Are equity traders voting with their feet?
Stephane Loiseau, managing director, head of cash equity execution, Societe Generale, Corporate & Investment Banking, predicts that execution preferences will continue to evolve in response to regulatory and competitive changes to equity market structure in Europe.
With the MiFID review ongoing, mega-mergers in the exchange space raise for some the fear of decreased competition and diminished investor choice. Others see healthy M&A activity as an opportunity for newcomers, resulting in innovation and increased fragmentation, for the benefit of the market at large. While there has been much scepticism in the press recently about the true benefits of exchange mergers for shareholders and users alike, recent history suggests that competition and innovation in the equity markets have actually come from smaller venues (like MTFs - multilateral trading facilities - in Europe) or brokerdealers (broker crossing networks and algorithmic trading tools, for example).
In this uncertain context, recent trends in trading patterns across Europe may point to the future of equity markets. This author has long argued that it is by systematically analysing liquidity - in particular how it shifts - that we can best understand trader behaviour and consequently detect potential outcomes for the new equity landscape.
First, looking at lit MTFs, we observe a concentration among the main venues with a pan-European focus - Chi-X, BATS and Turquoise - with an additional niche venue - Burgundy - displaying meaningful liquidity in one market primarily (Sweden). These four venues combined represent more than 98% of the displayed liquidity provided by MTFs in Europe. This newly-formed concentration, which might be further reinforced with BATS' acquisition of Chi-X, and which mirrors the concentration of regulated markets, increasingly resembles the US landscape where the top four exchanges handle nearly 90% of all lit volumes.
We also observe a steady growth of auction activity, essentially in the close. Already above 10% of public market volumes throughout 2010, auction trading in Europe peaked above 14% in September and December. This represents around 100 billion euros of liquidity each month. Ironically, while auctions were once the topic of much debate about the quality of the closing mechanism and the potential for adverse price movement, they are now regarded as a 'safe harbour' for many investors, due to their simplicity and more importantly their transparency, with the official closing price being printed in the newspaper the next day.
Catching up quickly, we also notice the rapid rise of dark trading. While dark trading on MTFs and regulated exchanges only represented 1.5% of trading activity across all organised European markets in January 2010, this has increased steadily to reach 2.7% in 2011 and has more than doubled in monthly value from 10 billion to nearly 23 billion euros, thanks to new venues and more institutional usage, benefitting the leading platforms (Chi-Delta, Turquoise, BATS and SmartPool).
Finally, while the debate is still raging over the true size of OTC trading in Europe, everyone agrees upon the need to improve the transparency of OTC prints. Best is to recognise that those who are the closest to OTC trading, i.e. the banks, are also best placed to know what really happens there and in particular what is 'accessible liquidity' versus what are essentially 'technical' prints (i.e. non-price forming trade reports which do not represent liquidity that can be interacted with). If we abide by this rule, a number in the range of 10% has been calculated by some. We need to be confident that one of the proposals laid out by the Committee of European Securities Regulators (in its technical advice to the European
Commission ahead of the MiFID review) is going in the right direction by proposing to flag OTC trades in three categories - B for benchmark trades, C for cross trades and T for technical trades - which will make the determination of what is accessible liquidity straightforward for all market participants. It is worth noting that so far this year, the share of all OTC reports has actually decreased versus last year (the relative weight decreasing by 12% from December to January).
Is this observation on OTC trading, along with the growth of auction volumes and the very rapid rise in institutional interest in dark trading on organised markets, an indication of things to come? Are traders voting with their feet?
In this rapidly changing landscape, liquidity must therefore be continually analysed and wisely accessed. Sometimes however, investors remain concerned about the implicit cost involved in accessing alternative sources of liquidity. At SGCIB, we have developed a proprietary QVM indicator* which quantifies the implicit cost of interacting with each type of venue (e.g. lit vs. dark) but also which ranks individual venues according to the quality of their liquidity. When combined with the aggressive or passive trading scenarios used by sophisticated algorithms, this indicator helps determine the routing strategy and selects the optimal execution venue. This approach alleviates the fear or lack of information about alternative venues and ensures investors are getting the best of the new market microstructure, as it evolves on the back of investor behaviour and regulatory changes.