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An Industry Briefing Researched and Written by POWERING WINNING LOW-LATENCY TRADING STRATEGIES GAINING AN EDGE THROUGH SERVER PERFORMANCE February 2013 In Association with POWERING WINNING LOW-LATENCY TRADING STRATEGIES Introduction It’s appropriate to begin with a little levity: Two campers are walking through the forest when they suddenly encounter a big grizzly bear. The bear rears up on his hind legs and lets out a terrifying roar. Both campers were frozen in their tracks. The first camper whispers “I’m sure glad I wore my running shoes today.” “It doesn’t matter what kind of shoes you’re wearing, you won’t outrun that bear,” replies the second. “I don’t have to outrun the bear, I just have to outrun you,” answers the first. In the world of the financial markets, securing an edge over the competition can mean life or death for a trading firm. Whether it is acting on news alerts or price movements, determining the best trading opportunity, or delivering an order to the marketplace, microseconds mean the difference between winning or just playing. Reducing those microseconds – referred to as latency – is a continuing focus of trading firms, and an increasing challenge as that latency is pushed down to double and single digit microseconds. The “race to zero” becomes increasingly difficult and expensive to engage in as it nears its conclusion. To date, much of the focus on latency reduction has been directed at reducing the physical distance between trading firms and the markets in which they participate, which results in so-called propagation latency. Nowadays, co-location of trading firms’ servers in the same data centers as markets’ matching engines has nearly eradicated that distance and associated latency. With local network latency essentially addressed, an emerging but still challenging area of focus for latency reduction is on trading execution and matching system applications, and on the servers that host them. This industry briefing outlines the low-latency trading landscape, details the latency characteristics of key data and trade execution processing applications, and introduces microprocessor techniques, such as Dell Processor Acceleration Technology, designed to reduce latency in a cost-effective manner. AN INDUSTRY BRIEFING RESEARCHED AND WRITTEN BY LOW-LATENCY.COM FOR DELL 2 POWERING WINNING LOW-LATENCY TRADING STRATEGIES The Business of Low-Latency Trading Market Automation, Fragmentation and Execution Latency Whether in the U.S., Europe, Latin America or Asia/Pacific, exchanges and ATS have in- vested heavily in low-latency automation. In the U.S, competition among these marketplaces was encouraged by the 2007 implementation of Regulation NMS, an initiative by the Secu- rities and Exchange Commission. For trading firms, those exchanges offering the fastest execution times are sought, so that the best price can be achieved before the markets move against them. Today, with 13 regulated equities markets and around 50 ATS in existence, round trip matching times of less than 100 microseconds are commonplace. In Europe, similar cross-country regulation in the form of the Markets in Financial Instru- ments Directive (MiFID) was introduced and exchanges across the continent have engaged in similar competition for order flow, with the SIX Swiss Exchange – leveraging technology from NASDAQ – offering a matching time of less than 40 microseconds. Markets in Asia/ Pacific – from Singapore to Japan to Australia – and in Latin America – where Brazil and Mexico are leading the way – are also following the low-latency matching trend. And it’s not just the cash equities markets that have become fragmented and seen low- latency technology investment. In the U.S., the addition at the end of 2012 of the Miami Options Exchange brought the number of equity options markets to 11, and applications are pending for more. Meanwhile, major futures exchanges, such as the Chicago Mercantile Exchange, NYSE Liffe in London and the Frankfurt-based Eurex, have updated their technol- ogy to reduce matching latency. As a result, trading firms are able to engage in low-latency arbitrage between cash and derivatives markets. New automated marketplaces unrelated to equities – including foreign exchange and fixed income – are also emerging and investing in latency reduction. Markets such as FXAll and Hotspot FX have emerged to support FX HFT strategies, while a number of Swap Execu- tion Facilities are expected to establish themselves and will compete, at least in part, on the latency of their trading functions. Algorithmic and High Frequency Trading As new markets in all asset classes have emerged, and market fragmentation has risen alongside advances in technology, trading firms have adopted new approaches to electronic trading for both their proprietary operations and for their investment management customers. Algorithmic trading – which might be broadly defined as computer-initiated trading of finan- cial instruments – began in the purest sense in the 1980s as a means to trade baskets of securities, sometimes arbitraging between