Q&A interview with Chi-x: The trading revolution

A rash of new execution venues in Europe, with Chi-x, Turquoise, Bats and many others challenging the supremacy of the old incumbent national exchanges, is causing a revolution in trading and a Darwinian fight for volume and survival. Neil Ainger interviews the respective CEO and COO of Chi-x, Mark Howarth and Hirander Misra, to find out if there is room for all these players, and who'll have the technological speed, capacity, or continuity edge

Q. How do you think the execution marketplace has changed since MiFID allowed more competition and do you think the revolution in Europe will mirror that of the US with initial fragmentation, then consolidation. Is there room for all of you?

Mark: I think we've had a structural shift with multilateral trading facility's (MTFs), such as ourselves, coming into the marketplace. The cost structures that we've brought to the European trading venue marketplace - and the way that we've taken out many of the cost inefficiencies that the old national monopoly stock exchanges previously had - has encouraged change, and assisted the rise of algo trading arbitrage strategies. This change is now impossible to roll back.

We're already starting to see a mirror of the trends that electronic communication networks (ECNs) caused in the US, so yes that's definitely happening. There are few things to bear in mind though; one is that the overall size of trading in the European markets is only about 14 to 15 per cent of the size of the US markets - even allowing for demographic differences, that's a significant delta. A lot of that is due to structural inefficiencies in the European marketplace. The EU's Markets in Financial Instruments Directive (MiFID) regime is starting to remove some of these and allow proper competition. If you surmise that the cultural differences account for say a 2 x differential that still means European markets are going to increase two/three or even four times over the medium-term, just to get to some sort of continent-wide equilibrium.

Q. What about market share? According to the Federation of European Securities Exchanges March 2009 figures on order book equity trading, featured in our May-June stock exchanges feature [see HERE], Chi-x was the leading MTF with over 10.5 million trades, with Turquoise on 3.4 million. How far can you and other MTFs go in challenging the incumbent exchanges?

Mark: We've seen market share move across from the national incumbent exchanges to the new MTFs. In the continental European marketplaces, MTFs now collectively take over 20 per cent of the flow. In the UK market, it's 30 per cent. Chi-x was larger than Deutsche Börse's for the whole of last week, for example, and the trend is upwards for us. There hasn't really been a notable response yet in over two years of our existence. The most interesting thing on the horizon is possibly the Xetra International launch [in Q4 this year] where Deutsche Börse are intending to start an MTF even after earlier decrying MTFs as parasites upon the marketplace!

If you look at NYSE in the US for trend comparisons - I believe it's more illustrative than looking at Nasdaq - you'll see that there was a distinct ramping effect at around 30 per cent - i.e. when its own marketplace reached below 70 per cent for the first time there was an acceleration. The ECNs market share kicked on again, then levelled out at approximately 40 per cent, leaving NYSE currently with just over half of its own listed stocks. My view is that we'll see that trend being mirrored in Europe.

Q. Can you tell me about your technology, its latency, capacity and if it can cope with the growth you're hoping for?

Hirander: We build all our technology in-house. It's scalable because it's built on commoditised hardware with very adaptable software components. When we started out over two years ago we had a capacity of 30,000 messages per second in our core matching engine capacity, then we went up to 75,000 - this is via code and software optimisation - and, most recently this year, we've gone up to 225,000 messages per second. In terms of utilisation rates, so far this year our peak day has been about 40,000 messages per second so, as you can see, we've got a large amount of 'headroom' [i.e. room for growth].

All this is on a single fully redundant matching engine, running primary with a backup business continuity capability - we can keep optimising this but after a while you will hit a limit. But there are things we can do beyond this - additional instances of the matching engines can be introduced, for instance, and we can do alpha split. This involves allocating a certain letter of the alphabet so you use this matching engine, while for that letter of the alphabet you use this engine. With this setup capacity is very very scalable, even beyond the constraints of optimising the code as we have been doing so far.

Q. Can you give me your latency figures?
Hirander: We've got some high frequency customers who are co-located right next to our trading engines in our primary data centre and they're seeing roundtrip latency times of 400 microseconds, that's 0.4 milliseconds, average latency under existing loads. You can obviously optimise this even further but I wouldn't like to be quoted on actual numbers as its commercially sensitive information. When we launched, more than two years ago, we started off at 10 milliseconds, then went below one and are now at sub half a millisecond speeds, so we're happy. There's more to come as well, although speed of light [i.e. cabling and connectivity limits] is the ultimate constraint.

