| As exchanges transform
their business models into for-profit enterprises and
look to demonstrate to shareholders that they are growing
their bottom lines, many are scouting for new asset
classes to add to their electronic trading platforms.
Offering executions in a variety of cash and derivatives
instruments is a way for exchanges to beef up their
trading volumes and increase their transaction fees.
"When you are a for-profit entity, you look at
the NYSE or the CME or CBOT, and you need to show shareholder
growth and earnings - you have to move into other product
lines," explains Dave Herron, CEO of the Chicago
Stock Exchange (CHX).
Further, exchanges must please a new generation of
hedge funds and algorithmic traders executing complex
strategies that cut across different asset classes.
Today, hedge funds are creating these strategies on
their front-end trading systems and then executing each
trade on multiple exchanges. However, there may be an
opportunity to offer combination trades that execute
multiple financial instruments in a single transaction.
Exchanges that have built electronic trading infrastructures
would like to provide access to multiple instruments
on a single platform. Since they've already made the
investment in technology, those with the strongest platforms
will try to expand into multiple asset classes.
New rules in U.S. equity trading also are causing
some options exchanges to consider trading equities,
the underlying securities for many of their options.
Under Reg NMS, an exchange can attract order flow in
equities if participants post the best prices on that
exchange. This may lead options exchanges to start their
own facilities for executing stock trades because the
rules will enable them to compete against established
equity markets.
Because exchanges are considering the potential for
trading a variety of asset classes - including stocks,
options, futures and foreign exchange - on a single
electronic platform, the trend is expected to lead to
consolidation among U.S. exchanges as the strongest
players acquire their way into each asset class. To
transform itself into a more automated marketplace,
for example, the New York Stock Exchange (NYSE) - dominant
in trading listed stocks - is acquiring Archipelago
Exchange, an electronic marketplace. Archipelago started
as an over-the-counter ECN and now is trading listed
stocks, ETFs and options, with plans to add corporate
bonds and futures to its platform.
Meanwhile, the International Securities Exchange (ISE),
an electronic options exchange, is considering a move
into equities. There also is speculation that the Chicago
Mercantile Exchange (CME), a multiproduct futures exchange,
is going to make a deal, perhaps acquiring the New York
Mercantile Exchange, to expand into energy. And regional
exchanges have jumped on the multi-asset bandwagon,
too. The Philadelphia Stock Exchange (PHLX), which always
traded equities and options, for example now owns a
futures exchange.
Putnam's Plan
Archipelago has been the most aggressive in building
a multiproduct, single platform exchange. "Once
you have your core technology in place, diversifying
the business and increasing the number of transactions
comes naturally," says Jerry Putnam, CEO of the
Chicago-based electronic marketplace. Because the technology
platform is scalable, Putnam says, "You just drive
the bottom line of the business by putting more transactions
through it, and obviously one way to do it is to diversify
asset classes."
Since Archipelago already trades stocks (both listed
and over-the-counter) as well as bulletin board stocks
and ETFs on the same technology, Putnam envisions adding
more asset classes to its platform. "We've always
viewed our business as a trade factory, and we've got
the right engine to do the trades," he says, adding
that it's cheaper for Archipelago to create new components
and, therefore, easier to add more products than it
is for a trading floor. "We have an open technology
and the ability to modify it to make new products -
that certainly is going to be one of our advantages,"
says Putnam.
Even before conversations about merging with the NYSE
began, Archipelago decided to enter the options frey
by acquiring the Pacific Exchange (PCX) last year. Recently,
Archipelago announced that it's scrapping the PCX-Plus
options platform it acquired from the Pacific Exchange
and instead is building a new options platform in-house
based on the same architecture that Archipelago has
in place for trading everything else, according to Putnam.
"The scalability of the system really pushes us
to want to put [options] on the same technology that
we operate for the other businesses," he says.
Additionally, in November, Archipelago announced plans
to trade listed corporate bonds. Though the NYSE has
participated in the business since the 1970s with its
Automated Bond System (ABS), its corporate bond platform
needs a technology upgrade, Putnam asserts. "In
the past, they had a pretty significant bond business,"
says Putnam, but that has declined because, "They
needed a technology upgrade, and we have the platform
to do it." One major advantage is that the NYSE
has huge distribution hooks into all the market data
vendors. "It takes time to get all of that in place,
and they have it in place," says Putnam, who notes
the new corporate bond platform currently is in development
and is close to going into production.
