Direct market access for exchange-traded derivatives

Frances Maguire Email: [email protected] Received: 16th March, 2006

Frances Maguire is a freelance journalist with more than ten years’ writing experience, specialising in topics such as derivatives, risk management, banking IT, securities processing and fund management. She was previously Associate Editor on Futures & Options World,EditorofFutures & Options Week, Banking Technology and technology writer for Financial News.

Abstract switched from trading to Direct market access grew up out of the equities electronic trading has been spectacular. market in the late 1990s,in particular when the Volume on the Chicago Mercantile number of electronic marketplaces, or ECNs, for Exchange (CME) Globex electronics trading stocks greatly increased in the US, and trading platform increased 62 per cent for spurred on again by the wider use of the FIX the year, with total volume of 730 protocol for communicating indications of interest. million contracts and average daily Now that direct market access is fairly standard volume of 2.9 million. CME Globex for stock trading, the same firms are looking to volume represented 70 per cent of total expand these operations to exchange-traded CME volume, compared with 57 per futures, made possible by the move to electronic cent in 2004. trading by the derivatives exchanges. The Chicago Board of Trade (CBOT) also experienced an increase in electronic While Europe and, to a certain extent, trading volume, the latter representing 65 Asia-Pacific have grown up alongside per cent of total exchange volume in 2005, electronic derivatives trading, with the up from 58 per cent in 2004. Furthermore, London and Paris markets making the the electronic average daily volume grew switch from open outcry trading to 24 per cent to 1.7 million contracts from electronic fairly swiftly, the two biggest 1.4 million contracts reported in 2004, and financial futures markets in Chicago have the number of the CBOT’s financial grown their electronic trading volumes, options that traded electronically surged by

Derivatives Use, despite the fact that their open outcry 180 per cent in 2005. Trading & Regulation, Vol. 11 No. 4, 2006, trading floors have remained open. Electronic trading is a prerequisite for pp. 375–380 ᭧ Palgrave Macmillan The speed at which the international direct market access (DMA). It was only Ltd 1747–4426/06 $30.00 exchange-traded derivatives markets have when the FIX protocol enabled fund

Derivatives Use, Trading & Regulation Volume Eleven Number Four 2006 375 managers to send electronic indications of The next step is the idea that buy-side interest that electronic communication of can build their own algorithms to orders between firms truly became schedule trading strategies, for large orders, widespread. The growth of the number of to operate in very fast, liquid markets. By equities marketplaces meant that DMA was crunching historic data and combining the essential to ensure fast and best execution. profile of the order to create parameters and algorithms to conduct computerised trading, buy-side firms can build-in NEED FOR LIQUIDITY different levels of complexity for their The second necessary prerequisite for DMA own trading schedules. But for now, firms is liquidity. Where markets are illiquid, are using broker’s algorithms, and for traders still reign. For this reason, DMA is exchange-traded futures more than only really used for exchange-traded futures options. contracts, and very rarely for options on He adds: futures traded at the same exchanges. The correlation between the growth of ‘Exchange-traded futures are well behind electronic trading and the growing use of pure equities in terms of development. DMA is clear in that only 10 per cent of At the moment, there are a limited options volume on CME is currently number of brokers, which have a limited electronic, compared with around 80 per number of algorithms that they are cent of the exchange’s futures trading making available to their clients. There volume. are some hedge funds and quant shops Simon Thompson, managing director and that have developed their own algorithms head of equity trading at Barclays Global for futures, but there are a limited , oversees equities, equity number generically available to the derivatives trading and commodities, and buy-side.’ says that BGI took its first steps to establish DMA to derivatives exchanges about a year ago. Besides the constant drive to harness BUYORBUILD? optimal trading techniques, the two main Thompson adds, however, that while BGI is reasons BGI is turning to DMA for using DMA for derivatives, it does not derivatives is to gain control over trading necessarily mean there is a rush to using and more importantly, gain complete complex algorithms, similar to the equities anonymity. ‘By going through a pipe, markets. He says: ‘We are not necessarily directly to the exchange, there is no trader constantly building algorithms. FlexTrade at the other end at the broker. We are gives us access to a broker electronically, and entering the orders directly onto the a broker can provide the algorithms. There is exchange. Where there is a large order, it is a lot we can buy from a broker before we market sensitive and anonymity is a big start writing our own algorithms.’ issue’, says Thompson. Instead, FlexTrade provides GGI with a

