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The New Arms Race and the Coming Revolution

Note: This feature length story by Chris McMahon originally appeared in the November 2008 issue of Futures Magazine.
Link to original @ Futures Magazine

Back in the old days, runners, the people who grabbed orders and ran them into the pits where trades were executed, were called the "wheels on the bus," and speed was of paramount importance. Today that responsibility falls to the software, hardware and network infrastructure that connects traders around the world with the exchanges. And as electronic trading matures, trade execution times are measured not in seconds, but in milliseconds. In this new electronic trading environment, the need for speed is still there, but it is increasingly a given as independent software vendors (ISV), brokers, futures commission merchants and other technology providers battle to create and market superior technology and traders search for new ways to establish or keep their edge.

In the new world of electronic trading, traders operate with increasing precision and more technical prowess than ever thought possible, never mind affordable. Tools that were previously available only to the select few have become cost effective for smaller shops, sophisticated individuals and retail traders who are entering the market in ever greater numbers. The institutional trader's long-held technological lead might be evaporating, prompting their search for the next new edge.

We call it the new arms race and it is revolutionizing the ways we trade.

"If you want to talk about futures intraday, you are talking about a zero-sum game. If you are going to win, someone else has to lose," says Bruce DeVault, president of Quantevo Corporation, a creator of customized algorithmic trading solutions. "It behooves you to deploy your own technologies to try to gain some sort of competitive edge. That is a cycle that market pressures tend to perpetuate."

The need to execute trades as soon as a signal was confirmed led to the integration of data, charting, analysis and trade execution on a single screen. That blurred the lines between data providers, ISVs, brokerage firms and futures commission merchants.

"Those things were fragmented," says Salomon Sredni, CEO and president of TradeStation Securities. "In the recent past, we have seen those things come together," he says. In this increasingly competitive environment, Sredni says traders need to understand why and how they trade, and what drives their decisions. "Speed alone, while very important, that's not enough to make you money," he says. "We believe in a rules-based methodology." The TradeStation platform is an end-to-end solution that allows users to create automated trading strategies and include testing tools and customizable analytics.

Interactive Brokers (IB) is another company that offers end-to-end trading solutions, including the brokerage services. In doing so, Steve Sanders, IB's senior vice president, says the company saves money and development time, while offering their customers an integrated set of technology tools. "You get a more seamless solution going to just one firm and it's cheaper," he says. Sanders has noticed another trend, though. An increasing number of developers are writing trading applications to work with IB's application program interfaces (API), leveraging IB's technology and multiple exchange connectivity but layering on their own trading interfaces. Such orders now account for at least 10% of order flow. "They can build an excel spreadsheet or a C++ program or a Java program or Visual Basic program," he says.

Patrick Kenny, managing director and officer of Patsystems North America, has noticed the same trend. "As the sophistication of traders increases, they are coming up with their own front ends, or own algorithms, and not using the standard front ends that are out there. They write to our API, but that is just to route the orders to the exchanges," he says, adding that the big push is towards the sophistication of algorithmic and spread trading. "We created something called the MEL - the multi-exchange legger that would allow you to create it yourself. Now it is done automatically for you," he says. The ability to automatically spread trade is an important recent advancement, but even that is increasingly commonplace, he says.

Joe Guinan is the president and CEO of Advantage Futures, a clearing firm and futures commission merchant. He says Advantage has opted not to compete in the front-end arena, but maintains, monitors and supports the software its clients use. "If you have a vanilla front end, that's not competitive anymore. Because of exchange convergence, there are fewer exchange specific APIs that technology developers needed to create, lowering a significant barrier to entry," he says, and the same holds true for clients developing algorithmic or 'black box' systems. "In January 2006, I didn't have one black-box program going through our firm. Now we have a couple dozen." While the increase has been dramatic, Guinan says point-and-click traders can still trade, but it requires they be clever and creative and recognize that they are trading against automated systems.


Trading solutions are comprised of multiple layers of technology and each layer slows your trade execution. At the root is market data, which originates at the exchange and is packaged and distributed to the subscribers of the data services. Traders then use that data to drive charting and analysis tools and execute trades. Each order then travels through the hardware and software to the brokerage, then the exchange and finally to the clearinghouse. Each step in that process requires time and processing power. And it has to be stable. One advancement benefiting electronic traders is called server side technology, also known as low latency solutions, which serve to increase the speed and reliability of delivering orders to the exchange.

"You have to take into consideration the entire order submission process," says Raymond Deux, president and CEO of NinjaTrader LLC. One typical weakness for retail traders when trading from a home computer or a laptop is their internet connection. "If you are waiting for the right conditions to exit the market, and you are getting close, and your connection suddenly tanks, you're up a creek. You cannot close your position. However, if your trade parameters are uploaded to a server at the broker or a web hosting company, a crash at home won't leave you stranded."

