Here Today, Here Tomorrow

As politicians in the US and Europe look to quell populist dissatisfaction with the state of their economies, high-frequency trading (HFT) has been made out to be something of a scapegoat. Yet, while there are still issues that need to be addressed with regard to dark pools, and the regulation of over-the-counter (OTC) derivatives and naked access, high-frequency trading is here to stay in one form or another.

"High-frequency trading is an evolution and to me, there is not much that can stop it-and there is no reason to stop it," says Paul Zubulake, senior analyst at Boston-based research firm Aite Group. "It is bringing efficiency to the markets and making tighter markets."

This form of algorithmic trading is still relatively nascent. But as the strategy has grown in popularity in the US and in Europe, it is now spreading in earnest to South America, Asia, Canada and Northern Europe. As technology, pricing and talent improve across the globe, and as governments and regulators become more comfortable with the volatility inherently involved, high-frequency trading (HFT) is set to become a more global affair.

Waters has extensively covered the controversies and regulations inextricably linked with the evolution of high-frequency trading. This coverage has traditionally focused on the more mature markets of the US and the UK. But four regions-Brazil, Canada, Japan and the Sweden-are steadily becoming attractive destinations for high-frequency traders around the world.

Merging Opportunity in Emerging Brazil

Perhaps the best example of an emerging high-frequency power is Brazil. Why? As Daniel Mendonça de Barros, CEO of Link Investimentos, the largest independent brokerage house in Brazil, explains, Brazil has an important trifecta going for it: "We have size, easily understood regulation and volatility-it is the best combination for high-frequency trading," he says.

Brazil has made significant strides in the trading world since the BM&F futures exchange and the Bovespa stock exchange merged in 2008. If size does indeed matter-and when it comes to execution venues, it invariably does-BM&FBovespa is the third largest exchange in terms of market volume worldwide. High-frequency traders also enjoy a market volatility percentage, which indicates price volatility, of 40 to 50.

Furthermore, the market has been buoyed by what Barros calls "intelligent regulation." He says the rules are clearly defined, and that has helped to provide a calming effect for outside investors. For example, there is no sponsored, or naked, access. If a high-frequency firm in Chicago wants to trade in Brazil, it has to open a 2689 omnibus account that will make the Brazilian brokerage that firm's legal representative.

And BM&FBovespa's figures are impressive, too-citing data provided by the exchange, Barros says that in February 2009 there were 250,000 high-frequency contracts traded. By October, that figure had spiked to 2.8 million contracts. The exchange is currently averaging somewhere close to 100,000 contracts traded per day, according to Barros.

On the latency side, as of March 2009, a roundtrip trade took about 85 milliseconds. Barros says that has been reduced to 10 to 15 milliseconds.

"It has really improved from the level we had," he says. "They are working hard to cut latency."

But there is still room for growth. Algorithmic trading makes up a relatively small 5 to 6 percent of trading volume at BM&FBovespa. The exchange hopes to have that number hit 40 percent by the end of 2011, but that is going to take some significant investment, which is already in the works.

In February, BM&FBovespa raised its stake in CME Group to 5 percent, an increase of 3.2 percent. As a result, CME, which was created by the mid-2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade, will help the Brazilian exchange develop new technologies to broaden BM&FBovespa's high-frequency product offering.

Bumps in the Road

Barros says that for high-frequency trading to fully take hold, BM&FBovespa must first reconcile its two matching engines. Bovespa used NYSE Euronext's NSC V900 engine, while BM&F's platform was developed internally. As a result, there have been bumps in the road when attempting to trade cash equities, although Barros says the investment into CME Group will help solve this issue. BM&FBovespa hopes to have the two engines merged by the summer of 2011.

"The bottleneck in the market is on the cash equities platform, in terms of number of trades per day and in terms of latency. They know that, and the movement they made last month-with the integration with CME and the plans to have a new combined platform in mid-2011-is an answer to the market that they realize this is a problem," Barros says.

"They are working hard, but it is tough because they are two completely different matching engines," he adds. "They have to make these two platforms talk to each other and it is not easy."

