separate technology arm in the form of Chi-Tech. Most recently, the Tokyo Stock Exchange (TSE) launched its long awaited Arrowhead platform with hopes of entering the low latency trading world. CME Group, BATS, and numerous others have also invested heavily in ensuring they have the latest and greatest technology. Some are working to maintain their dominant market position and the others are continuing their quest to take liquidity from the incumbents.
Exchange differentiation under the new paradigm is not easy. Twenty years ago NYSE traded NYSE listed securities and OTC securities were traded via NASDAQ; shares in UK based companies were traded on the LSE, shares in German companies were traded on Deutsche Boerse, and so on. Now, especially for US and European equities, shares of anything can be traded virtually anywhere. I’m over-simplifying of course, but with globalization flattening the world of stock exchanges, regulations keep everyone on a level playing field and with all measuring speed in microseconds the only obvious differentiator left is the name of the venue. Even if we assume traders naturally migrate to where liquidity is deep and spreads narrow, only through an understanding of exchange technology can one rationalize what causes that situation to occur.
It is a poorly kept secret that high frequency trading firms and proprietary trading desks at investment banks co-locate to shave off microseconds. This practice is at the heart of exchange-client connectivity. These high speed orders are generated within the servers of proprietary trading desks and hedge funds, and are sent via a high speed network into the exchange’s matching engine, all literally residing under one roof. This practice generates the majority of order volume in the US and increasingly in Europe.
Large agency orders from traditional buy-side sources are also important to an exchange’s success, but it is more often the job of the broker to ensure connectivity to the data center for their client flow. Simply put, the sell-side handles inter-data center connectivity and the exchanges handle intra-data center connectivity. TABB Group estimates that North American spending on market connectivity sits at just over $2 billion annually, with 70% of that number coming from the sell-side.
That leaves the exchange to ensure the pipes coming into their matching engine are big enough to handle the volume and fast enough to get orders to the market before prices change sending traders elsewhere. To do so exchanges have put a heavy focus on the physical networks (reducing hops, upgrading to newer standards such as 10GE, etc.), messaging middleware and message format to ensure orders travel to the matching engine as efficiently as possible. Some (such as NYSE and the London Stock Exchange) have taken this entirely into their own hands by owning and operating their data center, whereas others (such as BATS and Chi-X) prefer to build an ecosystem in a shared services data center choosing to keep their technology expenditures literally close to the exchange itself.
It is interesting to note that despite the drastic reduction in latency in the past decade, FIX continues to be the protocol of choice for most order routing. Of course FIX has undergone change since the mid-90s, but its core remains the same with simple key-value pairs. But in a nod to its original designers, those messages remain relatively small by today’s data standards leaving them suitable for high speed trading.
Once the orders are received exchanges must then do what they are famous for – match buyers and sellers. If you were lucky enough to spend time on the floor of the NYSE pre-Y2K you fundamentally understand what order matching entails. Things today are no easier or harder than they were before; they are simply automated and fast really fast. Matching engines from BATS, DirectEdge and NASDAQ all hover around 200 microseconds. NYSE will sit at a similar level when its Universal Trading Platform (UTP) is fully implemented.
We’ve become jaded over the past few years about what fast really is. What the exchanges have done with matching is nothing short of extraordinary. The human negotiation process seems straight forward, but programming a machine to handle the subtleties of a trader’s mind is quite complex. This process, now simply referred to as order matching, includes much more than just matching the next buyer and seller of the same security at the same price. Risk checks, microsecond precision time stamps, order type and a number of other factors must all be considered before a trade is executed. And what really makes this process extraordinary is that the major exchanges have whittled this process down to a few thousand lines of machine code that match orders in millionths of a second and do so millions of times a day for hours on end.
Finally, executed orders become market data quotes that must be distributed to the world. TABB Group estimates that 60% of the $2 billion spent in North America on connectivity is for gathering market data. Furthermore, as trading has become increasingly automated and latency sensitive, the use of traditional market data aggregation platforms has declined in lieu of leased lines which now account for 43% of connectivity spend. Many of the same aspects apply to market data distribution as to client connectivity. Those exchanges that can get market data back to their clients fastest will attract more traders, more volume and hence higher profits.
