Committee on the Global
`Financial System
`
`The implications of
`electronic trading in
`financial markets
`
`Report by a working group established by the
`Committee on the Global Financial System of the
`central banks of the Group of Ten countries
`
`January 2001
`
`GAIN CAPITAL - EXHIBIT 1015
`
`

`

`Copies of publications are available from:
`Bank for International Settlements
`Information, Press & Library Services
`CH-4002 Basel, Switzerland
`Fax: (+41 61) 280 9100 and (+41 61) 280 8100
`This publication is available on the BIS website (www.bis.org).
`
`Bank for International Settlements 2001. All rights reserved. Brief excerpts may be reproduced
`©
`or translated provided the source is stated.
`
`ISBN 92-9131-613-X
`
`

`

`Preface
`
`The Committee on the Global Financial System (CGFS), known until 1999 as the Euro-Currency
`Standing Committee, serves as a discussion forum for the central bank community on financial
`stability questions. The CGFS has frequently been asked to examine the potential implications of
`innovations in global financial market practices.
`Recent projects by CGFS working groups have concerned the functioning of international interbank
`markets, financial derivatives and the systemic consequences of standard risk management practices.
`Last year, the CGFS decided to organise a working group to take a preliminary look at the possible
`implications of the use of electronic trading platforms for the functioning of global financial markets.
`The migration of financial trading to electronic platforms merits monitoring because of possible
`system-wide consequences. The Working Group was chaired by Jos Heuvelman of De Nederlandsche
`Bank. The Committee was most grateful to Mr Heuvelman and his colleagues for their careful work.
`The publication of this report is intended to contribute to the general understanding of developments in
`global financial markets.
`The CGFS continues to be interested in this topic, and expects to continue monitoring the significance
`of changes in information processing and communications technologies for the functioning and
`stability of financial markets.
`
`Yutaka Yamaguchi
`Chairman, Committee on the Global Financial System
`Deputy Governor, Bank of Japan
`
`

