FINANCIAL TIMES SPECIAL REPORT | Wednesday November 3 2010

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EXCHANGES,TRADING & CLEARING

Caution the byword asBeijing looks to futures

When it comes to equitymarkets, China never doesanything hastily. So, beforeBeijing introduced stockindex futures trading on themainland, it set up anexchange that spent morethan three years practising;sent regulators to tour thecountry educating potentialinvestors; established a 30-minute examination inves-tors must pass before theyare allowed to trade;insisted on high deposit andmargin requirements; andbanned foreigners from tak-ing part.

Then last April, Chinafinally passed an importantmilestone on the path tobeing a market-driven econ-omy by announcing thestart of stock index futurestrading in mainland China.This is part of a broadertransformation of mainlandmarkets that has alsoincluded the introduction ofa pilot programme of shortselling and margin tradingof equities this year.

Trading began with con-tracts based on the CSI 300index, which tracks theShanghai and Shenzhenmarkets. Only investors

who maintain a minimumdeposit of Rmb500,000($74,845) are allowed totrade, and there is a 15-18per cent margin require-ment.

The rules were designedto keep out the small retailinvestors who are the life-blood of China’s markets –but also the most specula-tive investors.

Regulators say such toolsare crucial to allow tradersin China to profit from fall-ing as well as rising mar-kets, and to hedge theirpositions against down-turns in China’s notoriouslyvolatile markets. The ulti-mate goal is to improve cap-ital allocation in the Chi-nese economy, and bringthe Chinese stock market

closer into line with west-ern norms – part of a driveto transform Shanghai intoa global financial centre by2020.

But introducing indexfutures made the regulatorsnervous. Commodities suchas gold, soyabeans and fueloil have been traded in Chi-nese futures markets foryears, but these are the firstfinancial futures to betraded in China since themid-1990s, when the govern-

ment bond futures marketcollapsed just two yearsafter it started as marketmanipulation spiralled outof control amid a lack ofregulatory oversight.

Regulators were notgoing to make that mistaketwice, so they have kept aclose eye – and a firm hand– on trading of indexfutures.

Volumes in the early dayswere huge, but governmentofficials became concernedthat investors were usingthe contracts mainly tospeculate rather than tohedge risk. Volumes havefallen since then – nearlyhalving between July andSeptember – and officialsnow say the market isdeveloping well.

Regulators say there is nodoubt that financial futurestrading will be expanded –and many local analystsexpect foreigners to beallowed to trade indexfutures soon.

Over time, barriers toentry may be lowered. Butfor the moment, risk pre-vention remains the top pri-ority.

“Derivatives like futuresare a double-edged swordthat is not only a tool tomanage risks but is also asource of risks unless it isused appropriately,” thePeople’s Daily said whenfutures were launched inApril.

Caution is likely toremain the byword for sometime to come.

ChinaA ban on tradingby foreigners mayend soon, saysPatti Waldmeir

Region in f lux asbourses fragment

The fragmenting of stockmarkets away from tradi-tional exchanges is spread-ing quickly to Asia fromEurope and the US, shakingup the region’s sedate insti-tutions as it does so.

Change is everywhere. Inthe latest shock to the sec-tor’s system, the SingaporeExchange has offered $8.3bnto acquire the AustralianStock Exchange, largely asa way of gaining scale andprotecting against maraud-ing alternative exchanges.

Until recently, such a bidwould have been unthinka-ble, because Asia waslargely protected fromemerging alternative plat-forms by its patchwork ofnational regulations. As aresult, traditional nationalstock exchanges still have afirm hold – unlike theircounterparts in London andNew York.

Yet Asia is now theworld’s second-biggest secu-rities trading region afterthe US, according to theWorld Federation of StockExchanges. Even withnational boundaries firmlyentrenched, that makes itan enticing prospect.

As Steve Grob, director ofgroup strategy for Fidessa,the trading systems sup-plier, puts it, fragmentationis now “very much a globalphenomenon”. Neverthe-less, the process is movingat different speeds and indifferent ways around theregion.

Japan has emerged as afertile ground for alterna-tive trading platforms,where shares are tradedelectronically in much thesame way as on the TokyoStock Exchange, with simi-lar degrees of transparency.

Several exchanges arenow hosting high-frequencytrading systems like thosethat have captured a major-ity of trading in the west,where most trades are nowdone in nanoseconds bycomputers designed to spotthe arbitrage profit in tinyprice differences betweenmarkets.

Liquidity is also movingfrom exchanges into auto-mated trading systemswhose membership is openonly to financial institu-tions. Some are an extensionof traditional “upstairs trad-ing” – bilateral deals thatold-fashioned brokers usedto handle on the phone.

Others are “dark pools” ofcapital – closed platformsthat allow financial institu-tions to match trades inlarge blocks of shares out ofsight of other investors.Examples include US-basedLiquidnet, and Singapore-

based BlocSec, owned bythe Hong Kong brokerCLSA.

Behind the scenes, Asianstock exchanges areactively discussing how toreact to the trend towardsfragmentation. However, inthe absence of region-wideregulatory regimes such asEurope’s Markets in Finan-cial Instruments Directive(Mifid) and Reg NMS in theUS, the response appearspiecemeal.

In some countries, theexchanges are respondingwith innovations of theirown. Sydney-based ASX iscutting fees and introduc-ing a block trading facility

ahead of the entrance intothe domestic market ofChi-X Global, the equitiestrading platform, followinga change in regulations toallow competition.

The Australian, Tokyoand Singapore exchangeshave announced technologyreforms to accommodateand attract high-speed trad-ers. And the New Zealandstock exchange has joinedAustralian and US invest-ment banks in setting up an

alternative platform calledAXE ECN.

One of the most dramatictransformations is occur-ring at the SingaporeExchange. Once highly crit-ical of dark pools, the SGXhas responded to theirappearance in the islandstate by winning regulatoryapproval to set up a pooljointly with Chi-East, anoffshoot of Chi-X Global.

Magnus Böcker, the Sin-gapore Exchange’s chiefexecutive, talks passion-ately of turning the SGXfrom an old-fashionedbourse into a global hub fortrades in equities, commodi-ties and derivatives – overthe counter, in dark pools,or bilaterally, with thetrades cleared by theexchange.

“My approach is to saythat if the institutions inthe market want to trade indifferent ways and the bro-kers want to support themin that, why wouldn’t wehelp them facilitate it?”says Mr Böcker, a formerpresident of Nasdaq OMX.

“It’s not up to me todecide what investorsshould do; I don’t decide

what they should invest inand I can never decide whatplatforms they should tradeon,” he said in an interviewwith the Financial Times.

