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Exchange Views: ISE - Automation Inspiration

Published in Automated Trader Magazine Issue 02 July 2006

In April of this year, the International Securities Exchange announced that it would be entering the equities market through the launch of the ISE Stock Exchange. AT talks to David Krell, President and Chief Executive Officer of the ISE about this initiative and how it will fit with the exchange’s existing automated trading activity in stock options.

Has automated trading been a prominent feature onthe ISE?

Yes it has, in fact automation has been an integral element in the operation of the market for a long time. All our option market-makers' quotes are generated automatically based upon computer models. We are therefore very used to the concept of participants quoting not on the basis of opinion, but in a highly automated systematic manner.

Some futures exchanges have in the past struggled with the bandwidth challenges implicit in automated trading. For an options exchange these challenges must presumably be exponentially greater?

Well, we have more than twenty market-makers who are all "shouting electronically" across a substantial market. In the 850 stocks, indices and exchange traded funds on which we list options, there are more than 88,000 different options series. All the quotes for these are being automatically and continuously updated in terms of both price and size in real time. So we are taking in a lot of traffic and distilling it into the highest bid, lowest offer and best size and then disseminating these through all the quote vendors.

We think the expertise we have gained in dealing with this scale of traffic volume could be leveraged across other markets. Hence initiatives such as the ISE Stock Exchange we announced in April. The quote traffic volumes for a stock exchange will obviously be far lower than those we already handle on options.

How do you plan your bandwidth capacity?

When the exchange first opened, we sized the bandwidth capacity requirements to what we felt would be the initial load, but part of the design process was an emphasis on scalability. Therefore, although we underestimated the original requirements, this wasn't a major problem as we could quickly scale capacity to suit. One rule that we have had since the outset that has stood us in good stead has been to have 100% headroom over peak load message traffic at any given time. As our market has increased in activity and quote traffic we have added capacity throughout to maintain that ratio.

Have you noticed significant automated arbitrage activity on the exchange?

We did see some arbitrage activity from the buy side early on. However, that is less prevalent now, as all our market-makers update their quotes very frequently and rapidly.

How do you gauge the level of automated trading activity (other than the arbitrage you mentioned above) on the ISE?

We can't obviously tell whether the order was generated by a human or a machine, so don't have hard numbers on this. Our general presumption is that small orders from individual investors are more likely to be manually initiated. Larger, more frequent, trading we assume is more likely to be systematic or automated.

In the press release announcing the ISE Stock Exchange there was a reference to the proposed MidPoint MatchTM being "especially suited for orders generated by algorithms". What did you mean by that?

Each one of the messages we send out can contain up to 192 quote changes. So at present our option market-makers are updating or bulk quoting in many different issues simultaneously, and that is something that algorithmic traders favour.

The other element of this is that anybody who is trading with an algorithm or managing a portfolio to a benchmark would benefit from our MidPoint matching platform. This is because they will have the opportunity to trade a portion of their order through the midpoint without impacting the NBBO (National Best Bid and Offer). That minimises market impact and also fits seamlessly into any of the trading they are already doing, so they don't need another front-end application. It is already automated so they will connect to us through the existing sell side connections we already have established.

What was the thinking behind the formation of the ISE Stock Exchange?

It was driven by three elements:

• The changes in the mechanism of trading.

• Technology changes.

• Regulation NMS, which will take effect in early 2007. Under this, quotes that are generated electronically are protected. We felt it was important for us to have that capability.

In addition, we felt that the ISE had some prior experience in this space that could be leveraged. Several years ago we introduced stock plus option combinations, so we already trade some stocks. Participants submit stock and option contingent orders; we trade the options here and pass the stock order to an electronic crossing network. Participants asked us if we could provide the stock element of that service internally here. We think the ISE Stock Exchange will satisfy those requests by facilitating this type of contingent order, which has grown significantly in popularity over the last year or so.

Were there any other areas of possible expansion you anticipated in the creation of the stock exchange?

The other area we have a great deal of interest in is index options and options on exchange traded funds. We would therefore clearly have an interest in trading some of the popular exchange traded funds as well as stocks.

Do you think the close synergy of options and stocks on the exchange will promote new trading techniques? (For example, opening a position through the options market if it is not possible to do this in the cash stock market and then unwinding the option position as the stock position is subsequently accumulated.)

In active options, I think brokers are already providing some of their more sophisticated customers with the tools to do this sort of trade today. We obviously hope that it will be easier to execute this sort of trade now that we are offering both markets.

How much of a role do you see automation playing in the ISE's strategy going forward?

We are committed to automated trading because we think it is a more efficient tool or vehicle for obtaining the best price, the lowest impact on the market, and the best available size at an optimal cost.

One of our objectives is to differentiate ourselves from any other offering that is already in existence. For example, the last thing we need in the US is another exchange or marketplace where you can buy a couple of thousand shares in Microsoft. That isn't really adding value, so what we have tried to do here is provide services and/or product offerings that do not exist today.

In brief, we developed a fully automated, anonymous, MidPoint Match product that allows for continuous price improvement at a competitive price. We hope that this will encourage new market participants and grow the overall business, just as occurred in the options market.

Do you intend to produce your own execution algorithms for users of the ISE Stock Exchange?

No, we view that as a service provided by vendors and brokers and not something for an exchange to offer. While electronic crossing exchanges such as Instinet provide this sort of service, they are also broker dealers and this is therefore more part and parcel of their day-to-day business than it would be for us.

Looking ahead, what other areas of possible expansion do you see for the ISE?

We bought a company called Longitude at the beginning of April. This has some rather intriguing technology that could be used in situations where a market-making system of trading may not be the optimal choice of market structure.

We are also currently examining other potential applications of this technology. Some of the possibilities include weather derivatives, real estate, and insurance. Rather than a single counterparty (such as a market maker) selling the option, a pool concept (such as in reinsurance) might be used.

Do you have any other new product aspirations, such as in exotic options?

Ultimately that will depend upon customer demand. At present we are not experiencing much demand for exotics, although the Longitude product already supports binary options. However, we have had a significant number of enquiries for currency options and credit derivatives, but we have not as yet found a mechanism to satisfy that demand.