Eric Noll, a Nasdaq OMX executive vice president responsible for transaction services in the U.S. and U.K, discussed his various businesses during Nasdaq’s Investor Day on May 10. What follows is an edited transcript. In this, the second part of a two-part series, edited by Peter Chapman, Noll discusses Nasdaq’s moves in options as well as trends in the options industry.
>>On the need for the new Bx exchange Customer orders are highly price sensitive and [the retail brokers] aggressively seek rebates to [offset] their shrinking payment-for-order-flow pools. So they’re looking to replace with other functionality and other sources of income that what they were getting directly in terms of payment for order flow. So they are aggressive rebate seekers.
>>On the new BX as a solution for the decline in payment for order flow [Nasdaq Bx] gives us a chance to be the first options exchange to offer a model that pays takers of liquidity as opposed to makers of liquidity. Payment for order flow has become increasingly opaque. It has become increasingly difficult for earners of payment for order flow to know what they’re getting paid and how they’re getting paid. [Nasdaq Bx] is a model that actually makes their rebate for taking liquidity transparent, competitive and certain. And we think that has real value to them. So every other market model that operates out there operates primarily for the benefit of the provider of liquidity. This is going to be the first model out there that operates to the benefit of the taker of liquidity.
>>On the expectations for Bx We think we’re going to hit about a 3 percent market share by the end of 2013. We expect it will be accretive [to earnings] very quickly as we grow our business and we think that it gives us the chance to continue to expand our footprint in the equity options space.
>>On low-latency trading in options There’s an increasing demand for low latency and low cost execution. That’s relatively new for the options market which is probably a generation behind the equities market in that respect. Plus there is an increasing demand for co-lo services and market data. The split right now of [our] Access Services division is about 80 percent equities and 20 percent options. So we do think that there is real space to grow the options side of our business.
>>On the shift in options flow away from the over-the-counter market There’s a shift from the OTC markets to the regulated market. This is hard to quantify and a lot of this is anecdotal information, but as Dodd-Frank has rolled out, particularly with OTC individual equities product, we’re seeing more and more of that flow coming onto the exchanges. The largest growth that we have seen in that business is in what we’re calling our complex order flow. These are complex spreads, often tied to stock, and they’re coming from brokers who have traditionally done this business in the over-the-counter market. So they’re starting to address their Dodd-Frank concerns by getting this in the clearinghouse and getting it on a transparent market. But they’re also bringing more transparency and lower costs. So we expect that business to continue growing.
>>On the impact of this new business on Nasdaq’s trading floor Our voice business and our floor business remain surprisingly robust. I would have expected over the long term that business to start to wither as electronic trading became more and more prevalent in options. But the floor remains quite active for us. And with the growth in complex order flow, it remains an important part of our business.
As the quantity of data for trading grows exponentially, it is creating challenges for the industry and its regulators. Computing experts descended upon the Times Center in New York City on Tuesday to discuss some of the issues caused by the explosion of data in the financial markets.
The event, produced by Tabb Forum, saw panelists make a number of startling predictions, including that regulators will soon be able to track and record every equity trade made.
Daryan Dehghanpisheh, director of the financial services and institutions team at Intel, said as the industry becomes more complex, investing in more efficient infrastructure is vital. While data is important to all traders, he noted that it is far more important for some strategies than for others.
“It’s about what you do with the data,” said Dehghanpisheh. “How you think about data if you are a latency arbitrager is completely different from if you are a global macro fund.”
Most startling, however, was Dehghanpisheh’s comments about the improved ability to track and store information. Soon, the government will have the capability to monitor every single equity trade and to store that data indefinitely, he said. Though the cost of doing that might seem to be prohibitively expensive, those costs are coming down, and they could soon be within reach for regulators.
“That day is coming quicker than you think,” Dehghanpisheh said.
Speaking on another panel, Scott Ignall, chief technology officer of Lightspeed Financial, said financial firms are becoming a lot more amenable to using off-site firms to store their data. Still, there is a lot of skepticism in the finance sector about cloud computing, in which firms share resources and store information on remote servers.
“It’s control,” Ignall said. “The industry has been built on this entrepreneurial spirit of controlling your own applications, your own network, your own everything.”
But the industry is learning that when it gives up some of that control and stores its data remotely, it can have cheaper access to larger amounts of data while still maintaining security. In fact, Jeff Bell, chief executive officer of Wedbush’s Lime Brokerage, said more and more firms have been coming to him saying they don’t want to manage their own infrastructure.
Much of that attitude comes from a desire for cost containment. Firms don’t want to have to upgrade all of their technology every three years, and outsourcing data can make financial sense. The main barrier to using the latest off-site technology, cloud computing, is security concerns.
W. Brennan Carley, global head of the Thomson Reuters Elektron platform, said the cloud is not quite ready for trading applications, though his firm has already chosen not to own its own physical data centers. Wedbush is using the cloud to deploy strategy development software, and Ignall said the increased use of iPads and other tablets could push trading into the cloud.
