With jthe days counting down to the introduction of the Markets in Financial Instruments Directive (MiFID) is promulgated, prospects for Europe’s leading stock exchanges might appear to be set slightly on a downward path despite some very recent exchange initiatives to cut trading reporting and internaliser tariffs in the wake of Projects Turquoise and Boat.
Officials at the London Stock Exchange (LSE) might express anger at attempts by US and European banks to organise an alternative investment exchange through Project Turquoise, but should they really? Anyone familiar with this business should have seen it coming when MiFID was first drafted in November 2002.
Peter Randall, head of Instinet Chi-X, a trading system or “destination” that is co-operating with Fortis’ clearing service in German, Dutch and shortly UK equities, says: “Liquidity will move. There’s nothing magical about liquidity and stickiness. And, while there were plenty of issues in the past that made it difficult to move liquidity, one by one those barriers have been removed.”
Multiple destinations
Conceivably a plethora of different destinations could spring up, according to Mr Randall. “Provided they are all able to broadcast their service processes the smart order routers will look at them all and provide the best and most appropriate price from different pools of liquidity.”
Peter Bennett, principal, Exchanges & Market Data, HCL Technologies and the architect of the LSE’s systems used when it moved from floor trading to a screen system in 1986, even foretold of the ‘demise’ of traditional exchanges in a paper titled ‘Who Needs Exchanges?’ released in 2003.
He explains that with the big banks controlling the lion’s share of order flow (approximately 40 to 50 per cent), the liquidity barrier that “dogged” previous initiatives such as Tradepoint is no longer the problem. “The investment banks can save money by systematically internalising order matching under the MiFID regime.”
By building a hub akin to the US National Market system they could “link” their liquidity pools and publish consolidated market information to meet MiFID best execution and transparency requirements in a “compete/co-operate” business model.
“The hub could be built using cheap and accessible technology and the arrangement could allow for other banks to join and lead to a global exchange anchored in the UK,” explains the ex-LSE IT veteran.
Once critical mass had been achieved, the hub becomes the price reference point for the securities traded, with the consortium banks becoming what Mr Bennett describes as the “net producers rather than consumers of market data”. That arrangement should avoid exchange transaction costs, and furthermore reduces market-side settlement costs.
John Barker, managing director at Liquidnet Europe, who thinks the traditional exchanges and the LSE in particular could lose “significantly” from any forthcoming market fragmentation, says aggregators would have to come to the fore to provide a consolidated market view.
“As much as I think that the exchanges are in a weak position, they are going to have to look to their own models to see where they offer value,” Mr Barker states.
The LSE could become the “last option” on the food chain as fund managers work their way down the path of best execution and one “works out where those orders will be last”.
Take a BGI, Fidelity or State Street. Mr Barker suggests that they “probably” will want to cross as much volume internally through their own house, then the fund manager might wish to cross via a Liquidnet with buy-side only participation, followed by an ITG PositNow where sell-side activity resides. A subsequent option might be obtaining a “risk price” from a bank. Perhaps “less than 10 per cent” could be left for the order books.
Times changing
“So, gone are the days when the LSE could command 100 per cent of the order book. Potentially they could be left with less than 20 per cent of the order flow within three years.”
Dr Anthony Kirby, an Accenture consultant, commenting on a possible liquidity “land grab” in Europe, says: “It’s a great idea, but at the same time all kinds of issues come to the surface. I think the big four or five exchanges in Europe are not exactly quaking in their boots at this prospect.”
There will be significant opportunities and threats for the leading exchanges in Europe, Dr Kirby says. “Certainly they know what it’s like to run an exchange business and they can also scale their business model accordingly, and can provide market surveillance.” Nevertheless, pressure will be exerted over their trading tariffs and revenues generated from market data.
Glenn Bedwin, head of research, Europe, at Thomson Financial, says: “I’m quite convinced that we’ll see fragmentation. And, while here have been failed attempts to move liquidity in the past, the situation has changed markedly today.”
The change is two-fold. Firstly, due to the abolition of concentration rules in certain European territories there is “[no] scope to see liquidity moving on a pan-European basis rather than just between domestic markets”. Second, leading European exchanges are increasingly earning more revenues from execution as the volume of trades is growing exponentially, while the average size of each trade declines.
