What is an FMI? And why do I care? An intro for those building the crypto-y future of trading.

I’ll admit that I have been pretty irregular with writing, I suspect that this will continue and as such will make no further apologies for it.

One thing that has become a personal pet-peeve of mine with the crypto-community (of which I have several), is the lack of understanding of financial market infrastructure.

I often hear adages about software developers being able to learn how to build cars, medical devices, or banking systems quicker than incumbents can learn to code. While this may be true, and yes I do acknowledge that innovators often need to “do what’s never been done before to innovate”, it’s been 8 long, and painful years since Mt Gox launched, so perhaps a few more crypto-preneurs could take a few moments between Tweets to understand the precedents in their industry. To this end, I am going to write a few articles covering the financial markets and their components, then comparing them with what currently exists in this emerging field of crypto-assets (a term that I still dislike, but not a hill that I am going to die on).

Kicking this off, first want to take a giant step back and look at why financial markets exist. At their heart, financial markets allow ventures to raise money for a common endeavour from a large pool of potential investors, and for investors to trade interest or risk in that venture with other potential investors.

The ‘Pieter and Paul’ on the IJ in Amsterdam in 1698 (Abraham Storck)

The first example of modern financial markets appeared in Amsterdam in the 17th century, allowing many relatively small investors to buy a stake in companies like the Dutch East Indies Company (a primary market). This company was interesting, not only because of its importance in the history books for its expeditions to the East Indies, but for its structure and the impact that it had on shaping financial markets, giving birth to a secondary market.

Other companies in the same business as the Dutch East Indies Company had previously employed a mechanism of sourcing funding from small investors, and used that financing to complete a single expedition under a charter, and were then dissolved, returning proceeds to investors. The Dutch East Indies Company broke from this model by renewing its charter with the Dutch crown, this left many investors with the issue of needing a return of their capital, whilst others remained happy keeping their interest in the company (funding secured!). The result was the formation of a secondary market, where investors could buy and sell their stake in the Dutch East Indies Company amongst each other.

As fixed capital companies eventually reached England one hundred years later, traders began to realise that while a company could be a success or failure, the highly commoditised cargo that their ships carried from far-flung plantations could go up or down in price during the months long voyage, or that the ship could sink along the way. The result was that secondary markets evolved to trade the commodities themselves, including coffee.

Chicago Board of Trade 1885

Many traders, for example in the United States in the 19th century, realised the need to fix the price at which they bought or sold commodities like cotton or grains, and developed exchanges in New York and Chicago. Contracts were designed to allow traders to hedge prices by simply exchanging Dollars between the two counterparties, without the need for the underlying to trade hands.

Back in Europe, the coffee trading houses developed a novel system, whereby each trader would enter into a contract, not with each other but via a caisse de liquidation — a process known as novation — who would handle a process of margining whereby each counterparty would need to keep up to date on their obligations or face becoming in default to the caisse de liquidation, and losing their contracts. This offered a greater form of security for both counterparties and helped facilitate more liquid markets as traders did not have to worry as much about the likelihood of an individual paying their debt, only that the caisse de liquidation could meet its obligations.

What bears repeating here is that the coffee house where traders met and agreed upon price was legally and financially separated from caisse de liquidation, in the same way that a car dealer is different from a car insurance company. This system, known as clearing, eventually became standardised across large financial markets around the world, making the leap from derivative contracts to ‘cash’ products such as stocks and bonds. While the need for an independent central party to manage risk and provide insurance seems relatively obvious for contracts which can start today and last over months, it may not be so for products like stocks which trade for cash balances over shorter periods.

While recent regulations have forced the timeline from trade to settlement (when the buyer receives the stock and the seller receives the cash) from five business days, to three, to two there is still a considerable risk that the buyer or the seller don’t meet their obligations, especially when one considers that many professional traders trade on a daily basis and as a result are in a continuous position of owing or being owed stocks and cash. This is particularly true for the largest traders who control a large enough share of the market that if they failed to deliver it could cause severe disruption to the operation of the financial market.

Given the importance of these clearing organisations, and the grave implications were they to fail, the Bank for International Settlements (BIS), an organisation of the world’s largest central banks, formed a committee with the International Organisation for Securities Commissions (IOSCO) a group of the largest regulators in the world published the Principles for Financial Markets Infrastructures (PFMI). The PFMI lays out standards for regulating entities such as:

  1. central clearing counterparties (CCPs) — interposes itself between counterparties to contracts traded in one or more financial markets, becoming the buyer to every seller and the seller to every buyer and thereby ensuring the performance of open contracts (or clearing house, it’s not perfect but for simplicity I will use these two terms interchangeably).
  2. central securities depositories (CSDs) — provides central safekeeping and asset services, which may include the administration of corporate actions and redemptions, and plays an important role in helping to ensure the integrity of securities issues, and may also operate an SSS.
  3. payment systems (PSs) — a set of instruments, procedures, and rules for the transfer of funds between or among participants; the system includes the participants and the entity operating the arrangement.
  4. securities settlement systems (SSSs) — enables securities to be transferred and settled by book entry according to a set of predetermined multilateral rules.

