European markets' choice: Cut milliseconds or die

An employee works at the Tradeworx office in Red Bank, New Jersey November 17, 2009.

LONDON (Reuters) - Increasing demand for instantaneous trading is driving Europe's stock exchanges and other equities markets to spend heavily on technology to stay competitive -- and not all of the 33 players will survive.

Small venues that cannot attract enough liquidity or afford to keep up with rivals are likely to fall by the wayside or become niche venues dedicated to specialized domestic markets.

"In the end, you are going to see three or four major execution venues account for close to 80 percent of all pan-European trading," said Sang Lee, managing partner specializing in market structure at consultants Aite Group.

In Europe over the past 12 to 18 months, high-frequency trading has grown to account for an estimated 35 to 45 percent of all equity trades at the biggest venues.

High-frequency traders use algorithmic, or automated, trading to seize on pricing anomalies, trends or events and execute trades instantly. The programs make many thousands of trades in a day, each of a modest size in a liquid stock to capture the intended price.

"The ability of high-frequency traders as a group to exercise buyer power and shape market infrastructure is massive," said Instinet Europe Chief Executive Richard Balarkas.

Many exchange executives expect Europe to catch up with the United States, where Aite forecasts high-frequency trading will account for more than 70 percent of trades by year-end.

But Lee said fast trading could stabilize in Europe at a lower share, partly because of the lack of the simpler, single post-trade clearing and settlement infrastructure of the U.S. market.

London-based Chi-X Europe, which has become a major European trading venue even though it was only launched in 2007, has seen high-frequency trading hold steady at around 40 percent of its European trading activity for the past year and expects it to remain at about that level, said Chief Operating Officer Hirander Misra.

"You do have firms out of the United States coming into this space and an increase in activity, but we are seeing an uptick in non-high-frequency trading as well," he said. "With any venue you need a mixture of players for the market to work."

The rise in high-frequency trading in Europe came on the heels of European Union deregulation two years ago that opened up the exchanges to cross-border competition.

"The increased competition has pushed the regulated market to invest heavily in technology and the software behind their order books," said Axel Pierron, senior analyst at consultancy Celent.

LATENCY AND LOCATION

A key way to measure the result is latency -- the time needed to send and receive trade information.

"There has been a huge improvement in latency overall in the European cash equity markets," Pierron said. "It has evolved from a few seconds to milliseconds."

Many big venues now measure latency in microseconds, or millionths of a second. Latency also depends on distance. Data takes about one millisecond to travel 100 kilometers (60 miles) on a fiber-optic network.

That makes location vital. Exchanges offer co-location -- placing the client's computer adjacent to its own servers in its data centers -- to provide the quickest speeds.

"London is emerging as the central place for high-frequency traders, and most of the order books are going to be located in London," Pierron said.

NYSE Euronext is building a new data center in Basildon, a town near London, to host all its European business -- the NYSE Liffe derivatives business, the cash markets and co-location.

"We wanted all of our markets to be centralized physically in one location," said Anthony Attia, senior vice president in charge of its Universal Trading Platform.

The new site is also close to many of its biggest customers, not only high-frequency traders, he said. Its current primary centers in Paris and London will be maintained as disaster-recovery sites.

Speed is essential for most players in equity markets, not just algorithmic traders, said several trade venue officials.

Deutsche Boerse is keeping its Xetra data center in Frankfurt next to servers for Eurex, its derivatives exchange.

At the same time, it upgraded the link with London, shaving off several milliseconds to below 5 milliseconds. And with Xetra International Market, it is starting a program to directly trade 96 blue chips from across the continent by mid-January.

Michael Krogmann, executive director of Xetra market development and sales, sees Deutsche Boerse making investments every year for the foreseeable future in data centers and software to continue improving speed, capacity and reliability.

"It's never sufficient, of course," he said. "For customers that make a lot of money implementing arbitrage strategies, it's important to be just a microsecond faster than the other guys that might have a similar strategy."

SIX Swiss Exchange's strategy includes lowering tariffs and finding other ways to reduce costs, as well as improving latency and capacity, said Chief Executive Christian Katz.

Falling prices are encouraging clients to add connections across Europe, he said. "Many of the prop (proprietary) trading companies and banks that maybe had several servers at five co-locations across Europe, now may be able to afford more servers set up in over a dozen sites."

As the competition heats up, "Europe is already being sorted into winners and losers," said Randy Williams, head of global communications for U.S.-based BATS, which launched its trading platform in Europe just about a year ago.

Some venerable players have lost market share. The London Stock Exchange has seen its share in the FTSE 100 blue chips dip to near 50 percent from more than 80 percent a year ago.

Another possibility could be the emergence of a two-tier market, with a few pan-European players and a second tier of smaller venues dedicated to specific domestic markets, Aite's Lee said.

Still, competition on speed and pricing will eventually reach natural limits, Chi-X's Misra said. "Speed can't be a race to zero, and neither can trading tariffs."

(Reporting by Jane Baird; additional reporting by Daisy Ku; editing by John Wallace)