As MiFID nears its third anniversary, Nicholas Pratt examines whether the fragmentation of the securities market has been consistent and led to true competition, or if it has just created more problems to be solved
The Markets in Financial Instruments Directive (MiFID) was launched exactly three years ago with the intention of creating a harmonised European securities market. In common with many EU directives, the ambition to create a level pan-European playing field has proved difficult to achieve. While some markets, particularly London, have seen alternative venues thrive in the post-MiFID era, other markets have been slower to embrace competition and the domestic dominance of the incumbent exchanges has remained.
There have also been some unintended consequences as a result of MiFID. The competition created by alternative venues has led to fragmentation meaning that where traders could previously find all the relevant information about a specific stock on one or possibly two locations, the same stock can now be traded on many more venues making it much harder for traders to keep track of liquidity. A better standard of execution is available but it is much harder to find. So while MiFID has created greater competition and cost savings, buy-side dealers are having to spend more money on smart order routers (SORs) and transaction cost analysis in order to take advantage of these savings.
The challenge of tracking liquidity in a fragmented market is underlined by the paucity of post-trade resources available to market participants to see exactly where trades have been executed and at what price. And although it is possible to tell which markets have seen greater involvement from alternative venues and which have not, it is still unclear whether the markets with the greatest extent of fragmentation represent a better deal for buy-side traders or not.
The Fidessa Fragmentation Index is one of the best resources currently available for assessing best execution in that it lists the different rates of fragmentation at specific venues, countries, stocks or indices. The fragmentation rate is calculated by assessing how many venues a specific stock must be traded on in order to achieve best execution. In terms of countries, London leads the way with an average fragmentation rate near 2.5. At the opposite end of the scale, Spain and Italy have seen very little fragmentation.
As far as Fred Ponzo, managing partner at consultancy Grey Spark Partners, is concerned, the different rates of fragmentation are down to the levels of liquidity within each national market. “The most important thing is the liquidity. Alternative trading facilities can only be sustainable if there is enough liquidity to share around. If the available liquidity is not large enough, it will not fragment and there is no point splitting it up onto several venues.”
Even the cultural and political issues that are present in the unfragmented markets could be solved if there were enough liquidity, says Ponzo. “In Spain, you need to have a physical presence and cannot trade remotely. Also the Spanish market is less automated than others and the speed of order entry is very slow because SORs depend on complete electronic activity. But if the Spanish market was more liquid, these barriers would be overcome and there would be more fragmentation. The Euro Stoxx indices are all traded on alternative exchanges and multi-listed but if you go down from the top blue-chip stocks, then the liquidity is very small.”
Ponzo believes that MiFID has achieved its aim of creating competition and reducing costs in those markets that are liquid enough to sustain at least four competing venues. But a consequence is that we might see a two-tiered market develop where there is a pan-European market for the big stocks and a domestic-based market for the smaller stocks that cannot sustain multi-listings. However, the first thing that has to be overcome is the confusion over geography that MiFID and its pan-European template has created. “Is the geography based on the stock, the execution venue or the market participants? When we say that the UK market has fragmented do we mean UK stocks or UK dealers? In Italy there are no home-grown MTFs [multilateral trading facilities], but you can trade certain Italian stocks on multiple venues.”
According to Tony Nash, head of execution services at Execution Noble, the different rates of fragmentation are down to regulation first and foremost. “The UK has a far more open and liberal approach to embracing alternative venues and remote membership than countries like Spain for instance.” Technology has also been a factor now that SORs are in greater use. Brokers also had a vested interest in seeing competitive pressure being put on the primary stock exchanges from alternative venues in order to drive down their costs. Nash also believes that fragmentation has not been limited to the most liquid stocks and goes all the way down to the smaller stocks, but concerns over post-trade clarity and transparency still remain.
“From what we’ve seen, fragmentation has been ferociously embraced and has opened up more opportunities for HFTs [high-frequency traders] and arbitrage traders, but it is less clear whether fragmentation actually aids best execution. There is no consolidated tape – the Fidessa Fragmentation Index is the closest thing to it. Brokers can tell you where you’ve traded but they don’t look at where you should have traded. This is what fund managers should be asking – if 8% of their trades have been executed on Bats [a trading venue], is that underweight or overweight compared to the market for those stocks?”
