The Gateway to Algorithmic and Automated Trading

Algorithmic Traders & Their Impact on the Derivatives World

Published in Automated Trader Magazine Issue 06 July 2007

Having revolutionised the equity markets, algorithmic trading is already reshaping the derivatives sector. Neal Brady, Director of Products and Services Technology, CME, looks at the technology and infrastructure changes that are fast attracting algorithmic traders to the futures and options markets.

Neal Brady

In one respect, today's financial markets are a quiet place. That's because an increasing number of today's global traders never pick up a phone to call in an order, shout out a bid or even click on a mouse to send a buy or sell order to the market. Today's trading is increasingly conducted between computers executing algorithmic trading strategies and driven by complex arrays of 'what-if ' scenarios.

These algorithmic - or algo - traders are helping to drive change and innovation across the spectrum of the financial markets. To understand just how great an impact these firms are having on the derivatives sector in particular, it's helpful to look at recent developments in our financial markets and see how exchanges and algorithmic traders are working in tandem.

Simply put, the biggest reason algorithmic trading has blossomed is the continued advance of trading technology. In just the past several years, the ability of hedge funds and proprietary trading firms to trade the markets has improved exponentially. The power of today's technology has made it possible for hedge funds and proprietary trading groups to seize opportunities across a multitude of markets and asset classes in less than a blink of an eye. Armed with astrophysics and computer engineering graduates, firms have been able to convert the knowledge and strategies of traditional traders into cutting-edge trading programmes that buy and sell with mindboggling speed, complexity and precision.

Technology-fuelled migration

Yet, algorithmic trading would not be the force it is today without technology and structural change at the exchanges as well. At CME, for example, approximately 90 per cent of our capital expenditures today are devoted to technology. This investment in technology has helped fuel the migration of traditional floor-based trading to screen-based trading. Trading of highly liquid futures and options on futures contracts - once only offered in a trading pit - is now offered electronically virtually around the clock. While the argument could be made that we've seen electronic trading in North America, Europe and Asia for many years,some of the deepest and most liquid contracts have made the transition more recently from the pit onto the screen. CME Eurodollar futures, the world's most actively traded futures contract, for example, began trading electronically on the CME Globex® platform along side the floor during daytime hours in 1999. But it wasn't until 2004 that electronic volume topped floor-traded volumes. Today, roughly 90 per cent of Eurodollar futures trade on CME Globex.

Advances at futures exchanges have been complemented by the same type of technology evolution in cash markets for equities, interest rates and foreign exchange. And the migration of cash markets to electronic trading has driven volume growth as algorithmic traders enjoy more spreading and arbitrage opportunities.

"Direct access means faster execution times for all participants, but it is especially crucial for many algorithmic traders."

Algorithmic traders are more likely than point-andclick traders to move across asset classes, just as long as they can trade on a platform that offers direct access, robust technology and maximum price transparency. We have witnessed this trend firsthand as algorithmic traders active in the equity markets have migrated into interest rates, foreign exchange and now agricultural commodities as volume on each of these markets has moved to the CME Globex platform. These firms have made significant investments in technology and trading infrastructure that is portable to new product lines. Unlike pit trading, the electronic environment allows firms low-cost points of entry and access to new sources of order flow.

Open door policy

Yet, simply putting a contract on the screen is not a recipe for liquidity. Accessibility is another key component for the growth in algorithmic trading on the derivatives markets. The futures exchanges have been at the forefront of providing direct access to hedge funds and proprietary trading firms. These players bring tremendous liquidity to the derivatives markets. CME, for example, offers such firms special classes of membership that provide them with direct access, discounted transaction fee rates on contracts and trading incentives that promote even more liquidity. Such volume fee discounts appeal to algorithmic trading firms because they are already high frequency traders and very sensitive to the 'frictional costs' of potential trading strategies. By lowering transaction costs, an entire new set of strategies are opened up to these firms.

"… algorithmic traders active in the equity markets have migrated into interest rates, foreign exchange and now agricultural commodities."

Beyond that, hedge funds and proprietary trading firms have also been given direct market access to futures exchanges, which has been another major driver of trade volume growth at exchanges. Direct access means faster execution times for all participants, but it is especially crucial for many algorithmic traders.

The popularity of direct access among algo traders brings us inevitably to the question of speed. In every market, speed of execution is critical and the futures markets are no different. At CME, for example, the exchange has lowered its roundtrip execution time to 27 milliseconds from 127 milliseconds five years ago. CME has also increased the size of its data lines to 100 megabits per second from 1 megabit per second lines three years ago. Those numbers promise to improve dramatically in the coming months as new technology is implemented. In July, CME plans to roll out FIX FAST, a new data compression and market data technology that could reduce bandwidth usage by 70 per cent.

Each time CME has made technology advances, volumes have risen dramatically. As execution times improve, more liquidity flows into contracts. As more participants apply algorithmic models, volumes will continue to increase and trading will continue to expand dramatically across all asset classes. The enormous volume growth poses an interesting challenge for firms as well, because the amount of data that is being produced is unprecedented and accelerating.

Getting closer to the exchange

The next step in exchange technology comes in the form of colocation, which means that firms can physically place their trading platforms next to the exchange's servers. Colocation is literally the next frontier for algorithmic trading firms, because by putting their servers onto the exchange network, firms eliminate lag time that is created by geographic distance and transport over telecoms lines. And when a one millisecond delay means the difference between a profit and a loss, colocation becomes an ideal solution. Not only that, but colocation further opens up the markets globally because the lag time that firms experience due to pure physics is now a level playing field regardless of location.

"And as the traditional walls between cash and futures markets continue to fall, algorithmic traders are enjoying far more flexibility…"

Overall, what we are seeing with all of these technology and structural changes is a much lower barrier to entry for hedge funds and proprietary trading firms. Algorithmic trading firms not only have greater access at lower prices, but they also are spurring other efficiencies that may not be so apparent. Take prime brokerage for example. Prime brokers now offer margin offsets across multiple asset classes and venues to hedge funds in large part because algorithmic firms trade across so many different assets and are active in both cash and derivatives markets. This is a crucial piece of the overall model for hedge funds and proprietary trading firms because in order to trade across OTC and exchange-traded futures markets, they need to make efficient use of their trading capital. Having noted the trend toward market diversification by a growing number of clients, prime brokers now provide that valuable service.

CME Globex Monthly Total Order Volume vs. Average Response Time (Round Trip Turn) January 2004 to May 2007

And as the traditional walls between cash and futures markets continue to fall at prime brokers and futures commission merchants in terms of trading and clearing, algorithmic traders are enjoying far more flexibility to trade the markets they want.

Looking ahead

The rise of algorithmic trading is not a trend; it's a revolution in our markets. These traders have spurred innovation and capitalised on other improvements with no end in sight. Investment banks and large Wall Street firms are also jumping into the 'algo game', developing their own trading systems.

When it's all combined - computing power, direct access to markets, speed of execution and transparency - the future for algorithmic trading looks bright indeed. Futures exchanges in particular are in a great position to grow by offering firms fully displayed order books that allow for greater analysis and use of market depth. CME has also been among the leaders in rolling out new functionality such as fully electronic options trading and cross-commodity spreading functionality. Futures exchanges also offer centralised clearing, which ensures market integrity and many of those margin offsets that are passed along to the end user for more efficient use of capital.

All of this is good news for the growing ranks of algorithmic traders. Market depth, integrity and risk management structures are now being enhanced by improved speed and functionality. So this is the new marketplace that is silently making a big noise in the markets around the globe.