Mr Böcker’s bid for theASX is, in part, an attemptto back up his vision withaction. If approved by regu-lators, the bid will createthe world’s fifth-largestexchange by market capital-isation, with a mandate totake on the competitionhead-on with a range ofplatforms across the region.

However, other exchangeheads are seeking to erectbarriers to block newentrants before theybecome established.

Ravi Narain, chief execu-tive of India’s NationalStock Exchange, says darkpools have “come in on aplatform of opacity”. Ron-ald Arculli, chairman ofHong Kong Exchanges, saysfragmentation risks are cre-ating a “mathematical play-ground for the few to thedetriment of many”.

As in the US and Europe,however, that is not anargument that cuts muchice with investors seekinglower costs.

AsiaThe pace of thisfundamental changeis far from uniform,says Kevin Brown Global hub plans: SGX’s Magnus Böcker and Robert Elstone,

chief executive of ASX Bloomberg

In some countries,the exchangesare respondingwith innovationsof their own

Marketstructuresface testof trust

When MagnusBöcker, the chiefexecutive of Singa-pore’s SGX

exchange, and Robert Elstone,his counterpart at the ASXexchange in Sydney, unveiled abold plan last month to combinetheir bourses it was confirma-tion that the world of trading,exchanges and clearing – knowncollectively as “market struc-tures” – is a global affair.

It is also a part of the finan-cial world that is undergoing itsmost radical change in livingmemory – a change thatmatches the revolution in theway banks are regulated in thewake of the financial crisis.

That change is being drivenby a cocktail of three things:regulation, competition andtechnology.

Regulation has created compe-tition between exchanges andnew platforms in cash equities –such as Chi-X and BATS – lead-ing to fragmentation and a bat-tle for market share.

At the same time that has ledto complexity. Technology isnow vital to navigate multiplemarkets, be they exchanges or“dark pools”, where largerorders are handled with pricesposted only after trades aredone. It is a far cry from 10years ago, when most trading inthe US, for example, took placeon the floor of the New YorkStock Exchange.

This market structure hasopened the door for new types ofparticipants as the traditional“specialist” and marketmakerroles have largely disappearedand proprietary traders havetaken their place.

Such traders can generate

more than 1m trades in a singleday and now represent morethan 50 per cent of US equitymarket volume, according to theSecurities and Exchange Com-mission (SEC), the US regulator.

Trading speed is now an armsrace, with trading done atspeeds unthinkable only threeyears ago. Last month NasdaqOMX introduced a new tradingsystem that can handle a tradein less than 100 microseconds,pipping the London StockExchange’s 126 microseconds,announced a few weeks earlier.

To attract high-frequencytraders, exchanges are buildingdata centres where traders canplace their computer systems –packed with algorithms – to beas close to the exchange’s trad-ing system, shaving crucialmicroseconds off trading times.Thirty miles outside London,NYSE Euronext has built one aslarge as eight football fields.The trend is sweeping Asia,where the National StockExchange of India built a centrein January.

Yet, as Mary Schapiro, SECchairman, says: “This transfor-mation of market structure hasraised serious questions andconcerns.”

She questions whether thequality of “price discovery” hasdeteriorated as a result of frag-mentation, and whether thesechanges to market structurecould “undermine the fair andlevel playing field essential toinvestor protection, capital for-mation and vibrant capital mar-kets generally”.

It is these questions that havetransformed what may haveseemed like an arcane subjectinto a vital public policy issuefor regulators, operators of mar-ket structures and investors.

Even though the SEC wasalready studying market struc-tures, it took the “flash crash”of May 6 for the issue to explodeon to the public consciousness.On that day, 1,000 points werewiped off the Dow Jones aver-age as a computer algorithmtriggered panicked selling.

That brought home to ordi-nary investors how far removedmarkets now are from the tradi-tional images of traders on thefloor of an exchange. One resulthas been a sharp outflow ofequity mutual funds since May,highlighting a worrying loss oftrust in market structures.

Jim McCaughan, chief execu-tive of Principal Global Inves-tors, a US fund manager, says:“The SEC has made a good startin correcting the damage doneto the equity market by 10 yearsof deregulation. But much moreneeds to be done to restoreinvestors’ confidence.”

At the same time, equally pro-found changes are under way inanother crucial area of marketstructures – over-the-counter(OTC) derivatives and clearinghouses.

The collapse of LehmanBrothers in 2008 sparked thebiggest regulatory overhaul offinancial markets in genera-tions. A key part of that isbuilding new structures thatwill help safeguard the systemagainst the fallout from anotherbig default.

New rules are being imple-mented where swap dealers willbe regulated; where most deriv-atives will be traded on trans-parent trading facilities – either

exchanges or swap executionfacilities (SEFs); and wherethere will be a requirement toclear “standardised” swapsthrough clearing houses toreduce the risk in the system.

A clearing house standsbetween buyer and seller in atransaction, stepping in if thereis a default, using funds postedto it by its members as insur-ance.

These moves are contained inthe Dodd-Frank act, signed intolaw by the Obama administra-tion in June.

The SEC and the CommodityFutures Trading Commission,the US futures watchdog, arescrambling to complete a “rule-making” process that will workout the finer points of Dodd-Frank so that the industry canimplement it.

In Europe, the same agenda isbeing pushed by the EuropeanCommission, which produced itsproposals for OTC derivativesand clearing in September. HowOTC derivatives are to be tradedis being handled separately in aBrussels review of the Marketsin Financial Instruments Direc-tive (Mifid).

Many new businesses are upand running, illustrating howthe industry is already embrac-ing change. Last month CME

Group launched clearing of OTCinterest rate swaps, withLCH.Clearnet, a UK-based rival,expected to join the fray withinweeks.

In September, BGC Partnersbecame the first interdealer bro-ker to launch electronic tradingof interest rate swaps, followeda week later by larger rival Icap.

Yet much uncertaintyremains. It has yet to be decidedwhat a “standardised” OTCderivative looks like. Nor is it

clear what an SEF would be, orindeed how many of these newplatforms will emerge.

On clearing, no one is surewhat the “right” number ofclearing houses is, although JeffSprecher, chief executive ofIntercontinentalExchange, says:“I think you’ll see the samemarket participants supportingmultiple market offerings, espe-cially in a time of crisis.”

In the US, ownership caps areunder discussion as a way ofpreventing conflicts of interest –such as dealers being able toinfluence what can and cannotbe cleared. Yet dealers worryabout exchange ownership ofclearing houses too. AlexMcDonald, chief executive of theWholesale Market Brokers’Association, which representsinterdealer brokers, says thenew rules “should not allow forclearing houses operatingwithin a vertical silo to favouran internal trading platform”.

Given their increased sys-temic importance, clearinghouses may yet become the next“too big to fail” institutions.

But a bigger worry is the over-arching concern that, as long asthe new rules of the road areunclear, it is hard for banks,brokers, exchanges and othersto know where – and when – tocommit investments.

