Jul 31, 2018
Eurex | Eurex Clearing
The art of designing markets. Part II
Market design recognizes that well-functioning markets are more than the confluence of supply and demand. They depend on detailed rules. Market designers try to understand the rules and procedures as well as the workings and requirements of particular markets well enough to fix problems or to build completely new markets when they seem promising.
This is the second article in a series of topics related to the market design of electronic market places. This time we are covering the various components of an order-generating process in regard to defining its arrival time. The first article discussed the most common execution models in electronic derivatives markets. It explained that the arrival time of an order/quote in the order book, where the matching takes place, could have a significant influence on the probability of an order being executed as desired. The arrival time is obviously influenced by the path an order/quote takes into the exchange, i.e. its connectivity path. However, exchange connectivity is for most orders only a small part of the overall drivers of the arrival times. Therefore, before we can dive deeper into the connectivity subject, we first need to explain the various components of an order-generating process defining its arrival time.
Randolf Roth, Member of Eurex Frankfurt Executive Board, responsible for market design
Timing and speed matter for all market participants
As to what degree and in which form is mainly a function of the investment horizon. For an institutional investor with an investment horizon of months or years, the timing of an order is mainly a function of minimizing market impact rather than being as fast as possible. Consequently, larger orders may be executed over hours or even days. At the other end of the spectrum are liquidity providers in derivatives who may change their prices with every single price movement of the underlying – sometimes several times per second. Independent of which type of participant sends the order, the order submission to the exchange can be clustered into three steps:
1. Receive order-triggering information: In the example above, the long-term investor may decide to send an order on the basis of some fundamental research or information he receives from an analyst call or simply by the arrival of new money in the fund, which needs to be invested. In contrast, the speed-sensitive liquidity provider will be triggered even by the price move of a small underlying or another reference. He will respond immediately as he has otherwise outdated prices in the market, which can be seen and taken advantage of by any market participant. Consequently, he will already optimize the speed at which he receives the triggering information. This results in the liquidity provider ordering the fastest data feeds such as Eurex Enhanced Order Book Interface (EOBI) and Enhanced Market Data Interface (EMDI) or significant investments in cross-market place or even cross-continent connectivity outside the exchange as markets are globally connected.
2. Generate the order: Both the long-term investor and the liquidity provider need to translate the triggering information into a concrete order, defining all relevant order parameters. In the case of the long-term investor, that may be a process involving interaction with other humans discussing the overall strategy, risk appetite etc. and therefore takes a while. In sharp contrast, our liquidity provider will have an automated algorithm that generates the order within nanoseconds (10-9 seconds) of receiving the order-triggering information. This does not happen in his office premises but in the co-location center of the exchange – which is where he also receives the order-triggering information extremely fast.
3. Sending the order to the exchange: Our institutional long-term oriented investor will submit the order to his broker – who is typically an exchange member – electronically or via phone/chat. A major driver for the path to the broker and beyond to the market place is the size of the order. If it can easily be executed in the exchange’s order book then the order is most likely routed electronically via the broker’s Direct Market Access (DMA) or Order Routing offering to the exchange’s order book. This will take less than a second. Alternatively, if the order is large, it may be sliced over time or market places by the execution algorithm of the broker or it may even be negotiated outside the order book via telephone. For this process, the also timing matters, but it is a different quality of time. The main goal is to minimize market impact rather than being as fast as possible. In contrast, the liquidity provider will send their order as fast as possible from the co-location center of the exchange to the order book where it arrives within microseconds (10-6 seconds).
It is only in the third step where exchange connectivity plays a part. In the next article, I will discuss the connectivity element for market participants who are not members of exchanges, typically institutional investors, covering DMA and Order Routing. Thereafter, we will dive into the connectivity options for members and the methods deployed by an exchange like Eurex to manage connectivity for the speed-sensitive participants in order to generate a level playing field of fair and transparent markets.
