Direct Market Access Participants, Market Access Channels and Controls May 2012 Evolution of Exchange Traded Derivatives Markets th th th Exchange trading of commodities and securities contracts in the 16 , 17 , 18 century Antwerp Bourse, followed by Amsterdam and London 19th century END USER EXECUTING BROKER & LOCAL • Chicago Board of Trade est. 1848 as first official Derivatives Exchange • Interest to buy or sell “flashed” in the Open Outcry market by brokers representing interest of end users (hedgers) and locals, trading for their own account (often referred to as speculators) OPEN OUTCRY MARKET 1990s END USER EXECUTING • Futures Exchanges in Asia and BROKER Europe start going electronic • “Floor to screen” migration brings a series of benefits to all players, lowering barriers of entry, reducing transaction costs and increasing transparency (price discovery) and efficiency MARKET ELECTRONIC MARKET (execution) MAKER END USER 2000s ELECTRONIC MARKET EXECUTING BROKER • Exchanges introduce the concept of “Non-member Order Routing” (aka DMA), bringing the end user even closer to the market MARKET MAKER Market Participants HEDGERS MARKET MAKERS • Investment decision made based on • An institution or individual that quotes bid and offer variables such as price (and expected prices for specific stocks or other marketable future price) of the underlying instruments that it holds in inventory (often referred to as commodity, existing holdings and 'makes a market in'), and is prepared and able to buy or inventory, etc. sell those securities at any time on its own account. • Main driver is risk management/ • Market makers are normally tasked with providing minimization sufficient liquidity in order to reduce volatility in prices and maintain a 'fair and orderly market' for stocks. For • Position often held to expiry, taking example, they will typically buy a stock when there are delivery of the underlying asset few or no other bidders in the market yet many investors wish to sell this security INVESTORS • Can be either private or Institutional (on behalf of a group of end investors) • Mid/Long Term investments made based on general views of the market, valuation of the underlying commodity, etc FT , Nov 2011 SPECULATORS Getco will now be the assigned trader of 850 symbols on the NYSE, including for stocks of 120 S&P 500 companies such as General Electric, McDonalds and Coca Cola. Getco also handled the price auction for the • Aim to benefit from price changes by initial public offering of General Motors last year. committing capital and taking risk Alison Crosthwait, head of global market structure research at Instinet, • Speculator buying a contract low in said: “In today’s resource-constrained and economically difficult order to sell high in the future would environment, Getco can likely leverage those Market Making spots better most likely be buying that contract from than BofA could. Those spots have value to them in a way they didn’t to a hedger selling a contract low in BofA.” anticipation of declining prices in the future Getco and other high-speed market-making firms have said that they continued trading during the flash crash without any obligations, unlike • Don’t actually seek to own the asset managers and other traditional investors, who placed large sell commodity in question orders. Direct Electronic Access – Market Access Channels END USER EXECUTING BROKER EXCHANGE CLEARING BROKER 1 VOICE 6 “DECISION Electronic “CARE ORDER” IMPLEMENTATION” 2 ALGORITHMS NAKED SPONSORED “BLACKBOX” ACCESS CONTROL MANUAL DMA 3 AUTOMATED DMA 4 (aka Algorithmic Trading, not always High Frequency) “DECISION MAKING” ALGORITHMS 5 CONTROLLED SPONSORED ACCESS Trade clearing Trade decision Trade implementation Price discovery and Trade matching Controls : Technical Fault or Human Error END USER EXECUTING BROKER EXCHANGE CLEARING BROKER PRE-TRADE : “Fat-finger” limits/filters, aimed at • POST-TRADE : Comprehensive “credit/counterparty 1 VOICE preventing a single risk exposure and contingent market risk” analysis erroneous order (incorrect taking into consideration not only current aggregated price and or quantity) from position and market conditions but also a series of “what if” scenarios and stress tests Electronic “CARE ORDER” reaching an execution 2 venue EXECUTION “BLACKBOX” TOOLS AND CONTROL ALGORITHMS MANUAL DMA 3 AUTOMATED DMA 4 (aka Algorithmic AT-TRADE : “Margin consumption” limits/filters, Trading, not always aimed at preventing a High Frequency) series of unwanted orders (“algo running away”) from reaching an execution venue – given the multi- contract, multi-asset, multi-venue nature of Technology supporting these checks, “margin Decision making process consumption” is considered to be more accurate representation of 5 the Exchange Member’s exposure to a counterparty CONTROLLED than “lots” SPONSORED ACCESS Trade clearing Trade decision Trade implementation Price discovery and Trade matching Controls : Market Abuse and Fairness of Access END USER EXECUTING BROKER EXCHANGE CLEARING BROKER VOICE ORDERLY MARKET / MARKET ABUSE 1 MONITORING: Monitor trading activity in as-close-to- possible as real-time for potential signs of disorderly trading or market manipulation. Electronic “CARE ORDER” 2 EXECUTION “BLACKBOX” TOOLS AND CONTROL ALGORITHMS MANUAL DMA 3 AUTOMATED DMA 4 (aka Algorithmic Trading, not always FAIR ACCESS: Ensure co-location , proximity and High Frequency) general access to the Exchange is available and a clear and fair access policy is articulated, especially as it relates to Direct Non Member (i.e. Technology supporting Sponsored) and Non- Decision making process Clearing Member self- execution 5 CONTROLLED SPONSORED ACCESS Trade clearing Trade decision Trade implementation Price discovery and Trade matching .