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John Bates, Progress SoftwareJohn Bates of Progress explains how complex event processing works and how it can simplify the use of algorithms for finding and capturing trading opportunities.

A brief summary of Complex Event Processing

Complex Event Processing (CEP) is about treating actions that happen all the time as specific events, which describe the action, and then being able to analyze those events as  they are streaming through a system, while looking through them for patterns that create opportunities or threats. In the trading world, this means things like trading opportunities, such as monitoring a set of instruments across multiple trading venues and looking for particular patterns. Those patterns might be high frequency trading (HFT), statistical  arbitrage, correlation relationship between two items, or even execution algorithms that are slicing orders based on some predefined metric.

The threats often focus around pre-trade risk. For example, will placing the trade exceed predefined risk levels, or run into potentially abusive trades, like a wash trade. CEP is about being able to monitor business in real-time to analyze what is happening now and, based on that, to try to predict what is about to happen and act on it immediately.

The value of Complex Event Processing

The world of trading is so fast moving. Research done by the AITE Group suggests that the average lifespan of a trading algorithm can be as short as three months. This is because new trading patterns are constantly coming to light and ones that might have been very successful might no longer be available as the markets become more efficient. In the old days, trading algorithms were like a cottage industry, in much the same way as the making of muskets used to be. Highly paid and highly skilled craftsmen would handcraft the algorithm. It was the domain of the very rich and not very many could be involved in the game.

With the advent of CEP technologies in the last ten years, now anyone can find patterns in fast-flowing data feeds, but more importantly, CEP provides the tools for business people to describe new algorithms quickly. This means that traders can keep up with a trading world that is moving ever faster, and which the handmade craftsmen struggle to keep up with. Suddenly, it has become easier for smaller firms to create algorithms to compete with the larger ones. There has been a revolution in software for the trading space, in that firms of all sizes now have access to the technology that was previously available only to Tier 1 banks.

Peeking under the bonnet

In a CEP platform, there is an engine which has the tools that allow you to model and visualize new strategies as they are running, as well as see any opportunities or threats. On top of this is an adaptive layer, with connectors to convey different formats of events in and out of the processing engine, taking in market data and sending out trades. CEP platforms can work off a simple consolidated feed, but organizations find that it is better to connect to trading venues directly because it reduces the latency and things can be seen as they happen.

The emergence of alternative trading venues, including dark pools, has provided the buy-side with increased liquidity, flexibility and additional execution options. Lee Porter, Head of Liquidnet Asia-Pacific, looks at the opportunities and challenges that lie ahead for the industry.

Prior to 2000, the two incumbent US stock exchanges, the NYSE and NASDAQ, dominated the equity trading landscape, leaving little choice among traders for execution venues. More than 90 percent of all executions were transacted on these exchanges. The opportunities to execute a trade of significant size were fairly limited: your broker would either commit capital or try to execute the order “upstairs” and find a natural contra to cross the trade. This was the original dark pool.

How times have changed. Through advancements in technology, altered regulation and increased sophistication of buy and sell-side participants, traders now have a plethora of alternatives to execute their orders. This applies to both the venue and method. The exchange duopoly in the US has been broken, efficiencies gained and trading costs have tumbled, all to the benefit of end investors.

The US has led the way with the evolution of MTFs, ECNs, dark pools and broker internal crossing networks, among others. Data from Tabb Group (next page) clearly shows the trend over the past few years of the incumbent exchanges’ decreasing market share to the advantage of new entrants.

Today, over 60 ATS’ are registered with the SEC in the US. Liquidnet, the largest block crossing platform in the US, according to the TABB Group, was one of the first to emerge and remains the only venue focused exclusively on the buy-side. Market share estimates for off-exchange trading in the US and Canada vary dramatically, but all show the market share on incumbent exchanges declining with flow migrating to venues that offer differentiated execution quality.

With US-based alternative venues providing clear benefits to the industry and end investors, it was only a matter of time before operators eyed opportunities abroad. Their arrival in the UK and continental Europe immediately challenged the local exchanges, which had long enjoyed the safety of favorable regulations to protect their monopolies. Today, according to figures released by the Aite Group, an estimated 16 percent of equity volume is executed through MTFs, with Chi-X leading the way.

