Exchanges are increasingly under pressure to account for multiplying order types, maker/taker models, and technological outages. William O’Brien, CEO of Direct Edge, examines customisation by exchanges, and their changing relationship with the buy-side.
I really view an exchange as no different to any other kind of social business institution. In some ways exchanges were the original social business institutions. In the modern era exchanges are essentially social. You have a community of members that are all connecting in and using the communal service for wildly different reasons but for a common purpose; to move their business life forward. For example: It does not really matter if you are a hip hop DJ, a real estate agent, or the head of the PTA, you are all on LinkedIn and Twitter and using them for wildly different reasons but for a common purpose – to move your business life forward.
In the same way, whether you are a regional brokerage firm or an institutional algorithmic provider or you are an electronic market maker or you are just a proprietary trader, you are all connecting into exchanges for wildly different reasons, but again for a common purpose, to move your business life forward and that of your customers where it is relevant to your business model and the market at large. So what that requires is for the stewards of those communities, to promote something that everybody sees common value in, that is usable by all but at the same time customisable by those who need it and not utilised by those that don’t. There are a host of features in LinkedIn or Facebook or Twitter that you may find completely useless or that you don’t even know about, that others find highly valuable.
Customisation on the exchange
With exchange functionality it is the same principle; You go to the drivers of order type customisation on exchanges. For Direct Edge one of the biggest drivers for some of the customized functionality we have are in fact our retail brokerage clients. A retail brokerage will come to us and say, “My system starts at 7 o’clock in the morning and so all of the orders that retail investors put in overnight I want to send to you right away to avoid any operational risk, but based on what my customers want I don’t want them available for trading until 8 o’clock and then some of them I don’t want available for trading until 9:30 and even those…” and so on. There is a lot of customisation in that request. There is wide variety in our customer base and we have done a lot of order type functionality and behavioral functionality for our institutional brokerage customers, so in terms of where we are focusing, like any good business I would like to believe we are focusing on all.
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And again, as a steward of a community you need to make sure that the demands of one constituent are not disadvantaging others and we take that responsibility very seriously. We have that backed up by a formal review process for new functionality. We have to file those changes with our regulators and we have to take a comment period from our members before we implement those changes and only after those conditions are all satisfied can we actually move forward and implement anything. There are processes in place, central and apart from just being our natural incentive to try and do the right thing to satisfy the needs of all of our members. Now that being said, is there more that we can do in that regard? I absolutely think so. One, because this customisation raises the engagement customers need to have about what we offer and to ensure that they are using all the features that are right for them, as well as if there is a feature that could be advantaging them, to be made aware of that and for them to be able to voice their opinion about that in those processes. We have done a lot of things to heighten those efforts over the last year or so to fulfill that responsibility in a better way and to reach out to a wider group of stakeholders, including buy-sides.
Changing relationship between the buy-side and the exchanges
We are doing a lot more outreach to buy-side firms directly and not exclusively relying on the relationship they have with their brokers but making them feel like they have a direct relationship with our exchanges. Even if we are not asking for orders from them directly, they feel like they are a customer in every sense, in terms of understanding from us how our functionality works and providing their feedback as to how it can be made better, where it is relevant and the other thing is making sure we put in plain English some very intuitive tools at their disposal, to make sure they understand how our exchanges work.
We realise that we can’t just say, “read our filings with the SEC if you want to understand it”, or “read our rule book if you want to understand it”. They are sources of information and they are always available publically but we need to supplement those with other material that are a bit more intuitive. We just released our Direct Edge Order Type Guide, which is a 40 minute online interactive presentation, which everyone from the active individual retail trader to the senior portfolio manager can get a lot of value out of to understand how our exchange works. Not that this is the sole source, but combined with the other things that are publically available, for those that want to understand complexity rather than just complain about it, I think they can get a solid knowledge base.
The buy-side firms that are the forefront are recognising that they can have a tri-lateral relationship, between themselves, their brokers and the exchanges and other venues that their brokers trade to on their behalf. These are highly skilled, highly knowledgeable professionals that when they get access to the information in an intuitive unfiltered way they can understand it very quickly. One of the challenges is that there has been so much criticism of market structure, from a lot of sources that really have no interest other than criticising it, that it can often times put a broker in a very difficult situation. In the sense they are viewed as an apologist, even though they may be conveying accurate and true information they are not necessarily incentivised to do so, because if some market structure critic is relentlessly hitting the buy-side with “this is how your exchanges and brokers are ripping you off”, a broker in defending himself is only validating the criticism to some degree. So there is a demand among both institutional investors and the brokers who serve them, for exchanges to take a more active and direct role in communicating to them about market functionality and other market structure issues. You talk about exchange fragmentation, the buy-side fragmentation is infinitely greater, so there is no universal answer here about what the buy-side is doing, but I can tell you that the firms that I have typically seen at the forefront of trends like this, are getting more active and becoming intelligent contributors.
Systemic risk and regulation
There are legitimate priorities that need to be addressed, such as reducing some of the systemic risk in the system from these operational failures. I think a lot of companies, exchanges and otherwise have made significant investment in dealing with those risks on an inter-firm level, ie: within the realms of what we can control. For example, where there are failures at a third party that could have a big disruption on your own operation and how do we reduce those single points of failure system wide. That is a lot of work to make sure we do that right, but at the same time it is a discrete project as it is not a structural change it is just an enhancement of the market wide approach to enterprise risk management. This may have an effect on our resource allocation but it doesn’t have an effect on our ability to strategically plan.
“The buy-side firms that are the forefront are recognising that they can have a tri-lateral relationship, between themselves, their brokers and the exchanges and other venues that their brokers trade to on their behalf. These are highly skilled, highly knowledgeable professionals that when they get access to the information in an intuitive unfiltered way they can understand it very quickly.”
In respect to reform and market structural changes, I think that much of the talk out of Washington has been about data driven, all-encompassing holistic reviews and I think that is the right approach as everything is so inter-connected. This also means that that process is going to take some time and rightfully so. Therefore if there are things we think our customers can benefit from in the next 12-18 months, we are going to do them and not worry about what the market structure is going to look like five years from now.
