In the world of trading, you have to talk a good game. Nowhere is this truer than in the European execution-venue landscape, a marketplace that is undergoing enormous structural, commercial and cultural change. Now observers are watching eagerly to see how well what has often been heralded as a new era of competition will serve the market’s long-standing players and ambitious new start-ups. Meanwhile, market participants are talking a good game and talking it loudly.
Emergence of the titans
The present state of flux can be traced back to developments that unfolded during the early part of this decade. In a mere five-year period, major exchanges across both the US and Europe moved to demutualise, actively transforming themselves from introspective, member-owned clubs into publicly traded, fully accountable and commercially competitive entities.
Two further hectic years were to follow. Enabled by rich valuations, large market capitalisations and under pressure from shareholders, the world’s biggest exchanges entered a period of intense merger and acquisition (M&A) activity. Between 2005 and 2007, the global exchange market experienced no fewer than 15 major M&A deals.
According to research house TowerGroup, more than one-third of these transactions were cross-border, while 50% of them were between exchanges operating different product sets. In this startlingly short but intense period of activity, the global landscape has been transformed beyond all recognition.
Five global titans have emerged dominant: top of the league is NasdaqOMX, following Nasdaq’s bid for the Nordic exchange operator in May 2007; NYSE Euronext is close behind after NYSE outbid its chief rival Deutsche Börse to create the first transatlantic exchange in June 2006; Eurex, after the Deutsche Börse-operated futures platform completed its takeover of the International Securities Exchange last December; the Chicago Mercantile Exchange (CME), following its acquisition of the Chicago Board of Trade; and finally, although far smaller than its counterparts, the London Stock Exchange (LSE), which – having fended off numerous attempted takeovers – acquired Borsa Italiana in June 2007.
In the battle to become global, multi-asset powerhouses, these five exchanges have collectively sucked up the vast majority of exchange-based instrument trading: together they account for some 80% of transactions in the global exchange markets in the products that they trade, says TowerGroup. Many of these players – armed with a powerful combined product mix, technological capability and brand recognition – are already proceeding to sweep up regional exchanges and purchase stakes in emerging market exchanges in order to achieve yet greater global scale.
Structural change
But the exchanges do not have it all their own way. For while self-styled commercialisation, globalisation and diversification have driven a swift period of consolidation among the largest stock exchanges, three key external forces have been working simultaneously to undermine this trend. This has been particularly true within the European cash equities trading marketplace, which itself has been thrust into a state of transition during the past 12 months.
First and most-often cited have been fundamental changes in the capital markets structure – brought about by the European Commission-led Markets in Financial Instruments Directive (MiFID) which came into effect last November. Of the directive’s several measures, the most important was the ‘best execution’ mandate to transact trades at the least possible cost. In one stroke, MiFID abolished the comfortable framework by which European exchanges had effectively operated monopolies for hundreds of years – much to the delight of the broker-dealer community that had long resented the exchanges’ easy existence in an industry that, in almost every other respect, is characterised by hyper-competitiveness.
Cheaper technology
But MiFID did not act alone. The practical barriers to competition have, until recent years, been defined by infrastructural technology costs. During the past 10 years, however, the resources with which exchange-like platforms – that is high speed, high-resilience matching engines – are built, have become dramatically cheaper. What might have cost £50m ($97.4m) to build some 10 years ago, can now be constructed and operated for less than one-tenth of historical costs. Meanwhile, the irrepressible rise of electronic trading has effectively served to standardise the process of equities trading, meaning the creation of cheap electronic equities trading platforms is now not only economically feasible but also structurally preferable.
These platforms – known under MiFID as multi-lateral trading facilities (MTFs) – are of course nothing new. Prior to the directive, Europe had already experienced the emergence of a number of (what were then generally referred to as) alternative trading systems for electronic equities trading. But these venues were disadvantaged by the pre-MiFID market structure and the high-cost barriers to entry. Now, lower operating costs should, in theory, allow MTFs to charge significantly lower fees while best execution – which is determined by price, speed and certainty of execution – more or less mandates brokers to consider execution at a number of venues.
Rise of the pretenders
Combined, these forces have created a febrile equities execution environment in Europe, in which the transition to a hyper-competitive market has been much anticipated. Thus far, several new trading venues have been announced (many of which have been long in the making).
These include investment bank-backed Turquoise, the much-discussed pan-European platform first announced in November 2006; Chi-X, a pan-European order-driven platform owned by agency-broker Instinet; PLUS Markets, a recognised investment exchange designed to compete with the LSE’s AIM market; BATS Trading Europe, the European version of the spectacularly successful American bank-backed venture BATS Trading; NYFIX Euro Millennium, another pan-European platform that also has a well-established US counterpart, NYFIX Millennium; and Equiduct, the Börse Berlin-owned venture based on a re-launched version of Easdaq, the failed platform touted as the European Nasdaq.
