Chi-X has launched, Turquoise is coming, Rainbow is announced and there are a multitude of hopeful new trading venues waiting in the wings. Transatlantic airline company share prices are soaring as anyone with decent order matching technology fills up business class capacity armed with a plan to launch a multilateral trading facility (MTF). The Markets in Financial Instruments Directive (MiFID) certainly seems to have caused a stir. There is a lot of excitement and some encouraging signs. But there is also a danger that the promise of a highly competitive execution venue environment, awash with deep, low-cost pools of liquidity, turns out to be a huge investment for the industry, for just a few extra puddles here and there.
November 1, 2007 was never going to be an overnight revolution in the way in which equities are traded – unlike Big Bang or the introduction of order-driven electronic trading in the European markets. The true impact will take time to roll into the market microstructure, despite brokers now being much more accountable for execution quality and transparency.
To some extent, we have seen it all before with Tradepoint in the 1990s – the first alternative execution venue, which eventually morphed into
Virt-X and never challenged the London Stock Exchange (LSE) as an execution venue. Although it was a fully-fledged exchange, and despite the backing of some major market makers, it struggled to get off the ground for four basic reasons:
- Brokers were not obliged to use it as a means to achieve best execution and brokers’ clients were not obliged to select brokers who could;
- The algorithmic trading technology necessary to sweep and de-fragment the price formation process did not exist;
- Agency commission rates were much higher and brokers were less concerned with the marginal difference in trading costs between venues;
- Lack of efficient linkages between clearing systems increased the cost and risk of settlement.
Constraints reduced
At least three constraints have been reduced, but they are not yet eliminated. The indicators of change are beginning to appear. Euronext has introduced its on-market crossing service. This enhancement has allowed Société Générale to raise its crossing rate on the CAC 40 for institutional business from 8 per cent to 15.5 per cent, with peaks over 40 per cent and to merge retail and institutional liquidity. It is an impressive move by the exchange to keep liquidity on its book while requiring zero incremental technology investment from its members and benefiting the market users. This would be hugely beneficial on other markets but could also reduce the incentive for trading on MTFs.
The data shows that volume on Chi-X is there, around half a billion euros per day in Q4 2007, but still small compared with main market volume. Trades are frequently inside the bid-offer spread of the associated main market (49 per cent in December 2007), but not in sufficient size to affect the average spread across both markets. So things are happening, albeit slowly, that would not have happened before.
Some of the challenges of a fragmented environment immediately become clear as brokers are now forced to consolidate trades data from multiple sources – including Boat, for example – in order to build up a true picture of market volume-weighted average price (VWAP) and volumes. This data is critical to the algorithmic trading engines that closely track average daily volumes and current daily volumes to guide their execution. Traders are becoming more dependent on IT systems and driven towards algorithmic trading tools as it is impossible for humans to monitor so much data in real-time.
Unlike Reg NMS in the US, MiFID stopped short of enforcing the brokers to access multiple execution venues. It is likely that the next step will be self-fulfilling as more brokers put their smart routing technology into place and update their best execution policies to including multi-venue trading. Contrary to what much of the marketing material says, smart routing technology is still quite rare among brokers – the largest have the technology but there are still hundreds who do not. This will change mid year as key software houses begin the mass distribution of smart routers around the time Turquoise comes on stream. From that moment, there will be a critical mass of brokers capable of offering multi-venue trading, which in turn may drive up liquidity on the alternative venues.
We should not forget the ongoing impact of unbundling. More and more asset managers are signing Commission Sharing Agreements and the mid-sized to smaller brokers are beginning to focus on their areas of specialisation without the need to maintain an expensive execution platform. At Société Générale, we are seeing some brokers coming to us for a wholesaling service, allowing their clients to access our liquidity pools and take advantage of our technology platform without the broker having to make the investment. That way they can meet their best execution obligations, remain competitive and still get paid for their services. Of course, this trend consolidates liquidity on fewer brokers and their associated dark pools, leading to greater fragmentation and driving liquidity away from the light pools.
Meanwhile, the transparency regime is also driving the growth of direct market access (DMA) and algorithmic trading as an execution method of choice for clients that are now obliged to find the lowest cost execution methods. This is getting up towards more than 50 per cent of client flows and has driven commission rates well below the sub 5 basis points figure. This in turn has made the brokers much more cost conscious and they will be looking for the lowest cost venues to trade in to maintain margin.