That might seem like pie in the sky to some, but Chris Concannon, a partner with electronic trading firm Virtu Financial, noted that the industry has seen changes that were previously barely imaginable.
“Five years ago I looked at the markets and said, ‘We can’t get any faster,’” Concannon said.
Market participants continued to bash Nasdaq OMX Thursday over the exchange operator’s botched handling of the Facebook IPO, even as its chief executive continued to unveil further details of a plan for addressing the debacle.
The plan, "is underwhelming at best," declared Thomas Joyce, chief executive of market maker Knight Capital, during an investor conference hosted Thursday by Sandler O’Neill & Partners.
"This is not the solution. Nasdaq has to go back to the drawing board and come up with something sensible," he added.
Nasdaq had created a "voluntary accommodations fund" of $40 million to compensate trading firms "disadvantaged" by technical problems that beset the initial offering of Facebook shares on May 18.
The funds would be paid out to "qualifying members" of the Nasdaq Stock Market who were affected by the inability of its IPO Cross system to deliver messages for executing trades. Messages to execute orders were supposed to be delivered at 11 a.m. Trading in Facebook shares did not start until 11:30 a.m.
NYSE Euronext immediately had decried the plan, saying the plan is "wholly inconsistent with fair practice and an undue burden on competition.” In effect, the voluntary accommodations plan that Nasdaq submitted to the Securities and Exchange Commission earlier in the day incents trading firms to move orders to the Nasdaq Stock Market in order to receive discounts.
During the Sandler conference, Nasdaq chief executive Robert Greifeld defended the plan, declaring that it was not a grab for more market share. He also said that when the exchange replayed the opening of the trades, prices for the IPO did not change.
Previously, Nasdaq had announced that it will retain IBM to review its systems.
Greifeld has also publicly declared Nasdaq’s penitence on major media outlets.
"We have been embarrassed and certainly we apologize to the industry," he said on CNBC Wednesday.
None of these efforts have eased the public outcry over the Facebook fiasco.
Four major market makers involved told Reuters that they expect their losses to be around $115 million.
These include: UBS AG, $30 million; Knight Capital Group, $30 million to $35 million; Citadel Securities, $30 million and Citigroup, $20 million.
UBS, Citadel and Citigroup all declined to respond to comment requests on the plan, but Knight Capital’s Joyce was vocal on the subject during Thursday’s Sandler event.
Joyce noted industry rumors that actual losses tied to the fiasco could run as high as $200 million.
"I have no doubt that they are true. I would not be surprised if the number was in the higher end of the range," he said.
Moreover, Joyce declared that Nasdaq needs "to go back to the drawing board and prove they are a client-focused organization. Without their clients, they won’t have a whole heck of a lot. Right now, they have some unhappy clients."
"I said in the recent past that Nasdaq created the problem, period. Nasdaq made decisions that created this problem that the industry suffered through. It is up to Nasdaq to create a solution," he said.
In a report on the compensation plan, Raymond James equity analyst Patrick O’Shaughnessy wrote that proposal was "unlikely to resolve customer discontent."
"We believe NASDAQ’s proposed accommodation fund is unlikely to satisfy firms that experienced trading losses from a trading glitch during a recent, high-profile IPO. While this announcement does quantify NASDAQ’s immediate financial exposure, we believe the overhang of unsatisfied customers and potential lawsuits will remain," he wrote.
Moreover, O’Shaughnessy warned that "there is also no guarantee that the SEC will approve the proposal, which NYSE Euronext has already publicly criticized."
"Will the SEC even allow targeted customer rebates? We are not convinced that SEC rules will permit NASDAQ to provide preferential pricing to certain customer," he wrote.
Ultimately, O’Shaughnessy argued that Nasdaq was in a no-win situation.
"If it fully accommodates all claims deemed legitimate by FINRA, the financial hit could easily exceed $100 million and it could set a dangerous precedent for the industry," he wrote. "On the other hand, if NASDAQ sticks to the $40 million accommodation pool, it faces the specter of upset major market participants directing their order flow elsewhere, thus harming market share and, as a result, trading revenues (potentially in its U.S. options business as well as U.S. equities) and market data revenues."
In addition, he stated, NASDAQ may face highly-publicized lawsuits from member firms, although we believe NASDAQ would likely prevail in those lawsuits due to the protections provided by Rule 4626.
This story originally appeared in Traders Magazine’s sister publication Securities Technology Monitor
BATS Global Markets reported its U.S. equities matched market share totaled 11.7 percent in May, rising from 11.5 percent in April, and jumping up from 10.8 percent a year ago. The exchange operator saw an average daily matched volume of 830.6 million shares last month.
In April, BATS saw an average daily matched volume of 781.9 million shares.
In May, BATS Options saw its matched market share remain at 3.0 percent, unchanged from April but still up from 2.4 percent in March. However, average daily matched volume did rise 2.5 percent in May, with 501,649 contracts traded. April saw 488,878 contracts trade.
The options exchange had an average daily matched volume of 589,425 contracts one year ago.