`

`

`

`Table of Contents
`
`Preface
`
`Chapter 1 – Introduction and main findings............................................................................................. 1
`
`Chapter 2 – Definition, context and use of electronic trading.................................................................. 3
`2.1
`Electronic trading defined.................................................................................................... 3
`2.2 Market architecture.............................................................................................................. 4
`2.3
`Interaction between various market participants................................................................. 6
`2.4
`Current use of electronic trading systems........................................................................... 7
`
`Chapter 3 – The impact of electronic trading on market structure ........................................................ 10
`3.1
`Increased operational efficiency........................................................................................ 10
`3.2
`The impact of electronic trading on market access, price formation and transparency.... 11
`3.3
`Factors driving users’ choice of trading systems .............................................................. 13
`3.4
`Suitability of financial instruments for centralised ET markets.......................................... 15
`
`Chapter 4 – The impact of electronic trading on financial stability ........................................................ 16
`4.1
`Consequences of ET for efficient price formation and liquidity......................................... 17
`4.2 Market fragmentation and consolidation across trading systems..................................... 18
`4.3 Market resilience in times of stress................................................................................... 19
`4.4 Operational risk ................................................................................................................. 21
`
`Annex: Mandate of the Working Group ................................................................................................. 24
`
`Glossary................................................................................................................................................. 25
`
`References and further reading............................................................................................................. 29
`
`Members of the Working Group on Electronic Trading ......................................................................... 31
`
`i
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`Chapter 1
`Introduction and main findings
`
`One task of the Committee on the Global Financial System (CGFS) is to further the understanding of
`how financial markets function, with particular reference to central bank operations and financial
`stability. Electronic trading (ET – defined in Chapter 2) platforms are rapidly gaining ground in financial
`markets. In March 2000, the CGFS established a working group to examine the potential impact of ET
`systems on the structure, dynamics and stability of financial markets, and on firms active in these
`markets. (The mandate of the group is appended in an annex.)
`The Working Group on Electronic Trading bases its findings on its own research (including case
`studies) and discussions with a wide range of market participants, including dealers, end-users and
`system providers. The members wish to record appreciation of assistance from these institutions. The
`members met as a group three times, in Basel, New York and Amsterdam.
`Since the situation is evolving rapidly, the Group has not tried to make a detailed assessment of which
`particular systems are used in the various markets and of their market shares. Rather, it has focused
`on developing an analytical framework that facilitates understanding of the actual and potential
`changes brought about by ET and analysis of their implications for the stability of the financial system.
`The analytical framework that is developed fits a wide variety of financial instruments and markets.
`When using the framework to tentatively assess the current situation, however, the report mainly
`concentrates on those markets which are traditionally of greatest interest to central banks, ie on the
`spot foreign exchange and government bond markets.
`The structure of the report is as follows. Chapter 2 defines ET systems, places them within a typology
`of trading systems and markets, and briefly sketches their use. The impact on the structure of financial
`markets and price dynamics is discussed in Chapter 3. The subsequent implications for financial
`stability are dealt with in Chapter 4. A glossary explains acronyms and technical terms used in the
`report.
`The main findings are:
`
`Context and use of ET
`Electronic systems are used to varying degrees for trading in financial markets, differing between
`markets, between types of trades and users, and between the various stages of the trading process.
`The situation is evolving rapidly. ET is the dominant method in the inter-dealer foreign exchange
`market, and is rapidly gaining ground in the inter-dealer fixed income market. So far, ET has been
`used less for transactions in these markets between dealers and their customers, although it is
`growing rapidly in fixed income markets. Strong competition seems to have led dealers to actively
`promote new systems to their customers in order to retain their business or to attract new customers.
`At this stage, ET is not significant in the OTC derivatives market, with the issue of counterparty risk
`being one factor impeding its development.
`In general, ET is being applied first to transactions in liquid and homogenous instruments. Current
`systems are generally more suitable for smaller transactions than for larger transactions. ET is not
`widely used in markets where counterparty credit risk is significant, unless the system has been
`designed to manage this risk (for instance through the incorporation of a set of limits).
`
`Impact on market structure, efficiency and transparency
`At this stage, the foreign exchange and fixed income markets remain segmented (in terms of access)
`into an inter-dealer segment and a dealer-to-customer segment. Some institutional investors would
`prefer to trade directly without intermediation, and technologically this is feasible through ET, but most
`others indicated that they would rather use a dealer. In the inter-dealer market, trading is moving from
`bilateral OTC relationships towards a marketplace with more centralised price discovery and
`transparency. This is happening to a greater extent in the foreign exchange market than in the fixed
`income markets, where there are several competing systems. The role of voice broking and direct
`dealing between dealers is diminishing. In the dealer-to-customer segment, some dealers initially
`established single-dealer systems but, as these proved insufficient for all of the customers’ needs,
`they have since formed various consortia to establish multiple-dealer systems. As it is not clear which
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`systems will succeed, and since network effects and economies of scale may create a “first mover”
`advantage, many participants have sought to be involved (as owner and/or user) in multiple systems.
`All in all, the current market structure can be best described as a hybrid one, where many different
`trading mechanisms coexist.
`It is too early to say how the various markets will develop, but several market participants expect a
`transition in certain markets to a fairly centralised and open network allowing all market participants to
`transact directly with each other. This might occur in different ways. For example, multiple-dealer
`systems (single platforms where customers can approach several dealers at the same time) may
`widen access to include other dealers, thus enabling inter-dealer trading on the system. Alternatively,
`inter-dealer systems may give access to end-users. It is also expected that there will be some
`consolidation of systems, although ET could allow the coexistence of a variety of systems to suit
`different types of trades and instruments.
`The structure of an electronic market may largely depend on the extent to which it is contestable.
`Although ET is generally associated with low variable costs, entry costs may be considerable if fixed
`costs for the initial development of the IT infrastructure are taken into account. Initial costs may be
`mitigated when the existing infrastructure is used, but, even then, first-mover advantages and network
`externalities may make it difficult to attract business away from established systems. Liquidity does not
`move easily from one platform to another, unless the alternative is much better. This means that, in
`spite of the appearance of new competitors, existing players may be able to protect their business
`interests.
`ET is more cost-efficient. Interviews with market participants indicate that in particular the scope for
`straight-through processing means that ET offers a significant advantage but has yet to be fully
`realised in most markets. For this to occur, standard settlement and clearing procedures are needed.
`ET offers the potential to make markets more transparent. This does not only relate to price discovery
`and information about the depth of the market, but, on a more micro level, most systems provide the
`owner with a full log of the transaction behaviour of the users. From a business perspective, this can
`be valuable information. In practice, there are several reasons why market transparency might not
`improve to the full extent possible. Furthermore, it was pointed out that full disclosure of trading
`information does not always lead to better market functioning. In particular, a degree of anonymity