Brian Daly, managing directorof consolidated equities atMorgan Stanley, says: “Theregulators globally are aboutto establish a brand new ecosys-tem in capital markets forOTC trades. Our clients need toprepare their 2011 and 2012budgets today for this eventual-ity. Being unprepared will notbe acceptable.”

Regulators arestruggling to take thelid off trading that isoften super­fast andsometimes opaque,writes Jeremy Grant

Inside this issueTrading platformsThe growing murkiness ofdark pools makes for a difficultbattleground for regulators,says Jeremy Grant Page 2

Regulation Pressure mountsover derivatives clearing, writesAline van Duyn Page 3

Chicago City traders(pictured above) build ona reputation for fast finance,reports Hal Weitzman Page 4

On FT.comPenny pricing has fragmentedliquidity, writes Hal Weitzmanwww.ft.com/exchanges­trading­clearing­2010and www.ft.com/tradingroomsee alsowww.twitter.com/FTTradingRoom

‘The SEC has madea good start incorrecting the damagedone to the equitymarket by 10 yearsof deregulation’

Off - exchange trading picks upEuropean equities turnover

Sources: Thomson Reuters EMSR; TABB Group

By type (%)

Jan 2008 09 Oct100

10

20

30

40

50

60

On exchangeOTCOff order book

US equity market sharePer cent

Jul 2008 09 Sep100

5

10

15

20

25

30

35

NasdaqNYSE & ArcaBATS & DirectEdgeInternal by banksand brokers

NYSE/Nasdaq average trade size

35000

05000

1000015000200002500030000

40000

0200400600800

1000120014001600

Average shares per day (m)Average trades per day (’000) Average shares

per trade

1997 98 2000 02 04 06 08 09

These are the firstfinancial futures tobe traded in Chinasince the 1990s

Illustration: MEESON

2 ★ FINANCIAL TIMES WEDNESDAY NOVEMBER 3 2010

Exchanges, Trading & Clearing

Andeantrio planmarketalliance

ContributorsJeremy GrantEditor, FT Trading Room

Kevin BrownAsia Regional Correspondent

Patti WaldmeirShangai Correspondent

Aline van DuynUS Markets Editor

Michael MackenzieUS Markets Reporter

Telis DemosUS Markets Reporter

Hal WeitzmanChicago and MidwestCorrespondent

Philip StaffordReporter, FT Trading Room

Naomi MapstoneAndean Correspondent

Rohit JaggiCommissioning Editor

Steven BirdDesigner

Andy MearsPicture Editor

For advertising, contact:Hope KayePhone +1 212 641 6548hope.kaye@ft.com

Chile, Colombia and Peruare poised to launch thefirst stage of a stock marketintegration that will openthe gates for foreign inves-tors who have never ven-tured beyond Mexico andBrazil.

The new kid on the LatinAmerican block will be theregion’s top issuer, with 563stocks and second in mar-ket capitalisation at $563bn.It will be third in terms oftraded volume – albeit a dis-tant third, at $48bn, behindMexico with $79bn and Bra-zil, the region’s behemoth,with $554bn.

“It’s a pretty attractiveoffering – they just neededscale. And the tie-up they’regoing to roll out reallygives them the scale to com-pete with a Brazil or a Mex-ico and quite frankly with aSingapore or a Mumbai or aJo’burg,” says LaurenceLatimer, senior vice-presi-dent and managing directorfor Sungard’s trading andclient activity in the Ameri-cas.

Chile, the establishedheavyweight of the trio,with a market capitalisa-tion of $291bn and tradedvolume of $30bn, offers astrong portfolio of service,retail and industrial stocks,while Colombia, with$199bn market capitalisa-tion and $16bn traded vol-ume, is dominated byenergy stocks.

Peru, the minnow of thetrio, with a market capitali-sation of $47bn and tradedvolume of $2bn, is heavilyweighted to mining stocks.

While the total value ofstocks traded on all threeexchanges last year was$56bn, that could increaseeightfold, if the Andeans

repeat the success of Euro-next and Nasdaq OMX Nor-dix integrations.

“We are very excitedabout the project; there’s anupside for everyone,” saysFrancis Stenning, chiefexecutive of the Lima bolsa.

The first stage, which rollsout on November 22, willgive traders in each countryaccess to partner markets. Asecond stage, to be com-pleted by December 2011,will allow for direct accessto markets and the stand-ardisation of regulation.

“Strategically, each of uskeeps control of our ownplatform, it keeps liquidityin one single market, and itkeeps the aspects related toconfidentiality, control – allthe aspects related to thetrading activity – in one sin-gle market under the super-vision of their own regula-tory market,” says Mr Sten-ning.

Cristián Moreno, head ofLatAm Equity Research atSantander, argues thatColombia is ripe for an IPOboom and points in a reportpresented at the New York-based Council on the Amer-icas to Peru’s “catch-uppotential”.

Peru has 17.5 per cent oflisted companies in LatinAmerica but just 0.6 percent of traded volume, MrMoreno notes.

Cristhian Escalante, ananalyst at Celfin in Lima,says: “Our daily volume oftrade in Peru is less than$20m. In Chile it’s morethan $200m and in Colom-bia it’s almost $100m. Weare seeing strong interestfrom investors in Colombiaand Chile because they seePeru as cheaper.”

Mr Latimer says the inte-gration will be a strongdriver of growth in theregion, as domestic andinternational investors takeadvantage of lower costs,lower risk and greater easeof access.

“There’s a recognitionthat Latin America is muchmore than Brazil and Mex-ico and you want to makesure you have a strategythat gives you exposure toas many markets as possi-ble, particularly those thathave proved themselves sta-ble,” he says.

‘Flash crash’ blamed on computer, but not error

In the wake of the May 6“flash crash”, sellers andbuyers were quick to pointthe finger at each other asthe trigger for the market’ssudden turbulence.

At 2.30pm the S&P 500index was down by about4 per cent as images ofGreek riots played on televi-sion screens. Investors incompany shares were sell-ing, fearing the effects of aEuropean sovereign debt cri-sis on the global economy.

At about the same time,electronic market makers,seeing overwhelming sellorders with few buy ordersto match, stopped buying

for fear of being stuck withpositions they could notquickly resell. By 3pm, theS&P 500 index had plungedalmost 6 per cent, before itzoomed back up by roughlythe same amount.

A September staff reportby the SEC, jointly with theCommodity Futures Trad-ing Commission, describedthe sequence of events thatled to the crash, but did notsettle any debates aboutwhether it was the pan-icked seller or the skittishbuyer who was to blame.

What the report did saywas this: at 2.32pm amutual fund (later identi-fied as Waddell & Reed)entered an order to sell75,000 e-Mini S&P 500 indexfutures on the CME.