Forces Driving the Trend
Proponents of multi-asset trading say the main reason
exchanges should go in this direction is that electronic
trading systems can scale up to trade multiple asset
classes. And so it's economically more efficient to
trade multiple asset classes because these exchanges
support higher volumes and generate higher revenues
leveraging the same investment in technology. "When
you are able to trade multiple products on the same
platform, it has the same scale and flexibility as a
car company [that] can build several models on the same
assembly line," says Bill Cline, partner in charge
of Accenture's global markets practice.
In addition, differentiation is another factor driving
the trend. "Once Nasdaq and NYSE are both electronic
and trade each other's stocks, what's the differentiator?"
asks Larry Leibowitz, managing director and COO of UBS
Americas. "They need to grow with new products,"
he says.
Moving into multiple asset classes also may help U.S.
exchanges face off against global competitors such as
Euronext and Deutsche Borse. Both of these European
exchanges already trade cash securities and derivatives,
and clear trades under the same umbrella. In addition,
they both have tried to acquire the London Stock Exchange.
"At this junction, the market is going through
a complete rethinking," says Philippe
Buhannic, CEO of Trading Screen, an electronic trading
platform that facilitates order routing, and execution
management and clearing across asset classes. "The
difference between equities, derivatives and securities
is blurring - all of these markets are electronically
traded. That will mean it's extremely low cost and it's
all about volume," he continues, adding that "It's
better to do as many products as you want."
Customers also want exchanges to integrate products
to reduce connectivity costs. If exchanges integrate
multiple products on a single platform, customers can
consolidate the number of FIX order routing connections
they have to exchanges. "It's simply a matter of
cost," says Jason Penniman, director of client
service and marketing at GL Trade Americas, an order
routing network provider. "If you were to have
three or four interfaces for options, equities, futures
and fixed income, and FX, you'd have to multiply your
infrastructure by four or five times," he says.
"Whereas if you have a common gateway, you are
splitting your costs."
As hedge funds execute more-complex trades that play
off equities and options, there is an opportunity for
exchanges to capture those orders if they offer multiple
products under one roof. "You have more and more
strategy trading taking place within a single instrument
or between instruments," says Trading Screen's
Buhannic. "Some people are betting that it's better
to find everything in one place."
According to Will Sterling, managing director of equities
at UBS Securities, by expanding into multiple asset
classes, exchanges could create hybrid products. For
example, a trader could buy an option and sell the underlying
stock in a single transaction. One reason for doing
this would be to eliminate the opportunity for "slippage,"
when one leg of the trade is filled but the other is
not - at least not at the desired price, he notes. By
creating products that allow participants to trade with
less risk, exchanges can improve the quality of prices
and efficiency of their markets.
According to Archipelago's Putnam, the exchange plans
to combine options and equities into a single transaction
in the near future. However, Archipelago will face competition
from the ISE, which is the first exchange to automate
buy-writes - an option plus an equity in the same order.
"Other exchanges have done that for years, but
ISE made that fully electronic," notes GL Trade
Americas' Penniman. Until now, the ISE has had to route
the equity leg of the trade elsewhere, through a relationship
with NYFIX.
Recently, in public statements, the all-electronic
ISE said it's exploring opportunities in equities. The
ISE declined to be interviewed for this story. One of
the factors driving options exchanges to offer equities
trading is that the NYSE is going to compete in the
options markets, relates the CHX's Herron. "Traditionally,
the largest customers to the NYSE have been the options
customers with their equity volume," he explains.
"With the advent of Reg NMS and smart order routing,
options exchanges have to determine if they want to
let their equity flow go into the New York [Stock Exchange]
or if they want to have their options participants post
their equity interest [i.e., bids and offers] on their
own venue."
Skeptics Abound
Meanwhile, critics of the strategy question whether
moving into multiple asset classes is a smart move.
Jamie Selway, managing director at White Cap Trading,
an institutional brokerage firm, suggests that sophisticated
traders use front-end technology and smart order routing
to aggregate the different markets today. Selway contends
that legging risk has been reduced and transaction costs
have declined because many of the options and equity
markets already are electronic. "Most traders look
for the front-end technology" to create combination
trades, says Selway. "They don't look in a venue
- they're not necessarily looking for exchanges to be
multiproduct."
