Vox Pop: Liquidity fragmentation: crisis or opportunity?

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Dave Lauer, Senior Systems Engineer, Tervela

Dave Lauer, Senior Systems Engineer, Tervela

The liquidity fragmentation trends in Europe have substantially accelerated since MiFID regulations have begun to be enforced. This fragmentation is leading to a landscape very similar to the highly-fragmented US markets, primarily concentrated in traditional venues with an increasing amount of liquidity to be found in dark pools and other less transparent execution venues. Though some would argue that requiring best execution protects against liquidity fragmentation, latency in market data and computational impedance in the order flow process actually exacerbate it.

While there are significant differences between MiFID in Europe and Reg NMS in the US, both market landscapes are dramatically changing. With a projected CAGR growth rate of 46% over the next two years for the percentage of value traded by off-exchange crossing networks, anyone working in the industry - buy-side, sell-side and vendors - must pay attention to current trends.

The advent of fragmented markets is an example of pure competition - many venues using innovative technology, price improvement strategies and pricing incentives to meet differing requirements. While this sounds wonderful in theory, the current reality became all too apparent in September 2008 with the LSE outage. Instead of routing to lesser-known venues, many brokers stopped trading. This served as a wake-up call to market structure immaturity and brought attention to subpar liquidity discovery technologies.

Iosif Itkin, Senior Analyst, Allied Testing

Iosif Itkin, Senior Analyst, Allied Testing

Every crisis presents an opportunity. Accelerated liquidity fragmentation makes the marketplace more interesting. First of all, new and incumbent exchanges constantly introduce innovations. New price determination strategies are available for retail and standard size order, e.g. pan-European pegged orders and execution at VBBO. Larger orders will benefit from dark liquidity offerings to be available shortly on most exchanges. Execution venues are now proud to be cost efficient, and recent announcements regarding Quote MTF show that the battle to decrease fees will continue. Current investment in more scalable and faster platforms will pay off when the down-turn ends, and when the markets become more active.

Secondly, liquidity fragmentation generates enhancements in the Smart Order Routing area. Most vendors replace simple routers with adaptive solutions, which is good, because adaptive platforms are the future of trading. MiFID regulations will speed-up this inevitable transformation.

Overall, I am optimistic about the changes and look forward to see more comprehensive metrics for fragmentation and execution quality. We have Fidessa Index, recently introduced Equiduct LFI, and I am rather confident that vendors and venues will introduce more of such metrics. At some point, I hope to see a recognized industry-wide method that will incorporate hidden liquidity, commissions, both sides of the trade, etc.