Technology in Financial Markets

Kaushik Gala

19 Jan 2009

Technology Infrastructure (NSE)

Software Providers

(FinTech, NSE.IT, Omnesys)

Messaging Protocol

(CTCL, FIX)

Telecommunication Protocol

(x.25, TCP/IP)

Physical Connectivity

(Satellite, Terrestrial)

Driven by:

• Regulation

• SEBI

• Competition

• BSE, FT

• Market participants

• FIIs

• Security concerns

• Hackers

Connectivity: VSATs & Leased LinesA Very Small Aperture Terminal (VSAT), is a two-way satellite ground station with a dish

antenna that is smaller than 3 meters.

VSATs access satellites in geosynchronous orbit to relay data from small remote earth stations (terminals) to other terminals (in mesh configurations) or master earth station "hubs" (in star configurations).

http://en.wikipedia.org/wiki/VSAT

NSE’s VSAT network

3000+ VSATs

2 VSAT hubs

1500+ cities

NSE’s leased lines

1000+

64 / 128 kbps

http://www.nse-india.com/content/us/us_technology.htm

http://www.nse-india.com/content/members/mem_vsats.htm

Sun Outages

“A sun outage is an interruption in or distortion of geostationary satellite signals

caused by interference from solar radiation. The effect is due to the sun's

radiation overwhelming the satellite signal.

Generally, sun outages occur in February, March, September and October, that

is, around the time of the equinoxes. At these times, the apparent path of

the sun across the sky takes it directly behind the line of sight between an

earth station and a satellite.”

http://en.wikipedia.org/wiki/Sun_outage

http://www.satellite-calculations.com/SUNcalc/SUNcalc.htm

Issues

Trading suspended for several minutes

Intraday data feeds need to be adjusted

Patterns in trading across the outage

2009: No Sun Outages?

“SEBI has advised that henceforth, during the Sun Outage Period markets

would not be closed and trading would continue in the normal course.”

For those with only VSAT:

a) In Mumbai, Chennai, Ahmedabad, Delhi and Calcutta, use 2Mbps IP

Leased Lines

b) Others, connect via Internet using internet based software like NOW

http://www.nse-india.com/content/circulars/memb11821.htm

Networking: X.25 → TCP/IP

“NSE’s current Trading System uses the X.25 protocol over its terrestrial and

satellite based Wide Area Network (WAN). In order to facilitate higher

bandwidth, expansion and scalability, consolidation of technological

infrastructure at member end, better uptime, WAN connectivity to the BCP

centre, and migration away from the X.25 protocol, the Exchange has

decided to migrate to a TCP/IP protocol based Wide Area Network..”

http://www.nse-india.com/content/circulars/memb10833.zip

Faster (2 Mbps)

Cheaper (WWW uses TCP/IP)

Necessary (High-frequency trading)

Migration to finish by Q1 2009

CTCL

Computer to Computer Link

Messaging protocol, used to transmit/receive market data & trade

information

Software Vendors

Financial Technologies (FT), NSE.IT, Omnesys, TCS, Asian CERC, …

CTCL → FIX

Open, free, global, industry-driven messaging standard

Protocol, not software

Adopters: Banks, exchanges, broker-dealers, software providers

http://www.fixprotocol.org/what-is-fix.shtml

http://www.fixprotocol.org/adopters/

NSE’s IT Setup (Security)

http://www.skoch.in/Exchange_Level_Security_CKajwadkar.pdf

NSE’s IT Setup

http://www.networkmagazineindia.com/200211/nse.shtml

Software Solutions

http://www.networkmagazineindia.com/200211/nse.shtml

Order matching

Front-end (quotes,

charts, queries)

Risk management

Front-end (quotes,

charts, queries)

Risk management

Admin, Access

control, Risk mgmt

Transaction

processing

Audit

Program trading, DMAHistorical &

live data feeds

Order Matching vs. Market MakingNational Exchange for Automated Trading' (NEAT)

• Fully automated screen based trading system

• (Limit) order driven system (vs. quote driven system)

• Everyone can access the same market and order book, irrespective of location, at the same price and cost

• Best buy order is matched with the best sell order

Market Making

• Market-maker provides both a sell and a buy quote

• The bid-ask spread is the profit for the trade.

