Whose Liquidity Is it Anyway? – 10 December 2009

Two events this week crystallised the need for better pre- and post-trade information.

Firstly, BATS joined ranks with Chi-X to question the LSE’s decision to set its market to auction mode during its recent outage.

In a related white paper on the subject BATS also claims that “it is questionable whether the market was orderly on the LSE given publication of data which did not represent legitimate trading interest or available liquidity”. It would be interesting to find out, therefore, why the LSE decided to put its market into auction this time rather than suspending it altogether (as it has when it has suffered previous outages). But, whatever the LSE’s motivations were, you only have to look at the widening gulf in fragmentation between the LSE and other European primaries to see how critical the battle for liquidity in London has now become.

The crucial issue, however, is agreeing a mechanism to provide the market with a pre-trade tape of prices that has an agreed “market outage protocol”, an agreed standard for deciding on fungibility, and a means of determining which venues to include or exclude from the tape. Without this it would seem that effective price formation when a primary market is down is still some way off. This is especially the case when there is uncertainty over if or when the primary market will reopen (a point that is acknowledged in the BATS white paper). Anyway, rather than deliberate on this, the guys at Fidessa Towers and I thought we would take the “ask the audience” option and allow you to make your views known to the trading community at large.

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The second development was the announcement that Nomura is going to reclassify its dark pool (NX) as an MTF and adopt a more transparent approach to publishing post-trade information by publishing its trades to Markit BOAT. Whilst Nomura is to be applauded for playing the game, it’s still only a partial solution to the problem. Other broker dark pools, such as BlockMatch from Instinet, have taken the MTF high ground, too, but still report in a different way (BlockMatch trades are printed to the Chi-X OTC tape, for example). The net result is that it is still pretty hard for the chaps back at Fidessa labs to assign all these dark trades to the right categories. This point was highlighted by CESR chairman Eddy Wymeersch who commented in the FT Trading Room article “we have very contradictory figures with regard to dark pools”. Maybe I’ll ask Santa to put a Fragulator in his Christmas stocking.

A point that all venues (primaries, independent MTFs and broker dark pools) need to remember, however, is that it’s not actually their liquidity in the first place. Markets have always been about trying to bring together willing buyers and sellers in order to meet the needs of both. So, in reality, liquidity belongs to them and not to the venues. What we need, then, is a clear set of rules for both pre-trade price dispersal and post-trade reporting. Only then will the real liquidity owners (market traders) be able to get a fair deal out of MiFID.

Should I Stay or Should I Go? – 27 November 2009

Few can have missed the furore over the LSE outage yesterday.

During the outage the MTFs made repeated attempts to convince the trading community that it should go and trade on them whilst the LSE was unavailable. The chart below, however, shows that they were pretty unsuccessful in this and that, instead, traders simply stayed away from the market altogether until trading resumed. This shows that, in London at least, traders are still reluctant to use MTFs without the comfort of knowing that the primary market is open at the same time. Market makers, too, are reluctant to make prices when the primary is down and so this further encouraged traders to stay at home rather than go and play on the MTFs.

Another factor in play this time, though, was technology. The majority of smart routers are (correctly) configured so as to direct all orders to a primary market when it is in auction. During yesterday’s glitch, however, the LSE put its market into auction which had the effect of creating an “artificial auction” that sucked up available liquidity from smart routers. This then led to the huge spike in trading on the LSE when it reopened at 2 pm. The net result was that LSE market share jumped by 7% compared with its daily average for the rest of November. This last point highlights, yet again, the ironic interplay in the post-MiFID world whereby the MTF community is still dependent on the LSE being open in order to try and increase its own share of UK stock trading.

Finally, as some of you may have guessed, it’s been “Clash week” here at Fidessa Towers. For those that don’t know, The Clash were pioneers of punk rock in London during the 70s. Their aim, together with other similar bands, was to disrupt the hegemony of the established music industry. Only time will tell whether the MTFs will be as successful in changing the face of European equities trading.

