September 2007

EXCHANGES: MIFID: Unmanageable liquidity

As the Mifid deadline approaches and the competition hots up between the traditional exchanges and the new entrants, Nicholas Pratt asks what fund managers can expect in terms of pricing and additional services There are less than two months to go before the Markets in Financial Instruments Directive (Mifid) goes live in Europe, bringing with it the promise of a brave new securities market. The central premise of the directive is that it will level the playing field for those firms trading in Europe’s capital markets. The concentration rules that have hitherto helped domestic exchanges to hold monopoly-like status in their own markets will be done away with and a host of new entrants could come into the market. For fund managers there should be two chief benefits in terms of lower, competitive fees and a host of new services. But how sustainable will the anticipated effects of new competition be? Once the market overcomes the initial introduction of Mifid, will the pricing settle down and a status quo resume? Will the implications of fragmented liquidity have more effect on fund managers than the reduced pricing and additional, post-trade services? Will fund managers simply be reluctant to go with any of the new entrants, preferring to stick to whom and what they know? At the Trade Tech forum in Paris earlier this year, one of the most popular discussion points was the exchanges market and how it might look post-Mifid. A panel discussion – provocatively titled ‘Do the exchanges have a future and what lies in store for the evolution of the execution landscape?’ – took place between two bastions of the traditional exchange market, Euronext and Deutsche Börse, and representatives from two of the new competitors – Instinet Chi-X and UBS Investment Bank, a member of the soon-to-be-launched pan-European trading platform Project Turquoise. The first question pitted to the panel was what role the central exchanges could expect to play in this new, post-Mifid level playing field. Roland Bellegarde, deputy chief executive of Euronext, spoke of the exchange’s current strengths, its liquidity, and the integrity and technology of its offerings. But he also spoke of the “need to expand on that liquidity and to adapt to customers’ demands”. Similar sentiments were expressed by Rainer Riess, managing director of Germany’s Deutsche Börse. “As an exchange we have always been in a competitive environment. This forces us to be innovative and cutting edge so the current issues around Mifid and new execution venues are not much of a change. For the central exchanges, our unique selling point will be integrity, the sunny side of liquidity [as opposed to the dark liquidity that alternative venues may offer] and investor protection.” But while the exchanges stuck to their message of integrity and resilience, Robert Barnes, managing director, market structures, at UBS, stated that the most important issue is pricing rather than resilience because it is pricing that ultimately attracts liquidity and ultimately leads to a better market. “I think the resilience issue is disingenuous. We have seen some serious issues over resilience and I think we are paying too high a price for it. The exchanges are not always as resilient as they would have us believe.” Fortunately, said Barnes, the exchanges had recognised the importance of pricing and, with Mifid approaching, most of the major exchanges had been reducing their prices, something which Barnes hopes will still occur post-Mifid. “We hope that we continue to see price discounts from Euronext and Deutsche Börse and that we continue to see a growth in the number of bargains from the London Stock Exchange,” said Barnes. “But we should not forget about post-trade costs. At the moment they do not seem to tally so we would like to see some more reduction in clearing costs.” “We need to concentrate on the cost of the entire value chain,” admitted Riess. “On pricing we will look at how we can incentivise more liquidity – in the German retail market for example. But there are different needs for different investors and we need to focus on that fact.”   Not enough added value Peter Randell, director of the new trading platform Instinet Chi-X, felt the exchanges should be seeking to reduce price through headline tariff cuts and a reduction of frictional costs as well as increasing liquidity. “While the exchanges are efficient enough, there is not enough value-add, such as offering post-trade services and support.” While Euronext's Bellgarde questioned how much "subsidised liquidity" might appear on the new entrants' platforms in their initial stages, Randell dismissed the concerns preferring to concentrate on what he felt were Chi-X's early successes. “I don’t think subsidised liquidity is the right term,” he said. “Our platform has only been going for a short term but is already going well.” According to figures announced by Randell, Chi-X now accounts for 14% of the German blue chip equities market and is soon to be adding UK equities to its books. “It is about changing the landscape. For too long the exchanges have not listened to their customers. That’s why Mifid was introduced.” According to Hugh Brown, head of secondary markets product management at the London Stock Exchange (LSE), the exchange has been reducing its prices and improving its services for some time now. “For example: we announced new tariffs earlier in the year, including a headline reduction, steepening of the volume discount and a SETS internaliser tariff for self-executions,” he says. The vast majority of fund managers are “massively insulated from exchange-trading costs” anyway, says Brown, as these expenses are dwarfed by commission costs, however there is an increasing number of fund managers choosing to use direct market access (DMA), where the commission is much lower and exchange-trading costs are of much more direct relevance. “But on the whole I don’t think fund managers will notice the changes in price too much in the short term,” says Brown. Of more importance will be the expansion of services offered on the exchanges, says Brown, and the LSE has acted accordingly. “We've broadened