`seems to have positive effects on the way many markets function.
`Greater competition, resulting from lower costs and increased transparency, is putting pressure on
`dealers’ margins, to which they are responding in different ways. The larger ones may try to
`compensate for lower margins by chasing more volume; ET can facilitate this by enabling greater
`scalability. Others unbundle their services and concentrate on certain niches. For instance, they use
`other dealers to provide a “white label” service to their customers, ie they keep the customer base but
`outsource (part of) their trading to a larger dealer.
`
`Impact on financial stability
`Financial stability is enhanced if markets are efficient, liquid, orderly and resilient. ET could potentially
`affect all these dimensions. The financial industry is restructuring rapidly and ET facilitates the trend
`towards fewer dealers. Ceteris paribus, this may lead to less liquidity being provided by dealers, but
`the reduced costs and greater efficiency of ET systems should make it easier for both dealers and
`end-users to transact, thus enhancing liquidity. Related to the low cost of arbitrage, the fragmentation
`of markets was not considered to be a major concern; moreover, it was noted that OTC markets in
`particular are becoming more rather than less centralised. Contrary to earlier fears, there are so far no
`firm indications that liquidity has suffered from the introduction of ET, although many systems have still
`to be tested in volatile times. It was observed, however, that hitherto trading has not moved away from
`electronic platforms in times of stress. In the same vein, it is not obvious that ET leads to higher
`volatility.
`To the extent that the reduction in the number of dealers might result in a net withdrawal of risk capital
`from the marketplace, this may hamper the provision of liquidity by dealers in times of stress. It is,
`however, not clear that dealers are the ultimate providers of liquidity in a crisis, as it is likely that end-
`users play an important role as well. Insofar as ET facilitates price discovery, it may thus pave the way
`for a quicker return to a normal trading situation in times of stress. On the other hand, managing
`counterparty credit risk becomes relatively more important during stressed times. Therefore, the extent
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`to which ET systems are designed to cope with counterparty credit risk may affect their use in times of
`stress.
`ET has the potential to improve the operational efficiency of individual firms, but also increases the
`dependency on these systems. So far they have been fairly robust, with only short disruptions to
`trading. During these times, traders reverted to traditional trading channels and reduced their trading
`activity. It remains to be seen how markets will function were there to be a prolonged disruption,
`particularly when traders are no longer familiar with the old trading methods and if trading is
`concentrated on a single platform. The design of the systems, their robustness and their contingency
`plans therefore deserve careful attention from both system providers and the authorities.
`In some cases, ET is leading to computers dealing with computers, lowering transaction costs and
`increasing the speed of execution, but also raising concerns as to whether there are adequate controls
`on systems, for instance relating to whether they allow timely human intervention. Examples include
`automated execution by systems with pricing engines (used mostly for small orders and the
`management of dealer inventory).
`
`Chapter 2
`Definition, context and use of electronic trading
`
`An assessment of ET and its impact requires a common understanding of what actually constitutes
`“electronic trading” and its key features. This chapter defines ET and indicates how it differs from
`traditional markets. Subsequently, the architecture of markets, whether electronic or not, is discussed.
`The interaction of the various types of market participants is elaborated. Finally, the current uses of ET
`are summarised.
`
`Electronic trading defined
`2.1
`The term “electronic trading” encompasses a wide variety of systems, ranging from simple order
`transmission services to fully fledged trade execution facilities. In this paper, we adopt a broad
`definition of ET systems. An ET system is a facility that provides some or all of the following services:
`electronic order routing (the delivery of orders from users to the execution system), automated trade
`execution (the transformation of orders into trades) and electronic dissemination of pre-trade (bid/offer
`quotes and depth) and post-trade information (transaction price and volume data). In particular, our
`definition includes electronic systems that do not provide automated trade execution. These systems
`have found wide acceptance in fixed income and foreign exchange markets in recent years and can
`affect the market’s structure and its dynamics (see Chapter 3 on this issue). In contrast to the broad
`definition, a narrow definition of ET systems is limited to facilities that automate all aspects of the
`trading process, including trade execution. The architecture of fully automated systems is often
`complex and differences between the various systems can be quite subtle.
`Electronic systems differ from traditional markets in several respects. The application of computer
`technology automates aspects of the trading process and the trading relationship both among dealers
`and between dealers and their customers. The effect, however, is not merely “to build a better
`telephone”, but potentially to create a new way of trading, different from either floor-based or
`telephone trading. ET affords users cost savings, increased efficiency and improved risk management
`capabilities. It differs from traditional systems in the following respects:
`• ET is both location-neutral and allows continuous multilateral interaction. For trading purposes, the
`common physical location of users is unnecessary as long as they can connect to the system.
`However, unlike traditional location-neutral trading, such as telephone-based dealer markets, ET
`allows continuous multilateral interaction (telephone-based systems are bilateral almost by
`definition). Consequently, ET systems facilitate cross-border trading and cross-border alliances
`and mergers between trading systems to a greater extent than traditional markets.
`• ET is scalable. Electronic systems can be scaled up to handle more trades simply by increasing
`the capacity of the computer network. With traditional markets, the size of the floor has to be
`physically expanded, or the number and/or capacity of intermediaries active in a phone-based
`market increased, a much more costly process. Thus, successful ET systems can potentially
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`exploit economies of scale and reduce operational costs to a far greater extent than can traditional
`markets. Scalability also tends to widen the reach of dealers, who have access to a far wider
`customer base than formerly.
`• ET is integrated. ET potentially allows straight-through processing (STP), ie the seamless
`integration of the different parts of the trading process, starting from displaying pre-trade
`information and ending with risk management. In traditional markets, different systems handle
`different parts of the trading process (for example, order placement and risk management). It is
`therefore worth noting that ET does not only affect front office activities, but can also have
`implications for the setup and functioning of the back office.
`
`2.2 Market architecture
`Markets can be described in terms of a number of key features (see Box A below), which can be used
`to discriminate between various types of trading systems, both traditional and electronic. Based on
`these aspects of market architecture, two illustrative archetypes can be distinguished.
`•
`In centralised order books, the interaction of market participants is fully multilateral. An order book
`is a largely order-driven market, though some market participants may choose, in effect, to quote
`continuous prices by maintaining limit orders in the book. The central element is an algorithm,
`which matches bids and offers subject to priority rules. There is no negotiation within the system.
`Examples are some stock and futures exchanges. Automated centralised order-driven markets will
`be referred to as electronic order books. It is possible for end-users to trade directly without
`intermediation in these systems, although, in practice, many systems limit access to dealers.
`Dealers may participate by quoting two-way prices, but generally they have no special role in
`providing liquidity in these systems.
`• Decentralised markets rely largely on bilateral interaction and are usually referred to as OTC
`markets. OTC markets are typically segmented between an inter-dealer and a dealer-to-customer
`market and are predominantly quote-driven. Dealers post bid/offer quotes, which are either
`indicative or firm up to a certain trade size. Prices are determined when a quote is hit. Interaction
`is bilateral and the price of larger orders negotiated. Examples of typical OTC markets are large
`parts of the fixed income and derivatives markets. Electronic dealer systems essentially automate
`enquiries and subsequent trade executions previously conducted over the telephone. If only one
`intermediary is involved, the system is usually referred to as a single-dealer system; if more
`intermediaries are involved, it is called a multi-dealer system.
`The architecture of both markets is summarised in Box A. It should be noted that, in practice, a wide
`variety of market types exist, so that the actual features of the markets are in between the models
`illustrated there.
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`

