Fragmented Liquidity in Pan-European Securities Hinders Transparency, Best Execution Apr 16, 2009 URL: http://www.advancedtrading.com/showArticle.jhtml?articleID=216600031
With fierce competition breaking out in pan-European securities trading among alternative trading systems and traditional exchanges, liquidity in the top 500 stocks has become increasingly fragmented across the various electronic execution venues. Amid the fragmentation, multilateral trading facilities -- particularly Chi-X -- have captured significant market share, but buy-side firms have been left to grapple with the ever more complex market structure.
While the European Union's Markets in Financial Instruments Directive (MiFID), implemented Nov. 1, 2007, paved the way for multilateral trading facilities, or MTFs, to compete with the incumbent exchanges, the alternative venues are not interconnected, and their price and volume data is dispersed (and in some cases hidden in dark pools or not required to be reported for several days), so the buy side is struggling to see the entire European marketplace. The fact that Europe -- unlike the United States -- lacks a consolidated tape to track the bids and offers on all of the MTFs and exchanges exacerbates the challenge for buy-side traders.
"At the moment, the [European] market is in chaos and everybody is going back to the usual [exchanges] because at least they have the feeling that they know what the price is," relates Mick Holman, adviser to the global chief investment officer at Axa Rosenberg Investment Management in London. "What we have here is simply fragmentation between the main markets and the venues created by MiFID."
"The major portion of the off-exchange volume is traded on Chi-X, while a decent amount is on Turquoise, BATS Europe, and with little bits going on in Equiduct Trading and Nasdaq OMX Europe," according to Anthony Whalley, investment director and head of dealing and derivatives at Scottish Widows Investment Partnership (SWIP) in Edinburgh.
Market Data Knowledge Gap
"While the MTFs have taken between 10 and 14 percent of the [pan-European] market, they have led to less knowledge on the trading desk as to where the real price and the real market are," asserts Axa Rosenberg's Holman. Further, the MTFs are mainly concentrated in the top index stocks, but most buy-side participants are interested in depth-of-market names, right down to the small-cap stocks, he notes.
Compounding this absence of market insight, there is a lack of consistency on post-trade data. MiFID removed the requirement to report all trades to the domestic exchange, so the MTFs -- numbering 10 and growing -- have different rules for disclosure of price and trade data, and trade reporting now is scattered among multiple printing facilities, such as Markit BOAT, a consortium of nine leading investment banks launched in response to MiFID in September 2006. Some MTFs even report their trades on their own Web sites.
"In order to have a tape that everyone trusts and everybody believes in and that reports in the same way and in the same fashion, you have to have levels of consistency and standards," says Miranda Mizen, principal at TABB Group. "You don't have that in Europe. Coupled with that, you have a choice of where you print, so that means you don't have the post-trade view of the market that we used to have."
Adds Axa Rosenberg's Holman, there is a "price reference waiver and size waiver [as part of MiFID] where the MTFs don't have to show what they've done as long as they are within the price -- or bid/offer spread -- or the normal market size." In addition there are rules in place for block trades that permit the reporting of trades up to five days after the deal. As a result, buy-side traders can't even confirm the total volume in a stock, he adds. "You could miss an awful lot of data."
Adding to the complexity of Europe's market structure -- not to mention the dearth of available market data -- is a wave of dark liquidity pools, which of course do not publish their prices. What's more, the "lit" MTFs -- including Chi-X, BATS and Turquoise -- now offer dark order types for hidden liquidity.
"[With] all the dark pools, you've got to go into each one to see if there is a match and wait," says Axa Rosenberg's Holman, explaining that the dark pools try to cross internally before sending the order to an external marketplace. "That leads to a worry that you will miss the best price [elsewhere]."
The lack of transparency created by the fragmented market and incomplete market data has emerged as a common theme among buy-side traders, notes Rob Maher, head of European sales at Credit Suisse Advanced Execution Services (AES) in London. "They used to be able to look at the primary exchange and know what was going on in the individual stock," he says. "In this new environment it can be challenging to know where and how a stock is trading," says Maher.
Coping Mechanisms
So how is the buy side coping with the lack of consolidated market data and navigating the fragmented European market? Other than buying the consolidated data from Bloomberg or Thomson Reuters, which allow users to view the aggregated data from exchanges and MTFs along with real-time market share figures, traders can go to the individual MTFs' Web sites, which provide free real-time data. But consolidating the data is time-consuming and costly.
