The New Exchange

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.