The fund used a “partici-pation algorithm” to sell asmuch as 9 per cent of themarket’s volume. This tradesparked a cascade of buyingand selling in the futuresand equity markets that

panicked market makers,leading them to stop trad-ing, which resulted in themarket’s 6 per cent swing.

That finding surprisedmany, who had expectedsome kind of computerglitch – Warren Buffettspeculated on CNBC that itmay have even been a“cyber attack”. That wouldhave put the smoking gunin the hands of high-speedtraders who rely on massivecomputing power to buyand sell shares in microsec-onds to earn a stream oftiny profits.

But the focus on Wad-dell’s trading order high-lighted the fact thatincreasingly, institutionsare also tapping such auto-mated trading programs.

Tabb Group, a marketstructure research firm,estimated in a recent reportthat so called “low-touch”algorithms that determinehow, where and when totrade will represent 35 per

cent of trading in 2011, on apar with “high-touch”trades where humans decidehow to trade at each step.

Many traders were criti-cal of Waddell’s very large,trade-at-any-price order, aswere regulators. Shortlyafter the release of thereport, Mary Schapiro,

chairman of the SEC, said:“We are looking at whetherthese algos ought to havesome kind of risk manage-ment controls.”

That has sparked arethink among traders onthe buy side. A study byInstinet, an agency broker-

age that sells tradingservices to institutions,advised its clients that “thereport could be read as awarning against using algo-rithms that send ordersbased only on volume with-out price controls”.

Groups that sell algo-rithms to institutions have,since the crash, put anemphasis on how those pro-grams track market liquid-ity in a way that can detectwhen conditions are similarto May 6, according to EranFischler, head of researchat Pragma, a trading tech-nology group.

Buy-side groups also saythey are asking their bro-kers for more informationabout trade execution, suchas which venues trades areexecuted in, and why.

“It’s a five-year head-startfor high-frequency traders,”said Kevin Callahan, chiefexecutive of X41 Trading, ata recent forum at BaruchCollege in New York. “The

fundamental trading worldneeds to catch up.”

However, high-frequencyproprietary traders werenot excused by the report.The SEC report also high-lighted the “stub quotes”,or prices at one penny or$100,000, at which manyindividual stocks tradedbetween 2.30pm and 3.00pm.

HFTs, who have replacedthe specialists who used tobe tasked with maintainingorderly markets on theNYSE trading floor, con-stantly enter such quotes tomaintain a “two-sided mar-ket” at all times, as isrequired of market makers.

While that might meetthe letter of the rules, thefear is that it does not meetits spirit of keeping themarket orderly. As thosequotes were never intendedto become active, somebelieve that adding morehuman judgment wouldhave prevented such trades.

“Liquidity vanished com-

pletely during the ‘flashcrash’ when natural partici-pants needed it the most,”says Diego Perfumo,exchanges analyst at EquityResearch Desk.

Regulators are now key-ing in on the distinctionbetween real liquidity,which stays in place whenmarkets are uncertain, andmere volume, which cansuddenly evaporate.

The SEC, along with USexchanges, has exploredbanning stub quotes. Prac-tices such as “quote stuff-ing”, which is when a trad-ing firm enter trades andquickly removes them, cre-ating a false impression ofmarket demand, have alsocome under scrutiny.

“The issue is whether thefirms that effectively act asmarket makers during nor-mal times should have anyobligation to support themarket in reasonable waysin tough times,” Ms Scha-piro said in October.

Market stabilityFinger pointed atincreasingly wideuse of automatedtrading programs,says Telis Demos

‘Liquidity vanishedcompletely duringthe “flash crash”when naturalparticipantsneeded it the most’

One­size­fits­allapproach riskskilling f lexibility

Last month, leading forcesin the over-the-counterderivatives industry trek-ked to a basement confer-ence room in the GrandHyatt in Washington to dis-cuss a crucial issue; howwill regulators define SwapExecution Facilities orSEFs.

This new term for derivativetrading platforms is enshrinedin the Dodd-Frank reform actand next month the Commod-ity Futures Trading Commis-sion (CFTC) and Securitiesand Exchange Commissionwill release initial rules gov-erning SEFs. This will be fol-lowed by a comment period,with plans to implement therules for these new tradingplatforms by July 2011.

Many in the derivativesindustry are expected toweigh in at length on the pro-posed rules for SEFs duringthe comment period. There isplenty at stake for banks,interdealer swap brokers, cor-porations and institutionalinvestors who trade and/oruse swaps and derivatives.

Under Dodd-Frank, SEFsare required to permit multi-ple parties to trade with eachother and also publish stream-ing prices. It also appears thatSEFs will enable the com-bined use of voice and elec-tronic systems through ahybrid model, which findsfavour with interdealer bro-kers such as Icap and TullettPrebon.

In general, SEFs reflect thedesire of regulators for a moretransparent and open marketand moves over-the-counterderivatives trading towards afutures type model.

“The CFTC prefers a futuresbased model of many partici-pants with many liquidity pro-

viders,” says John Jay, ana-lyst at Aite Group.

Except, argue many in theindustry, what works in theworld of futures and equitiesis not easily applied to OTCderivatives.

OTC derivatives are thedomain of banks, institutionalinvestors and corporationslooking to hedge interest rate,credit and currency risk, or totrade these instruments.

Unlike the futures and equi-ties markets, OTC derivativescan trade infrequently asmany trades are bespoke innature, and have been manu-factured between a dealer andtheir client to hedge a specificinterest rate or currency risk.Often, such trades can be sub-stantial, with notionalamounts in the hundreds ofmillions.

Thus a big concern at therecent conference in Washing-ton, which was billed asSefcon1, was that liquidity inswaps will suffer if trading isstandardised on to platforms.A large trade will move themarket adversely against aninvestor seeking to buy or sella $500m swap trade, say – notan uncommon amount forinterest rates.

Some in the industry, suchas the International Swapsand Derivatives Association,have written to the CFTC andSEC asking that SEF’s includeswap trading platforms whereinstitutions conduct request-for-quote trades, or RFQ’s.

This cuts to the heart of theissue between regulators seek-ing more open and transparentderivatives trading and theunique nature of how swapsare priced and transacted.

At Tradeweb, an electronicplatform where banks provideswap prices for institutionalclients, they have discovereda middle ground between con-tinuous prices and RFQ thathelps investors transact largeamounts of swaps.

“Many clients are using ourstreaming prices to checkpricing before they use anRFQ for trading,” says LeeOlesky, chief executive officerat Tradeweb. “The streamingprice adds a lot to pre-tradetransparency.”

Icap’s swap platform forbanks trading swaps inEurope also enables two par-ties to a trade to subsequentlybuild up the size of theirtransaction from an initialamount. This platform is seenas being easily applied to USswaps once the SEF rules aredefined.