Dan Hubscher, principal product marketing manager at the Apama division of complex event processing (CEP) technology provider Progress Software, concurs with Barros. He says that Progress Apama has seen a great deal of interest from Brazilian firms looking to capitalize on high-frequency trading opportunities due to the fact that BM&FBovespa has invested so much into its product offerings.

"As BM&FBovespa got aggressive at the end of 2008 and the beginning of 2009, and began officially launching algorithmic products in the middle of 2009, that had a huge ripple effect and opened up participation in that market to automated trading techniques and technologies," Hubscher says. "They rapidly increased their product offerings and what they are able to accommodate."

The Great White North

While Brazil still has a lot of growth to achieve, Canada is following a similar path to that of the US. Today, high-frequency trading's daily average volume is about 20 to 25 percent of trading across all venues, according to Tabb Group senior consultant Laurie Berke. But what truly opened the door for the expansion of high-frequency trading was the Toronto Stock Exchange's (TSX's) October 2008 introduction of its Electronic Liquidity Provider (ELP) program, Berke says. The ELP offered aggressive differential pricing, a vital ingredient for high-frequency trading strategies.

"One of the things that was critical to bringing high-frequency trading to Canada was pricing," Berke says. "You need speed and technology, but you also need maker-taker pricing."

That led to an increase of co-location venues and the establishment of trading engines close to the alternative trading systems (ATSes). This also led to greater competition. TSX had dominated the market, but as exchanges began to compete on differential pricing, Alpha Trading Systems and Chi-X Canada have made large inroads, according to Berke. She says that Alpha, in particular, has had the most success. By the beginning of 2009, the consortium of seven Canadian banks that owns Alpha, began developing maker-taker pricing models that would be attractive to high-frequency flow.

Still, TSX commands the large majority of trading volumes in Canada and has been the venue breaking down barriers in the market. In addition to its ELP program, the Toronto Stock Exchange rolled out its TSX Quantum trading platform in 2008 and earlier this year completed the rollout of its Quantum Gateway, the trading front-end of the engine, according to Kevan Cowan, president of TSX Markets and group head of equities.

"Through all of those Quantum changes, both to the engine and the front-end, we have seen significant improvement to response time, which is, of course, significant to everybody in the world of electronic trading," Cowan says.

The new hurdle that Canadian exchanges face is how to deal with the increased data requirements. TSX is making a "significant investment" to ensure that the exchange has the capacity to accommodate all classes of trading, he says.

"We are also undertaking an enterprise expansion, so that in addition to the response times, we can also increase capacity," Cowan says. "Capacity is a hallmark of attraction for the high-frequency players who are, in many cases, willing to put as much into the pipe as you can accommodate."

But as with all things technology-related, growing pains need to be addressed and, ideally, learned from. For the Toronto Stock Exchange, one such "lesson" occurred in December 2008 when the exchange shut down for an entire day due to what it described at the time as a "data glitch."

Japan's need for speed

Whereas Canada is currently grappling with capacity issues, it's all about speed in Japan. The country is playing a game of catch-up that has culminated with the launch of the Tokyo Stock Exchange's (TSE's) Arrowhead matching engine. Since its launch on Jan. 2, high-frequency trading has grown from between 10 and 20 percent of average daily volume to somewhere closer to 30 percent, according to Carrie Cheung, director of Asia-Pacific electronic trading at Bank of America Merrill Lynch (BAML).

According to TSE Group, Arrowhead offers five millisecond order response times and three millisecond information distribution. As of December it was an "excruciatingly" slow two to three seconds of latency.

As has already happened in Toronto, the upgrade at the TSE is likely to lead to a spike in co-location offerings. To compliment Arrowhead's launch, Merrill Lynch Japan Securities (MLJS) introduced the nation's first third-party hosted service for electronic trading. Cheung says that hedge funds "residing" in MLJS's datacenter will get market data in 100 to 200 milliseconds.

In light of the ongoing financial meltdown, trading outfits are asking for multiple prime brokerages to mitigate certain operational risks and find more favorable pricing, Cheung says.

