The European Commission's MiFID review should enhance the competitive environment in Europe in a manner that will deal a second, more decisive blow to Europe's exchanges. But the latter are not going down without a fight. Writer Michelle Price

When the European Commission's Markets in Financial Instruments Directive (MiFID) was first unveiled in 2004, many market-watchers merrily predicted the demise of Europe's incumbent stock exchanges. With the outdated consolidation rule swept aside, a plethora of competing trading venues would rampage across Europe, slaying the flabby incumbents that had for too long languished in a state of monopolistic complacency.

It was a narrative destined to disappoint. Three years since the implementation of MiFID, no major European exchange has met its demise. Indeed, many of Europe's long-awaited and much-celebrated multilateral trading facilities (MTFs) continue to eke out a barely profitable existence, while Turquoise, that much-hyped broker-owned start-up, has been acquired by the London Stock Exchange, the very institution it was conceived to undermine. MTFs such as NYFIX EuroMillennium and Nasdaq OMX Europe, meanwhile, have shut up shop altogether. True, Europe's MTFs have managed to grab a chunky 35% to 40% market share of trading in FTSE 100 stocks, but this is hardly the rout that many market-watchers so eagerly anticipated.

Indeed, far from laying waste to Europe's outmoded old guard, MiFID has in fact proved considerably more benign to the exchange community than anyone anticipated. There are two key reasons for this.

First, the disruption of the global financial crisis wrought havoc in equities trading globally and led to a major slump in trading volumes across Europe. This slump in turn reduced income from the only revenue stream MTFs presently possess - equities trading. Europe's exchanges, on the other hand, were buffered by the diversification, global scale and strength of their franchises.

The second reason Europe's exchanges have managed to cling on so tenaciously during the past three years relates to MiFID itself. Not only is the directive yet to be properly enforced in some respects but, where it has been embraced, it has wrought unforeseen consequences that continue to stifle its true purpose. In particular, the fragmented and chaotic state of European post-trade reporting, combined with the lamentable inefficacy of best execution (the obligation to achieve the best possible overall cost for each order), continue to suppress fair and transparent competition.

But a much-needed forthcoming review of MiFID, already colloquially dubbed 'MiFID II', may change all of this. By plugging the gaps found in the first iteration of the initiative, MiFID II should enhance the competitive environment in Europe in a manner that will deal a second, more decisive blow to Europe's exchanges. But the latter are not conceding without a fight and are lobbying vigorously to protect their current position.

Data disorder

In April, the Committee of European Securities Regulators (CESR), which has been tasked with advising the European Commission on changes to MiFID, opened its consultation process on the review. Industry feedback was extensive, and one contentious issue that garnered more attention than any other was the chaotic state of Europe's post-trade data environment.

Although MiFID provided for competition in the trading of equities and in data reporting, it did not mandate any standards relating to how and where post-trade data should be reported. As a result, not only are trades reported to a variety of venues, but the reports themselves do not conform to a single standard.

Confronted with disparate and inconsistent data reports, trading desks - in particular those on the buy side, which tend not to be as technologically well equipped as those on the sell side - have limited visibility of the location and volume of tradable liquidity across Europe, which in turn impedes their capacity to measure execution quality. Investment managers have long been crying out for regulators to address this issue. "Post-trade data is a priority for us," says Guy Sears, a director at the Investment Managers Association (IMA). "We need high-quality post-trade data: without it, what can we do?"

The first iteration of MiFID assumes that market forces will provide a commercial, industry-led solution to the post-trade data disorder, and for most brokers and MTFs this should take the form of a single point of reference for all European post-trade data, known as a 'consolidated tape'. Despite the best efforts of many parties, however, a comprehensive and affordable commercial tape has failed to materialise for two key reasons: first, the extremely poor quality of data reports proved too mammoth a technical problem to overcome; more contentiously, brokers and MTF chiefs argue that the exchanges' inflated and inflexible trade-data pricing regimes have rendered industry efforts commercially unviable.