London Calling – 26 November 2009

There has been a lot of coverage of the LSE’s first half results this week. Most of the comment seems to focus on the erosion of its market share by the MTFs and whether the pricing of the MTFs is sustainable in the long term. Whilst there is little doubt that these are both valid areas for discussion, I wonder whether there are some more subtle issues involved.

Firstly, it’s not just about pricing per se but about pricing models. The MTFs have adopted maker/taker models that reward those traders posting liquidity on their platforms whilst charging those who remove it. This favours the Electronic Liquidity Providers at the expense of the large banks and brokers which generally prefer a wholesale discount pricing structure. The LSE has switched between both pricing models and, to date, neither approach seems to have stopped its market share from declining. Ironically, though, this is where the LSE (and other primaries) may have an advantage. This is because they can use the various MTFs they have built (or acquired) to separately meet the needs of these different market segments. In this way, they can create a range of sub-brands that can experiment simultaneously with different pricing/delivery models (how about trading FTSE 100 stocks in Euros, for example?). And, just like the high street supermarkets, shoppers benefit from the economies of scale regardless of whether they buy premium, regular or budget priced products.

Another point that maybe needs more emphasis concerns exactly who the enemy is. Maybe the real challenge for the LSE is less about protecting its UK market share from “troublesome MTFs” and more about establishing the LSE Group as a genuine European/global supermarket for stock and other financial instrument trading. Deutsche Börse’s creation of its international market (XIM) demonstrates where its own thinking is heading in this regard and, of course, NYSE Euronext has always made a big play about its pan-global, multi-asset credentials. The LSE, however, has a number of situational advantages in this battle, too – not least of which is the fact that London is generally seen as the financial trading capital of Europe. In addition, it has its acquisition of Borsa Italiana and its Canadian and Japanese connections to play on.

The MTFs face a similar dilemma. Is the enemy the primary exchanges or should they be vying instead to establish themselves as best alternative trading venue for Europe? Breathing down their necks are the ELPs and other market makers who have realised that, in the post-MiFID world, maybe they don’t need venues at all and can instead interact with order flow directly.

As the folks in Brussels start writing the script for MiFID 2 “where we went wrong and what we intend to do about it”, it looks like there is some doubt over what the right shaped entity for pan-European equities trading really is. Maybe the answer lies in the old axiom – keep your friends close and your enemies closer still.

MiFID hits Main Street – 18 November 2009

There was an interesting article in the FT yesterday about how IG Index (the spread betting company) will now be connecting to Chi-X and, I assume, other MTFs too. The story reminded me of how MiFID is starting to permeate outside the immediate professional trading community and enter the consciousness of the public at large.  My own experiences in this area have been mixed -  I bought a bunch of shares the other day and, on the spur of the moment, decided to ask my broker what his best execution policy was and which venues they had considered before executing my order.  I was surprised and disappointed with the response.  My broker had only the sketchiest knowledge of what best execution really meant and an even hazier grasp of the different venues that have sprung up since MiFID was introduced 2 years ago.  Most alarming of all, they seemed almost resentful that someone had dared ask “the MiFID question”.

Besides making a mental note to find another broker,  this experience set me thinking about how far MiFID has (or has not) affected the retail trading community across Europe.  It depends where you look – Holland and, in particular, Amsterdam seems to have always enjoyed a thriving almost semi professional retail sector.  Italy is similar, but the rest of Europe doesn’t have anything like as active a retail audience.  This divergence explains why several months ago one of Europe’s largest liquidity providers – Optiver -  set up a  joint venture with Holland’s Binck Bank called The Order Machine or TOM for short.  TOM dispenses with the need for an exchange altogether as it allows retail order flow to interact directly with Optiver’s market making capabilities to the benefit of both the retail trader and Optiver themselves.  It will be interesting to see if this is just a Dutch phenomenon or a pointer to the future of equity trading across Europe.  If it is the latter, then we may see this model replicated as other Liquidity Providers build or buy MTFs so as to interact with order flow in a similar fashion.

Another dimension to this issue is the level of understanding amongst corporate brokers and main board directors of exactly how (and where) the stock of the firms they represent  is trading.

