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Fragmentation Diversifies - 14 October 2009

Fidessa : Fidessa - 1st January 1970

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It's hard to miss the widening gulf in fragmentation between the London Stock Exchange and the other primary markets. The gap started to appear during the summer but seems to have been widening to the point that fragmentation on FTSE 100 stocks is now around 30% higher than in France or Germany. NYSE Euronext and Deutsche Börse will doubtless be monitoring the London situation carefully as, so far, the London experience of fragmentation has been played out in mainland Europe, too. Intuitively, you would expect fragmentation to be a bit higher in London as the MTFs are based here but maybe there are other reasons to support this gap.

One of these is BATS Europe which has led the way in aggressive pricing against the primaries and, most recently, has been focussing these efforts directly against the LSE. As a result of this, BATS' market share in FTSE 100 stocks has doubled since August but, of course, these incentives are not economically viable in the long or even medium term and so the real question is what happens to liquidity when the rebates are removed. Obviously, MTFs can't expect to hold on to all the flow they win in this way but, according to BATS' CEO, Mark Hemsley, that's not the point. These discounted pricing campaigns act as an incentive to get the market focussed on connecting to new, alternative venues and to smooth out all the post trade workflow issues. When the price incentives are removed then some liquidity naturally shifts again but, as Mark points out, the damage has been done because more trading firms are now connected to the venue in question and confidence in their operating model is established.

The primaries will rightly argue, though, that the MTFs still aren't making any money and so have yet to prove that their business models are viable. As the MTFs creep towards break-even, however, this argument may carry less weight in the future. On this point, it was also interesting to read that Chi-X has announced that as of the 1st January it will start to introduce market data fees for some non-trading users. If other MTFs follow suit then this could further squeeze the primaries. Traders will be reluctant to accept the current market data fees from the primaries if they also have to write another cheque out to the MTFs for the same thing. If this does happen it will reignite the whole consolidated tape issue and will also open up the debate as to who really "owns" this market data.

The game is most definitely not over, though. Just fragulate any of the most fragmented stocks and you can see that in most cases "non-lit" trading accounts for around 50% of the total traded volume. The obvious step for the primaries, then, is to find ways of harnessing this flow. This could be through the creation of liquidity aggregation services such as those offered by the LSE's Baikal or through regulation - forcing better transparency and reporting on non-lit venues.

No wonder everyone is busy lobbying the regulators over dark trading.