While Icap services bankstrading solely with eachother, there is a bigger battlebrewing.

If regulators strictly enforcea “many to many” model withstreaming prices supplied bybanks and investors, it wouldrender obsolete the platformsused by dealers, who marketswap prices directly to theirclients via Bloomberg screens.

“The broker-dealer commu-nity will continue to fight theproposed changes in trading,arguing that single-dealerplatforms should qualify aslegitimate execution facili-ties,” says Mr Jay.

It remains to be seenwhether regulators willimpose rules that strike acompromise between theirdesire for derivatives tradinglike other markets and theunique trading of swaps.

Mr Olesky says: “It’s criticalto have sufficient flexibility intrading rules governing SEFsso overly rigid rules do nothurt innovation or liquidity.”

OTC derivativesThere is a great dealto discuss as rules inswap deals are likelyto change, writesMichael Mackenzie

Regulators face uphill battleas dark pools grow murkier

It would be hard to find aphrase less suited to generat-ing confidence in markets, ormore specifically market

structures, than “dark pools”.It conjures up a world where

trading is done in secret, awayfrom public view. It suggests pos-sibly nefarious activities carriedout beyond the sight of regulators.

The latter statement is (proba-bly) false. But the former is notfar from the truth. Dark poolsexist to allow institutional inves-tors to do large share trades awayfrom standard exchanges, whereprices are posted for all to seebefore trades are done. In a darkpool, prices are advertised onlyafter trades are done.

Dark pools account for up to 10per cent of US share trading, bysome estimates, and about half ofthat proportion in Europe. Butthey are growing, because manyinstitutional investors, especiallyasset managers and pension fundmanagers – the so-called “buyside”, are finding it increasinglydifficult to get large orders done onexchanges and their smaller rivals,known in Europe as “multilateraltrading facilities” (MTFs), such asChi-X Europe and BATS Europe.

That is because the average sizeof orders being placed onexchanges and MTFs (collectivelyknown as “lit” platforms, becauseprices are visible before trades aredone) is rapidly shrinking ashigh-frequency trading and theuse of computer algorithms toslice orders into ever-smaller sizesis changing the composition ofsuch venues.

As orders become smaller, sothe risk increases that a traderplacing a large order into the mar-

ket will find an order jeopardisedas other traders see the largeorder coming into the market –and move the market against it.

To some, using the off-exchangemarkets for specific purposes likethis is little different from the olddays of the telephone-brokered,off-exchange, or over-the-counter(OTC) market.

Kay Swinburne, a UK Conserva-tive member of the European Par-liament and author of a reportinto dark pools and “high-frequency” trading as part of aBrussels review of tradinginfrastructures, says: “Despiteits ominous name, a dark pool canbe considered at the most basiclevel to be an electronic equiva-lent of a disintermediated OTCtransaction.”

However, there are two trendsthat are troubling regulators andsome market participants andmaking the evolution of darkpools uncertain.

First, while dark pools are still arelatively small part of the mar-ket, they are growing fairly fastand that trend is unlikely to stopas long as markets continue to bebifurcated between the “lit” plat-forms where high-frequency and“algo” players are trading, and thedark pools where asset managersare increasingly forced to get theirbusiness done.

Some critics, usually exchangesbut not exclusively so, say thatthe overall “price formation” proc-ess is being undermined as moreand more trading takes placeaway from exchanges, where ordi-nary investors tend to make theirtrades. The US Securities andExchange Commission is studyingthe issue as part of a sweepingreview of market structures.

In a letter to the SEC, Dutchproprietary trading firm IMC says:“Dark pools take advantage of thepricing of the public exchangeswithout contributing to the pricediscovery process themselves,using publicly disseminatedquotes and prints as a referencepoint for the initiation of tradesoutside of the public markets.”

Ms Swinburne says: “As moretransactions take place in thedark, questions can be raised as tothe validity of the price creationand discovery process on theexchanges and MTFs.”

A second issue is that whiledark pools are perceived as placeswhere blocks of trades are done,in fact average trade size in darkpools is also falling. That isbecause larger so-called “parent”orders placed in a dark pool aretypically split off into smallerchunks, called “child” orders, andmay even be worked over hours –or even a couple of days.

Many suspect that, as part ofthis, high-frequency traders arenow operating in dark pools,meaning that the original purposeof dark pools is being lost.

However, Tony Nash, head ofexecution services at ExecutionNoble, plays down the impact ofhigh-frequency trading: “It is

important to note that high fre-quency traders (HFT) are drivenby reacting to signals in the mar-ket and, therefore, given that darkpools are constructed to minimisethis ‘noise’ it is a far less interest-ing hunting ground for HFT thanthe lit venues,” he says.

Nonetheless, it is important alsoto realise, industry experts andregulators say, that not all darkpools are the same. Some are oper-ated by banks – and are known as“broker crossing networks”. Oth-ers are run by independent opera-tors, such as Liquidnet, whichoperates pools as far afield asMexico and New Zealand inaddition to the US and Europe.And exchanges themselves oper-ate their own versions.

This makes any assessment of

the pros and cons of dark poolstricky, since they do not all do thesame job.

Indeed, some exchanges haverecently started offering newtypes of block trading platforms totry to attract some of the institu-tional business that has beenleeching away to dark pools backto the exchanges.

Last month, Nasdaq OMXlaunched just such a platform,called PSX. TMX Group, operatorof the Toronto Stock Exchange,said in September it would launcha new platform for “dark orders”that would be integrated into theexchange’s existing order book.

Regulators are acutely focusedon increasing transparency andrestoring trust in the way equitymarkets function, especially in thewake of the “flash crash” on May6 in the US, when an algorithmsparked a massive fall in the DowJones average.

Brussels is also conducting athorough review of equity marketsin Europe three years after theMarkets in Financial InstrumentsDirective brought about competi-tion and a flourishing of types ofvenues.

Industry experts say they expecta “back to basics” approach whenit comes to market structures,that could affect dark pools too.

Seth Merrin, founder and chiefexecutive of Liquidnet, says: “Per-haps more important is the vitalfunction that venues like Liquid-net, which cater specifically toinstitutions, provide that protectthem from the many types of trad-ers and investors with competinginterests.