Additionally, BATS Chi-X Europe capped its sixth straight month as the largest European market center by market share capturing 25.1 percent of that market share in May, up from 24.6 percent in April. One year ago the exchange had a 22.8 percent market share.
The BATS 1000 Index ended the month down 1079.57 points, or 6.8 percent, to close at 14.742.56.
BATS operates two stock exchanges in the U.S., the BATS BZX Exchange and BATS BYX Exchange; as well as BATS Options, a U.S. equity options market; and BATS Europe and Chi-X Europe, which operate FSA-authorized multilateral trading facilities.
Eric Noll, a Nasdaq OMX executive vice president responsible for transaction services in the U.S. and U.K, spoke about the exchange operator’s new initiatives during Nasdaq’s Investor Day last month on May 10. What follows is an edited transcript by Peter Chapman. This is the first part of a two-part series, covering Nasdaq’s moves in cash equities. The second part will cover Nasdaq’s options business.
>>On Nasdaq’s Retail Investor Auction proposal The New York Stock Exchange has made somewhat of a big deal about their “Retail Liquidity Program.” We think that there are some problems with the structure, what they’re trying to do and ultimately, some problems with the way that process will work. So we have created what we believe is a much more innovative and effective competitive tool.
>>On the mechanics of the program We will re-segment the market, attract flow from dark pools from retail investors. We will give them a live auction process for them to get price improvement on a lit exchange with competitive market makers competing to provide that price improvement. We expect that to add about 1 percent to 2 percent market share when we grow it out. We think it’s an opportunity for us to segment the market in a realistic, competitive and transparent way that adds value.
>>On the problems of wholesalers If I am a liquidity provider to retail equity order flow [providers] today, I have to guarantee them price improvement on a certain percentage of their orders. And I have to use my own capital to do that. So what this model allows them to do is to say, ‘You know what, I don’t want to use my own capital to price improve those orders because either I don’t know where the market’s going or I’m capital constrained. I want to go to more of an agency model, but I do want that order flow. I want to continue to service that retail broker-dealer and that retail customer.’
>>On the benefits of R.I.A. to wholesalers This model opens up the price improvement process for that order consolidator to every liquidity provider on the street. So they can route the order to Nasdaq and we will run a retail auction price improvement option. Market makers who wouldn’t otherwise get a chance to interact with that retail order flow will compete to offer price improvement. The consolidator gets to pass that price improvement number back to the retail broker, meeting their obligations to the retail broker. And this allows them access to a much larger pool of liquidity and a much larger pool of price improvers that they wouldn’t otherwise have access to.
>>On offering VWAP algorithms to brokers The most interesting thing I think we’re doing this year is the introduction of what we call benchmark orders. VWAP, TWAP and percent-of-volume strategies have become relatively commoditized in the algo space. So what we intend to do is offer those as order types on our exchange. This is not to go directly to the buyside customer. This is intended to provide order functionality to our broker-dealer base. [We will] provide a cheaper, better, faster product than having them all develop their own algo offerings and go out into the marketplace and compete for that low-end commodity business.
>>On the target market This is not intended to compete with the high-end, high touch, highly sophisticated algo providers. It is instead addressed to the largest part of the market, which is the VWAP and TWAP market and say, we can do this for you better, faster, cheaper than you can do it for yourself. We expect to roll that out in the second quarter.
>>On the problems with the PSX exchange PSX started out as a price-size exchange and still is a price-size exchange. One of the issues with that is that the rest of the market is a price-time market and this exchange is locked into that National Market System. The advantages of quoting on size haven’t really been apparent to the liquidity providing community. So while you had some modicum of success in the last month-we’ve increased market share to 1 percent, 1.5 percent, up-it hasn’t grown the way we wanted it to. It’s really intended to provide services to core institutional users who are looking more for liquidity than for speed.
>>On the proposed changes to PSX So what we’re proposing to the SEC is that we create a speed bump in that system that allows our liquidity providers to really provide size quotes without being exposed in a way that has been at risk for capital for fast-moving orders. This is not to violate price, the best price in the marketplace. It’s intended to address what’s the real concern, which is how can I quote in large size in the marketplace and not be taken advantage of? And so, we hope that we’ll have some success with this. There is some interest in the end-user community. And there’s quite a bit of interest in the broker-dealer community to provide markets in that. So we think that should, over the long term, grow to be a 3 percent to 5 percent market share. Again, all of this is pending SEC approval.
>>On segmenting the market What we’ve been able to do-which some of our competitors have either chosen strategically not to do or have not executed as well as we think we have-is to figure out how to segment the market to meet the needs of some of the other market participants. Some of our competitors don’t segment at all. It’s a “one size fits all” strategy and we’re going to barrel down that path. They’ve had some measure of success with that. But I ultimately don’t think that that’s a long-term growth strategy. Other competitors have tried segmentation strategies that have not really been successful yet. I think we’ve demonstrated our ability to attract different kinds of order flow to our platforms.
