Future of the Trading Platform

Transcription

1 Future of the Trading Platform Associate General Manager Capital Market Services Narayanan V Introduction The stage is set for some major changes in trading in the years to come. One glimpse at the trading scenario will give you enough proof that algorithmic trading volumes have gone through the roof. Regulations like MIFID, implemented in November 2007, are threatening to change the way in which banks trade. And the changes are happening fast. The trading community firmly believes that this trend is here to stay. On the other hand, the rapid changes of excessive peaks, troughs and volatility in the recent market fall outs have been blamed on the black box trading techniques. If you look from the telecom industry s perspective that caters to the needs of the trading industry, there are major changes that are sweeping in with customers asking for more bandwidth, storage and data centre services. In the last 18 months alone, several trading houses upgraded most of their exchange connections by 500% to handle the increased market data and trading volumes.

2 Algorithmic Trading The impact of algorithmic trading has been discussed time and time again. The idea of being able to automatically build into algo black box trading strategies - a switch to the trading blocks that is based on automatic updates coming from news tickers - means building towards an automatic market place that switches, routes and smarts the orders around the market without any human involvement with integrated trading strategies. But when we talk about algorithmic trading, issues around security and end to end authentication are not far behind. Another key issue is the constant need to upgrade the infrastructure. This calls for a huge investment into hardware, software, communications and capacity. Constant upgrades to infrastructure costs money, in addition to the end to end cost of trading. This cost is double-fold with investment banks paying huge sums to external vendors for providing the infrastructure to keep the algorithmic trading going and the second set of costs are costs about which the investment banks would dearly love to do more but they cannot, which is the cost of complexity - the cost of a broken Europe, the cost of the absence of a single approach to regulation, market microstructure issues, conduct of business. The potential for a significant win in that area, as a result of the Financial Services action plan, is still in the yet-to-be-delivered-box as far as the industry is concerned. Challenges With these challenges of algorithmic trading, industry players are also facing other challenges that of co-location, attention to detail and catering to the ever-changing needs of the client. One of the services that major exchanges are offering is called co location. This is an attempt to work around the speed of light by allowing people to put very resource hungry applications very close to the exchange s trading engines rather than having that tiny extra latency of sending large quantities of messages from the bank s trading engine to the exchange s trading engine. When it comes to attention to detail, the industry needs to pay attention not just in terms of capturing business requirements to code them but also a keen eye for the application of the laws of physics. Along with attention to detail goes constant attention to the changing needs of the clients. The clients needs have always been and will continue to be very heterogeneous. The clients are always going to be heterogeneous and the challenge for bankers and investment bankers is to find ways of meeting those needs efficiently. The success of an industry where trading really occurs, be it an exchange or a trading venue or, ECN will depend on how it responds to these five issues. Latency The importance of dealing with the latency issues can never be overstressed. Latency means different things to different people and its definitions are many. But from a common man s point of view let s say you enter an order to buy or sell whatever it might be and till you get the response, you do not know what has happened to that order. So if you say: Buy me 100 and if the response you get is Bought 50, 50 in the book, we are talking about serious latency issues here. And this is one key area that has to be addressed. Since exchanges have brought down considerably the time they take to accept, process and confirm an order, traders too have responded similarly.

3 Resolving latency issues and quicker execution times is definitely high on the priority list and the players too are aware of this and the race to do this is heating up. The key differentiators in this space are network speed and location. Clients call even just a five millisecond delay as an outage. Let s look at it at a global level. The bulk of the capacity and trading that exists today around the world tends to go west; it goes via the US. It takes a 240 millisecond link to go from London round to Tokyo via the US. If you go via Russia it is 60 milliseconds. So are we going to see all of the trades going that way and what about the security implications of having all the trades running via Russia? Consistency It is not just enough to resolve latency, because what the huge volumes with respect to number of trades and values that we are seeing in the market during peak periods need high consistency. So in such a situations when there is too much of trading happening, the traders except the same behavior from all IT infrastructures; be it outside providers, exchanges or ECNs. Here in lies the challenge. High-speed Market Data So it s not only just knowing what your order has been doing, whether it has been matched or you re in the book, but also knowing where the market is. All this, of course, consistently with low latency. Hence the need for high-speed market data. Overcrowding and Risk Management The general trend is that trading venues don t want to have a large footprint on members or participants, whether it is exchanges or ECNs, just to bring down the cost. This, to ensure that there can be consolidation on the service front or technical infrastructure front. The other very important issue, of which we will hear quite a lot in the future, is risk management. Today, if you look at the investment decisions being taken by machines with extremely high speed and the order rates coming in at hundreds per second, the value at risk is extremely high on very low time scales. From that perspective, it is quite clear that there will be drastic changes since it can t be just the trading side which can speed things up but also clearing and risk management The Derivatives Exchange s Stand From a derivatives exchange point of view, the above mentioned success criteria are all different investment strategies. Not everybody needs this ultra-low latency and the other attributes. We have strategic investors who want to buy 5% or 3% of a company, maybe have a certain influence on certain decisions at that company, who are thinking about a much longer time scale. And they are not doing statistical arbitrage. So we have different groups of investors and this is another generalistic thing we will see in the future - that there is more diversification with respect to technology as well. But there are some who want to be in this high-speed game, which obviously, comes at a cost. So as a result, we will have a strong segmentation of the market. Another interesting trend that the market is witnessing today is that of formation of electronic pits. Earlier, you used to have the pits with the traders, but today it is all service moving close to the exchanges, around the globe. We will see this happening not just on the trading front but also on the clearing front. This calls for real-time risk management since the risk of all these guys sending their orders at very high frequency is only going to further burden the market.

