The Gateway to Algorithmic and Automated Trading

European Equities: The Great Debate

Published in Automated Trader Magazine Issue 14 Q3 2009

John Howard, Automated Trader’s Publisher and CEO, had a busy June moderating a series of seminars on MiFID and related topics. The last in the series was held in London, where panelists participated in a discussion hosted by RTS Realtime Systems. With two exchanges, four MTFs and one exchange/MTF represented, the audience were treated to a ’full and frank’ exchange of views!

Mark van Vugt, Global Head of Sales at RTS Realtime Systems opened the event by welcoming the panelists and audience. Mark remarked that the event might be seen as something of departure by RTS, which some still saw as primarily futures-focused. In fact, in response to the multi asset requirements of its clients, RTS had made a major investment in both product capabilities and connectivity to multiple equities venues that now rivalled its existing futures markets coverage.

Mark van Vugt: opening proceedings

Mark van Vugt: opening proceedings


John Howard

Master of ceremonies for the event, John Howard, Publisher and CEO of Automated Trader

John Howard then opened the discussion by highlighting the broad range of feedback from Automated Trader readers on the pros/cons of MiFID. Some have seen it as an opportunity to trade at reduced cost, while others felt that it had made the whole business of trading equities unnecessarily complex. He then moved on to ask the panellists if they felt that MiFID had delivered on its intent and promise.

London event panellists:

Hugh Brown, LSE
Todd Golub, NASDAQ OMX
Mark Hemsley, BATS
Duncan Higgins, Turquoise
Michael Krogman, XETRA
Hirander Misra, Chi-X
Cees Vermaas, ARCA Europe

Event organiser and sponsor:

RTS Realtime Systems

Hirander Misra said that Chi-X was very positive on MiFID and very much saw it as an ongoing process rather than an event. Hugh Brown of the LSE said that contrary to common perception the exchange was by no means averse to MiFID. The absence of a concentration rule in London meant that the LSE had always been exposed to competition anyway and the removal of those rules in the rest of Europe had actually presented the exchange with opportunities.

Mark Hemsley of BATS felt that MiFID was certainly delivering on its objectives. In his view, the appearance of MTFs had proven that the national exchange model was anachronistic. The ability to trade pan-European equities had definitely been proven as something that was immediately deliverable.

Duncan Higgins of Turquoise highlighted the issue of resilience; with the multiple alternative venues implicitly created by MiFID, traders were no longer at the mercy of single market resilience. If a venue had technical issues, others would still be available for trading.

Duncan Higgins

Duncan Higgins

"We now find that while they are still trading on Turquoise, they are doing so through brokers and no longer using their direct connection"

Best execution

John Howard then posed the question of whether MiFID's requirement to publish a best execution policy was sufficient or whether best execution should have been more explicitly defined.

Cees Vermaas of ARCA Europe saw best execution as a protection mechanism for retail investors, but was dubious as to whether the retail investor was actually better off after MiFID. Todd Golub of NASDAQ OMX's view was that having a vague definition was beneficial. Customers of broker-dealers could define and enforce an acceptable definition of best execution by voting with their feet if they felt they weren't getting it. Michael Krogman of XETRA regarded this market-defined approach as positive; focusing only on price (as in the US) in a fragmented European landscape with varying regulations would be unlikely to deliver the best result for investors. However, he felt that MiFID had not yet delivered the full value proposition; transaction costs for both institutional and retail investors had not appreciably declined in the past eighteen months.

Two factors that will assist MiFID in delivering more of its proposed benefits are back-office efficiencies and interoperability. With those in place, functionality that is commonplace in the US, such as trading venues order routing between each other, become feasible. At present this is far too expensive in Europe to be practical due to back-office inefficiencies.
More generally, smart order routing as provided by brokers is still patchy in terms of best execution. In some cases these tools are very effective and smart routing levels are high, in others their shortcomings make smart routing almost non-existent. The obvious remedy for this is buyside pressure and there are signs that buyside firms are becoming more severe in their interrogation of sellside execution performance (right down to the individual child order level) and striking off those that they regard as underperforming.