In the simple pre-MiFID days you need only to look at the trade feeds from the LSE or other primary exchanges to get a good idea of the on and off exchange activity in your stock.  It’s pretty different now.  Take Imperial Tobacco for example – 18 months ago the trading of this stock was split mainly between the LSE and Chi-X.  Last week it traded on over 12 separate lit and dark venues and each of these achieved a different VWAP.  Also interesting is the average trade size which, aside from Liquid Net, was broadly comparable between the lit and dark arenas. This is of more than just academic interest as this breakdown will influence which executing broker you use and, ultimately, what kind of price you should expect to pay or receive.  (You can see this for yourselves if you log in and use the new forwards/backwards buttons on the Fragulator)

Anyway, next time you buy or sell shares, don’t forget to ask your broker the MiFID question.

The Emmental Enigma – 13 November 2009

Those of you that have followed this blog know that I have commented a few times on the impact on fragmentation when a primary market has been unavailable (see the croissant hypothesis and the bacon roll theory). Well, yesterday it was the turn of SIX Group to run the experiment. Due to a technical glitch, SIX was unable to provide prices on major Swiss stocks for a few hours yesterday afternoon. A quick spin through the Fragulator shows some intriguing results that seem to counter the conclusions that were drawn before.

Total average volume of SMI stocks was around 111,000 trades on the 3 days prior to the problem. This fell by around 30% yesterday due to the outage, but the interesting bit is how the remaining volume traded. Chi-X, BATS, Turquoise and Nasdaq Europe all traded the same or greater volumes than they had previously despite the fact that the primary market was unavailable. This seems to counter the view that traders ignore a stock altogether when primary markets are down and, as a result, price formation happily took place between the MTFs only without the need for a “parent” exchange. What this shows is that, for Swiss stocks at least, the MTFs are now regarded as completely legitimate venues in terms of providing credible price formation even when the primary is down.

It’s not all going the MTFs way though, as further analysis shows that OTC trading increased by 46% yesterday when compared with the average of the three days before. OTC trading, therefore, was actually an even bigger winner than the MTF community as a result of the SIX outage.

The MTFs that find ways to attract this volume onto their own dark segments could be the liquidity winners of the future.

Monopolies Bad, MTFs are Good? – 11 November 2009

I was chatting with the guys at Fidessa Towers the other day about what constitutes the “right” business model for venues in the post MiFID environment.  It’s an interesting question, and one the European regulators seemed to completely ignore when they first introduced MiFID back in November 2007.  The evidence so far is uncertain.  MiFID has undoubtedly broken up the monopolies of the national exchanges and we are all enjoying lower trading fees as a result. At the same time, though, the industry is struggling to manage both the increased technology costs and the greater complexity associated with the post MiFID world.  Buy-sides in particular are claiming that they are paying a high price in terms of lack of transparency and increased transaction complexity.

Any basic economic textbook will tell you that monopolies are not inherently “bad” and that, in some cases, the customer is actually better served by a monopolistic market than a competitive one. Maybe this is one such case?  Some of the MTFs that have emerged seem to face an uncertain future and the broker dark pools that have sprung up have fuelled the debate over trade reporting and transparency.  Both these issues seem to underline the economists’ argument.

The latest moves by the primaries maybe give us a few clues as to their view of the world.  First there was the launch last week of Xetra International Market (XIM) by Deutsche Börse. XIM is a segment on the main Xetra system that will contain 99 non German stocks (i.e. that are listed on other exchanges) that will now be tradable on Xetra.  This looks like the first steps by Deutsche Börse towards becoming much more pan European in its approach and will increase its ability to meet the threat of both MTFS and other primary exchanges.

In a similar vein, the LSE announced its support for hidden orders this week – this will allow it to compete with the dark order books of the MTFs and brokers.  Also, few people can have missed the announcements that NYSE Euronext has invested huge sums in co-location facilities (and that the LSE is doing the same).  It seems that the primaries are now playing to their strengths rather than just launching their own flavour MTFs.  Looking ahead maybe the real battle is going to be between the big guys as they slog it out for European dominance.