Presently, only three of these six announced ventures are live: PLUS Markets, which officially went live in its current form last November; Chi-X, which first began settling trades in April 2007; and Euro Millennium, which went live this year. Of these venues, Chi-X is by far the most noteworthy. During the past year, the platform appears to have fulfilled the key criteria for success in this landscape: liquidity grab. In March, Chi-X claimed that nearly 10% of the total value of trading in UK-listed companies had taken place on its platform for two consecutive days.
More importantly, in having secured market share of about 12.2% of the FTSE 100, some of the platform’s overall liquidity appears to have been gained at the expense of the LSE. Peter Randall, CEO of Chi-X, is bullish. “Our stall is separated from the competition because we are faster, cheaper and smarter,” he says, echoing the platform’s often-repeated marketing slogan. These combined qualities, says Mr Randall, will ensure the platform’s consistent growth during the next 12 months. In a year’s time, he predicts that Chi-X will have a 25% market share of the stocks traded on the LSE, as well as a 15% market share of stocks that are traded on Germany’s DAX 30, Amsterdam’s AEX 25 and France’s CAC 40.
For some, the success of Chi-X proves that there is now a strong appetite for change within the marketplace. “Our message is being received loud and clear, as proved by the extraordinary volumes we have been able to prove,” says Mr Randall. But Chi-X’s success will not go unchallenged for long. Despite the initial evidence – that new MTFs are succeeding at the expense of one of the large incumbent exchanges – the emergent MTF community will be forced to do battle within itself – as well as against the incumbent giants. This being the case, it seems pertinent to ask the question: what, if any, points of differentiation can these venues offer and on what basis do they hope to compete?
Divide and rule
Explicit trading costs are at the heart of the debate on competition in the equities execution landscape. In recent years in particular, the commoditisation of the equities business has ensured that the associated costs of trading have come under ever-closer scrutiny. To an extent, Chi-X’s platform – which Mr Randall claims is up to 10 times cheaper from execution to settlement than the incumbent exchanges – has proven that a lower-cost model is persuasive to some, particularly the hedge fund community for whom the costs of trading have proven prohibitively high.
But as Martin Graham, director of equities markets at the LSE points out, it is fee structure that is critical. Here again, Chi-X has been smart, operating the so-called ‘maker-taker’ discount model in which the MTF pays a rebate for orders that add liquidity, and charges for orders that remove liquidity.
The incumbent exchanges, particularly the LSE, are acutely conscious of the cost argument and have taken steps to reduce their costs and lower their fees: during the past year, for example, the LSE has reduced fees in three instances.
Unlike Chi-X, however, the LSE has a far more complex client base, which makes devising a fee structure more challenging. “The fee structure has to do three things: share the benefits of growth with the market; increase business on our platform; and allow firms to do new types of business,” says Mr Graham.
Price formation
Best execution is not determined by overall costs alone; it is also part-determined by pricing. In this regard, the incumbent exchanges feel they are in a better position. In her preliminary results speech in May, Clara Furse, CEO of the LSE, made reference to Chi-X, recognising its “relatively high volume in UK equities”. But she went on to note that the LSE offers tighter spreads (the difference between the ask and the bid price) for 97 of the FTSE 100 securities with the same tick size as Chi-X, as well as offering four times the liquidity at the best bid and offer. She also claimed that much of the rival platform’s success is, in fact, enabled by the LSE, against which Chi-X’s customer base – high-velocity hedge fund traders – are able to perform statistical arbitrages (a heavily computational, high-speed trading strategy that exploits pricing inefficiencies between securities).
Technology and politics
In this respect, Ms Furse claimed in her speech, Chi-X’s success is “in fact a compliment to TradElect”, the LSE’s new trading platform. This observation, self-serving as it is, aptly points to how central technology has become to the execution venue debate. Indeed, for the past 30 years, broker-dealers, and more recently hedge funds, have been at the forefront of trading innovation. But their operations and trading strategies have – to a large extent – been restricted by the capacity of the exchanges. Speed, capacity and reliability will therefore become ever-more important.
Art Fischer, joint-CEO of Equiduct, believes the MTFs will continue to have an advantage in this regard, not just in terms of cost but in terms of ongoing agility. “The old exchanges are trapped by a history of investment,” he says. To some extent, this is true. The LSE’s overhaul of its technology system cost the company approximately £40m; it would have been cheaper to start from scratch.
