Next month marks the biggest change to London's stock market since Big Bang of 1986. On October 20 the London Stock Exchange (LSE) will replace its current quote-driven system of market-makers with an electronic order book - initially for the market's top 100 shares and later, perhaps, for the whole market. This innovation, accompanied by a number of other changes to trading practices and regulations, will have a major impact on both the liquidity and transparency of the stock market, But it may, inadvertently, erode the LSE's virtual monopoly on securities trading in the UK.
This technological revolution brings the LSE into line with stock exchanges in Europe and America, where order-driven systems predominate. Under the new system, orders to buy or sell shares in FTSE 100 securities will be entered on an electronic system - the Stock Exchange Electronic Trading Service (SETS) - and executed when they match. With the largest stocks accounting for the greatest volume of trading, the stock exchange predicts that 75% to 85% of its business by value should go through SETS after the new system is introduced.
This is the latest step in a gradual move away from the LSE's traditional quirky system. Big Bang moved the majority of business from the exchange's trading-floor to computer-based dealing-rooms and ended the legal distinction between stockbrokers and market-making stock jobbers. For 10 years the city's old jobbers have fought to retain their market-making role, arguing it guaranteed a price for shares - even though investors might not particularly like the price - in any market conditions. But now they must redefine their business and learn to survive without the exclusive right to make a market in the exchange's most heavily traded stocks.
Not all the market's players are resisting the change. The order-driven system will suit many of the major trading firms whose client business as a whole has become more order-based in recent years. These firms complain that the current quote-driven system makes it hard to work orders through. The new order book will make it easier to trade close to a standard amount each day, which is more in line with the demands of international clients. "They may be more comfortable with the new system, feeling less likely to be ripped-off," comments one trader. As a result, the LSE hopes to see an increase in business from overseas investors, with the changes representing a mini-Big Bang which helps to keep London among the world's leading trading centres.
There will also be cost savings for many firms, even the market-makers. The present system is labour-intensive, with traders having to adjust prices continuously. In October, the old market-makers will reinvent themselves as intermediaries, but will remain the primary risk-takers in the market. The emphasis, however, will be on using the order book as a guide to market trends. It remains to be seen whether they can make a success of this new role.
The new system also increases the transparency of the market, another long-term goal at the exchange. Under the present system, those carrying out large trades are granted a fair degree of anonymity. Details of any deal more than six times larger than what the LSE's defines as a normal market size are not published for one hour - before 1996 it used to be three times normal market size and a 90-minute delay in publication. Now any deal up to eight times normal market size will be published immediately. Trades over the threshold can operate under the worked-principal agreement, whereby firms may seek to rework the price and size of the trade, and must then publish when either 80% of the deal is worked, or at the end of the working day.
Trading in FTSE 100 shares may still take place outside the order book for blocks that are smaller than normal market size or have non-standard terms.
The Securities & Investments Board (SIB) believes that increased transparency will not adversely affect the liquidity of the exchange. In its recent report to the chancellor of the exchequer, the board indicates that the order book will give a more accurate reflection of price in the market, but not to the extent that price becomes inflexible. And yet transparency brings the risk that LSE will lose business to more opaque markets overseas.
As traders rehearse for using the new system during weekend training sessions, some suggest that rival stock exchanges closer to home may also stand to benefit from the changes. One area in which they may gain a competitive edge is with London's inter-dealer brokers. These brokers deal exclusively with market-makers, allowing the large securities firms to avoid disclosing their positions to each other. At present, they are charged only 50 pence ($0.80) per trade, but the new LSE regulations will remove this privilege and force the inter-dealer brokers to pay the same rate as other firms, £10 per transaction.
To avoid these high charges, three of the market's four inter-dealer brokers have agreed to switch their business to a new exchange, Tradepoint, which was launched in 1995 as an alternative share market to the LSE. While three of the brokers, Tullett & Tokyo, United Broking and First Equity, will move to Tradepoint, the fourth, Cantor Fitzgerald, is rumoured to be setting up its own exchange. Tradepoint, which also operates entirely on an order-based electronic system, has been struggling to win trading volume and has yet to break even. It will charge market-makers and inter-dealer brokers £2.50 per trade.
The brokers' defection to Tradepoint represents a blow for the LSE. It may lose all larger trades and be left with only lower-value client and retail business. Certainly, one banker thinks that all block deals and business between market-makers will go through Tradepoint. As a result, London's equity market will fragment, and the value of trading through SETS will be much less than the LSE predicts. The lower trading charges at Tradepoint will represent a significant saving over the LSE's proposed fees, perhaps as much as several million pounds a year. For the inter-dealer brokers, the Tradepoint charge is substantially higher than the present system, but as one dealer puts it: "At least we will have a business."