Check your speed

How relevant is the current focus on low latency to buyside traders, asks Robert Flatley, global head of Autobahn Equity at Deutsche Bank.

In this fast evolving marketplace where buy-side traders are constantly looking for ways to add value to their execution process, and with low latency services such as high speed market data, proximity hosting and colocation now being offered by exchanges and service providers alike, just how much focus should be placed on speed? Is a sub millisecond difference in transaction speeds between local market participants and market data and execution venues relevant? What is the impact of new execution venues and liquidity fragmentation, and how do these low latency services benefit the buy-side and hedge fund community?

What does speed mean to traders?

To understand what latency means to the buy-side trader and the benefits that low latency services have to offer, we need to begin with the trading objective. Latency will be of significant importance if the objective is to capture a spread at a point in time. In the context of best execution, speed is relevant but it is not the only contributor to achievement of the goal.

Based on these objectives, the buy-side community can be split into two broad categories: arbitrage driven and fundamental driven.

Arbitrage driven trading is focused on market data and information. Complex quantitative models are designed to capture temporary opportunities in the marketplace. This trading technique is specifically designed to capture alpha, which can erode within milliseconds. In many cases these models have optimised everything in terms of throughput capacity and the ability to react to changes in information and trading opportunities. At this point of parity, the trader will be left with basic physics – he will have to turn to faster response times rather than changes in information for alpha capture. As latency increases with distance, locating trading technology close to the market centre is the obvious next step in minimising alpha erosion. And at what point does distance make a significant impact in terms of latency? An additional source of arbitrage may be targeting the trading venue itself – by trading the faster venue in order to optimise the relative differences in speeds.

Fundamental trading is opportunistic – unlike the arbitrage-driven trader, the fundamental trader’s main concern is about participating in a fragmented market while minimising impact and delay cost. Most orders are duration orders which may potentially be on the order books right the way through to market close. Alpha erosion over the course of the day is of more importance than split second speed. While latency is not of primary concern, speed is still a key component of best execution and ensuring the capture of liquidity at the best available prices. Venues that enable anonymous trading are becoming more of a feature in this environment, and can be seen in the recent proliferation and popularity of dark liquidity pools. In order to meet their trading objectives, fundamental traders require a solid understanding of order placement methodologies and their broker’s infrastructure and technology.

The impact of regulations on speed

From the introduction of the first telephone onto the trading floor of the NYSE in 1878 to the present day focus on sub-millisecond transactions, speed has always gone hand in hand with technological advancements in the marketplace. Latency improvements from various sources: physical infrastructure (machines at the application layer are getting faster, down to the transport, network and physical layers), coupled with technological advancements (with the move from floor to electronic trading and high speed market data), has led to the development of sophisticated low touch/ no touch trading strategies.

But the velocity of change is increasing, due in part to changes in the regulatory landscape. The impact of MiFID in Europe and Reg NMS in the US on the market structure is well documented. In Europe, market fragmentation brought about by MTFs, coupled with the opening up of sources of market data dissemination and distribution, and the massive shifts in liquidity seen in the US over the last 18 months, mean that smart order routing, market access and low latency services such as proximity hosting need to be revisited and clearly understood.

Co-location vs. proximity hosting

Co-location reduces the physical distance to the exchange to zero by physically placing the hardware (trading engines and algorithmic servers) at the exchange, whereas proximity hosting involves broker and client locating their hardware in the same hub, but not physically at the exchange itself: e.g. locate in London (proximity) versus at the LSE (co-locate). Proximity should in theory be near enough to the required trading venues for the latency impact to be equivalent to that of a colocation solution and provides the added benefit of the ability to connect to more than one venue.

For the arbitrage trader, colocation becomes problematic in a fragmented market as managing orders across multiple order management systems deployed to each market center’s co-location site adds significant operational complexity and risk versus low millisecond to microsecond difference in order transit time from a single proximity center and single order management system to each market center. Putting all your eggs into one basket by co-locating at a single exchange would mean losing out on liquidity as it shifts venues. In Europe, where the primary exchange will no longer be obvious in a post- MiFID environment, co-location would potentially be required at multiple sites. In addition, it cannot be assumed that all exchanges will offer this service. Proximity hosting therefore appears preferable by offering a point of equidistance between all of the target venues.

While latency is clearly of key importance to the statarb trader, it is less relevant to the profitability of the fundamental trader’s strategy. Unless a low latency solution is coupled with sophisticated order placement strategy, it does not guarantee participation in as much trading volume as possible. In-line with the trading objective, venues that enable traders to execute size with little impact are popular even though they are not necessarily fast. For these traders, proximity hosting and co-location has less relevance, while placement strategy is key.