Indeed, while the exchanges are keen to stress the stumbling block presented by dross data, the rest of the market puts the blame firmly at the door of the exchanges' pricing regime. "Our long-held view is that a major impediment to the consolidated tape is the pricing of the exchanges for their market data and the way they bundle pre- and post-trade data together," says Mark Hemsley, CEO of BATS Europe, an MTF. According to CESR, a full set of all pre- and post-trade data from all European trading and reporting venues costs about €450 per user. "This makes it very difficult for a commercial supplier of a consolidated tape to provide the data to their customers at a reasonable cost," says Mr Hemsley.

cp/95/Mark Hemsley.jpg

Mark Hemsley, CEO of BATS Europe

A creeping assault

In its consultation paper on equity markets, CESR proposes two possible solutions. Initially, data reporting could be standardised through the creation of a new approved publication arrangements (APA) regime, whereby approved venues, such as an MTF, an exchange or an alternative initiative such as the trade-reporting platform Markit Boat, would collect and clean post-trade data.

This standardisation aspect of the suggested solution, which most agree is a critical first step to addressing the post-trade chaos, would provide high-quality data at reasonable cost, so that a commercial provider, such as Thomson Reuters or Bloomberg, could create a consolidated tape.

In an attempt to address pricing concerns, the APAs could also be required to provide their data free of charge to a consolidated tape provider after a delay of 15 minutes, suggests CESR. But, since most exchanges already supply this 'delay' data free of charge, this suggestion offers little in the way of pressure on exchange data prices. More worrying for the exchanges, however, is CESR's suggestion of possibly compelling exchanges to unbundle their data by making pre- and post-trade data available separately.

The regulator also offers a further solution. Instead of relying on a commercial provider to create the consolidated tape, the APAs and trading venues could be compelled to deliver their highly valuable real-time data free of charge to a consolidated tape that is mandated, and potentially operated, by the regulators. The market would ultimately subscribe to real-time trade reports from this mandated consolidated tape (MCT) for a fee, although data would become free after 15 minutes.

The full details and potential outcome of these arrangements, both of which have proved highly controversial, remain unclear. What is clear, however, is that the CESR consultation process represents a creeping assault on what has long been a closely guarded, sizeable revenue stream for Europe's exchange community. A glance at the annual reports of Europe's major exchanges illustrates just how important data revenues are for the incumbents: according to Deutsche Börse's annual report for 2009, some 10% of the exchange's annual revenues are generated through the fees associated with real-time pricing and trading data. At the London Stock Exchange (LSE), meanwhile, the figure is just under 17%.

By contrast, the vast majority, if not all, of Europe's MTFs provide all their data free of charge. Jarod Hillman, head of real-time data at the LSE, argues that MTFs do not operate comparable business models and this, of course, is true. As unknown start-ups, it was not feasible for MTFs to charge for data on such a fractional market share, while eliminating practically all the frictional costs associated with trading was necessary to attract clients and accrue liquidity to their markets. But the notion that trading venues should provide free of charge the pre- and post-trade data that relates, after all, to the activity of their own clients is not new, and has gained wide acceptance throughout the market in recent years. Mr Hillman protests, however, that this would be neither fair nor tenable for the exchanges.

"Exchanges should make their post-trade data available, and it should be made available in discrete services," he says. "We do not, however, share a particular view expressed in some quarters that exchanges should make their core and value-added content available free under a mandated model, especially when they are the only content contributors singled out and the same rules do not also apply to vendors' or even users' own proprietary content."

Reply and decry

The debate regarding the consolidated tape, however, has served to rephrase the pricing question and it is becoming ever harder for the exchanges to defend their position - and they know it.

"The exchanges think that these changes will be very dramatic," says Andrew Allwright, the business manager for MiFID solutions at Thomson Reuters. He goes on to add, however, that it is not a foregone conclusion that unbundling would necessarily dent revenues.

Nor is the suggestion of a slow tape delayed by about 15 minutes problematic from a pricing perspective, given that it is more or less the status quo throughout Europe to provide 'delay' data free of charge. However the suggestion of any type of consolidated tape, either delayed or in real time, threatens at least to devalue, if not to entirely commoditise, the exchanges' trade data franchises.

