With the Markets in Financial Instruments Directive (MiFID) deadline now long passed and the slow-burn process of change under way, the future shape of the European equity trading landscape is becoming clearer. With, as expected, liquidity fragmenting to a number of trading venues and small, nimble electronic crossing networks (ECNs) and dark pools taking a more central role in trading, some industry observers suggest that the eventual form will be similar to that developing in the US.
However, the interim stage will be marked by a number of pain points, not least of which will be the costs associated with Europe’s legacy infrastructure and tariffs. Driven by the electronicisation of the marketplace and uptake of algorithmic strategies, order sizes have come down, while volumes have risen.
 | “However, the dark pools push it the other way, so you end up with visible liquidity fragmentation and constantly falling execution size, although it reaches a point where, because of the cost structures on the current exchanges, it becomes too expensive to execute,” says Richard Semark, COO, European client trading at UBS. “While historically that has been a problem for the sell-side and not for the buy-side, as the gross margins go down on direct execution, the buy-side is becoming more aware of where those costs are. That is one of the reasons why MiFID came into existence, contrasting those costs here with what they would be, for example, in the US.” |
Discrepancies
Comparing the discrepancies in trading efficiencies (that is, costs) between the US and Europe became a popular sport in the run up to MiFID, which was designed to force down the cost of the European marketplace by introducing competition between trading venues. Mr Semark says some benefits are already being felt, as new entrants have adopted different cost structures in order to take business from incumbent venues.
“The way that they [incumbent venues] charge by bargain rather than by value on the exchanges is also something that I hope is unsustainable,” he says. “One of the benefits that we have already seen is that those structures have started to change and the cost levels, at least, have started to come down because of the new entrants coming in. I hope that there is a long way to go.”
“We do think we can get down to the same level of costs,” says Niki Beattie, head of EMEA market structure at Merrill Lynch. She says the cost is a function of two variables, the first being the sheer volume of trading, which she believes will naturally rise as a result of MiFID’s structural shift.
“The other function of cost is that every single market in Europe has its own infrastructure, and every time you do a trade, you’re paying for 25 different countries’ infrastructure,” she says. “If we could get that consolidated, it would most definitely bring costs down.”
Smaller order sizes and greater volumes clearly increased the trading costs for the sell-side, which are largely charged on a per-transaction basis by the major exchanges. “It used to be one transaction and was settled as one transaction; now we’ve got thousands of transactions going on to the order book to be cleared and settled, and there’s a price with that,” says Ms Beattie. However, she says: “At the back end, at the clearing and settlement side, it’s really about the volume.”
Clearing and settlement is still by far the most significant component of the total cost of a trade and so, while higher volumes and smaller orders may increase brokers’ overheads, the back end is in greater need of streamlining.
It is a situation long recognised by the European Commission. In 2006, internal market and services commissioner Charlie McCreevy called for an industry-led initiative to improve efficiency, leading to the EC-backed code of conduct, signed in November 2006. The major players pledged to address the lack of transparency in their pricing, discuss interoperability between providers and consider the unbundling of vertical exchange and clearing operators, such as the Deutsche Börse group and Monte Titoli. Historically, issues of sovereignty and the de facto monopolies in various European states have prohibited such an initiative.
Brighter future
A year on and progress has not been dramatic, but the future is looking brighter. “If you look at the concept of consolidation in clearing, what we have at the moment is a very vertical structure and there is no competition in terms of marketplace to marketplace or within those marketplaces,” says UBS’s Mr Semark. “You end up in a situation where you have a smaller number of clearers, but they operate across the different market streams and this gives you the benefits of competition in terms of lower cost, as well as the benefits of consolidation.
“The code of conduct means that all of those vertical silos should open up to competition at the clearing level and you would then expect to see perhaps DTCC, x-clear or others competing across a number of different marketplaces. This is the process that MiFID really starts off, as it introduces competition into a fragmented market structure and through that competition, some winners emerge and you will see consolidation across the marketplace as a whole. That is the clear difference between the European and US approaches, where perhaps counterintuitively the US has imposed a regulator-driven market structure, while in Europe the current approach is to see if the market can come up with a solution,” he adds.
The Depository Trust and Clearing Corporation (DTCC), through its new European subsidiary Euroclear, has entered the market on the coat-tails of Turquoise, the interbank trading venue due to launch later this year, and will provide it with settlement services. In the US, the DTCC operates as a utility. Its presence in a liberalising market is seen as significant, particularly if it can make a genuinely pan-European facility work. Chi-X, the execution venue created by Nomura’s Instinet subsidiary, offers clearing across borders through an arrangement with Fortis.
“There is starting to be competition. Ultimately we would prefer for there to be only one clearing-house as we think this would bring greater efficiencies and improve competition between trading platforms,” Merrill’s Ms Beattie says. “The central depository element is a huge issue to try and resolve quickly. Things like legal and tax constructs make it very difficult to bring those things together, at least for the time being. Certainly, I think those things can be brought together, it’s just a function of time.
“We’re moving towards an era where we are going to get consolidated clearing and people are going to be able to clear on a pan-European level. The vertical silos are going to have to respond,” she says. “Any major exchange with a vertical clearing model is going to be shaken up by new pan-European clearing platforms like EuroCCP. They can’t sit still, they will have to respond. Yes, the settlement issue still remains, but if we can take 50 per cent off the [overall] clearing and settlement cost then we’re a long way to solving some of our problems.”
The incumbent exchanges have a major role to play in working on the interoperability of their clearing infrastructures, and Ms Beattie says that they are feeling the pressure from alternative venues and are working on solutions. But the former monopolies are facing demands in many areas, with market data costs and tariff structures under intense scrutiny from customers. “A concern I have with some of the exchanges and infrastructure providers is that some of their technology and the way they have built their processing is not easily adaptable,” she says.
Making comparisons between the operating costs of the national exchanges and the young pretenders is always likely to draw blushes from the incumbents. The availability of cheap technology and a lack of legacy infrastructure allows new organisations to be nimble and flexible – unlike the incumbents, for all their investment in high-quality matching engines.
There is some irony in this. The calcification of the exchanges’ technology comes at the end of a long period of innovation and adoption of new trading methodology, which was a major factor in the European landscape’s diversion from the US model. Although, clearly, the native liquidity of the domestic markets provided a different dynamic than that extant in the US, the all-electronic nature of European trading alleviated the need for the ECNs and alternative markets that developed in the US, says Ms Beattie.
Convergence
The open-outcry trading floors prevalent in the US over the past decade meant that the there was scope for alternative, all-electronic markets. This is partly why, according to Simon Nathanson, CEO of agency broker Neonet, the US and European landscapes diverged. Europe has seen a decade or so of consolidation, while the US has seen fragmentation. “What is interesting is that what we see is a consolidation in the US, where we see mergers and acquisitions among traditional exchanges and the new competitors,” he says. There are different dynamics at work – in Europe the breaking of monopolies, in the US, the effect of technology – but the two are moving to a mid-point.
If that is the case, technologies such as smart order routing, already used widely in the US will become transferable to Europe – but not until the national exchanges and clearing houses can reach a degree of interoperability and efficiency, Mr Nathanson says. This creates an interesting conflict of interests between the investment banking behemoths that have built systems for the US marketplace, and see huge potential in bringing their technology and expertise to bear, and the former exchange monopolies who need to preserve their business models. But for the buy-side, efficiency should mean that brokers’ costs will drop, and they will expect that any savings are passed on to them.
