Last month a group of seven investment banks got together to announce that they planned to launch a pan-European MTF to compete against Europe’s incumbent exchanges. Chi-X, a pan-European MTF run by Instinet, also launched, injecting a real dose of competition into the business.
While the clients of stock exchanges will be pleased to see competition erode the pricing power of exchanges and can look forward to lower exchange costs, the flipside to exchange competition is liquidity fragmentation.
Competition might lead to lower explicit trading costs but fragmentation risks raising trading’s implicit market impact costs because a drop makes a much bigger ripple in a small pond.
In order to mitigate this, traders will be forced to reduce the size of their orders and send many more.
This at least is the US experience since competition between exchanges took off in the mid-1990s. Brokers claim that liquidity seeking and aggregating technologies can connect small puddles into larger pools. This is true to an extent, but it normally still requires traders to break up their block orders into a number of smaller ones.
While brokers in Europe complain about high exchange fees, brokers in the US complain about the difficulties they face in trading blocks.
What this should teach Europe is that there is room for competition between liquidity venues along the lines of models of trading and price formation as well as service price.
Alternative block trading venues such as Posit and Liquidnet have been active in Europe for several years now. Although they have had some success they have been held back by disappointing volumes.
If competition between Europe’s incumbent exchanges and alternative but fundamentally similar venues takes off in the next few years and liquidity fragments, the ability to trade in size will become more valued and so too will those venues that can offer it.
