That is not to say that the decision was necessarily wrong, but the reasoning behind it doesn’t seem to stack up. As one of our previous polls showed, the market was pretty evenly divided on the issue but with a significant number of “don’t knows”.

For these swing voters, maybe it’s all about capital efficiency. Ever since the financial crisis, capital has become an increasingly valuable commodity as market regulators around the world are steadily upping the requirements. Would a combined entity have been able to offer more efficient use of capital through margin offsets or otherwise netting positions for traders? Or, would a combined entity have been able to drive up prices and exploit its position without exchanges like the CME or NASDAQ  jumping in?

Personally, I think Brussels might end up adding this decision to the “Not sure we got it right” pile.

Even if the idea of such a tax were a good one, have they thought through how it will work in practice in the equity markets (let alone other asset classes)? Reports suggest that France will go it alone even if it cannot co-opt Germany into its plan. But, around 40% of the trading in the CAC 40 and DAX now occurs outside of Paris and Frankfurt (as the charts below show) with most of this liquidity residing on London-based (and FSA-regulated) MTFs such Bats/Chi-X and Turquoise.

So, even if the French can extend their jurisdiction, it seems unlikely that the City of London will support such a tax, especially as any revenue raised will stay in French (and possibly German) pockets.

Looks like it’s time that European governments recognised that, in equities trading at least, the go it alone nationalistic approach went on the scrapheap the moment the chaps at MiFID mansions first got their pens out. Maybe I should drop a note directly to Monsieur Baroin at the French Finance Ministry …

The video shows end of day trading in Mizuho stock on 26th September 2011 and you can clearly see that SBI trades inside the TSE spread nearly all the time. The benefit is that price improvement is delivered nearly 80% of the time for both sides of the trade and, in this case, was around 10-11 bps.

Tick sizes in Japan vary considerably between the incumbent (1 to 100,000 JPY) and the PTS folks which begin at 0.1 and are capped at 10 and 100 at Chi-X and SBI respectively. Smaller tick sizes are only part of the game, though, as alternative venues need to provide low latency platforms and other incentives so as to encourage liquidity providers to step up and make prices in these smaller increments. And, for their part, these providers need to operate at sufficient frequency on and between venues so as to achieve an acceptable balance of profit and risk. The resultant liquidity, typified by smaller trade sizes and narrower spreads, isn’t always good news for institutional investors that want to trade in larger size. But, then again, maybe that’s what dark liquidity is supposed to be all about.

The Japanese situation can be contrasted with Europe where combatants have grudgingly agreed a scheduled process for tick size reductions, and with the US and Australia where tick sizes are standardised. It’s not all peaches and cream for alternative Japanese venues, however. Until recently they have had to contend with prohibition of maker taker pricing and a unilateral short selling ban.

Anyway, this all got me thinking about what the right ingredients really are for alternative venues to prosper and I thought it would make an interesting topic for the first poll of 2012. As always, I’d be interested to hear your views.

Thanks to everyone for their comments on the last blog and thanks to Chuck Chon of SBI Japannext for pointing me to the video in the first place.

As always, feel free to comment.

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Also, I imagine that most regulators would see themselves as gamekeepers rather than poachers but this does help highlight the fundamental problem our industry faces. The minute you interfere in any ecosystem and try to protect one species or another you invariably invoke the law of unintended consequences. This is especially true in financial markets that are going through a rapid period of evolution driven by a technology-inspired natural selection process. The tendency then is to try and adjust for these consequences with yet more regulation and so the vicious cycle continues. This is confirmed by the fact that it was the regulators themselves that inadvertently fuelled the HFT boom by breaking up the national (natural?) monopolies of stock exchanges in the first place.

We begin 2012 much as we left 2011 with fear, uncertainty and doubt being the prevailing sentiments, so maybe regulators on both sides of the Atlantic should take a second look at their groaning inboxes. Perhaps a return to lighter touch regulation is the lesser of two evils. Why not let the natural evolution of financial markets play itself out. Of course, there will be individual winners and losers but the overall ecosystem will emerge stronger to the benefit of everybody who is either directly or indirectly affected by capital markets. The alternative will be ever-growing mountains of retrospective regulation that will be arbitraged, hidden behind or simply never understood.

The irony, of course, is that that the politics and regulation that forced exchanges to look for partners in the first place has also been the primary reason for the failure of these deals. Regulators around the globe have deregulated markets and allowed low cost alternative venues to establish themselves. Unfortunately, it’s pretty hard to tell if our industry is any better off as result. The HFT boys have made hay by exploiting multiple platforms, maker-taker pricing and different tick sizes, but ask the average punter (retail or institutional) if he’s getting a better deal and the answer is much less clear. What is certain, however, is that the resultant decline in their domestic market shares has forced exchanges around the world to look beyond their national boundaries for potential tie-ups. And yet many of these deals have been met with suspicion and consternation by both politicians and regulators.