The next logical step for alternative trading venues was expansion into Asia-Pacific, a region of growing global importance, but with geographic, cultural and technological challenges not yet encountered in the US or Europe.

Among the first to establish a presence in the region was Liquidnet with the launch of trading in Hong Kong, Singapore, Japan and Korea in 2007. Australia followed in early 2008. In addition to these socalled “dark-pools”, such as Liquidnet and BlocSec, several internal broker pools and crossing networks have already sprung up across the region.

Yet, the number of venues, as compared to Europe and the US, remains small. Market share is also a fraction of that traded on traditional platforms. An estimated 1 percent of executions in Asia-Pacific are performed away from local exchanges, according to a report from Aite Group.

Still, forecasts for industry growth are encouraging. Aite Group estimates that by 2012, 20 percent of equity trades in Asia-Pacific will be executed through alternate venues.

Aite Group’s Sang Lee argues that while naked sponsored access is causing concern among market participants, regulation alone cannot remove all systemic risk.

After years in obscurity, sponsored access emerged as a regulatory hot button issue in early 2009. More recently, it seems to have fallen off the regulatory radar screen, upstaged by high frequency trading, co-location and dark pools. Nevertheless, any future regulatory discussion regarding high frequency trading cannot take place without addressing the issues around sponsored access, and especially around the unfortunately named “naked” sponsored access.

One of our December 2009 reports titled ‘Land of Sponsored Access: Where the Naked Need Not Apply’, defines the sponsored access market, and provides estimates of sponsored access penetration of the U.S. equities market. This report also provides predictions on potential regulatory changes and possible impact on the overall evolution of the U.S. equities market. But, let’s start at the very beginning.

Reducing Latency

Sponsored access has many different meanings for market participants, and, while widely talked about, it is often misunderstood. The origin of sponsored access can be traced back to the practice of direct market access (DMA), in which a broker, who is a member of an exchange, provides its market participant identification (MPID) and exchange connectivity infrastructure to a customer interested in sending orders directly to the exchange. In this way, the broker has full control over the customer flow, including pre- and post-trade compliance and reporting. The DMA customer, in turn, gains direct access to major market centers. While firms opt to go through a sponsored access arrangement for many different reasons, reduction in latency is one of the main factors. Other, more basic reasons include additional revenue opportunities and hitting volume discounts.

There has been a lot of focus on the need for ongoing latency reduction to gain competitive edge. When breaking down the key sponsored access infrastructure components, network connectivity typically accounts for a significant portion, with an average of 450 microseconds. Exchange gateways add another 85 microseconds, and the industry average for typical pre-trade risk checks accounts for approximately 125 microseconds, with per-risk checks averaging anywhere from five to ten microseconds.

Latency levels across the three often-used types of market access (traditional DMA service; co-located, filtered sponsored access; and unfiltered sponsored access) vary widely, leading to a potential competitive edge for those firms able to achieve ultralow latency trading infrastructure. For traditional DMA services, the industry average currently ranges from four to eight milliseconds. For co-located, filtered sponsored access, the latency level dips into microseconds, ranging from 550 to 750 microseconds. Unfiltered sponsored access, not surprisingly, has the lowest range of latency, with 250 to 350 microseconds.

Challenges of Sponsored Access

Of course, sponsored access also has specific risks and challenges for participating parties as well as for the market overall. These include:

  • Supporting non-filtered sponsored access can lead to sponsored participants taking unacceptable levels of risk, which can cause both great financial burden and reputational damage to the sponsoring broker.
  • In order to support non-filtered sponsored access, sponsoring brokers must develop strong risk management and due diligence teams capable of handling the credit and operational risk of sponsored participants.
  • Broker-to-broker sponsored access can lead to a situation in which the sponsoring broker loses track of the activities of the sponsored broker’s customer.
  • Providing filtered sponsored access often leads to a higher pricing point for sponsored participants, leading to favorable competitive conditions for those brokers offering unfiltered sponsored access.
  • While the potential is slim, there is a chance that a rogue sponsored participant can increase overall systemic risk.