Given that Europe’s exchanges are now run for profit – an ethos that may be compounded by prospective mergers with expansionist US exchanges – users complain that their needs have become secondary and are threatening to set up their own pan-continental multilateral trading facilities. Dan Barnes explains.

It seems only a short while ago that the state-of-the-art thinking about stock exchanges was this: biggest is best and publicly listed is better than mutually owned.

But that was before the Market in Financial Instruments Directive (MiFID) made its impact felt and banks began to discover the disadvantages of exchanges owned by shareholders rather than users.

Now the arrival of new trading platforms is going to give the buy-side and sell-side an array of different choices. Prices will be transparent as never before – as stipulated by MiFID – but liquidity may become ever more fragmented as it is spread around the new venues.

The great hope for the major European exchanges is still that they can consolidate, cut costs and remain the focal point for business. But they need to move fast to prevent the newer platforms from stealing their thunder.

The situation is complicated because the US exchanges – NYSE, AMEX and Nasdaq – are also trying to get in on the act, driven by over-regulation in their domestic market. Regulations such as those of the Sarbanes-Oxley Act have deterred foreign companies from listing in the US and so American exchanges are trying to diversify into Europe – Nasdaq by tying up with the London Stock Exchange (LSE), New York Stock Exchange (NYSE) by merging with Euronext.

Heavy hand of regulation

In the equity markets it appears that the heavy hand of regulation is causing all kinds of consequences, some intended and others less so.

Not for the first time, US regulation is creating business opportunities in Europe. The Eurobond market grew up on the back of US restrictions and now Sarbanes-Oxley, with its corporate transparency and accounting stipulations is helping to stage a repeat performance.

In Europe, with MiFID due to be implemented in November, some investors are concerned that the price transparency that the regulation seeks to promote may unintentionally cause liquidity fragmentation.

Simon Thompson, head of strategic accounts at Barclays Global Investors, says: “There is a balance to be struck between price and liquidity. Competition should certainly help to reduce the total price of trading, however, split liquidity can make it difficult for the buy-side to formulate trading prices. Quite simply, they have to cover more venues and manage more data.”

Part of the banks’ response in the new environment is driven by their disillusionment with publicly-owned stock exchanges. However, their initiatives have been made possible because of the new freedoms under MiFID to trade off-exchange and set up alternative platforms, or even to become systematic internalisers and trade on their own account away from any platform.

Two-pronged attack

Exchanges have two lines of business that will be challenged by the banks. The first line is market data provision. A trading organisation supplies the exchange with the prices at which they are trading. The exchange consolidates this data and forms a price list that is supplied to the banks at a cost, something that Peter Randall, director at trading venue Chi-X, says “really annoys the banks because from their perspective, it’s their data in the first place”. The price list provides an advantage for the buy-side in that it is a definitive guide and so assists with their own price formation.

The second line of business is creating a venue at which buyers and sellers can meet. The exchanges gain income by charging banks fees for trading on their platforms.

Nine investment banks, ABN AMRO, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, Merrill Lynch, Morgan Stanley and UBS, announced in October that they would build a platform called Project Boat to publish price data coming from the off-exchange trades they can now carry out as systematic internalisers. In publishing this data, the banks are challenging the income of the exchanges, says Alasdair Haynes, CEO of IT provider ITG. “If Boat succeeds and a significant amount of trade reporting moves onto it, it will affect the exchanges. The price you can charge when you have an effective monopoly compared with the price you can charge when you have 50% of something is very, very different. I think that’s very beneficial to the market place because the price of data will move. That’s got to be good news for transaction costs in the market place,” he says.

The banks are also challenging the exchange as a trading venue. In November, the same group of banks, minus ABN AMRO and HSBC, announced that they would be taking advantage of the relaxation of the rule that previously placed limits on trading stocks away from national exchanges. As MiFID allowed the creation of non-exchange trading venues called multi-lateral trading facilities (MTFs), the banks decided they would build one, calling it Project Turquoise.

