At Solace, the shift to electronic trading has been at the core of our business in capital markets for many years. We’ve seen a variety of recurring use cases that are now mainstream, specifically for equities. For example:
- Buy-side firms engaging in high-frequency trading (HFT), either onsite or at a co-location facility.
- Sell-side firms offering smart order routing or internal order crossing to increase revenue or save on costs of order processing.
- Exchanges accelerating and enhancing their services to compete with ever more sources of liquidity.
- All kinds of capital markets participants improving how they handle real-time risk across trading systems, and/or automate middle-office settlement and record keeping.
Reg NMS and the Explosion in HFT
The path to these systems began with decimilization of equities in 2001 which dramatically increased electronic trading. Then in 2007, Reg NMS opened the door for many more competitors to supply liquidity, which created a n-way set of very-short lived arbitrage opportunities across trading venues. Reg NMS included rules that regulated order fills to assure they were at the best price (across all available liquidity) within a time window (National Best Bid and Offer — NBBO). That led all sell-side participants to require very low latency technology, because they had to fall within the NBBO window to play at all. Mix in a bunch of clever quants to develop models and programmers to automate them and you have the HFT explosion in equities.
Dodd-Frank Sets the Stage for HFT Across More Assets
Over the past 12-18 months we’ve had more and more conversations with people looking to improve capacity of systems that support electronic trading of other asset classes such as foreign exchange, fixed-income and derivatives. I didn’t think too much about why until I read something Patrick Whalen, head of trading for AllianceBerstein, said in this article about the growth of HFT and electronic trading. In a nutshell, Patrick points out that the Volcker Rule will prevent banks from holding assets like bonds or currency positions on their books — they’ll need to move ’em out quickly and efficiently, which means more electronic trading. As part of the new Dodd-Frank rules about the clearing of swaps, regulators are also pushing for an end to the over-the-phone transactions in favor of more transparent electronic trading. That will change the dynamics of those markets in terms of the need for efficiency, and the mechanics of acquiring those assets.
Thinking about his observations makes the future of electronic trading far more clear. Dodd-Frank will drive more asset classes to electronic trading for transparency and increased monitoring of adherence to rules. Most of these asset classes trade across many venues, which means there will be HFT-style arbitrage opportunities between them. Most of the trading firms have already made investments in low-latency technology, so the implementation times can be very short as the markets increase in liquidity. Therefore the barriers to HFT in asset classes like derivatives, FX or fixed income should be far lower than when equities underwent the shift.
Settle in and Watch the Trading Landscape Shift
Every significant new financial regulation has its own batch of winners and losers — the winners are those who best understand the secondary implications of the new rules, individually and collectively, and position themselves to capitalize on change. “Skating to where the puck is going to be, ” as the Wayne Gretzky line goes. As Reg NMS gave birth to accelerated HFT for equities, the changes driven by Dodd-Frank will leave at least as big a change in the markets across many more asset classes, and will accelerate the spread of electronic trading across capital markets. Grab a big bowl of popcorn and settle in to see which firms ride the wave to new levels of success. Like the best movies, there will be lots of plot twists as well as plenty of heroes and villains.