Published On: Tue, Sep 22nd, 2009

Creating a Warrant Market Making Engine

Creating a Warrant Market Making Engine: A discussion on alternative approaches.

Background

For a period of time warrant trading was a highly profitable easy business in equities trading. Today it is still profitable but becoming operationally more difficult in developed markets such as Taiwan and Hong Kong. There are a number of reasons to this. First more players are entering into an already crowded market multiplying the number of active warrants available for trading. Secondly, there is a growing acceptance of algorithms to make markets. Any trading firm with an IT budget can buy an off-the-shelf product to auto quote warrants. Lastly, the highly volatile nature of the stock market has made hedging more difficult and expensive. All of these factors have together turned the once lucrative warrant market in Taiwan into a highly competitive and lean business.

The warrant business is about an issuing firm selling warrants to potential investors. Success here is based on a few things:

• Efficiency in distributing as many warrants to investors as possible
• Whether the firm possesses the right techniques and the ability to make markets in warrants by providing the best price and liquidity to attract investors
• The final factor is the ability to properly manage the risks and exposures inherent in market making

With the right technology and sound knowledge of market making techniques, the factors above can be overcome with a properly designed market making engine.

Why Do I Need A Market Making Engine?

Look at the below questions. If you answer YES to most of them you probably need either a new engine or at the very least seriously consider upgrading your current system.

• Are your traders still making markets manually?
• Are you finding it difficult to manage all your active outstanding warrants?
• Do you have plans to scale up your operations by issuing more warrants?
• Do you want to issue stock and Exchange Trade Fund (ETF) warrants?
• You have lots of ideas to make markets but you just don’t have the systems and tools to implement them ?
• Your traders sometimes misprice warrants causing losses ?
• You spot mispriced warrants in the market but by the time you react the opportunity to trade them has gone ?

How Do I Get A Market Making Engine?

There are a number of ways to set up a market making system for the trading desk. You can choose to do it in house, buy an off-the-shelf package from a software vendor, or a mix of both.

Off The Shelf
At first glance choosing an off-the-shelf package may seem to be the easiest solution, many vendors claim theirs is a plug-an-play solution that you can start trading “the next day”. In reality every vendor product will require customization to fit your internal trading needs, compliance and risk requirements. Additionally, you will need to integrate with the exchange’s trading gateway. The biggest drawback of a vendor product, however, is that it does not give you any trading edge, as you will be using the same product some of your competitors use for making markets.

In-House
How about In-house development? An in-house system is tempting as it carries the impression that it will be tailor-made for the desk as such it would work exactly the way your traders desire. Also, you won’t need to to pay the hefty service fees or be tied into a contract for using a vendor product. Best of all, the proprietary trading technique is only known within the company.

However, considerations must be made that unlike building an exchange gateway or a simple stock trading system, market making requires a handful of complex technologies to work together in order to make the system work successfully.
• Are your developers familiar with the essence of market making business?
• Are they familiar with Complex Event Processing (CEP)?
• Do they have the knowledge to build auto-trading systems from the ground up?

For a firm that does not have a system but would like to own one, it is tempting to think of building one of its own. But be prepared. The potential risk of a run-away project with a hefty price tag and months or even years of time spent without being able to get the system live in the end.

Combination
Finally there is the mix-and-match approach. In this scenario, you choose a finance software company that has the right expertise. Most likely they already have a working and proved algo trading system with most of the necessary functionality built in. The idea here is to bring the expertise of the finance software company who have both the technical and business know-how to implement in tandem with you traders and firm’s IT. When done correctly, the final product combines both the best of in-house professionals and off the shelf applications. The firm minimizes the risk of placing their IT into the unfamiliar territory of complex auto trading technologies. This approach helps to lower the risk of project failure and at the same time enjoying the benefits of a system that will give the firm its edge over their competitors.

The below table presents the pros and cons of each approach.

In-House Vendor Combination
Competitive Advantage High Low High
Time To Production Longest Short Long
Cost Variable Variable Variable
Risk Of Project Failure High Low Medium to Low

What Is A Market Making Engine?
A market making engine is a highly efficient piece of algorithm that reacts to external events and performs corresponding action(s). To provide an analogy, think of your TV as an example. Your LCD TV continuously receives data from the antenna, processes the analog signals and converts them into digital format for projecting to the LCD panel. At the same time it listens to commands coming from you pressing buttons on the remote control. In return the TV carries out the corresponding actions for things like turning up the volume, change a channel, or powering off the TV. Now replacing your TV with an algo engine, think market quotes instead of broadcast signals, and buy and sell orders versus the action of switching a channel.

There are several types of co existent events contributing to a warrant market making engine:
• Market information events such as quote data (bid/ask/last/high/low/close)
• Trade events (order placement/order cancellations/order amendments/execution fills)
• User driven events (clicking the buy/sell order button, changing the parameters for example the trade volatility or the spread value)
• System events (market status, system health states, network links)

Typical actions in response to above events include:

• Pricing of fair values and implied volatilities
• Cancel and replace bids/offers in the market
• Computing individual and overall exposures
• Trade misprice opportunities in the market
• Update the latest status to the user
• Start/stop the quoting mechanism

What are some of the features required in a market making engine?
• The ability to process large amounts of data efficiently without slowing other system components
• The ability to compute fair values and/or intrinsic values for large amount of warrants instantly in real-time
• Accessing and processing ‘low-latency’ market data from exchange connectivity
• Support high volume trading such as placing tens and thousands of orders in a burst
• An architecture to support various placement strategies
• A highly responsive GUI front end for the traders monitoring and adjusting market making strategies.
• Highly customizable GUI allowing traders to select what they want to see and control
• The system must process safety features to avoid potential huge losses. This may include the control of limits and order size, a panic control to withdraw all active orders in the market, or stop quoting when it detects the possible mis-pricing of its own warrants.
• The ability to monitor ‘greeks’ and react with auto-hedging actions and warning alerts ability to withdraw and place new orders without self-matching own orders that comply with exchange regulations and trading rules

Conclusion

Setting up a market making engine is not a trivial task and requires careful planning from the outset. The different approaches described each have their pros and cons. A warrant market making engine listens to thousands of events and reacts at lightning speed based on preset parameters and predefined algorithms.

The warrant business has become competitive due to the the surge in firms entering to supply the demand among retail investors. The business is gaining ground in Asia and it is expected that more exchanges will list warrants to boost liquidity and offer a diversity of products for the public at large. Warrant market making can be a profitable business here in Asia especially among new entrants such as Thailand.

About TradeHub-Asia

TradeHub-Asia are the systems integration arm of DNA Financial , a financial markets service company. www.dna-financial.com

Trevor Jarrett
tj@tradehub-asia.com
www.tradehub-asia.com
D: (852) 21432888
M: (852) 91013963

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