“The exchanges and the inter-nalisation engines cater to manydifferent customers, which includehigh frequency traders and othersthat have very different goalsfrom the long-term investor. If weare going to restore investor confi-dence in the equity markets,investors need the assurance thattheir orders are not being takenadvantage of by predatory tradersand are being executed at the bestprice possible. “

Trading platformsMore deals, many ofthem much smaller, aretaking place out ofthe public gaze, writesJeremy Grant

In secret: some critics say the ‘price formation’ process is being undermined as more trading takes place away from exchanges Alamy

‘Dark pools takeadvantage of the pricingof the public exchangeswithout contributing tothe process themselves’

Latin AmericaChile, Colombiaand Peru arejoining forces, saysNaomi Mapstone

‘Strategically eachof us still keepscontrol of our ownplatform’

FINANCIAL TIMES WEDNESDAY NOVEMBER 3 2010 ★ 3

Exchanges, Trading & Clearing

Pressure mounts over derivatives clearing

Acentral part of policymakers’response to the financial cri-sis has been legislationrequiring that large amounts

of the $615,000bn privately tradedderivatives market is pushed on toclearing houses.

At present, only a small proportionof this over-the-counter derivativesmarket is centrally cleared.

Of the parts that are, most of theclearing is of trades done directlybetween dealers. Investors – the so-called “buyside”, which includes largeasset managers, insurance companies,pension funds and hedge funds – willhave to start clearing the derivativesthey use, too.

In the US, the Dodd-Frank Act willmake this mandatory for many ofthem, probably by the middle or endof next year. In Europe, there is a bitmore time. New legislation probablywill not kick in until 2012.

“Everyone thought buyside clearingwould become a reality last year,”said Jeff Gooch, chief executive ofMarkitServ, which electronically con-firms many OTC derivatives trades.“In practice, very little has happened;everyone is waiting for the detailedrules.”

Clearing became a central focusafter the demise of Bear Stearns andthe Lehman Brothers bankruptcy in2008, because of the exposure bankshad to each other through the billionsof dollars worth of derivatives con-tracts they had agreed to.

A default of one bank couldthreaten the entire financial system,although these contracts, anythingfrom interest rate swaps to creditderivatives, could be worthless if the

bank writing the contract went under.Since 2008, the big derivatives deal-

ers have put hundreds of millions ofdollars into making clearing a reality.Clearing puts a third party in the mid-dle of every trade, which means therisks and costs of defaults areabsorbed by the clearing-house mem-bers.

At the moment, there are a handfulof potential clearers that could cap-ture a share of future business.

Some, such as LCH.Clearnet’sSwapClear are already widely used bydealers. SwapClear is active in thedollar interbank market; some 35 percent of its clearing is dollar-denominated and seven of Swap-Clear’s 32 members are US legal enti-ties. It is also still working on settingup an entity that can be used by thebuyside in the US.

Others, such as CME Group’srecently launched interest-rate swap

clearing business or the Nasdaq-owned International DerivativesClearing Group (IDCG), are beingdeveloped by exchanges that arebranching out into OTC derivativesfor the first time. CME’s swap clear-ing business was launched with thebacking of dealers and large deriva-tives users such as Fannie Mae andFreddie Mac, although this does notmean that investors will not also useother clearers in the future.

For exchanges, getting paid a smallfee every time a derivative contract iscleared is a potentially attractivefresh source of revenues, especially astraditional equity trading volumesand other activities decline.

The shape of the OTC derivativesclearing model is still murky, how-ever, and there are still a lot of keyissues that are up for grabs, as regula-tors flesh out new laws with detailedrules and regulations. For investors,

questions include exactly when theyneed to start clearing, what types ofcontracts need to be cleared andwhether any of them will be exemptfrom clearing rules. Clearers are won-dering whether they will have toaccept smaller members and whethercurrent rules for clearing houses willchange.

Indeed, the questions loom so largethat, for the most part, investors arestill sitting on the sidelines. “I wouldsay that although 80 per cent of ourclients have not made final decisionsabout which clearing house to use,they are reasonably open to multipleplatforms and are waiting for therules,” says Dave Olsen, global headof OTC clearing at JPMorgan. “About20 per cent of our customers are mov-ing forward on clearing.”

Yet, even as efforts begin to signinvestors up to clearing systems, thefuture shape of the clearing businessis still difficult to picture.

Investors have raised concerns thatthe current rules for clearing houseswould expose them to new risksbecause the assets held by the FCMsare in pooled, not segregated,accounts. If the rules are changed,clearing houses say it could sharplychange the economics of clearing, andsome banks may withdraw.

Looking ahead, there are concernsthat too much competition for newbusiness, as well as regulators’demands that clearers be based in spe-cific countries or regions, could leadto inefficiencies.

“Clearing two or more classes ofderivatives in separate [clearinghouses] always increases counter-party exposures relative to clearingthe combined set of derivatives in asingle [clearing house],” says DarrellDuffie, a professor at StanfordUniversity.

RegulationDetails of the centralisedoperations are still unclear,reports Aline van Duyn

Rulemakers: (left to right) US presidentBarack Obama with Senator Chris Doddand Representative Barney Frank aftersigning their legislation AFP/Getty Images

Stock exchanges musclein as clearing housesprepare for shake­up

The business of clearingcash equities in Europe, ahitherto unglamorous andnot wildly profitable seg-ment, has become one ofthe central issues affectingthe structure of the market.

On the face of it, a clear-ing house plays a functionalrole in trading. Sometimesknown as a central counter-party (CCP), it standsbetween buyers and sellers,ensuring that trades areconfirmed and stepping into complete a transaction ifeither party defaults.

But it has become theunlikely setting for aheated debate betweenexchanges, banks, brokersand other clearing houses.Market participants expecta new wave of business toshift to exchanges andclearing houses as a resultof financial reformsdesigned to safeguard andboost the transparency ofthe opaque over-the-counterderivatives markets.

Ownership of a clearinghouse has helped seal adominant position in USfutures markets for CMEGroup, the Chicago-basedoperator, and in Europeanderivatives for Germany’sDeutsche Börse. NYSEEuronext is looking at thismarket while the LondonStock Exchange is expectedto follow suit. In doing so,NYSE Euronext is set tobuild its own clearinghouse.

The European landscapeis highly fragmented, partlya legacy of national stockexchanges’ longstandingrelationships with clearinghouses that clear mainlydomestic stocks. New clear-ing houses have emerged inrecent years, taking largeslices of business from themyriad of alternative trad-ing venues that havesprung up. The EuropeanAssociation of ClearingHouses has no fewer than21 members.

New entrants have helpedforce down prices, but anoft-cited statistic is that thecost of clearing in Europe isup to eight times the cost ofsettling in the US. Up to 40per cent of the total cost ofa trade can be taken up inclearing costs.

The likely emergence ofvertical clearing houses

runs counter to market par-ticipants’ preferences. Theywould like to see a marketconsisting of several clear-ing houses as it would bringdown prices. Being forcedinto a vertical market,owned by an exchange, hasraised fears that pricescould be kept high.

Many investors haveargued that this is a disin-centive to raising tradingvolumes, which remain wellbelow US levels.

