Transformation of the securities space

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THE PANEL:

THE ISSUES

• The impact of MiFID on the securities market

• The development of dark liquidity pools and their role in the market

• Can a voluntary scheme work in the clearing space? The case of the Code of Conduct

• what models and players are best suited to the clearing business?

• Which players are best suited to the clearing business?

• Target 2 Securities: how a harmonised European settlement system will re-shape settlement houses custodians and

• The impact of the credit crunch

THE KEY ISSUE

•  The effects of MIFID on the securities market

 But John Lowrey, head of European electronic trading services at Lehman Brothers, disagreed and said that MiFID was proving a success. “From the point of view of what the regulators were trying to do, I think it’s been a very big success,” he said.

Hirander Misra, COO at Chi-X Europe, represents a platform that couldn’t have existed without MiFID. He agreed that this piece of regulation was the key to change and removed some of the concentration rules that existed across the marketplace. “It allowed some of those new entrants to come in with a commercially viable business model and challenge the existing exchanges; it’s been good for the market as a whole,” he said.

David Shrimpton, head of equity market development at the London Stock Exchange (LSE), one of the established exchanges, shared such views and added that this was just the beginning of the process. He also noted that the European legislator did not go down the route of the US and did not prescribe heavy legislation. “There is a relatively open framework for the market to provide competitive solutions,” he said. He added that it was taking time for some of the existing national barriers to come down and that the pan-European offerings coming from the multi-trading facilities (MTFs) and new venues were putting pressure on those national boundaries and creating efficiencies and market growth.

With change there is bound to be teething problems. Mr Caplen asked panellists if brokers were reluctant to connect to the new players.

Tom Isaac, global head of financial institutions, client and sales management for intermediaries at Citi, said it was still early days and that the big players were getting connected. He also pointed out that some of the platforms were not up and running yet but that it was positive to see change within established exchanges, such as the LSE, that were bringing innovation to their existing client bases.

“I think providers have to try and make it as easy as possible [for brokers] so that both execution and the back-end capabilities are simple and very quick to connect to,” he said.

He also remarked on the internalisation of trades in banks, and said that it would be interesting to see, once the market moves to the next stage, if there was enough business to sustain all the new platforms or if there would be consolidation.

Best execution is one of the hottest topics in the MiFID debate and Mr Caplen raised the subject that the EU had not provided the market with a proper definition.

Eli Lederman, chief executive officer at Turqoise, said: “Best execution is a complex topic and I think that they were right not to be too prescriptive in that regard.”

Mr Lowrey said: “The fact that the rules are not prescriptive is a tremendous benefit to growth in Europe.” As a comparison, more rigid rules in the US have been detrimental to costs and price formation, he said. In Europe, the regulatory framework allowed for more competition and brokers and exchanges were not going to be used if they didn’t measure up to expectations.

Diana Chan, CEO at European Central Counterparty, commented on the state of market readiness which some observers have described as poor. “As the regulation came into force less than a year ago, we needed to give time to the market to get up to speed,” she said. “Everything requires technology investment and there are many different demands on the same resources. Different business models are going to have different priorities.”

• The development of dark liquidity pools and their role in the market

The idea behind MiFID is to foster a competitive and transparent market. Mr Caplen asked the panellists where dark liquidity fitted into this framework. Mr Shrimpton said clients were looking for liquidity and that they were not necessarily interested in sourcing a certain amount from lit liquidity and another amount from dark liquidity, “they are just looking at execution quality”. This has promoted investment in technology and automation. “Whether on the client or broker-end, whether on the exchange and MTF end, everybody is making trading more efficient.” The fact that block trades on the lit venues have become so much bigger than they were three or five years ago has prompted clients to look for other liquidity pools. “When you are moving 10% of the securities market capitalisation, you don’t go lit first,” said Mr Shrimpton, “because the information give-up in [those] venues means that your trade, your market footprint and your implicit trading costs are too high.” He added that there was an interplay between lit and dark pools but that they have a fundamentally different proposition, and that they need to be developed in tandem but on different execution venues.

Turquoise is also going to work in both lit and dark liquidity and is going to operate an integrated market-model. Mr Lederman pointed out that smaller and smaller orders executed at higher frequency were present alongside traditional big, institutional-sized trades.

