The US and European stock exchanges have long dealt with competition from alternative trading systems, but with the challenge from Project Turquoise, is this trend likely to go global? Frances Maguire reports.

There was a time when an exchange was considered a centralised marketplace rather than a monopoly, and exchanges were member owned. Although Project Turquoise was born out of the Markets in Financial Instruments Directive (MiFID), which seeks to open up competition by splitting the listing function of an exchange from trading and pricing, many believe it is a sign that the equities market has come full circle following the demutualisation and commercialisation of exchanges.

The initiative is already being echoed in Canada, where seven Canadian banks have joined forces to develop an alternative trading system (ATS), Project Alpha, to challenge the Toronto Stock Exchange’s dominance of securities trading in the country. And in Australia, the largest financial market participants have joined forces with the New Zealand Stock Exchange (NZX) to create Asia’s first electronic communications network (ECN).

Jos Schmitt, regional head, Americas, at CapCo, who heads Project Alpha, says: “Alpha is in line with the trend globally, particularly in the US, around the emergence of ATSs to create a more competitive space. The concentration of trades in a single environment does not ensure the greatest efficiency for a market. ATSs are there to provide alternatives to the exchange and create healthy competition.”

The Alpha model

Alpha will operate a fully transparent central limit order book, connected to multiple data vendors to ensure full transparency for the outside world. Participation in the ATS is open to all dealers. Launch is scheduled for the second half of 2008, pending regulatory approval. It will operate along the lines of a multi-trading facility (MTF), such as Equiduct and Project Turquoise, but there will be no internalisation or dark liquidity pool service offered.

Mr Schmitt says: “Internalisation is not something we are looking at within Alpha. Our priorities in Canada are establishing an execution venue that complies with the requirements of the industry, providing in particular the technology required to support algorithmic and high frequency trading. This will attract new business and increase the overall liquidity in the market to the best interest of the investors, the issuers and the Canadian capital markets as a whole.”

Mr Schmitt believes the ownership structure of exchanges has also played a part in the growth of ATSs. “The demutualisation of exchanges – followed by a transition of ownership to organisations outside of the capital markets industry – led to an ownership structure focused more on value creation than servicing the industry,” he says. “This shift in strategic viewpoint has created some of the inefficiencies that Alpha is addressing.”

He believes the trend in Asia and the rest of the world is likely to be similar, unless they can skip some stages, if they look closely at who should be the shareholders of an exchange.

Similarly, in Australia, the 50/50 joint venture between NZX and Citigroup, CommSec, Goldman Sachs JBWere, Macquarie Securities and Merrill Lynch will challenge the dominant position in securities trading held by the Australian Securities Exchange (ASX) with the launch of the AXE ECN next month.

Asia’s new network

Asia’s first ECN will offer trade execution and reporting services for securities listed on ASX by enabling crossing and direct negotiation between market participants, and providing execution services to support internalisation. ASX crossing rules restrict the circumstances in which internalisation, or crossing, may occur.

Greg Yanco, CEO of AXE ECN, says: “We believe AXE will have a positive impact on the Australian equity market because we will be competing not just on price but with a better market structure that will reduce the three key costs of execution: market impact, implementation shortfall and costs of delay.”

Although AXE ECN differs slightly to the Project Alpha model, in that it will not operate a central limit order book, it will enable participants to choose in which market they will execute and report their transactions, and open up competition in the same way. Much of the future development of ATSs depends on changes in regulation of these markets. Currently, some markets restrict trading strategies and many require a local presence – this is stalling both challenges to traditional stock exchanges and direct market access.

Regulatory constraints

Mark Akass, chief technology officer at BT Global Financial Services, which will help to provide connectivity and hosting to Project Boat (a consortium of banks set up to handle equities post-trade reporting) and LiquidityHub (an investment bank consortium set up to be a central fixed income pricing aggregator), says: “The regulatory regime in each country dictates what can be done in terms of alternative trading venues. In Europe, we are working with consortiums in setting up new infrastructures and this is driving change in other markets as the same participants are looking to use the same trading models elsewhere. But not all exchanges are deregulated in the same way, which limits what can be done.”

