The evolution of stock market technology

Technology has contributed to a bang and a crash at the London Stock Exchange and created an invisible world where billions of pounds changes hands in milliseconds. But with EU red tape altering the financial sector's landscape, technology's evolutionary journey at the London Stock Exchange is far from over.

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Technology has contributed to a bang and a crash at the London Stock Exchange and created an invisible world where billions of pounds changes hands in milliseconds. But with EU red tape altering the financial sector's landscape, technology's evolutionary journey at the London Stock Exchange is far from over.

Nestling in Paternoster Square in the shadow of St Paul's Cathedral, the London Stock Exchange, which makes its money through charging investors fees for trading shares and selling market data, is a technology pacemaker.

For a trading venue, the faster and more efficiently it can carry out a deal and the more up to date information it can store and retrieve, the more attractive it is to investors. These investors want to buy or sell shares quickly, to prevent changes in price during the transaction. Accurate market data is also important for investors to make informed choices.

Share trading took centre stage almost 300 years after share prices were published twice a week on a 10-by-4-inch sheet of paper and distributed from Jonathan's Coffee-house in London. The year 1986 saw what is known as the financial sector's Big Bang.

It was the end of October 1986 when the Stock Exchange Automated Quotation system replaced the trading floor. This screen-based quotation system was used by brokers to buy and sell stock rather than meeting face to face.

Technology's major impact

The shortening of the period between a trade being initiated and complete, or the reduction of latency as it is known, is the ultimate aim of any stock exchange worth its salt.

The Big Bang of 1986 did this and more. "It brought significant benefits to both institutional and private investors, with private investors gaining low-cost independent access to the market through the proliferation of new services," says Robin Paine, chief technology officer at the London Stock Exchange.

Cheap and efficient trading is what securities traders wanted and that is what they got. Volumes transacted saw unprecedented increases, with the average daily number of trades going through the ceiling.

The trading floor where dealers met remained, and was used in emergencies while the technology was in its infancy. However, this soon became a thing of the past as electronically-generated trading volumes rose unabated.

Just before the Big Bang's meteoric impact, the average number of daily trades at the London Stock Exchange was 20,000, amounting to about £700m worth of shares changing hands. After the introduction of automated trading the figure went up to a daily average of 59,000 trades a few months later.

In 1987 the London Stock Exchange was transacting as much business in a month as it did in a whole year before 1986, with an average daily value of £1bn. Today, the average daily number of shares traded is 566,000, with an average daily value of £16.6bn.

These figures would be impossible to reach without technology that can reduce the time taken to complete a deal and handle massive volumes.

"Without technology, exchanges could not accommodate the increased transaction flows that are generated both by the proliferation of end investors, and by electronic trading, algorithms and low latency," says Bob McDowall, analyst at TowerGroup.

The stock market crash

But the technological transformation was not plain sailing. No major technological advance with such a deep impact on how an industry operates can be introduced without a hitch.

This was no exception, and the stock market crash of 20 years ago that saw share prices plummet was more than a hitch, and was partly a result of the immaturity of the new technologies introduced in the Big Bang.

Trading in certain stocks could not be stopped and spiralled out of control. Eventually stocks across the world lost billions of pounds in value, and the London Stock Exchange lost 23% of its value in a single day.

McDowall says that although technology and the automation of selling did not cause the 1987 crash, technology did contribute to the velocity of the fall in share prices.

"The technology at that time lacked refinement to react to a wider range of factors beyond the share prices themselves," he says.

Technology went through a quick facelift after the City woke up the morning after 1987's Black Monday.

McDowall said the exchange had to introduce circuit breakers very quickly into the markets. These limited the velocity at which share prices could fall, before a halt was called to trading in the particular stock.

Algorithmic trading

These circuit breakers became more important with the proliferation of algorithmic trading. It is not humanly possible to manually transact the number of trades done on the stock exchange today. To reach these levels there must be a certain level of automation. Hence computers are today initiating many trades using algorithms.

Algorithmic trading, or "algo trading" as it is known in the financial sector, relies on computer systems to buy shares automatically when predefined market conditions are met.

This method of trading is the future, says Paine. "The markets will continue to be further digitised with the proliferation of algorithms set to increase. About half of all volume on the exchange now is electronically generated and we believe this trend will continue."