Interestingly, although each of these three components is core to the value proposition of the major global exchanges, NYSE Euronext (via NYSE Technologies), NASDAQ OMX, Chi-X (through Chi-Tech) and a few others are all willing and hopeful about selling the technology they use in-house to other global exchanges. Besides the obvious driver for more revenue, the thought is that if a global network of exchanges can be created with all of them running the same technology, then that technology will become a standard, thereby making global liquidity more easily available regardless of your physical location.
The trading floor model is tried and true. A few such floors still exist, and a smaller few are still thriving. However it is hard for investors, traders and exchange shareholders not to see that technology is bringing efficiency to the market that just makes dollars and sense. The exchanges of tomorrow will make most of their money not as execution venues, but as data and technology infrastructure providers.Connectivity and order matching functionality is already expanding to include pre-trade risk, latency monitoring, cross-product execution and numerous other forward looking initiatives. This exchange metamorphosis has become truly global with national exchanges worldwide looking to technology to get an edge on the world stage. So I wonder, how long until Microsoft sees NYSE Euronext as a competitor – the Bing Stock Exchange anyone?
The New Exchange
Maintaining Vibrant Competition Among Exchanges – A Key Driver of the Rapid Development of the Indian Financial Markets
By James E. Shapiro
When I accepted a job in the Indian financial markets six months ago, my thinking was simple. First, I believed (and still believe) that India has an once-in-a-lifetime opportunity to pull away from the pack and establish itself as the largest and most dynamic financial market in Asia. Second, I thought I could contribute to the efforts of my new employer to compete more effectively and grow its business.
I expected to draw on my experience working at and for exchanges in the US and Asia for more than two decades. I also expected to draw upon my training in finance and economics. What I did not expect, was that I would find myself regularly reaching back to wisdom and inspiration from books I had read in college – particularly the inspiration and observations of US revolutionaries and civil rights heroes. Let me explain.
The Opportunity
From most perspectives, the opportunity in Indian financial markets today is spectacular. There is the confluence of factors that – unless some or all of them are seriously derailed – will allow Mumbai to emerge as a major global financial center.
First, India has the virtue of a large domestic market. In Asia, this gives China and India, a big advantage over Singapore and Hong Kong, today’s front-runners in the race to become Asian Financial Centers.
Second, the Indian economy is growing rapidly and this growth, because of India’s early stage of development, is likely to continue in the 6-8% range, and quite possibly the 8-10% range, for the next decade. Even if the size of India’s financial sector relative to GDP stays constant, it will double in absolute terms over the next decade, assuming 7% growth. A much more likely scenario, however, is that we will see dramatic financial deepening in India over this time period.
Third, India already has much of the basic financial market infrastructure in place. Admittedly, there are a few gaps – such as a vibrant “Stock Borrowing and Lending” market. And there is always room for improvement – especially when it comes to coming more into line with global best practices and standards. But, most would agree that India’s financial market “plumbing” is working well. In terms of trade processing in the equities market, for example, Indian exchanges match, clear and settle a phenomenal number of transactions each day – putting both BSE and NSE easily in the top ten globally.
Fourth, India has a reasonably effective and transparent regulatory environment – focused on investor protection and market development. Regulators are appropriately cautious in some areas. The focus has been on risk management and the gradual introduction of new products. This has generated some frustration at times for market participants who want regulatory changes to come more quickly. But, by and large regulations are evolving well, taking into account the views of the market, international practices and Indian ground realities.
Fifth, Indian financial markets are quite open to foreign participation. While there are some notable impediments — for example, restrictions on foreign retail investors – it remains true that offshore participation by foreign institutional investors (FIIs) is substantial. More significantly, if a foreign securities firm wishes to come “onshore” in India, it is to a very large extent free to compete with domestic firms. The benefits from this foreign participation, in my view, have been substantial, bringing global practices, global talent (much of it Indians working at foreign firms), and global competition into the market.
Sixth — and most relevant to my comments here – India has a competitive exchange environment that will be a critical factor in lowering trading costs, increasing liquidity and driving the development of the markets through innovation.
