By Francesco Margini, Head of Product Management for Cleared Derivatives, ION Markets
Ask any experienced derivatives trader how he or she achieved success, and, after initially pointing to his or her own expertise, it will become clear that there’s more to the story than simply formulating the most effective trading strategy.
The best strategies are typically underpinned by the best execution logic, enabling traders and their clients to maximize market opportunities. This is not only about providing advanced trading strategies and new algorithms (algos) aimed at achieving the best execution but also optimising and automating the buy-side flows received by the sell-side to ensure timely and accurate execution.
Despite increasing demand for advanced trading-execution tools and algorithms implementing sophisticated strategies, far too many transactions still rely on deeply inefficient, high-touch workflows. Obstacles to this ideal execution remain in place, not least built into the very systems used to execute complex trading strategies.
Traditionally, the derivatives market has worked through the buy-side while managing the sell-side process as a manual, high-touch workflow. This creates extensive time delays between receipt of orders and actual execution on exchanges. Added to the time delays, when managers effectively submit their strategies manually, they create more opportunities for human error.
Issues on both sides
There is no single culprit for these inefficiencies; problems abound on both sides of the market, exacerbated by the FIX (Financial Information eXchange) protocol, the language each side uses by default to communicate.
On the sell-side, firms employ a plethora of tools that aim to reduce the impact of large orders received from institutional investors and mitigate the risks of the market moving against them when a large order is placed. This arsenal includes dissecting larger orders into smaller, separate ones to minimise the risk of a large shift in the market. This execution workflow is now largely automated through the extensive use of algorithmic trading tools. However, selecting the correct algo or combination of algos is often managed on a high-touch basis.
The buy-side also often sends multiple orders that need to be aggregated together and executed as a single strategy or stitched to a combination of strategies, which can be onerous and error-prone to manage manually. Sometimes, the strategy is not supported as a listed strategy on an exchange and requires further automation and careful management to execute efficiently through an automated spreading tool.
Having received the orders in an inefficient manner, the sell-side, owing partly to the limits of existing order management systems (OMS), is required to break up, aggregate and action these complex order instructions quickly and efficiently to achieve the best execution possible while maintaining accuracy and avoiding any human errors. Without one-to-one mapping from buy-side to sell-side orders, manual entry is often required to book the trades back to the buy-side, which can result in costly re-keying errors.
It is, of course, important for these brokers to action the requested strategies, but doing so accurately invites a trade-off between the time pressures on the sell-side and successful strategy execution. Existing systems offer no way for this breakdown to be completed other than manually by brokers who are working under intense time pressures and often see their desks overwhelmed with demands. Currently, therefore, it can take minutes to place these orders accurately: a lifetime in derivatives markets.
The costs of continuing in such a way are clear. Remarkably, however, large swaths of the market continue to operate in this fashion. Almost everywhere we look, we see avoidable inefficiencies and individual errors in implementing these complex strategies, and these are recognised across the board.
With increasingly complex strategies, we are likely to see the issue of high-touch flows only become a bigger problem without proper solutions. Only with the best automation technology in place throughout the flow from buy-side to sell-side will gains be realised.
There are several key benefits of employing automation technology in this way.
Firstly, the process of manually selecting the correct execution strategy and converting multiple orders into a single execution strategy is traditionally complex and extremely time-consuming to manage, adding minutes to each order’s lifecycle. Through automation, brokers can turn these minutes into mere seconds. This time-saving is a major step forward in making the market more efficient and relieving pressure on the brokers themselves.
Secondly, by delegating this work to automation, the capacity for human error is also reduced, and, therefore, so are the risk profiles of large transactions. This also simultaneously allows more time for work in other areas, allowing firms to focus on growing their businesses.
The good news is that both sides of the derivatives market are aware of these issues and possible solutions. Forward-looking brokers and managers know that the future of trading depends on innovative technological solutions, and the most successful are the ones already prioritising automation and technology.
FIXing the protocol
This, however, does not translate into an operating environment without any obstacles. For instance, the FIX protocol, the standard transport protocol that carries messages amongst traders, creates significant difficulties in streamlining the process. The protocol is now almost 30 years old; while it remains an incredibly useful technological baseline, the requirements and, indeed, the very nature of the markets in which we operate have changed fundamentally.
While it is used across a large number of asset classes, FIX lacks the specialisation required for areas such as cleared derivatives. For instance, it is unable to recognise overarching strategies or aggregate individual orders as required. Trading strategies can employ hundreds of individual orders across several legs of a single strategy in any given minute—these are all, to the manager, a logical part of the same overarching strategy. But the FIX protocol lacks the ability to recognise these disparate transactions as being linked. In order to recognise these strategies and, therefore, know to aggregate their individual transactions, the FIX protocol would need to be able to implement the sophisticated business logic that underpins the strategies. The protocol, as a relatively straightforward messaging standard used across a range of transactions, is simply unable to do so.
Further to its failure to recognise strategies for what they are, the FIX protocol lacks the other basic functions required to support the kind of trading that makes up the fundamentals of a cleared-derivative strategy. The issue is exacerbated as more and more institutional flows are now routed from buy-side OMS systems via FIX, making it very difficult for brokers to execute business in a timely manner without the assistance of an automated solution, especially during specific periods such as the “rolls”, when open positions are rolled from one expiry date to the next.
Clear problems, clear solutions
The problems facing the derivatives market are clear: too much manual inputting, leading to unnecessary risks and inefficiencies, with a protocol currently unable to recognise and facilitate the complex strategies that managers are attempting to operate.
The solutions, however, are also clear, and managers and brokers fortunately already recognise them. Technology can automate those manual processes that currently take up valuable time and invite human error. We know this remedy will work, and we also know the technological solutions to achieve successful automation.
More challenging are the additions and expansions to the FIX protocol, which is, of course, the internationally recognised standard. The aggregation required here will need different technological solutions, but until they are implemented, inefficiencies and wastage will continue to plague the derivatives market needlessly.
Advanced trading strategies and algorithms are necessary for best execution in the cleared derivatives market. However, they alone are not sufficient. Fortunately, technological improvements in automation and aggregation, the vital missing pieces to make these strategies function as required, already exist—all we need to do is seize the opportunities they offer.