• MMs add to liquidity & depth of market (?)

• Brokers!http://en.wikipedia.org/wiki/Market_maker

Software Providers

Note

• FT is by far the largest (80% market share, ODIN)

vendor for Indian markets

• NSE.IT is a subsidiary of the NSE

• FT owns MCX (largest commodity exchange in India)

• FT owns Ticker Plant, a data/news vendor

FT Product Portfolio

http://www.ftindia.com/solutions/exchangesolutions/DOME.zip

NSE vs. FTJune 08

NSE picks up a 26% stake in software vendor Omnesys

August 08

NSE launches currency derivatives

SEBI gives approval to MCX (in which FT has a 32% stake) for launching currency derivatives

September 08

NSE refuses to share currency segment API (application programming interface) with FT → FT can’t add it to ODIN front-end

NSE does share API with Omnesys & Asian CERC

October 08

NSE puts FT on “watch list” because of complaints over the past two-and-a-half years from its trading members w. r. t. bugs in FT software

December 08

FT sues NSE alleging “malafide intentions of stifling competition...and with a view to cause loss to the plaintiff (FT) by benefiting its competitors.”

Market Data

End of day, Intraday (hour, minute, tick)

Stocks, futures, options, . . .

Order book

Trade book

SPAN Margins

Corporate information

Actions (eg. bonus/split), financials (quarterly, annual), news, etc.

Adjustments & corrections

Holidays, sun outage, floods (eg. Jul 05), unforeseen circumstances, etc.

IPOs, Delisting

M&A, Divestiture (eg. Reliance)

Vendors: Asian CERC, Capital Market, Bloomberg, Reuters, eSignal, etc.

SWIFT

Society for Worldwide Interbank Financial Telecommunication

Carrier of messages (financial information)

“Secure exchange of proprietary data, ensuring confidentiality & integrity”

Mean Reversion?

http://paul.kedrosky.com/archives/2009/01/23/bankers_pay_as.html

http://pages.stern.nyu.edu/~tphilipp/papers/pr_rev15.pdf

Mean Reversion?

15-20% CAGR since 2003

http://www.gold-eagle.com/editorials_03/marais031003.html

Michael Mauboussin, Legg Mason Cap Mgmt

http://www.michaelmauboussin.com/press_room.htm

Direct Market Access (DMA)

“ Direct Market Access (DMA) refers to electronic facilities

that allow buy side firms to more directly access

liquidity for financial securities they may wish to buy or

sell. Using DMA, the firms still use the infrastructure of

sell side firms but take over more of the control over the

way a transaction ("trade") is executed.” – Wikipedia

Why DMA?

Fast

Cheap

Less error-prone

Efficient (Arb → 0)

Liquidity (eg. Options)

Proprietary

Audit

Why not DMA?

Correlations

Technology failure

The October 1987 Crash

Computers out of control?

Program trading (no manual intervention by broker)

Portfolio Insurance: Short sell futures to hedge equities

Selling → Stop losses → Selling

“Orders for 396 million shares were entered into the New York Stock Exchange's DOT system . . . This overwhelmed the DOT systems . . . resulting in significant delays in executing market orders and in entering limit orders . . . market orders were executed at prices very different from those in effect when the orders were placed.”

http://www.jstor.org/pss/2328969

http://www.newlearner.com/courses/hts/bec4a/ecoho16.htm

DMA → 20% of Total Equity Trading

http://www.celent.com/PressReleases/20080313/DMA.htm

DMA in India

Fully automated / computerized

✓ Order placement

✓ Order matching

✓ Risk management

✓ Payment and settlement

But, until mid-2008:

“only one trading strategy could be automated: one-shot futures arbitrage through cash-and-carry or reverse cash-and-carry. NSE staff read the computer programs of the trading house to verify that this is the only strategy that is being used before permission to trade is given.”