376 Maguire trading platform, FlexTrader, that takes Now, adopted by the derivatives exchanges, real-time pricing input and indications of iceberg orders mean that a buy-side firm interest from brokers, via FIX and routes can send the complete large order directly orders to multiple liquidity destinations — to the exchange’s trading system, without exchanges, ECNs or brokers. This platform ever revealing the full size of the order to monitors P&L in real time and is no any market participant, including its own different for equities and exchange-traded broker. Instead, only smaller lots are derivatives. Now that equities are well displayed to the market and automatically established on BGI’s FlexTrader platform, replaced when filled until the full order is the fund manager began accessing finally executed. Says Thompson: ‘Is this derivatives exchanges through FlexTrader ? Some would say it earlier this year. was. To me, this is a fairly linear strategy Other advantages of using DMA are the that does not involve historical data and is lower execution costs and the pure DMA.’ straight-through processing that computer-to-computer brings, enabling, according to Thompson, near elimination VIRTUAL TRADING of errors. He says: Mario Muth, global head of electronic trading for listed derivatives, at Deutsche ‘Telephone orders can be misheard. If Bank, one of the earliest to enable fast you are dealing direct from your own DMA, says: system, the communication of an order from a fund manager to your desk is ‘DMA means there is no human electronic, you can only fire orders you intervention between the client and the physically have hold of, so there is no exchange. It enables clients virtually to opportunity to over-trade or trade the trade directly into the exchange. There wrong way due to the way that the are, however, complex risk checks in front-end is set-up.’ place and we ensure that the rules of the exchanges are adhered to. But ultimately Cost is a big driver towards DMA. By it means that no one is manually trading directly, DMA-execution costs are intervening the client flow. Traditionally, lower because a broker is not handling the when order flow was sent to traders, and execution. for example there was an order larger Inevitably, the rise of DMA is beginning than the available liquidity, the broker to affect exchange-traded derivatives. One took these trades and worked them to upshot is the rise in the use of iceberg manage the market impact. Today, orders. The concept originated on the algorithms can take care of the large world’sstockexchangesasawayof orders and manage market impact. minimising the impact of the large buy or ‘We have been doing DMA for listed sell order from a single market participant. derivatives for the last five years and the

Maguire 377 volume of business has significantly HEDGE FUNDS WANT OWNERSHIP increased, with both existing clients and According to the providers of software for new customers. As these technologies direct market access trading, buy-side firms become more cost effective they become are becoming more sophisticated, led by more widely available to new users, so it the increasing number of hedge funds that is no longer just the large players using it are starting up. Dr John Bates, Vice forlargeorders.Atthesametimethe President Products, Progress Apama, says increase in speed has allowed customers ‘JP Morgan and Deutsche Bank use the to be much closer to the market and Apama algorithmic trading platform for reacttopricechangeswithanorder their institutional customers, but a growing amend or a new order.’ number of hedge funds are coming direct to Progress as they want ownership of the Deutsche Bank has written directly to the algorithmic trading engines.’ application programming interfaces of the According to Bates: derivatives exchanges. ‘We have invested heavily in faster systems over the past three ‘Derivatives have almost leapfrogged years and are continuing to closely examine equities in terms of what they can trading speeds closely. Speed and stability offer. The derivatives market is a little are the most competitive issues as they bit more forward thinking in terms of make a difference between DMA where the market is going. Equities systems.’ were the only players in DMA and The other key element needed to enable algorithmic trading for a long time. DMA is liquidity. Algorithmic trading helps And when futures came along, they customers where liquidity is an issue. were behind, but they had a clean However, even algorithms need to find sheet of paper and could catch up very some liquidity and narrow bid–offer quickly. The buy-side realised that the spreads. For this reason, algorithmic trading way the market is going is DMA, and in derivatives still only really occurs in the rather than rely upon the broker, they futures market. actually have the intellectual property Deutsche Bank has developed specific on board to be able to carry out their algorithms in-house for high-volume own trading, by simply leasing the equities clients, including money managers, DMA capability from the broker and pension funds and hedge funds, using get access to the markets and the algorithms every day. Muth adds, there is a broker’s order management systems.’ another, group of clients who have a specific trading strategy and the bank gives Bates believes hedge funds today are less them the ‘ExchangeLink Complex Trading’ likely to use black boxes because there is system to help them to express those ideas no advantage if everyone has access to the into a systematically and trade them directly same algorithms. With black box trading, on the exchanges. someone else has built the strategy, and the