Kevin Chapman, managing director and head of trading at San Diego-based Nicholas-Applegate Capital Management, says he relies on a Bloomberg screen that shows the volume distribution of a stock -- for example, how much was done on the London Stock Exchange versus Chi-X or Turquoise. But, he notes, since under MiFID many block trades are not reported in real time and other trades are not printed at all, even Bloomberg can't provide a complete picture of the market. "Europe is going to need a consolidated tape feed so we can see [all] the prices at the time of execution," Chapman says.
Other buy-side firms are counting on their brokers to provide the consolidated data. For example, Bloomberg Tradebook, the electronic agency broker, built a montage across the exchanges and MTFs that shows full market depth with built-in data feeds. "If an exchange has not traded that security in a minute, the color changes from green to amber so clients can see if certain markets are fading in terms of their liquidity," explains Jim White, global manager, equities and algorithmic trading, at Bloomberg Tradebook.
In addition Fidessa, a global supplier of trade order management systems, has created the Fidessa Fragmentation Index (FFI) to track the market's shifting liquidity patterns. "We created this index based on a mathematical formula, which is the average number of venues you would need to visit to trade a particular number of stocks," says Steve Grob, director of strategy at Fidessa in London.
Though the buy side can purchase the consolidated data from vendors, the cost of getting that data is far higher than the cost charged by a consolidated feed provider, points out SWIP's Whalley. And on the post-trade side, even though "The FSA [Financial Services Authority] has tried to reiterate the guidelines as to how trades should be reported," the trade reporting still is "a nightmare," Whalley adds, reiterating that not all of the price and volume data is visible because of inconsistency in reporting requirements.
The lack of transparency is a concern for the buy side because they have many more venues to consider when making their best-execution decisions. "In my view, they are struggling due to the opacity," comments Roland Bellegarde, group EVP and head of European execution at NYSE Euronext, the multinational exchange conglomerate. "Investors have difficulties comparing the trading venues," he says. "It's not like the U.S. where best execution is based on the execution price, and there's not a single mandatory place to report the trades to."
In January the Financial Times reported that Equiduct Trading, Chi-X and BATS Europe had discussions about launching a consolidated data service. Equiduct, majority-owned by Boerse Berlin, has a real-time complex event processing engine that pulls in prices from seven venues in Europe at millisecond speed. Equiduct then calculates the volume-weighted best bid and offer, or VBBO, as a benchmark price. "There are a number of parties who provide a consolidated tape," says Artur Fischer, co-CEO of Equiduct Trading. "What the industry needs is a standard that everybody accepts."
Staying Connected
Given the fragmentation of and lack of transparency into the European market, buy-side traders tend to lean on the sell side to stay connected with the multitude of venues and to help them attain best execution as mandated under MiFID, according to SWIP's Whalley. "The vast majority of buy-side traders are relying on their brokers to ensure that their orders are spread around using smart order routers to achieve best execution," he says.
Though buy-side firms could request sponsored access from their brokers and trade directly on the exchanges and MTFs, many are reluctant to do that. "The buy side can go direct, but do they want to?" asks Whalley. "If there are a half a dozen venues to go to, by the time I've manually sent it to one, then to another, the stock could have traded massively in the one I didn't send it to," says Whalley.
"One has to appreciate that orders are going to and from markets in nanoseconds," he continues. "The whole process has sped up dramatically as compared to five years ago, and the technology is critical in terms of executing orders efficiently," Whalley adds, suggesting that most buy-side firms don't have the same connectivity as is offered by the sell side.
According to TABB's Mizen, "The brokers tend to have the infrastructure that is geared up to access all the markets." In fact TABB Group estimates that global brokers spent approximately US$950 million on order management and execution management systems, algorithmic trading, market data and compliance modules. "They have to spend that to be able to trade across Europe," says Mizen, who notes that some buy-side firms also have been investing in execution management systems, so they are equipped with algorithms and smart order routers that allow them to conduct some trading themselves.
Axa Rosenberg's Holman says the investment management firm relies heavily on its EMS to direct order flow. "You have to have a good EMS system and then make sure it has the appropriate links to all of the major places where you are likely to see volume happen and have algorithms that will work across [those venues] that are transparent to you," he explains. "The other way is to find a series of brokers [that] you trust and have their own smart order routing systems behind them and measure those brokers to make sure they are performing."