For others, such as Richard Balarkas, CEO and president of agency broker Instinet Europe, the issue is competition, not fragmentation. “We have plenty of evidence that fragmentation has not only reduced exchange fees for traders, but also improved the price at which they trade. Many critics of fragmentation fail to acknowledge that the market turmoil of the last two years and prolonged decline in equity trading volumes are wholly unrelated to the question of fragmentation.”
Instead the criticism should be levelled at MiFID’s failure to ensure competition by forcing brokers to trade on venues with the best prices. “MiFID has not altered the market as much as it should have done. There is no obligation on brokers to find the best prices and there is no penalty for brokers that have chosen not to invest in new technology. For example, the traders capable of trading on MTFs are mostly UK-based, whereas German, French, Italian and Scandinavian and brokers predominantly trade on their national exchanges.
“Let’s not get deluded by the success of Chi-X and Bats,. MiFID has not resulted in the major exchanges competing with each other. If MiFID had been a real success, you would have Xetra, Euronext and the LSE scrapping it out over pan-European trading. An exchange is a very simple business where the aim is to get as much volume as possible across a largely fixed-cost platform. If the exchanges’ strategy is to wait for the MTFs to disappear then revert to business as usual, then MiFID will have been a disaster. It is down to the fund managers to demand more of their brokers.”
Fragmentation in Germany has not occurred to the same extent as in London, mostly because the market experienced a fair amount of fragmentation back in the 1990s when electronic trading was introduced on Deutsche Boerse’s Xetra platform which took liquidity from the six regional exchanges. According to Rainer Riess, managing director of Xetra market development at Deutsche Böerse, the German stock exchange group, MiFID has created a somewhat distorted picture of competition because many of the MTFs are not yet making money.
Fund managers and other buy-side dealers will make their choice of trading venue based on the overall economics and not simply where the execution price is lowest, says Riess. “It is not always about the lowest price, particularly if you need to spend a lot on technology to find alternative sources of liquidity but cannot be guaranteed that these alternative sources will produce the best execution. It is about the implicit cost as well as the explicit cost.”
He also refutes the charge that there is currently no competition between the incumbent exchanges. “We are seeing competition between the big exchanges in terms of trading pan-European equities and also in areas such as ETFs and IPOs where the instruments are not linked to a domestic market, but I think people are realising that it is not easy to tap into the deep liquidity pool held by a home exchange.
“European equities markets all have different tax regimes, legal structures and corporate actions so changing all of this will take a lot of time. MiFID has been a great success in terms of creating a competitive pan-European market but there are all the other issues outlined above (tax, legal structure etc) that have to be addressed before we have a wholly harmonised equities market where exchanges are competing with each other.”
Of course MiFID is currently under review by the EU’s internal markets commission and the inconsistent levels of fragmentation across different markets may be something that is addressed, particularly in terms of those markets such as Spain where MiFID is yet to be fully implemented and it is still difficult for international firms to practically obtain remote membership of the exchange. “Looking ahead, market fragmentation could continue to spread across Europe, and the EU may encourage Spain to open up,” says Lee Hodgkinson, chief executive of SmartPool, the dark pool offering from NYSE Euronext. “On the other hand, the forthcoming MiFID review could bring changes to the regulatory framework which may slow the advance of fragmentation in the next few years.”
In general, most people feel that fragmentation has gone as far as it is likely to go and is very unlikely to be reversed. Furthermore, many feel that there are greater priorities for the MiFID review to consider, such as the lack of competition in clearing and settlement, the confusion over the classification of execution venues and what constitutes an exchange, the lack of a consolidated tape facility, and the worrying increase in trades being executed on dark venues as opposed to the transparent world of the lit markets. Set against this backdrop, it is likely that the MiFID review board will consider fragmentation, despite the inconsistency, to be one of the more successful consequences of the first three years of MiFID.©2010 funds europe