Multiple Trading Venues in Europe: The Changing Nature of Electronic Trading in a Fragmented World
By Peter Randall
The European equity trading landscape has undergone a period of rapid change, since the implementation of MiFID (Markets in Financial Instruments Directive) in November 2007. The new regulation shook up the financial industry in an unprecedented way mainly by the abolition of the concentration rule and the determination to make Best Execution the ultimate guarantee of protection for the investor. Although MiFID has not been successful in every aspect, it certainly succeeded in bringing a competitive edge to European equity trading, resulting in a drop in trading cost for brokers. On the flipside: the market has become more fragmented, and the complexity and cost of providing best execution are emerging as important factors.
Breaking barriers to entry
As new trading venues have started, the main challenge faced by market participants has been to facilitate the connection to new platforms. The use of FIX Protocol standards, making it easier and cheaper to connect to an exchange, was one of the key elements of the success of the Multilateral Trading Facilities (MTFs). And now the reality is that stocks can be and are actually traded on several different venues: traditional exchanges, MTFs, Systematic Internalisers and dark pools. The main European indexes are now traded, on average, on more than 5 visible venues. Furthermore, to attract liquidity, new players offer an innovative and simpler fee structure: no membership fees, no market data fees and attractive trading fees: posting liquidity is now rebated while in the meantime, removing liquidity from MTFs is still less expensive than on traditional exchanges.
With reduced costs, new liquidity available and frequent tighter spreads, MTFs have all the assets to attract the brokers. And it works. On the main European indexes, traditional exchanges have lost up to 44 % of market share.
Of course, traditional exchanges launched their own MTFs and dark pools and lowered their fees to compete with alternative platforms, but by and large these have not enjoyed as much success as the new entrants.
Despite the drop in costs of connection and membership, trading on alternative platforms generates new costs: costs of physical connectivity of course, but also unexpected costs due to the increasing complexity of trading.
Bringing Together Fragmentation
By Fidessa
Post- MIFID, the rate of fragmentation in Europe has been extremely rapid. The Fidessa Fragmentation Index (FFI) provides a simple, unbiased measure of how different stocks are fragmenting across primary markets and alternative venues.
FFI shows the average number of venues you should visit in order to achieve best execution when completing an order. So an index of 1 means that the stock is still traded at one venue. Increases in the FFI indicate a fragmentation of trading across multiple venues and as such any firm wishing to effectively trade that security must be able to execute across more venues.
Here are a few points that we see the data supporting…
Non-Displayed Venues: Finding Ways to Benefit Asian Investors
By Ned Philips
Ned Phillips, CEO at Chi-East, elucidates on how despite the lack of a regional trading framework, non-displayed venues are gaining momentum in delivering benefits to Asian investors.
Trading in Europe and North America is now faster and cheaper than ever before. Under the umbrella of regional regulations such as MiFID and Reg NMS, the proliferation of technology has revolutionized the ways trades are executed. An endless choice of non-displayed venues (NDVs, also commonly referred to as dark pools), lit-pools and traditional exchanges have clamored to offer traderssimplified connectivity, lower latency and better execution.
Although lacking the number of choices as their Western counterparts, Asian investors are not being left behind in the technological race to provide better trading execution and lower costs. Despite the disjointed nature of the Asian trading environment, and perceived barriers such as multiple regulatory and settlement systems, NDVs still allow Asian investors to aggressively pursue the same benefits as those enjoyed by their American and European counterparts.
Reduced spreads
Asia is an expensive place to trade, especially in comparison with the US and Europe. Large spreads have lowered liquidity in many parts of Asia, which has made life difficult for many investors, especially algorithmic and high frequency traders, by restricting them to more liquid and well-known stocks. For these investors, NDVs are alternate means for them to access both lower transaction costs and higher liquidity, allowing them to undertake more diverse trading strategies.
NDVs do this by helping the market achieve its real purpose – efficiency. Liquidity pools allow traders to reduce spreads by meeting each other halfway between a bid and an offer (mid-point pricing), rather than forcing one party to give in and meet the spread. This has enabled investors to seek best execution and capture significant savings with every trade.
