Friday, January 8, 2010

Direct Market Access

When an institutional client wishes to trade some stock on a particular exchange, there is a definite path that his orders go through before they reach the exchange. There are multiple players involved along this path. Lets consider a very superficial view of how this flow looks like:

So, in this, as usual the broker acts as the middleman between the client and the exchange. He provides the client with certain  services for which he charges a fee. A ten thousand feet view of these services would include three main services -
  • Sales desk: which enables the clients to send orders, mainly. At this point, the order is converted to a form that the broker systems can understand. 
  • Trading Desk: which is responsible  for actually working upon these orders strategically, using  some algorithms like TWAP, VWAP etc before sending them to the exchange. 
  • Order routers: which act like an exit point, for the orders, from the brokerage house  to the exchange. These routers have knowledge of multiple  exchange and may route  to the  exchange where the order will get best possible execution prices.
Once these orders go to the exchange, the exchange has appointed market makers who quote bid and ask prices for different securities. These orders go to these market makers who then  ultimately send them to the exchange trading systems and order books.

Although this traditional model works  great  for retail clients, there are some big hedge funds, single huge institutional investors who need more  than this. These clients are sophisticated  clients having their own expertise in all respects - infrastructure as well as traders. They don't need any extra services provided by the broker. They prefer to use trading strategies, slice-and-dice orders as per their own expertise. So, in such a scenario, all they need from the brokers is for them to provide these clients with exchange connectivity. So, the above flow  now looks something like -

This is what we call Direct Market Access (DMA) flow.

There are two kinds of DMA's mainly:
  1. In the first type, the client has his own expertise. However, he still needs to use the order router service of the clearing member (basically broker) which then routes his orders to different exchanges. This was the first step towards DMA and removing the "call by phone and place order" stage. Thus, in this stage, orders still go through the market  makers before entering into the order books.
  2. In the second type, the client, in true sense, needs only exchange connectivity from the broker. For this purpose, the brokers may provide the client with a  platform which has global  connectivity across exchanges in the world. This platform is deployed on the client end rather than working on the broker side. Examples of such a platform are Morgan Stanley's Passport, Goldman Sachs' REDIPlus etc. These tools allow clients to place orders which will directly be entered into the exchanges order books. This is DMA in its true sense! Its as shown in the diagram above by the rounded arrow flow.
  1. Self expertise: The clients can rely  on their own expertise rather than using some brokers services. This enables them to build custom strategies suited for their firm while trading. They can synthesize orders as they like. they also have their own infrastructure . All this saves them the cost of equivalent services provided by the broker.
  2. Lesser commisions per trade, since they no longer use broker services,  but their own internal expertise.
  3. Ability to quote their own prices. Normally, they way it works is, the clients may quote their own prices. The market makers quote the prices they can offer to the brokers. The brokers in turn can offer only these prices  to the clients. However, with DMA, since we skip the market makers, the clients are free to place their own prices on limit orders as they want.
  4. Faster time to processing. Since DMA enables clients to enter orders directly into the order books, it saves the time of going through all the intermediaries which in the normal case take more time.
  5. Ability to capture arbitrage opportunities due  to high  speed.
  6. Visibility: in the normal case, the market makers may choose to show only some orders on the order book and not show some. However, with DMA, clients are guaranteed that all their orders can be seen by everyone on  the market. This enables faster executions.
  7. Ability to capture high liquidity pools.

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