But as Rainer Riess, managing director of cash market business development at Deutsche Börse points out, buying a basic exchange trading system might be simple to do, “but to run one with scale, to run one with distribution around geographies, to ensure that you never lose an order, to ensure that you have the resilience that the market expects, is something that requires state-of-the-art technology”.
Equiduct and Turquoise, both of which have been slow to market, are evidence enough that the MTFs are not as agile as they would have the market believe. This is rarely due to technical problems. Steve Grob, director of strategic partnerships at Fidessa, a trading solution and connectivity provider, has been working with several MTFs on building out Fidessa’s trading connectivity platform. He says that the MTFs’ platform procurement decisions have been dogged by many considerations, “not the least of which is politics”.
It is no secret that this statement is particularly true of Turquoise. However, the putative platform’s CTO, Yann L’Huillier, believes that too much emphasis is popularly placed on the technology aspect of the debate. “I don’t promote the technology, because no matter how I promote it, what’s going to make a difference is more market participants,” he says. “If I promote the technology, it is a marketing exercise and I can twist the numbers the way I want.”
Innovation and survival
Number twisting is a common function of the present market condition. Hence costs, fees, as well as speed and capacity of technology, have been popular talking points. Turquoise has spent rather more time focusing on its market model. “You have to get the model right,” says Mr L’Huillier. This means costs, fee structure and technology; but it also implies the scope of innovation.
The rise of ‘dark pools’ (liquidity pools in which information relating to the prices and sizes of orders is not displayed) reflects a growing trend to attempt to differentiate through innovation. Turquoise and Equiduct both plan to offer some dark liquidity, while Euro Millennium is a dark pool in its entirety. “Dark pools are recognition of the fact that the market needs different tools to execute different types of trading activities: it is about how a different platform can support different trading activities and different volumes,” says Chris Smith, director at NYFIX International and head of Euro Millennium.
Flexible models
The MTFs are not the only platforms innovating in this way, however. Many of the exchanges are also reviewing their models and are moving to exploit the greater flexibility of the MTF. Swiss exchange SWX Europe has partnered with Euro Millennium, to which it has effectively outsourced dark trading. Meanwhile, NYSE Euronext has announced that it will launch its own pan-European dark liquidity MTF offering in Europe. NasdaqOMX has also unveiled plans to launch a pan-European market, due to go live in September. Both of these platforms claim to offer unique features. The Banker has also been reliably informed that the LSE plans to launch an MTF. The LSE has neither confirmed nor denied this.
No demise
As these announcements demonstrate, the established exchange giants are responding to the prospective contenders that are due to enter the market during the next 12 months. But few market participants – either MTF providers or exchange operators – now believe, as has often been said, that the demise of the exchange is inevitable – or even probable.
The smaller regional exchanges not bought by the big five, and that are unable to reduce their costs, might well find themselves pushed out of the marketplace. However, the larger exchanges will move to diversify their offerings. NasdaqOMX, for example, believes it can, by operating as both an exchange and an MTF, gain market share both from other exchanges and the MTF community. Meanwhile, successful MTFs will carve out a niche for themselves.
The trick, says Lee Hodgkinson, CEO of SWX Europe, “is to be very clear about what business you’re in and who you want to serve with excellence”. It remains to be seen which players will master this art.
EUROPEAN TRADING VENUES TIMELINE
1995: Tradepoint Financial Networks established as a direct rival to the LSE.
1996: Easdaq, the failed platform touted as the European Nasdaq unveiled.
2000: Jiway, the failed cross-border equities trading platform operated by OMX (then OM) launched.
2001: Virt-X, a later incarnation of Tradepoint, re-launched in 2001 as a cross-border equities platform.
2002: Virt-X bought by the Swiss exchange SWX Europe.
Jun 06: NYSE outbids its chief rival Deutsche Börse to acquire Eurex and creates first transatlantic exchange NYSE Euronext.
May 07: Nasdaq acquires Nordic exchange operator OMX to create world’s largest exchange, NasdaqOMX.
Jun 07: LSE acquires Borsa Italiana.
Jul 07: Chicago Mercantile Exchange acquires Chicago Board of Trade.
Dec 07: Eurex, the Deutsche Börse-operated futures platform, acquires the International Securities Exchange.
Nov 06: Consortium of investment banks announce Project Turquoise.
Apr 07: Chi-X goes live.
Jul 07: PLUS Markets becomes a recognised exchange.
Feb 08: NYSE Euronext announces SmartPool.
Mar 08: Dark pool NYFIX EuroMillennium goes live.
Mar 08: BATS Trading announces its plans to enter Europe.
Mar 08: NasdaqOMX announces its Pan-European Market.
Sep 08: Turquoise due to go live.