It is not entirely surprising, therefore, that the exchanges decry the MCT as a US invention that could not work in the larger European marketplace. Even if this proves to be the case, however, it is not an argument against making their real-time data more affordable for a potential commercial solution. MTF chiefs, meanwhile, regard a delayed tape as a poor substitute for a real-time tape that they say would provide very useful price-formation information for traders. But their argument is not entirely technical, either: the MTFs know that, in order to survive, they have to continue their slow-moving war of attrition against all the exchanges' revenue streams.

Exchange chiefs such as Christian Katz, the CEO of Swiss Exchange, argue that the price of market data should simply be determined by market forces - by competition. But, as CESR's review explicitly acknowledges, and as many other practitioners continue to stress, the dynamics of the fragmented European equities landscape renders competitive market forces powerless.

"One area where competition cannot apply is market data," says Andrew Bowley, head of electronic trading product management at Nomura, the Japanese-owned financial group. "If a trading venue has a 100% share in a country's equities or a 40% market share, that venue still has a monopoly on its own data and, as a result, it is at liberty to charge whatever it wants. Competitive forces can never work while each venue has a monopoly on its own market data."

If competition cannot work, what will? MiFID states that exchanges may charge a "reasonable" price for data, a definition that has evidently proved too vague to affect prices. Mr Allwright says the exchanges are worried about price interference by the European Commission, and these concerns may well be valid. According to one broker, Europe's competition bureaucrats have already been brought into the discussions, although no proposals on pricing have yet emerged.

The LSE's Mr Hillman, however, rejects the notion that data pricing is a legitimate matter for the competition authorities but, in what many will interpret as a concession to market pressure, the LSE has recently announced plans to split out and cut the price of its Level 1 post-trade data package.

"We feel both internally and from consulting with our clients that the time is right to launch a discrete service with separate pricing of our post-trade content," says Mr Hillman. He goes on to add, however, that the LSE is not bowing to market pressure. "We feel that we want to take a lead to make sure that we're positioning ourselves well in the context of the whole European exchanges debate."

cp/95/andrew bowley.jpg

Andrew Bowley, head of electronic trading product management at Nomura

A question of enforcement

Putting aside the arguments regarding the cost of market data and the practical difficulties in constructing a consolidated tape, few could argue with the principle that a post-trade tape of record is a vital means of providing transparency on that most fundamental of issues: execution quality.

Indeed, long before the European Commission unleashed MiFID, it was best execution that commandeered column inches and sparked debate on many an industry panel. But when the best-execution requirement finally arrived in 2007, it proved, as with 'reasonable' data pricing, little more than a meaningless fudge.

"Best execution was a very enlightened piece of the [MiFID] legislation," says Rob Boardman, CEO of agency broker ITG. "But when you read the contracts, they are all worded deliberately vaguely and are highly non-specific. There is a good reason for that, since brokers have to cater to different clients. But most of them are worded in such a way that brokers cannot fail to meet them."

This ambiguity has allowed many brokers to largely retain their pre-MiFID contracts. Research into best-execution policies undertaken by Professor Peter Gomber of the E-Finance Lab at Goethe University in Frankfurt shows, for example, that the majority of German brokers' best-execution policies have changed little, if at all, under MiFID. Taking a sample of 75 such policies and comparing their content immediately following the implementation of MiFID in 2008 and five quarters later in 2009, Mr Gomber found that 60% of policies had not been revised to rank or prioritise execution venues, and the vast majority simply cited a German exchange as the required execution venue.

MiFID aimed to create best execution as a point of competitive differentiation not just between trading venues but among brokers too, but this has also fallen short. "Competition regarding best execution does not work: informed customers provide direction on the execution venue to use, and uninformed customers don't understand the policies. It's a question of enforcement," says Mr Gomber.

Richard Balarkas, CEO of agency broker Instinet, meanwhile, argues that the persistence of bundling execution commissions with research - in spite of an attempt to put an end to this practice under the MiFID inducements rule - undermines the general importance of execution quality in the broker-dealer buy-side relationship. Furthermore, some brokers privately believe that many broker-dealers necessarily have a conflict of interests due to their ownership stakes in certain European trading venues, to which they have a vested interest in directing order flow.