The Association for Fin-ancial Markets (AFME), abanking lobby group, saysits members want fewerclearing houses. “The con-solidation of CCP clearingallows users to gather andoffset their open positions

in a single portfolio,” says aspokesperson.

At the same time regula-tors, banks and clearinghouses have been pushingfor greater co-operationbetween clearing houses.Known as interoperability,two or more clearinghouses connect with oneanother and trading plat-forms. It enables the clear-ing house to clear its partic-ipants’ trades irrespectiveof the platform the tradewas executed on.

To date, the industry hasbeen encouraged, but notcompelled, to interoperate.It escaped prescriptive regu-lation when the Markets inFinancial InstrumentsDirective (Mifid) waslaunched three years ago.

Instead, participantssigned up to a code of con-duct which insisted thatclearers create links witheach other to give marketparticipants a choice about

where their trades weresent.

There have been someagreements, such as atie-up between LCH.Clear-net and X-Clear of Switzer-land, but by and large it hasnot happened. In the wakeof the financial crisis regu-lators have been more con-cerned about inadvertentlyintroducing systemic risk.

Areas of the system areon the verge of a break-through. Regulators in theUK, the Netherlands andSwitzerland are putting thefinishing touches to anagreement that would seeLCH.Clearnet, X-Clear andEuropean Multilateral Trad-ing Facility (EMCF), aDutch clearer, interoperate.An agreement is expectedas soon as this month.

But newer entrants andbanks have argued that amore fundamental problemis at work.

“Investors (and intermedi-aries acting on their behalf)trading on a given tradingplatform are obliged to usethe CCP selected by thatplatform to clear theirtrades,” says AFME.

“In terms of disincentive,interoperability will in-crease liquidity and vol-umes, and the cost willcome down further,” saysTony McGuigan, generalmanager at X-Clear, part ofthe SIX Group, the Swissexchange. “Flow is finite.To survive you need flow.”

Some are willing to runnot very profitable, possiblyeven lossmaking opera-tions, to position them-selves for the coming busi-ness from OTC derivatives.

All are considering theiroptions. Consolidation isunder way, with discus-sions between the Deposi-tory Trust & Clearing Cor-poration of the US, EMCFand Euro CCP, the DTCC’sEuropean arm, about thecreation of a quasi-utilityclearer for Europe.

Others face a scramble forbusiness. LCH.Clearnetfaces the loss of NYSEEuronext as a client and thepotential loss of the LSE.

But even if clearinghouses become interopera-ble, fears remain that newobstacles will be erected.

“Interoperability is onlyhalf the solution,” saysDiana Chan, chief executiveof EuroCCP. “Central coun-terparties that interoperatealso need access to the trad-ing venues that areupstream from clearing, inorder that users can havereal choice and benefit fromeffective competition.Access and interoperabilityare inseparable.”

SettlementNew regulationsare set to create aboom for businessin Europe, writesPhilip Stafford

NYSE: studying the market

‘Interoperability willincrease liquidityand volumes, andthe cost will comedown further’

4 ★ FINANCIAL TIMES WEDNESDAY NOVEMBER 3 2010

Exchanges, Trading & Clearing

High­speed electronic tradingleaves regulators far behind

Seven years ago MichaelSpencer, chief executive ofIcap, the world’s largestinterdealer broker, made aspeech to a conference heended with: “The future’selectronic!”

He was speaking in 2003soon after Icap bought Bro-kerTec, the electronic bondtrading platform. As themania of the dotcom bubblesubsided, the number offixed-income trading plat-forms was reducing rapidlyfrom more than 100. Therewere many platforms butfew could attract the vol-ume necessary for success.

Mr Spencer’s point wasthat his audience of banksand brokers had not mis-read the market – thedemand for electronic trad-ing was there but they hadgone about fulfilling it thewrong way.

Fast-forward seven yearsand Mr Spencer’s vision hasarrived. Traders no longersimply buy shares on theLondon Stock Exchange butcan make complex tradesinvolving equities andderivatives on a host oftrading venues at bewilder-ing speed.

Algo Technologies, a US-based trading technologygroup, last month claimedit could complete a sharetrade in 16 microseconds.To put that in context, theaverage housefly’s wingflap is three milliseconds –and one millisecond is madeup of 1,000 microseconds.

For many, the extent ofthe gap between reality andthe stereotype of tradersshouting at each other andpunching in orders onscreens only became evi-dent in May when a “flash

crash” sent the Dow JonesIndustrial Average downnearly 1,000 points in littleover 20 minutes with seem-ingly little news to triggerthe collapse.

Regulators have nowbecome highly aware of thistechnological revolution. InAugust Mary Schapiro,chairman of the US Securi-ties and Exchange Commis-sion (SEC), the markets reg-ulator, said advances intechnology had “opened thedoor for entirely new typesof market professionals” –such as certain breeds ofhigh-speed trading firms –and warned the marketstructure changes had“raised serious questionsand concerns”.

Communication networkshave played an importantrole in financial marketssince Paul Julius Reuter –founder of the news service– used a new telegraphcable under the EnglishChannel to provide stockexchange prices to brokersin both the UK and conti-nental Europe.

But rather than simplytransmit prices rapidly, thenetworks are now the foun-dation for a complex net-work in which computerprogrammes increasingly

do the jobs of a human.As Mr Spencer observed,

demand was growingamong brokers for softwarealgorithms that could breakup orders and sell themundetected in smallerchunks or react swiftly tomarket rumours.

Regulations such as theMarkets in Financial Instru-ments Directive (Mifid)three years ago allowed foralternative trading venuessuch as Chi-X Europe andBATS Europe to flourish. Italso required brokers todemonstrate to investorsthat they were getting thebest price for their trade –so-called “best execution”.

Brokers became involvedin a technological race.Opportunistic traders couldattempt to gain small prof-its by purchasing assets onone platform and immedi-ately selling them onanother – but it neededlightning-fast connectivityand firm, accurate prices.They needed the best“smart order routers”,effectively black boxes thathelp send sharetrades to thebest locationfor the buyeror seller.

A l g o r i t h -mic tradinghas grownin thep a s t

1 0y e a r s

to be thedominant

source ofliquidity on

the largest Euro-pean and US trading

venues and alternativetrading systems. Butfor many it came tolight only with May’sevents. An SEC reportfound that an algo-rithm used by amutual fund trig-gered the crash.

Regulators onboth sides of theAtlantic are nowq u e s t i o n i n g

whether the technology isdistorting the balancebetween those who canafford the tools and thosewho cannot.

“We’re in a market wherealmost half of traded vol-umes are not on the LondonStock Exchange,” says AlexWalker, head of post tradeservices for securities atSungard, the trading tech-nology group. “It meanshalf the time the best pricesare elsewhere. Mifid isabout how you can reallyget best execution but it isso difficult and expensive ifyou’re not smart-order-rout-ing. It’s getting to the pointwhere sustaining the ideaof best execution is a worryfor smaller brokers.”