In turn, lower spreads are also bringing liquidity back to lesser-traded stocks, thereby further increasing trading volumes and the overall strength of the market place.
High latency and low impact transactions
NDVs also provide investors with a fast, and most importantly, anonymous pool of liquidity on which to trade large blocks of securities without risking price movements against them. This feature is particularly attractive to brokers, who are coming under increasing pressure from algorithmic and high-frequency traders to provide discreet, fast and low-cost ways of trading Asian securities.
Lower trading costs
Commission payments still make up a large part of trading costs in Asia; while trading costs charged by exchanges remain relatively high (see side-table). NDVs are already contributing to the reduction of these costs. A report by Greenwich shows commission payments in Asia ex-Japan fell sharply in 2009, as fund managers switched to electronic trading options.
Traditional exchanges have also been forced to respond to the price challenge imposed by alternative trading platforms. Already, venues such as Hong Kong Stock Exchange are reducing their fees for certain listed products. Despite this, Asia-based NDVs continue to offer trading fees which are lower than traditional trading venues, allowing brokers and fund managers to pass on further savings to investors.
The Electronic Trading Scene in Eastern Europe
By Andrea Ferancova
I
t’s really happening now. The machine/black-box trading boom has arrived in Eastern Europe, says Andrea Ferancova, Partner and Director of Capital Markets, WOOD & Company.
After the successful adoption of electronic trading technology in developed markets, traders are now increasingly using algorithmic strategies to achieve their goals in more exotic markets. This trend is growing rapidly with new players coming to the market every day, in an attempt to grab some marketshare and make the best of the opportunities available. Thanks to technology and its active engagement by local players, it is now easy to connect and easy to trade in Eastern Europe.
So much has changed since that first electronic trade in Eastern Europe by one foreign institution! Starting the trading technological implementation very recently (after the communist era) had its own advantage, as all the exchanges were founded on an electronic base, but there have nonetheless been multiple barriers to reach the markets directly – local legislation, closed-end technology and protectionism to name a few.
The Past
Just few years ago, exchanges existed without any interface to allow connectivity from external systems, and orders had to be retyped manually. On those where some connectivity was possible, algorithmic processing was forbidden by law, and the frequent modification of order parameters was something that regulatory bodies viewed as market manipulation. Latency was measured in seconds, and the number of orders one could process was only limited to between tens and hundreds a day.
Apart from the trading obstacles, up until recently it was also very difficult or expensive to settle. Thanks to rules that vary from exchange to exchange, unconventional order types and behavior quite different from that of the developed markets, the region has earned its reputation as the “Wild East.”
It took some time and considerable effort to navigate a common and more reasonable course, but it has paid off in terms of market accessibility. Though there is lots of room for improvement, simple trading solutions can be found on most markets. Offering Direct Market Access (DMA) to Eastern Europe has been very challenging for us for many years, due to the non-existence of a system that would cover all or at least a majority of the markets.
Vendors were not keen on investing in developing products for closed markets due to extremely limited demand and those who tried, discovered it was difficult to sell such a product, as they would be interceded by either a lack of documentation or language barriers.
Local vendors supported only local exchanges and offered only closed-end applications. Not to mention that no one had heard of FIX or any other connectivity option either. It was also difficult to find vendors delivering options for a reasonable price, which makes a lot of sense, when you take into account the limited volume and money that could be generated on any one market. Since the markets were really difficult to reach from outside, it was very difficult to become a member locally, and almost impossible as a remote member. So, as the market was limited to only a handful of prospective customers, it simply did not seem reasonable for system vendors to offer a “bigger” solution. So, if you were to offer a particular market to trade, you had to either have a local solution and request an expensive, tailor-made integration to other market infrastructure; or get a buggy system from a renowned vendor (if any existed); or just build it completely by yourself . Local vendors were not really motivated to create and offer solutions for regional markets apart from their local ones and the big “global” vendors offered (and still offer) only incomplete “alpha state” solutions and getting them to work proved almost impossible, requiring huge investments especially as no one vendor offered solutions for many markets, making it necessary to integrate the systems of various vendors.
EUROPE – Past, Present and Future
By Matteo Cassina
FIXGlobal puts forth some questions to Matteo Cassina of Citadel Execution Services on the changes in the European arena.
