In the latest round of debate about the pros and cons of internalisation, the UK’s Financial Services Authority has entered the fray with new rules governing alternative trading systems, while the US regulator is reviewing the filing for the Boston Options Exchange. Frances Maguire asks if this is about politics or truly in the best interests of the investor.A storm is brewing over the securities market, on both sides of the Atlantic, and in both the equities and the derivatives markets. The row about internalisation is one that threatens to strike at the very heart of how securities are traded, and centres on somewhat academic arguments as to whether transparency, liquidity and best execution can sit comfortably together. Put simply, the argument against internalisation is this: internalisation – the practice of matching large orders outside of the main market mechanisms so that the orders can be executed with minimal market impact – impairs transparency, which must therefore be bad news for investors.
The Financial Services Authority (FSA) is one such antagonist. It believes that greater transparency in the equities markets will protect the retail investor. In July, the UK regulator issued its final rules for alternative trading systems (ATSs) which will come into force in April 2004. They will increase the level of pre-trade transparency – requiring publication of information about orders and quotes – and, says the FSA, enhance market monitoring of trading platforms.
Yet others point out that the rules could in fact be costly to retail investments as the large orders in question are executed on behalf of pension and other funds managed by institutional players – who could see dramatic changes in portfolios when trying to manage large sell and buy orders if internalisation is curtailed. Opponents to the new regulations argue that if you accept the view that, in any market, the price should be lowered when you buy in bulk, and that you are much more likely to find a better price from someone needing to sell (a natural seller) than from someone making a market in the goods, you have, in essence, the heart of the defence against further limits upon internalisation.
Best execution
John Romeo, director, capital markets, at consultancy Mercer Oliver Wyman in London, believes that no considerations about internalisation can be made without reference to best execution. He says: “The growing market and regulatory need towards proving best execution to the client actually supports the value of internalising order flow. While best execution can be shown in the most liquid stocks, it is virtually impossible to show that trades in illiquid stocks have been executed at the best price. To further limit the use of internalisation is simply trading off risk management for transparency.”
This view is backed up by the banking associations, some of which will go one step further in saying the quest for transparency is even a little overrated by the regulators and regulated markets.
Timothy Baker, director at the London Investment Bankers Association (LIBA), says: “Transparency is a good thing only up to a point. It is the quality of the markets and the liquidity they create that need to be considered against the value of transparency. LIBA’s concern is that banks are able to serve their customer base without their needs being impeded by regulation based on the theoretical importance of transparency, to the detriment of the quality of the market.”
Defensive line
LIBA has long argued against the exchanges that have been pushing for regulators to ban internalisation, responding fairly extensively to pan-European exchange Euronext’s paper on internalisation with one of its own in May 2002, entitled Innovation, Competition, Diversity, Choice – A European Capital Market for the 21st Century.
Mr Baker adds: “There are many reasons why a bank may seek to internalise order flow besides price – to give the customer immediacy of execution or to enable transactions that customers are not able to do on exchanges or ATSs. With such a diverse industry, a diversity of products is needed.”
Earlier this year, the ATSs operating in the UK came under scrutiny from the FSA, resulting in the new rules that will come into effect next April. Some argue that the rules are highly “targeted”. Because ATSs Posit and E-Crossnet match orders at the mid-market price at set times each day, the regulations have little impact – ‘mid-market’ pricing is seen as transparent enough. But US-based Liquidnet, which has brought a very different model to Europe, is a different story. It enables firms to up-load their order books into the Liquidnet system and searches for matches between buyers and seller of equities, alerting firms when a match is found to enable them to negotiate prices bilaterally. The FSA’s demand for pre-trade transparency flies in the face of this.
Liquidnet, naturally, is unwilling at present to comment on potential outcomes or ramifications for its trading model. John Barker, Liquidnet’s European managing director, says: “We are currently in discussions with the FSA and are optimistic that we will be able meet the applicable ATS requirements to the satisfaction of the FSA and the company.”
