Multilateral trading facilities (MTF) are transforming the market landscape of Europe. While traders worldwide can now access pan European markets electronically, the matching engines and their ecosystems are concentrating ever more. By May, trading platforms within reach of the greater London metronet already accounted for over 55% of European lit and dark electronic equity trades reporting through the Federation of European Securities Exchanges (FESE) or just under half, based on turnover. Once the NYSE Euronext platforms migrate to Basildon, these numbers will rise to over 74% (or around 63% by turnover). The gravitational pull of liquidity and low latency are exerting a growing attraction for London based trading engines.
"Chi-X Europe began trading more than three years ago with a low latency, high capacity engine in central London," recalls Graham Dick, head of business development for Chi-X Europe. "Then, as volumes started to grow - we're now up to 30% of the market - we realised we needed a lot more co-location space, which just wasn't available in our data centre. So we made a strategic decision to move to a green field site in Slough to ensure low costs for our clients. We now have a broad mix of the historic trading houses in Europe together with US high frequency players."
The basic challenge for brokers is to be close to the key markets. "Our goal is provide the best possible execution using our sophisticated algorithms and smart order router," says Alexandra Foster, Head of UK Sales, Instinet Europe. "We're members of dozens of exchanges globally and are connected to every MTF. That means either co-locating or proximity hosting our servers. Even in London with Euronext in Basildon to the East and Chi-X in Slough, brokers like us will need to be located in multiple centres." She explains how in the past, there was always a race for the best locations on the exchange floor. Those with the fastest runners got the trade. "Co-location is no different," says Foster. "It's important for some but perhaps not so much for others."
"Co-location and proximity hosting are all about speed and thus primarily of interest to high frequency traders who build their own trading strategies," says Rob Maher, head of AES Sales EMEA at Credit Suisse. While they make up a high percentage of the volume, these high frequency traders represent a small subset of the client base. "The vast majority of our clients come to us for our algorithmic trading, smart order routing and connectivity," continues Maher. "If you need to access 10 different dark and lit liquidity pools, positioning is less relevant and we manage them from our own data centres. For high frequency traders we offer distribution capabilities and can host their servers as well, but it comes at a premium.
For some buy side traders speed is everything. Trading Cross Connects (TXC) is an incubator of high frequency algo trading teams, offering capital, technology and expertise to start-ups. Gray Lorig, their chief information officer, explains their approach. "Currently all of our clients are black box, ultra high frequency prop traders focused on FX, futures and commodities," says Lorig, "but we can cover other asset classes as well. We have hosting facilities in Chicago, New Jersey, London and Tokyo. It only takes us two to three months to integrate a new exchange."
Positioning can be a finely balanced decision. "For FX we tend to colo with EBS which is typically the primary leg for many trades but then try to be near the regional exchanges as well," says Lorig. "For basis trading it's a balancing act whether you're near the futures or cash end of the trade." He explains how traders might run multiple strategies perhaps in different locations, emphasizing or de-emphasizing them during the day as markets, positions and exposures change. They also do shadow trading and real-time mark-to-market to evaluate relative performance."
Rising numbers of trading participants and customer demand for services have both tended to snowball. "Now we're seeing matching engines moving to London as well," says Dick at Chi-X. "The Italians moved here with LSE, NYSE Euronext will move to Basildon, and there are many new MTFs and dark pools. So all the big European investment banks have started to move their electronic trading to London. Not so much the smaller agency brokers. They'll probably rely on fast fibre links, at least for now."
"People come to London because that's where the honey is: MTFs offering price improvement and liquidity," says Foster at Instinet. "More importantly, where will liquidity shift to next? These are interesting times. BATS won a 3% market share very quickly in the UK, for example. Chi-X is now 30% of FTSE 100 trading. Now NYSE Euronext is moving to Basildon. What will be next?"
"It's not just where liquidity is now, but where it will be," says Lorig at TXC, "A big balancing act if you don't have much money to spend."
Art of Global Positioning
"In choosing locations you need to take a macro view," says Foster. "In Europe today liquidity is mostly centred in London, Paris, Frankfurt and Zurich. In the US it's found in New York/New Jersey, Boston, Chicago and the West Coast. In Asia in Hong Kong, Tokyo, Singapore and Australia. Asia is an interesting market and is on the cusp of taking off in terms of fragmentation and the investment community will need to invest in smart order routing in order to seek out the best possible trading performance."
