Max Bowie: Meeting in the Middle: Marketplaces of the Future?

As the holiday season approaches again, our thoughts turn to finding gifts for family and friends at home and abroad. And aside from the quandary of what to buy, we now have much more choice available as to where we buy something—at our tried-and-trusted local store; a large department store that gives greater choice; a discount store that provides better value; or through the wonder of the internet, where we can connect directly to local merchants all around the world.

The same choices exist in the world of market data—you can source data on your local market close to the venues where you execute, or you can obtain data from regional specialists in other parts of the world.

In recent years, the low-latency demands of algorithmic trading and the pressures of dealing with increasing volumes of data have prompted exchanges and other trading venues to host matching engines and data-processing plants inside third-party datacenters that provide sufficient capacity for their own needs, while also providing space for clients to co-locate their trading servers next to exchange systems to achieve the lowest possible latency.

This trend has centralized large volumes of trades across multiple markets in a relatively small number of physical facilities—essentially creating arbitrage marketplaces where firms can trade between different locations out of datacenters themselves.

However, at the same time, there are other forces at work as the global financial crisis prompts traders to seek out new markets with the prospect of higher returns. For example, India is a growing market with new exchanges and a willing investor population, which has so far been largely untapped by the West, while the more mature Asia-Pacific region in general has weathered the crisis and has emerged largely unscathed,  and is now attracting increasing interest from traders abroad.

Obstacle
The obstacle to broader participation in foreign markets around the world has been the issue of timely market data and execution. This is especially true if a firm does not want to trade exclusively on one venue—in which case they could simply open a local office—but wants to arbitrage similar instruments listed on different exchanges, such as a stock on a company’s local market and a depository receipt listed overseas.

In a recent paper titled Relativistic Statistical Arbitrage published in Physical Review, Massachusetts Institute of Technology (MIT) academics AD Wissner-Gross and CE Freer describe a trend in the opposite direction—toward a decentralized model where advances in low-latency technology make it both possible and necessary to create intermediate trading nodes in locations around the world equidistant between important trading centers for a firm’s trading strategy.

Of course, the communications infrastructure in each of these locations—some of which would be in the middle of the ocean—may not be sufficient to support the latency requirements of high-frequency or any time-sensitive arbitrage strategy. This might eliminate some locations from contention immediately, or it might prompt firms or vendors to build their own infrastructure—just as Spread Networks constructed its own fiber route between New York and Chicago—if they feel there is sufficient opportunity to be gained from a large investment.

And that’s the bottom line: Such projects are an expensive proposition, and as long as they generate an advantage that translates into profit, and don’t prove too costly for their own good, firms will continue to fork out the cash to stay ahead of the competition, and we may see the creation of offshore “arbitrage centers” that become the financial centers of the future.