What are your views on the regulatory changes that have taken place over the past couple of years?
We have seen a significant change in the equities markets in Europe over the past two to three years. This change can be attributed both to regulatory developments through the introduction of MiFID and changes that were already occurring in the marketplace, such as the increased awareness and usage of electronic trading systems. The regulatory changes have had a broadly positive impact, including increased competition and reduced execution costs, however there have been other, less desirable impacts that are limiting the benefits and effectiveness of these changes. For example, an increase in the fragmentation of trade transparency data has made price discovery and the consolidation of data more problematic. Also investors are not always gaining the full benefits of the new trading venues open to them, as brokers are not always connected to the venues where the best price with the lowest trading fees may be. We are still in the relatively early stages of the post-MiFID transition and there has been an unprecedented period of market volatility in the recent past. We anticipate that there will be further changes in the market as participants continue to react and adapt to the market conditions and the needs of investors. It is a constant challenge for regulation to keep pace with a fast moving marketplace; a comprehensive and flexible regulatory framework at a European level coupled with focused and consistent implementation through local regulators is vital for the fair and efficient functioning of the European secondary markets.
The Brazilian Electronic Landscape
By Carlos Barros
At a time when the world is facing the prospect of severe change in its power relationships and the financial industry is under worldwide scrutiny, there are few places that inspire more confidence for long-term investments than the BRICs with Brazil probably presenting the most balanced profile of growth, democracy, economic stability and diversification. Carlos Barros of Agora CTVM explains.
After many years of doing their homework across the political and macro-economic spectrum, Brazil finally emerged from the recent turmoil as an interesting harbor for the highly demanding and sophisticated international investor, and is now set to become the access point for all Latin American markets.
Technological Evolution
The Brazilian market place is rapidly evolving and following many international best practices under a regulated environment, which definitely allows innovation but also aims to protect both the market and its participants’ integrity. Practices like ‘sponsored access’ and ‘co-location’ are already being used, while concepts like best execution is being discussed by the local regulators.
The basis of this development was created by the markets’ electronification. Bovespa, the equities market, ended its pit activities in 2005 and BM&F, the futures market, followed suit in 2009, almost a year after the two exchanges merged to form BM&FBovespa, the world’s 3rd largest exchange by market value.
To meet this challenge and be more cutting-edge, not only have the exchanges and the sell-side started to arm themselves with high-end technology, but the buy-side community is increasingly interested in high frequency algorithms, low latency EMS/OMS, Straight Through Processing (STP), risk systems, and all sorts of technology solutions that might impact their trading activity in this new environment.
Once the race started, the great majority of brokers, both local and foreign, began to look for some kind of electronic capabilities in the Brazilian market, creating an incredibly strong demand for specialized services and products within the electronic trading arena.
This trend was reinforced by the exchanges’ demutualization followed by their IPOs, which provided to brokers, who formerly owned the venues, sufficient capital to invest in infrastructure and technology, at the expense of losing the subsides that formerly kept some of them alive.
Without this steady inflow, players had to pursue other options to generate commission and their business models became increasingly linked to their choice of technology.
Their options were:
- Buying technology from an Independent Software Vendor (ISV), which creates dependency, but provides the assurance that the provider is fully focused on its core business;
- Acquiring and merging with an ISV or another broker, which might be more expensive, but provides the assurance that the firm is incorporating a proven and tested solution as well as the knowledge base;
- Developing the solution in-house, which might not be the quickest solution, but is definitely the option with the lowest cost prospects and highest knowledge aggregation rate.
In fact, the most appropriate model depends on a firm’s electronic business size, its technological maturity and its willingness to spend on both IT capital as well as personnel expenditure. However, it has been noticed that the most agile and sophisticated independent firms are being targeted by the bulge-bracket brokers and investment banks willing to increase their electronic operations.
The results of these unions are firms that evolve faster than independent ones, as they have more capital and more solid balance sheets. They are also faster than traditional full-service broker-dealers, since they are leaner with more specialized staff, and are focused on moving ahead of the market in identifying new trends.
