A lack of headline-grabbing glitches had many dismiss MiFID as
something of a non-event, following its launch last November. But
after the hype came the reality. Buy- and sell-side firms have
been getting on with the business of adapting to a new
environment in which they must choose between venues for trading
and trade reporting. While MiFID's introduction was never likely
to bring Europe's equity markets to a standstill, the Directive's
teething troubles are now beginning to bite. Brokers admit that
their clients face harder workloads as they adjust to an
increasingly fragmented market. And with barely a multilateral
trading facility (MTF) or dark liquidity pool out of the starting
blocks, large asset managers are already complaining of the
problems of aggregating liquidity and comparing transaction cost
Daemon Bear, JPMorgan Asset Management
"Understanding the true liquidity of a security is becoming more difficult, …"
In February1, the Financial Times reported disquiet among London traders when off-exchange trading and reporting allowed Montague Private Equity to build up a 10 per cent stake in Biffa, a waste management group, unnoticed until Montague announced its holding the next day via the regulatory news service. The impact of MiFID has varied across Europe. While London has undoubtedly suffered a temporary loss of transparency, for example, trades are now more visible in Germany. Buy-side attitudes to Chi-X are instructive. Launched by Instinet just over a year ago, the pan-European MTF has emerged as the first serious competitor to established national exchanges and now boasts 5-10 per cent of total trading in UK, Dutch, German and French listed stocks. While some asset managers - eager to benefit from a reported average price improvement of 2.67 basis points since launch - are frustrated that their brokers appear unable to direct more volumes to the venue, others fight shy either simply due to caution or because their back-office systems cannot cope with receiving order fills from two venues. For every institution keen to employ the latest smart order routing technology there's another that has yet to hear of Chi-X or Turquoise.
The invisible trade
So far, the main impact of the introduction of choice via MiFID
has been to throw a blanket of fog over the certainties upon
which trading was previously based. "Understanding the true
liquidity of a security is becoming more difficult," says Daemon
Bear, Head of Equities Trading, JPMorgan Asset Management. "Some
brokers have done a very good job in helping us identify where
our orders are getting executed, i.e. the percentage being routed
away from the primary exchange. But overall, it's still pretty
opaque. The consolidated order book is something of a myth at the
Michael Sparkes, Managing Consultant, ITG, a leading provider of transaction cost analysis (TCA), acknowledges that venue-specific analysis of trade performance is a challenge. "The question of venue is still a work in progress for the whole industry. Data from OMSs is not venue-specific, so the buy side has generally relied on the sell side for this kind of information," he says. Brokers want TCA to provide verification for the execution data they provide to clients and to monitor their own trading performance and costs, says Sparkes. "The sell side is increasingly interested in post-trade analytics, including venue-specific data. And where they're using a third-party broker to access an exchange, they're increasingly using TCA to focus on the trading costs incurred," he says.
"… the main impact of the introduction of choice via MiFID
has been to throw a blanket of fog over the certainties upon
which trading was previously based."
According to JPMorgan's Bear, the fact that the buy side has largely relinquished its trade reporting responsibilities to brokers has contributed to the confusion. "Do we ask the brokers for greater transparency or do we sit back and make the best of what is currently a very opaque and confusing picture? It's very hard to paint a picture that reflects accurately on our execution performance using external TCA, because of the inconsistency in volume profiles," he explains. For JPMorgan, the solution is to take matters into its own hands. "It places even greater emphasis on the factual evidence of our own experience in the market," says Bear. "This is one of the reasons why we will take more ownership of the tools needed to gain access to liquidity pools; we can't make the assumption that other people will do it for us."
Brian Mitchell, Head of Dealing & Portfolio Control, Baring Asset Management, also fears that the buy side is not yet getting full visibility of execution performance under MiFID, but says the sell side and other providers will respond to evolving needs. "Double-counting can be an issue with trade reporting providers, for example, but the likes of BOAT are pro-actively trying to clean data. TCA providers will have to tap into that to ensure they are providing the whole picture, in the absence of a consolidated tape," he says. "During 2008, the buy side will ask for more granularity in terms of how and where brokers are executing on our behalf, including references to direct market access (DMA), smart order routing (SOR), latency, and algo usage, preferencing and functionality, as well as the actual relatively high costs of cross-border clearing and settlement."
