At first blush, the concept of a central hub of liquidity housed under a single roof feels nostalgic. There is no probable scenario under which U.S. equity markets will recentralize, as execution venue competition is spreading across geographies and asset classes. And yet, we keep hearing more about liquidity centers.
Perhaps the term "liquidity center" is hype, Orwellian double-speak masking the fact that liquidity is no longer centered anywhere. Perhaps it is just clever marketing -- a way to make data center sales sexier. Or perhaps it represents the opportunity to create the next-generation financial center.
There are parallels between what occurred in U.S. equity markets over the past decade and the opposing fates of city and suburban populations. Cities suffered net losses, in part because newly built infrastructure and transportation enabled worker mobility. In equities trading, cheap bandwidth, storage and computational power -- coupled with well-documented regulatory mandates -- allowed liquidity to shift to an increasing number of disparate execution venues. In the short-term, everything seemed swell: Kids had bigger backyards and spreads tightened.
The Cost of Decentralization
But a decentralized design has systemic costs. In the U.S. equity markets, geographically dispersed matching engines introduce increased explicit costs, including connectivity, as well as implicit costs, such as latency arbitrage. From 2000 to 2010, these costs could be ignored because the rapid growth in volume generated additional revenue well above the increase in costs. Today, however, annual share volume is at its lowest since 2006, and we are seeing the first two-year volume drop since 1973-1974. The time to reexamine the industry cost structure is here.
Still, massive consolidation is unlikely. A more likely outcome is the creation of shared utilities for a common technology toolset that in and of itself offers little value-add. Likewise, matching engine technology is nearly commoditized.
A great example of this is the Goldman Sachs SIGMA X MTF in Europe. The SIGMA X MTF is hosted in the NYSE Euronext European Liquidity Center in Basildon, England, and run by NYSE Technologies. It shows how shared technology enables different business models to proliferate at a much cheaper maintenance cost. If that model were to become more common, the industry could maintain robust competition while eliminating much of the frictional costs that work against it.
Can't We All Just get Along?
While it is unlikely that direct competitors would agree to share the exact same platform, there is plenty of room for "coopetition." NYSE Euronext does not see SIGMA MTF as a direct competitor (at least as much as it might view Nasdaq OMX and Chi-X Europe in that light). Indeed, in some cases, bringing matching engines that cover different but related instrument types under a single roof could create a more diverse and vibrant trading environment. Imagine the benefits if on-the-run treasuries, interest rate futures and swaps were contained within the same data center and cleared by the same clearinghouse.
Matching engines offer just one example of how some industry costs could be eliminated. There are a number of other areas in which a common technology platform, or even front end, could be shared among multiple organizations. The buy-side execution management system (EMS) often has been cited as a technology that could be provided as an industry utility.
The idea would be to consolidate the operations into a single shared unit, maintain a fair pricing scheme and host it at a liquidity center. If done correctly, the cost savings to the industry would be significant. An EMS utility could allow each broker to define its own screens, layout, and look and fee; but by sharing the commoditized infrastructure, brokers could allocate more resources to innovation and value-added services.
Thus, the short-term benefit of liquidity centers is cost savings, but the long-term benefits are similar to those identified by champions of urban planning: multi-use buildings are the cornerstone of creating a more diverse and vibrant community.
U.S. capital markets are ripe for reinvention and transformation. In the long term, the events of the past decade will only be a prelude to what lay ahead in the coming decade. In fact, it is the long list of circumstances that often are blamed for freezing innovation in its tracks that is creating the groundswell of change that will overturn the conventional wisdom that the greatest change in trading is behind us.
Adam Sussman is director of research for Tabb Group.