So the scene is set for the perfect storm. The only piece that is still missing is the pan-European clearing and settlement venue. Why is this an issue? If you split your client’s order in Vodafone between LSE, Xetra, CHI-X and Virt-X, you have four trades to settle with your client, or you can settle one trade with your client and have your back office process four trades between up to four clearing systems – either way it’s expensive.
The clearing agents are still in their silos and do not have a good history on interoperability; LCH Clearnet still operates two systems after six years. This may ultimately have to be addressed by the regulators, although the European Commission is indicating that it will be left to the market and there are signs that the market may step in. Look at European Multilateral Clearing Facility (EMCF), which offers multinational settlement capabilities in Chi-X names.
The greatest test of market efficiency is the average spread. Table 1 shows how US average spreads, at 5 basis points or less for the S&P 500 Index, are much smaller than in the European region, where investors are generally paying 5 basis points or more for dealing in European equities.
The two key factors that have to change before the gap closes with the US are the European tick size and exchange execution fees. Figure 1 shows how US average spreads were dramatically reduced following decimalisation, which enabled the reduction of tick sizes and drove the growth of algorithmic trading. (It is interesting to note the impact of the recent volatile markets on the cost of trading). Meanwhile, US exchanges and alternative trading system venues have charging models that encourage frequent order amendment and the fine slicing of orders that is so important to keeping the order book mobile.
Big tick sizes make it hard to move inside the bid-offer spread, allow liquidity to pile up at price levels that do not necessarily reflect where you would trade, and drive liquidity upstairs into the over-the-counter (OTC) market for crossing at the mid. Small tick sizes mean you can get inside the spread, slice your order more finely and let you more closely replicate the desired benchmark. This leads to a virtuous circle because it encourages algorithmic trading as computers can react in milliseconds to micro-movements in price.
Effects of computerised trading
At Société Générale, we are processing around 85 per cent of our ‘execution-only’ client business through algorithmic trading engines and an increasing amount of block trading business. This is a remarkable figure that reflects the increasing dependency of the industry on quantitative, computerised trading as the key tool to seeking out liquidity in dark pools and achieving multi-venue execution performance. While it is especially true for portfolio trades, where the trader needs to concentrate on the harder parts of a basket while the algorithms can process the rest, it applies across all business types.
Direct electronic trading empowers the client dealing desk with the same capabilities. Whereas previously, telephone conversations induced operational drag on the speed of trading, electronically delivered trading services have opened the pipe for more frequent trading. In 2007, and in anticipation of MiFID, most exchanges upgraded their systems by an order of magnitude, permitting an immediate increase in exchange traded volume and thus liquidity.
So, how is the trend developing? Euronext has announced a reduction in its tick size through introducing greater price precision – already offered by Chi-X, while Eurex has announced a reduction in trading fees to encourage the algorithms. Everything points in the right direction, but these initiatives need to be adopted widely throughout the European markets. It is still too early to say how the liquidity seascape will look in 12, 24 or 36 months’ time.
There are two scenarios at the extremes that could be contemplated. Perhaps MTFs will gain traction and, through innovation, force exchanges to defend their positions and make their venues more attractive, leaving the bulk of liquidity on the main market. Obstacles in the clearing and settlement process, and reluctance by brokers to invest in sophisticated but expensive smart routing and algorithmic trading platforms, would drive towards this scenario.
On the other hand, perhaps exchanges will be slow to react, leading to a gradual seepage of liquidity to MTFs and dark pools. This would produce a fragmented market and concentration of order flows among a few brokers with a sizeable investment in technology and the ability to de-fragment the market. In the US, Société Générale accesses more than 25 exchanges’ electronic communication networks (ECNs) and dark pools and the technology required to do this is a substantial investment. Any broker active in the US markets is well placed to get ready for this scenario.
The two scenarios will ebb and flow, with perhaps a further wave of consolidation among venues, as in the US, and super-consolidators like DirectEdge to bring liquidity back together. Then there are investor initiatives to throw into the mix. Liquidnet is a way for the buy-side to bypass the brokers and the exchanges, while there are also the players with big inventories who can directly offer up their liquidity to the market – namely Citadel’s US trading platform.
We will be watching those average spreads with interest over the coming months to see how changes in the market structure take effect – and we will also be keeping the technology department very busy.
