Electronic Trading: The Next Generation
On a relatively uneventful trading day early last February the New York Stock Exchange (NYSE) reported a total trading volume of slightly more than one billion shares. On that same day, NASDAQ reported a total trading volume of more than 1.7 billion shares. This means that in one eight-hour trading day, two of the world's most prestigious exchanges had traded roughly ten shares of equity for every man, woman and child in the country.
These are definitely impressive numbers, but what is even more impressive is what these will look like in the very near future. Three years from now, our industry's trading systems will routinely have to handle volumes at least three times as large as these, and handle them three times as quickly. SRI Consulting predicts that the shift to decimal pricing alone will increase quote traffic 256 percent for listed equities, 700 percent for Nasdaq equities, and more than 3,000 percent for options. If you think this last figure sounds a little over the top, be advised that the Securities Industry Association agrees with it, and major financial exchanges are taking these estimates quite seriously. This is good, but not good enough. The entire securities industry must get on board and find a solution to the combined problem of higher trade volume and faster settlement.
Nasdaq plans to handle a projected traffic volume increase of 700 percent by boosting its systems traffic capacity from a current peak of 460 messages per second to more than 5,000 messages per second-a 987 percent increase. And downtown at the NYSE, system managers are shooting for a year-end traffic capacity increase of 233 percent, up to 2,000 messages per second from a scant 600. The NYSE has also implemented a new network that is both 100 times faster and allows 100 times more traffic than before.
Move Over Decimalization...
While the effects of decimalization pose significant ramifications to existing system architectures with respect to trade volume and message traffic, other forces are poised to add to that strain, including the continued proliferation of electronic communications networks (ECNs) and after-hours trading networks, the growth of multiple options listings and the introduction of worldwide trading operations like the International Securities Exchange. We now have trading around the clock and across the globe.
And what about the boom in retail trading? The growing number of financial institutions offering Internet-based discount trading services to retail customers attests to the trend's continued proliferation. While the recent economic downturn may have given investors a lesson in caution, competition will continue to force transaction prices down, drawing new retail investors into the markets. Caution is just caution; most investors tend to see opportunity when the prices are right.
But competition alone won't fuel the retail investment flame; prospective pension reforms in Western Europe coupled with social security reform in the United States will have a major impact on consumers' desire to trade as both initiatives empower the consumer to control their financial destiny through direct stock investments and/or mutual fund and retirement account plans.
T+1: Government Mandated Strain
Decimalization, along with the growing increase in the number of investors pumping liquidity into the system, will definitely up the ante, placing enormous stress on the securities industry's trading systems; but there may be something out there that will pose an even bigger challenge: T+1. T+1 is a mandate from the SIA and the Securities and Exchange Commission (SEC) that by 2004 the securities industry will be able to settle all trades within one day. This deadline has actually been a moving target as industry players beginning to tackle the problem and come to recognize the tremendous work that lies ahead. Achieving T+1 means that the industry has to triple the speed at which it executes and settles trades, a concept that Federal Reserve Chairman Alan Greenspan has thrown his economic weight behind, arguing that a failure to achieve one-day settlement could compromise the health of the equity markets.
Given Greenspan's warnings about the potential effect of not achieving T+1, imagine his thoughts regarding firms still not settling trades within the three-day time frame (T+3) mandated in the wake of the 1987 stock market crash. And there are quite a few of them. Last fall the SIA estimated that roughly 12.5 percent of institutional trades (that's one in eight trades) fail to settle within the stipulated three-day period. And by the end of 2002, the SIA predicts that as total institutional trade volume increases by 56 percent over year 2000 levels, three-day failure rates could reach 40 percent.
Issues of decimalization, the sizeable increase in trade volume due to a growing number of traders and trading venues, and a significantly shortened settlement cycle all indicate trouble ahead unless the securities industry can find and implement a solution.
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