The Commoditization of Electronic Trading is the second article installment of a four-part Brokerage: Analysis and Execution series that will explore the rise of electronic trading, the commoditization of execution and the future of Wall Street. Read the first article Rise of Trading and Equity Research. Street Smarts insights are written by Blair Livingston, Chief Executive Officer and Founder, Street Contxt.
Historically analysis and execution have been of equal value to the client. That began changing in the late 90’s, and became truly apparent in the early 2000’s, with the rise of a new trend: Electronic Execution.
Geography is a Limitation to Sourcing Liquidity
One of the biggest challenges to trading is sourcing liquidity. In it’s early days New York Stock Exchange (NYSE) and curbside markets relied on geographical proximity. Sourcing liquidity was limited to those directly beside you or within shouting distance.Trading posts were organized around the lamp posts on the streets outside where the NYSE currently stands.
As communication technology came into play, and a larger communication network was possible, the potential for liquidity access increased. Geographies became connected by horse and buggy, telegraph, and then a phone. Local markets gained momentum with hubs opening up around the globe. Financial centres such as London and New York were gaining critical mass. However, it was not until the late 90’s that the biggest liquidity sourcing tool would enter the market: the computer and a connected network.
A Connected Network Centralizes Liquidity
A central limit order book is a collection of all buy and sell orders. The ability
to centralize liquidity in a central limit order book is one of the greatest advantages that a machine brings to trading. A machine can index and update this book faster than any human and allow other machines to access the information. Electronic execution fundamentally altered the trading landscape on Wall Street. It started with homogenous asset classes such as currencies, equities, and then expanding to other asset classes over time.
The rise of electronic trading began the race to zero in two categories: time and cost. More money was invested into electronic trading and the systems improved rapidly. In 2000, an electronic trade might execute in seconds or milliseconds, in 2015 that number was microseconds, trending towards picoseconds. Systems are now beginning to approach theoretical limits – where the laws of physics won’t let them move any faster.
The lower costs associated with access to these systems resulted in a decline in access to liquidity. By leveraging technological scale, brokers could offer their clients execution at lower prices, which drove down the cost of execution as everyone raced to zero. With scalable electronic systems in place brokerages needed fewer bodies on the trading floor. There was now an option to remove the human cost overhead associated with traders.
Exchange Communication Networks (ECN) and Exchanges becoming electronically accessible centralized liquidity and resulted in commoditization of execution. Trading gradually became less differentiated and less difficult, resulting in clients placing lower value from the execution that their brokers provide. Even the differentiators that do exist today – market expertise, firm capital, etc. – are becoming less and less important. The commoditization of execution is almost complete.
Next, we will explore the The Commentary Advantage, Adding Context to Trading Execution as the third part of our Brokerage: Analysis and Execution thought series.
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The Street Smarts insights are written by Blair Livingston, Chief Executive Officer and Founder, Street Contxt. Mr. Livingston has committed his expertise in market structure, financial technology, financial commentary and communication practices to shape a new, more effective capital markets system. Street Contxt helps to clarify an increasingly fragmented marketplace, connecting sell side content with the preferences of buy side participants. Connect with Blair Livingston on LinkedIn.