There is a very old joke about a couple motoring to a lunch party in the English countryside. They end up getting hopelessly lost. Just when they are starting to truly despair, they happen upon a local rustic, the wisdom of ages etched upon his face. They tell him of their lunch-time rendezvous, asking for directions. "Well," he replies, "if I were going there I wouldn’t be starting from here."
A quick glance over the Atlantic at the fragmented, complex, bits-and-pieces nature of institutional equity trading would surely provoke most European buy-side traders to say they wouldn’t want to be starting from there. However, following fizzy pop (that’s soda for US readers), chewing gum, shopping malls and High School Musical, it looks as if another piece of unwelcome Americana might soon be washing up on Europe’s shores.
Cheaper trading promised
In September, the much-heralded Turquoise is set to begin trading European equities. This initiative, dreamt up largely by US investment banks, promises to make equity trading cheaper by breaking the long-entrenched quasi-monopolistic position of the established exchanges. It is not alone. This is a bandwagon that seems irresistible and unstoppable. Coming to a screen near you there will soon be Bats, Baikal and SmartPool to compete with the already established Chi-X and Euro-Millennium. As the old US comedy Soap used to say: "Confused? You soon will be."
These electronic trading venues are fashionably described as multilateral trading facilities or dark pools. In truth, they are little different in concept or aim to the less sexily entitled electronic communication networks and alternative trading systems that revolutionized US trading in the late 1990s, such as Archipelago, which was acquired by the New York Stock Exchange in 2005.
They are already having an impact. Chi-X aimed itself foursquare at the FTSE 100 stocks when it launched in March 2007. By most estimates, it is now capturing 15% of the trades in these companies. The onslaught from Chi-X, Turquoise and other MTFs is also weighing on the share prices of the European bourses. The London Stock Exchange is particularly hard hit, down 60% from its highs.
The LSE has always been vulnerable. This is not because its technology is poor. Far from it – in February 2007 when both Euronext and the NYSE suspended trading, the market was still functioning in London. Since then the exchange has introduced TradElect, which is leading edge. London’s problem is that it has always been too narrowly focused on cash equities. First, it failed to develop a presence in clearing and settlement when Taurus blew up. Then, it had Liffe stolen from under its nose by Euronext.
The acquisition of Borsa Italiana last October does at least give it a toehold in the lucrative clearing and settlement business. But this field is also becoming hyper-competitive, with the mighty US DTCC making boastful claims about its fledgling EuroCCP offering a WalMart solution that can crack the current vertical integration of trading and settlement infrastructure. However, any claim to the high ground must be set against the fact that it is a monopoly provider in its home market.
Market data devalued
With equities trading under threat from the new MTFs, and clearing and settlement revenues also the target of new players, the picture does not look good for the incumbent exchanges. Their other big source of income is market data. But if the market is fragmented this data becomes less valuable. Theoretically, there might be a bigger pie for all, but why would anyone sign up for market data from 15 sources, especially if true liquidity actually resides in dark pools?
Competition should be welcomed. However, it is far from clear that traditional buy-side traders will necessarily benefit from fragmentation of liquidity sources, for all the promise of so-called intelligent order routing. If you have to demonstrate best execution, outsourcing it to a sell-side operated algo does not seem the most rigorous approach.
MTFs, in spite of all the exciting talk about minimal latency and tapping new sources of liquidity, are in many ways quaintly old-fashioned. They are user-owned with a faint whiff of the old boys’ network, rather like good old-fashioned, pre-demutualization stock exchanges.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own