Exchanges have changed tremendously in recent years. The concept of a public market for trading securities has continued to evolve ever since the first exchange was established in 13th century Belgium, but the technology-inspired transformation that has taken place in the just the last 15 years has surpassed any of the developments made in the last 500 years.

Electronic trading is ubiquitous, often algorithmic and frequently conducted in milliseconds. Meanwhile, market data is disseminated and distributed at record speeds around the globe. In many ways, these changes simply reflect the impact that technology has made on every aspect of modern life, particularly from the internet. However, it is increasingly evident that exchanges are exceptional in this regard and are now as much as a technology shop as they are a commodities marketplace.

This evolution raises an inevitable question – does the increasing use of technology enhance an exchange’s effectiveness by attracting an ever-wider variety of trading participants, or does it in fact detract from its primary purpose which is to act as a source of funding for public companies and a marketplace for physical securities?

The issue is how exchanges achieve a balance between innovative use of technology and not technology for technology’s sake, similarly how they enable trading at greater speeds from a wider variety of participants and in a wider variety of ways but do not become just about trading for trading’s sake (i.e., trading is primarily a way to keep the market and the wider economy moving and not the other way around).

It is a complex argument and one that is exemplified by the different attitudes to the rise of high-frequency trading (HFT). Beyond the difficulty of sometimes differentiating between algorithmic trading and HFT, some perceive a predominance that is both unfair and harmful to market integrity. While others will contend that HFT adds valuable liquidity and keeps the market efficient and the same algorithmic techniques are now used across the market by a vast variety of participants.
The different approaches taken by regulators illustrate the different attitudes to HFT. For example, German regulators have imposed a code of conduct and capital requirement on HFT firms while the U.K., home to the largest number of HFTs, has taken comparably little action and the Securities and Exchange Commission in the U.S. is still considering what rules to introduce.

Force for good

It is abundantly clear that technology has largely been a force for good for exchanges. Great computing power has allowed them to increase their trading capacity, extend connectivity around the globe, enable sophisticated trading techniques to have a global reach and to ensure that markets are fair and orderly and more democratic. The days of trading floors and continuous auction have been replaced by electronic trading, all but eliminating human error and vastly reducing the chance of fraud.

Technology has also made global capital markets more accessible to a wider range of participants – the small and specialist hedge funds with a technology budget. The changes have not been limited to trading. Technology has also transformed the use market data making it instantly available to a global audience, including an increasing number of retail traders. And automated clearing and settlement has made the markets far safer, markedly reducing the number of failed trades.

Just as technology has enabled greater global connectivity, this has imposed a certain operational standard on exchanges. Users want a consistent trading experience regardless of where they are trading. This means all exchanges have to be fast, reliable, with exceptional matching capabilities, a high sub-set of execution functionality, instant provision of market data and accessibility to a wide variety of participants from high-frequency traders to occasional retail traders.

Technology innovation has also allowed global regulators to realize their ambitions of creating multiple venues for same listings (MiFID) through smart order routing technology which addresses the risk of market fragmentation. This, in theory, should lower costs for participants and make exchanges more innovative and competitive.

Examples of technology innovation

Co-location, whereby trading firms are able to situate their own matching engines as close as physically possible to those of the execution venues, is now a pre-requisite for the vast majority of exchanges and a clear example of the heightened expectation that market participants have of the technology standards on display at their chosen execution venues. High-frequency trading is commonplace in more than 80 international exchanges and the number is constantly expanding as exchanges look to cash in on the demand for ever lower latency. To some, however, co-location embodies the so-called arms race between exchanges and the pursuit of a benefit for a minority of participants at the expense of the wider majority.

Real-time compliance is another pre-requisite for today’s exchanges. Just as technology has allowed for faster trading, so it has raised the need to be able to guard against market manipulation and malpractice. Technology has forced exchanges to monitor, detect and act on any suspicious trading activity – from insider trading to spoofing to market manipulation or even genuine mistakes courtesy of human error or malfunctioning automated trading engines. As the pace of trading increases, exchanges need to be able to react quickly to protect the integrity of the markets and they need the tools to achieve this – to monitor transactions, analyze patterns, detect any abnormal activity, generate alerts and enact the necessary checks.

An exchange is now a technology shop. In general, exchanges have become great users of technology. In many ways, exchanges have always been based on competition (which has the most liquidity, the most prestigious stocks) and an element of national pride (New York vs. London vs. Frankfurt, etc.). Now this competition is being fought in terms of technology (who has the lowest latency and the most sophisticated trading platform).

Technology has also changed the nature of exchanges from national-based venues focused on single asset classes to multi-market entities. Connectivity advances have enabled large exchanges to pursue acquisition ambitions but also allowed smaller exchanges to link up (ASEAN, Mila in South America, etc.).

Technology also offers smaller, regional exchanges a chance to compete with larger more established exchanges by virtue of the fact that they are not beholden to legacy technology and fixed telecom infrastructure and can move directly to the latest technology as the base for their trading platform.
This advantage has been ably demonstrated by the Singapore Exchange which plans to develop its own messaging protocol based on the latest ISO 20022 standard which will cover everything from trading to settlement and corporate actions to proxy voting, putting at the very forefront of technology standards.

Achieving the balance

Exchanges have to avoid spending too much on technology for technology’s sake, for example an endless pursuit of low latency which could reach the point of absurdity whereby it costs an increasing amount of money to make ever smaller improvements in trading speed.

Another great example of technology innovation is the growth of peer to peer lending and crowd funding. Websites such as Kickstarter have used the internet and social media to great effect as an alternative way to finance films. Individuals can pitch their projects on the site and individuals can donate in exchange for a share of the potential profit.

These sites are also competing with smaller exchanges as a way to raise finance, not least because of the low cost when banks and brokers are not involved and the greater interest rates on offer (often as much as 5%) and a revolution is needed for these exchanges to compete. By making similar use of the internet and social media, they can offer a more insured and formalized way to engage in peer to peer funding.
Whereas there is a risk of the unknown in the likes of Kickstarter, an exchange can offer an organized infrastructure, protection against abuse and a mutualization of risk.

In essence, smaller exchanges must continue to use technology as a way to innovate and explore new opportunities but also to underline their core value as an organized marketplace for investors and entrepreneurs, as was the case back in 13th century Belgium.