The rest is generated by manual intervention where traders submit orders using an interactive screen.

Jonas Rodny, senior communications manager at the Nordic Exchange, said although it is difficult to be precise about levels of algorithmic and automated trading at the exchange, these are responsible for a significant amount of transactions.

"Our assumption is that both algorithmic and automated trading are growing very rapidly, currently accounting for at least a fifth of the overall trading volume on the Nordic Exchange and possibly quite a lot more," he says.

The Nordic Exchange was created in 2006 by integrating the exchanges in Stockholm, Copenhagen, Helsinki, Iceland, Tallinn, Riga and Vilnius. OMX operates the Nordic Exchange and has a technology arm that develops technology for the exchange as well as licensing technology out to others.

The London Stock Exchange

Given the technological advancement in the 1980s and the resulting metamorphosis of the London Stock Exchange, it is no surprise that the company takes technology so seriously.

In 2003 the exchange instigated its Technology Roadmap, and after four years the exchange's all-singing, all-dancing core trading platform Tradelect was launched.

Since its July launch the platform has set record after record in terms of the volumes and the values traded. In August this year the exchange processed a record £17.62bn of transactions in one day on Tradelect.

But there is no time to sit back and watch in a sector where technological innovation can so dramatically impact a company's financial performance.

Constant innovation is essential if the exchange is to be able to compete with an increased number of trading venues. To this end the London Stock Exchange's Technology Roadmap II has already been initiated.

Rodny said the Nordic Stock Exchange's heritage is built on technological innovation, and the challenges it faces are twofold. Exchanges need to be able to provide sufficient latency to support more regular and faster trading, which allows investors to take market opportunities more quickly.

"The other key challenge arises from the fact that the continuous increase in volumes puts further constraints on capacity, not just at exchange level, but along the entire transaction chain," says Rodny.

The future of European exchanges

Recent forces driving innovation at the exchanges across Europe stem from the European Union's Markets in Financial Instruments Directive (Mifid). This piece of pan-European red tape has introduced more competition in the stock trading sector.

Mifid has compelled EU nations to remove what is known as the concentration rule that states that all trades must go through local exchanges. This has been the case for some time in the UK, but now it is happening across Europe and will inevitably lead to the creation of more alternative trading and reporting venues.

Two projects known as Boat and Turquoise have been created to offer trade reporting and execution facilities, respectively, on the back of Mifid. Turquoise was set up by Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley and UBS as an alternative trading venue, while Boat was developed by a consortium including many of the above-mentioned banks to offer a trade reporting venue.

KPMG consultant Lee Epstein says Mifid has opened up the stock trading and reporting sector to new players because it becomes more attractive for them to be able to work across Europe. "Before this you had so many different rules across Europe it was difficult," he says.

A fragmented market

He says the introduction of alternative trade execution and reporting venues following Mifid will fragment the market, and technology will be important to differentiate venues.

Nemone Wynn-Evans, head of market development at UK-based exchange Plus Markets, says innovation will focus on succeeding in an increasingly fragmented market which increases competition and introduces new challenges.

"The impact of fragmentation and the lowering of transaction costs will mean huge volume increases in transaction data, and in particular market data," says Wynn-Evans .

Technical innovation is required to be able to use all this data to optimise trades, she says. "The challenge of data volumes is not just an issue for investors, but also for surveillance functions and regulators."

Plus Markets, which is a Recognised Investment Exchange in the UK, is currently installing new trading and market surveillance technology in conjunction with OMX to expand its stock coverage and enable algorithmic trading.

McDowall agrees that continuous innovation is essential. "It is an important factor if it provides business innovation combined with greater efficiency, speed of execution and reduction in costs."

Rodny says innovation around speed, capacity and flexibility are important. "Capacity to take care of the increased volumes, speed in order to provide algo trading and flexibility to be able to integrate trading across asset classes and across markets."

So in a computerised environment where high speed, high volume trading is critical, technology has a strong hand to play.

Add to this the need to retain massive amounts of data and be able to access it efficiently and you have a boardroom that appreciates the value of technology and will not shy away from investing in it.

The London Stock Exchange is an example of how a centuries-old organisation can meet today's business challenges through an acute focus on technology innovation.

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