Q. By the way, can you say where your primary data centre is?

Hirander: Yes, it's an Equinix facility in Slough - there's additional space and power there as it's out of town. You can't necessarily get that in central London.

Q. I suppose the laws of physics apply to latency and eventually, when you get fast enough, quantum physics come into play?

Mark: [Laughs] Actually you do, you start to get quantum effects - i.e. you've traded before you sent the order for instance; that kind of stuff! As soon as you start getting down to nanosecond scale events, several times over the order of magnitude of the speed of light, the engine room becomes enormously difficult to manage - for example, just synchronising the machines up gets very very hard.

Hirander: Time synching and time stamping is actually a very important point. We've got many participants connecting in and latency is vital to them. We need to ensure that they're totally aligned with our clock to ensure that they get the benefit of being so fast. The industry is getting to that level of technicality now, that's why we take time stamping so seriously.

Q. Are you expecting a fightback from the incumbent exchanges? The LSE has invested in its TradElect platform, for example, which although it has suffered some continuity and technical problems at least shows a response; NYSE Euronext has its Universal Trading Platform (UTP); and various other exchanges have responded

Mark: Eventually they will have to respond competitively but I don't believe they've truly done so yet. They seem to be taking a long time to do it as well, and I think that's because they didn't initially take the MTFs particularly seriously. Now that Chi-x has been in business for over two years and the other MTFs have come along too, collectively becoming significant players, a response is necessary but a notable one hasn't materialised. As I mentioned earlier Deutsche Börse's Xetra international MTF is an interesting development on the horizon, but all it really does is show that they're finally ratifying the MTF business model.

Hirander: The MTF business model has been further enhanced by other recent launches, such as the Euronext smartpool [offering dark non-displayed liquidity], and by other players - showing it simply works! It is, of course, an instance of yet another 'me too' business model though. We were first and we have the first mover advantage - we're certainly innovating and trying hard to retain that edge. The good thing is competition has led the traditional exchanges to try and innovate. For all too long they didn't do a lot in terms of introducing new products and innovations; the changed circumstances post-MiFID has forced them to alter their plans and the marketplace will benefit as a whole.

Q. Are you expecting further aggressive price cuts from the traditional exchanges in the future in order to better compete with you and other MTFs?

Mark: Well, it's interesting because traditional exchanges have validated the MTF business model [by launching niche offering themselves like smartpool] but they won't talk about the pricing seriously yet. Are they going to follow the MTF [i.e. cheaper] pricing model for their own MTF offerings in this area, in which case why can't that pricing be applied to their national exchanges, or are they going to follow their national exchange prices in their MTF-type offerings, in which case what's the point? It's an interesting conundrum that each incumbent exchange needs to navigate their way through.

Hirander: The key issue on pricing is that we were 90 per cent cheaper when we came into the market a couple of years ago, and we're working hard to maintain our advantage. I don't know if you saw a recent TowerGroup research report, authored by Bob McDowall, on pricing but it was clear from that, that we offer a very good deal and are the cheapest of the new entrants [see the FST feature on exchanges from the May-June09 edition, containing this report, HERE, and judge for yourselves].

What you've got to remember when it comes to pricing is that we've got about 32 employees, while the LSE have got more than 1,100 people, after the Borsa Italiana integration. It makes sense therefore that we can run at much lower costs and on much lower margins, in terms of trading fees and the services that we offer. The exchanges find it difficult because of their established cost base; that's the key issue. Also, a lot of them buy in the technology now [rather than build it themselves] and that's expensive.
[NOTE: the LSE has recently announced it is cutting 120 jobs - see HERE]

Q. What's next for you? I noticed the Chi-x Delta dark facility went live this spring. Can you give me an overview of that and your hopes for it, plus anything else on the horizon?

Hirander: We've got over a hundred participants live on our platform as I speak now, with multiple vendors as well, so we've got the largest network of all the MTFs. It's a case of now leveraging our established community, and differentiating with new products. On our new Chi-x Delta dark facility you can leverage all of our existing connectivity, our existing legal agreements, clearing framework, and so on. It's effectively 'plug and play' with us, with only very minor changes required. We can easily leverage liquidity into Delta using our established 'lit' base.