The PFMI have been used extensively to write regulations in various jurisdictions to ensure that these organisations are managed properly. What is key to note about all these types of organisations — collectively referred to as Financial Markets Infrastructures (FMIs) — is that they all deal with what happens after the trade (or post trade). Note that none of these are exchanges though several of these services can be bundled under a single umbrella group, for example Euroclear operates a CSD, PS and SSS, the Intercontinental Exchange (ICE) operates CCPs and Exchanges (not a FMI), and Deutsche Boerse operates all four types of FMIs in addition to Exchanges.

Regulations for where the trading is actually done is slightly less coordinated. The historical version of these is the coffee shops where buyers and sellers would meet, agree and a price. Modern versions of this process, mainly, take place in a high-speed digital medium with traders meeting with many potential buyers and sellers and collectively agreeing the price for a financial product.

Because of the “multilateral” nature of trading venues, the process has three principal steps, order submission, matching, execution and order confirmation. This process looks as follows (using a central limit order book):

  1. Order Submission: Potential buyer enters a price at which they are willing to buyer up to a fixed number of instruments (e.g., 1000 AAPL @ 216.00). These orders can be cancelled, and updated, a process which happens often for a variety of reasons.
  2. Order Matching: This buy is placed in a list ranked in descending order by price next to all other buy orders (bids), and a mirroring list of all sell orders (asks) in ascending order by price.
  3. Order Execution: Any “compatible” orders which have not been cancelled can be executed. This may not take place instantaneous, if for instance there are not enough compatible orders at the time. Let’s take the example that our 1000 AAPL shares are the highest bid at a given time (at 216), and there is no one currently willing to sell for less than 216.50, the order will no execute. One minute later someone posts an order to sell 400 AAPL at 216. Our order will be partially filled (executed), for 400 AAPL and sent on through the next step, leaving 600 AAPL on the order book.
  4. Order Confirmation: Once a trade has been executed the information about the buyer and seller is passed on to be processed. At this point we start the post trade operations, and interacting with the clearing house.

In Europe, the overarching rules are laid out in MiFID II/MiFIR. These directives, amongst other things, lay out how European Union countries should write rules to regulate trading venues, and ensure transparency. These rules define three forms of trading venues, regulated markets (RMs), organised trading facilities (OTFs) and multilateral trading facilities (MTFs).

The also define two types of execution venues, systematic internalisers (SIs) and OTC execution venues. These two types of venues only take matched orders and send them through the trade capture and onward to post trade.

It is also worth noting that in addition to these processes there are processes around reporting and trade enrichment (adding more data to the trade) which take place, in part to ensure transparency.

Opposed to the post trade operations of venues covered by PFMI, many of these venues are built to handle speed. The order submission (deletion) and matching may take place in microseconds. Some of these venues are so fast that traders work to physically place their trading engines closer to the exchange (co-location) to save on latency caused by the speed of light over fibre optics lines. This process can be so competitive that even the exchanges offering this service have to cut the networking cables inside these data centres to equal lengths so that one server in the data centre doesn’t have a one metre advantage over another (with data flying at the speed of light!).

If we draw this all out, simplistically, for our AAPL trade it looks something like this:

Simplified trade life-cycle

Before moving on, there is one important thing to point out here. Trades can be, and are made, before a trader has inventory (stocks) in their account, this allows for greater liquidity because a market maker can sell stocks to someone then go out and find stocks from someone to pass on to the buyer. There are all kinds of mechanisms to help handle the fall out from this if it doesn’t work exactly as planned, which are not for today.


Bringing this back around to a cryptocurrency exchange (let’s pick on Coinbase, but they are fundamentally similar), the process is slightly different. The first thing to know is that there is no separation between the organisation that runs the order book, and the clearing and the settlement. Because of this we have to trust the processes at Coinbase to make sure that the trading activity is transparent (and genuine), that the Dollars and bitcoin are correctly credited to your account, and that trades take place at the level which you thought that you executed them.

When you want to take “settlement” of your bitcoin or Dollars you need to request them from this same venue, and if you want to make a trade you need to make sure that you have sent enough Dollars or bitcoin to make the trade (pre-funding).

If you start the process at Coinbase and decide that you can find a better price of your bitcoin at Kraken or Bitstamp you need to request that Coinbase transfers them to the other venue, receive acknowledgement of that transfer then execute a trade. Best case scenario this takes about an hour, during which time the new venue might not have a better price than Coinbase.

The other major risk of leaving everything with the same venue is the risk of loss through hacking. Unfortunately the answer is not as simple as for securities which can be managed in a CSD, however. Of course there is always a risk of loss, and you should manage your private keys securely, but by moving them centrally the risk/reward to a potential hacker is greater than it would be if they had to attack each wallet holder individually.

In my next post, I will explore “decentralised exchanges (DEX): what they are, what they are not, and why I’m not convinced”.