Introduction
In the mid-19th century, the world of finance was revolutionised by the introduction of the telegraph, the 'Victorian Internet'. While communications technology has advanced substantially in the last 150 years, the fundamental communications paradigms have not changed.
Today, however, we are experiencing another change in the nature of communications with the introduction of the financial services extranet. This has the potential to contribute to and accelerate changes in the global financial services industry. As it was a hundred years ago, networking technologies have the power to re-shape the financial landscape. This article is about the fundamental changes in networking that are underway today, and some of the implications for financial services.
Samuel Morse's telegraph, invented in 1844, made it possible for investors anywhere to communicate quickly with their brokers. Later, in 1867, Edward Calahan of the American Telegraph Company invented the first stock telegraph printing instrument (the 'ticker'), which replaced the messenger boys who ran between the trading floors and brokers' offices. The New York Stock Exchange was one of the first users of these new technologies. The NYSE used telegraph lines to distribute price information and to provide access to the Exchange from various regions around the US, thus centralising order flow. The creation of a dominant pool of liquidity, and the relative ease with which brokers around the country could access that liquidity, helped to build the NYSE into the force it is today, and led to the demise of many local exchanges. In 1872, the London Stock Exchange also adopted the Calahan Stock Ticker and formed the Exchange Telegraph Company of London.
During the same period, Paul Julius Reuter set up a news and stock price information service, initially in Aachen and later in London. Reuter established a competitive advantage through the use of telegraph cables and a fleet of carrier pigeons. Through his innovative use of technology, Reuter quickly established a reputation for speed, accuracy, integrity and impartiality.
With the introduction of the telegraph came two dominant communication models: 'Point- to-point', and 'hub and spoke'. The point-to-point model is used for communications between two parties, much as a telephone call is established between two parties. The hub and spoke model is used to collect information (such as news or orders) into a central hub (an exchange, news service or other centralised service bureau) and then to distribute information out to users on the edge of the network.
Three closely linked changes are occurring today in networks and in how they are used. These are:
- A shift from 'point-to-point' and 'hub and spoke' models to a 'many-to-many' or 'extranet' model.
- An erosion of the distinction between private networks and public networks.
- The separation of application and messaging services from the underlying network.
From point-to-point to extranet
When the NYSE adopted the telegraph, it adopted a 'hub and spoke' model, where the Exchange was a central hub, with access to the Exchange provided by the 'spokes', i.e. the telegraph lines. While technology has changed, most networks today follow this hub and spoke model. Large information providers such as Reuters and Bloomberg, most exchanges and ECNs, and service providers such as SWIFT, all operate on the hub and spoke model. This network model maps very closely to, and reinforces, the business models which have dominated over the last century, in which exchanges act as centralised pools of liquidity, CSDs (Central Securities Depositories) provide a similar centralised hub post-trade, while banks and brokers aggregate transactions from their clients and interface to the central hub.
Many firms have also implemented 'point- to-point' networks. For example, brokerages have implemented point-to-point connections to exchange FIX formatted messages with their counterparties. As electronic trading has grown, so have these point-to-point connections, where it is now becoming an operational distraction to firms with higher business priorities than operating communications links. Imagine a world in which every bank required a dedicated phone line to every one of their counterparties.
A new networking model has emerged, the financial services extranet, offered by firms such as Radianz. (Reuters and global telecommunications operator Equant established Radianz in 2000 through the spin-off of Reuters global network into an independent company jointly owned by Reuters and Equant.) The extranet is a shared IP (Internet Protocol) network that connects many 'providers' of information and transactional services to many 'members' who access these services. Providers include exchanges, information providers, depositories, banks, brokers, and other industry utilities and market infrastructures. The extranet provides 'many-to-many' communication among participants based on selective permissioning. Hosting of web and other applications is offered to the 'providers' on the network.
There are several business drivers to move away from traditional hub and spoke and point-to-point models to an extranet:
- Straight-through processing (STP) requires an extranet communications model. For the promise of STP to become reality, a transaction needs to flow from an IOI through an order, an execution, allocation instructions, and so forth through settlement. Over the life of a single transaction, processing must occur at buy-side firms, sell-side firms, exchanges or ECNs, banks, CSDs and so on, and the transaction must be augmented with reference data from a variety of sources. This process is substantially enhanced if all of the participating organisations are electronically linked on a single network. Because post-trade processing will fail if information is not captured electronically at the beginning of the transaction, it is critical that the network extend from the pre-trade process right through settlement.
- Operational cost reduction. In a world of hub and spoke networks, the costs of operating the network is attributed to each hub (i.e. exchange, ECN, information provider). In the point-to-point model, either or both trading partners must bear these costs. As firms establish trading relationships with multiple counterparties, and as firms connect to multiple information providers and exchanges, these costs multiply, as do the internal IT costs associated with managing these networks. By contrast, in the extranet model, a single network is shared among many providers, allowing for a shared cost infrastructure.
