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The fragmentation factor

Published in Automated Trader Magazine Issue 31 Q4 2013

Many, though certainly not all, of the recent higher-profile trading glitches have occurred in the fragmented securities market rather than the more liquidity-centric derivatives venues. Jim Overdahl, representing the Futures Industry Association's Principal Traders Group, talks about why responding to the technological challenges can be different for the derivatives industry than for securities venues.

Jim Overdahl

Jim Overdahl

Describe the main difference between the situation for securities and for derivatives:

The main difference (for derivatives venues) is you don't have a linkage system like you have on the securities side within the National Market System in the United States.

On the derivatives side, liquidity tends to migrate to a single trading venue and stay there. For example, Eurodollar futures are traded almost exclusively at the Chicago Mercantile Exchange whereas if you have a product on the securities side, such as IBM stock or some type of ETF, it might be traded at multiple venues, perhaps as many as 50 venues, including exchanges and alternative trading systems, broker networks, dark pools.

On the securities side, the number of venues trading a single product adds to the complexity of trading.

In the derivatives world, related products are also linked. For example, the S&P 500 futures contract is going to be very closely tied to the stocks within the S&P 500 or to an S&P-linked ETF that's traded on a securities exchange, but by and large, on the futures side, you see trading volume and liquidity migrate to the single trading venue.

The main thing is that regulation has promoted a fragmented market structure on the securities side through deliberate policy choices to encourage competition between trading venues. I think, in some ways, if you looked at securities markets like options markets pre-NMS, they behaved very much the same way as derivatives trading venues behave today. And really what you're seeing is the network effect of concentrated trading, that is: a crowd attracts crowd.

Trading on the derivatives side resembles a natural monopoly in that trading costs become lower when more people participate in trading on a single trading venue. There have been instances through time where you saw contracts migrate from one trading venue to another. One example that people point to is the German Bund futures contracts that went from LIFFE to Deutsche Börse. However, these instances are so rare that they are noteworthy when they occur. The economics of moving liquidity requires that trading volume increase to a tipping point in order to attract additional trading volume.

That is why new product development is so important in the derivatives world - to try and be the first to attract liquidity and then have the network effects work to the exchange's advantage when launching a new contract.

On the question of how the dichotomy between the more complex, fragmented securities side and the more liquidity-centric derivatives side affects exchange performance:

A lot of exchanges, depending on their bandwidth, will define how many trades you have to do per number of orders submitted. It may be a fixed number like, say, 100 orders per trade. And they do that, first, to protect their bandwidth. Second, they're encouraging good quoting behaviour, that is, quoting behaviour that adds to market quality, while discouraging quoting behaviour that potentially detracts from market quality. On the futures side, where a single venue hosts the trading of a product, the exchange can say, 'Okay, here's our policy: 100 quotes per trade'. And other exchanges can do the same. In the securities world, establishing such a rule is harder because it has to be coordinated across different trading venues. A single exchange probably couldn't unilaterally come out with an order-to-trade ratio that would really mean anything, because of it being a National Market System.

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