the range of stocks on SETSmm [the LSE’s hybrid electronic order book], increased the range of asset classes available such as real estate investment trusts (Reits) and exchange-traded commodities (ETCs), and introduced our new FIX-based messaging service, FIX Gateway. “We are also bringing in order-driven trading and central counterparty support for a lot more securities,” says Brown. This includes incentives for those trading in the less liquid stocks to provide more liquidity for fund managers to consume. “We have a market maker scheme which rewards those liquidity providers that go up in greater size and tighter spreads.” It is a scheme that Brown believes is already showing dividends given that the exchange’s biggest year-on-year growth has come in SETSmm (3.3m trades in July 2007, an increase of 150% on July 2006). Providers from both the old and new sides of the market are, however, warning fund managers to look closely at any prices they are quoted and to consider what their total cost of trading will be should they decide to go with the new execution venues or take advantage of reduced prices from the traditional execution venues. As Chris Pickles, manager, industry relations, BT Global Financial Services, and also a member of the Mifid Joint Working Group, says: “A new entrant could be cheaper than the existing exchanges because of lower infrastructure costs. For example, an investment bank could offer fund managers the same price as the exchanges but without having to pay the exchange membership fees and the associated costs of exchange membership. However, at the same time, there may be an added expense as a result of the fact that a new entrant may not have the efficient clearing system that generally comes with exchange-based trading.” And then there is the cost of the related services. Brown of the LSE points to the costs associated with Project Boat, a newly-formed consortium of investment banks that provides trade reporting data to fund managers. “If you look at Project Boat for example, we charge 6p per trade report and you get the data that comes out of that for free as part of your data licence with us. If you do not have a data licence with us, then we charge £3.50 per month for the OTC data. Project Boat is charging £82 for its OTC data and also charging for delayed data, which we give away for free. So I don’t think that going with one of the new entrants will necessarily reduce costs and fund managers need to be aware of that and be careful of what they allow to happen with their trades.” 07_09_exchanges_mifid_frith.jpgFund managers
But what of the fund managers? What do the heads of dealing want to see and expect to see as a result of Mifid? “Competition is good if it brings about better pricing but it also brings with it the challenge of a fragmented market,” says Ian Firth, head of dealing at Morley Fund Management. “The more fragmentation there is, the harder it will be for us to find the liquidity we are looking for.” Admittedly, Europe has not reached the level of fragmentation that there is in the US, where there are as many as 40-60 pools of dark liquidity and the fragmentation will not happen overnight but, as a consequence of Mifid’s best execution policies, there is an obligation for fund managers to explore all available avenues and liquidity pools in order to give their investors best execution and Firth says he is not convinced that “there are any measures in place to prevent fragmentation becoming unmanageable”. A look at the current pattern of trading in Europe shows that there is already a fair amount of fragmentation in the market, with estimates that between 30% and 45% of Europe’s equity trading is done off-exchange, while exactly half (50%) of the UK’s equity trades are done off-exchange, meaning that a slight increase will make exchange-based trading the minority. Whatever happens to the liquidity as a result of Mifid, there will not be an immediate change in the landscape as of November 1. As yet, of the new entrants, only the Instinet Chi-X platform has started operating, while Project Turquoise and several other investment banks considering systematic internaliser status are not expected to be up and running until the second quarter of 2008. Until then most fund managers seem content to see what happens rather than decide on a pre-emptive strategy as to where they place their orders. “We don’t want to be seen directing any broker to a particular venue and we will have to go where the liquidity is, but we will need either some form of aggregator or be able to trade across multiple venues,” says Firth. “Smart order routing is a must if we want to get an aggregated view of liquidity.” Fund managers will have to undergo a lot more analysis of the market and the movement of liquidity, says Firth, but the problem is that too often they are not able to compare like with like. “We use transactions costs analysis but what is the primary benchmark to use? VWAP? Trades are reported by brokers but there are all kinds of data issues which are complicated now and will get more complicated post-Mifid.” Technology solutions Technology will certainly be a solution, says Firth, and those that innovate can be successful but the rate of technology change is so rapid that innovation may lead to even more fragmentation. For example, in London there looks likely to be the LSE and two new rivals – Chi-X and Project Turquoise, he says. “But with technology there is nothing to prevent another new entrant coming in and undercutting the pricing of the new entrants.” Will the traditional exchanges’ claims to integrity hold sway with any fund managers when considering which execution venues to use? “We’re concerned about the integrity of the market but we have to consider any new source of liquidity even if we do not end up using it,” says Firth. “We have to make a judgment for the benefit of our clients so we cannot have the luxury of choosing to stick with the traditional exchanges. If you get a series of settlement failures at one of the new venues then this will obviously make you wary but until that point, every source of liquidity has to be considered.” Fe

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