European cash equity markets: The year of the MTF?

MULTILATERAL TRADING FACILITIES have so far not enjoyed the same kind of success in Europe as their cousins the alternative trading systems (ATSs) have in the US. Estimates for the total market share of European equity trading held by MTFs range from 1% to 3%. Advances in smart order routing technology, a more favourable regulatory environment and familiarity with fragmented markets in the US, however, mean that the barriers to success have been substantially lowered and MTFs are expected to become much more influential in the near future. Consultancy Aite Group estimates that MTFs could capture as much as 20% of the market by 2011.

"It used to be that if alternative venues didn’t enjoy a big-bang start that people would rapidly lose interest and they would soon fall into obscurity and die," says Richard Balarkas, head of AES sales at Credit Suisse in London. "But traders no longer have to study two screens and agonize over what may or may not happen on a new venue. Smart order routing makes it much easier to give new venues a chance. There is nothing to lose by connecting to a new venue, there is little cost involved and you don’t use up desk space as you don’t even need a screen. Liquidity could appear one day and dry up altogether the next, but it doesn’t matter because whether or not you trade on them is entirely down to the smart order routing logic. If there’s nothing going on at one venue then the machine ignores it and moves on, but if attractive liquidity re-appears, it instantly moves in and gets it."

The spread of unbundling and of commission-sharing arrangements is also freeing those on the buy side to make more choices about where they want to send their trades.

"The amount of crossing a buy-side firm could do used to be limited by the amount of execution-only trading they could afford," explains John Barker, chief executive of Liquinet Europe, a buy-side-only MTF that has been in Europe for five years. "They couldn’t trade more than about 10% of their volumes themselves on alternative trading venues because they needed to trade with the brokers to pay for other things, such as research. Unbundling, however, means that the shackles are off."

Sensing that the confluence of regulatory factors and technological development has made the European market ripe for change, numerous groups are working on setting up MTFs in Europe. At least four (Equiduct, Euro Millennium, SmartPool and Turquoise), will be ready for launch in 2008. However, according to market sources, there are dozens of early-stage start-ups looking for cash to fund their ideas.

For established US ATSs, European expansion is high on the agenda.

"I think most ATSs will look at opportunities in Europe and Asia as a way to expand," says Sang Lee, managing partner of Aite Group. "Just because they’ve been successful at home, however, doesn’t mean that they will automatically be successful abroad. They will need to really study the local market conditions and figure out how they can adapt their models. They will also find that European exchanges are in a much better position to fight off competition than their US peers were. When competition began in the US, most of the exchanges were not even electronic, so the new competitors were really able to meet previously unfulfilled requirements."

"An exchange can be more than just an order book. By building a dark pool crossing platform we are adapting to the market" Roland Bellegarde, NYSE Euronext

Meanwhile, Bats, an ultra-fast order-book-style ATS based in Kansas that has made waves by winning 9% of the US market in just 18 months, and Pipeline, a liquidity pool so dark that its matching engine is described as blind, are both actively studying the European market with a view towards either setting up in Europe or at least signing up European traders to use its systems when trading US stocks.

Competition threat

The threat of competition has jarred European exchanges out of their complacency. Some, such as the London Stock Exchange, have improved the speed and capacity of their systems to better compete against MTFs offering higher speeds and capacity, such as Chi-X; others, including NYSE Euronext and the Börse Berlin, plan to launch innovative MTFs of their own.

NYSE Euronext has teamed up with BNP Paribas and HSBC to develop a dark pool MTF aimed at the block market, an area in which exchanges have traditionally been weak. The MTF, known as Project SmartPool, is scheduled to launch in the second quarter of 2008. Unlike the SWX/Nyfix joint venture and unlike Turquoise, SmartPool does not plan to integrate the dark pool with the order book, at least initially, and will focus exclusively on catering to the sell side.

"An exchange can be more than just an order book," says Roland Bellegarde, deputy CEO of global cash markets at NYSE Euronext in Paris. "Many large market participants, such as pension funds, do not typically do small trades but what you see on an exchange is exactly that – small trades. There is clearly a discrepancy there and by building a dark pool crossing platform we are adapting to the market."

Börse Berlin’s plans are more ambitious. The German regional exchange is set to launch a pan-European trading system that will offer best execution in the form of a European volume-weighted best bid-offer price that it will calculate from the prices of all displayed order books at exchanges and other MTFs (see Equiduct: evolutionary leapfrog).