Mark Winter, Insight Investment
"I need to justify what we do, what our processes are and how we evidence them to various internal and external parties, …"
Evolving buy-side demands
The need to provide clients with evidence that trading processes support MiFID's broad definition of best execution is driving buy-side data requirements, according to Mark Winter, Head of Dealing, Equities, Insight Investment, the asset management arm of HBOS, which manages more than £100bn on behalf of group and external clients across bonds, equities and other asset classes. "I need ever more comprehensive time-stamping, which is why FIX is so important to me now. I need to justify what we do, what our processes are and how we evidence them to various internal and external parties, from compliance teams to regulators to consultants to trustees," he says. Insight is also making much more extensive use of its TCA data. "There's been an evolution in the buy side's approach to TCA over the last three to four years," says Winter, "from a box-ticking exercise to a valuable management tool to identify what we're doing well and what kind of orders are being handled better by some brokers than others."
Central to demands for more information is the fragmentation of liquidity across more venues.
"I might well expect my brokers to itemise and evidence the venues on which my block of 100,000 shares has been executed to ensure best execution, which will be an increasing challenge as the number of venues increases," says Winter. "We are getting more information from brokers already, but not yet to this level of granularity. It may be that our risk and compliance people decide we need to store and deliver it to clients or regulators on request and it will be certainly valuable to me in determining the benefits of routing orders to different platforms."
And in attempting to bring greater clarity to the relationship between asset managers and brokers, MiFID is also changing its nature. Like many large asset managers, Insight Investment has chosen to be categorised by the vast majority of its brokers as a professional investor rather than an eligible counterparty in order to benefit from best execution guarantees under MiFID. "My team of traders is ultimately responsible for delivering best execution to clients, but we need the brokers' help to ensure we are tapping every source of liquidity from Euro Millennium to Chi-X to the broker's dark pool to flows seen by their programme trading team. The bottom line is not missing a trick," says Winter.
Prior to MiFID, Baring already monitored its panel of global execution counterparties through a biannual review, based on an ongoing analysis of their performance against key subjective and qualitative criteria: quality of execution; sales trading services and capital commitment; operational efficiency and electronic trade confirmation; and FIX, routing and connectivity capabilities (Baring conducts more than 98 per cent of its total global equity transactions via FIX). "The requirement for us is to analyse regularly who we're dealing with and being able to justify why. I don't see how you can do that by not knowing what their systems can and cannot do," says Mitchell. Since MiFID, Baring has had a strong preference for dealing with intermediaries that categorise the firm as a professional investor rather than an eligible counterparty. "An initial broad brush refusal to deal with those not granting professional status was not practical, as this could've limited our ability to provide best execution for our clients," according to Mitchell.
Brian Mitchell, Baring Asset Management
"An initial broad brush refusal to deal with those not granting professional status was not practical, …"
Clearing and settlement constraints
While the forces of competition unleashed by MiFID are causing confusion in the front office, the directive's promotion of competition in the clearing and settlement market may also reap disquiet in the back office. Today, there are 23 national central securities depositories (CSDs) in Europe, while the
number of clearing counterparties (CCPs) is currently six and
rising as new trading venues emerge. Chi-x is using a
pan-European solution (EMCF; European Multilateral Clearing
Facility) provided by Fortis, Equiduct is clearing through
LCH.Clearnet, Turquoise is working with EuroCCP (a subsidiary of
DTCC), while NYFIX Euro Millennium clears through BNP Paribas.
Bill Capuzzi, President of G-Trade, the global electronic trading unit of BNY ConvergEx Group, the US-based agency broker, says Chi-X's clearing solution has contributed to its success. "A crucial factor for the sell side is that there's no disadvantage from a settlement perspective," he says. "Generally speaking, sourcing liquidity from multiple locations and having multiple settlement events for a single order is a significant cost uptick. But if I place an order for Ericsson that gets filled on both Chi-X and the local exchange (OMX), the Chi-X executions are also directed back to the local market for a single settlement event."
But many believe it is even more difficult to create a pan-European market for equities clearing and settlement services than for trading. The first challenge is to ensure sufficient inter-operability between CCPs, trading venues and market participants to provide efficiency and choice. So far, progress has been slow because of the implicit competitive threat to established CCPs such as LCH.Clearnet, which was recently obliged to grant access to LSE trade flows to SIS X-clear. "There will be circumstances in which the dominant CCP for a particular venue will be asked for equal access by a CCP servicing a new MTF in order to make the market efficient for users. Inter-operability potentially runs counter to the incumbent's commercial interest, but without it, new execution venues will find it harder to gain traction if they introduce a new clearing and settlement structure," says Andrew Howieson, Managing Director, TABB Group Europe.
