Making a comeback
James Baugh, Head of Pan European Sales and Marketing, Capital Markets, London Stock Exchange Group discusses the major trading issues of the day.
What do you think are some key impacts of MiFID II on the trading landscape?
There are a number of areas that together will have a major impact on market structure and the way people trade. The first is the introduction of volume caps of 4% and 8% on dark trading, using either the Reference Price Waiver or the Negotiated Trade Waiver. The second is the requirement for brokers to find a new home for their internal crossing business. Under MiFID II, brokers will only be able to match principal business under a unilateral model against their own capital under the Systematic Internaliser regime. If not, they will have to externalise their flows by using public venues, which for some may mean establishing their own MTF. Some members are already registered as SIs and are looking to see how much flow they can put through these constructs, whilst others are no doubt looking at how they can become registered themselves.
Aside from dark trading, what are the other major issues?
Changing the deferred publication regime from three days to same day, or next day for those trades consummated two hours before close, will have an impact, particularly for those less liquid, difficult to trade names. Regulators are aiming to have details of transactions conducted on trading venues made public as close to real-time as possible, however the shortened timeframe will not give brokers much time to unwind their risk trades. It will increase the cost of capital and could make it even more difficult to trade certain less liquid names.
ESMA’s latest guidance on algo trading is also an area which needs careful consideration. It is recommending firms using algos, which provide liquidity, and essentially look like market making strategies, for at least 30% of the available trading hours will be required to enter a competitive price for 50% of the trading hours. This will definitely change the market making regime and could muddy the waters between what we would consider traditional market making and algo or specialist trading firms. It is unclear whether these obligations will lead to improved liquidity, particularly during times of stress when participation rates, incentivised or otherwise, might drop. Similarly, the definition of competitive price is causing some concern particularly where market makers today are not obligated to quote at the touch, which for less liquid names may not be so important. We believe offering a choice of schemes to best suit the needs of the participants would provide the best outcome.
Separately, the introduction of a new tick regime will result in a reduction in tick size for a significant number of less liquid securities, which could lead to a reduction in pricing stability and a reduction in available size at touch, which clearly we don’t support.
Lastly, price formation could be adversely affected by price band validations that are proposed to be required for all venues on order entry, particularly in less-liquid securities where genuine significant shifts in price cannot occur because orders trying to form the new price will be rejected.
How is the industry responding?
At LSEG we are already responding. In understanding the complexity and cost of developing such solutions we are well placed to work with the industry to address the challenges that MiFID II will inevitably bring about. We are working with 70+ institutions, many of whom have already helped shape our recent Turquoise Block Discovery” and mid-day auction initiatives.
Can you provide more detail on the offerings?
Turquoise Block Discovery” is a new block trading service launched in October 2014. Recognising that MiFID II and the introduction of the double caps will encourage a move to a more Large In Scale, block trading environment, and that those larger trades will be exempt from the caps, Turquoise Block Discovery” aims to address one of the biggest challenges in the market. Namely, the re-aggregation of dark liquidity, fragmented by the introduction of alternative trading venues following the introduction of MiFID I. Turquoise Block Discovery” is the first public European venue to introduce a non-firm conditional order type, which allows members to continue to search other liquidity pools for matching opportunities without the fear of over-trading.
Once a match is found in Turquoise Block Discovery”, members are requested to re-aggregate all their child orders and send the firm parent order to Turquoise Uncross” where the trade is consummated.
This results in a larger block trade, which on order entry is more likely to be Large in Scale and exempt from the caps, whilst saving considerable post trade costs. Already we are seeing average trade sizes resulting from Turquoise Block Discovery” of around €250,000. This is the first public mechanism in Europe to reverse the trend of decreasing trade sizes in dark book trading.
Another new offering is the London Stock Exchange intra-day auction, which is set to be launched in the second half of the year, and will be for all securities using the SETS electronic trading system.
We held a consultation last year with our members to help shape the timing and mechanism of the auction which will take place at midday for two minutes.
Many funds and market participants use midday as a marker to benchmark their portfolios and price a number of complex products and therefore welcome a midday fixing. The midday auction will also provide an alternative for business traded on dark pools which may be of a significant size but not Large In Scale and could be caught by the double caps. As a price forming mechanism on a lit venue, auction business will be exempt from the caps.
How do you see the relationship between the buy and sellside changing?
The buyside are becoming more empowered and want greater control of their order flow. There is also a greater obligation on them to prove to their portfolio managers and end clients that they have done everything they can to achieve best execution. The result is that they want more information as well as tools to measure how their orders are being matched up. They also are monitoring their broker performance more closely. We are also seeing a greater willingness and involvement from the buyside in how we develop innovative solutions to help address the challenges of changing regulation.
Looking ahead what do you think are the greatest challenges?
Regulation will continue to be a key driver for change and with that comes opportunity and innovation. MiFID II presents a number of challenges and working together with both the sellside and buyside, we hope to iron out some of the ambiguities and deliver solutions to address those challenges. Whilst others may also seek to develop their own services, this will take time. Given that monitoring and assessment against the double caps will begin in January 2016, one year ahead of the planned implementation date of MiFID II, this is time the market can ill afford.