When the concept of ‘straight-through processing’ was first introduced to the securities industry in the late 1990s, people laughed about its acronym ‘STP’ and wondered what relevance the popular American motor oil additive could possibly have on Wall Street. In time, as STP (the straight-through processing variety) became the mantra of the securities industry, the old STP oil jokes subsided and are long since forgotten.
Although STP remains an important objective ten years later, the discussion around STP had become passé, uninspired, and still associated with the back-office or, more specifically, the failed US T+1 initiative. Interestingly, however, STP is back and has come full circle. In fact, current implementations of STP in the securities industry are more closely aligned with the high performance motor oil additive (claimed in advertising campaigns of the 1960s to provide ‘The Racer’s Edge’) that we joked about, rather than with the mundane back-office automation projects we were so focused on in the T+1 era. With our sights now set on pre-trade decision information and support tools, algorithmic trading, front-end order processing and execution engines, all combined with superior client service, market participants may be more reliant now than ever on STP to drive the order through execution and settlement with the precision and performance of a finely-tuned engine.
The ‘new STP’ is a high performance additive that is required to get on the fast track and remain a competitor in today’s global markets. While not specifically labelled STP per se, the automation of exchanges and electronic trading platforms are, in fact, STP projects. Compliance with regulatory initiatives such as Regulation NMS (Reg NMS) in the United States, and the far-reaching Markets in Financial Instruments Directive (MiFID) in Europe, require significant STP capabilities. ‘No touch’ order processing, client-direct FIX connections, algorithmic trading and Direct Market Access (DMA), instantaneous routing of orders to market centres that will provide the best possible execution – it is all very sexy, leading edge stuff – it’s all STP. And while having all of these capabilities is quite necessary to succeed in today’s markets, it is knowing when and how to use them appropriately that is the key to maintaining ‘The Trader’s Edge.’
To provide a context for discussion about the ‘new STP’ that is required to compete in today’s markets, this article will highlight the regulatory, technology and market changes that have been driving STP projects most recently.
Front office technology in today’s environment
Front office technology investments ranging from networks for client connectivity to integration of order management and trade execution systems, are focused on attracting clients, reducing expenses, or simply complying with market and regulatory requirements. For many firms, major infrastructure upgrades have been required to keep pace with the speed, routing logic, the multiple destinations and the sheer amount of data that must be received, processed instantaneously and retained. It is unlikely that these multi-million dollar undertakings have been labelled STP projects in most companies (after all, they do want funding), but in fact, that is precisely what they are, enabling a straight-through process from trade decision through trade execution.
Regulation’s impact on market data
Many projects have been initiated in reaction to the downstream effects of regulation, as massive amounts of market data generated are, in part, the results of alternative execution venues and decimaliisation. Issues of scalability and bandwidth utiliisation have become overwhelming as message traffic exponentially increases. By midyear 2007, OPRA traffic is projected to reach 440,000 quotes/trades per second during peak periods. CQS feeds handling NYSE, AMEX and regional exchange top-of-book quotes currently reach 5000 messages per second, as does Nasdaq’s UQDF feed. To exacerbate the situation, with the implementation of MiFID in Europe and Regulation NMS in the US, trading firms and market centres will be obliged to capture and manage these enormous amounts of market data. Low latency requirements for incoming data are essential to ensure that broker dealers are making proper decisions regarding order routing, market making and internaliisation of trades.
Exchanges and electronic platforms are finding it necessary to utiliise compression techniques to keep up with the burgeoning quote traffic. While some have resorted to proprietary methods, several major exchanges have begun testing and implementing the FAST Protocol compaction methodology. FAST (FIX Adapted for STreaming) was developed in response to industry demand to accommodate high volume situations requiring greater bandwidth. FAST thrives on large quantities of data that share similarities in content and structure, such as market quotes and trades. The proof-of-concept tests that were completed with several international exchanges demonstrated that FAST is capable of radically reducing message size and bandwidth utiliisation. By leveraging implicit tagging, field encoding and binary representation of data, FIX data feeds have been compressed by up to 90% without negatively impacting latency. In fact, speed was significantly improved using FAST when compared to other proprietary compression techniques included in the test. The FAST Protocol also has many applications beyond the market data arena, such as high frequency trading, Direct Market Access and exchange interfaces.