Top-flight brokers would argue that they cater to sophisticated buy-side clients and make significant investments in technology to ensure execution quality for their clients. And the IMA's Mr Sears, as well as many brokers, are confident that those on the buy side are now more than capable of making an assessment on their broker's performance. "I think the buy-side traders are sophisticated enough to measure execution quality, despite the absence of a consolidated tape," says Bradley Duke, managing director and head of broker Knight Direct in Europe. "But MiFID does make assumptions about the level of sophistication of market participants."

The fact remains, however, that best execution under MiFID provides too much discretionary scope to guarantee that order flow will always be sent to the venue offering the best overall cost of trading - including tighter spreads, lower connectivity costs and fees, and post-trade services. Indeed, if this were not the case, then the MTFs would have grabbed even more market share than they have already claimed, say MTF chiefs, who argue that the current state of fragmentation obscures how competitive their offerings are.

"Our evidence shows that in many markets, we [MTFs] have the best bid and offer far more than 50% of the time, yet we don't have 50% of the market share," says Alasdair Haynes, CEO of the MTF Chi-X Europe, which has 27.5% of trading in FTSE 100 stocks. "This suggests that people are trading in worse prices, on more expensive, slower markets."

cp/95/Bradley Duke.jpg

Bradley Duke, managing director and head of broker Knight Direct in Europe

The art of lobbying

The best-execution issue is unlikely to be addressed by a potential tightening of the definition of best execution under the MiFID review, from which a thorough discussion of the subject has been conspicuously absent. In its consultation paper on investor protection, CESR does suggest requiring exchanges and trading venues to publish statistics relating to execution quality on their markets, or to provide comparable data to their clients. According to one source, however, national regulators have vigorously lobbied against this for fear that it will expose the poor performance of regional exchanges. Thomson Reuters' Mr Allwright doubts this CESR suggestion will be taken up by the commission.

In the absence of a more prescriptive and closely enforced definition of best execution, or the necessity to publish execution quality statistics, the consolidated tape assumes an even greater significance. It is the most compelling alternative means by which the industry can hope to create a recognised benchmark against which broker execution can be measured, transaction cost analysis can be performed, and by which exchanges and MTFs can begin to be ranked. As such, the consolidated tape provides the transparency required to enable MTFs to compete more effectively against the incumbent exchanges, say MTF chiefs.

"If there are markets out there with enough market share and with the best bid and offer, you cannot ignore it. A tape of record that shows that will help significantly, whereas today you cannot see it," says Mr Haynes.

If the MiFID review yields a consolidated tape in some form, as many hope and expect it to, then this could significantly damage the exchanges, in terms of both their data pricing regimes and their market share. But the exchange community is not to be underestimated. For if there is one thing at which exchanges globally have become extremely adept in recent years, it is the art of lobbying, and many in the industry believe the exchanges have the ear of the regulator when it comes to some specific issues.

In particular, the exchanges are hopeful about their capacity to attack the phenomenon of non-displayed or 'dark' electronic liquidity that has proliferated under pre-trade transparency waivers provided by MiFID. Dark liquidity undermines the importance of the major primary 'lit' markets, and it is widely acknowledged that the exchanges have fomented what has at times proved a bitter row regarding both the size and risks of European dark liquidity.

Fearing that the regulators would dramatically clamp down on dark liquidity by raising the transparency waivers under MiFID II, the rest of the market, including the buy side, is now vigorously defending its existence. As a result, it seems unlikely that the exchanges will win any catastrophic victories on this front, although small concessions relating to broker dark liquidity are possible. And even if the waivers are raised, says Nomura's Mr Bowley, there is no guarantee that what was once dark liquidity will end up on the lit books.

It remains to be seen how far the European Commission will go, but it is clear that the exchanges have more to lose than to gain. Equally, however, the tenacity of the exchanges so far suggests that MiFID II represents just the second bout in the broader European fight for equities trading.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter