Exchange Simulation Environments: assisting currency traders to validate their systems' performance

By Kireeti Reddy

The foreign exchange (FX) markets have grown rapidly in recent years. One of the primary reasons for this rapid growth in trading volumes at most of the dominant exchanges, is the rapid adoption of electronic trading by the exchanges as well as the market participants. Exchanges are providing open standards based interfaces (ex: FIX protocol based connectivity) to their markets, which allowed technology vendors specializing in exchange connectivity, to provide high speed electronic trading software.

The combination of electronic exchanges and the availability of high speed trading software led to the emergence of an important class of market participants that employ algorithmic trading at the core of their trading operations. These participants include Hedge Funds, Proprietary Trading Firms and Trading desks at all the major financial institutions. These trading groups have become the most active liquidity sources at all the exchanges, as algorithmic trading typically involves high frequency and high speed trading.

Demand for Exchange Simulation Tools:

The demand for exchange simulation tools come from different segments of the trading industry, both within FX and non-FX trading.
An FX trading firm that provides screen based FX Trading to its retail clients: The primary need for these retail customers is the ability to setup a practice account and trade in that account. In order to provide a trading experience that is close to the real exchange trading, the trading firm needs to provide a simulated exchange environment that simulates a real time trading environment.

• Algorithmic/Automated FX Trading clients: The primary need for these algorithmic trading clients is to have the ability to test their proprietary trading algorithms in a simulated exchange environment, before employing the algorithms. For these clients, some of the market opportunities may be short lived, and hence they need to be able to test their trading strategies quickly in a simulated exchange environment.
• ISV (Independent Software Vendor) firms developing specialized interfaces to the exchanges: Even though most of the exchanges provide testing environments, that provide simulated trading environments to ISVs, these are not available 24 hours a day. These ISVs need access to a simulated exchange environment that is available all the time, and can be controlled within their testing environment, without having to depend on an external entity.
• FX Trading firms that develop in-house exchange connectivity software: These firms need to certify their connectivity software with the exchanges. Having access to an exchange simulation tool will help in the development and testing phase, before actually testing and certifying the software with the exchanges.

Given the diverse set of demands for exchange simulation tools, from different segments of the trading firm industry, ISVs provide different kinds of simulation tools.
For majority of clients, a simulation exchange needs to provide the following support/features.

• Simulation Exchange must accept buy/sell trades (in the same format as the exchange it is simulating)
• Simulation Exchange must provide ability to cancel and modify trades
• Simulation Exchange must generate appropriate exchange responses that conforms with the actual exchange
• Simulation Exchange must perform trade matching and generate fills (including partial fills), and other execution responses
• Simulation Exchange must support all the order types that are supported by the actual exchange
• Simulation Exchange must generate appropriate end of day responses (for expiring day orders etc.)
• Simulation Exchange environment must allow for the client to be disconnected and re-connected from the trading session, just as an actual exchange would.

In an ideal scenario, a client application must be able to swap the actual exchange connection with a simulation exchange, with simple configuration changes.

The following diagrams (provided by Exchange Systems Inc.) shows typical usage of exchange simulation tools by clients. The first diagram shows the deployment of client applications connecting to actual exchange.

The next diagram shows the same client applications being deployed under a Simulated Exchange, displaying the fact that the same client side applications are being used with the Exchange Simulation toolset.

Major benefits of Exchange Simulation Tools:

• Increased productivity in developing and testing trading applications that require exchange connectivity. The productivity benefit comes from the fact that a dedicated simulation exchange is available all the time, and hence the client does not need wait for the exchange related testing environment to be available during development phase.
• Ability to test complex trading strategies in an isolated environment. As the exchange provided test environment is accessed by different trading firms, it becomes difficult to test certain specialized trading strategies, due to the impact of the test trades from other trading firms. An isolated simulation exchange would provide the ability to create and control the market for one or more trading instruments, helping with the testing of complex trading strategies.
• Increased Speed to Market: The ability to quickly test new trading strategies in an isolated exchange simulation environment will help an algorithmic trading firm to take a new trading strategy to the market quickly.
• Ability to create boundary conditions and extreme scenarios: An isolated simulation exchange would allow for creating boundary conditions and scenarios that may not have existed in an actual exchange trading environment.

Exchange Simulation providers are going to have to develop simulation tools that cater to the needs of different trading clients. Most of the trading software ISVs has integrated Exchange Simulation software that is bundled with their trading software. For example, Trading Technologies, Inc. (www.tradingtechnologies.com) one of the leading vendors, provides exchange simulator software that helps its clients with the initial testing of its GUI applications, before actually connecting to the exchange. Some of the newer application frameworks that are specifically targeted to Automated Algorithmic and Strategy based Trading clients and provide a complete framework that simplifies the development time of a new trading strategy. These application frameworks interface with other 3rd party industry solutions, for certain specific functionality, like exchange connectivity, risk management etc. These application frameworks can also be integrated with different 3rd party Exchange Simulation Tools.

This provides necessary flexibility to the clients in choosing exchange connectivity software (actual and simulation) with the development framework. For example, 4thStory Inc. (www.4thstory.com) provides a comprehensive development and deployment framework for automated trading applications. RTS Realtime Systems Group (www.rtsgroup.net) also provides similar software. RTS group software also provides proprietary exchange gateway software. Exchange Systems Inc provides Exchange Simulation tools that can be integrated into any FIX protocol compliant trading environment.

Conclusion

With the increasing number of market participants that use automated, proprietary algorithmic trading strategies, there is a demand for exchange simulation tools. Clients will also need specialized functionality from exchange simulation tools that can support testing of complex trading strategies.