Low latency solutions typically include trading applications hosted on professional grade servers near the exchange and connections via advanced telecommunications solutions. Traders then connect to the hosted application via remote access software. As that technology comes down in price, and the hosted solutions become commodified, smaller professional trading shops and individual traders, who previously could not bear the cost of maintaining that technology, are able to cost justify them.

Another important but evolutionary concept affecting trade settlement times is straight through processing (STP), which IBM defines as "the end-to-end automation of the pre-trade to post-trade settlement process." In a straight through processing environment, investment managers, broker/dealers, clearing agencies, global custodians and sub-custodians seamlessly share information streamlining the entire trade process.


A trader's job is to identify opportunities to make money and snatch them before another trader does, and the idea that technology can serve that purpose is one of the primary appeals of automated trading applications. Rules-based or program trading applications are widely available as do-it-yourself kits and as prepackaged closed systems that execute trades based on technical levels or market fundamentals. Algorithmic trading systems, although much hyped, remain less common for individual traders because they are intended to minimize the market impact of large trades.

"Some of these funds are getting so big that they have to find interesting ways to execute some of these orders," says John Karvelas, VanKar Trading's president, brokerage and trading. "The flip side is the guy trading active systems, and he is coming up with creative ways to reduce slippage," Karvelas says, adding for retail and individual traders, synthetic order types, executed on server side applications, are proliferating. By automating your exit strategy and placing it on a server, a trader would get price updates and react more quickly reducing the risk of having it on the desktop computer.

"What that means is that a trader can submit two orders," Deux says. "Let's say a stop-loss order and a profit-target order are bracketing an open position. Those orders are submitted OCO, meaning if one of those orders is filled or cancelled, the other one is automatically filled or cancelled on their behalf." That technology is now available from some ISVs on the server side, and others offer it as an application on local client computer as a kind of trading rule. "The difference is, if the ISV provides it at the server level, and your internet goes down, the logic is still in place," he says. "So the more stuff you remove from the client to the server, the lower the exposure risk the trader has."

And it isn't just that you're protected from outages. "Having a stop and target as OCO at the broker rather than being managed from your own trading computer gives you a critical speed advantage. That lets you consider having stops and targets closer together - targeting faster, smaller trades - without as much of the concern they both may execute in a fast market, leaving you in a reversed position," DeVault says.


This year there have been several high profile 'failures' of risk management systems; one in which the systems were actively gamed by an insider, and another in which the risk management system was actually turned off. Both were large scale and high-profile debacles that raised risk management not only as a feature/function, but as selling point for service providers.

At Advantage, Guinan says there are several risk management systems in place. At the most basic level, he says there is a control on the maximum order and position size and there is real-time staff monitoring, but they also have four full-time staff dedicated to monitoring their systems.

Patsystems has created a product, Risk Informer, that Kenny says has become extremely popular. The product aggregates and calculates margin requirements in real time and manages risk for exchange-traded derivatives, equities, foreign exchange and contract for differences using standard margin methodologies.

Considering the number of computers executing trades on autopilot, risk management may be more important than latency. "It's not just important to the firms; it's got to be important to the firm's vendors," says Rod Giffen, head of sales and support for CQG. "We've focused on a pre-trade risk management tool that supports very strong requirement."

IB's risk management system uses real- time margining to control risk, rather than the more typical end-of-day calculations. "When you have to wait until the end of the day, a lot of damage can be done," Sanders says. "Our real time margining computes every minute and liquidates if you get into trouble. It protects our customers and us from bad things happening."


As much as trading has changed just in the past five years, the migration from trading pits to computer screens has been evolutionary, as most of the trades have taken place between human beings, albeit through technological processes. But the real trading revolution is going to be trading between computers; and the data, analysis, charting and execution programs that seem so advanced today will soon be replaced by automated systems and other currently unimaginable technologies.

"The ISVs that remain strictly a human-trader interface-based execution system are probably going to disappear," in the next two years, Giffen says, and from the firm's perspective, it won't make sense to support multiple vendor relationships. Increasingly he sees firms maintaining relationships with fewer providers, even while technology firms create customized interfaces to those trade routing systems.

To make the best technology and broker decisions, DeVault says you should first define the edge you think you can exploit, the time frame you will use to make your trading decisions and the kinds of analysis you need to do. "There are brokers who cater to extremely short-term trading and they do that by having a lot of investment in execution speed. There are other brokers that cater to people who trade small accounts and want to exploit extraordinary amounts of leverage." But it's up to you to decide. "Once you have determined what edge you are trying to exploit, only then can you pick an appropriate broker and trading solution," he says.

Note: This feature length cover story by Chris McMahon originally appeared in the November 2008 issue of Futures Magazine.

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