Just as much work is required to Europe's settlement framework. The Giovannini report on clearing and settlement in the European financial markets, published in 2005, identified 15 barriers to harmonisation, of which just one is considered fully resolved. Howieson says these "deep-seated" differences between national regimes need to be resolved to create an environment in which the
European Central Bank's Target2-Securities (T2S) platform can operate effectively. "The aim is for T2S to be a common settlement platform at least for the euro-zone markets, but this is not possible without common procedures and processes. So unless the remaining 14 issues are resolved, costs will remain higher than they should be in what is technically now a pan-European trading market," he says.
"Banks have to consider their competitive positioning and where they're making most money, so it's understandable that they should be hesitant."
A key element of the sell side's response to fragmentation has
been the development of smart order routing platforms to access
liquidity intelligently and dynamically across multiple venues,
i.e. routing algorithmic order flow between venues based on their
performance against certain criteria. Although smart order
routing is already showing its value, buy-side traders should
query brokers both on the volumes and prices achieved at
different venues and their connectivity to dark pools, says
Valerie Bannert-Thurner, Managing Director, Skyler Technology
Europe, a market data aggregator. "In many cases, a broker's
algos will dip into its internal liquidity pool and then go to
the established exchange and MTF market if no matches can be
found. While it would be great if SOR technology could search for
liquidity not only across exchanges and MTFs but also
publicly-accessible dark pools and other brokers' internal dark
liquidity pools, but in reality only few brokers allow
connectivity from the competition," she says. "Banks have to
consider their competitive positioning and where they're making
most money, so it's understandable that they should be hesitant."
BNY ConvergEx's Capuzzi says that the way SOR capabilities and execution algos are adapted to Europe's increasingly fragmented European market will be a source of competitive advantage between brokers. "First, the model has to be scalable and speed to market has to be consistent with changes in Europe's market structure. If it takes me four months to onboard Turquoise, I'm going to lose credibility and opportunity," he says. "Second, being able to source market data directly and wring out all the latency when routing to venues are two increasingly crucial factors. If you have four to five exchanges or MTFs bidding a stock, you've got to be able to read the market data and make the right routing decision in milliseconds."
But TABB's Howieson says buy-side firms are not content to rely on brokers' SOR capabilities. "There is a market for third-party applications. There are already third-party algos that are specifically designed to look for liquidity in dark pools and rebalance orders as they find liquidity. Bringing those into a prop platform is a legitimate approach, but building that capability entirely might be a tall order for all but the largest buy-side firms," says TABB's Howieson. JPMorgan Asset Management's Bear confirms that the buy side has appetite for SOR platforms that do more than route an order to the best destination. "The next level is the ability to identify the strategy with which you want to execute a particular order in an automated and systematic way," he says. "This creates ownership of how a security should be traded, leaving the broker to decide where it should be traded."
Currently, price is the key decision-making parameter used in SOR, but the increasing ability to input a wider range of data means that additional parameters can be added - such as internal analysis of the execution likelihood and speed of different liquidity pools based on the firm's transactions - that may soon enable SOR to make more intelligent decisions, according to Skyler's Bannert-Thurner. "An additional challenge for banks' SOR capabilities is the amount of client-specific information that can be included. At the very least, they need to be able to support all the order types the client wants to use, including hidden orders, and be flexible enough to consider different sets of liquidity pools on a per client and per order basis," she says.
Chris Smith, NYFIX International
"… the buy side wants to find liquidity without the concern of interacting with anyone's proprietary flow."
The value of SOR platforms to the buy side expands with every new
trading venue or dark pool launched. Of course, the MiFID party
is hardly in full swing yet. Chi-X is the only venue to challenge
the established exchanges. NYFIX's Euro Millennium dark pool is
the sole new competitor to crossing networks POSIT and LiquidNet.
And many of the banks' own 'dark' liquidity pools are little more
than automated structures for handling growing algorithmic flows
from clients. Admittedly, RSVPs have been received from trading
platforms Equiduct and Turquoise, while NYSE EuroNext and SWX,
the Swiss exchange, have promised to bring their own dark pools.
But when they do arrive, perhaps with some unexpected guests,
it's by no means guaranteed that the buy side will break out the
champagne. TABB's Howieson says many buy-side firms are yet to be
convinced that fragmentation is to their advantage. "I've been
quite surprised by the strength of the reaction against the
proliferation of dark pool venues. People seem quite opposed to a
large number because it will be hard and expensive to manage
effectively, he says. "At the same time, there is a realisation
on the buy side that a reappraisal of trading tools is required
to manage the fragmentation of visible and non-visible liquidity.