SEBI April ’08 Circular

Allows DMA for institutional clients

Institutional investor can place orders w/o manual intervention by brokers

Trade and settlement obligations, risk management continue to apply to the broker

Brokers see trades as they happen → No front running!

“better use of hedging and arbitrage opportunities through the use of decision support tools / algorithms for trading.”

http://www.bseindia.com/dma.asp

http://www.bseindia.com/downloads/dma/Annex%20I.zip

DMA Software Providers DMA Live! By Financial Technologies

Execution Management System (EMS) allows institutional clients to place the DMA orders to multiple brokerage houses for execution

FIX complaint (FIIs)

NEST by Omnesys

In-house? Estimated cost of development ~ Crores of rupees

http://www.ftindia.com/solutions/brokeragesolutions/DMALive.htm

http://www.watersonline.com/public/showPage.html?page=807239

DMA Market Potential

1,000 brokerage firms

Top 15 account for 85% of total

institutional trades

1500+ FIIs

Hedge funds already use DMA in

developed markets

“Major brokerage houses are in a race with each

other to enhance their trading systems and be

among the first to offer these services.”

Estimate: DMA trades will amount to 11%

of total flow of trades by 2010

http://www.antara.co.id/en/arc/2008/8/8/financial-technologies-launches-dma-live!/

http://www.celent.com/PressReleases/20080730/IndiaDMA.asp

DMA Status – Jan 2009

1st trade executed by BNP Paribas / Geojit in July ‘08

Several brokers (esp. MNC) are up & running

MF Global

UBS

Morgan Stanley

JP Morgan

CLSA

Motilal Oswal

. . .

Issues

Paperwork

Technology (Software)

Market environment – liquidity, capital, leverage

Exchange Technology Upgrades

NSE

x.25 → TCP/IP

Snapshot → Tick ?

BSE

Enable international brokers via extranet

MCX, NCDEX ?

Algorithmic Tradinga.k.a. Automated / Algo / Black-box / Robo / Quant trading

(Computerized) algorithm decides:

What to buy/sell

When (time and/or price)

How much

When to get out

Algorithmic Trading - Types

Order execution

VWAP, TWAP

Arbitrage

Classic

Statistical

Market making

Indexing

Hedging (Portfolio insurance)

Patterns

Technical indicators (moving averages, etc.)

Neural networks / AI

News / Sentiment

. . .

http://www.sifma.org/tmc2007/pdf/JulioGomez.pdf

Algorithmic Trading – Nifty Options Arbitrage

http://nseindia.com/content/fo/optionChain.htm

Algorithmic Trading – Statistical Arbitrage

http://en.wikipedia.org/wiki/Statistical_arbitrage

"refers to highly technical short-term mean-reversion strategies

involving large numbers of securities (hundreds to thousands,

depending on the amount of risk capital), very short holding periods

(measured in days to seconds), and substantial computational,

trading, and IT infrastructure.” – Wikipedia

Long Term Capital Management (LTCM)

US, Japan, Europe bonds

Minute mis-pricings → Huge leverage (25x)

Russia defaults → Investors dump Japan, Europe bonds

Small mis-pricings become big mis-pricings

$1.6B loss

Algorithmic Trading – Side Effects

Order to trade ratio (Upto 100:1)

Order cancellation (Upto 90%)

Order matching – System delays/failures

Concentration in few instruments

IT spend (Billions)

http://www.tellefsen.com/Algorithmic_Trading_TCG.pdf

Algorithmic Trading in India: A BPO Opportunity?

MIFC Report, http://finmin.nic.in/mifc/mifcreport.pdf (Pages 69-74)

Algorithmic Trading in India: A BPO Opportunity?

Quantitatively orientated firms that analyze vast data feeds with decision-making by computers

Requirement: High quality skilled labor in

Econometrics

Quantitative finance

Advanced mathematics (statistics)

Computer science

Wage arbitrage!