`Box A
`Key features of market architecture
`Markets, both conventional and electronic, can be described in terms of some key features
`including:
`• Access: in some markets, end-users typically do not trade directly with each other, but do so
`through intermediaries. In such markets a segmentation between the inter-dealer market and
`the dealer-to-customer market exists.
`• Bilateral or multilateral interaction of order flows: bilateral interaction generally allows price
`negotiation and the establishment of relationships. Multilateral interaction refers to the
`pooling of trading activity on a single platform; it does not prevent actual trades from being
`executed bilaterally between individual market participants. It usually implies that orders are
`executed at the best price available to an individual client, regardless of who is the
`counterparty.
`• Price formation: prices can be determined within the system (the system provides price
`discovery) or taken from outside the system (the system does not provide price discovery).
`Price formation can be order-driven (prices follow orders) or quote-driven (orders follow
`prices). Under order-driven price formation, orders are sent to a central location and prices
`are derived from the interaction of these order flows. Under quote-driven price formation,
`market-makers quote prices at which they are willing to buy and sell securities. The
`willingness of customers to transact at these quotes determines market prices, although
`prices for larger trades are typically negotiated bilaterally. Prices can result either from
`multilateral interaction between market participants (quotes competing in a central location)
`or can be predominantly bilateral (fragmented price formation).
`• Need for dealers: whether execution requires involvement of dealers (or specified market-
`makers).
`• Transparency: the amount and extent of information that is disseminated. Under full
`transparency, systems would provide timely information, both pre-trade (for example, bid,
`offer and depth) and post-trade (for example, last trade price and volume), and disseminate it
`widely (to all market participants). However, actual systems offer various degrees of
`transparency.
`• Anonymity: whether the identity of the counterparty is disclosed, either pre- or post-trade.
`• Trading protocols: markets differ according to the type of orders allowed (limit, market, stop,
`off-market, etc), and rules regarding trading (the minimum tick size, trading halts, openings
`and closings, etc).
`• Degree of continuity: whether trading is continuous or periodic. In a periodic trading system,
`orders are batched and cleared at periodic intervals.
`
`The architecture of order books and OTC markets can typically be summarised as follows:
`
`Access
`Interaction
`Price formation
`Dealers
`Transparency
`Anonymity
`Trading protocols
`Continuity
`
`Order book
`No segmentation
`Multilateral
`Centralised, usually order-driven
`Often present but not necessary
`Potentially high
`Usually anonymous
`Standardised
`Continuous or periodic
`
`OTC market
`Segmentation
`Typically bilateral
`Fragmented, quote-driven
`Necessary for trade execution
`Limited
`Not anonymous, but limited disclosure
`Not standardised
`Generally continuous
`
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`