As observed in more mature markets, it’s possible to foresee that with more fire power, large brokers will establish a technological barrier that will prevent mid-tier houses from effectively participating in the game, thus generating more consolidation and even the disappearance of some firms. Meanwhile, smaller and more specialized firms can focus on niche markets, thereby protecting themselves from being highly affected.
Land of Sponsored Access
By Sang Lee
Aite Group’s Sang Lee argues that while naked sponsored access is causing concern among market participants, regulation alone cannot remove all systemic risk.
After years in obscurity, sponsored access emerged as a regulatory hot button issue in early 2009. More recently, it seems to have fallen off the regulatory radar screen, upstaged by high frequency trading, co-location and dark pools. Nevertheless, any future regulatory discussion regarding high frequency trading cannot take place without addressing the issues around sponsored access, and especially around the unfortunately named “naked” sponsored access.
One of our December 2009 reports titled ‘Land of Sponsored Access: Where the Naked Need Not Apply’, defines the sponsored access market, and provides estimates of sponsored access penetration of the U.S. equities market. This report also provides predictions on potential regulatory changes and possible impact on the overall evolution of the U.S. equities market. But, let’s start at the very beginning.
Reducing Latency
Sponsored access has many different meanings for market participants, and, while widely talked about, it is often misunderstood. The origin of sponsored access can be traced back to the practice of direct market access (DMA), in which a broker, who is a member of an exchange, provides its market participant identification (MPID) and exchange connectivity infrastructure to a customer interested in sending orders directly to the exchange. In this way, the broker has full control over the customer flow, including pre- and post-trade compliance and reporting. The DMA customer, in turn, gains direct access to major market centers. While firms opt to go through a sponsored access arrangement for many different reasons, reduction in latency is one of the main factors. Other, more basic reasons include additional revenue opportunities and hitting volume discounts.
There has been a lot of focus on the need for ongoing latency reduction to gain competitive edge. When breaking down the key sponsored access infrastructure components, network connectivity typically accounts for a significant portion, with an average of 450 microseconds. Exchange gateways add another 85 microseconds, and the industry average for typical pre-trade risk checks accounts for approximately 125 microseconds, with per-risk checks averaging anywhere from five to ten microseconds.
Latency levels across the three often-used types of market access (traditional DMA service; co-located, filtered sponsored access; and unfiltered sponsored access) vary widely, leading to a potential competitive edge for those firms able to achieve ultralow latency trading infrastructure. For traditional DMA services, the industry average currently ranges from four to eight milliseconds. For co-located, filtered sponsored access, the latency level dips into microseconds, ranging from 550 to 750 microseconds. Unfiltered sponsored access, not surprisingly, has the lowest range of latency, with 250 to 350 microseconds.
Challenges of Sponsored Access
Of course, sponsored access also has specific risks and challenges for participating parties as well as for the market overall. These include:
- Supporting non-filtered sponsored access can lead to sponsored participants taking unacceptable levels of risk, which can cause both great financial burden and reputational damage to the sponsoring broker.
- In order to support non-filtered sponsored access, sponsoring brokers must develop strong risk management and due diligence teams capable of handling the credit and operational risk of sponsored participants.
- Broker-to-broker sponsored access can lead to a situation in which the sponsoring broker loses track of the activities of the sponsored broker’s customer.
- Providing filtered sponsored access often leads to a higher pricing point for sponsored participants, leading to favorable competitive conditions for those brokers offering unfiltered sponsored access.
- While the potential is slim, there is a chance that a rogue sponsored participant can increase overall systemic risk.
Never Good to Be “Naked”?
Most of the current controversy in the marketplace regarding sponsored access has been focused on the unfiltered “naked”access model. The fear is that without real-time monitoring of sponsored participants’ overall trading activities, certain trading restrictions can be overlooked and potentially lead to a disaster. In the worst-case scenario, electronic fat fingering or intentional trading fraud that could take down not only the sponsored participant, but also the sponsoring broker and its counterparties, leading to an uncontrollable domino effect that would threaten overall systemic market stability.
