Over the past decade, a confluence of market, regulatory and technological events has radically changed the microstructure of many exchange traded markets. The decimalization of U.S. equity and equity options markets has resulted in smaller tick sizes, increased trading volumes and an explosion of market data information, which has challenged the data assimilation capabilities of human traders. At the same time, market liquidity has been fragmented among various equity trading venues. These changes, combined with technological advances in communications and digital computing, have expedited the migration from floor-based to electronic (point-and-click) to high speed trading (HST) where computers programmed by humans make trading decisions. So called black boxes are capable of reacting to market data, transmitting thousands of order messages per second, cancelling and replacing orders based on changing market conditions and capturing price discrepancies with little or no human intervention.
As the migration from floor trading to point-and-click trading progressed, some broker-dealers (B-Ds) and Futures Commission Merchants (FCMs) began to offer their trading platforms, which were either developed in house (proprietary) or purchased from a vendor, to their customers. Doing so provided customers with more direct access to markets, and quicker execution capabilities. Over time, some customers found the legacy point-and-click trading systems provided by B-D/FCMs were not keeping pace with some of the current technological advances and began to seek alternative solutions. In response, some trading venues and B-D/FCMs began to allow certain customers to access their markets directly (send their orders directly to the trading venue without using the B-D/FCM’s trading system) using proprietary trading platforms the customer developed and/or vendor provided trading platforms the B-D/FCMs approved.
Broadly speaking, regulatory and industry attention on high frequency trading has produced recommendations and best practices related to how pre and post trade risk controls at one or more levels of the trade life cycle — from trade execution to trade settlement — may be improved for firms that access the markets directly. Staff from the Federal Reserve Bank of Chicago’s Financial Markets Group used these recommendations as a baseline to elicit information on the controls that are currently in place at each level of the trade life cycle to manage the risks of HST. Over thirty interviews were conducted with primarily U.S. domiciled technology vendors, proprietary trading firms, B-Ds and FCMs, and clearing houses. Non-U.S. entities interviewed include one exchange, one clearing house and one foreign B-D. This article summarizes what was learned during conversations with five firms that are B-Ds and/or FCMs. The interviews focused on risk controls and other topics of interest or concern to these firms.