The Changing Face of Trading

The industrial revolution of the equities markets is spreading, slowly but surely. Technology has penetrated into all other asset classes at a deep level—whether it's through high-frequency trading (HFT), or just electronic execution, it's impossible to avoid.

Plans for a new stock exchange in Burma offer the classic exception to the rule. With the country coming in from the cold of international sanctions, the Tokyo Stock Exchange and Daiwa Securities signed a memorandum of understanding with the Central Bank of Myanmar this week to develop a capital market there. Given Burma’s infrastructure, however, it seems likely to be a market of paper certificates, at least initially. It’s interesting how quaint this seems when it hasn’t been very long since the decline of open-outcry.

Fixed Income
Fixed-income trading volumes are on the rise, which, says Kevin Arthur, director of fixed income at Omgeo, has a lot to do with increased automation.

"Most of the firms have started with the equity asset class, and that was really down to necessity - they couldn't get through the day without automating some of that volume," he explains. "There's growth in the middle office both on the asset management side and on the sell side. Once they've standardized equities and seen a significant reduction in risk, they look to increase automation across other asset classes. The next logical progression across the trading book is into the fixed income products, typically around capital market instruments like sovereign debt, corporate bonds, mortgage-backed securities and municipal bonds. Usually firms first phase-in with the longer-term fixed income products."

Straight-through processing and automated settlement processes in fixed income have been discussed for years, and now look to become the norm. Apart from the risk management side, it becomes a self-fulfilling prophecy. An automated system is, after all, only effective if the counterparty is automated as well, so as the larger banks and brokers begin to implement their own mechanized systems, they begin pushing clients to do the same. As fixed income trading volumes rise and equity volumes dip, it becomes increasingly necessary to have these systems in place.

Going Dark
Technology and automation also play a role in the continuing battle between lit and dark order flow. Research and consultancy firm Tabb Group released a commentary earlier this week that noted just over 30 percent of US equities trades are now executed wholly off-exchange, whether that's internalized flow or through dark pools. While this is partly down to lessening liquidity, the increasing sophistication of smart order-routers and declining latency has meant that it's increasingly easy, and cost-effective, to send orders to a firm's own desks, then broker crossing networks, before finally ending up on-exchange as a last option.

"It's driven by a few things," says Cheyenne Morgan, a research analyst at Tabb Group and one of the authors of the commentary. "One of the main things we heard was that the buy side was a lot more comfortable trading in the dark, they're a lot more comfortable letting the brokers internalize their flow. They're turning to off-exchange earlier in the process than they were before. Also, they're a lot more connected to all the dark pools, they're making sure that they have access to that liquidity."

Plugged In
Exchanges aren't the only ones who are being blindsided by technology, although they surely feel the loss of revenue from this significant share of order flow leaving their books. Yesterday, the US Second Circuit Court of Appeals ruled that the theft of HFT engine code from Goldman Sachs by a former employee didn't constitute a federal crime, as there was no tangibility to the asset taken, given its digital nature. The court said it wouldn't stretch the definition of a federal law, which it described as a "creature of statute,” to satisfy the demands of the digital age. It's clear, however, that the pace of technical development demands a rethink across the board.

If you'd like to discuss these issues, particularly the move to the dark, you can reach me at +4420 7316 9811, or james.rundle@incisivemedia.com.