He thinks the “pendulum” in the European market will swing from left to right from one with fewer venues of execution and choices to one that has greater choice in the short term, before swinging back to the left - but not entirely so. As the market adjusts and there is a shakeout in the numbers of alternative trading venues, some new venues will succeed, while others will fade and fail.
Cross-quoted stocks
Mr Bedwin thinks that whether or not Project Turquoise happens and creates a rival exchange, movements of liquidity will be seen. “The extremely liquid stocks in Europe could well be cross-quoted in London, Deutsche Boerse and Euronext. So they’ll be competition between the regulated European markets.”
With multi-lateral trading (MTF) platforms coming through, with Instinet’s Chi-X trading system offering ‘roundtrip’ of 10 milliseconds (versus 140mls from the LSE), and Equiduct is in the process of getting its model in place, the exchanges might have to fight a rearguard action to preserve their current dominant status.
Mr Bedwin says the introduction of smart order routing technology, which has been seen to good effect in the US where there has been a certain amount of fragmentation, will help drive the market forward in Europe.
“A smart order routing capability can allow firms to still have a consolidated view of liquidity…even if the market itself has fragmented. And, while smart order routing has yet to take off in Europe…it’s only a matter of time.”
With the New York Stock Exchange (NYSE) having merged with Euronext, and NYSE owning Arca, Mr Bedwin contends that we will “see it coming”. And, once that starts breaking in Europe, liquidity should become far more movable.
As for data aggregators coming in and providing a consolidated view of the market, Mr Bedwin adds: “From a Thomson perspective, we’ll be putting a capability together to allow our clients to see an aggregated view of liquidity. We’ll be displaying a ‘European Best Bid and Offer’ (EBBO) and displaying that in an effectively customisable way to the firm’s own execution policy.”
In that sense, data will allow a consolidated view of liquidity, but then smart order routing will allow orders to be automatically directed to wherever the liquidity currently resides at whichever price point it currently resides.
Peter Randall, at Instinet Chi-X in London, commenting on whether there could be a “liquidity grab” and consequences for price formation, says: “It’s not a liquidity grab but just that the market will favour certain things, which given all other things being equal, offers the same service at a lower price and a better service profile.”
Using the analogy of the internet where emails are split into smaller packets by an internet service provider, routed and stitched back into a coherent message, Mr Randall says: “That which technology rips apart…technology can also stitch back together again. And, that is exactly what is going to happen with the European landscape.”
“Sure, if there’s trading in some of the bigger named stocks on Instinet Chi-X and also trading on them on another exchange, one could have two screens or toggle between two prices. Or, they could use a smart router and it will tell them at any point in time which is the best venue to do that trade on.”
Alasdair Haynes, CEO of ITG Europe, adds: “Now what you might see is that price formation may not be done totally by the LSE, Deustche Boerse or Euronext, but there’ll be competing price formation systems.
“The technology will consolidate that in a similar way as you can see in the foreign exchange or bond markets, where very effective prices and levels can be seen through consolidators and via Bloomberg and Reuters screens. One might end up with a market like that, although I don’t envisage there will be concern about the actual price formation itself.”
Concentrated liquidity
Simon Nathanson, chief executive officer of agency broker NeoNet in Stockholm, adds: “In Europe there is no free competition regarding liquidity and the traditional exchanges have been extremely successful in concentrating liquidity to themselves, so to speak.”
“For us, the onset of MiFID and the Project Turquoise initiators can be regarded extremely positively and great news…and we will strengthen ourselves as a result.” We’ll be connecting to the successful MTF's and continue as an aggregator of access to liquidity.”
In that vein NeoNet, which provides coverage to 23 markets through its DMA services and XG product where clients trade using their own memberships but on NeoNet’s infrastructure, recently added access to three exchanges in Japan (Tokyo, Osaka and Jasdaq). Mr Nathanson says the agency broker will “continue to connect” to more Asian bourses.
The UK FSA will be monitoring events closely, but their greater concern will be for orderly markets rather than fragmentation of the market as such.
