The evolution of the markets has always been tied to the speed of transmitting information. Market participants wary of trading on outdated prices have relied on everything from carrier pigeons, trading pits, and telegraph lines to co-location, FPGAs, and microwave transmission to obtain the timeliest data.
Running alongside that history is a related trend: Technological advancements disrupt the market and are at first monopolized by a few powerful players. Specialist vendors then productize the technology and distribute it more widely to firms of all sizes, allowing those firms to sidestep a lengthy, expensive, and risky R&D process to focus instead on their strategies.
In this article, we will show how low-latency technology periodically disrupts the markets, giving new players a chance to compete and succeed. Exegy has been proud to be a part of that history with our introduction of low-latency market data technology. With our latest entry, the Xero Volatility Trading Engine (VTE), we’re applying that creative disruption to the trading platform itself, making ultra-low latency available to more participants in options market making.
Electronification and the Latency Race
Market information has steadily gotten faster and more precise, but in the past 50 years, that speed has accelerated exponentially. At a time when large institutions dominated the markets, the 1971 creation of Nasdaq as an electronic venue made it possible to trade stocks faster than the open outcry pits of the major exchanges.
By electronically linking securities market makers through a computerized quotation system, Nasdaq allowed information to be disseminated more equally to a larger group of participants, leading to more competitive quotes.
In 1984, Nasdaq started the Small Order Execution System (SOES) for retail investors. It offered immediate execution to electronic traders placing smaller orders at the market makers’ quoted price. This placed the retail orders ahead of those being entered by market makers and large institutional investors.
The system began to be leveraged by SOES investors, who created electronic communications networks (ECNs) and optimized their own infrastructure to act on mispriced orders. Speed, co-location, and automation all played a role in creating prime opportunities for latency arbitrage—using timely price information to reap alpha ahead of slower firms. In the late 1990s, the SEC enacted order-handling rules that required Nasdaq to display ECN-listed quotes that fell inside the spread. This development further leveled the playing field for firms who could access the networks. It also created efficiencies; the average proportional bid-ask spread on Dow Jones stocks dropped by two-thirds between 1990 and 2000.
The SEC’s 2001 requirement that exchanges convert stock prices from fractions to decimals effectively lowered the smallest price increment from 6.25 cents to 1 cent, creating an opening for firms that could exploit those incremental price improvements across millions of transactions.
This helped lead to the heyday of high-frequency trading and an explosion of innovation. Improvements were made to infrastructure linking major trading centers (New York-to-Chicago, London-to-Frankfurt, etc.). Transmission moved from copper cables to fiber optics, then to line-of-sight microwave links. Individual firms focused on improving tick-to-trade latency through innovations such as network optimization and purpose-built hardware using Field-Programmable Gate Array (FPGAs) devices. Exegy was at the vanguard of companies that helped make this technology available in the mid-2000s, offering FPGA-based ticker plants as a managed service to firms unwilling or unable to expend resources and time on in-house solutions.
The Maturing of HFT—and the Shift to Volatility
The initial effect on the markets was immediate: High-frequency trading (HFT) took up a greater and greater share of trades. From 2005 to 2009, HFT went from about 20% of all US equity trading to more than 60%.
But as the technology was more widely used, margins got thinner, and it became more difficult to realize alpha. Rising market data and connectivity fees, a growing number of exchanges to deal with, and of course, keeping up with improvements to the technology added more financial pressures. The race to chase down precious microseconds continued, but at great expense usually only achievable by the most well-funded firms.
Volatility and Risk
While all this was going on, the stage was being set for volatility trading to become a focus of HFTs.
In the wake of the 1987 Black Monday crash, large investors began trying to estimate their daily risks of loss, based in part on the historical volatility of the market. Volatility became more intertwined with measuring risk, using options and other derivatives instruments. Options pricing models such as the Black-Scholes model include volatility as a measure. Innovations such as the creation of the VIX (in 1992), variance swaps (in 1993), and tradable VIX futures (in 2004) all were based on derivatives. While their original use may have been in risk management, market participants soon were looking for ways to employ them to capture alpha.
Combining Ultra-Low Latency and Options
VIX products and strategies have come to dominate the public perception of volatility trading. But in fact, there are many volatility strategies firms can employ, including volatility arbitrage, mean reversion, pairs trading, and dispersion. An individual firm might have a portfolio of go-to strategies that it has refined for use with its specific volatility plays.
The feature they all have in common is their complexity—both financial and technical. As we noted in our introduction to volatility trading, tracking prices for all the derivatives involved requires the computing capacity to process changes to tens of thousands of bids and offers (which themselves can change thousands of times a second) to avoid falling victim to mispriced quotes.
Until recently, this type of sophisticated sub-microsecond trading technology required substantial financial investment and development time. HFTs, searching for more profitable outlets for their expertise, moved into this space, eventually driving other firms out of options market-making. Many existing firms assumed more defensive volatility strategies, narrowing their trading opportunities.
The required technology investment also served as a substantial barrier to entry for new firms, even those with the financial sophistication to devise profitable strategies and effectively manage risk.
There is reason to believe that many companies would like to participate more fully in the volatility trading market. Hedge funds in particular are looking for places to deploy capital but have been held back from volatility trading because they lack the technology to do it efficiently and at scale. In addition, the testing period of trading technology development involves risks that firms would have to assume.
Enter Exegy’s Xero VTE
Exegy developed the Xero Volatility Trading Engine to directly address this gap in the financial technology market. It allows firms to compete on their trading prowess and to enter the market on an equal or better technology footing than the firms that dominate the market today.
As a turnkey solution, Xero VTE provides the foundational building blocks for your firm to pursue the most sophisticated real-time strategies. A comprehensive suite of algorithms can be selected, configured, and controlled through easy-to-use interfaces that can represent any of your strategies in the market, while keeping them confidential.
To build Xero VTE, we’ve used the ultra-low latency FPGA technology that gives our Exegy Ticker Plant its unparalleled speed and capacity to create the fastest commercially available hardware trading platform.
Configurable canceling algorithms provide fiber-to-fiber tick-to-trade latency of less than 120 nanoseconds, while more complex mass quoting (making) and aggressing (taking) algos have tick-to-trade latencies of under 250 nanoseconds.
Designed for high-capacity and scalability, a single appliance can support more than 64,000 contracts and multiple appliances can operate in parallel to trade every contract on every market. Currently certified for the Chicago Mercantile Exchange, it will be available soon for use on other US equity options exchanges.
As the history of the markets has shown, the first firms to move on an innovation stand to reap the greatest rewards. Exegy’s Xero VTE allows your firm to be one of those first movers in this new options ecosystem. Experience the benefits of the power of Xero VTE, and the resulting increased profitability to your bottom line, by contacting us today.