Trading technology enabling a new market structure
Regulation has also set the stage for an increasingly competitive environment among exchanges and market centres, ECNs (electronic communication networks), crossing networks, market makers and investment firms offering trade execution services. Regulation such as that allowing Alternative Trading Systems to operate has created new opportunities, and technology has enabled those opportunities to be realiised, causing a significant change in market structure in recent years. Facilitated by sheer computer power and reach, electronic trading platforms have leveled the playing field to a great degree, permitting new market entrants to achieve critical mass through connectivity and ‘virtual’ consolidation to amass pools of liquidity. Smaller players are able to effectively compete against centraliised market centres, as enhanced technology allows them to offer execution services with lower transaction costs or reduced market impact, or expanded services such as central counterparty clearing to improve the settlement process.
Given the competitive environment, and certainly under Reg NMS, floor-based exchanges like the New York Stock Exchange have found it necessary to move away from their traditional specialists and auction models to create hybrid structures or more fully automated electronic order execution and trade routing platforms. The impact of Reg NMS on US market centres cannot be underestimated, from forcing the switch to automated quotation systems in order to have quotes protected, to establishing direct links to competitive venues in order to ensure execution at ‘top-of-book’. Market data revenue collected by the Securities Information Processors (SIPs) are now shared 50/50 between quotes and transactions which will encourage more aggressive quoting to have the best bid/offer in the market.
- Even more significant are the changes anticipated by market participants impacted by MiFID. Effects of MiFID on market structure include:
- Ending concentration rules in many European countries, which required equities orders to be sent to the national exchange. Multilateral Trading Facilities (MTFs) will be able to compete on an equal footing with exchanges.
- Introducing internaliisation of order flow by investment firms in countries where the practice was previously prohibited. Internaliisers will be required to publish firm quotes. Investment firms will be obligated to obtain the best execution for all instruments.
- Enabling investment firms to print their off-exchange trades through a variety of channels.
Determining if technology is the cause or effect of market structure changes is an interesting discussion, but what is important and clear is that technology is critical and integral to ensuring that participants are able to leverage market structure innovations and meet regulatory demands. Most would agree that technology’s ability to support greater price transparency has resulted in increased price efficiency, and at the same time caused havoc on the competitive landscape and reduction of already razor-thin margins. These many elements have come together to form a complex global market structure where technology reigns.
Meeting ‘best execution’ requirements
Buy and sell side firms realiise that the opportunity for ‘best execution’ is no longer dependent on longstanding relationships, but on having the necessary technology, access to complete information, speed, and ability to communicate through an electronic network using digital messages. For many of the firms gearing up to comply with MiFID best execution requirements, major adjustments are needed in terms of workflow, technology capabilities and, in extreme cases, even basic business models. In the US some changes will be required for most firms to be in compliance with Reg NMS, as best execution is now expected on an order-by-order basis, and requires that strict procedures be applied and quotes snapped for each execution subject to the Regulation.
Under pressure to reduce costs, minimiise market impact and ensure compliance in order to achieve best execution, firms not only need to determine which market centre to direct order flow to, but also when and how much order flow to send at any given time. The sheer volume of order book data, and the multiplicity of sources, including the addition of ‘dark pools’ of liquidity, have magnified the complexity of order routing. To the extent that order routing decisions are being automated to adhere to compliance policies and procedures, the regulators have hastened the trend away from frequent manual intervention to ‘no’ or ‘low touch’ processes. It must be remembered, however, that the definition of ‘best execution’ is truly client- and order-specific, and must consider such factors as the need for speed, anonymity, size, trading strategy and, ultimately, market impact in calculating the total execution cost. Particularly in fixed income trading, with a low percentage of automated trading in only the most liquid securities, establishing a process to ensure ‘best execution’ can be quite subjective.
Smart order routing tools for ‘low touch’ order processing
Far from replacing the human element, intelligent order routing services aim to increase institutional productivity by breaking up order flow based on the difficulty of filling the orders. Essentially, this extends the exception-based processing model (inherent in most back-office STP solutions) to the front office. To manage total execution cost, small orders for highly liquid securities can flow automatically through the system based on pre-set business rules, whereas illiquid or larger block orders are best approached in a different manner.
‘Low touch’ programme trading tools and algorithmic trading models offer the capability to slice orders based on real-time market data in combination with historical performance information (based on post-trade analysis and feedback) to assist traders in timing the placement of their orders. The trend is moving rapidly to the buy-side where this technology is being integrated with order management systems to dynamically control routing under differing market conditions.
The use of order management systems and routing technology are critical components of success in these competitive markets which require the ability to capture order flow, direct orders, cancel/replace orders and execute flawlessly. The abundance of trade support technology utiliised by the buy side and the sell side is rendered useless without the ability to take immediate action. To maximiise trading opportunities and achieve efficiency, buy side order management systems require electronic connectivity to the sell side or other market venues, with automation on the receiving end ready to process the transaction without need for manual intervention.