MIFC Report, http://finmin.nic.in/mifc/mifcreport.pdf (Pages 69-74)

Technology-driven Finance

http://www.euro-events.com/nyseeuronext/pdf/getpdf.asp?conf=nyse2008&getfile=Mark%20Wheatley%20-%20ML.pdf

Technology-driven Finance

http://www.euro-events.com/nyseeuronext/pdf/getpdf.asp?conf=nyse2008&getfile=Mark%20Wheatley%20-%20ML.pdf

Securitization “Securitization is a process for the reallocation of risk; assets

are converted into securities backed by those assets.” Diversification!

Why? Lower funding costs

Access the capital markets

Improve cash flow

Financial engineering Data: On performance of underlying assets

Structure: Model the ‘cash flow payment waterfall’

http://www.vinodkothari.com/seccont.htm

http://www.csfrc.com/research/UploadFiles_9404/200610/20061023102311343.pdf

Securitization

http://www.membersocieties.org/srilanka/linked%20files/Securitisation.pdf

What can you securitize?

Home loans

Car loans

Personal loans

Credit card loans

Education loans

Receivables

Intellectual property (patents)

Royalties

Aircraft leases

. . .

http://en.wikipedia.org/wiki/Asset-backed_security

Role of Technology in ABS

Research & analytics technology to assess

Pre-payment risk

Default (credit) risk

Refinance risk

Interest rate risk

Pricing & risk management models

Statistics (Monte Carlo)

http://www.euromoneyplc.com/images/covers/Asset%20Securitisation%20and%20Synthetic%20Structures%2

0Innovations%20in%20the%20European%20Credit%20Markets/02Watson.pdf

Credit Default Swaps A credit default swap (CDS) is a credit derivative contract between

two counter parties. The buyer makes periodic payments (premium leg) to the seller, and in return receives a payoff (protection or default leg) if an underlying financial instrument defaults.

http://en.wikipedia.org/wiki/Credit_default_swap

http://seekingalpha.com/article/77268-credit-default-swaps-and-counterparty-risk-beware-what-lies-beneath

Role of Technology in CDS

Research & analytics technology to assess

Credit risk

Counter-party risk

Mark-to-market valuation

Taxes

Pricing & risk management models

Statistics (Monte Carlo)

http://www.bnyconvergex.com/ASSETS/1BF669AE777B47DFA474CAE2D7916180/Lightening%20the%20Load.pdf

High Frequency Trading

Rapid analysis of tick data

Statistical, adaptive models

PhDs

Enabled by

DMA (Broker technology)

Broadband (Internet technology)

Real-time data feeds (Exchange technology)

Examples

Renaissance Technologies’ Nova Fund accounts for 10-15% of daily

equity volume on the NASDAQ

http://www.olsen.ch/fileadmin/Publications/Archive//hedgefuture.pdf

http://www.algorithmics.com/EN/media/pdfs/risk_highfrequency.pdf

http://richard-wilson.blogspot.com/2008/08/renaissance-technologies.html

Statistical Arbitrage

Combination of

Data mining

Modeling

Automated (algorithmic) trading

Enabled by

Computational power

Market makers in disguise?

Provide liquidity

Examples

D. E. Shaw, Citadel, etc.

http://www.cass.city.ac.uk/airc/pdf/Of%20MM%20and%20HF.pdf

Hedge Funds’ Technology Spend

$1.7B in 2008 Risk analytics, monitoring and control

Legal and compliance risk reporting

Pricing and valuation

Liquidity risk management

Performance measurement and attribution

Multi-prime broker platforms

Algorithmic trading

Smart order routing

http://www.securitiesindustry.com/news/23110-1.html

Client Interface

Analytics tools

Morningstar

Gridstone

Trading tools

Data feeds

Wealth-lab

Online trading

APIs

Order & execution management

Reduction in transaction costs

Direct purchase of mutual funds

Online brokerage fees

Demat, IPO applications, Fund transfer, …

Technology fails

3 exchanges down in a week (2000)