>>On winning business from broker dark pools These are products that are designed to take flow back from dark trading, by providing a better solution to what other people have gone to the dark to do. This isn’t so much directed at moving share from one of our lit competitors, though we certainly hope to do that. It’s really designed to answer some of the dark trading crush. We’re going to provide you with some additional functionality and services and price discovery that will pull business out of the dark side of the marketplace and back onto the lit venues.
>>On the growth in off-board trading If you look carefully at the numbers, there are some securities, actually a large number of securities-over 1,000-that have 50 percent to 60 percent off-exchange trading. So it has a significant impact. I think we can compete very effectively by segmenting the market, particularly with things like PSX or algos, or Retail Investor Auction. Also, some of the pricing we’ve done allows us to remain competitive with dark trading. But [speaking to the] larger macro issue, we’re concerned about the primacy of price discovery. So we want to make sure that as we’re managing our business and the regulatory postures that we’re taking in Washington, that we make sure that price discovery remains the highest priority of our lit markets. That it remains front and center in everyone’s mind as they’re thinking about how these markets evolve.
Chase Lochmiller, GETCO, New York; Sara Baker, ITG; Chris Amorello, GETCO, New York.
Paul Cashman, SunGard; Terry Flynn, S3, both New York.
Roger Peterkin, SS&C; Al Aloise, Moors & Cabot; Larry Peruzzi, Cabrera Capital Management; Eric Marchand, Moors & Cabot; John Nuzzo, guest, all Boston.
Scott and Jennifer Setzenfand, Federated Investors, Pittsburgh.
Scott Govoni, Linedata, Boston; Rich McGraw, Flextrade, New York; Alex Zinny, Flextrade, Boston; Terry Lavigne; Jared Baker, both Charles River, Boston.
Chuck Green, E*Trade, Chicago; Monica Vega, Linedata; Mark McDermott, Canaccord Genuity; Bob Holland, Linedata, all Boston; Steve Carolus, E*Trade, Chicago.
Bill Reilly, Cadence Capital; Sean Maloney, Knight Capital Group, both Boston; Robert DiGiovine, First New York, New York.
John Curtis, Direct Access Partners; Jim Yonchak, State Street Global Advisors; Peter Hoey, Direct Access Partners, all Boston.
Left to Right, Front: Bob Hofeman, Rampart Investment Management; Whit Conary, Level ATS; Larry Peruzzi, Cabrera Capital Management; Sara Baker, ITG; Tim Casey, Cabrera Capital Management; Gus Phelps, Saratoga Capital; Back: Charlie Whitlock, JP Morgan; Tim Love, ITG; Charlie O’Connor, Leerink Swann.
Patty Schuler, Boston Options Exchange, Chicago; Terry Lavigne, Charles River, Boston, Samantha Foerster, STA, New York.
Dylan Ade, JMP Securities; Susan Ellis, Granahan Investment Management, both Boston.
Kevin Molloy, Chris Lessard, both NYSE Euronext, New York.
John Graf, DirectEdge; Sean Wagner; John McCarthy, both ConvergEx, all New York.
What’s next for Aritas Group, the troubled company that ran into problems with clients and regulators for disclosure issues related to its dark pool? Not much, it appears.
After selling its crown jewels to Portware and disposing of the rest of its intellectual property to ITG, Aritas, formerly known as Pipeline Trading Systems, is winding down and looking to sell off anything left with value.
Jay Biancamano, the executive chairman of Aritas, is slated to move to Portware. That will be once a deal closes to sell most of the company’s key assets, including its AlphaPro product and algorithm switching engine, to Portware.
Last week, Aritas sold all of its remaining patents to ITG for an undisclosed amount, but Biancamano told Traders Magazine there are still some assets left, including the technology underlying its now defunct alternative trading system.
The Securities and Exchange Commission last year slapped Pipeline with a $1 million fine. The firm then changed its name and hired Biancamano, the former global head of marketplace and corporate strategy at Liquidnet.
“The broker-dealer is still around, though we are looking to deregister that,” Biancamano said. “The ATS and the technology associated with the ATS, the Block Board, is still around. And the connectivity is still around. So in effect, that’s really what’s left of Aritas.”
Once the centerpiece of the company’s operations, the famous (now infamous) Pipeline dark pool stopped taking orders in the wake of a scandal that revealed Pipeline was sending order flow to an affiliate without disclosing that fact to clients.
Biancamano said while the ATS is no more, the technology it used still exists. He said there is no chance of keeping the technology as a going concern but could not comment on whether or not there was a potential sale of the remaining tech infrastructure.
The company’s broker-dealer will be shut down, though Biancamano said that for legal reasons Aritas will have to be kept open for a while. He will depart, however, once the Portware deal officially closes, which should be before the end of the month.
Ultimately, clients didn’t come back to the firm’s dark pool, though its algo switching engine and companion AlphaPro system have managed to retain users.
A little bit of nostalgia amidst the high-tech trading world is a good thing.
That was the thinking of Doreen Mogavero, chief executive and principal of Mogavero, Lee & Co., a New York Stock Exchange-based floor brokerage, when she decided to bring back a piece of the fabled exchange’s history and reopened the 90-year-old Member’s Smoke Shop.