Because electronic communications have not been implemented in a rigid or rigorous manner, the electronic exchange of trading information has in some ways added complexity to the landscape rather than simplifying it, as each proprietary ‘feed’ requires custom programming. For this reason, industry-wide support has grown for the use of open standards in interface design, content formats, business rules, and message protocols. Firms have found that the adoption of an industry standard can advance internal profitability through increased efficiency while enhancing its market opportunities.
Achieving STP through a common messaging standard
The ultimate goal of connectivity is that a single point of entry (with appropriate back-ups) and use of a common language would link a firm to all its counterparties, utilities and third party service bureaus either directly or indirectly. Ease of connectivity to counterparties and service vendors is an excellent test of how well a firm is handling STP. While not all firms are completely there yet, many have adopted standard messaging formats such as FIX for pre-trade through pre-settlement messages to support front and middle office functionality, and use ISO 15022 messages for settlement and post-settlement reconciliation.
In a few short years, much progress has been made in this arena with the increased use of FIX for indications of interest, trade orders, and executions. FIX has rapidly evolved to become the de facto global standard to support counterparty communications, and many exchanges throughout the world have adopted the use of FIX protocol to receive trade orders and provide notices of execution. Use of this standard also supports STP with increased ability to process the trade seamlessly; incoming messages can be more readily applied to intra-company communications, and integrated with downstream systems, internal and external applications. Messaging implementations are also being leveraged to achieve internal STP and have become a means of realiising cost savings, reducing operational risk, and improving data consistency.
Pushing the middle-office forward
Most in-house proprietary and vendor order management systems (OMS) for the buy-side are adding modules to handle a firm’s internal middle office functionality requirements, including sending allocations to Oasys and/or back office systems. Some order management services are being expanded to include matching capabilities to catch and eliminate errors prior to settlement. Those interested in reducing costs and errors by streamlining processes and promoting a closer link between the front and middle office are using standard FIX allocations messages to send and receive allocations, either directly or through their third party OMS provider.
FIXing the trade lifecycle
To date, the primary focus of FIX Protocol Ltd (FPL) has been on automating the pre-trade through trade-execution aspects of the trade order life cycle. In these areas, users of the FIX protocol have enjoyed great success in expediting orders and trade executions in equities, while adoption is steadily growing in listed derivatives, foreign exchange, fixed income and other product areas. Research indicates that FIX users have also experienced significant reduction in operational errors as a result of electronic orders and trade executions using FIX. These positive results can be improved further as FIX messaging is leveraged to perform post trade functions in an end-to-end electronic process flow.
FPL members have developed FIX messages for post-trade processing as a practical and efficient alternative to manual methods, and these are also being used to support or supplement existing electronic methods. FIX post-trade messages include allocation, electronic confirmation, affirmation and reporting. The goal in expanding the application of FIX messages to the middle office is to allow the buy-side and sell-side users of FIX to extend their current method of communicating in the pre-trade and order routing space, to complete the next phase of the trade lifecycle. While FIX message formats for allocations are being incorporated in vendor solutions, some of the highest volume market participants are pursuing point-to-point electronic messaging directly with their counterparties, finding that FIX provides a consistent and efficient approach to communicating allocations.
STP to settlement
The term ‘straight-through processing’ describes the workflow of an order from the point of decision through settlement, without manual intervention. While STP is attractive from a cost-savings perspective, it is more desirable from a risk-mitigation point-of-view. In the 2000-2001 timeframe when the US was making a concerted effort to reduce settlement to Trade Date+1, the true goal was to reduce risk – both settlement risk and counterparty credit risk. But taking a different approach, many believe that regardless of settlement cycle, risk reduction can be achieved by leveraging the central counterparty clearinghouse model. Expanded involvement of institutional market participants in the central counterparty model will go a long way to eliminating settlement issues. In the US, DTCC is developing programmes for the institutional buy-side to extend the benefits of netting with a central counterparty, provide account aggregation and other automation tools designed to streamline the settlement process. In Europe, The Giovannini Group initiative has a key focus on this topic, as has The Group of Thirty (G30).
Moving toward the central counterparty clearinghouse model
In recent years, debate over the benefits of central counterparty clearinghouses (CCPs) in a global marketplace has been integral to any discussion of STP. While there have traditionally been many CCPs throughout Europe, they typically have little reach and are merely an extension of an organiised market such as a stock or derivatives exchange. The clearing infrastructure is a patchwork of local systems operating within their national boundaries; however, this is rapidly changing through consolidation among securities clearinghouses as the majority of trades are now being cleared in a very small number of clearinghouses in Europe. The tendency toward consolidation and/or seamless interfacing of CCPs is expected to continue with the growth in trading volumes, advances in technology, and the internationaliisation of the activities of clearing and settlement infrastructures.