The announcement was met with some scepticism at first, with many in the industry dismissing it as “sabre-rattling” – forcing the exchanges to drop their prices by threatening the exchanges’ income stream. However, a spokesman for Turquoise assured The Banker that pacifying moves on behalf of the exchanges would change nothing. “Project Turquoise will not be derailed by any price reduction on the part of the exchanges” he says. “It is in the best interests of the European market to be more competitive.”

Project feasibility

In combination, the two projects are a force to be reckoned with. Technology is inexpensive, making set-up costs for the trade reporting and trading platforms low. One of the biggest challenges will be moving trades away from an exchange and onto the new platform. The ability to find buyers and sellers, the liquidity of a market, is crucial to keeping it alive.

Where the banks have an advantage over other MTFs is in their ability to provide liquidity to a market. Turquoise’s spokesman says: “We in the consortium represent roughly 50% of the business that the LSE sees – maybe 50% of its revenues, we cannot be certain as those figures are not available – but you can calculate on the back of an envelope that we would have to waste a lot of money and go very wrong for the project to become a bad idea.”

Naturally, the banks will also seek to attract liquidity from elsewhere. They have implied that this would be facilitated by passing control of the MTF to a management group rather than leaving it in the hands of a consortium. “The group expects the facility to attract other market participants to join. We envisage that it will eventually be run by a management group rather than as a co-operative model but that it will be run with the users in mind.”

Demutualisation blues

There is some irony in this: it harks back to the mutual model that banks assisted in changing. The change has not been to the advantage of exchange users, says Jim Gollan, chairman at pan-European trading platform Virt-X. “Although you could say that banks were willing sellers in the demutualisation, public listing and subsequent disposal of Deutsche Börse, LSE and the Euronext conglomerate, has shown their users what happens at exchanges when user interests have become decoupled,” he says.

The banks are not the only group to attack the exchanges’ monopoly. Other venues are launching low-cost alternatives, hoping to attract liquidity through new models for trading and data reporting. As MiFID is intended to encourage retail investment in equities, one recently launched venture, Equiduct, specifically targets organisations that have retail orders to fulfil. Resurrecting the platform from Nasdaq’s previous foray into Europe, Easdaq, Equiduct contains two markets called PartnerEx and Hybrid. The first, PartnerEx, is a bilateral agreement market on which two parties can agree to meet, with the price to the trade supplied by Equiduct as the weighted average price across every venue in Europe.

“We have feeds from all of the stock exchanges, large multilateral trading facilities and systematic internalisers,” says Bob Fuller, CEO of Equiduct. “We create, in memory, the full depth of the European price order book for any share that is available on the PartnerEx market. In effect, we are creating the European consolidated order book in memory. So, mathematically, we should always have the best price in Europe, if we walk any incoming order through that order book, filling the trade with the best price as we go.”

Mr Fuller’s model allows for the partners to determine their own processes for clearing and settlement, another potentially expensive area of trading and, being bilateral, allows for comparatively high-speed trading because there are no delays from order routing. This is designed to appeal to the retail market as it fulfils many of the possible best execution requirements for retail brokering such as lowest cost or fastest speed.

Mutual access

The quid pro quo for trading on PartnerEx is that for all the stocks a broker offers to its partners by bilateral agreement on PartnerEx, it is also required to offer a two-way quote on the Hybrid market. Giving an example of Deutsche Bank and Santander being the only two participants using PartnerEx, Mr Fuller says that this would give the Equiduct Hybrid market all the German and Spanish stocks that the two banks provide to their customers on PartnerEx.

“If there is a better price outside of your venue but within your execution venue list, best execution rules state that you cannot carry out that trade on your platform,” says Mr Fuller.

“However, if you are with Equiduct on PartnerEx, you will always have the best price so you will always satisfy your best execution obligations to your retail protected order flow,” he says. Assuming that banks participate across the continent, he foresees this leading to an order book covering all of the stocks in 29 countries with access to a cost-effective clearing and settlement model across Europe.

Another challenger

The brokerage Instinet has also seized the opportunity that MiFID offers, launching Chi-X, a simple, central limit order book that is entirely electronic that will become an MTF on November 1, when MiFID takes effect. Chi-X is aiming to attract liquidity by undercutting the charges that an exchange imposes. Mr Randall says the MTF will target every major cost that trading currently incurs on an exchange and, uniquely, offer some organisations “Nowhere in the market rebates its participants – we will be the first,” he says.

