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Many Sources of Liquidity, Many Sources of Uncertainty
Traders Magazine Online News, July 4, 2018
We are six months into a European trading and investment landscape redrawn by MiFID II. But it’s still too early to tell with any certainty where liquidity will flow. In truth, we may not have a clear picture even by the end of the year.
This is partly down to the sheer scale and scope of MiFID II, but also because of the staggered timetable for rolling out a central feature of this new landscape: systematic internalisers (SIs), the mandated mechanism for bilateral liquidity provision. Suffice to say, the high degree of uncertainty demands that all market participants keep their options open. To deliver competitive execution service propositions, sell-side firms must identify which SIs will support best execution by their buy-side clients, and develop the most effective way of sourcing SI liquidity on an ongoing basis.
Why the fuss? It’s true SIs existed under the original directive, but their enhanced role in MiFID II marks a very distinct departure and poses new challenges to the routing capabilities of banks and brokers.
Diversity of business models
Critically, SIs fill the vacuum created by MiFID II’s ban on broker crossing networks (BCNs) – which previously pooled internal sell-side inventory with that of external electronic liquidity providers (ELPs) – and dark trading limits, which entered force in March. But SIs not only represent a new channel for liquidity but also a new business model and a new mode of interaction between liquidity providers and seekers.
One thing we can be certain of is the diversity of business models. Through SIs, ELPs must now deliver liquidity directly, a development which may finally stop these firms being lumped together as high-frequency traders. Some ELPs have grown into global, multi-asset liquidity providers developing close bilateral relationships with sell-side firms, others deal in equities as a consequence of their core business, such as ETF market-making, with distinctly different aims and inventory in their SIs. There is diversity on the sell-side too, with some firms promising block trading opportunities from their automated central risk desks, dependent on the nature of their relationships and franchises.
It’s far too early to tell which models will offer the best performance to the buy-side and ultimately the end investor. After all, we don’t even know the full universe of SIs yet. While many ELPs and brokers have registered, sell-side firms will not be formally obliged to meet their MiFID II obligations until September, a month after ESMA issues H1 2018 trading data, thus establishing which firms reached the regulation’s volume thresholds.
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