Over the past few months, I’ve shared my thoughts about the evolving space of electronic flow in derivatives. I’ve touched on the fact that:
1. All factors are pointing toward an accelerated change.
2. This is not trail-blazing. There’s a lot to be learned from other asset classes.
3. This is not simply about algos. It depends on the trader’s market expertise.
But the piece that maybe I’ve not explored relates to how we as an industry providing services to buy side clients actually go about making this change. And in particular, addressing the elephant in the room: why the buy side need to recognize that this marks a change to the service they’ve grown up calling electronic.
Before I start, it’s worth level setting what the electronic trading business looks like today in derivatives. Granted there could be exceptions, but for this purpose I’m focused on the service offered by the typical FCM.
Growing pains
Whether the buy-side trader uses a screen or it’s a computer model that’s sending the orders, both use the FIX protocol to communicate the intent of the order. For the sell-side firm, they have something called a FIX spec that defines the language of how to communicate that order.
Today, firms have a FIX spec that defines the algos in their toolbox. As they’ve added algos to their roster, so the FIX spec has grown. Given that different algo services or vendors likely have a different range for their ‘special’ algo tags that define an order’s behavior, this quickly ends up presenting technical complexity in certifying. This is typically a one-time piece of work, so though painful, it’s not ongoing. However, the complexity of having multiples of the same order type being potentially available as options on the buy-side order ticket does create an obvious ongoing friction. This complexity is the causality of how the flow has been defined. In the beginning, electronic flow was DMA. Then along came algos, and they too were treated like DMA – from a pricing and connectivity perspective. The broker never interjected in the flow. Whatever was needed for the Algo container was what the firm insisted was sent by the buy-side client.
Learning from the friends across the floor
Overcoming this complexity is actually relatively simple. It’s time to apply a little muscle to this and appreciate a thing of FIX-beauty that originated in Equities: FIX Normalization. Normalizing a FIX service is exactly as it sounds. Simplify the communication between the buy and sell side, and manage the outbound remapping requirements as part of your system, rather than pushing the complexity down the client’s throat. You then have a single consistent message format, regardless of how many VWAPs you can potentially access off the back of your OMS.
This does, however, raise another problem: now that you have a generic ‘I want to trade a VWAP’ instruction from the buy side, how do you manage where to send it? Again, it’s time to flex some muscle and use some routing logic that’s so standard across the floor that no one even asks if you do it. The concept is simple. Subject to terms, factors, or other decisions, the message is sent to the correct destination service. Adopting this solution in derivatives now does, however, have one advantage over Equities, in that the path has already been traveled. In Equities, we are at an inflexion point: low-touch is no longer accepted as a one-time routing process as the buy side is demanding more in terms of how their orders are executed. The routing logic is now expected to take ownership of the order throughout its life, giving rise to customization of order handling only previously seen managed by a human on a trading desk. Derivatives therefore have the opportunity to adopt this lifecycle workflow, essentially catching up with the evolutionary process in Equities.
Technology is an enabler, not the solution
Low-touch isn’t just a technology-focused story. Using these elements to make electronic trading more efficient will do just that, but we’re still just talking about a service that remains DMA-to-Algo – albeit with a little light lifting in between. As I said in the last piece, taking these technology muscles and overlaying the brain of the ‘trader expertise’ defining how the order is executed is what truly moves derivatives electronic trading to a tangibly valuable proposition for the buy side. Creating targeted execution plans is implicitly what an FCM care trader does with the orders they handle manually. And if there’s value premium in care flow and the human oversight and ownership of the order’s execution, then shouldn’t the electronic version of this command some sort of premium too?
In my view, all the FCMs wanting to provide an enhanced electronic algo execution capability – or low-touch as I’ve referenced it using the equities convention – stand at a fork in the road. Both routes will eventually get to the same destination, but the choice of the path will govern the success. Take the fork to the left and you continue down a one dimensional, narrowly focused DMA-to-Algo service. With this path comes a low degree of innovation, driven simply by the limited upside opportunity firms can recognize. The destination is therefore a lot further off and you’re going to take significantly longer to get there – ultimately mis-serving the investing buy side clients. Those taking the fork to the right see and embrace what’s at the end of the path. This path positions them to move their Algo access out of a low-value DMA channel and into a valuable service that provides the buy side with the functionality they’re looking for.
This is starting to happen. And I for one look forward to the redefinition of low-touch within the derivatives market.
