Exchange Trends—The Technology Challenges for Start-Ups

Exchanging Approaches to Trading

The most common type of trading that happens at exchanges is through the order book. Buyers and sellers interested in certain financial instruments will put their orders on a list—the book—and then the exchange matches them. This process of matching is at the heart of what any exchange does, and Sinara has developed matching engine technology to support the myriad complexities of how this can be achieved. But there are other types of trading processes for which both start-ups and established exchanges are looking to launch platforms. 

Auction-style trading, or “eBay-style trading”, is another approach that gives sellers control over the offers they accept. As on eBay, a seller would put up a listing for a bundle of securities or commodities, for example. The exchange would present that to the market for buyers to bid on. This works especially well for spot trading platforms as opposed to those for futures or options.

In a request-for-quote (RFQ) approach, buyers or sellers put their listing to the exchange and ask the market for a quote. Potential counterparties then submit a series of quotes for them to choose from. Here, the counterparties can specify certain terms, such as for how long their offer is valid. The role of the exchange is to facilitate these interactions in a secure, often anonymized way.

An extension of auction-style trading in RFQ is negotiations-based trading. In this approach, buyers and sellers can make various offers or counteroffers and enter a two-way negotiation—and not just on the price itself. The advantage of this approach is that participants can negotiate an unlimited set of very specific aspects of the contract. If, for example, they are trading a commodities warrant, they might negotiate on the location of the underlying physical goods.

Staying Agile in the Race to Introduce New Contracts

Exchanges are turning to flexible technologies to enable them to deliver new platforms for these different types of trading approaches. The SinaraTLC software framework allows exchanges to deliver these more rapidly. For example, using the framework to deliver a negotiations-based trading platform, rather than building their own from scratch, can dramatically cut time to market. 

Exchanges also need the flexibility in their core [exchange] technology to introduce new types of contracts and make them available on the exchange for participants to trade. For example, many established exchanges are introducing smaller versions of their existing contracts. Eurex introduced the first “micro contracts” in April 2021. CME Group has traded 1 billion of its own since launching them in August, and Cboe is planning to launch its own “nanos” next year.

Phil Bain, a founding director at Sinara, says new contracts cannot be launched overnight. “Exchanges must explore the business—as well as legal and regulatory aspects—and it can take a long time to get a contract ready to launch onto the market. So the last thing an exchange needs is to have to make extensive changes to their systems to be able to launch the contract onto the exchange, and be burdened with the associated technology overheads.” 

Digital Assets on the Frontier

Most institutional investors expect to include digital assets in their portfolios in the future, and exchanges are vying to be the first to offer these.

The SIX Swiss Exchange gained regulatory approval in September to operate a digital asset exchange. And, in October, Cboe acquired ErisX to create a digital asset marketplace, Cboe Digital, which aims to address this demand. And many more exchanges are exploring how they can offer contracts for digital assets. 

Cryptocurrencies are the most known type of digital asset and institutional demand for these is rising steadily. But there are other types as well. Digital assets make it possible to tokenize a multitude of types of value and to create liquidity for historically illiquid assets.

This process of securitization can vary, depending on the asset in question and the relevant regulatory framework. Bain says: “Exchanges are successfully using new technologies to create securities to be traded on the market for things that weren’t previously exchange-traded.”

But the creation of digital assets is a two-step process. As well as securitization, exchanges need to master the processes of tokenization. “Breaking these securities down into small fractions, or tokens, to represent them creates additional challenges, which exchanges need the right technology for,” says Bain.

To Be Regulated or Unregulated

The emergence of decentralized finance architectures and applications built on distributed ledger technology promises disruption to the very role of exchanges. In the meantime, regulators are grappling with how to regulate DLT and smart contract-enabled digital assets, and ensuring exchanges are held to account. But start-ups often find the assets they are trading don’t really fall under any current regulatory umbrella. Emerging as unregulated entities allows them the flexibility to launch without the regulatory restrictions, which offers reduced time to market. 

Bain explains: “Essentially, they are able to avoid all the complexities of launching new products onto the market and the associated up-front costs and legal fees. They can then concentrate on the new technology, which is often at the heart of what they want to do.” 

Equally, there is recognition that being a regulated exchange inspires investor confidence. “Many of these start-up exchanges ultimately want to bring these types of trading activities under the regulatory umbrella because of the confidence that it helps inspire,” says Bain. And many that are currently unregulated must therefore consider their future technology needs.

“They need platforms in place that will allow them to extract the data they need for reporting very quickly,” he explains. “So, when at some point down the line they become regulated, it will be easy to extract the data for their audit trail, for example, and they won’t be forced to add on extra systems at that point. The more prepared their systems can be, the better.” 

A Clear Mismatch

As well as teaming up and acquiring exchanges to gain a foothold in the digital marketplace, another area in which there is consolidation in the market is clearing. And Bain says there is a lot of interest from exchanges in trying to get control of their own. “There are more and more exchanges looking either to buy other clearing houses or develop clearing houses of their own. 

“Something exchanges are becoming aware of when they are considering bringing in an existing clearing house is the need to ensure the technology matches the type of trading they want to do. If a commodities exchange buys an equities clearing house, for example, there will clearly be a mismatch. So, exchanges will need to invest in making changes before they can use the technology.”

Conclusion

When it comes to delivering new trading platforms and contracts, the more flexibility exchanges have in their technology, the more rapid their time to market. Exchanges are also using new technology to create digital assets using the twin processes of securitization and tokenization. Finally, they are overcoming technology challenges in integrating systems with existing clearing houses.  

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