“What we have designed is a market model that reconciles the way markets are now. We have come up with a way that will marry the small order/high frequency activity in the order-book structure with people’s intentions to trade large orders,” he said.

Lehman Brothers has announced plans with the LSE to create Baikal, a pan-European MTF, and has an internal dark liquidity pool. “LX, our dark pool, is a very good product but it is only going to be as big as Lehman Brothers,” said Mr Lowrey. “If you put a dark pool into an environment that is exchange-led, a neutral environment, where that neutrality will attract order-flow of its own, I think that you’ll get something that is much more powerful.”

Mr Lederman raised the issue of defining what a dark pool really is. “A lot of the single-broker dark pools, to date, have really been about internalising small orders because it was so expensive to execute them on exchanges,” he said. “To a large degree, the new trading venues, Chi-X, Turquoise and others to come, are reworking this. People are going to look at some of the single broker dark liquidity pools in a totally different way now, and decide they might not be worth it.”

He added: “The reality is that a single broker is going to be severely handicapped but a single platform that casts a very wide membership net has a chance.”

• Can a voluntary scheme work in the clearing space? the case of the code of conduct

Designed to encourage competition in post-trade services, the Code of Conduct is self-regulatory and has no legal status. The panellists discussed whether such an initiative can be conducted on a voluntary basis or if it will have to be turned into a formal regulation, as MiFID is in the trading space. Ms Chan said that you needed to give time for the code to take effect. So far there had been a lot of requests for interop­erability, which was what the code catered for, but the market was still waiting for some of these demands to be implemented. However, she also pointed out that some parts of the code had been successful, such as price transparency. Alberto Pravettoni, managing director of group corporate strategy at LCH.Clearnet, said: “Unfortunately, the evidence [of the code’s success] is not great so far. We still have yet to see any examples of access and interoperability being brought to fruition in the marketplace.

“In Europe right now we are seeing new competitive markets and trading venues that are coming up with pretty much ­vertical silo solutions: Chi-X has come in with EMCF, Turquoise is going to come in with EuroCCP. There still is not the choice for members to use one single central counterparty (CCP) across these markets, which means effectively more time, resources and costs.

“What the Code of Conduct is trying to advocate is the ability for member firms to choose which CCP to select for their services, which will be a way to decrease costs. In order to have this, you need to have interoperability between the various parties. So far, we haven’t seen any new links being set up between the CCPs and that’s where I think there has been a bit of a mismatch between what the market has been able to do, what the European Commission wants and what the national regulators want.”

How big a problem is not having proper central clearing across Europe? Mr Lowrey said that this was a fundamental issue but he was certain that market forces would drive this to a rational solution and hoped that no legislation would be required. “What we are looking for are meta providers that can rationalise our processes. I think that there is new demand for new types of services and the market will readjust itself.”

Mr Lederman noted that the world of clearing had evolved significantly in the past few years. “If you had told people active in the European trading community, three years ago, that we would have pan-European clearing solutions at a tenth of the cost, they would have said ‘not possible’. But if you look at EuroCCP and EMCF, they did what would have seemed impossible. They’ve created pan-European clearing solutions with compelling economics. I think you are going to see this sort of thing playing out over time,” he commented.

Ms Chan said that you could not rely entirely on market forces because it could be said that the exchanges’ vertical model was a result of market forces. “I don’t think that market forces would necessarily deliver the desired results, because the platforms have their own commercial interests. And you could well see the MTF market going vertical. If some of the MTFs have an equity interest or a financial interest in the CCP they appoint, that [relationship] is going to be closed to other CCPs,” she said.

• What models and players are best suited to the clearing business?

There were, however, costs to be borne with having one clearing house for all markets, pointed out Mr Isaac: “The back offices of the large investment banks and the universal banks are set up against the current infrastructure. The cost associated with having one CCP and one settlement agent for all markets is an enormous investment, in-house and for the market. I think that there is going to be a meta layer with organisations such as Citi going to provide enhanced general clearing services.” He said that this will bring about the development of interoperability. “The CSDs talked about it for 10 years and we got nowhere. The CCPs are talking about it. But the commercial pressure on investment and universal banks’ back offices mean that they can’t just wait for two years and change all their infrastructure, as well as invest in market infrastructure. It is that meta layer that has to happen, and it has to happen fast.” He believed there would be more competition between the clearance houses and the custodian banks. Chi-X offered a good example as the exchange has appointed a Fortis subsidiary, the European Multilateral Clearing Facility, for its clearing.

