Monday, May 17, 2010

Out from the Shadows: Low-Latency Trading Services Gain Mainstream Attention

In the 1987 stock market crash, the world as a whole became aware of electronic information services that had enabled financial institutions to take advantage of small gaps in the timing of market activity between trading of securities futures and options markets and trading in stock markets. "Program trading" was tagged as one of the key villains in the market rise and fall, resulting in some self-imposed limitations taken by many securities markets on the actions that were allowed to trigger such electronic trading. Investor confidence returned, and the securities markets enjoyed a great, long run of successes. Yet both government regulators and the mainstream media did little to keep an eye on how content technologies were continuing to change the face of financial markets.

In 2010, of course, we are living with the consequences of this lack of awareness and responses to the continued progress of financial information services. It's somewhat strange and ironic, then, that while trade magazines have focused for many years on low-latency trading - the technologies that allow near-zero lag time in obtaining financial market information and executing securities trades instantaneously based on that information - mainstream outlets such as The New York Times are just beginning to catch up to the realities of how investment markets have worked in the low-latency era.

Low-latency trading technologies and services are in many ways just an accelerated version of the technologies that began evolving in financial markets during the 1980s. If financial markets have always had somewhat of a casino-like ambiance, then low-latency trading allowed the "whales" of finance to turn the computer-based "back rooms" where these systems work into huge profit-drivers, enabling these investors to move in and out of market positions fast enough to keep ahead of retail investors armed with slower and fewer information sources. Being able to trade in advance of generally available knowledge has always been at the heart of the profits for securities dealers, and information services have been only too glad to help design and deploy services on their behalf which can give financial institutions an inside edge.

Having an edge in today's Web-based world, though, is tougher to obtain than ever. Most dialed-in small investors are on top of the latest trends impacting markets through online financial information services that deliver news almost as quickly as news obtained by financial institutions. Many, using services such as Twitter, may in fact be on an equal footing with breaking insights that may trigger shifts in investments. It's no surprise, then, that financial institutions are dialed into social media statusing and discussion services almost as much as traditional information sources. With so much information transparency, it's hard for traders to profit from securities transactions without enormous volume or ontaking huge risk.

With the instability in financial markets of the past few years, regulators seem to be asking anew what the role of financial securities markets should be in advancing their nations' economies. Put simply, the question that needs to be answered is how best to encourage individuals and institutions to take on the risk of investing in capital markets in a way that helps economies to grow and investors to buy and sell their securities in liquid markets. Unfortunately, the answer to this question may not please either the financial institutions that have ruled financial markets for several decades or the information companies that have serviced them.

The answer to this question is, ultimately, to limit severely the ability of financial institutions to bet against those holding the securities that represent the primary risks in their markets by engaging in limitless trading of financial derivatives products. The derivatives beast unleashed by program trading in the 1980s was never put back in its cage; it was simply given the appearance of civility while it was on the loose. Yes, derivatives serve an important purpose in enabling investors and their trading partners to smooth out their investment risks, but when they displace capital investments as a primary focus and purpose then both those investors and the information services that support them are on shaky ground.

This is not to say that low-latency trading should die along with restricted derivatives trading. If shifts in the marketplace are likely to create new streams of demand for buying and selling a specific stock or bond, then traders should be allowed to stay ahead of that flow in an efficient manner. This can only help to support market liquidity in the long run. But what's been missing for the past decade in capital markets is a focus on the value of fundamental objective analysis of the underlying risks of capital investments.

It's no secret that traditional ratings agencies have fallen short in supporting this goal, even as investment banks have continued to outsource the analysis of many securities to third parties that usually lack detailed insights into the institutions that they are analyzing. At the same time there has been little incentive given to information services companies to bring more transparent fundamental securities analysis to global markets. Most developing nations fight issues of corruption and conflicts of interest in the regulation of their securities markets even worse than those found in North American, European and developed Asia/Oceania markets.

Yet if a fraction of the profits that flow out of today's low-latency trading were invested in developing more efficient global securities analysis services, how much better capital markets would be in the long run. I for one would love to have much more confidence in how to invest in small startups and going concerns in the U.S. and overseas. The ability to do this effectively has been lost as information services companies followed the lead of major financial institutions chasing profits in supporting trading in risky derivatives that drew capital away from primary investments.

With the relatively low profits obtainable from everyday securities trades it's doubtful that today's investment banks are going to bend backward to enable this to happen, though. Instead, it's far more likely that we'll see a regime of globally-sponsored regulations and funding sources that will begin to lay the groundwork for a new world of financial information services that will provide developing businesses and developing nations more efficient access to capital markets. The global propagation of XBRL as a data formatting standard for financial information reporting is likely to make the development of such services more cost-efficient than ever.

Will the likes of Thomson Reuters, Bloomberg and others be the ones to profit first and foremost from such services? Perhaps. But I do think that these emerging trends are just as likely to spawn a new generation of  Web-inspired financial institutions and financial information services companies that are willing to package financial information more the way that the investors seeking long-term growth in their holdings want to see it. We know where the era of "get rich quick" has lead us. It's time to get used to the idea that global "get rich slowly" investing is likely to gain more prominence for financial information services in the years ahead.
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