- Need for flexibility. Our financial markets are changing, with emergence of new liquidity pools such as ECNs, growth in cross-border trading, merging of exchanges, and a shift in the focus of markets from a strong geographic axis to a more global asset-class-based axis. The old network models are inflexible and do not accommodate this dynamic environment. Firms need a network that offers the flexibility to access new content and transactional services. A shared extranet model achieves that result.
- Electronic delivery of services by brokers to their institutional clients. While we traditionally think of banks and brokers as being consumers of information and trading services, these same firms are now moving to reach out to their customers electronically. Web-enabling the client relationship has the potential to both reduce costs and to enhance the richness of services that can be provided by brokers and banks to their clients, including execution services, order management, and risk management. While most firms have delivered such capability to their top-tier clients using point-to-point networks, they are looking to expand such services to the next tier of clients. Doing so with a point-to-point network is costly, time-consuming, and a management distraction. The extranet model is a natural fit for these firms, as many of their clients are already connected.
From private/public to a continuum
Until the introduction of the extranet, financial services firms have had a choice between two extremes:
- Private networks, which are secure, reliable, and high performance, but which have high operating costs and limited market reach. Examples of this include the private networks that have been operated by information providers such as Reuters and Bloomberg, and messaging services such as SWIFT.
- Public networks such as the public Internet, which have broad market reach, but which lack security, are not centrally managed, and provide no assurances of reliability and performance.
Over the past few years, many firms have outsourced their networks to telecommunications companies. Examples include Nasdaq, which has outsourced to Worldcom/MCI, and SWIFT, which has outsourced to Global Crossing. While this outsourcing allows firms to focus on their core competencies and have their networks run by networking experts, it is not fundamentally transformational. An outsourced network remains a private network, albeit one whose operation and engineering has been contracted to a specialist.
At the same time, other firms have extended private networks to include their clients, their suppliers, and their trading partners. These private networks have gone from being a platform for purely internal automation to a means of doing business.
Still other firms have looked to take advantage of the broad connectivity offered by the Internet while seeking solutions for security and reliability. And of course, in the consumer-oriented segment of the market, the Internet has had broad acceptance.
With this change in the usage of networks, the traditional either/or choice between private networks and public networks no longer applies. It now makes more sense to think of networks along a continuum that includes:
- Consumer-oriented Internet Service Providers
- Business-oriented Internet Service Providers
- Internet VPNs, or 'Virtual Private Networks', that provide a secure overlay on top of the Internet
- Industry extranets that connect many providers to many members
- Private extranets that connect a single firm to its client
- Private networks.
We are all familiar by now with Metcalfe's Law, which states that the value of a network increases exponentially with the growth in participants connected. For example, the value of a fax machine increases with the rise in the number of people with fax machines. Metcalfe's Law also describes email networks, the telephone network, and many others.
This article proposes Carley's Corollary: The value of a network increases exponentially with the growth in participants connected, until the network begins to include participants with dissimilar or conflicting interests, at which time the value of the network declines. This phenomenon becomes apparent as our email inboxes get filled with 'spam' or other junk email, as we get 'junk faxes', and as telemarketers interrupt our meals. Firms want to connect to networks that connect them to all of the firms that they do business with, but only to those firms. In particular, they do not want the network to provide connectivity to hackers or others whose interests are detrimental to their own. The financial extranet meets this requirement, by connecting participants in the finance industry to one another, but excluding those who are not engaged in financial services. It is an appropriate balance between the purely private networks and the public Internet. It provides the security, reliability, and performance needed for institutional finance, with appropriate market reach and the shared economics of public networks.
Separation of layers
In the early days of the automobile industry, companies like Ford Motors owned rubber plantations in Brazil. Networks in the finance industry have operated with a similar degree of vertical integration. Content, transactions, and networking were tightly integrated. Exchanges and information providers developed proprietary networking protocols, implemented directly in the applications. Information providers such as Reuters delivered content over proprietary networks, while industry utilities such as SWIFT and order-routing services such as GL Trade delivered messaging services and financial applications that were vertically integrated with the telecommunications networks that carried them.
With the introduction of IP technology, the industry has standardised on a single network protocol. IP technology allows for the many-to-many model of the extranet, and it also allows for applications to be built separately from networks, using a standard set of interfaces between the application and the network. The model that is emerging consists of three layers:
- The IP layer, which proves the network connectivity among participants.
- The messaging layer, which provides standard formats for describing information and transactions. This includes standards such as FIX, ISITCI, ISO15022, and others.
- The application layer, where the business rules and workflow are implemented.
The adoption of such a three-layer model allows application developers to focus on business logic and their added value, without consuming their resources to build the underlying plumbing. It facilitates greater application connectivity, which is critical for straight-through processing. And it enables the use of a shared network infrastructure, which makes the connectivity possible and reduces costs for the industry.
Benefits
Extranets benefit both providers of service and their clients or member firms. For providers:
- They can achieve faster time to market by connecting to an extranet that has broad market reach and a community of clients that are already on the network.
- It allows them to focus on their core competencies, rather than tying up financial and intellectual capital building networks.
