12 December 2008 Comments

 

Comment: changing liquidity landscapes

Barry Thompson, CTO & co-founder, Tervela

The baby is all grown up. BATS, the electronic communication network founded in 2005, has received exchange status from the SEC, making it the first ECN to reach this level organically. And it's not going unnoticed.

This means the threat level for traditional exchanges has just hit red alert. Infamous for highlighting weaknesses in traditional exchanges while advocating its price, technology and latency advantages, BATS has taken over 10% of the US equities market since its launch. As an exchange, BATS no longer has to publish quotes via other exchanges, which reduces overall trading latency vis-à-vis traditional exchanges. What's more, its newness means there is no legacy infrastructure dragging down performance. Instead investments in the latest technologies provide lower latency and more efficient use of human capital required to support internal systems.

The proliferation of ECNs - or multi-lateral trading facilities as they are known in Europe - also threatens the evolution of traditional liquidity pools around the world. Seeded by some of the largest market makers from exchanges like NYSE/EuroNext and Deutsche Börse, these investments are more than financial. They bring immediate order flow, enabling ECNs to quickly build up liquidity. Like BATS, they also are able to easily leverage new technologies to maintain advantage and can be more aggressive when it comes to pricing structure.

The "maker-taker" model, originally popularised by the equity and options trading industries, was also adopted by the US Futures Exchange last month. The pricing model offers rebates for market makers while charging fees to customers who remove liquidity from the exchange. It brings together favourable market conditions and supports market growth by encouraging market makers to add liquidity, which results in tighter bid-ask spreads. The difference in price between the two becomes profit for the execution venue. This is where the lower cost base of the ECN model proves a key competitive differentiator over established exchanges.

The exchange strikes back

In today's volatile market, traditional exchanges are seeing order flow and liquidity being threatened. As such, they are actively seeking new ways to improve service, increase product 'stickiness' and remain competitive.

CME Group, which operates the CME, CBOT and NYMEX, has leveraged its innovation in technology to rapidly grow its business on the CME Globex trading platform from less than 15% of total volume in 2000 to nearly 90% total volume today. With more than two billion trades taking place at the exchange in 2007 (worth a notional value of $1.2 quadrillion), CME Group has differentiated itself from other exchanges through a vast distribution network. They have customers in more than 85 countries with access to the exchange through Globex nearly 24 hours every trading day and offer speeds of approximately 10 milliseconds within the CME network.

In August 2008 CME Group completed its acquisition of Nymex and has publicly stated that the over the counter success of the ClearPort platform will figure into its future. Volume on the ClearPort platform is already up nearly 40% to 470,000 contracts a day over last year. CME Group also has strategic partnerships with several other key exchanges, building on the strength of Globex, including BM&FBovespa in Brazil, KRX in Korea, the Dubai Mercantile Exchange and the Green Exchange.

Interdependencies within the trading technology domain

Central to high-velocity trading, stability and resiliency are not traits synonymous with legacy architectures. The primary impediment to innovating through the addition of new asset classes or integrating new applications to bring about competitive advantage is a sagging foundation. Many traditional exchanges have built their market data distribution frameworks on outmoded software-based messaging infrastructures. When these systems break down the traditional mechanisms they use to compensate only exacerbate the problems.

Any time you are dealing with the sheer physics of information movement within complex systems - especially in a high-volume liquidity environment - your foundation needs to accelerate and integrate the entire trading ecosystem. The capacity requirements for this kind of trading are way beyond what software alone can provide. Only a hardware-based system can yield the substantial headroom and horsepower to handle large data bursts and unforeseen peaks in volume.

Because messaging systems are at the core of the vast array of financial applications running on an exchange backbone, they are often the prime culprit when system failures occur. With emerging trends like the proliferation of algorithmic trading influencing technology requirements on a constant basis, exchanges must ensure that they have a solid foundation on which they can layer the adjunct services they need to remain competitive.

The Appeal of the Physics of Co-Location

Recently the ISE, LSE and the Tokyo SE launched co-location hosting services to attract more liquidity. Co-location allows exchange members to reduce latency without redeveloping existing systems. Trading firms can extend the life of their applications while remaining competitive in the race for the lowest latency. Exchanges benefit tremendously from this, as member firms are more likely to send orders to a co-located exchange. 

In a 'best execution' environment, even if the co-location exchange doesn't have the best Bid/Offer, the exchange will give its market makers an opportunity to try and make a match before routing to an ‘away exchange'. Co-location services are also appealing to smaller firms because they can leverage one exchange's connectivity to other liquidity pools without having to negotiate multiple relationships.

Technology is the Path

Having the most stable and resilient underlying technology is critical when building out services to keep clients and attract new ones. Having close physically proximity to an exchange is crucially important as is deploying latency- tuned applications that add value and attract liquidity. Market demands are fuelling the need for smarter technology architectures so that migrating applications and adding new services no longer requires a complete overhaul of the existing system. The liquidity venue with the most modern and scalable infrastructure is always going to win.

www.tervela.com