Exchange competition: It’s a win-win game, for now

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By:
Peter Koh
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Competition between trading venues is leading to soaring trading volumes in Europe. Brokers are reaping the benefits and incumbent exchanges have yet to feel any pain, despite the success of new competitors.

David Easthope, Celent

"Important structural changes are taking place in Europe"
David Easthope, Celent

Chi-X, still the only order-book-model pan-European alternative trading system, has made impressive progress since it launched in April 2007. Volumes have soared and Chi-X has made a significant inroad into the market share of Europe’s leading exchanges, reporting on some occasions as much as 13.18% of total trading in FTSE 100 stocks, 6.82% of Dax 30 trading, 10% of all trades in Dutch AEX 25 companies and 5.36% of CAC 40 volume.

Plus, an upstart London-based exchange offering a quote-driven market catering mainly to smaller brokers, has also shown impressive growth, winning market share from the London Stock Exchange. In the first quarter of 2008, Plus traded more per day on average than AIM. Plus also traded more than half the volume in more than 600 small and mid-cap companies in March 2008, the most recent month for which figures are available. In the first three months of the year, Plus traded 1.1 million bargains representing 6.26 billion shares worth £8.83 billion, more than in the whole of 2007.

However, European exchanges, including the LSE, continue to post strong volume growth themselves. The number of trades executed in the first quarter of 2008 on the LSE’s London order book was up 78% on the same period in 2007.

Exchanges have been able to pull off such growth while losing market share because the size of the pie is growing, which is also great news for brokers.

"Important structural changes are taking place in Europe," says David Easthope, a consultant at Celent. "New entrants have created new possibilities to trade more quickly and cheaply, attracting the type of high-frequency stat arb strategies that previously couldn’t work in Europe. This is bringing in new liquidity from a whole different client base that incumbent exchanges don’t really appeal to.

"The other reason," says Easthope, "is that regulatory changes have encouraged competition, and exchanges have responded to it by improving their own order books, technology and market data services. European exchanges, which were years behind the electronic platforms of those in the US in terms of innovation, are achieving what took years to develop in the US in a matter of months or quarters."

Volumes are also growing as a result of the increased used of algorithmic trading, which divides trades into numerous smaller ones.

Incumbent exchanges, however, will not be able to escape the effects of a falling market share for ever. While the vast majority of the volume at Chi-X is believed to come from new participants, the significance of its flows means that it is now attracting greater attention from traditional clients of the stock exchanges.

New trading venues are just as susceptible to the arrival of even newer competitors with similar models. Turquoise and Bats, both expected to launch in Europe later this year, will target a similar user group as Chi-X, although Turquoise also plans a dark book to go after larger blocks.

A growing proportion of trade volumes is becoming highly sensitive to speed, and the ability to quickly receive, manage and relay order book information is now critically important to the competitiveness of exchanges and their competitors. Consultancy Tabb Group estimates that 56% of all exchange revenues are exposed in 2008 to latency risk, up from 22% in 2003.

"It’s about time to market, literally," writes Willy Reporter, senior consultant at Tabb in a research report. "The benchmarks for speed have reduced latency in exponential terms. Open outcry was measured in seconds, whereas electronic venues now boast matching capabilities in microseconds – and the stakes are high." He adds that as matching engines within newer execution-venue infrastructures move into single-digit microsecond capabilities, this competitive advantage will need to be equalled by the traditional exchanges "or the 8% loss of market share experienced by other execution venues in 2007 will only continue to grow".

Speed is just as big an issue for brokers. Tabb estimates that if, for example, an agency-broker’s electronic trading platform was five milliseconds behind the competition, it could lose at least 1% of its low-touch flow, putting the industry-wide value of those first five milliseconds at $4 million each. Up to 10 milliseconds of latency could result in a corresponding 10% drop in revenues.