LSE

8 hour outage

Heavy volumes → Problems in real time data feeds

Toronto

Software bug

Nasdaq

Heavy volumes & volatility → Performance degradation

http://www.computerworld.com/news/2000/story/0,11280,43791,00.html

Tokyo Exchange: $330M typo (2005) Down for a full day

“Computer glitch”

Mizuho Securities

Typo → $330M loss

An employee at Mizuho, a subsidiary of the Mizuho Financial Group, mistakenly typed an order to sell 610,000 shares at 1 yen, or less than a penny each, instead of an order to sell one share at 610,000 yen ($5,057) as intended.

Mizuho’s systems didn’t catch the error

Risk/margin?

TSE system blocked the cancellation request for 10 minutes!

Outdated systems, poor safety measures

http://www.nytimes.com/2005/12/13/business/worldbusiness/13glitch.html?_r=2

A Virus in Russia (2006)

1 hour shutdown at Moscow’s Russia Trading System

Virus attack

Entry via a test trading system connected to the exchange

"The infected computer started generating huge volumes of parasitic

traffic, which overloaded the RTS's support routers. The result was that

normal traffic - data going into and out of the trading system - was not

processed,"

http://www.scmagazineus.com/Russian-stock-exchange-attacked-by-virus/article/32918/

Quant (Credit) Crisis, August ‘07

“The events of August 6 2007 may have been the result of a rapid

unwinding of one or more large long/short equity portfolios, most likely

initially a quantitative equity market-neutral portfolio. This unwind

created a cascade effect that ultimately spread more broadly to

long/short equity portfolios, 130/30 and other active-extension

strategies, and certain long-only portfolios (those based primarily on

quantitative stock-selection and systematic portfolio-construction

methods).”

“August 2007 is far more significant because it provides the first piece of

evidence that problems in one corner of the financial system (possibly

the sub-prime mortgage and related credit markets) can spill over so

directly to a completely unrelated corner: long/short equity strategies”

http://web.mit.edu/alo/www/Papers/august07.pdf

United Airlines $12 → $3

Sunday, Sept 6 2008

A 2002 article with the headline "UAL Files For Bankruptcy" suddenly

appeared in the "Most Popular" section of the web site of the Tribune-

owned Florida newspaper Sun-Sentinel.

Googlebot found the article and made it searchable within Google

News.

A securities analyst summarized the article and uploaded the

summary to Bloomberg.

Monday, Sept 7 2008

UAL stock drops 75%

$1B in market cap wiped out

http://www.alleyinsider.com/2008/9/when-algorithms-attack-how-googlebot-and-tribune-and-some-idiot-killed-united-air-

lines-stock

LSE down for a day (Sept ‘08)

Suspended for 7 hours

“one of London's busiest trading days of the year, as markets

rebounded worldwide following the U.S. government's decision to

bail out Fannie & Freddie.

Huge volumes → Connectivity problems

“The UK Financial Services Authority, in its Financial Risk Outlook

2008 report, says the risk of such infrastructure failures is growing

with the rise of electronic trading and straight-through processing.”

http://www.reuters.com/article/ousiv/idUSL01084620080908

Could technology have caught Madoff? $50B scam

‘Fund of funds’

Due diligence

http://www.financetech.com/feed/showArticle.jhtml?articleID=212903239&cid=RSSfeed_FTN_All

Read: Charlie Munger

The Art of Stock Pickinghttp://www.vinvesting.com/docs/munger/art_stockpicking.html

The Psychology Of Human Mis-judgementhttp://www.vinvesting.com/docs/munger/human_misjudgement.html

Collection of articleshttp://www.sandmansplace.com/Articles_Munger.html

Watch: Niall Ferguson

The Ascent of Money 5-part series @ YouTube

http://www.youtube.com/watch?v=Px5tKq7s9DY

Technology in Financial Markets

Kaushik Gala

2 Feb 2009