“As far as we are concerned, market participants fall into two categories, the makers and the takers. The people that make the trade – the people that put the liquidity there in the first place – will receive a rebate. The takers, that take the trade away from the market by buying or selling the security, will pay a fee. There is a difference between the price we pay to the makers and the price we charge to the takers and that difference is 0.1 of a basis point (bp). That’s what Chi-X will take as its fee to cover its costs. We will trade report on a flat-fee basis for £210 [€320] per month. The LSE charges as much as £2.75 per trade report. And Chi-X will make its market data available for free.”

Exchange reaction

The exchanges have faced the challenge by reducing fees but this may not be enough. A spokesperson for the LSE says that it already faces competition in London, where alternative venues already exist, and that it is addressing the cost of trading through use of the latest technologies. “Our investment in technology and trading services continues to reduce the cost of trading markedly for all investors.

“Since the introduction of SETS, the average weighted spread [difference between the cost to buy and the cost to sell] of shares in the FTSE100 has reduced from 96bp to 14bp. That’s an effective reduction of £8.20 for every £1000 traded. To put exchange fees into perspective, for every £1000 traded on our market, the exchange fees account for less than 7 pence,” says the LSE.

One such established player, equity market services provider PLUS Markets Group, has been not only competing against, but also winning market share from the LSE, according to CEO Simon Brickles “It is one of those hoary old chestnuts that it is difficult to shift liquidity from an established exchange. It’s not true. We’ve started to shift it in the FTSE Fledgling that is about 250-60 companies. We’re already experiencing more than 45% of the number of trades on the Fledgling on some days. We have additional brokers joining in the next month that will take us to more than 50% in just over a year.

“Some people will be slightly dismissive as it is only the Fledgling but that is our first target. And the City is backing us. We raised £25m in December, 2006. That shows the model works. If the City thought we couldn’t capture more liquidity from the LSE, it wouldn’t be backing us,” he says.

Pricing difficulties

If liquidity can be moved, and the value of the exchanges’ price list reduces, the asset managers will have to check out multiple venues for pricing data, making accurate price formation more difficult. Although technology enables the connectivity to different venues, understanding the prices can be confusing.

At existing exchanges, different types of trade result in different prices per share, and there are multiple codes at every venue identifying the types of trade. The complexity of these codes is known to challenge even the exchanges themselves. If the exchanges have difficulty understanding the data that they themselves provide to market, it indicates that organisations trading across multiple venues could find it incredibly difficult.

Despite some scepticism about the potential threat these alternative venues pose to exchange business, highly leveraged trans-Atlantic consolidation such as NYSE/Euronext or Nasdaq/LSE, could limit their manoeuvrability on competitive pricing, says Max King, investment strategist at Investec. “If by any chance the Nasdaq were to successfully bid for the LSE, that would greatly enhance the opportunity for the banks to set up a rival platform,” he says.

“It would kybosh the stock exchange and create a huge opportunity. I don’t think the banks’ platform has really got much of a future so long as LSE is independent and is reasonably proactive and responsive to market challenges.”

Nasdaq expansion

With almost a 30% share in LSE already, the Nasdaq looks unlikely to give up the chase. This is a strategic move driven by US regulation, not purely cost, says Mr King. “The US regulators are still well behind the curve, and the result of that is they have effectively hamstrung the Nasdaq, which is basically, like the NYSE, now a stagnant market.

“The consequence of this is the Nasdaq and other American exchanges are seeking to expand overseas to get out of the cul-de-sac that they are stuck in, in America,” says Mr King.

Mr Haynes agrees that this could be a nail in the coffin of European exchanges and, therefore, pooled liquidity. “If I was [Nasdaq CEO] Bob Greifeld and all of a sudden I had to raise extra money to upgrade the bid, now I’ve got larger debt and I need to finance it. So my first move on takeover will not be to reduce my income by cutting fees. And if [the exchanges] can’t lower their costs, they are in a position where they could be threatened.

“I think that’s a worse move for him because they could fragment liquidity. It would be the first time that we’ve seen that take place.”

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