"In Asia some traders have geographically dispersed strategies and autonomous trading engines because communications can be problematic," notes Lorig at TXC. "Connectivity to London and the US has always been difficult, although as new routes continue to come on line through Siberia, etc, the situation is improving." The sheer length of these connections, however, presents vulnerabilities. "Two years ago we lost half our connectivity when a quake broke two of three trans-Pacific cables south of Taipei," says Lorig. "You have to provide alternative routes or make other provisions."
Latency and security of access are not the only considerations however. "Liquidity is still moving to the MTFs away from the primary exchanges," says Foster. "It's not just a matter of speed. Some brokers may be attracted by pricing issues, others -unlike Instinet Europe - may have shares in the platforms or may be simply chasing liquidity. They all have different reasons. With so many traders in London, the London venues will inevitably gain market share."
For some dark pools such access to liquidity is key. "Over 50% of the dark pool business currently arises in large, London based sell side banks," says Lee Hodgkinson, CEO of SmartPool, and head of European sales and relationship Management at NYSE Euronext. "It's important for us to be near our customers. All the major European banks have substantial trading hubs there as well, and that's where the high frequency flow is based."
Hodgkinson explains that dark pools are about reducing market impact, so latency is not so important. However, as technology advances, the algorithms used by brokers are becoming more latency sensitive. "We're not yet at the extreme low levels perhaps, as in the lit markets," he notes, "but speed is still important, especially if you want to cancel a dark order. So conventional wisdom is beginning to change and we see advantages for firms to co-locate with us in Basildon later this year, for example."
Basildon, Gateway to the World
"The closer the trading connectivity, the lower the uncertainty," says Ken Barnes, VP head of global connectivity and co-location services at NYSE Technologies. "Trading and market making are facilitated by reductions in risk, so the more we can improve predictability, the greater the confidence, the more liquidity and the tighter the spreads our investors will experience. Our global strategy is to condense liquidity into a few locations to attract even more market facilitators to reduce costs for everyone."
"In Basildon for example, we'll aggregate NYSE Arca Europe, Smartpool, NYSE Liffe, and the Euronext," says Barnes. "In Mahwah, [New Jersey], we're aggregating NYSE, NYSE Arca, NYSE Amex, NYSE Amex options and NYSE Arca options as well as the FIX Marketplace hub into the centre so that all the flow using NYFIX will cross connect directly broker-dealers co-located in the facility."
The move to Basildon will impact many participants. "To work out the fastest routes you need to measure time in microseconds, syncronise clocks across multiple sites and monitor latency with real-time probes," says Al Moore, a co-founder of Fixnetix, the front office outsourcing specialist. "It's a constantly moving target as exchanges move and new fibre routes become available. When Euronext moves to London, for example, we'll be migrating connectivity from Paris to Basildon, and rebalancing the optimal fibre routes/latencies to the other matching engines. For prop desks, as the performance increments are getting ever smaller and the costs rise, it becomes an arms race with potentially huge returns balanced against the opportunity cost of targeting those returns."
The whole ecosystem is reconfiguring itself as liquidity moves from one physical location to another and best of breed solutions may be short lived. "New low latency routes come up quickly," says Emmanuel Carjat, CEO at Atrium Network, the first connectivity specialist to build a dark fibre 'exchange ring', so that clients just need to connect once to get ultra low latency connectivity to all the exchanges, MTFs, ECNs, CCPs, and CSDs both in Europe and North America. "What used to be the fastest route London to Frankfurt three months ago, may now be slower by 2 milliseconds. People engineer faster routes, so competition is intense. What do you do if you have a 24-month contract? Write it off? Or accept that you are slower and try to make up for it with clever software?"
In such an environment it is important to foster long-term relationships. "We'll continue to leverage our strong relationships with our NYSE Euronext participants in France, Belgium, the Netherlands and Portugal," reassures Hodgkinson, "but we are keen to capture new types of flow as well."
To capture that flow, collaboration with third party vendors and service providers can be key. "We also work closely with the independent software vendors," says Hodgkinson. "These EMS/ OMS firms are becoming more important in Europe and we need to be accessible to their customers as well. It all plays into the decision to locate near London together with the lit markets and with Liffe's derivatives exchange as well. It opens up some exciting opportunities for new trading strategies."
"The main interest is coming from broker dealers and market makers," says Barnes at NYSE Technologies. "Traditional long-only investment companies are typically less interested in the "raw materials" of big pipes and colo cabinets - they're looking for integrated solutions from their broker dealers and vendors. "
Increasingly people just want to be together. "We're starting to see multiple exchanges under one roof," says Lorig at TXC. "They see advantages, and it's better for us as well and easier to cross-connect. If you're trading treasury futures in Chicago, you'll want the cash leg and basis there too. People are beginning to think that way."
