Liquidity is King
Liquidity is a vital, if nebulous, conundrum. For a securities exchange, it is of the essence. Traders love it. Corporate issuers consider it crucial when choosing where to list. Yet at times it can depend on nothing more substantial than market sentiment. It is proverbially ‘sticky’ – liquidity attracts liquidity, yet it can ‘dry up’ without warning. There when you don’t need it, liquidity is often missing when you do.
As electronic trading matures, markets become highly competitive and global. Liquidity too becomes more mobile, shifting intraday from one venue to another. ‘Risk-on’ or ‘risk-off’ sentiments then drive global flows of funds to raise or lower prices across entire markets. Understanding where liquidity comes from has become a key success factor in today’s global financial markets.
The ongoing financial crisis has created a liquidity squeeze and driven market participants to look at innovative ways of working as they strive to stay ahead of their rivals. Growing competition, convergence and collaboration between trading venues are forging new ecosystems within the electronic trading community, and these ecosystems are driving liquidity around markets.
Electronic trading works in much the same way as a traditional market, with towns looking to set up stalls (trading venues and exchanges) in order to attract a variety of different store owners (traders) to set up their business for consumers to purchase goods (stocks). Stall holders would be attracted to a critical mass of customers, while the customers themselves would be able to do all their shopping in one place. While we now have automated trading systems to do the work for us, these systems have the same need to be in close proximity to both buyers and sellers – global financial centres.
The volatile trading world is populated by a variety of operators with different business models, but they all have one thing in common: a demanding list of services that they require from their exchanges. The boundaries of a modern exchange business are limited only by imagination and opportunity, and so they must offer everything from post-trade processing to proxy voting for corporate issuers, plus direct feeds for all.
A High Speed Market
Electronic orders can now reach most global financial centres in the blink of an eye, providing they have access to the right networks. An alpha signal, such as a macro economic news release in Washington, London or Tokyo, can now reach waiting matching engines in Chicago, Frankfurt or Hong Kong in just a few hundred milliseconds, including all of the related news analytics and algorithmic trading arbitrage. Prices move quite suddenly and subsequent trading continues at the new level. Only when the news falls outside the expected range of analyst opinion is the volatility likely to linger for seconds, minutes or even hours. The markets have shifted up a gear, so the agile exchange business needs to do likewise.
But the hard truth is that no network is truly global, and transit times vary enormously depending on the physical topography and technology deployed. Therefore, most financial networks are built on high-speed, secure, financial extranets with typically a few thousand end points at most. If traders wish to access local brokers in emerging markets, very few local telecommunication carriers are likely to be capable of reaching them. When capacity is scarce and demand limited, premium prices rule.
To access electronic markets, brokerage houses and service providers have created global connectivity networks to offer traders increased visibility, lower execution latencies and a greater diversity of choice for both ‘lit’ markets and ‘dark pools’. In turn, market participants and their supply chains have co-located in metro trading hubs, creating financial ecosystems built around network-neutral data centres in proximity to the main liquidity venues in order to share costs and reduce time to market.
In this sense, a trading hub is like a supermarket while local brokerages are more like neighborhood shops; while trading is still possible from the peripheral stores or branch line exchange, it is less connected and offers limited selection, while the main market has much more retail space and offers many more options to connect. In areas where networks are driven by competition and volume, costs come down and the essential commodity of liquidity is increased.
One of the key challenges for modern exchanges is to look past the top order flow providers – brokers like Barclays, HSBC and Morgan Stanley – to those further upstream, typically the buy-side of the asset management firms. As these actors balance and rebalance their portfolios, they drive the trading – it is thus crucial for those executing trades on the exchange to have good connectivity to these asset managers, such as pension companies.
Similarly, exchanges must look beyond the first rank of downstream market data providers such as Thomson Reuters and Bloomberg to those further along in order to be better informed about market demand. These second-rank downstream companies help normalise the data coming out of exchanges, adding great value for trading firms by analysing, formatting and aggregating the data across multiple exchanges. They blend in pertinent external newsfeeds such as central bank announcements or information from an area of government, such as an energy ministry, which might impact on an area of trading. It is this process of enriching the data stream with added knowledge, combined with the speed provided by low-latency networks, that gives traders the confidence to execute trades and thereby leads to liquidity.
A Road Map for Maximum Order Flow
To complete the road map of activity that traders need to succeed, market operators should assess their requirements and strategy options against different risk and opportunity scenarios to determine the optimal positioning for matching engines and customer access nodes. Ecosystems span multiple data centres and geographies, so given the pace of change in today’s market structures, it is vital to model the impact of such scenarios.
Maintenance of liquidity requires investment. If financial traders do not invest in colocation with the trading venue’s own matching engines or network access nodes, they are set to lose their battle for liquidity. It is in this context that network-neutral data centres can make all the difference. The lesson to trading firms is clear; to increase your chances of benefiting from liquidity, co-locate in a data centre ecosystem.
[In order to better understand the source and flows of liquidity, Equinix’s industry white paperexplores how connectivity and proximity to markets can help drive liquidity for securities exchanges, traders and corporate issuers.]