Some feel that European regulators missed an opportunity with MiFID by not looking at the efficiencies achieved in the US and replicating those by simply mandating pricing and service levels. However, one of the downsides to that approach is that unless onward routing is imposed at the platform level then a large proportion of the market will have to endure considerably higher cost. Under the current MiFID model for best execution, the cost benefit of connecting to a new market is a decision factor. For example, will connecting to a new market deliver sufficient return to pay for the connectivity and software development?

Hugh Brown

Hugh Brown

"Our trading platform doesn't cost very much to run and can be operated effectively with similar headcount to MTFs' technology"

Market share and survival

The panel also discussed the issue of market share, with John Howard asking why only some 25% of volume had so far left the primary exchanges. (There are some short term signs that this situation might be changing. For example, the day before the London event the LSE had around 66-67% of the volume intraday.)
Based on the US experience, Mark Hemsley thought that this situation could change quite suddenly. "In the US NYSE's share stayed at around 60-70% for quite a while and then dropped dramatically once people realised there would be volume on other trading venues," he said.

John Howard moved the discussion onto survival by challenging the panel to predict how many of them would still be around in a year's time. The consensus was that any absenteeism would be down to takeovers rather than collapse. Comparisons with the US were unlikely to be valid, as current European exchange technology was well ahead of the state of US exchange technology at the time US exchanges were acquiring ECNs. Furthermore, the US ECNs had already seen significant consolidation before these exchange acquisitions began. However, there were still disparities between European exchange and MTF technologies/cost bases that could push some exchanges to acquire MTFs in order to raise their technology game.

Hugh Brown confirmed that the LSE was certainly open to considering any suitable acquisition opportunities. He was also keen to refute the assumption that exchanges have a huge cost base. "Our trading platform doesn't cost very much to run and can be operated effectively with similar headcount to MTFs' technology," he said.

The discussion then moved on to consider the types of participant that were driving growth in Europe. Many panellists noted the emergence of new players from the US using a variety of strategies including statistical arbitrage and more conventional time series models. However, there was a distinction between London and the rest of Europe in this respect. UK based firms had been first to move in terms of pan-European stock trading, but this was now being replicated on the continent with proprietary trading, sellside and institutional firms all trading more actively. This process was rather highlighting the disparities between categories of participant. "In Scandinavia the buyside are more advanced than some of the sellside and are looking at direct market participation because they are frustrated by what their brokers offer," said Hirander Misra.

Hirander Misra

Hirander Misra

"In Scandinavia the buyside are more advanced than some of the sellside and are looking at direct market participation because they are frustrated by what their brokers offer,"

Sponsored access

John Howard moved the conversation onto sponsored access by asking why it had taken equity markets so long to get their house in order on this in comparison with futures markets. It was apparent that regulators were a significant hurdle in this respect. Simply getting regulatory approval for a sponsored access framework was a major challenge; one panellist remarked that it had taken about five months for the FSA to grant regulatory approval for his trading platform's sponsored access solution. There was inevitably a feeling that regulators were being ultra-conservative in reaction to their shortcomings over the sub-prime crisis.

Regulators clearly had a preference for sponsored access solutions that include monitoring and validation at the exchange level as opposed to those that have a separate level of upstream control. Prime brokers are similarly uncomfortable with this sort of separated solution, preferring more centralised control and they were looking to the trading venues to provide that. However, this creates something of a conundrum, as these brokers also want standardised controls per client regardless of the market. Accomplishing that requires them to employ their own technology and interface it with each trading venue.

The actual outcome will ultimately depend on the type of client. To date, the US trading operations getting involved have total control over their technology. They therefore want no more than the minimum control layer possible so as not to negate the benefits of a direct connection with latency.

Mark Hemsley felt that much of the necessary framework for sponsored access was already in place at many MTFs. The next step was to get broker dealers on board offering a service supported by that. "We have a number of global investment banks who are working on sponsored access services and looking to market it to their buyside clients who trade high frequency," he said.