There are however some challenges. "The total market cap of European and the US companies are similar," notes Maher at Credit Suisse, "yet volumes, messaging rates, and liquidity are ten times higher in the US. Much of the difference comes down to costs, especially on the clearing and settlement side, and hence the type of participant this attracts. Europe has a long way to go to rival the US in terms of costs to trade."
Low latency may be driving much of the dynamics but it too brings challenges. "Besides latency there's jitter and volatility," says Lorig at TXC. "A lot of the exchange flow is very bursty. Our business is driven off volatility, so we work best in this environment. That's where opportunities lie. It plays out in the software design to catch the bursts in a timely fashion in one or a series of boxes." He notes, however, that sometimes you get a microburst storm. With colos you can get lots of sharp spikes very close together. If baseline volumes grow, the spikes will get higher and higher. "Algo trading has been a stabilizing force in the market in terms of price discovery and spreads," says Lorig, "but it drives the bursts. The transaction flow is likely to get spikier. Currently we're only facing a few hundred high frequency firms, but soon that will be thousands."
Lorig argues that ECN technology can dampen these bursting behaviours. "In FX where the major volume is done they're very strict on flow restrictions," he says. "We see bursts, but not like other exchanges. EBS updates only once every 100 microseconds. Reuters too imposes controls. So it smoothes things out, but platforms like Currenex with streaming prices are less restrictive and thus more prone to bursts."
These proximity trading hubs and co-location centres attract vendors as well as markets and participants. "Data vendors too are themselves in the latency game and have had to up their game considerably using direct feeds and local nodes in the trading hubs," says Dick at Chi-X.
"ASPs in a trading hub make a lot of sense for market data vendors," says Carjat at Atrium. "They can put in a couple of servers, not even a full rack, and then fan out locally thus saving on bandwidth. A number of them want to do that. They just get someone to manage it for them 24x7."
"The two main drivers in these places are latency and cost," continues Carjat. "The prime reason shared data centres were built in the first place was to lower capital expenses for long only firms hosting in the back room. Those back rooms are now exploding with increasing demands for power, cooling and space. It's getting very difficult. Shared facilities reduce costs, but low latency comes at a premium. So facilities managers may focus low latency capability in only one part of their buildings, so they can sell to both groups. It's a balance."
Outsourcing may also be driven by more than just operational efficiency. "Co-location is becoming a tax position issue," says Moore at Fixnetix. "A number of firms are coming to us requesting we oursource their servers/hardware, as a service. It is becoming clear that a number are increasingly concerned that owning hardware in a jurisdiction may create a potential tax liability in the country in which they are trading."
All of these factors stack up into revenue opportunities. "When vendors move into a new geography they now assess which colocation centres are the best to set up shop in," says Carjat at Atrium, "where they think their target client communities will be." Carjat explains that there are a number of players stacked in layers in the supply chain: the physical access layer, the managed services layer, the hosting layer, the application layer. The higher the layer the greater the specialization by industry vertical. Some people try to offer fully integrated services, and exchanges often limit the carriers and other services that can enter their colo space. Others adopt a much more open model so people have competition and can configure best of breed solutions."
Exchanges too are targeting these opportunities. "Our colo offering includes cabinets, power and cooling with options for managed services to reduce the customers need for any onsite engineering," says Barnes at NYSE Technologies. "More recently we've launched a 'Compute on Demand' service offering managed dedicated blades linked to our networks, allowing firms to participate in low latency trading with a lower total cost than ever before possible. This is live in our Weehawken data centre next to NYSE Arca in New Jersey, and will next be launched in Mahwah and Basildon. We've considered a full cloud service with virtual machines on demand, but the greater share of demand requires dedicated infrastructure. Our customers place a premium on dependable latency, security and availability."
SmartPool too is getting into the services game. "We're also planning to offer a high speed, real-time liquidity discovery tool, called MatchView," says Hodgkinson, "to pull together all dark pool post trade data to allow traders to gain insight into where liquidity is. We think traders will want to be close to data sources, so they can see how their trades compare."The latest generation of high speed, low latency networks and proximity trading hubs are clearly driving change in financial markets. Will everyone join in?
"We see the co-location business growing further but not exponentially at the moment," says Dick at Chi-X. "It's not for everyone, but we think it's attractive because, unlike central London, it has no limits on power density or space." Clearly Dick is not alone, as change sweeps through the markets.