There is little doubt that the Markets in Financial Instruments Directive (MiFID) will have a big impact on trading in the European Union. With its establishment of linkages among markets and the mandate for providing best execution, MiFID's goal is to make Europe a united stock market by posting best quotes across borders. But, many industry sources say, it also is likely to provide a catalyst for increased fragmentation as well as an added push for algorithmic trading in Europe.
According to Randy Grossman, an analyst with Framingham, Mass.-based Financial Insights, the new requirements are likely to cause alternative trading systems (ATSs) such as electronic communication networks (ECNs) to emerge in Europe. "One need only look at what happened in the U.S. markets in the mid to late 90s," Grossman points out. "New order-handling rules created opportunity. When companies were made to post their best quote, ECNs saw an opening to compete." They posted data on multiple bids and offers electronically so that traders could see the data in real time, he explains. For the first time, information was available on trades made off floor-based exchanges, Grossman stresses, adding that he believes a similar scenario could play out in Europe.
Of course, any new Europe-based ECN or existing player that decides to develop an electronic trading venue would have to overcome regulatory obstacles, as well as figure out where and how it would clear its trades. The primary problem, according to Grossman, is that there are only a few central depositories in Europe for clearing, and it is unknown how an ECN in London, for example, would clear a stock that only trades on a German exchange. In spite of these hurdles, however, Grossman predicts that within six to 12 months these new competitors could be taking order flow from their more-traditional brick-and-mortar competitors, including the London Stock Exchange and Germany's Deutsche Borse.
Naturally, the exchanges will be forced to respond to retain order flow. To remain competitive, Grossman says, small market centers, such as Austria and Spain for example, not only will need to boost liquidity by increasing listings and broadening the asset classes that they trade, they also may find themselves either partnering with an ECN or building out ECN technology of their own.
Large Banks to Spawn ECNs?
While acknowledging the possibility that the exchanges could pull together their liquidity, Larry Tabb, CEO of Westborough, Mass.-based advisory firm TABB Group, says a more likely scenario would see new ECNs - either formed by large banks or through partnerships with the banks - emerge in Europe. The logic, Tabb relates, is that the large banks, such as Goldman and HSBC, would have access to liquidity that start-ups wouldn't have. Plus, they might be able to create and/or use existing clearing infrastructure to handle trades. Both Goldman and HSBC declined to comment for this article.
As far as how the European exchanges will react if and when other trading outlets emerge in the EU, Tabb says that because many of these institutions are "older, and not particularly cost-conscious, they might not respond quickly to new ECN competition." With that in mind, he adds, the biggest factor will be cost. If alternative venues formed by existing banks "can keep trading costs low, then they stand a real chance of gaining market share from the major exchanges," Tabb says. In turn, he notes, increased fragmentation may lead to an uptick in algorithmic trading as firms look for ways to find liquidity.
Thomas Price, an analyst with TowerGroup, a Needham, Mass.-based research and advisory firm, agrees that the competition to the exchanges likely will emanate from the large banks, or anyone else he refers to as a "systematic internalizer" - any firm that regularly takes an order from a customer and then crosses it with an order in another client's account, Price explains. These firms, he says, have the technology and the access to liquidity. Further, Price continues, "In many cases, they would actually prefer to do business without the hassle of dealing with the exchanges."
The two biggest advantages for big banks, or internalizers, that build out ECN technology, according to Price, are that they won't have to pay an exchange a reporting fee, and they can report trades in a venue of their own choosing, such as a Web site. Price says he believes that the exchanges will try to dissuade new market participants by lowering reporting costs. As a result, he adds, the banks will counter by clearing trades internally, providing access to liquidity and effecting transactions at an even lower cost than the exchanges (due to the lack of reporting costs) and/or storing data on price ticks (which MiFID mandates exchanges do for a period of at least five years).
Exchanges in Driver's Seat?
Tom Davin, a managing director at the Software & Information Industry Association (SIIA; Washington, D.C.), takes an opposing view. While he acknowledges the possibility that ECNs are likely to emerge in Europe, he says that it's the big exchanges, such as the London Stock Exchange - not the big banks - that are in the driver's seat, especially when it comes to data collection and distribution.
"Upstream, the exchanges have the infrastructure in place to collect market data, such as quotes. And downstream, they have the contacts and the relationships to provide data, such as trade reports to clients," Davin says. "A newcomer would be starting from scratch," he points out. As a result, Davin doesn't share the opinion that increased fragmentation - and, in turn, a demand for algorithmic trading solutions - is a certainty under MiFID.
While Jackie Chung, president of Competitive Metrics, a Toronto-based consultancy, believes that MiFID ultimately will cause fragmentation in the markets, she cites different reasons. Although exchanges are supposed to work together under MiFID, Chung says, she believes there is a cultural factor that people are overlooking. In fact, she says, "Because of the existence of national identities, it may be quite hard for some of these nations to work together, such as France, England and Germany, which have all had long, historical rivalries."
Chung adds that this distraction could cause others to develop new ATSs. This, in turn, could stimulate an interest in algorithms as well, she notes. However, exactly when - and how - this all will happen is an "uncertainty," Chung stresses.
Simon Nathanson, CEO of agency broker NeoNet, praises the technological advances made by the European exchanges. However, he says, he worries that perhaps they may "get too big, and thereby slow." While MiFID in and of itself won't lead to the emergence of new ECNs, Nathanson suggests, "slower, less-nimble exchanges" could encourage new venues, he says.
In order to compete, Nathanson adds, as in the U.S., virtually everyone - from buy-side firms to exchanges - is under pressure to realize efficiencies. And this, ultimately, will lead to the increased use of algorithms. Although, he adds, because of the way European firms do business - often by phone or in person in many instances - algorithms will take a bit longer to penetrate the region.