"I ended up presenting the re-opening of the shop as a bit of the tradition of the old NYSE, amid all this new technology," Mogavero said. "In that respect, I decided to keep it the way it was. No real changes—we just cleaned it up, and maybe we could offer a few retired guys a job there."
That was her pitch to NYSE management in the spring of 2011.
The store, located at the 12 Broad Street entrance to the New York, traces its roots back to the 1920s. It was then that Morris Raskin, a floor broker on the exchange, moved the stand from its original 20 Broad Street locale and opened a larger smoke shop where busy traders, brokers and others could run and get their cigars and cigarettes without missing a beat or a trade.
The store is a throwback to the days of an exchange when you could smoke on the floor and tickertape littered the trading posts. The shop is located down a flight of stairs from the main trading floor – a place it has resided since its opening. Polished wood shelves, nooks and crannies are filled with traditional candy bars, sodas and water bottles to cater to on-the-fly traders. The shop also sells sundry items such as aspirin, personal grooming items and the store’s trademark red and white peppermint sucking candy.
It stands in stark contrast to the Starbucks that opened on the floor in June 2010, as part of the exchange’s trading floor revamp. That store is situated in a corridor linking the options exchange and main equity trading floor. And it serves up a different type of fare – lattes, schmaltzy cold beverages and sandwiches in modern glass encasements, all served by trendy baristas.
Mogavero’s sweet shop serves up more traditional candy store items, distinguishing her stand from the Seattle, Wash.-based coffee purveyor. The most popular items it sells? It’s 1.5-liter bottles of water and gum.
It’s come a long way from the spring of 2011, when the whole idea of re-opening the stand started with an inquiry by Mogavero about what caused the stand to close in the first place. When the NYSE told her how the prior operators had taken ill and shuttered the shop’s gates, it asked her if she was interested in doing something with the space.
"They said come to us with a proposal," she said. And the rest is history. Mogavero, along with her family, spent the summer of 2011 fixing up the store after the exchange did large-scale carting away of debris. Her crew cleaned shelves, revamped the store room and installed new lighting.
They also added a flat panel TV so shoppers could keep tabs on the markets.
"I remember coming in on weekends and nights polishing up the wood myself here," she said, proudly pointing to the wood panels that adorn the walls. "It was old and dark when I got here."
Mogavero understands the importance of nostalgia and history behind the exchange. She began her career on Wall Street at age 19 as a summer intern for her father, William Earle, who was a member of the American Stock Exchange. By the end of that summer in 1974, Doreen had found her life’s calling.
Within a few years, Doreen moved to the New York Stock Exchange where she became its youngest member in 1980. In 1989, Doreen opened her own firm, Doreen Mogavero, Inc. as a broker-dealer executing NYSE-listed equities on an agency basis for other brokerage firms. It was then, and still is today; the only 100 percent women owned and managed brokerage based on the floor of the NYSE, according to Mogavero.
Now she also runs the candy store, which she re-named The Original Candy Exchange. But many traders, including Mogavero, still refer to the stand as "Morris’," a nod to the original proprietor. And like him, she will from time to time go down from her floor booth or office and man the stand, selling water and popping popcorn for NYSE staff.
"Sometimes I’ll relieve Steve," she said, referring to her one full-time employee, Steve Strickman. Strickman is a retired NYSE floor clerk who finished a 26 year career on the exchange, working for Legg Mason. He is joined by Mogavero’s great-nephew, Billy LaFave, who is a part-time stock boy. Her husband, "Arcky,"a former floor trader himself and member of the exchange, is in charge of inventory management.
"Nobody here likes it when I run the store, as I really don’t know the prices of things," she joked. "I wind up giving stuff away."
Nothing grabs attention like a good scandal. That’s the story right now in the currency trading business, as two custodial banks fight claims that they "picked off" their pension fund clients with poor executions on their foreign exchange trades. The news of pending lawsuits, filed by some of the nation’s largest pensions, has put every institutional money manager on alert, and scrutiny of execution quality in FX has never been higher.
Both State Street and BNY Mellon have defended their FX trading practices and said they’ve done nothing wrong. But as the saying goes in politics and business, "Never let a good crisis go to waste." During a two-week stretch beginning in late April, three separate vendors announced the rollout of equities-style transaction-cost measurement products for FX.
The move to measure FX trading costs by ITG, Abel/Noser and TradingScreen is part of an expansion in the availability of equities-like trading tools and technologies in the FX market over the last decade.
Technological developments in FX trading, in some ways, look like a sequel to what happened first in equities: the rise of ECNs, algorithmic trading, smart order routing and internalized crosses. FX has an element of high-frequency trading, too.
The foreign exchange market is pegged at $4 trillion per day, with spot trading and FX swaps dominating, according to the Bank for International Settlements. Corporate treasurers account for the bulk of all trades, but money managers are a significant customer base, rising along with the expansion of overseas investing in recent years.
Trading by telephone, once the norm, is falling by the wayside, and today, 61 percent of all trading in foreign exchange is done electronically, according to Greenwich Associates. That’s up from 57 percent the previous year.
