New technology for global trading is winning clients, writes Nick Huber
The last few years have been bruising for the worlds' stock exchanges. Economic downturn and the threat of terrorism have taken a heavy toll on profits and market confidence, but a greater threat could lie in new technology and upstart rivals, experts believe.
Incumbent stock exchanges face growing competition from alternative trading systems and "crossing networks". These fast-growing companies, such as E-Crossnet and Liquidnet, bypass stock exchanges by automatically matching and selling institutions' large orders using peer-to-peer and instant messaging-style technology. Fund managers simply install the software on their desktop, dispensing with the need for a special terminal, and trade anonymously among themselves.
Research from Accenture predicts that new technology will play a key role in sorting out the winners from the losers in the fight for market share between incumbent stock exchanges and their new rivals.
"Potentially disruptive technologies allowing intelligent order routing and direct trading between institutions are increasing in importance and becoming ever more prevalent," said the research into the future of the London and European Exchanges, which was published last year. "The emergence of electronic crossing networks and other types of alternative trading systems is important and represents a significant threat to incumbent exchanges. In the future it is thought that liquidity will be more fragmented with the different pools being linked by alternative trading systems."
Although the Accenture research focused on Europe the new kids on the trading block have global aspirations.
The alternative trading systems have seen spectacular growth since their launch three to four years ago. Liquidnet, a US and European-based business, was launched in 2001, and now has 185 firms, which manage around $6,000bn (€5,000bn) in equity assets, using its trading system,
Firms using the Liquidnet system include Barclays Global Investors, Deutsche Asset Management and Schroder Investment Management.
Other alternative trading systems, such as E-Crossnet, use a different model, which requires the trader to input orders into the E-Crossnet system to be matched during set times of the day.
Competition to stock exchange technology is also emerging from well-established firms such as State Street, a US bank founded in 1792, which allows financial firms to trade directly over an online network.
The technology used by alternative trading systems is breaking the mould of traditional trading systems.
Liquidnet, for instance, is an internet-based trading system that uses peer-to-peer style technology to match prospective buyers with sellers in real-time. The trading system, which was developed in-house, links into fund managers' order management systems to see what trades they want to make and then goes out into the market to find suitable matches. When a match is found an alert pops up on the trader's desktop, and he or she can then decide whether or not to proceed with the deal.
Liquidnet uses messaging software from Tibco, a supplier of integration software, while its back-end systems run on large servers from Sun Microsystems.
"Our model [technology] is our value proposition," says Seth Merrin, founder and CEO of Liquidnet, who compares the Liquidnet system to the online marketplace eBay. "We have hundreds of buyers and sellers who deal among themselves [bypassing exchanges and brokers] - it's a very much do-it-yourself system."
Despite the relative immaturity of alternative trading systems Mr Merrin claims that its internet-based service is less vulnerable to crashes than traditional trading systems.
The emergence of alternative trading systems is the latest milestone in the evolution of trading technology. Up until the early to mid-1990s most fund managers would trade using a combination of phone, fax and electronic terminals, such as Bloomberg and Reuters. The manual processes were prone to errors and misunderstandings but things became more streamlined with the introduction of the Financial Information Exchange (FIX) Protocol - a messaging standard developed specifically for the real-time electronic exchange of securities transactions.
The next step forward came with the introduction of order management systems, a desktop application to help brokers to receive, track and execute orders. Then, around four years ago, alternative trading systems started to appear.
Nigel Solkhon, global segment manager, asset management, at IBM agrees that peer-to-peer type technology is well-suited to the needs of traders because automating the trading process requires the minimum of effort from traders.
"Liquidnet's peer-to-peer technology sits like a heartbeat behind the order management system matching buyers and sellers," he says. "The [Liquidnet] business model fits very nicely with traders who are paid stacks of money to be smart cookies and know when to come in and out of the market at the right time."
But despite the rapid expansion of alternative trading systems and their technological advantages some experts believe that the size, reputation and resilient nature of the incumbent exchanges will stop alternative trading systems from poaching large chunks of their business.
"There are reasons to believe that stock exchanges are under threat from new technology and upstart rivals," says Daniel Cohen of PA Consulting Group. "[However] The stock exchanges can provide the most liquidity [the ease with which financial assets can be converted to cash] and the advantages to traders of carrying out their activities in the biggest pool of liquidity typically outweigh any advantages provided by new technology, even despite lower execution costs."
On the New York Stock Exchange, for instance, only 7 per cent of total trades are executed automatically, on its electronic trading service, Direct+. However, the US exchange is making the servicer available to a wider range of investors, and also equips brokers on the trading floor with handheld wireless devices (Pico Cells) to communicate.
In response to the threat posed by alternative trading systems the London Stock Exchange says electronic crossing networks have been more successful in winning market share in the US than in Europe, adding that this is because European exchanges have traditionally been "ahead of the curve" for trading systems technology.
Despite tensions between incumbent stock exchanges and rivals offering alternative trading systems both, according to IBM's Mr Solkhon, are likely to use similar technologies in the future.
These include an increasing reliance on open source software - widely viewed as a cheap and scaleable alternative operating system to Unix or Windows NT - and algorithmic trading systems (powerful software that helps clients develop trading strategies and their transactions).
However, for financial firms and traders to reap the full benefits of trading technology stock exchanges and alternative trading systems will need to work more closely together in future, according to some industry watchers.
"For the start-up [alternative trading exchanges] to be successful, they need to find subtle technological and organisational solutions that enable them to provide the benefits of the new systems while not cutting off customers from the existing liquidity pools," says Mr Cohen at PA Consulting Group. "Curiously, these solutions will often involve entering into a symbiotic relationship with the exchanges they are supposed to be destroying."