`Interaction between various market participants
`2.3
`In all types of markets, trading systems act as a nexus between market participants who can interact
`in various ways. The overall trading process can be described in terms of this interaction. For a proper
`assessment of the impact of ET, it is necessary to understand the interaction between the various
`market participants in a typical OTC market such as the foreign exchange or fixed income markets. As
`discussed, these OTC markets typically involve segmentation between an inter-dealer and a dealer-to-
`customer market. The interaction of the various market participants in an OTC market prior to the
`introduction of ET systems is schematically summarised in Figure 1.
`
`Figure 1
`Interaction between market participants prior to electronic trading
`
`multilateral
`
`Inter-dealer
`broker
`(voice/screen)
`
`multilateral
`
`Dealer
`
`Dealer
`
`Direct dealing
`(bilateral)
`
`bilateral
`
`End-user
`
`bilateral
`
`End-user
`
`The end-users provide the underlying supply and demand that ultimately determines prices, although
`fluctuations in dealers’ inventories may affect short-term price dynamics. End-users range in size from
`individual traders to institutional investors, large corporations and dealers’ proprietary trading desks.
`Various classes of intermediaries can be distinguished by the type of services they provide. Brokers
`do not take positions or trade for their own account; they are merely conduits for the orders or quotes
`of others. Dealers take positions and trade for their own account as their primary business and usually
`make markets for their customers by providing bid and ask quotes. In the process of seeking to profit
`from a bid-ask spread and exploiting pricing anomalies, they add liquidity to markets and thereby
`assist their customers in trading and hedging.
`Traditionally, when an end-user needed to transact in traditional foreign exchange or fixed income
`markets, he incurred the search cost of calling one or more of the dealers with whom he had a
`business relationship. A price would be negotiated and a transaction executed at the best price
`available.
`If the dealer did not want to keep the acquired position, she would either have to find another
`customer with whom to conduct an offsetting transaction or she would have to go to the inter-dealer
`market. She could then directly call another dealer to do an offsetting transaction, or go through an
`inter-dealer broker, where dealers put up the bids and offers at which they are willing to trade. The first
`type of interaction is bilateral, but the inter-dealer broker channel (bid/offers are transmitted either
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`

