There have been a number of articles recently (Jostling for Market Share, FTSE Global Markets – January/February 2009; European exchanges and MTFs squeezed by falling deal volumes, Financial News – 12 January 2009; and Chi-X braces for 2009 with £12m in fresh funds, FT.Com – 28 December 2008, among others) which have included references to the trends in fragmentation. Some commentators seem to imply that fragmentation has reached some level of equilibrium. The suggestion is that this is partly due to the fact that the MTFs have attracted “different” liquidity which was relatively fixed in size and/or that there is some kind of limit to just how much liquidity will move away from the primary venues.
I beg to differ. It’s true that the MTFs have attracted new arbitrage volume but the idea that the MTF community is now scrabbling over the scraps thrown out by the big traditional exchanges is simply not supported. With the exception of the crazy events of last October, the FFI for all the major European indices has continued to rise month on month since we started collating the numbers. As an example take a look at the DAX. The simple fact is that, as smart routers become more efficient and more widespread, liquidity will continue to leak away from the primary exchanges. Against this, however, is the fact that total volumes traded are likely to be lower for everyone. This means that each MTF will have to win greater market share as a percentage of the total pot in order to reach break-even or profitability. At the same time many of the backers of these new ventures have other things on their minds.
Anyone involved in the liquidity arms race should know that there is no limit to how far trading will fragment. This is becoming increasingly evident as more and more stocks regularly breach the statistically significant barrier of having an FFI of 2 or higher. The winners will be those venues that can combine lowest prices, but (as we saw in October) still allow certainty of execution and counterparty risk to be prioritised as necessary.