- It provides an easier path to straight-through processing, as the extranet connects all of the parties involved in a transaction, from pre-trade through post-trade.
- Costs are reduced through access to a shared network.
- Higher service quality is possible, because a specialist firm provides the network.
- Relative to the public Internet, greater reliability, security, and performance, and because the network is centrally managed, accountability for results.
Member firms also benefit, through:
- Reduced costs, which ultimately reflect in lower transaction costs or fees for service.
- Simplification of their infrastructure, as they can use a single connection to access all of the network delivered services that they use.
- Greater competition among content providers, as 'switching costs' are reduced if multiple providers are equally available over a common network.
Implications for the industry
The introduction of the telegraph and later the telephone fundamentally re-shaped business in general and the finance industry in particular. The Internet has had similar effect in consumer markets. The financial extranet will also have a number of implications for the finance industry. These include:
Enhanced market efficiency
Basic laws of economics tell us that efficient markets result from:
- A standardised product to be traded.
- A large number of buyers and sellers. The financial extranet connects large numbers of buyers and sellers, facilitating the liquidity needed for an efficient market. Metcalfe's Law, referenced earlier, is really an Internet era re-statement of a fundamental economic principle, i.e. that a large number of participants in a network increase the liquidity of that network, and hence the value of that network. Carley's Corollary also applies here, as there is an upper bound on the number of desirable participants in a market. For example, for an institutional trader, the value of the order flow on an ECN is reduced if institutional orders are commingled with smaller retail orders. In exchange markets, this principle is implemented by allowing a limited number of member firms to trade on the exchange, while other firms trade using the members as intermediaries.
- Perfect flow of information. By providing a shared network, the extranet enables competition in the delivery of information, and facilitates the exchange of information among connected firms.
Enables new entrants
One of the biggest challenges in establishing new trading venues is to quickly build liquidity. By providing a network on which many buyers and sellers are already connected, the financial extranet reduces this challenge. Not only does it facilitate greater liquidity in established markets, but it also makes it possible for the formation of new markets. Internet communities like E-Bay have made it possible to establish auction markets in everything from antiques to astrology; the financial extranet does the same for financial instruments.
Accelerating the separation of content from networks
With the availability of a standard shared network, it will be less attractive for firms to connect to multiple private networks. This will create pressure for firms that operate private networks to move to an extranet model. Many of these firms today tightly link their content or application services with the network, and part of their perceived value is in the network. The extranet model will create pressure for these firms to demonstrate the added value in their content and applications. At the same time, it will allow them to free up their resources from networking to focus on these more valuable and differentiating services. Not all firms will make this transition with equal ease, although the early movers already have a head start as they have begun to reallocate their resources further up the value chain.
Acceleration of global markets
The financial extranet is global, connecting firms around the world onto a single network. This makes it easier to access information and trading services across borders, and will accelerate the globalisation of financial markets. One consequence of this is that the financial extranet facilitates a 'horizontal approach'. For example, Europe has historically organised along a vertical model, in which clearance and settlement are along national lines and closely linked with national exchanges. In the 'horizontal approach' to Europe, there would be pan-European exchanges, clearance and settlement functions. A single pan-European (or global) network facilitates the horizontal approach.
Blurring distinctions between exchanges, brokers, banks, and information providers
These distinctions are already being eroded today. The financial extranet makes it easier for exchanges to provide directly to their customers without an intermediary. Equally, they make it easier for information providers to move from static content to 'smart content' and integration of content with order routing and trading services.
Potential shift from centralised to decentralised trading
The adoption of the telegraph by the New York Stock Exchange was a powerful centralising (hub and spoke with NYSE as the hub) force. It reinforced the powerful pool of liquidity established at the NYSE, and accelerated the consolidation of US stock exchanges. The financial extranet however, is not a centralising technology. Rather, it enables direct communications among a large number of participants. The initial conclusion might therefore be that the extranet has the potential for decentralisation and disintermediation. As we have seen from the public Internet, disintermediation very rarely happens, as intermediaries serve many useful functions. While one can imagine traders interacting directly across a network without a central stock exchange, in practice this seems unlikely given the many valuable functions that an exchange performs. It is more likely that exchanges will evolve in their scope and function, while new forms of intermediary will emerge, able to compete on a new playing field based on cyberspace instead of physical trading floors. It is unclear at this point whether the natural winners in cyberspace will be super-national stock exchanges, or niche trading venues that link across the network to form a 'virtual' marketplace.
Many of these are trends have been recognised already. They would be happening to one degree or another without the financial extranet. The financial services extranet exists at least in part because of these industry trends. And of course, there are many other pieces to the puzzle (for example, globalisation is aided by common currency, deregulation, and harmonisation of clearing/settlement regimes.) The introduction of the financial extranet, however, is a critical component of the re-shaped financial industry. Like the telephone and the telegraph before that, it is a fundamental change in the communications paradigm. The financial services extranet is a new phenomenon, so we are just beginning to appreciate its consequences for the industry. The end game has not yet emerged, but it will be fascinating to watch as it unfolds.