So where does it all end up? Well, the biggest such merger is between the mighty NYSE Euronext and Deutsche Börse and latest reports seem to indicate that it’s too close to call whether the Eurocrats will give it the thumbs up or insist upon remedies that will scupper the deal (why not have your say and vote in our poll below?).

Maybe Asia (yet again) can provide some clues as to the future. The fragmented geographic and regulatory nature of different Asian markets has meant that exchanges have a track record in seeking co-operation through cross-listing of each other’s products (especially as regards derivatives). This allows each of them to stay relevant and offer new trading options to their members that actually lead to a net increase in overall activity and liquidity for all concerned.

Right now anything that achieves a similar result would surely get the approval of all market participants and, hopefully, the regulators and politicians too.

It was reported this week, however, that they may be backing down on the demands they are placing on the HFT community to permanently make markets in instruments they trade.  Is this a more benign side that we are seeing from the regulators or just the realization that they can’t regulate something that they can’t even define?  Whatever the reason, the simple fact is that the assumptions made about our industry when MiFID and other regulations were first being conceived, seem woefully inaccurate nowadays and the original objectives (transparency and lower execution costs), have been subsumed beneath a far more political agenda.

As our industry transforms itself to meet the emerging trading and regulatory landscape, the winners, just as with any ecosystem, will be those firms that can adapt fastest and the most creatively.  Early signs of this already seem to be emerging especially as market participants of all types adapt the business models they have created in the US and Europe and start deploying them throughout Asia.

Oh and the good news? Well with so much bad news around we are pretty much spoilt for choice as to what to moan about………

It’s also interesting to note that average trade size for Chi-X Australia is around one third of the market average. Is this indicative of greater HFT activity? And, if so, will this mean greater volumes for all concerned, or is it just more noise for the buy-side to contend with (one of the great unintended consequences of the pro-competition regulations in the US and Europe)?

Whatever happens, Australia will take its own path and I am sure that other alternative market operators will be studying its progress with interest.

Transparency – this has been one of the single biggest failures of MiFID I – why then is Barnier trumpeting that the Commission will extend this to other asset classes when they haven’t even got it right for equities yet?

More competition in derivatives trading – I wonder if the Commission understands that exchange-traded derivatives are created and owned by the exchanges that list them (in complete contrast to the world of equities). Is the commission seriously going to introduce its own standardised contracts across Europe? If so, who will pay for all this and why would any derivatives exchange have any incentive to innovate if it could not then benefit commercially from its IPR?

Tougher rules for OTC trading – the traditional ‘call around’ or OTC market has existed for just as long as the exchanges themselves and facilitates the execution of large or odd-shaped orders. What has happened is that the phone and the Filofax have been replaced by computers and the regulators mistakenly suspect that this, somehow, takes volume away from lit markets.

Automated trading assault – given that to date no one has successfully defined HFT, it’s hard to see how the Commission intends to regulate it. The majority of high frequency activity is simply electronic market making equivalent to the traditional jobber of old. Admittedly they are not making liquidity available in size, but hey-ho, welcome to today’s markets.

Position limits – as my friend John Lothian has often maintained, the job of regulators is to regulate markets not prices – see his recent open letter on the subject.

Consolidated tape will be commercial – commercial equals choice equals different. How will the market know which of the commercially available consolidated tapes to follow (just like now)?

The contrast with ASIC (the Aussie regulator) couldn’t be greater. Rather than the ready/fire/aim approach of Europe, ASIC is stepping through the difficult process of creating a multi-market infrastructure in a calm, non-politicised way that seeks to understand the big picture and avoids tampering with the details unless absolutely necessary. On this point, it was interesting that the theme I was given for my presentation at the FIX conference in Sydney was “What can Australia learn from the rest of the world?” Maybe the title should have been the other way round.

Both markets are in Europe – check. Both are subject to the MiFID directive – check. Both have significant levels of liquidity – check. So what is going on?

The difference was highlighted at a Fidessa seminar in Madrid last week that brought together key participants from Spain’s equity markets to try and understand why the fragmentation dial in Spain just refuses to budge. The reason most often trotted out is that all Spanish trades still have to be “put through” the BME, although the introduction of Title V removes this requirement.

Chi-X certainly is gunning for Spain and has introduced a price promotion on 6 key Spanish stocks. Will this be enough to turn the tide? Perhaps, but as in other countries Spain will need the active participation of the high frequency liquidity providers too, and I haven’t seen too many of them getting their Spanish phrase books out just yet. The other issue, though, is that assuming Spain does follow the pattern of other countries, then it’s likely that BATS, Chi-X and Turquoise will be the winners and that may not necessarily be good for Spain plc. This fact, combined with the intertwined relationships that surround the BME and its key trading members, means that Spain may remain an anomaly for a while yet.