Mr Akass believes that technology is quickly enabling the globalisation of local markets and that having a common infrastructure is making fragmentation of trading venues much less of an issue. “Technology means that the buy-side community can participate in venues around the globe on an equal footing, regardless of where they are based and exchanges can attract investors outside local markets. This is driving change,” he says

Another potential challenge to the stock exchanges is the rise of so-called ‘dark liquidity pools’ in the Asian markets. The experience in the US and Europe points to a proliferation of exchanges and alternative trade venues before any kind of consolidation can begin.

Alasdair Haynes, CEO of ITG International and co-chair of FIX Protocol’s EMEA regional committee, says: “Just as in Europe, there are dominant exchanges in Asia and it is almost certain that dark pools of liquidity are going to appear in Asia in some form.”

ITG, which already operates its electronic trading system Posit Match in Hong Kong, Japan and Australia, launched its indication system, BLOCKalert, in Australia earlier this year. And it is understood that LiquidNet is waiting for approval of an indications cross in Australia. “This is a global phenomenon. It may come under different jurisdictions but there are many global companies that will be complying with MiFID and [the US’s] Regulation NMS that will want to apply the same best execution practices in Asia-Pacific,” says Mr Haynes.

It is not only the regulatory constraints in the Asia-Pacific region that are holding back ATSs, but also the disparity of the region’s markets. “Each one of these regulators within the region is being much more open-minded than they were 12 months ago,” says Mr Haynes. “If you look at the problems in Asia, quite often they are liquidity, the different regulations, the multiple currencies and different settlement systems. It is a market more similar to Europe than in the US. There is no doubt that it is behind Europe today but things are moving at a faster pace.”

The Tokyo Stock Exchange is a prime example. It is under new management and is opening up to enable more international participation. In June, it bought a significant stake in the Singapore Exchange (SGX), which has prompted widespread speculation on mergers and acquisitions (M&A) activity among Asian stock exchanges.

Mr Haynes says: “I would expect to see a series of alliances in the Asia-Pacific region, in the same way that Europe started, which could progress to a series of M&As, just as in Europe. This won’t happen in the next 18 months but certainly in the longer term.”

Instinet operates Asia’s dominant block trading network, JapanCrossing, through which about 4% of the Tokyo Stock Exchange’s total daily turnover flows each day. Also, CBX in Japan, a high-speed continuous market, is now linked directly with Credit Suisse’s CrossFinder in Asia and is gaining momentum.

John Fildes, managing director at Instinet Pacific, says: “In the US and Europe, the growth of alternative platforms was driven in part by best execution mandates. In Asia, there is still work to do on this front but, given the buy-side’s desire for competition in the trading venue space, we’re cautiously optimistic that the regulatory bodies will enact the changes necessary for alternative platforms to truly take off. Asian ECNs/ATSs are still in their infancy, but change can happen very quickly in Asia.”

Driving forces

The demand from the buy-side and the hedge funds to apply trading strategies globally, as well as the banks’ desire to globalise their operations, may be the driving force behind how other markets develop. Simon Nathanson, CEO of NeoNet, an agency broker that provides direct market access to exchanges, says that although regulation such as MiFID has served as a catalyst, the trend to trade away from exchanges is being driven by users who are looking for better execution and lower costs. “Exchanges have become monopolies. They are no longer owned by the users, and by starting something from scratch it can be very competitive, with newer technology and a much lower cost base,” he says.

NeoNet connected to three Japanese markets earlier this year, and later offered access to Hong Kong and Singapore, bringing the total number of markets accessed by NeoNet to 25.

“We expect the same trends to occur in Asia,” says Mr Nathanson. “In the US, there has been a fragmentation of trading venues and now there is consolidation. In Europe, exchanges are consolidating to protect their market share as liquidity fragments under MiFID, but the fragmentation of liquidity is a truly global phenomenon and not the reserve of Europe or the US.”

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