Chris Concannon, EVP of transaction services at The
Nasdaq Stock Market, says there is less demand for exchanges
to offer linked order types because traders now are
able to execute these orders through electronic destinations.
Though Nasdaq looked closely at offering options strategies
linked to equities, or so-called linked order types,
it decided against moving in this direction, according
to Concannon, who contends that the linked order type
has to be put in the same matching engine so that both
legs are executed together as a single transaction.
But Concannon doesn't see much demand for this order
type. Today, he says, traders are able to execute electronically
on the options exchange and write the call on the option
without missing the price.
There also is debate about whether an exchange can
do this with several matching engines, or if it needs
to combine multiple assets in a single matching engine.
"The idea of a single platform that can do different
models, different rules, different algorithms, is kind
of a whimsical, fanciful idea," said Craig Donohue,
CEO of the CME, at a Dec. 6 press luncheon in New York.
According to Donohue, the CME has five matching engines
for trading futures and options on Globex, it's electronic
trading platform.
Nasdaq's Concannon says there already are strategies
for trading in multiple asset classes. The front end
can talk to different matching engines - one can trade
equities and one can trade options, and the two engines
don't have to talk to each other.
If an exchange wants to input multiple asset classes,
the difficult part is adapting its central matching
engine, says Christophe Dacre-Wright, COO at GL Trade
Americas. While exchanges don't necessarily need a single
engine, they need to invest time and money to get these
capabilities, he notes. "Maybe they will have a
second engine dedicated to options and a third engine
dedicated to bonds," Dacre-Wright says. "There
is a lot of work to do."
On top of that, brokers have a best-execution obligation,
so they must route the order to the exchange that has
the best price, White Cap Trading's Selway points out.
"Just because an exchange provides one-stop shopping,
or just because you can buy socks and orange juice at
Wal-Mart, doesn't mean you go there," he says.
Nasdaq's Order Routing Strategy
Nasdaq's Concannon contends that in the electronic
trading world there is less of a reason to have all
of the instruments together under the same roof. Though
basic administrative savings may be realized from common
infrastructure such as a common data center, building
a single matching engine wouldn't result in major benefits,
he relates. The main reason to venture into multiple
asset classes is the "diversified revenues argument,"
says Concannon, noting that Nasdaq didn't see a compelling
advantage to entering these other asset classes.
Instead of becoming an options exchange, Nasdaq will
launch an order routing service to options exchanges,
using the smart order routing capabilities of Brut ECN,
which it acquired from SunGard, according to Concannon.
Brut has memberships on all the exchanges, and Nasdaq
added a couple of options-only exchanges such as the
ISE. Nasdaq will launch the service in the first quarter
for its current customer base.
Sources say the order routing strategy is a smart
approach because Nasdaq can charge a fee for routing
and eventually may be able to match those trades on
its own book. John Margolis, SVP of transaction solutions
at HyperFeed Technologies and a former options trader,
says that exchanges can compete for order flow in other
asset classes by becoming a "single-source gateway."
If they can't meet the best price, they will use their
outbound order routing functionality for stocks, options,
futures - everything, according to Margolis. "That
is why you will soon see very little differentiation
in order entry ability between a listed stock exchange,
a regional exchange or a futures exchange," he
adds.
But Trading Screen's Buhannic contends that routing
an options order through Nasdaq "is just adding
a layer." "The bottom line is, Why would you
go through them? It adds latency, which is key in strategy
trading," he says.
Despite the contention between the two strategies,
sources expect the multi-asset trend to lead to a wave
of consolidation among U.S. exchanges. There is speculation
that players such as the NYSE will acquire the ISE,
or perhaps the CBOE or the American Stock Exchange,
to get a higher market share in options. In the future,
says Accenture's Cline, "Maybe we're not going
to be talking so much about New York versus Nasdaq,
but rather New York versus the Chicago Mercantile Exchange
or New York versus the ISE."
Whatever happens, Archipelago's Putnam is convinced
that technologically, all assets need to be traded on
a single platform. But, when the NYSE and Archipelago
complete their merger, the NYSE's Hybrid Market will
be on separate platforms - and it will have two trading
floors (the NYSE and Pacific). But, Putnam says, as
the U.S. market structure evolves for listed stocks,
eventually NYSE/Archipelago will end up with one platform.
"A multiproduct, low-cost, simple system to operate
should be a winning combination," he says. "As
the competition evolves, [our platform] really will
evolve around the technology."
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