First published in Börsen-Zeitung on 28 June 2019
The derivatives industry – which often has the reputation of being a rather dry and analytical undertaking – has been going through a quite emotional phase for some months now. This has been triggered by the plans of several stock exchange operators to introduce speed differentiation in some market segments, which slows some of the orders entered.
Eurex has been a pioneer here. Three years ago, we started looking at the topic of speed and analyzed its role in the order books of our large product portfolio. The result: in some market segments, the speed race has reached its limit because it no longer increases liquidity or the efficiency of pricing.
Interaction of different actors
But one thing at a time: Basically, the issue of speed plays a role for all market participants - to what extent is merely a question of the investment horizon. For a long-term institutional investor, the speed of order execution is primarily a question of minimizing the market influence of the order. Therefore, these transactions are executed over hours, sometimes days.
At the other end of the spectrum are the market makers, who, with every price change of the underlying of the respective derivatives, sometimes change their prices several times per second. Market makers provide liquidity and serve the end customer – this could be, for example, our long-term institutional investor – by enabling them to trade the hedging instruments they need to efficiently manage the risk profile of their portfolios at any time.
An exchange like Eurex thrives on the interaction of the various market participants with their different investment horizons. When I think back to the discussion of recent years about high-frequency trading, I am always surprised by the prevailing black-and-white attitude. After all, speed is not good or bad per se, and is only partly a matter for the stock market. Because basically every order goes through three phases.
The first is receiving the information that leads to a transaction decision. For our institutional investor, this could be new cash inflows or information from an analyst rating. In the case of the market maker, short movements of the underlying trigger actions, as they must ensure that they does not have old prices in the order book. Market makers therefore already maximize the speed at which they receive information.
The second phase is order generation. For many end customers, this initially requires human interaction when discussing strategy or risk appetite, for example. The market maker, on the other hand, has an algorithm that generates an order within nanoseconds.
We only come into play when the order is sent to us. The institutional investor does this electronically or verbally via his broker. The market maker, on the other hand, sends his order within microseconds.
A heterogeneous, healthy market structure emerges when different trading interests meet with their different time horizons, because then everyone can find their counterparty.
Market makers, as described, need a low-latency environment to pursue their business model - and it is they who provide prices to funds administrators, insurers and pension funds as counterparties. Our role as exchange operators is to ensure that the rules of the game are fair to all market participants. We achieve this through various security mechanisms and regular communication with our participants, regulators and trading supervisors.
Speed also has its limits
While reviewing our various market segments, we found that the speed of the options markets has reached its limit. In this area, market makers must recalculate option prices each time the price of the underlying security of the option changes and, if necessary, update their prices in the market accordingly.
Because this process takes longer than generating faster, individual orders that trade against the original, now outdated market maker prices in the order book, all market participants who provide liquidity to the market were at a disadvantage. We eliminate this disadvantage by minimally delaying the speed of all aggressive orders, i.e. orders that immediately lead to a trade when they arrive in the order book. This enables market makers to provide investors with a better liquidity picture.
First, we introduced this speed differentiation – in the form of Passive Liquidity Protection (PLP) – for German and French equity options.
Now, for six months, we will be taking a close look at whether the speed differentiation is having the intended effect and whether liquidity in the order book is increasing. We will talk to both market makers and long-term end customers about this. And then, in line with the market, we will decide how to proceed – objectively and transparently based on facts. The aim is to further develop our marketplaces to meet our mission as a publicly regulated exchange in the best possible way. And that is to design efficient and robust markets with equal treatment for all participants.
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