Unprecedented growth in the number and variety of trading venues will challenge even the bravest market participants
Today's capital markets face an incontrovertible truth: the world of trade execution is entering a new era. Following widespread demutualization, the staid, monopolistic, member-driven exchanges of the past have evolved into commercialized, profit-oriented organizations, where shareholder value is king. Now they face new challenges from a number of emerging platforms, technologies and new competitive threats driven by wholesale regulatory change. Will these future challenges change the way markets operate?
The capital markets have made tremendous improvements in the terms of increased openness, transparency and trade volume since the introduction of electronic trading, direct market access (DMA) and, more recently, algorithmic trading. The long-anticipated dawn of exchange consolidation through mergers and acquisitions is now well and truly "in play" and promises increased efficiency and margins and many opportunities for reducing execution costs.
The advent of the E.U.'s Markets in Financial Instruments Directive (Mifid) and its focus on increased transparency and obligations for providing customers with best execution will play further into the hands of those who champion greater competition.
Markets across Europe are preparing to engage a wave of diverse new trading models and supporting services in the wake of Mifid implementation in November. These venues, such as Projects Turquoise and Boat, are backed by bank consortiums that are eager to disrupt the status quo by offering access to their off-exchange anonymous block trading, or dark liquidity, and an alternative platform for market data services. They intend to challenge domestic bourses at the very heart of their business and revenue models.
Then there is the new pan-European exchange Equiduct, which adapted Nasdaq's European Trading System (ETS). Equiduct aims to offer internalization, best execution and market data publishing services for the post-Mifid market. Equiduct will offer two market solutions: PartnerEx, aimed at bilateral professional investor trading between market makers, retail brokers and buy-side firms; and a hybrid central limited order book for more ad-hoc trading activities.
Another model is Instinet's Chi-X, which is currently classified as an alternative trading system (ATS) but is expected to operate as an authorized multilateral trading facility (MTF) following Mifid implementation. Chi-X brings smart order routing to the pan-European equities market. This technology systematically scans multiple trading venues to offer trading participants a tool for achieving best execution in a multi-market environment.
Against the backdrop of accelerated growth in innovative new trading models and technologies, one cannot overlook the domestic bourses, which have announced their own measures, new tools and services to enable members to achieve compliance in a post-Mifid market.
An unpredictable future
With this proliferation of new trading models and services, small and mid-sized brokers have a complex and diverse set of choices. Trading venues may need to take action to allay concerns that threaten to impact their chances of success. First, they'll need to address the smaller market participants' confidentiality and competition concerns about these new platforms. Secondly, they'll have to attract liquidity to prevent them from going the way of Jiway, a joint venture between Morgan Stanley and OMX Group that launched in 2000 and closed in 2003 due to the lack of liquidity. Smart order routing may or may not be the answer with its critical dependency on extremely low systems and network latency to ensure that the prices reported are actually available to trade.
Finally, there is the underlying fact that liquidity tends to be sticky. Will the market interest in introducing greater competition to the incumbent domestic exchanges, to stimulate cost reductions and disrupt the current monopoly pricing model, be enough to open the door to newcomers?
Perhaps regulatory change, in the guise of Mifid, will be the agent that drives the market to vote with its feet. In the face of such diverse trading models, firms are set to face some difficult strategic and tactical decisions.
Fortune may favor the brave, who take big bets. Conversely, the winners may prove to be those who seek the "late mover's advantage," focusing on a strategy that enables them to be more agile and responsive in the potentially volatile early stages of this new era.
Best execution under Mifid is expected to accentuate the natural tipping point at which large-scale liquidity moves occur. Liquidity will increasingly seek those venues able to offer the most cost-effective trading, in turn bringing economies of scale and further cost reduction opportunity in a kind of self-perpetuating cycle of growth. The challenge facing trading platform owners is whether they will be able to provide sufficient differential in execution costs and pricing to kick-start this cycle in an intensely competitive environment. Or, will the larger choice of trading venues be counterproductive and inhibit the move of liquidity off the incumbent exchanges? Though there will certainly be a wider choice of venues and trading models, brokers may face fewer opportunities to choose how to execute their trades as regulation increasingly determines where they perform their business.
The European capital markets face an interesting and challenging future as trading venues fight to maximize gains from an unprecedented change in the trading environment. It remains to be seen whether this proliferation of new venues simply results in Hobson's choice for market participants—that is, no choice at all.
