OPPORTUNITIES AWAIT, IF YOU KNOW WHERE TO LOOK.
By James Hilton, Co-Head, AES Sales, EMEA at Credit Suisse.
In 2007, MiFID I brought significant change to the trading landscape in Europe. Regulation was introduced to encourage competition in the industry, leading to the evolution of Multi-lateral Trading Facilities (MTFs), the breakdown of monopolies, and ultimately more efficient markets. Buyside clients had more choice in terms of execution venues, and brokers became more differentiated by developing ways of sourcing the newly fragmented liquidity. Whilst a consolidated European “tape” was not mandated, the majority of buysides have had access to a consolidated view of the market. The market became more fragmented, but with some proactive and constructive efforts from industry participants, price discovery and transparency have not been significantly impacted.
Whatever your view on the objectives or outcome of MiFID II, the industry will inevitably adjust in a logical and commercial manner. Just as MiFID I resulted in new entrants to the market, we can expect the same thing to happen again. We anticipate several significant developments in the coming year.
One of these is the Systematic Internaliser (SI) construct. Whilst previously a choice, banks offering risk capital to their clients must now do so under this construct. This is not a particularly interesting development in itself, but the evolution of non-Bank SIs could drive significant change. The market-makers, who have been prevalent for so long on lit and dark venues, are finally being brought into the spot-light for all to see. Not only will market participants be able to specifically measure and monitor the experience of trading with market-makers, but we think there is a strong likelihood – assuming you have the right technology and intellectual capability – that trading with them could be very beneficial. By avoiding the fee for trading on an exchange or MTF, SIs have more scope to offer price or size improvements. Preliminary analysis doesn’t appear to show any degradation in performance when interacting with these venues versus traditional lit markets; in fact, we have seen the opposite so far.
Initial results at Credit Suisse have been very encouraging both on the parent and child order level. Average trade sizes on SI streams above SMS are multiples of primary and lit MTF venues (see Figure 1); frequently at significantly better prices. Certain SIs are offering significant size, with Credit Suisse achieving fills above $600k. It is clear that in many instances, SIs are able to offer unique liquidity unavailable elsewhere in the market, which make this venue category difficult to overlook from a best execution perspective. Even where SIs offer equivalent liquidity, their fill rates can be significantly higher than those of primary exchanges.
As the proliferation of SI venues continues, it is clear that a strong SOR and routing infrastructure is crucial to intelligently sourcing this type of liquidity. Now more than ever, brokers will offer different experiences depending on their setup. As the SI landscape is likely to become saturated, it is the responsibility of the brokers to decide which SIs are likely to be additive or unique. A strong framework for managing information and performing detailed venue analytics is therefore essential and will be a key challenge for brokers.
The second major development is the growth in periodic auction volumes. Whilst these venues have existed for some time, they became instantly more attractive upon the introduction of the double volume caps. Our research shows that impact when trading on a periodic auction venue is far lower than on a traditional lit market. As dark trading becomes significantly restricted it seems logical that periodic auctions will fill the void – but there is probably a limit to how successful periodic auctions will become. Investors have different urgencies, and there will always be a requirement to post and take liquidity on lit order books. We anticipate the market finding a natural equilibrium, just as we saw with dark trading after MiFID I.
Finally, we think there is scope for further change on the lit markets. Primary exchanges have been rampantly raising their prices: both trading fees, and also market data fees. This hasn’t gone unnoticed, and ESMA, “…shares the concerns expressed by some respondents over the recent increases in fees for market data” as stated in their recent report to the European Commission (26th March 2018). Intuitively it makes sense for the investment community to use the most cost-efficient means of trading and price increases have provided an enhanced incentive to identify opportunities to achieve best execution at alternative venues. Perhaps most challenging is the closing auction – which enjoys a monopolistic position – but as costs continue to rise, alternative solutions could potentially become more attractive to explore.
Every time there are changes to the rulebook, the market will adapt. Just as we saw new venues emerge after MiFID I, we will see new constructs and order types emerge in the coming year. More than ever, those brokers who have invested significantly in order routing technology, and who have broad market reach, are those that will succeed. We hope there is some value to all the change, but right now, the industry needs a period of stability in order to reflect on the changes and measure the impact, before any further rules are proposed.