But Liquidnet stoutly defends its model thus: as the execution size on the exchanges continue to decline, it becomes increasingly difficult for fund managers to trade their large orders. Liquidnet enables institutions to deal large block trades efficiently. Fearful of market impact and other hidden transaction costs, institutions are forced to break up their large orders into small pieces – leaving the majority of the liquidity on the trading desk while a small portion of the order is executed in the marketplace. “Searching for that liquidity is very costly. Liquidnet helps institutions eliminate those costs by bringing natural contras together and enabling them to negotiate directly and anonymously,” says Mr Barker.
Backing up
The FSA has given some ground. In the policy document posted on its website in June, the FSA states: “Our proposals to introduce pre-trade transparency obligations (ie, requiring publication of information about orders and quotes) for ATSs in a broad range of instrument markets aroused significant opposition. Some respondents observed that investors do not necessarily want or benefit from blanket pre-trade transparency where they have decided that confidential trading enables them to reduce their costs or find new liquidity that cannot be found on the market.”
The regulator has accepted that a balance between transparency and liquidity needs to be struck and has concluded that, outside of the equities markets, it will not require pre-trade information to be made available at this time. This is the biggest departure from the proposals in the original consultation paper (CP153). However, it argues that the main reason for making the distinction between equities and other markets is the larger number of retail investors in equities, as well as the greater degree of transparency already available through regulated markets.
Derivatives debate
Other markets are having a similar debate about whether on not internalisation is in the interests of the customer and the requirement for brokers to show best execution is spilling over into the derivatives market. Best execution is a slightly different concept in the derivatives market because most exchange-traded contracts are non-fungible – ie, the market for a listed futures contract usually held in one place, one exchange, in contrast to equities, which can be bought at one exchange or electronic communications network and sold on another. For futures, the market guarantees the best price. In the over-the-counter (OTC) market, where contracts are bi-laterally traded, it is a completely different story.
However, in exchange-traded futures, internalisation still occurs, where the agent (futures broker) might take the other side of an order. Here the firms cherrypick orders and profit from internalisation. Opponents to internalisation believe these orders should be exposed to customers to enable those that are not necessarily benefiting from internalisation to shop around and get a better price. But because the OTC market is much larger than the exchange-traded derivatives market, there is less transparency here than in equities. This has, in turn, led to its own problems. The trend towards anonymity is slowing because of the lack of information. Now the search is on for liquidity and information, to the extent that some electronic trading platforms are becoming more of a hybrid between OTC and exchange markets in seeking to show best prices – and moving away from internalisation.
Pragmatic Europe
In the “pragmatism versus ideals” debate, this pragmatism is more prevalent in Europe where there are better off-exchange, OTC trading and block trading practices in place at the exchanges. Eurex and, to a lesser extent, Euronext.liffe enable block trading to be carried out in some of the bigger contracts.
The London Stock Exchange (LSE) has also been one of the most innovative equities exchanges in terms of offering block trading. When the SETS electronic order book was launched in 1997, a Work Principle Agreement was established that allows firms with large orders to report the orders to the exchange’s surveillance team and depending upon the size, the order would be given time to unwind before being reported at the end of day, or when a certain amount of the order has been filled.
While some of the US stock exchanges enable crossing of trades, none have gone this far, hence the reason the ATSs were born in the US. Although the LSE does not publish the figures, it is estimated that block trading makes up around 20% of the exchange’s traded volumes.
The fact that banks themselves refuse to discuss publicly their views on whether internalising order flow should be limited or banned indicates the political nature of the issue – and the cost to their bottom lines.
The jury is still out on whether internalisation harms the investor, or simply takes order flow away from the regulated markets, hence hurting the exchanges commercially. But what is clear, as more exchanges demutualise and become for-profit entities rather than not-for-profit member-owned organisations, is that this debate can only get more intense.
