Electronic Market Microstructure

According to a new 10-year industry forecast by a large service provider to the financial services industry, electronic trading, regulatory pressures and interest in emerging markets will change the very foundation of the world’s capital markets businesses; the convergence of market transparency, the speed and completeness of modern electronic markets and the investor’s demand for greater returns will lead to a major market shakeout. Some of the already emerging initiatives in electronic trading include the following:

Automated Pairs Trading: Pair trading is a trading strategy with a relatively low-risk position. The goal is to match two trading vehicles that are highly correlated, trade one long and one short and when the pairs price diverges “x” numbers of standard deviations – “x” is optimized using historical data. If the pair reverses to its mean trend, a profit can be made on one or both of the positions. With new computational scale availability and the increase in electronic connection to liquidity, firms are employing computationally intense algorithms that can search massive amounts of opportunities, much more than ever thought. One firm searches 180,000 pairs, searching for Alpha, and presents their clients with the top 15 per day.

According to the TABB Group, Hedge funds are under pressure to increase Alpha, which is defined as the returns attributed to the fund manager and not newly exposed risk. Automated Pairs Trading is one way to find more Alpha.

– TABB GROUP

Regardless of Alpha, Firms are looking for ways to provide their clients with valuable ideas and generate commissions. To keep commissions flowing firms plan to expand into cross-border pairs — like Vodaphone versus Verizon or Boeing versus Airbus.

For a truly high performance automated Pairs trading system to be realized, a firm will need state of the art direct-market-access liquidity aggregator, and sustantial computational power among other things. This will provide them with a greater liquidity pool with lower cost to access, and the ability the ferret out as many Pairs opportunities as possible.

High Performance Data: With the availability of quote data, historically and in real-time, has change the approach of many banks methods of how they will conduct analytics for algorithmic-based trading. For example, Reuters Tick Capture Engine analytics platform provides a competitive advantage by back-testing theories and strategies across massive amounts of data to bring new trading strategies to market quickly because it employs a new technology contained in Vhayu’s database; the heart of their engine. Vhayu, not unlike Xenomorph and KX, are specialized databases that can handle and process data in orders of magnitude greater than a conventional procedural database. These tools will enable banks to do business in much greater volumes.

Dark Books: Dark Books are liquidity pools that match buy and sell orders without publishing a quote. They are similar to crossing networks, Dark Books are an alternative to the public equity markets that brokers are exploring for their algorithmic-based executions. Many banks are including this ability to sweep Dark Books in their algorithms to optimize best execution.

While TABB Group believes that the incorporation of dark books into algorithms and aggregation tools is well underway and will be the common way to access many of the block trading systems and dark pools of liquidity within the next two years, TABB Group CEO Larry Tabb adds a cautionary note. “There’s not sufficient room in the market for the number of continuous blind crossing networks that exist today. As we saw with the closing of Harborside , if your market structure doesn’t differentiate and add value, it will be impossible to survive as a competitive venue.”

Derivatives and fixed-income electronic processing outsourcing: Some leaders in analytics, quantitative financial, derivatives, fixed-income, asset securitization and risk management markets are making their way into the ASP space for electronic trading. Even though these instruments are illiquid, there are several places that the process can be optimized by making it electronic. This will improve the overall process until the liquidity improves and a full electronic platform can be executed.

DMA Penetration: As technology advances, investors’ need to shift and regulations allow for their new business models, sell-side firms will compete directly with stock exchanges sometime during the upcoming decade, according to a lot of experts.

No-Longer Just Equities: Lava Trading (New York) on Tuesday revealed what it calls a “major initiative” to introduce an interbank foreign exchange trading platform for FX program Trading.

Electronic OMS Service provider: Firms are starting to redistribute, sell and support fully integrated SOA-based OMS solutions to the buy-side community. When delivered it will offer buy-side clients an end-to-end investment management solution that spans portfolio modeling, real-time trading applications, trade processing and portfolio accounting — all through a single access point and available as an ASP (application service provider). A source says that in addition, some of the solution will span multiasset classes and multicurrencies.

Major exchanges start to cross trades!: Exchanges are looking to diversify their revenue streams everywhere; they are pursuing the crossing network business, throwing them into direct competition with the sell-side community. For instance, Nasdaq has been quite successful in offering crossing services in direct competition to POSIT, Liquidnet and other crossing networks,” .

A New ECN?: It is known that Citigroup will operate a new electronic trading network separately from its business of executing trades for clients. And Citi’s ECN will be accessible to other Wall Street firms trading stocks. Some say it is in defense of the duopoly – the New York Stock Exchange and Nasdaq – raising prices charged to brokers. But another ECN??? Is this Crazy? Because of all the uncertainty surrounding Reg NMS and how it’s going to play out, brokers are investing in ventures that can help them generate market data revenues and avoid paying fees to other venues. But does the industry really need another ECN? There were as many as dozen ECNs created during the late 1990s as Wall Street firms placed bets on electronic trading. Remember Strike, REDIBook, BRUT, GlobeTrade, Island, Attain and MarketXT? All of these ECNs have either merged with other ECNs or pulled the plug.

In theory, more ECNs should benefit from the new regs which require trading centers to route orders to the destination displaying the best price. If ECNs have the best price, other trading centers are obligated to hit them first. Then, ECNs could improve their internal match rates without having to route out and pay fees for taking another venue’s bids and offers…watch out more electrons!!!!