We do believe in the lit book - and obviously that overrides everything we do - but trade sizes have generally been falling as participants are wary of 'moving' the market; some participants however still have large sized trades they want to get done without alerting others to their actions, and this is where a dark pool of liquidity can help. In addition, another driver for dark liquidity is that capital is more expensive now [post-crunch] so broker-dealers are taking less and less on risk, and therefore need an ability to find a natural match on the other side, discovering liquidity - this is where Delta can help. Broker-dealers can execute trades on our lit book but also find natural counterparties on our dark book - the two exist in parallel. Of course, execution costs on both, in my opinion, are very low.

Q. Any other new launches?

Hirander: Sponsored access is another big thing for us, which launched this spring. This ties into co-location / proximity hosting services. It gives certain customers, especially high frequency customers coming over from the US, who might not necessarily know the market micro-structure in Europe, the ability to connect directly to our platform but trade in the name of their trading participant, so it might be one of the banks that sponsors and their prime brokers. We provide the central monitoring risk management controls, so these firms have an environment in which they can trade but they overcome any latency overheads by connecting directly. The key is you don't have to go through the broking systems and then into Chi-x [cutting latency]. It's been a very well received product and there are a number of prime brokers now looking to go live with their participants right now.

Q. For my own clarity they're going to come straight to you, rather than going through the dealer network to adversely affect speeds, but they're sponsored by the bank in doing that.

Hirander: Spot on. What changes is the technical connection; the legal framework remains exactly as it is today. We have a relationship with the bank or the prime broker and they have a relationship with the client but technically they can come straight in, minimising latency.

Q. Finally, is there anything else you'd like to add? For instance, how will the changing clearing & settlement landscape affect you? We've had Giovanni, the EU Code of Conduct, T2S and various changes that collectively will have a revolutionary effect further down the line in the trading procedure, perhaps mirroring the fragmentation and latter consolidation changes seen in your own execution space

Mark: We're already seeing this. This year is definitely the clearing year. If the past couple have been the execution years, in 2009 it is clearing's turn in the limelight.

Hirander: Trade sizes are falling so clearing is now a higher proportion of your overall costs - we've still therefore got frictional costs. The more cost is removed, the more that firms who are sensitive to price can continue to trade.

We announced recently three-way interoperability. We've live with EMCF [the Dutch clearer who is Chi-x's partner] at the moment, but in Q3 this year, around about when Sibos will be, we'll also be offering SIX x-clear and LCH.Clearnet to our participants. We'll be the first trading venue to actually offer three-way clearing interoperability. [As an illustration of the changing clearing space the battle for control of LCH.Clearnet, involving DTCC, ICAP and others, shows how the post-trade space is now perhaps beginning to mirror the changes seen in the exchanges space - Ed].

Of course, the LSE have currently got two-way clearing and Swiss Exchange have got two-way, but I believe our three-way offering will really give our users choice. As I mentioned earlier, the cost of capital is expensive at the moment so we'll be allowing customers to choose a central counterparty (CCP) that suits them. They'll benefit from cheaper margin costs because they will be able to offset margins, gaining cheaper overall clearing costs because you can net off business [i.e. play clearers off against each other, or target effectively based upon who's got the best deal, where, at what volume, etc.]

It's down to the three clearing companies to work out the technicalities and ensure interoperability is possible. Chi-x's role is to say 'this is what the industry wants. We've got 100 participants who are demanding interoperability because they've seen the cost of trading come down [with more competition], so now it's clearing's turn'. Naturally, there's still a lot of work to do on our side as well. Technical connectivity to each venue has to be undertaken, there's a lot of standardisation work to do, plus operational processes need to be standardised as well, to encourage interoperability in the clearing space.

EMCF is our partner, but obviously - horizontally - we want all the key CCPs there in our offering. We'd like to see equal competition in the clearing area generally. We'd also like to see the likes of the LSE give up their trade fees to EMCF and other CCPs.

Mark: For the moment, EMCF have a couple of options that our participants can try out, so they can tailor their clearing costs slightly more to the way they trade. Change is on the way in the clearing space though, just as the exchanges area has been revolutionised, so will it too.

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