In the post-MiFID market, European equity brokers are discovering that to be a smart operator, they need to be smart order routers.
Just 18-months after its implementation, it is clear that the Markets in Financial Instruments Directive (MiFID) is starting to reshape the European equity trading landscape as many predicted. Fragmentation has become a reality and several of the new breed of multilateral trading facilities (MTFs) have already captured enough market share to suggest that they are here to stay.
Chi-X, which opened for trading in March 2007, is now responsible for around 11 percent of the equity volume transacted in Europe. More impressively, it handles closer to 20 percent of the daily turnover in FTSE-100 stocks, around 17 percent in AEX 25 issues and 15 percent of the business in the CAC-40. It has been joined as a viable alternative trading venue by, among others, the consortium-owned Turquoise, which currently has a pan-European market share of around 2.25 percent, and more recently BATS Europe, which is currently seeing around 2 percent of pan-European volumes. With other new ventures planned, including dark pools and various initiatives from the incumbent exchanges, market participants have to consider where they route their trades.
The process of evaluating the benefits of trading across multiple venues started before MiFID’s implementation. The UK’s Financial Services Authority (FSA) reported at the time of MiFID’s implementation that “under particular assumptions, MiFID could plausibly be estimated to generate quantifiable benefits of up to £200 million per year in direct benefits, accruing principally to firms in the form of reductions in compliance and transaction costs.” It added: “MiFID could also generate another £240 million benefit in ‘second round’ effects…These figures could be higher under certain, stronger, assumptions. However, they could also be lower.”
That proviso has undoubtedly affected the strategic thinking of some firms, especially as connectivity comes at a cost. But many realise the benefits and a recent report from dark-pool operator Liquidnet states that a majority of buy-side firms (54 percent) plan to increase their use of dark pools. Tellingly, this figure rose to 73 percent of the European participants it questioned. But the report added that, “MiFID has not been wholly successful in ensuring access to instant liquidity in Europe. Despite the introduction of a number of new platforms in the wake of MiFID, 40 percent of European respondents said that their access to instant liquidity has actually decreased since the directive came in to force in November 2007.”
Lifting the fog
Faced with these issues and other uncertainties, some banks and brokers have so far held back because they have been unsure whether the costs of wider connectivity will be recouped through new revenues. However, the fog surrounding the post-MiFID landscape is lifting and it is becoming clearer how the market will look; this has given decision making a firmer basis.
Of course some uncertainties remain, such as how many venues can be sustained and also whether consolidation of the fragmenting European equity market will occur at some stage in the future. Nobody can be sure, but events elsewhere, particularly such as in the US where fragmentation is an established reality, provide some clues.
Another factor that has perhaps held some participants back is the fear that some of the new platforms and venues pose a threat, not only to the established exchanges, but also the banks and brokers themselves. According to Liquidnet, a third of the respondents of its survey with less than five years of trading experience believe that the sell side can be replaced with technology.
The wisdom of smart order routing
These fears obviously need to be faced and market participants will come up with the solutions that they believe best suit their needs. One solution that definitely will not work is the adoption of a head-in-the-sand strategy.
The reality is that the cost savings envisaged by MiFID are starting to occur. According to Instinet, the use of smart order routing to the new MTFs in the three-month period between August and October 2008 resulted in a price improvement per trade of 6.06 basis points. Chi-X, whose majority shareholder is Instinet, reports that in March 2009 92 percent of the trades transacted on its screens were done at a better price than on the primary exchange, resulting in an average price improvement of 2.64 basis points. Given the emphasis of MiFID on best execution, it is hard for any active equity market player to ignore such claims. Further, while figures on trading and clearing cost savings are not published, brokers active on the new MTFs talk of overall cost reductions in the order of 20%.
Various approaches have been adopted. Some firms have been very proactive and connected to most of the available venues. It would be easy to dismiss this as simply betting on every horse in a race to be sure of picking a winner; but these firms are seeing the benefits of reduced trading fees and settlement costs, while at the same time securing the ability to deliver the best prices, and by default better execution, to their clients. This includes the provision of routing by the larger players to Tier 2/3 brokers, many of whom have adopted a wait-and-see approach to the issue.
European equity markets have fundamentally changed and, while they will continue to evolve, they will not revert back to how they operated before MiFID. Banks and brokers basically have three choices:
- Continue to wait and see,
- Build or acquire smart order routing technology, or,
- Partner with a larger player to obtain direct market access (DMA).
The first option is not a realistic strategy for long-term survival, let alone success. Option three has proved popular, because the majority of implementation costs are borne by the larger player, but clearly it also carries longer-term risks of disintermediation in important areas of a broker’s business. The second option requires effort and investment, but enables retention of control of the order flow, and delivers the full benefits of lower trading and clearing costs. Experience to date suggests that these benefits will often outweigh the costs, and will allow regional and specialist brokers to become more competitive in their overall service to clients than if they partner with a Tier 1 house. And that will of course be a crucial issue in determining their ongoing success.1 The overall impact of MiFID, November 2006
2 Liquidnet’s Annual Buy-Side Voice Report