The technology poses par-ticular challenges to regula-tors. Their options includedemanding an electronic“audit trail” of trades, mon-itoring trading patterns,and upgrading regulatorymonitoring systems. TheSEC has also introduced cir-cuit breakers to regulateunusual price movements.

“Circuit breakers providea valuable safety valve inglobal equity markets andI’d support their implemen-tation more broadly,” saysPhil Allison, global head ofcash equities at UBS.

But a consistent regula-tory approach may not beeasy. The SEC is mandatedby Congress to protectinvestors and the integrityof the market. Driven byMifid, European marketsare mandated to provideeffective competition –which made the technologi-cal advancements possible.

Richard Balarkas, chiefexecutive of InstinetEurope, the agency broker-age, argues that regulatorsshould not be aiming tocapture every bit of infor-mation. “It displays a lackof understanding of themarket,” he says. “If youdon’t understand how mar-kets move ... you can easilywrite regulation that makesmatters worse.”

TechnologyA revolution hasleft rules in need ofan overhaul, saysPhilip Stafford

Vision ofthe present:MichaelSpencer’sfuture hasarrived

Chicago builds on its reputation for speed

The building on the cor-ner of Larrabee Streetand Chicago Avenue,near the city centre,

does not look like a high-tech-nology centre. Solid and indus-trial, it reflects its original use –a warehouse for the Mont-gomery Ward mail-order cata-logue company.

Now it is base for a string ofproprietary trading firms andother companies in the world ofelectronic trading. High-speedtrading groups such as InfiniumCapital Management and JumpTrading are headquarteredthere, as are derivatives broker-ages Penson GHCO and thinkor-swim.

The transformation of a build-

ing that represents Chicago’sindustrial past encapsulateshow, quietly and without fan-fare, the city has emerged as aglobal centre for both tradingtechnology and algorithmictrading firms.

Chicago’s derivatives-tradingcommunity has always flour-ished on the ability to reinventitself. In the early 20th century,the city became a global centrefor agricultural futures trading.In the 1970s, it created financialfutures and listed options. Sincethe late 1990s, it has seen aboom related to the “electronifi-cation” of financial markets.

The city’s top proprietary elec-tronic trading firms havebecome some of the most power-ful participants in global finan-cial markets. Groups such asGetco, DRW, Infinium, ChicagoTrading Company and Peak6are, in some respects, as impor-tant to the markets as WallStreet’s biggest names.

These companies – and hun-dreds of smaller “prop shops” –have spurred the development

of Chicago-based financial tech-nology vendors such as TradingTechnologies, which sells trad-ing software, and 29West, amaker of high-speed messagingsoftware, owned by Informatica.

The roots of all this were thedynamic trading pits on thefloors of the Chicago MercantileExchange, the Chicago Board ofTrade and the Chicago BoardOptions Exchange.

Since the 19th century, thecity’s fiercely competitive open-outcry system had attractedrisk-takers to become independ-ent market-makers. Young peo-ple typically started as runnersor clerks on the floor, movingup as they learnt the ropes.

Although, nowadays, the trad-ing floor is a shadow of itsformer self, most of the heads ofthe Chicago prop shops weretrained in open outcry. Asexchanges introduced electronictrading and 24-hour markets,they saw the opportunity totransfer their skills to thescreen.

Old-fashioned Chicago trading

ingenuity enabled them to takefull advantage of the electronicage. “Technology is extremelyimportant, but the most impor-tant piece is still the tradingknowledge,” says GeorgeHanley, president of the HanleyGroup, a proprietary tradingfirm and an early backer ofInfinium and Blink Trading,which was sold to Getco.

Speed and technology hadalways been important in Chi-cago. Whether it meant havingthe fastest runner deliveringorders to the floor or the abilityto flash orders into the tradingpit using hand signals, speedhad always been critical, whilenew gadgets – telephones, Tele-type machines, calculators –

were seized upon by traderslooking for an advantage.

Chicago was not, however,first to electronic trading. Deut-sche Terminbörse, the first bigfully electronic exchange whichlater became Eurex, launched in1990. Many Chicago traders sawit as the future, some even mov-ing to Frankfurt.

“Eurex started out as purelyan electronic exchange and itopened people’s eyes,” recallsFarley Owens, executive vice-president of product manage-ment at Trading Technologies.

In 1992, the Chicago Mercan-tile Exchange responded withGlobex, its electronic tradingplatform, setting in place a proc-ess of the gradual shift of floor-based trading to the computerscreen, ever-faster trade execu-tion and now co-location facili-ties enabling lightning-fast algo-rithmic trading.

Many of the now-big proprie-tary electronic trading firms setup shop in the late 1990s, oftenseeded with money made on thetrading floor, and in many cases

maintaining a floor-based opera-tion alongside their electronictrading desks.

Chicago’s markets had longbeen based on proprietary trad-ing, as small groups of tradersbanded together. These groupswere used to trading acrossasset classes and looking forarbitrage opportunities.

The awareness of technologyand the desire to trade differentassets led to the creation in Chi-cago of Archipelago, the elec-tronic stock-trading platformacquired by the New York StockExchange in 2005.

Alongside Chicago’s deriva-tives trading know-how, thecity’s infrastructure also helped.

Holly Duran, a commercialrealtor who serves the Chicagotrading community, says thecity had plenty of former indus-trial buildings that could accom-modate the cabling and coolingsystems needed to run a lot ofcomputer hardware, as well assmall spaces in or near theexchange buildings that couldbe rented relatively cheaply.

Although they now haveoffices around the world, tech-nology has enabled Chicago’sproprietary trading firms toremain lean compared with theWall Street banks.

“They’re more technology-de-pendent than people-depend-ent,” says Kevin Krumm ofObjective Paradigm, a localfinancial technology headhunt-ing firm.

As high-speed electronic trad-ing grows across all assetclasses, the prop shops arebecoming more institutional-ised. That could accelerate withUS financial regulatory reform,as it becomes harder for the bigbanks to do proprietary tradingand over-the-counter marketsbecome more electronic andtransparent.

“The industry is maturing,”says Steve Brodsky, managingdirector of Vernon and ParkCapital, a Chicago privateequity firm that focuses on thefinancial sector. “The prop firmscould become the new invest-ment banks.”

TransformationOld open­outcry skillsand high­tech are apowerful combination,writes Hal Weitzman

‘Eurex started out aspurely an electronicexchange and itopened people’s eyes’

Into the future: the headquarters of Jump Trading and other high­speed trading groups in a former warehouse near the centre epitomise the Windy City’s metamorphosis from industrial powerhouse to global high­tech centre