Latency and the Exchange Ecosystem

Market Ecosystem


In a global community that increasingly values intelligence while simultaneously pursuing financial security and business success, you might conclude that greater intelligence means greater wealth. But you would be mistaken.

In several studies on the subject, proof has emerged that there’s no direct link between IQ and wealth. One study found that people with above-average IQ are only 20 percent more likely than those with below average IQ to have a comparatively high net worth.  When it comes to predicting wealth, research has shown that emotional intelligence, not IQ, provides a more accurate forecast.

There’s a correlation here to financial exchanges. The trait that’s commonly used as a predictor of success for an exchange is latency. That is, the lower the latency for transactions, the more efficient and liquid an exchange must be. But like the correlation of IQ and wealth in humans, the relationship between latency and efficiency for financial markets does not usually hold up. At least not on its own.

Low latency matters for exchanges but only within the context of the ecosystem.  Without the proper liquidity, distribution, risk controls and market integrity, latency itself is not going to drive great efficiency for market participants.

Said another way, latency is key.  But it isn’t the only key.

In that way, low latency without a healthy ecosystem is a bit like owning a Ferrari in Hong Kong.  The island of Hong Kong is only 9.3 miles long and 6.8 miles wide, but is home to about 1.3 million people, and is extremely dense with what seems like thousands of traffic lights.  It’s unlikely that a Ferrari owner would be able to get out of 2nd gear for more than a moment. However, more than 1,000 Ferraris have been imported to Hong Kong.  Why would so many people buy an expensive, high performance car in a place where they cannot fully enjoy its capabilities? Of course, we know the answer. A Ferrari is a status symbol, and those who drive one are not just after a fast car. It’s an exercise in image marketing.

A similar exercise happens for financial markets when they boast of higher speeds and lower latency, but have not yet constructed the rest of the ecosystem that will attract more trading.  Yes, the car can go very fast, but the value of that information is realized only to the extent that people know it’s true. People in Hong Kong know Ferraris are fast, even if they can’t see them reach high speeds. The trading community knows if an exchange has lower latency, but without the proper ecosystem, the speed capabilities don’t matter much for market participants.

The trading world cares about speed, but not as much as they care about the whole trading environment offered by a particular market – one that has the proper risk controls, liquidity and market integrity in place.

Take an example from the exchanges I work for. Last week, CME Globex – the first global electronic trading platform for derivatives – celebrated its 20th anniversary. On its first day in 1992, less than 2,000 contracts were traded.  Last month, around 8 billion orders were placed on Globex.  Speed is one reason for the growth. The platform continues to get faster but only in the context of the ecosystem. Its growth is driven by factors the trading community is interested in which create a complete ecosystem – factors like liquidity, reliability, predictability and market support.  It’s in this environment where you can see that latency’s relationship to markets, like the relationship between IQ and wealth, is a threshold measure.

 

A version of this post first appeared on Terrapinn’s blog, The Trader.

About the Author

Ari Studnitzer is managing director of platform development at CME Group.

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