cash and futures markets. During the past few years it has become more widespread and is now directed at a wide range of markets. So-called execution algorithms are widely used by investment management firms to buy or sell large blocks of equities in the marketplace with minimum market impact. These algo- rithms seek out liquidity across trading markets by examining the order books published by each and break down a large order into much smaller ones, trickling them out across mar- kets over an extended period of time. Latency is an important factor in such trading strategies to ensure that best execution is achieved with the minimum of price slippage while orders are being fed into the various mar- kets, which will seek to respond by adjusting bid/offer prices accordingly. AN INDUSTRY BRIEFING RESEARCHED AND WRITTEN BY LOW-LATENCY.COM FOR DELL 3 POWERING WINNING LOW-LATENCY TRADING STRATEGIES For some algorithms, just as important as latency is jitter, or variance of latency from the norm. These strategies take account for known price variances on markets over microsec- ond timespans, and so it is important to keep those timespans consistent for the algorithms to work effectively. High-frequency trading – or HFT – is an important class of algorithmic trading, where trading strategies determine the very rapid buying and selling of an asset, individually or as portfoli- os, with the intent to aggregate small profits per transaction over many trades. For HFT, price slippage must be kept to a minimum for the strategy to be profitable, and hence low-latency execution is a must. Many trading firms access markets via the Direct Market Access (DMA) services of sponsor- ing brokers, who are continuously reducing the latency of their offerings. Against that trend, regulatory pressure is requiring these brokers to implement compliance and risk monitor- ing functions. Thus, implementing this functionality while adding the minimum of latency is important. The Market Data Explosion As a result of market fragmentation and competition, the growth in automated trading of options, derivatives and foreign exchange trading, and the introduction of algorithmic and high frequency trading, the marketplace has witnessed a massive increase – an explosion as some have termed it – in aggregate market data (trade report and quotations) rates. Given that market data is the life blood of algorithmic and HFT strategies, being able to digest it – including never missing an update, processing and storing each – with minimum latency is a crucial first step in the automated trading process. A major challenge to processing market data is coping with peak volumes, which generally occur when markets open and close, but also occur during the day as trading firms react to corporate, economic and political events. Aggregate peaks for U.S. markets have recently been as high as 6.65 million price messages per second (according to www.marketdata- peaks.com), with options market data accounting for much of that. Moreover, despite the current period of low trading volumes, aggregate market data rates are increasing, and marketplaces expect market data rates to continue to increase in future years. For example, OPRA, which consolidates data feeds from the U.S. options markets, is advising market participants to plan for peaks of nearly 13 million messages per second for 2013. Thus, the challenge for automated trading systems is to cope with both high data through- put, in the form of many millions of price updates, and low-latency processing of that data. AN INDUSTRY BRIEFING RESEARCHED AND WRITTEN BY LOW-LATENCY.COM FOR DELL 4 POWERING WINNING LOW-LATENCY TRADING STRATEGIES Low Latency Trading Technology As marketplaces across all asset classes and geographies automate and provide faster matching, so trading firms are reducing the latency of their execution technologies to be competitive with their peers. Broadly speaking, the latency associated with trading infrastructure is related to two components: the latency of moving data from point A to point B; and the latency of processing that data at point A and point B. Much of the focus to date has been on the latency of moving data – propagation latency – between marketplaces and trading firms, and the primary contributor to that latency is the distance between the parties involved. Propagation Latency and Co-Location Reducing propagation latency by making use of fast direct fiber and wireless connections has been a common approach for trading firms, many of which are now leveraging co- location, which involves a firm placing their execution systems in the same data center as the matching engines they are trading against. Within a co-lo data center, connectivity leverages local area networking technology and is measured in 10s of microseconds. Ethernet at 10 GBits/second is the most common technology in place, with switches from the likes of Cisco Systems, Arista Networks, Juniper Networks and Gnodal. Data transports are commonly TCP/IP for transactional data and UDP for the broadcast of market data.

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