Exchange Revenues are Exposed to Latency Risk

TABB Group Says over 50% of All Exchange Revenues are Exposed to Latency Risk, Up from 22% in 2003.

According to TABB Group in a new research note, "The Value of a Millisecond: Finding the Optimal Speed of a Trading Infrastructure," the ability to quickly receive, manage and relay order book information has become critically important to the competitiveness of exchanges and electronic communication networks (ECNs). This has lead exchanges to evolve toward the newer ECN model, which is why TABB Group estimates that 56% of all exchange revenues are exposed in 2008 to latency risk, up from 22% in 2003.

"It's about time-to-market, literally," writes Willy Reporter, senior consultant at TABB Group and author of the research note. "The benchmarks for speed have reduced latency in exponential terms. Open outcry was measured in seconds, whereas electronic venues now boast matching capabilities in microseconds - and the stakes are high." He adds that as matching engines within newer execution-venue infrastructures move into single-digit microsecond capabilities, this competitive advantage will need to be equaled by the traditional exchanges "or the 8% loss of market share experienced by other execution venues in 2007 will only continue to grow."

For U.S. equity electronic-trading brokerages, handling the speed of the market is of critical importance, writes Reporter, because "latency impedes a broker's ability to provide best execution. In 2008, 16% of all US institutional equity commissions are exposed to latency risk, totaling $2 billion in revenue."

As in the Indy 500, the value of time for a trading desk is decidedly non-linear, he says, and accordingly, TABB Group estimates that if, for example, an agency-broker's electronic trading platform was five milliseconds behind the competition, it could lose at least 1% of its low-touch flow, putting the industry-wide value of those first five milliseconds at $4 million each. Up to 10 milliseconds of latency could result in a corresponding 10% drop in revenues, and from there it gets worse, explains Reporter. "If a broker is 100 milliseconds slower than the fastest broker, it may as well shut down its FIX engine and give up on offering low-touch business."

While overall IT spending specifically on messaging infrastructure is expected to remain flat - approximately $1.8 billion through 2010 due to a reduction in maintaining legacy investments while shifting resources toward improving latency-related management - TABB Group estimates that low-latency expenditures will almost double, from under $100 million currently to about $170 million by 2010.

As the markets continue to race ahead due to the technological improvements in analyzing and executing trades, participants on both sides of the trade need equally fast market- and operational risk-management capabilities or the consequences will "net" a dire result at the most inopportune time, says Reporter. "Governance is lacking when front- and mid-office latency concerns are addressed without including back-office concerns such as risk management."

Adds Adam Sussman, director of research at TABB Group, "But dealing with overall performance is like the classic 'Whac-a-Mole' game. Hammer down one problem and another pops up somewhere else."

The 17-page research note investigates how various functions within the trading world, from execution venues to brokers, are now dependent on the speed of the trading infrastructure. The research looks at why, from an enterprise infrastructure perspective, the core challenge resides within messaging and its related touch points, generically referred to as middleware and how middleware connects applications and passes data between them, thereby playing the role of infrastructure plumbing. The research also addresses the role of smart order routing and focuses on recent advancements within middleware, including the ability to tune the interaction of the applications to find an optimal balance between the three major causes of latency: throughput, persistence and jitter, detailing these causes and the negative impact each has on business functions.