It is still too early to tell how beneficial MiFID has been because the promised reductions in transaction costs have yet to work their way down from the brokers to the end investors. What is clear is that the market has fragmented and liquidity no longer resides solely in the order books of the incumbent exchanges. Multilateral trading facilities (MTFs), dark pools and crossing networks have become recognised features of the market and look set to make further gains over the coming years.
While MiFID is restricted to the markets of EU member states, the alternative execution venues, the algorithmic trading software developers and the network providers are looking to expand their offerings to the emerging markets – such as the Brics (Brazil, Russia, China and India), Latin America and Central and Eastern Europe. And while these markets may have great interest from investors, the trading service providers are now discovering the challenges that await them once they venture outside of the relative comfort of mature equity markets.
“When you look outside of the European Union, there is no MiFID construct and less familiarity with the concept of multiple execution venues,” says Mark Howarth, chief operating officer of Chi-X Global, an MTF. “So we have to look at the regulatory and economic environment of each market separately.” The difference between Europe and Asia, for example, is best illustrated by Chi-X Global’s latest initiative in Singapore. Whereas Chi-X Europe, now a separate company to Chi-X Global, has been notable for its competitive opposition to incumbent exchanges, in Singapore, Chi-X Global is set to launch a joint venture with the Singapore Stock Exchange – a dark pool that will allow block trades in a range of Asian markets.
“Our overall concept is the same – that Chi-X can bring structural improvement and efficiency to each market. This attracts investors to that marketplace, increases liquidity and lowers overall transaction costs; it is a virtuous circle. Whereas the general underlying technology is the same – a central matching engine that can work very quickly and manage a high volume of transactions, the difference lies in the regulatory, legal and political issues of each national market.”
Some of these issues are easier to manage than others, says Howarth – particularly if they are more mechanical than macro-political. “For example, Australia has always been very open to foreign investors, but not to multiple execution venues. This has been our discussion with the regulators. However, the Australian market structures are changing and Chi-X Australia is set to go live in Q1 2011. But India, for example, is less accessible to foreign investors and political discussions are needed to change capital markets policy, which is outside of our sphere.”
The markets that Chi-X Global has entered so far – Japan, Canada, Australia and Singapore – would be considered as developed rather than emerging and this is a necessary condition for the Chi-X concept to thrive, says Howarth. “For there to be a multiple market construct, there needs to be a certain level of maturity present in terms of market structure, technology and volumes of listings. Investors need to be assured of the risks involved in trading less mature markets.”
However, the relative inefficiencies of the emerging markets do create other opportunities for Chi-X Global, says Howarth. “In Brazil we are currently looking to deliver an FX-based software product that will allow outside investors to transact in Brazil in a different currency, in real time, on the Brazilian exchange. This helps manage currency risk and also encourages more involvement from investors outside of Brazil. We think this may be a concept that could be replicated in other emerging markets.”
Crossing network Liquidnet, which anonymously matches orders between different buy-side firms, started off as a US company before expanding into Europe and Asia and now covers 36 global equity markets, a number of which would be considered as emerging. The emerging markets of particular interest are Poland, Czech Republic, Estonia, Slovenia and Lithuania and Liquidnet has also started trading in Mexico which it is hoped
will provide a gateway into the Latin American market.
“We have a simple operating model and it has remained consistent throughout this expansion into different markets,” says Drew Miyawaki, head of the European and Asian trading desk at Liquidnet. “From our perspective, all we need is the integration with buy-side order management systems and access to the local market data to connect to a new market. There are nuances with each market and some regulatory obstacles –– but the overall model remains the same.”
Although Liquidnet is registered as an MTF, it is quite different from most MTFs and this is a big factor in the consistent model that Liquidnet is able to bring to new markets, says Miyawaki. “All we are trying to do is provide a forum in which buy-side institutions can cross large blocks of stock without any adverse effects for either side. We are not competing for quotes and we are not competing for exchange or lit market-displayed volume. This means we do not run into some of the issues and confrontations that other MTFs would. All we are doing is adding a level of service that the exchanges cannot offer.”
When entering a new market, the initial interest comes from Liquidnet’s existing membership. The next step for Liquidnet is to recruit domestic players. “Our model is based on two counterparties matching trades so if we can add local asset managers to the existing membership, this helps everybody in the liquidity pool. The big global firms tend to have similar investment ideas and strategies and it is the domestic managers that are most likely to add contrary liquidity. So it is our job to get as many people plugged into the system as possible.”
ITG Europe, an agency broker and provider of trading services, has its primary focus on markets in its time zone, such as the Middle East and Central Europe, says Rob Boardman, head of ITG Europe. “When we look at the mechanics of trading and settlement in these markets, we see a lot of inefficiency and, consequently, a lot of potential for our services.” The lack of openness to electronic trading makes some of these markets expensive places to trade but there are signs that this is changing. For example, Tel Aviv was recently upgraded by MCSI from ‘emerging’ to ‘developed’.
“Our clients would like to trade these markets in the same way they trade on the LSE and the NYSE and there are signs that this change could happen relatively quickly,” says Boardman.
Each emerging market has its own story when it comes to the efficiency of their trading environments. Some markets, such as the Czech Republic, are not overly accommodating to newcomers as the local market makers tend to dominate the order flow. Similarly, Turkey has limited order rules that create issues for many of the electronic trading firms looking to offer services. Market data quality can also be difficult in some markets, although Boardman concedes that there is no such thing as perfect data, even in Western European markets. Above all though, Boardman would rather face technical obstacles as opposed to political ones where public policy limits the involvement of foreign service providers. “The technical challenges are easier to overcome and they are under our control.”
Boardman says he is happy with the progress that ITG has made in establishing trading algorithms in these new markets, but he is also realistic about the number of stocks that are currently suitable for electronic trading. “At the moment, we would not look beyond the top 20 stocks in some of these markets, but over time we expect to be able to cross less liquid stocks and maybe even include dark pools in the future. The long-term test will be whether the asset managers eventually treat these markets in the same way as they currently treat Western markets. Currently these trades tend to be stripped out and given to specialist brokers that trade them in different ways, but hopefully in the future they will be included in the same basket trades and executed using the same algorithms and electronic tools.”
The underlying network infrastructure and ease of connectivity is likely to play a big part in how these emerging markets develop because trading is becoming so focused on electronic execution and low latency, says Alan Schwartz, president of the financial services division of Transaction Network Services, which provides network connectivity for exchanges and brokers. “Mexico is not a tremendous market but its proximity to the US makes it easy to connect to. On the other hand, Brazil is a massive market and quite simple in its structure, but it is a long way from the US. For long-term investors who may place their orders by phone or fax, this is not a major issue, but for the increasing number of investors that are trading electronically and looking for low latency or direct access, this is an issue.”
There are a lot of infrastructure issues and concerns about the availability of local telecoms and network providers in Brazil and this makes the cost of colocation very high, says Schwartz. There is also some investor concern about the lack of history in the Brazilian financial market. “We have had more success in Warsaw which is one of the more longstanding emerging markets. We moved down there three to four years ago when the Warsaw Stock Exchange looked to revamp its system and since then we have picked up more business from Eastern Europe, such as Bucharest and Budapest as well as Istanbul.”
Is it getting to the point where the efficiency of the network and ease of connectivity is becoming more important than the liquidity within the market itself? “You could have the best network in the world but it means little if there is no investor interest in the market,” says Schwartz. “However, it is fair to say that those countries with a great deal of interest in their equity markets, but with very poor infrastructure and telecoms, are putting the future prospects of their equity markets in jeopardy.”
©2010 funds europe