As banks’ risk management abilities have been challenged in the financial markets, Mr Caplen wondered if the clearing business was maybe too crucial to be trusted entirely to banks. Mr Pravettoni said that even in current market conditions, banks were performing a very important and valuable role in terms of management of credit. However, he added, if you looked at a CCP such as LCH.Clearnet, there was a very clear default structure and that 73% of the company is owned by the market. If a bank owned a CCP, other banks that were clearing clients would effectively pay margins to a competitor.

Mr Caplen also noted another market dysfunctionality, mentioning that Turquoise and EuroCCP had not been allowed access to settle in Italy and Spain. Ms Chan said that the situation in the two countries was different. In Italy, local resources had not been allocated to allow the EuroCCP account to be activated, which meant that the company could not settle, and Turquoise could not trade. In Spain, there was a long-held market practice that had become an impediment to multilateral trading platforms.

• Target 2 securities: how a harmonised european settlement system will reshape custodians and settlement houses

Mr Caplen asked Mr Lowrey if Target 2 Securities (T2S) would have a big impact on his business in terms of settlement efficiency. “It is getting us on the road but is one of those vaguer pieces of work that has to be done and carried out over time,” said Mr Lowrey. Mr Misra added: “It goes out in 2013: a lot can happen in that time.” He said regulatory change was needed for certain elements [of the settlement business], but the rate at which the market moved was much faster than the rate at which the regulators brought out new policies. T2S was about bringing down costs, said Mr Caplen. The European Central Bank’s aim was to achieve 29 cents of a euro per trade. Mr Pravettoni was sceptical as to how the current cost reduction goals will fare in five years’ time, when the system was meant to go live. “If you look at the changes in tariffs, even for us at LCH.Clearnet, they have gone down quite substantially in the past 12 months. You can see how infrastructure can achieve [lower costs] in the next five years, to the point where the 29 cents that was being heralded now as a great number, will not be a great number anymore.”

T2S is also about harmonisation of the European settlement area. Ms Chan said she thought it was very important to distinguish the effect and possibility of competition in the trading, clearing and settlement space. “In clearing and trading, competition is possible; in the central depository business nobody has tried, because nobody thinks that they will actually succeed,” she added.

With a harmonised system and custodian banks competing with CSDs for the intermediary business, would banks consider entering the depository space? asked Mr Caplen.

“That’s not where we think banks should operate,” said Mr Isaac. “T2S is five years out. The challenge between now and then is to continue to innovate on top of where T2S is going.” Mr Shrimpton agreed: “The regulators need to stay pretty close to market ­evolution.”

• The impact of the credit crunch

Mr Shrimpton said: “What the credit crunch has indicated to the market is that there needs to be a bit more governance going on.” Mr Lowrey commented that what they were most focused on was collateral management and he said that there would have to be a market solution that came out of the crisis, possibly in the form of an independent utility, as opposed to a commercial banking solution. “What one learns from the credit crisis is that some degree of transparency is better than no degree of transparency,” said Mr Lederman. He said that the equity markets were much more transparent than the fixed-income space and that regulators were already looking into what can be gleaned from the former and applied to the latter.

Mr Isaac added: “I find it extraordinary that we have such a fundamental change in the equity market at the same time as the fixed-income market is going through a cardiac arrest. You have this great innovation happening, even with the very tight budgets that everybody has, within large and small banks, they are still devoting resources to push the equity market and get innovation on board. The credit crunch doesn’t seem to be stopping it. In some ways, it is forcing innovation.”

Mr Pravettoni said that innovation was not only happening in the equity space. “While probably the equity space is grabbing the headlines, there is a huge amount of work in other asset classes these days: energy and the commodity space are growing ­dramatically.”

• Summary

The securities services space is undergoing a spectacular transformation: more competition, new trading and liquidity venues, European harmonisation. Given the time to adjust to the new frameworks, the market is expected to grow, be more transparent and become more efficient. “I hope we see MiFID produce the market growth that everyone wanted,” said Mr Shrimpton. “And if we can work as an industry, to deal with best execution and transparency issues, I think that we will see good prospects for equities.”Sponsored by: