YESTERDAY’S GONE.

James Hilton* takes a look back at the changes in market structure over the last six years and argues that, despite pressure from some quarters, for the end investor it would be a retrograde step to try and turn back the clock.

Observing the development of equity market structure over the last 6 years has been fascinating. Introducing competition into a monopolistic industry has been, at times, disorientating and has presented both challenges to the established order and opportunities for new entrants offering services to investors. The resulting market structure, which includes fragmentation of lit liquidity and an increase in non-displayed liquidity, has proven to be an irresistible target for established players keen to demonise the shift away from the old status quo, exchange-concentrated trading environment. However, even as this is to be expected from threatened monopolies, so is the result of the change; when the rhetoric and scaremongering are stripped away, it is clear that competition has measurably and significantly reduced transaction costs, at great benefit to the end investor.

Costs down

The Credit Suisse Composite Cost Index (Fig.1, red line) compiles the trading costs of a broad range of institutional investors, adjusted for trade size and execution style. Our Transaction Cost Index (Fig.1, blue line) goes one step further by normalising for spikes in volatility, creating a better apples-to-apples comparison of structural costs over time. Transaction costs began to fall in late 2009 and have, on average, been almost a third lower since the beginning of 2010. Even though costs have risen slightly recently, they remain 16% below their pre-2010 levels. While numerous market structure changes have taken place, making it difficult to attribute the reduction in transaction costs to a single factor, our analysis suggests that alternative venues and crossing networks are major drivers.

Competition

Multilateral Trading Facilities (MTFs) introduced competition into what was previously a monopolistic environment. They have disrupted the existing order, offering attractive pricing in a bid to lure market share away. To keep pace, traditional exchanges have been forced to reduce fees (though many have increased the charge for auction trades, where they retain a monopoly). Given the reduction in revenues, it is unsurprising that exchanges have complained about MTFs – and their pricing in particular – time and again. However, what’s bad for the bourse seems to be good for trading counterparties.

In our analysis of Credit Suisse orders sent using time- and volume-based tactics in 2012, we found that trades exposed to alternative venues outperformed on a relative basis by 4.4bps versus Implementation Shortfall (IS) and 0.1bps versus VWAP. It is worth remembering that total transaction costs are down, so the relative outperformance from MTF exposure seems to be an overall improvement rather than a zero-sum gain. This suggests that the introduction of competition in the exchange space has increased the efficiency of the market, lowering transaction costs for its users by reducing the rents accrued by its operators.

Crossing Networks

Crossing “networks” have existed – in some form – for as long as stock has changed hands. Traders would hold certain orders in their pocket (sometimes literally) and try to cross them off without disturbing the market. As this practice has become more automated, it has introduced further competition into the execution space. Automated crossing networks are now operated by brokers, MTFs, and the exchanges themselves, allowing traders to cross stock without displaying their size.

Our studies indicate that trading in this manner has a clear, positive impact for the end investor. For orders using time- and volume-based tactics, those that were exposed to the dark performed a full 3.3bps better when measured against IS and 0.8bps better versus VWAP (both statistically significant at the 5% level). Some detractors have argued this practice is damaging to market quality and should at least be restricted to the largest orders only, but in our studies, we have found that there is no evidence that higher levels of crossing activity adversely affect the market. In fact, we found evidence of a positive impact on several measures of market quality, including spreads and autocorrelation. We also showed that posting visible quotes for even small orders causes market impact, undermining any argument for a minimum size restriction.

Clear and measurable benefits

With the knock-on effects of changes to the market’s structure coming into focus, it stands to reason that the regulatory framework will need to adapt to the new environment. Many common-sense reforms – like order-to-trade ratio limits – have been put forward or are underway. However, other proposals seem designed to roll back or hamstring new forms of execution in order to reduce the competitive pressure on established business interests. The lobbying efforts of the exchanges clearly reflect this anti-competitive sentiment. They have strongly pushed for minimum trade sizes and market share caps for crossing networks. The research papers they fund to bolster their position employ questionable methodology – such as declaring that on-exchange crossing networks are “lit”, while off-exchange crossing networks are “dark”; or conflating macro trends in volatility with market structure changes when it proves convenient. They argue that these restrictions would improve market quality, while the only obvious effect would be to force volume back to the old regimes, restore market concentration and transfer money directly from pension funds to the bottom line of exchange profits through increased investor costs. The market, by and large, knows this: Pensions Europe, for example, an association of funds representing the workplace pensions of 83 million Europeans put it succinctly when they noted that these and other proposals: “offer trading venues the opportunity to take undue commercial advantage from pension funds’ investment activities… affecting the returns on investments and, ultimately, the contributions paid to workplace pension beneficiaries.”

The European markets have undergone an enormous transition since 2007. MTFs have driven down exchange fees, and crossing networks have enabled investors to trade orders without distorting the market. While entrenched interests have painted these developments negatively, warning of deteriorating market quality with subjective or questionably supported claims, the net result of increasing competition is clear and measurable: a significant reduction in costs, with the benefits going to the end investor. It would be a shame to roll that back.