Technology will be critical to manage trading effectively across
One reason for concern over the proliferation of dark pools is that efforts to attract liquidity are actually raising the barriers to entry. Smart order routing technology may route algorithmic flow between exchanges offering visible liquidity, but will it be able to do the same for dark liquidity? Brokers admit that reciprocity between dark pools barely exists in the US, let alone in Europe, and POSIT can only be scoured by ITG's algos. "If the sell side don't provide linkage, how does the buy side manage to access these pools at the same time?" says Tabb's Howieson.
"It's not always clear exactly which dark pools are looked at and in which order. The buy side would like to see more transparency in this field."
Chris Smith, Director, NYFIX International, which launched Euro
Millennium in March, says openness and neutrality are prized. "As
they're executing a range of different strategies, some
algorithmically executed, the buy side wants to find liquidity
without the concern of interacting with anyone's proprietary
flow. Building a position up in a mid-cap stock over a period of
time can be very difficult due to the inherent liquidity
constraints. So the least information that leaks into the market
about your trading intentions the better," says Smith.
Although brokers might be reluctant to share liquidity with each other's dark pools, they are willing to work with third parties such as NYFIX. While 'conditional' or 'resident' orders seek liquidity only within Euro Millennium, a 'pass through' order first reviews the Euro Millennium order book for matches then passes on to a pre-defined destination if it has not been fully completed, such as an exchange or a preferred broker. "The question the sell side has to ask is: where are you
going to meet your clients and your counterparties? They recognise that they're not going to meet their clients in their dark pool all of the time," says Smith. "They do need to connect to other pools."
Not only are buy-side firms in the market for third-party SOR
solutions. Competitive pressures on second-tier brokers are
increasing sell-side demand for SOR and algorithmic trading
capabilities. "Domestic brokers are feeling the need to offer
trading capabilities across Europe and beyond," says BNY
ConvergEx's Capuzzi, "and they're also feeling pressure from the
buy side to offer algorithms, either from their trading desks or
white labelled out to clients," BNY ConvergEx already has ten
sell-side clients across Europe using an 'Algo Rental' service
which provides access to the firm's trading infrastructure and
range of execution algorithms.
The need to reach ever more venues across Europe is prompting a variety of sell-side responses. Sell-side firms have always maintained relationships with other brokers to handle some of their execution business, but they're now expanding the range of tools deployed. "We're seeing an emergence of a blended approach whereby a UK broker might use the smart DMA service of an Italian broker to execute Italian stocks, but might develop its own SOR logic to route UK orders between Chi-X, Turquoise and the LSE," says Ian Salmon, Head of MiFID, Fidessa, the technology vendor.
Across the sell side, increased automation is seen as the key to handling fragmentation. "There are contrasting approaches between larger brokers that have developed their own SOR capabilities in-house, which link to multiple venues including their own dark liquidity pools, and those that are combining SOR packages from ISVs with the services of local brokers in markets where direct exchange connectivity can't be justified," says Salmon. "Some brokers are even looking to send core domestic flow to DMA providers to access particular venues."
Bill Capuzzi, BNY ConvergEx
"Domestic brokers are feeling the need to offer trading capabilities across Europe and beyond, …"
IT: solution or problem?
Baring's Mitchell asserts that MiFID is prompting a wholesale
review of technologies and tools deployed by asset managers in
the trading process. Baring has recently upgraded its Latent Zero
Minerva order management system (OMS) to version 4.0 and Mitchell
says the ongoing obligation under MiFID to connect to established
and emerging liquidity pools that offer best execution is also
driving industry debate on how to secure adequate execution
management functionality. "Do you think your OMS / OEMS (order
and execution management system) provider will be able to do that
with its established clients or will a separate independent EMS
platform like FlexTrade or NYFIX be able to maintain the ongoing
capital and IT investment required?" posits Mitchell. "There's
also a third option - using a sell-side solution such as Goldman
Sachs' REDIPlus or Lehman's LMX platform, for example. To my
mind, that's a reasonably big call you've either made or may need
to make in 2008."
While technology can put together what fragmentation has torn asunder, it inevitably comes at a cost. "The logical expectation would be that more fragmentation will lead to higher costs. But against that we have technology-driven solutions, e.g. algorithms and dark pools, to help people access liquidity," says ITG's Sparkes. "I do wonder whether the technology creates a barrier to entry to asset management because without these tools I fear performance will deteriorate."
1. Brokers' MiFID grumbles are transparent, Financial Times, February 29, 2008