To some extent, the recent ramp-up in self-trading has been driven by the big brokers that pioneered electronic trading in equities. Today they offer algorithmic trading tools for FX. In 2006, for instance, the brain trust of Credit Suisse’s electronic trading group, AES, concluded that the market structure in FX looked very much like the equities market did before the onslaught of electronic trading there, said Paul Buckley, a director at Credit Suisse’s AES FX. First, there were multiple liquidity sources, like ECNs and single bank feeds. That, combined with clients’ appetite for electronic trading and the growing importance of transaction-cost analysis, meant that the time looked ripe to introduce FX algorithms.
"We started to spread the word that clients could use these tools to take their destiny into their own hands and take control and work that order, or use these technologies to transfer risk instantly, so you have a full range of options," Buckley said. "It really resonated with the buyside. They said, ‘Wow, I can work my own orders. I’m comfortable taking short-duration risk. I think I can improve the outcome for my investors.’"
Money managers have choices when trading currencies electronically. First, they can trade on a fully disclosed basis with a bank with which they have a relationship-essentially a principal trade in which the bank acts as a dealer. Clients can receive a direct feed with pricing from banks, with either streaming pricing or requests for quote abilities. They can also access their providers through a multi-bank platform-one connection gets them to everyone.
Clients can also trade anonymously through an ECN, using their FX prime broker. The advent of the FX prime broker is the single largest catalyst for the rise of electronic FX self-trading. This brings equities-like capabilities to the FX market. Since each trade is a credit trade, clients need someone to enter the market on their behalf. In an anonymous trade, the dealer never knows who is behind the client.
There’s always the phone, too, but that is becoming less important and is said to constitute about 10 percent of the total business, used primarily for the least liquid currencies.
Dealers Dominate Despite the rise of such ECNs as Hotspot FX and Lava FX a decade ago, the foreign exchange market is still a dealer market and will be for some time. The top 10 dealers (all banks) control nearly 80 percent of the $4 trillion of notional value traded each day, according to a Euromoney FX survey. The share of ECNs is a much smaller but growing presence, and has been around for a decade. Banks also trade on ECNs, as do high-frequency traders.
"Banks are huge," said John Miesner, global head of sales for Hotspot FX, an anonymous ECN and subsidiary of Knight Capital. "They have always been and will continue to play an instrumental role in foreign exchange. They have to be around."
Dealer internalization of orders is said to be a major reason dealers are in the catbird seat. It’s about 80 percent of the FX flow, according to industry sources. Investors like this for several reasons. First, there is no ECN fee. Second, there is less potential for market impact compared with the public market-if a buyer lifts the offering, the market moves higher. Lastly, with resting orders, there is the possibility for price improvement with a midpoint match, which cuts execution costs in half.
Equity pros, however, might be surprised to learn that firm quotes aren’t the norm, though some ECNs do provide them. Some have likened a quote from an FX dealer to an indication of interest, or a willingness to trade. Others have compared them to flash orders. One trading executive involved in FX likened an FX quote to SelectNet, the long-gone order-delivery mechanism on Nasdaq. SelectNet didn’t obligate a dealer to trade off his quote and be firm. "FX is a world of flash orders and SelectNet," the executive said. This function is often referred to as a "last look."
Despite equities-like products in the market, FX dealers are expected to hold the keys to the marketplace for some time. First, there is no regulatory mandate to make changes to the market structure, as happened in equities in the 1990s. In the middle part of that decade, Nasdaq and its dealers settled collusion charges with regulators that led to the order-handling rules and Reg ATS. The two rules, respectively, forced dealers to post their best-priced limit orders and allowed the creation of ECNs and other alternative execution venues, like dark pools. FX could never have that problem because it is unregulated. The pressures to change the industry aren’t political, but client-driven. Over time, FX has benefited from some of the technology that came from equities, while keeping its dealer imprimatur on the market.
Catching Up Mike Harris, director of trading at Campbell & Co., has seen FX trading develop during his 12 years on the buyside. Harris, whose sellside background spanned futures, options and FX, has seen the migration from voice trading to electronic trading-the model his firm favors. Campbell & Co., a commodity trading adviser, manages about $3 billion in futures, currencies and equities. It uses a wide variety of systematic strategies, including trend following, quantitative macro and statistical arbitrage, and relies heavily on technology.
"One of the reasons our firm is considered a leader in technology-based trading is that we began trading equities about 10 years ago, so a lot of what has happened in FX played out earlier-and in many ways, just like the equities markets," Harris said.
Having an equity trading desk provided a road map for Campbell to help strategize how it wanted to trade FX, Harris added. Clearly, FX is behind equities in the electronic trading revolution, he said. "The guys on my equities desk kind of laugh when we’re trying to figure out a problem in currency land, and they’re like, ‘Hey, we solved this 12 years ago. Let me whiteboard this for you.’ Currency trading is one of the last asset classes to go fully electronic."
