Layer 2 in 2011: E-Financial Markets & Market Infrastructures
(Prof. Dr. Peter Gomber)
The pace of innovation in financial markets has accelerated dramatically in the past years: New financial products have emerged and market infrastructures have changed significantly, both of which have been driven by information technology. IT is the lifeblood of today’s globalized and networked financial markets. These developments and new regulatory requirements have significantly affected the banking, brokerage and trading industry. Boundaries between the players have become blurred. Institutions try to diversify by moving up and down the securities trading value chain and thereby compete with incumbent players. Traditional investment banks find themselves competing with specialized new service providers in banking and brokerage, specifically concerning high frequency trading and related products and services. Electronic Financial Markets face dramatically accelerated numbers of transactions as their customers further automate their market processes and make use of intelligent order splitting and timing techniques that drive the reductions in transaction sizes. Furthermore, the financial crisis has created a new debate on the merits of centralized trading and clearing infrastructures to improve counterparty risk management and market integrity. This requires increased standardization that has to be balanced with the flexibility and innovation capacities of the OTC markets. Regulatory initiatives that in the past pushed primarily for competition, efficiency and interoperability between infrastructure providers now have switched to a focus on topics like safety, integrity and stability, e.g. the European market infrastructure regulation (EMIR). Regulatory changes, a transformation of financial intermediation, and innovative brokerage concepts are the drivers that shape financial markets and market infrastructures. Therefore, these three aspects are subject to research and detailed analysis within this layer.
- The layer analyzes the impact of regulation on securities markets, such as the Markets in Financial Instruments Directive (MiFID), the Code of Conduct for Clearing and Settlement (CoC) or the EMIR. As we have seen in recent years, such regulation significantly affects securities markets and demands for suitable management approaches. The research in this layer, for example, addresses the effects of MiFID on the competitive landscape among execution venues in Europe, on order execution policies and on the balance between OTC trading and regulated venues. Another key aspect in this work stream is the massive change in the structure and operations of the European Post-Trading Industry where initiatives like Target2-Securities and the debate on OTC derivatives clearing are assessed from the perspective of market infrastructure providers and market users.
- A second focus is on the transformation of financial intermediation that affects both, the parties involved in financial value chains and the capital market itself, including its microstructure. This work stream for example explores the impact of automated trading strategies on the role of market intermediaries and their competitive relationships. Effects on capital markets are analyzed on the basis of empirical studies that for example address the influence of decreased latency in IT-supported securities trading.
- Additionally, the research activities aim at contributing to the design, development and evaluation of innovative brokerage concepts that range from new technologies to novel financial concepts or products. Here, technical innovations include automation and standardization of central business processes or the application of novel approaches to support decision making in complex situations. Furthermore, we investigate innovative IT-based trading services such as “Algorithmic Trading” or “Smart Order Routing” that do not only lower transaction costs, but also enable market participants to cope with liquidity fragmentation.
The research results of layer 2 are published in major scientific journals, industry journals as well as at major international and national conferences. These are selected key results of layer 2:
Regulation of Securities Markets
The impact of MiFID on European securities markets and on investment firms was analyzed by six empirical studies. Two of them in 2008 and 2009 respectively examined best execution policies of German investment firms. The studies came to the conclusion that minimum legal requirements have recognizably been implemented in nearly all investigated policies. However, the usage of the policies as a competitive instrument cannot be recognized yet. In 2010, the discussions of MiFID II were underlaid by a study that measured the impact of the new competitive landscape on market efficiency. It came to the conclusion that competition works in favor of investors and has lead to the desired effects in terms of technology and trading model innovations, service competition, significant fee reductions and improved market quality in terms of reduced spreads and deeper order books. However, another empirical study shows that OTC activities in Europe are very different from the orginal MiFID intention. Additional contributions to this area of research were made by a systematic comparison of MiFID and its US counterpart RegNMS (Regulation National Market System) concerning market transparency and best execution requirements. Furthermore, several studies analyzed the evolution of the European Post-Trading industry and assessed the usage of management tools like the balanced scorecard by market infrastructure providers.
Transformation of Financial Intermediation
New technology-driven execution opportunities like High Frequency Trading, Algorithmic Trading and Smart Order Routing foster the transformation of intermediation relationships and enable institutional investors to self-direct trading. Simultaneously, the complexity of institutional trading desks’ tasks and technical infrastructure increases. As the management of this complexity requires a structured approach, we derived the concept of Order-Channel Management (OCM). OCM aims at supporting institutional investors by identifying suitable execution venues and strategies. Based on a quantitative study among the Top 500 asset managers in Europe, we identified the main drivers and inhibitors for the usage of new execution opportunities.
Innovative Brokerage Concepts
IT-driven brokerage innovations play an important role in a competitive landscape. Machine learning techniques that have been applied successfully in different problem domains represent a promising approach for novel brokerage concepts. In IT-supported decision-making, including decision support systems and Algorithmic Trading, the application of machine learning techniques is at an early stage. By applying state-of-the-art techniques such as Artificial Neural Networks or Support Vector Machines, we illustrated how such technologies can be applied successfully to support or automate investment decisions. Furthermore, we propose a text mining approach that allows for the pre-interpretation of unstructured data according to pre-defined criteria, i.e. forecasting objectives. The proposed text mining approach might serve to support intraday risk management. Another subject is Algorithmic Trading behavior and its impact on market quality and market volatility. Based on a dataset that allows an identification of orders submitted by Algorithmic Trading engines, we investigated order placement strategies in comparison to human traders. We showed that Algorithmic Trading engines fundamentally differ from human traders in their order submission, modification and deletion behaviour as they exploit real-time market data and latest market movements. We provide strong evidence that Algorithmic Trading does not increase volatility, at least not more than human traders do.