Duncan Higgins observed that Turquoise buyside clients seemed to have changed their stance on direct membership in the past year. In 2008, many were actually signing up to become direct members. "We now find that while they are still trading on Turquoise, they are doing so through brokers and no longer using their direct connection," he said. This might change again in the future as technology available to the buyside improved and they were able to post business in an intelligent way that would let them benefit from the maker/taker model Turquoise operates.

Michael Krogman

Michael Krogman

"It is vital to maintain the risk standards that are in place as of today even when expanding into new markets"

Clearing

One of the last discussion topics of the session was clearing, with John Howard starting by asking if panellists felt that the clearing community was doing enough to facilitate the modern trading landscape.
The general consensus on this was no, or at least not as yet, though there had been a series of promising recent announcements from various MTFs and the clearing community about further interoperability. The MTF panellists felt that their pan-European viewpoint had been a factor in taking pole position on clearing issues recently, with their influence in the formation of EuroCCP and EMCF being two examples. The credit crisis had served to boost the importance of clearing interoperability. Where margin costs for a T+2 or T+3 equity trade were once negligible, they had now risen dramatically.

This could have a significant impact on the activity level of certain participants. For example a day trading firm might be flat overall at the end of the day, but it might be equally long and short across two different venues and therefore still liable for margin. Eradicating clearing inefficiencies such as this through greater interoperability would enable these firms to increase their trading volumes.

Mark Hemsley

Mark Hemsley

"In the US NYSE's share stayed at around 60-70% for quite a while and then dropped dramatically once people realised there would be volume on other trading venues"

Todd Golub remarked on the proportion of total cost not attributable to trading. "While we have all made major efforts to reduce pricing to competitive levels, this still only represents some 20% of the overall cost of both child and parent orders," he said. Much of the remaining cost could be reduced by clearing improvements, particularly interoperability. Cees Vermaas observed that ARCA Europe had opted for a horizontal business model two years ago, so while it did not clear itself it was nevertheless active. "We do not control clearing but we have made a conscious effort to engage with pan-European clearers and would ideally like to see other trading venues opt for interoperable solutions," he said.

There was an obvious temptation to look to the US for an example on this, where the DTCC provides an extremely cost-effective clearing model. However, despite huge volumes driving down price, the DTCC's monopoly meant that it was not necessarily as efficient as it could be. While a plethora of clearers in Europe would not be a desirable outcome, a half way house of three or four interoperating clearers might offer the best solution. This would provide choice and competition, but each clearer would still have sufficient volume to reduce costs through economies of scale. In fact some panellists already detected the beginnings of this scenario in the price and functionality competition between EMCF and LCH.

Michael Krogman felt that competition on both clearing and trading was vital, but was keen to emphasise the importance of risk management in the clearing process. "It is vital to maintain the risk standards that are in place as of today even when expanding into new markets," he said.

Cees Vermaas

Cees Vermaas

"We do not control clearing but we have made a conscious effort to engage with pan-European clearers and would ideally like to see other trading venues opt for interoperable solutions"

Conclusion

While MiFID seem to score little more than a 'B' from most panellists, there was an overall sense that this could change over time. Despite its limitations there was consensus that a more prescriptive regulatory approach would have been inappropriate for Europe. Over time, greater interoperability would assist best execution by facilitating smart routing between venues. Panellists generally accepted that consolidation among European trading venues over the next twelve months was likely. Exchanges looking to acquire leaner technology were cited as likely acquirers of MTFs, though one exchange was keen to dispel the belief that exchange technology wasn't already lean.

Todd Golub

Todd Golub

"While we have all made major efforts to reduce pricing to competitive levels,this still only represents some 20% of the overall cost of both child and parent orders"

Sponsored access was seen by most panellists as something that would become more widely available, once regulatory hurdles were surmounted and available technology allowed buyside traders to take advantage of make/take pricing models. Finally, clearing was still seen as a significant obstacle to an efficient trading process and currently acting as a brake on higher levels of trading activity, as well as impeding MTFs' ability to list additional asset classes.