Financial services

Commentary:

A quantum gap

8 November 2007

The financial community must make a successful transition from screen-based to program-based trading, says Stéphane Leroy.

There has been an ongoing revolution in trading since the first exchanges went fully electronic back in the 1990s. At that time, screen-based trading applications began to be created to meet the needs of users regarding reliability, speed and volumes. Those applications rapidly covered a wide scope of work in order to enhance day-to-day tasks related to market data processing, market research, risk management, order management and clearing and settlement.

More than a decade ago, full end-to-end automatic financial processes like electronic trading, black box trading, algorithmic trading, automatic execution engines and direct market data feeds were concepts on which a few leading edge experts were working. Program-based trading innovators were already showing the path along which trading technologies would ultimately evolve. Today the combination of regulatory changes, technology's rapid evolution and new trading needs are forcing the financial community to change at an even faster pace to stay ahead. How will the financial community bridge this quantum gap? Should the business model of the company be adapted, and if so how? What organisational and staff changes will be required? How should new technologies be assessed and selected?

A number of drastic changes are happening at the same time, and there is no doubt that the market impact will be far greater than if those changes where happening one after the other over a decade. The long-established structure of the market – in silos, where buy side, sell side and exchanges interact with one another in a very structured way – is not valid anymore. The financial market is entering a period where the 'any to any' type of business model is making the world flat.

It is difficult to establish how the financial ecosystem will adapt: who will benefit from this increased competition? The exchanges? The sell side? Maybe the buy side will prove that intermediaries are not needed anymore. Size is always an asset for a company and this is why major mergers and acquisitions are taking place between exchanges, sell-side firms and financial technology providers alike. Everyone is trying to prepare for an environment in which there is increased competition, and where creation capabilities and speed to market will be key success factors.

The buy side is gaining access to an environment, trading tools and knowledge to change the way it interacts within the financial markets. For those wishing to reduce the holding period of financial instruments, going monthly to weekly, daily and ultimately intraday, the need to endorse new program trading technologies is paramount.

But to research, develop and back test automated trading strategies, new talents are required to complement existing profiles. The current knowledge of screen-based trading users is not sufficient. Everybody will have to make this quantum leap, especially the traders.

Contrary to what a poll sponsored by IBM revealed at the end of 2006, traders will not disappear. This survey predicted that in the next couple of years, more than 90 per cent of traders would be out of a job. What is vital is for firms to determine how financial knowledge, technology expertise and organisational structures will be combined in order to create the ultimate trading process for an optimum return.

The organisational structure of a program-based trading organisation will have three key talents working together. First the trader, who will be able to have a very synthetic view of the markets in order to detect trading trends and look after existing trading strategies running on the market to make sure the expected behaviour is under control. Then the researchers, whose job it will be to define and validate new trading strategies. Third will be the quant developers, whose role it is to develop those trading strategies using sophisticated languages such as C++ or C#.

We are talking here about algorithmic trading strategies, not about algorithmic execution strategies. The trading strategies are developed by buy side members to generate orders to be sent to their execution services provider: a broker or directly to an exchange or other pool of liquidity. An algorithmic execution strategy is a program managing the order to make sure that it is sent to the right destination for minimum market impact. Most of the time, those applications are included in the services delivered by brokerage firms to their buy-side clients and are considered a commodity.

The rise of new trading techniques and new talents will significantly push technology to do more with less: more asset classes, more volume and more high frequency with less time, cost and risk. The key steps of any program-based trading activity are: research, development, back testing and execution of trading strategies.

It will become important for any asset management company to get the most powerful and productive tools for their teams. The notion of an integrated development environment will certainly become central to any organisation. These types of tools will allow clients to drive the trading strategy development cycle within one single development environment for optimum time and resource utilisation and process optimisation.

Market data storage, cleansing and maintenance will become a key element of risk management and business performance for asset managers. Due to the complexity of market data management, back testing on demand will become another concept that is pivotal in the overall process. It will allow clients to outsource the storage and management of historical market data to third parties and to test their strategies on demand without the burden of designing and maintaining massive storage infrastructures.

Infrastructures will also have to change to accommodate the fact that the new users, the robots, are much more demanding than human beings. Ultra-low latency market data, accurate data with full market depth, market replay capabilities, complex back testing processes and execution through DMA on a global basis will become standard. Buy and sell side firms with heavy legacy infrastructures will face some significant challenges when it comes to coping with this new market demand.

Do we have to be frightened by this next evolutionary step? Are there more constraints than benefits for the vast majority of today's market participants? Is this a good thing after all? I don't know. The only thing which is certain is that everyone – every single organisation whether involved in the program trading business or not – will have to make this quantum leap.

As with every market shift, you had better formulate your own ideas about how it might affect you, your organisation and your client base, in order to be ready to embrace this change and exploit the opportunities which will arise for everyone.

Stéphane Leroy is head of global sales and marketing at Quant House