WHEN THE MARKET began worrying about the EU’s Markets in Financial Instruments Directive a couple of years ago, many feared that when they woke up on the morning of November 1 2007 the sky would be a different colour. As the deadline approached, however, the ambitious legislation, which has been billed as the most significant change in the structure of a financial system, began to look a lot less scary. The predictions of nightmare IT bills now look a bit silly and no one now expected a meltdown of any kind on day one. Although the market expects change to come about gradually, rather than overnight, the changes expected are no less profound, especially for the cash equity market, where Mifid’s encouragement of competition between trading venues has already sparked a wave of innovation.
Mifid encourages competition between trading venues directly by abolishing the special status of incumbent exchanges’ prices and the concentration rules that in some European markets forced trading to take place on a particular exchange, levelling the playing field for multilateral trading facilities and other alternative trading venues, such as dark pools, to compete. It also supports competition indirectly by compelling brokers and fund managers to communicate their execution policies to their clients, in which it is hard for them to make the case for ignoring the existence of multiple execution venues.
But while the brokerage community is all for breaking up the exchanges’ monopoly pricing power, competition also raises the spectre of what is known as the ‘F’ word in the equity market: fragmentation. Although brokers are keen to see lower exchange costs, which have spiralled over the past few years as electronic trading techniques have chopped up large trades into many small ones, fragmentation risks complicating the search for best execution and, some fear, the quality of price discovery.
"I think the real test will be to see what happens to total execution costs," says Rainer Reiss, managing director at Deutsche Börse. "Competition is good because it creates a more vibrant marketplace and lowers explicit transaction costs, but the risk is that liquidity fragmentation could lead to a rise in implicit costs, which are far more significant than the explicit costs."
In the US, the problem of fragmentation has been dealt with through the use of smart order routing technology, which quickly scans the prices being quoted at a given choice of venues and then routes orders to those with the best prices.
The problem, however, is that most smart order routers are simply not that smart. Most work by just hitting the best price being quoted at the depth being quoted and then moving on to the next best price, without taking into account the possibility that there might be more available at the first price hidden in an iceberg order.
The other problem with simply importing the technology developed in the US for use in Europe is that the definition of best execution differs. In the US, traders need only look for the best price, whereas in Europe it is recognized that best execution might mean different things in different circumstances and take into account more factors than just the price, such as the speed of execution.
"A lot of players have taken the US as their template for Europe but the situation in Europe is in fact much more complex, so we are likely to see a good deal of innovation," says Ali Pichvai, managing director of Quod Financial, an OMS/EMS (order management system/execution management system) provider. "A number of investment banks have had to go back on their initial decisions to use the basic routing formulas and to invest in adaptive, liquidity-seeking strategies that use optimization formulas to take into account latency and other parameters. This technology doesn’t exist in the US, where routing is based just on the best price quoted."
Alasdair Haynes, chief executive of ITG International, says: "I think it is clear that we will see more fragmentation but the change is going to be evolutionary not revolutionary because Mifid is allowing for gradual change. It won’t be an overnight story like Big Bang in 1986 but it will probably play out over 12 to 18 months. The danger is that people might not realize how much has changed and continue as they were, oblivious like the passengers on the Titanic who didn’t realize the ship had a hole in it until it was too late.
"But the effects of fragmentation here won’t be the same as it was in the US because the market microstructure is different. The exchanges here are much better than they were in the US when the order handling rules were introduced; their issue is more one of pricing than price formation. You have to consider both the competition effect and the fragmentation effect because the costs of fragmentation will hopefully be offset by the gains from competition. Where we’ve seen competition in the past the end user has benefited."
Fruits of completion
The market had already started to see some of the fruits of competition before Mifid formally came into effect, with Chi-X, a multilateral trading facility (MTF), making better progress than many had expected, and some of the incumbent exchanges fighting back with the launch of innovative new services.
Chi-X, run by Instinet, now offers trading in Dutch, German, UK and French blue chips with a service it claims is many times cheaper and faster than its rivals. It has been designed to be particularly attractive to high-volume statistical arbitrage hedge funds and electronic market makers, which in the US account for 30% to 40% of trading volumes but which previously found trading in Europe too slow and expensive to be profitable. It has already had significantly more success than any other MTF in Europe, capturing on some days as much as 30% to 40% in some of the most liquid Dutch blue chips such as Royal Dutch Shell and Philips.