As soon as the industry began moving away from voice trading, Harris said, ECNs began to dot the landscape. This was around 2000, just a few years after the transition in equities. Investor appetite to trade electronically drove the industry to open up and offer more venues. Clients simply weren’t allowed to trade in the primary interdealer market until access was granted in 2005, after a strong buyside push. The EBS platform, owned by ICAP, and Reuters Matching, have dominated the interdealer market for years and are still widely considered to be the primary market for FX. Banks also allow sponsored access to these systems by money managers and hedge funds.
Multi-Bank Platforms The original interdealer platforms were the forerunners of today’s multi-bank platforms, and today they compete with these newer entrants. FXall, Currenex, Hotspot FX and Bloomberg are all active in this space. FXall, a publicly traded company originally launched by banks, also has a multi-dealer platform and an ECN, the former Lava FX, which it bought from Citi in 2010.
Currenex, owned by State Street since 2007, has FX Connect and is another popular multi-bank offering. Hotspot FX, owned by Knight Capital for the last six years, is an ECN and was launched in 2000. Bloomberg has a multi-dealer platform, which also offers broker algorithms, while a separate ECN is housed in Bloomberg Tradebook, a broker-dealer.
The advantage of multi-bank systems is that clients see all their prices through one connection. Lenore Kantor, a senior director and head of marketing and communications at FXall, said that her firm’s execution-quality analytics indicate that clients get better prices when they go out to more than one provider. However, she added, there is a diminishing return to this. "If you go out to more than five banks, you’re running the risk of damaging your relationships. Of course, there are many occasions when trading with a single bank is preferable-for example, when collaborating on a large portfolio with emerging markets exposure-and it’s important to take advantage of the most effective trading method to accomplish your specific objectives," she said.
In FX, clients who reduce their business with a bank can expect to see less competitive pricing or flexibility. That could come back to haunt a client when it needs to make a tough trade, particularly if it has fewer banks willing to deal on its behalf.
Conversely, there is a certain level of trading responsiveness clients expect, as well. Industry pros say that when dealers’ or venues’ rejection rates get beyond 15 or 20 percent, they stop getting routed to-just like in equities.
HFTs and ECNs The FX market is described as very liquid and ultra-competitive, not only among dealers but also in the ECNs, where high-frequency traders compete with banks and hedge funds for the best price. The HFT crowd represents from 20 to 50 percent of the volume, according to sources. The importance of high-frequency traders was evident in September 2008, when traditional market makers pulled out of the FX market after the collapse of Lehman Brothers."The HFTs are vitally important to our marketplace," Hotspot’s Miesner said. "Unfortunately, they get a bad rap, but they were the ones still standing when other market makers pulled out."
Because FX is a dealer market, there is no central market to see the top and depth of the order book, so vendors have worked to create a synthetic National Best Bid and Offer by bringing in various feeds. This is at least giving traditional money managers and hedge funds a view into the market.
The quality of FX execution is a high priority today for money managers. More of them are looking to represent themselves in systems and working their orders. According to Jamie Benincasa, a longtime sales executive at FlexTrade, a trading front-end firm, the buyside is looking to see where it can become more efficient in capturing alpha.
For cross-border trades, one way to do that is to execute the currency hedge in a prudent manner, usually as close to the time of the stock transaction as possible. Suppose a stock that requires an FX hedge trades in the morning. If a trader waits until the afternoon, the FX rates "could have moved significantly" in a few hours, he said. The buyside is aware of this today, and the FX portion of the trade is no longer an afterthought.
"There has been a greater emphasis placed on foreign-exchange executions, so there is a renewed interest in best practices," Benincasa said. "If your stock pickers have great ideas, you want to retain that performance after the FX trade gets done."
Consequently, Gary Stone, chief strategist at Bloomberg Tradebook, reports that traders are watching their FX transactions much more closely and taking greater responsibility for their executions, using electronics for FX when they can. "We’ve seen a lot of investment advisers start to move their FX trading function from the back office to the trading desk," Stone said. "The desire is to have the same tools they’re comfortable with in equities."
Algos Rising Because there is no tape measuring volume like in equities, FX is different when it comes to algorithmic trading. Beyond simple iceberg orders and time-sliced orders, such as TWAP, it is difficult to come up with FX algos that function like equities algos. While a VWAP algo for FX is hard to develop, there are still algos out there for FX traders.
The multi-bank platforms offer their own algos, and so do execution management systems. Bloomberg also offers access to seven broker FX algorithms. The beauty of FX algorithms is that even though they may be less scientific in their approach than in equities, they still allow a sweep function across the market, as some of these systems put together a synthetic NBBO equivalent from the various liquidity providers.
Credit Suisse’s Buckley expects there will be wider adoption of FX algos among money managers after the current first wave of early adopters-mostly big institutions and hedge funds. "That is the story for the next two or three years: a further build-out," he said. But he doesn’t know how deeply algo trading will ultimately penetrate in FX, or whether it will get to the level it has with equities.