378 Maguire buy-side user cannot make any changes to ‘A lot of the hedge funds are beginning it. The larger players, such as hedge fund to need the same technology as the Aspect Capital, which has recently bought brokers in order to gain competitive the Apama platform to build their own advantage. Direct market access and algorithms, are now moving to ‘white algorithmic trading are inextricably boxes’, where they build and can tweak linked. Once you have access, combining and tinker with the algorithms. Says Bates: it with algorithmic trading gives you the ability to apply greater intelligence to ‘Some smaller hedge funds, with fewer how you access the markets. If you don’t people, rent the algorithmic trading innovate in this area, they won’t survive, platforms from the broker. So they get which is there has been has been such a introduced to algorithmic trading by the rush to adopt new technology.’ broker, and want to take control of the algorithms in-house. There is this area in Much of the focus on DMA is on speed the middle, of those who realise if they — where a fraction of a second can make don’t start building their own algorithms all the difference. Jon Steward, president of to differentiate themselves they will go NYFIX Overseas in London, says that the out of business.’ electronic trading technology provider recently raised the ante in terms of speed by incorporating a tier one bank’sorder SINGLE PIPE TO MULTIPLE MARKETS book into NYFIX’s own network. Steward Apama also offers the brokers adaptors to says: ‘The fastest possible way of getting an connect to different markets, such as GL order to the market is by writing a direct for access to the world’s exchanges, or the application programming interface (API) FX markets of EBS and Hotspot, so from the broker’stotheexchange.Wehave brokers can give their buy-side customers gone one step further and taken a tier one access to multiple markets through a single broker’s order management system and put pipe. What many of the brokers are doing itinthesameroomastheNYFIX is buying Apama algorithmic trading network, which has a direct API platform and then building tailor-made connection to the CME.’ This cuts down strategies for the hedge funds, so that the the split seconds sending the orders via a black boxes they are using are in fact gateway, and instead the orders came customised. The brokers are constantly directly from the NYFIX creating new algorithms from what their Management System. NYFIX provides customers want, and customising business global trade routing connectivity, straight strategies to match their customers’ through processing and execution services requirements. to worldwide equities, derivatives and fixed Mark Palmer, Vice President, Event income financial markets. Through NYFIX, Stream Processing (ESP), Progress Apama, institutions have the ability to anonymously adds: access new customisable technology

Maguire 379 designed to fit a wide range of trading providing onward connectivity for their strategies. These technologies include direct customers.’ The trend is continuing, adds market access, the NYFIX Millennium MacGregor, as the exchange continues to traditional anonymous matching system and work with developers to support direct algorithmic trading models. According to connections to the exchange across a Steward, the future trading of derivatives broader coverage to include the cash and will be highly dependent on the derivatives markets on a single platform. sophistication of the DMA software. Only a few years ago, the electronic ‘Software now manages an increasingly trading landscape was one in which the percentage of derivatives orders. This is major players were small software moving so fast that it will be impossible to companies that were sometimes attached to compete without sophisticated direct equities brokers. These small software market access systems in place.’ providers were running rings round their full-service competitors. Now, those same full-service brokers have acquired the some DMA EXPLOSION ofthelargerdirectmarketaccess(DMA) According to Paul MacGregor, director of providers and are busily folding them into technology partnerships at Euronext.liffe, their full-service environments. Within the there has been a real explosion in the lasttwoyears,BankofAmerica,Bankof number of member firms using direct New York and Citigroup acquired Direct market access since the exchange Access Financial, Sonic Trading published an open application Management and Lava Trading, respectively. programming interface (API) a few years But, where will brokers take DMA next? ago, McGregor says: ‘There has been a So far, firms seem to be tentatively headed distinct rise in the number of firms in all directions: international equities, writing to our open API in the past year foreign exchange and derivatives, seem to — from around 30 in the previous year be in everyone’splansbutitisbecoming to more than 100. While most are using very clear that the gangbusters DMA to connect their own internal expansiveness of the booming ‘90s won’tbe trading desks to the exchange, some are making a comeback.

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