The irony, of course, is that the market still needs the MTFs in order to keep pricing pressure on the primaries, yet a multitude of different venues operating under different rules creates operational inefficiency in the market as a whole.  It would seem, therefore, that finding ways to smooth out these inefficiencies must be the goal for anyone interested in keeping the monopolists at bay.

Index Fragulation – 3 November 2009

Following a number of requests the boys in the Labs have now added the ability to fragulate entire indices, not just stocks. To do this you can either click the abacus icon next to each index on the main site or select them directly from the Fragulator™ page.

This helps provide another dimension to understanding what’s really going on in Europe. I’ve been having an initial fragulate comparing different date ranges across various indices and have come up with some interesting facts:

The LSE’s share of the FTSE 100 and FTSE 250 total markets (i.e. lit and dark) has almost halved in just a year from 62% to 35%.

In just 12 months BATS Europe has managed to get nearly 5% market share of the total liquidity (lit and dark) in the FTSE 100.

Average trade value on the DAX has fallen from €34,000 to €15,000 in the last 18 months.

SIX Swiss Exchange’s share of the SMI has fallen by 10% in the past twelve months.

There is increasing convergence of trade sizes between the lit and dark categories on nearly all stocks and indices.

Perhaps most interesting of all is the growth in non-lit volumes (dark, OTC and SI) and this highlights how the market needs greater transparency in reporting. It seems unfair that the areas that are growing at the fastest rate have the least obligation to report their activities clearly, concisely and in a timely manner. Anyway, have a fragulate of your own and let me know what results you manage to come up with.

On a different note, thanks to Helle Søby Thygesen who invited me to participate at an event for the Danish Securities Dealers Association in Copenhagen last week. The event was packed and the conclusion reached was that the Nordic markets show all the same signs of fragmenting as their European counterparts. The real question is whether the trading community is ready in terms of making the necessary investment in technology.

And finally, it’s nice to see that Spain now gets the joke with regard to fragmentation and will be simplifying its clearing structure to allow easier access by MTFs. This highlights another point made by Karel Lannoo, CEO of the Centre for European Policy Studies, at the Copenhagen event. Karel was explaining how the next round of legislation from Europe will be armed with real teeth and that the new regime will be far more rules based than the principles based approach we have witnessed up to now. Karel even went on to say that we will end up with a single European style FSA to enforce all this regulation on every country. Let’s just hope the guys making the decisions avoid the ready, fire, aim approach that seems to have characterised their approach so far.

The Bacon Roll Theory – 16 October 2009

I wrote a while ago about the impact on fragmentation caused by an outage at NYSE Euronext (see The Croissant Hypothesis, April 2009). Well, we had another chance to re-run the experiment here in London this week. Basically, what happened was that on Wednesday the LSE suspended trading in a small handful of stocks because of some technical glitch in part of its market data feed. Spotting the opportunity, all the MTFs enthusiastically emailed the market confirming that they were still open for trading in the stocks in question. But, just as happened in Paris back in the spring, the expected surge in fragmentation failed to materialise and London traders simply munched on their bacon rolls until the LSE fixed the problem a few hours later.

This was shown by the fact that the average FFI of the stocks in question (2.25) was, in fact, slightly lower on Wednesday than it had been for the previous week (2.3).

This highlights, yet again, the subtle interplay between the MTFs and the primary markets. There appear to be three reasons for this. Firstly, the primaries are responsible for maintaining an orderly market in the stocks they list and so traders are reluctant to trade a stock without its “parent exchange” being open. Secondly, a lot of liquidity providers use the primary market price as the starting point for their calculations – without this they simply can’t make markets in those stocks. Finally, there is the psychology of the market that still feels that stocks “belong” to particular markets.

So, the paradox of the current situation is that without the primaries the MTFs simply couldn’t exist. The bizarre implication of this, then, is that the LSE could beat the MTFs simply by taking its ball home and refusing to come out to play at all but, that way, everyone loses. More likely is that the calls for a consolidated tape will be re-ignited yet again but, in order to really fix the problem, any such tape would need to be fully mandated by the industry. My suggestion is that we all get together to define this and fix the problem – otherwise we may find the regulators doing it for us.

If you would like to be part of such an initiative then please let me know.