4 Dealers: Are They Here to Stay? With all this automation catching up like never before, a section of the trading industry believes that dealers will disappear. But there are others who believe that they will simply find new ways of doing business, more intelligently and with more sophistication. But the debate rages on and the questions keep coming: Will algorithmic trading push the dealers out of the dealing room or will social networking combined with low cost high band (inaudible) change the whole nature of trading and dealing? Will markets operate locally, nationally, internationally or globally? What are the implications for market credit operation and, most importantly, systemic risks as a result? What technologies will drive the evolution of trading? A recent IBM report on algorithmic trading and latency revealed that nine out of ten dealers would be out of their jobs by From a trading house point of view, this might be different for everyone and it depends on their technology as well as how much the industry will move away from the human touch in investment market. If you look at the automation story it is a story which is fundamentally about simplification. If you look at the Ford s insight into the production line, automation of production, and the prefabrication of buildings, we see a pattern here that of - deskilling jobs, making jobs simpler, making jobs easily replicable & exportable. But however, this doesn t necessarily mean that the results of automation will satisfactorily suit the changing needs of the client. In the long-term, in the area of say more straight forward, plain vanilla, high liquid products we will see less human interaction. Only those who know how the automation machines work will find a place here. But on the other hand, products like complex derivatives pricing, where you don t want to fully rely on a machine and where innovation is extremely important, the intervention of human beings is vital. Such kind of complexity deserves rational decision-making, which the machines lack. What s In Store? More products will enter the foray In the coming years, we will see that more products will come on exchange or on large trading venues, which are at the moment OTC, essentially to bring down the total cost of the process by means of standardization. Derivatives will boom The derivatives will continue to grow at enormous rates in the future and eventually, we will see some global geographical clustering of exchanges. If latency is really very important then it might lead to all the services of the exchange or trading venues -- for example the US equity market has lots of trading venues. New York is a natural centre for equities trading in the US. For the plain vanilla, high-liquid trading - which will be highly automatic in the future and already is to some extent - industry will need people who have sound IT background and good understanding of the laws of physics. Complex Products and Skill Sets On the other hand, there will be a lot of complex products and the skill set that was good 10 years ago or 15 years ago to get a job in the financial industry will still hold good. The demographics of who gets employed by investment banks have changed dramatically and more so in trading compared to pure investment banking. There are enough indications to believe that this will continue. The definition of a trader is changing and the question is how many people are going to be employed by operations that do trading because it is all about building systems, designing systems and using systems.

5 CRP Consolidation, Rationalization and Proliferation Consolidation - This is an extraordinarily difficult, expensive business to be in, not just for the sell-side but even the buy-side, who have invested very heavily in their trading operations over the last few years. It s entirely reasonable to expect that there will be something like the old world where people on the buy-side looked to brokers to provide the science and technology behind trading and we get into an environment where people are competing on the objective quality of what they re doing because these things, after all, measurable, are getting more measurable. With dark pools and all the different things that people have to navigate through to do a best execution job, it s entirely reasonable to imagine a world where there are only five or ten providers of such a service. It will be, in any event, extremely complex and people will have obligations to demonstrate that they have done as well as the pre-eminent providers of these services. Rationalization It is extremely important to look around and see what s happening and to remember what exchanges were built for in the first place. This evolves a system of interconnected pools of liquidity that are effectively a playground for arbitrageurs and people who are not really fundamentally about investing in assets that they care about. If that is the way things have been and if that continues, it will be difficult to understand exactly why we all have to invest so much. So there s not some evil machine out there that s lurking, waiting to gain the system or pick up the footprint of an institutional order to trade against. This last phase, it s imminently reasonable to expect that market participants, either in concert or not, look at the market and say, We ve got to rationalize this and look at crossing tools to reintroduce some order to the trading world. Proliferation - We are clearly on the cusp of some very dramatic changes in the trading landscape, the proliferation of trading venues. When there are multiple liquidity buckets you inevitably get fragmentation. This happens immediately upon the creation of these alternative liquidity sources but the fact that the orders get smaller. So there will be an exponential growth in data because they re probably the only real beneficiaries of this. Digital news driving investment decisions will lead to a whole new type of investment strategy and there will be more black boxes and they ll do more insidious things when the markets get rocky. It s all about incredible complexity and the requirement, of course, for more people to design and build systems to deal with it. Finally, let s talk about black boxes, which made headlines when things started to go bad. People took notice and turned off the black boxes and people decided when to turn them back on again. So it s not just all robotic or automation. BATS The Better Alternative Trading System (BATS) in the US came up with an aggressive pricing model and in just about a couple of months had 20% market share. The New York Stock Exchange market share is plummeting. The critical thing to note about BATS is that it has something like 30 employees and the LSE has a lot of employees. It makes good business sense to start thinking about how industry is going to diversify if a major competitor is undercutting from a price point of view and doing it all on the basis of technology. Let s face it - they don t have fancy marble columns in their façade. It s just a completely different model and if that is who their new competitor is they better be thinking about what s next including potential barriers due to the local exchange regulatory bodies or governing bodies. On the volumes front, every exchange is continuing to increase its capacity with clients. Banks are trading more than they did before with multiple exchanges and need more data quickly. As a result, there is huge uptake in the requirements to telecom providers, not just for connectivity but for data centers space. This includes co location which is providing some interesting challenges to the industry because the requirements are growing fast with regulatory requirements like SOX, Basel II and OCC.