George Andreadis, head of liquidity strategy for Europe at Credit Suisse AES, confirms that the buy-side firms and hedge funds are tapping the sell side's technology for connectivity, citing the infrastructure overhead and complexity. "The most common way [for the buy side to connect to venues] is to pick amongst your existing brokers which have the capability to access multiple venues with their smart order routers -- not only the lit venues, but the dark venues."
But not all connectivity is equal, adds Andreadis. "Contrary to popular belief, there can be differences in how smart SORs [smart order routers] can be. For instance, let's say you have five different venues and some offer lit liquidity as well as dark liquidity, and some clients using passive strategies want to rest liquidity on the order books. An SOR has to know where the stock is trading in each name and then allocate portions of the order to the appropriate venues," he explains. "SORs have to be smart to make that allocation in the first place, and then if the volumes shift the SOR has to dynamically shift the orders it initially placed."
According to Gary Stone, global director of trading research and strategy at Bloomberg Tradebook, "The buy side wants to make sure their orders are getting all the available liquidity." To meet this demand, in February Bloomberg Tradebook released a sophisticated smart order router called SOAR (Smart Order Algorithmic Routing), which is capable of performing liquidity and price sweeps and is integrated with a market-depth feed across all the European venues. "Basically, the first thing that SOAR does is answer the question, 'In a fragmented marketplace, how do I smartly and intelligently deliver orders?' " says Stone.
But while the sell side claims to smartly and intelligently deliver orders, the buy side wants proof. "Really, with these MTFs we want to make sure we are seeing liquidity, and we want to make sure that we are being represented," Nicholas-Applegate's Chapman says.
To ensure that representation is comprehensive, Chapman advises, the buy side should examine potential brokers. Do they have the fastest connections to the venues in which they trade? Are their routers colocated in the same data centers as the venues? Is it possible that another trade could get to the venue ahead of yours?
Ultimately, Chapman adds, he doesn't want to be in one location and find out his firm missed out on potential executions elsewhere. "That's happened in the U.S.," he says. "You think you're in three or four locations, then you find out that the broker was not representing you in those locations."
Part of the problem, according to Dhiren Rhawal, managing director at Quod Financial, a trading technology provider in New York and London, is that different brokers can define "best execution" differently. "Each broker can define [its] own best execution policy in Europe" based on the venues to which it is connected, Rhawal claims. "There is some noise about what 'best execution' means in Europe," he adds, noting that brokers will connect to the venues that have the liquidity.
Nicholas-Applegate's Chapman says the buy side has to ask brokers point-blank if they plan to access certain venues: "What are their plans to expand into these other MTFs, and if they start getting volume, will they represent us in the other names they're trading in?"
According to SWIP's Whalley, it's up to buy-side firms to ask the sell side for destination reports -- on a weekly, quarterly or monthly basis -- so they can check whether the broker is routing orders to the most efficient destinations. But checking on the brokers does not necessarily need to occur on an order-by-order basis, he says. Rather, if a buy-side firm looks at its top 10 brokers, it could find that nine executed 50 percent of its orders on the LSE, 20 percent on Chi-X and the rest elsewhere, while the tenth broker executed every order against its internal dark pools. This type of comparison, Whalley says, "gives you the ability to police what the brokers are doing."
But with so many MTFs, even such policing isn't a guarantee that a buy-side firm will get best execution from the sell side on all of its orders. And simply trying to stay connected to all of the venues -- even via brokers -- is an expensive proposition.
"Trading is not cheap. They have to invest in technology," says TABB's Mizen. "The cost of trading hasn't come down and probably won't come down until we see some changes in the clearing and settlement environment."
Several industry observers predict that MTFs will start to consolidate over the next nine months. "I can certainly see there will be a fallout -- there will be a number of players that will disappear," contends Equiduct Trading's Fischer.
In the meantime, however, buy-side firms still need to be connected to most venues because there is no requirement that they route to each other, adds Harrell Smith, SVP, product development, at Portware, a leading EMS provider. "Until this market really shakes out," he says, "the mandate is with our clients to explore all sources of liquidity."
Given the evolving fragmentation in the European market, however, some market participants have begun to question the wisdom of MiFID altogether. "I say, 'Why bother?' " comments Axa Rosenberg's Holman. "Get rid of the MTFs and get rid of the dark pools."
Holman proposes that a pan-European regulator run the pan-European markets under centralized rules. "I still don't see what is wrong with having one single pan-European market where orders can be placed there in any fashion you like, but it's regulated by the official European regulator," he says. "It would get rid of duplication."