Fragmentation Diversifies – 14 October 2009

It’s hard to miss the widening gulf in fragmentation between the London Stock Exchange and the other primary markets. The gap started to appear during the summer but seems to have been widening to the point that fragmentation on FTSE 100 stocks is now around 30% higher than in France or Germany. NYSE Euronext and Deutsche Börse will doubtless be monitoring the London situation carefully as, so far, the London experience of fragmentation has been played out in mainland Europe, too. Intuitively, you would expect fragmentation to be a bit higher in London as the MTFs are based here but maybe there are other reasons to support this gap.

One of these is BATS Europe which has led the way in aggressive pricing against the primaries and, most recently, has been focussing these efforts directly against the LSE. As a result of this, BATS’ market share in FTSE 100 stocks has doubled since August but, of course, these incentives are not economically viable in the long or even medium term and so the real question is what happens to liquidity when the rebates are removed. Obviously, MTFs can’t expect to hold on to all the flow they win in this way but, according to BATS’ CEO, Mark Hemsley, that’s not the point. These discounted pricing campaigns act as an incentive to get the market focussed on connecting to new, alternative venues and to smooth out all the post trade workflow issues. When the price incentives are removed then some liquidity naturally shifts again but, as Mark points out, the damage has been done because more trading firms are now connected to the venue in question and confidence in their operating model is established.

The primaries will rightly argue, though, that the MTFs still aren’t making any money and so have yet to prove that their business models are viable. As the MTFs creep towards break-even, however, this argument may carry less weight in the future. On this point, it was also interesting to read that Chi-X has announced that as of the 1st January it will start to introduce market data fees for some non-trading users. If other MTFs follow suit then this could further squeeze the primaries. Traders will be reluctant to accept the current market data fees from the primaries if they also have to write another cheque out to the MTFs for the same thing. If this does happen it will reignite the whole consolidated tape issue and will also open up the debate as to who really “owns” this market data.

The game is most definitely not over, though. Just fragulate any of the most fragmented stocks and you can see that in most cases “non-lit” trading accounts for around 50% of the total traded volume. The obvious step for the primaries, then, is to find ways of harnessing this flow. This could be through the creation of liquidity aggregation services such as those offered by the LSE’s Baikal or through regulation – forcing better transparency and reporting on non-lit venues.

No wonder everyone is busy lobbying the regulators over dark trading.

Fragulation Fever – 7 October 2009

Firstly thanks to everyone who has emailed me with such positive responses to the Fragulator. Thousands of fragulations have taken place on the site since Friday and it’s great to know that so many of you are finding it useful.

We’ve had all sorts of interesting feedback, especially in terms of the classifications we have chosen and the different levels of reporting transparency. A full guide to the different trade types can be found on the FAQ page but basically we still classify a trade as lit provided that at least one side came from a lit order book. So, for example, a dark order that interacts with a lit order is still classified as a lit trade. You can see this in the Fragulator tables which separate out dark to dark interactions at Chi-Delta or Turquoise from other trades in their lit books.

The bigger issue, though, is one of transparency and the fact that dark and other non-lit venues observe completely different levels of transparency. The activities of the big broker dark pools have especially come in for some stick in this area and I know that the primary exchanges are crying foul at the regulators over this. Basically, their view is that if you act like an exchange (i.e. by matching orders), then you should have to report like an exchange. The risk they claim is that, without a level playing field, transparency goes down and Europe potentially becomes a dealer market – neither of which were the intended consequences of MiFID. On the other hand, the brokers claim that they are providing a very necessary liquidity operation by allowing traders to interact in their dark pools in different ways. It all seems like the next chapter in a subtle power play between the big exchanges on one side and the big banks and brokers on the other.

Meanwhile, the folks at CESR are getting lobbied from all sides on what is best for the market. For more information on this you might want to look at FT Trading room which features a video interview with a certain shiny headed industry observer.

It seems certain, though, that more regulation is on the way. With this in mind it’s interesting to note the sudden outbreak of accord between the LSE and the big banks over Turquoise. Maybe it’s recognition that these participants would rather sort out their own issues than have the regulators do it for them.