It is certainly expected that the sponsoring brokers will conduct thorough due diligence of sponsored participants’ overall trading infrastructure. However, the opponents of unfiltered sponsored access fear that during live trading, without the sponsoring broker monitoring pre-trade risk checks in real-time, the chances for catastrophic trading error increase even with strict post-trade trading analysis. One danger of focusing on pret-rade risk filters in today’s high frequency trading market is that a significant percentage of false positives can occur when these filters are applied to specific trading strategies that produce many limit orders which are consequently cancelled. As a result, there has to be a certain level of distinction between the traditional pre-trade risk checks that are ideal for preventing “fat-finger” mistakes and “at the trade” risk checks (i.e., real-time immediate trade risk checks) that can provide risk coverage over high frequency trading activities.
Certain firms and unfiltered sponsored participants (e.g., brokers, hedge funds, and high frequency trading firms) contend that risk checks monitoring at the exchange-level, followed by post-trade drop copies, should be sufficient to analyze the overall trading risk being taken by the sponsored participants. The main arguments of this prounfiltered sponsored access segment include the following:
- Sponsored access helps level the playing field against larger brokers that are able to consistently hit volume discount.
- Detailed due diligence is conducted by sponsoring brokers to ensure that the sponsored participants do not cross specific risk thresholds.
- Sponsored participants typically operate their own sophisticated, pre-trade risk compliance platforms that adhere to the limitations set by the sponsoring brokers prior to going live.
On the other hand, firms like FTEN and Lime Brokerage, along with most of the bulge bracket firms, have highlighted the dangers behind unfiltered sponsored access, and emphasized the need for instituting a minimum level of sponsored, broker-monitored pre-trade risk checks within the sponsored participants. The main arguments of this antiunfiltered sponsored access segment include the following:
- Growing systemic risk due to usage of unfiltered sponsored access arrangements by unfit, less capitalized sponsored participants with questionable risk management capabilities.
- Use of unfiltered access provides unfair competitive advantages to firms that provide both clearing and market access services at a fraction of the cost of filtered sponsored access.
- Post-trade drop copies are not good enough risk management tools, and pre-trade risk checks should be a must-have to avert any inadvertent trading errors.
Despite the potential negative market impact caused by unfiltered sponsored access, there is considerable ambiguity from a regulatory perspective over whether or not “naked” access is currently legal. In order to have an efficient and profitable sponsored access service, the sponsoring brokers must have the following areas covered:
- Market center memberships;
- Relationships with third-party technology vendors or service bureaus with a low latency infrastructure that is stable and measurable (with an emphasis on consistency and reliability);
- Cost-efficient clearing arrangements;
- Cost-effective and operationally efficient collocation arrangements;
- Creation of an experienced due diligence team to analyze technology and the business stability of sponsored participants;
- Ability to hit market center volume tiers for volume discounts.
Touching the Points
By Ben Springett
In this article, Nomura’s Ben Springett provides a brief overview of some of the key issues currently impacting European market structure, and shares his own thoughts on some of the changes likely to occur in Europe this year.
Introduction
European market structure, has been, is, and will continue to be, in a state of change for the foreseeable future. Whilst European Commission regulation has been a significant catalyst in this, the industry itself is now looking to progress issues at a faster rate than the expected regulatory change. As such we are seeing increased interest in “self” regulation within the community, particularly in the areas of post trade reporting and efforts to provide a consolidated tape. All market participants are active in this, but it is not unreasonable to assume that it will be down to the broker-dealers to drive any change, as they typically are the ones that have the resources to invest in the process.
Liquidity Fragmentation
Market share amongst trading venues can be measured in many different ways and people can be forgiven from choosing one that paints their own venue in the best light. The accompanying two charts (Charts 1 and 2) show the steady decline of market share amongst the key primary exchanges, to the benefit of the MTF venues, although the total volume levels remain significantly lower than the pre-credit crunch days. When considering primary exchange volumes versus MTFs it is necessary to bear in mind that the primaries are only just starting to compete in each other’s markets, and as such the pan- European MTFs have had more blue chip names with which to capture their market share. This is set to change in 2010; Euronext launched ARCA last year, Xetra have launched their International Market (XIM) and the London Stock Exchange (LSE) have just completed the acquisition of a majority (51%) stake in Turquoise.