Market participants have increasingly expressed support for the idea of a single European central counterparty clearinghouse, which would provide multi-currency and multi-product (equities, bonds, derivatives and commodities) services. In a report Global Clearing and Settlement – A Plan of Action, The Group of Thirty reinforced the view that CCPs bring substantial benefits to the global market and also emphasiised the need for increased interoperability among clearing and settlement venues.
The Giovannini Group continues to study the opportunities for more efficient ‘pan-EU coverage’, having established a series of working groups for the purpose of identifying “a small number (2 or 3) of possible alternative arrangements for clearing, settlement and depository functionalities. A possible set of alternative arrangements would be (i) a centralised pan-EU utility for clearing, settlement and depository functionalities; (ii) a centralised pan-EU clearing counterparty with multiple settlement systems and depositories; and (iii) multiple vertically integrated clearing, settlement (and depository)‘silos’ linked to ensure pan-EU coverage.”
Among the operational benefits of a large CCP infrastructure where economies of scale can be realiised is the fact that netting transactions with a central counterparty reduces settlement costs, as significantly fewer trades actually proceed to settlement. While the debate continues from a systemic risk perspective, most agree that operational and settlement risk is drastically reduced, and a concentration of systemic risk can be controlled by a rigorous risk monitoring programme and regulatory oversight.
Crossing the finish line
Straight-through processing is not an end in itself; it is a means to reduce risk and increase profitability. The move to STP offers an opportunity to create an infrastructure that supports the business requirements of today’s environment, and provides a competitive advantage for firms looking to retain and win new business by leveraging core competencies and enhancing efficiency, both internally and in dealing with clients.
STP often involves moving from a tangled, disparate system of discrete processes to a continuous, integrated flow of data and communications. All trading firms, even those that outsource their clearing and settlement activities, need to support activities such as:
- Communication with clients and external parties;
- Bi-directional flow of information internally between front, middle and back-office or service providers;
- Ability to share common data between pre- and post-trade functions;
- Automated order-handling systems that integrate business logic to manage order protection rules, extended trading or 24-hour trading across markets;
- Cross-asset trading strategies; and
- Enhanced capabilities to meet risk management, customer relationship management, and enterprise-wide regulatory reporting requirements.
Firms implementing STP have realiised tangible benefits for their businesses. Beyond reducing fails, a well-designed STP strategy has enabled firms to manage liquidity better and offer clients diverse products. Straight-through processing has positioned firms to adapt quickly to fundamental changes in the business, including globaliisation, new market participants, and new distribution channels.
In summary, firms have improved their processing capabilities by leveraging technology to deal with the impact of regulation, changes in market structure and market practices. Amid all of these drivers, meeting client expectations is paramount for success in the financial markets. The ‘new STP’ projects are those that ensure performance in the rush to the finish line. Firms need the ‘new STP’ to navigate through an array of trading strategies and market venues to choose the best course for execution under a deluge of market data. And, under the pressure of client demands, the firms that win are those that are able to satisfy client needs – profitably. Those would be the firms that have ‘The Edge’.
1 The Financial Information eXchange (FIX) Protocol is a messaging standard developed specifically for the real-time electronic exchange of securities transactions. FIX is a public-domain specification owned and maintained by FIX Protocol, Ltd. (FPL).
2 FIX Protocol Ltd (FPL) released the FAST Protocol Specification Version 1.1 in January 2007. FAST was developed by the FIX Market Data Optimisation Working Group and is now publicly available and downloadable from the FPL website, at www.fixprotocol.org/fast.
3 Dark liquidity pools offer opportunities for institutional clients to enter orders into a system or crossing-network that is not required to display their quotes to the market, but provides execution by matching orders internally using a black-box matching engine. These are often vendor systems, but to attract more order flow dark pools are increasingly facilitated by sell-side firms that also offer price improvement over the national best bid or offer.
4 Current uses of FIX as a messaging protocol to support trading applications are being expanded, as some high volume exchanges are now implementing or considering implementation of the FAST Protocol to address their needs to distribute low latency market data.
5 The Giovannini Group is a group of financial-market participants, under the chairmanship of Alberto Giovannini (chairman – Unifortune Asset Management SGR), which advises the European Commission on financial market issues.