Since 2008, many firms throughout the industry have preferred to employ a multi-prime broking strategy to cut down on costs and reduce risk exposures. "Being in these exchange-neutral, third-party datacenters, you have optimal access to multiple exchanges," Cheung says. "For example, you will have reasonably high-speed access to the Tokyo Stock Exchange, the Osaka Stock Exchange, as well as others. So you are not bound to one particular exchange."

Cheung says high-frequency trading will continue to grow in Japan thanks to Arrowhead since the nation already has competitive pricing.

"We think the new system upgrade with TSE is a good opportunity for a lot of these firms to look into the Japanese market because it is very inexpensive to execute a trade here and it offers reasonably good liquidity," she says. "With all these changes, high-frequency firms are finding that it makes sense to have a local presence in Japan."

It is hoped that as Japan leads the way in HFT in Asia, other emerging markets in the region will follow suit. There are already positive signs as walls in China and Singapore are crumbling. The key to this advancement is growing local talent, says Aite's Zubulake. Right now, US and European talent dominates the scene, and that talent is more likely to go to Singapore rather than China, Zubulake says, because the political climate there is more favorable.

But even in China, there are clearly capitalistic advancements being made. In February, the Chinese government opened the door for investors to begin trading stock index futures as well as allowing for the short-selling of stocks.

"China is not exactly the most receptive [country], but that is definitely changing," Zubulake says. "We have a long way to go, but if you are looking at trends three to five years out, that is definitely going to be a hotbed of potential trading shops opening up with local talent as opposed to talent from the US and Europe going over there."

It is also hoped that as the talent gap shrinks, so too will the technology gap.

"The bottom line is that the Asian exchanges will realize that their technology is antiquated," Zubulake says.

HFT Takes off in Nordics

Mirroring Japan and Canada, the Nordics have been building their algorithmic trading capabilities since the region saw an up-tick in interest back around 2005. This has most recently culminated with Nasdaq OMX Nordic's October partnership with the European Multilateral Clearing Facility (EMCF) to launch a central counterparty (CCP) clearing service on the Nasdaq exchanges in Copenhagen, Helsinki and Stockholm. According to the parent company, Nasdaq OMX Group, since the launch of the CCP clearing service, cost for traders has fallen by about 80 percent.

As of summer 2009, algorithmic trading accounted for about 20 percent of the trading in the Nordics, says Hans-Ole Jochumsen, executive vice president and head of Transaction Services Nordic for Nasdaq OMX. Jochumsen estimates that thanks to the introduction of the clearing service and switching to a new trading platform, algorithmic trading now accounts for 30 percent of trading in the region. And, he adds, "We expect that number to grow over the coming years."

Prior to 2009, there were two major hurdles for high-frequency traders in the Nordics: no CCP clearing service and the lack of a scalable, high-speed, low-latency trading platform. In February 2010, the latter problem was addressed as Nasdaq OMX went live with its Inet trading platform, which cut costs for traders by an estimated 20 percent. The exchange says the Inet system is capable of handling 1 million messages per second at an average speed of sub-250 microseconds, down from a reported 2.5 milliseconds.

"These two things are now in place, and I therefore don't see any hurdles for high-frequency traders that would be particular to the Nordic region, as opposed to other markets globally," says Jochumsen. "Since last summer, we have gotten more specialist high-frequency trading firms connecting to our exchanges. A number of our customers actually held off becoming members until the CCP functionality was launched."

The OMXS30 index is currently the third-most traded domestic index in Europe, according to Nasdaq OMX, although it accounts for less than 10 percent of European equities trading volume. In 2009, the exchange enlisted 24 new members to trade Nordic equities and received 34 new members for trading and clearing Nordic derivatives.

Jochumsen is confident that high-frequency trading in the Nordics will continue to grow as foreign investors become more comfortable and confident in the exchange's offerings. This is a necessity-as has happened in other developed high-frequency trading regions-because low-latency trading brings liquidity to the market.

Now the concern becomes finding a balance between those in-and-out traders and investors that are in it for the long haul, Jochumsen says.

"I believe that a sound balance between the high-frequency trading and the long-term investors would be most productive," he says. "A market where all trading would stem from one investor type or the other is definitely not desirable, but if you strike the right balance, then high-frequency traders provide liquidity to the market that enables longer-term investors to move in and out of positions with less risk."