Franklin Templeton has "dabbled" with FX algorithms in the past and plans to try them again for the larger, more liquid currency pairs, said Mat Gulley, director of global trading at the firm, which manages $726 billion. To date, the global money manager has preferred to use brokers because of the complexities on the back end of its trades and the unclear nature of the electronic marketplace.
"If a firm does a lot of cross currencies, there is too much work involved to do it electronically, so it is more economical to do it through a broker," Gulley said.
In general, Gulley said he’s encouraged but uncertain about the future of electronic FX trading. He cited recent positives like greater use of TCA and algorithms. Right now, it is easy to electronically trade liquid currency pairs in small size. "But for the more complex and challenging trades-to trade less-liquid pairs and in size-I think the industry is still trying to find how to appropriately access the few liquidity pools in order to do it electronically and efficiently."
Gulley is not as optimistic that FX can evolve as fast as equities into an efficient electronic system. "I just do not see the value proposition of using algos in a marketplace dominated by just a few players who control their own liquidity, without any institutionalized ECNs and in which institutional liquidity pools connect through an interdealer market system. Outside of operational efficiencies, we are still trying to understand how to capture the execution value-add through technology."
But he agrees the equities electronic trading model is influencing FX. "I think it will evolve. I don’t see why it shouldn’t. It is headed that way, to some extent. All asset classes are heading in the way that equities pioneered."
SunGard’s Fox River on Monday launched a “dollar certain” algorithm for traders who want to execute in dollars rather than in shares.
The algo helps eliminate manual management of trades when firms know they want to execute a certain amount in dollars rather than in a certain number of shares. That in turn helps avoid calculation errors and reduces operational risk, the company said.
Currently, traders who wish to trade a dollar amount must manually convert the figure into a specific number of shares and then enter that number into their trading systems. The Fox River algo automates that process.
Paul Daley, head of product development at Fox River, said one of the firm’s customers approached it about the idea, and once the firm developed the algo, others wanted to use it as well.
“The quickest way to be relevant is to listen to your customers when they tell you things,” Daley said. “We went out and built it for these guys, and very quickly found that they were not the only ones facing this problem.”
Though the system is based on a simple idea, Daley said the engineering was a little tricky, because nearly everything in equities is geared toward trading in terms of shares. The dollar certain algo is able to make that conversion, and is offered as an overlay to Fox River’s other algos. That way, traders can execute in dollars regardless of which other algorithmic strategies they are using.
Daley said the product appeals mainly to the buyside, including mutual funds and bank trust departments, both of which take orders in dollar terms. It can also be used when companies perform corporate buybacks, which are typically authorized in dollar rather than share amounts.
Traders Face Futureshock Over Big Data
As the quantity of data for trading grows exponentially, it is creating challenges for the industry and its regulators. Computing experts descended upon the Times Center in New York City on Tuesday to discuss some of the issues caused by the explosion of data in the financial markets.
The event, produced by Tabb Forum, saw panelists make a number of startling predictions, including that regulators will soon be able to track and record every equity trade made.
Daryan Dehghanpisheh, director of the financial services and institutions team at Intel, said as the industry becomes more complex, investing in more efficient infrastructure is vital. While data is important to all traders, he noted that it is far more important for some strategies than for others.
“It’s about what you do with the data,” said Dehghanpisheh. “How you think about data if you are a latency arbitrager is completely different from if you are a global macro fund.”
Most startling, however, was Dehghanpisheh’s comments about the improved ability to track and store information. Soon, the government will have the capability to monitor every single equity trade and to store that data indefinitely, he said. Though the cost of doing that might seem to be prohibitively expensive, those costs are coming down, and they could soon be within reach for regulators.
“That day is coming quicker than you think,” Dehghanpisheh said.
Speaking on another panel, Scott Ignall, chief technology officer of Lightspeed Financial, said financial firms are becoming a lot more amenable to using off-site firms to store their data. Still, there is a lot of skepticism in the finance sector about cloud computing, in which firms share resources and store information on remote servers.
“It’s control,” Ignall said. “The industry has been built on this entrepreneurial spirit of controlling your own applications, your own network, your own everything.”
But the industry is learning that when it gives up some of that control and stores its data remotely, it can have cheaper access to larger amounts of data while still maintaining security. In fact, Jeff Bell, chief executive officer of Wedbush’s Lime Brokerage, said more and more firms have been coming to him saying they don’t want to manage their own infrastructure.
Much of that attitude comes from a desire for cost containment. Firms don’t want to have to upgrade all of their technology every three years, and outsourcing data can make financial sense. The main barrier to using the latest off-site technology, cloud computing, is security concerns.
W. Brennan Carley, global head of the Thomson Reuters Elektron platform, said the cloud is not quite ready for trading applications, though his firm has already chosen not to own its own physical data centers. Wedbush is using the cloud to deploy strategy development software, and Ignall said the increased use of iPads and other tablets could push trading into the cloud.
That might seem like pie in the sky to some, but Chris Concannon, a partner with electronic trading firm Virtu Financial, noted that the industry has seen changes that were previously barely imaginable.
“Five years ago I looked at the markets and said, ‘We can’t get any faster,’” Concannon said.