`through screens or through voice contact) can be characterised as a multilateral interaction, since all
`quotes are pooled on a common platform and are thus in direct competition with each other.
`Apart from providing price discovery and execution of transactions (provision of liquidity and
`immediacy) dealers provide other services to their customers, such as research (economic,
`fundamental, technical), trading expertise, information about the current state of the market and
`clearing and settlement services.
`
`Current use of electronic trading systems
`2.4
`Electronic systems are currently used to varying degrees for trading in the markets for foreign
`exchange and fixed income. Penetration differs between markets, between market segments, between
`instruments, between types of trading and between the various stages of the trading process.
`Moreover, the situation is changing rapidly; a dominant system can give way to another in as quickly
`as a few months. The main impact of ET so far relates to the inter-dealer (voice) broker, who is
`increasingly being replaced by electronic systems. This does not necessarily imply that brokerage
`firms are going out of business as they may reinvent themselves by offering an electronic service.
`Furthermore, electronic trading makes the direct dealing relationships redundant, ie the interaction in
`the inter-dealer market is becoming increasingly multilateral. The dotted lines in Figure 2 indicate the
`reduced importance of the direct trading channels and the traditional inter-dealer broker channels.
`
`Figure 2
`Interaction between market participants after the introduction of electronic trading
`
`inter-dealer e-trading
`
`Inter-dealer
`broker
`(voice/screen)
`
`multilateral
`
`multilateral
`
`dealer/multidealer
`
`direct dealing
`(bilateral)
`
`dealer/multidealer
`
`bilateral
`
`bilateral
`
`End-user
`
`End-user
`
`In the foreign exchange market, the inter-dealer market is dominated by ET. There are two systems
`(EBS and Reuters), each being dominant in certain currency pairs (see Box D). Both voice broking
`and direct dealing between dealers have become much less important. The penetration in the dealer-
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`to-customer market is far less advanced at this stage. Many intermediaries have created their own
`single-dealer sites, replacing (or supplementing) telephone contacts with customers. Several business
`plans for multi-dealer sites have been announced (for instance Atriax and FxAll), but are not yet
`operative on a significant scale. There is still a clear separation between the inter-dealer and the
`dealer-to-customer markets. Even though the technology is available, especially due to the
`counterparty credit risk involved in foreign exchange dealing, so far the market has not moved to an
`open network in which end-users and intermediaries have equal access. Firms still want to know
`before execution of a transaction with whom they are dealing.
`In the inter-dealer G10 government bond markets, ET systems are gaining ground rapidly (names
`often mentioned include BrokerTec, eSpeed and EuroMTS). Several systems are competing for the
`same business. Since it is not clear which systems will prevail, intermediaries are trying to be involved,
`as owner and/or user, in several of these systems. Again, in the dealer-to-customer market, the extent
`to which ET systems are used is less pronounced than in the inter-dealer markets, but it is growing
`rapidly. A number of multi-dealer systems (examples are Bondclick and Tradeweb) are
`operating/announced whereby customers can request quotes from several dealers at the same time,
`putting them in direct competition with each other. These systems are particularly useful for end-users,
`since many of them are obliged to ask for a number of prices before they can transact. Initially, dealers
`started by offering single-dealer sites, but these were not able to cater to all of the customers’ needs.
`The subsequent move to multi-dealer sites was therefore partially motivated by the desire to retain
`their customers and perhaps to pre-empt third-party providers, who were likely to fill the gap.
`In the OTC derivatives markets, the use of ET systems has been limited. Again, the counterparty
`credit risk involved in these instruments is an important reason for its limited penetration. Exchanges
`do not face this problem if they use central counterparties, which mitigate the credit risk. Therefore,
`and because of greater standardisation, electronic trading systems are more widespread in exchange-
`traded derivatives markets.
`Beside its applications to secondary trading, ET has the potential to change the primary market (Box
`B). Issuers might use ET systems to target investors directly, thereby cutting out the intermediaries.
`However, the dealers provide other services than just finding end-users. They sometimes “guarantee”
`to a certain extent the primary issue, meaning that, with insufficient demand, they will temporarily take
`the remainder of the securities on their books, and they act as market-makers in the secondary
`markets. So far, in the government bond markets, dealers have remained the primary vehicle through
`which issuers reach end investors.
`
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`

`Box B
`Electronic auctioning of securities in prim