Europe Overhauled

MiFID Pushes Trading into New Era

In mid-November of last year, seven powerful investment banks announced they had formed Project Turquoise to create a new execution venue for European stocks. On the news, the share price of all the big publicly traded exchange operators in Europe dropped by 7 to 10 percent. Although the stocks recovered, the market activity showed the fear and uncertainty exchanges face as a new world order dawns on the European equities trading landscape.

Project Turquoise was created for the new MiFID world. Starting in November, the European Union’s Market in Financial Instruments Directive is expected to transform trading.

As newly fashioned competitors get up and running, venues like Turquoise could grab flow from the established exchanges and threaten their businesses. Currently, more than 95 percent of European equities trading is consolidated in the hands of the seven largest exchange players.

“All things equal, if the price of a stock is the same on Turquoise as it is on a regulated market, we’ll route to Turquoise because it will be cheaper,” says Niki Beattie, European head of market structure for Merrill Lynch. She was recently named to Turquoise’s board of directors. Other trading executives connected with Turquoise echo her comments.

MiFID comes into force on November 1. Although the change will be gradual, MiFID’s top-down overhaul of cross-border European trading is likely to spur competition between execution venues, reducing costs and increasing liquidity. But whether MiFID-at least in the short run-will deliver actual competition or merely the benefits resulting from the threat of competition remains unclear.

More Liquidity

Right now most trading in European stocks takes place on the main exchange of a stock’s home country. Countries have traditionally had different rules dictating where and how trades occur. “The European trading landscape is fragmented by country,” observes Roland Bellegarde, head of European cash markets and a member of the management committee at NYSE Euronext.

The EU’s MiFID is a set of sweeping regulations that lays the groundwork for a single financial market in Europe, where 30 segregated domestic markets previously existed. It does this by dismantling barriers to cross-border trading and creating a level playing field. Adopted in April 2004 by the European Parliament, MiFID is due to become law in the 27 EU member states as well as Liechtenstein, Iceland and Norway (see “MiFID in Brief,” p. 42).

MiFID’s myriad rule changes should catalyze algorithmic and quantitative trading and fuel the growth of dark liquidity. The end result, market participants say, will be increased volumes and lower trading costs. Bryan Koplin, director of electronic trading at Goldman Sachs, says trading volume in Europe could increase 25 to 30 percent in 2008.

Perhaps most important, MiFID abolishes the “concentration rule” operative in a number of countries, including France, Italy and Spain. This rule, permitted under the 1993 Investment Services Directive, the EU-wide regulation that MiFID replaces, enabled national regulators to require that all equities trading in domestic shares take place on the main domestic exchange. That prevented off-exchange trading in domestic stocks by broker-dealers in those countries and limited competition from other execution venues.

MiFID institutes other changes to encourage execution choice. Among them, it authorizes the creation of multi-lateral trading facilities (MTFs) by exchange operators or broker-dealers. These are the equivalent of electronic communication networks in the U.S. With the concentration rule gone, these platforms can vie with the main exchange, competing on speed, cost or other factors. Turquoise, for example, will be an MTF.

“MiFID promotes competition across exchanges and enables broker-dealers to compete with exchanges,” says Brad Hunt, head of electronic transaction services in Europe at Goldman Sachs. “It does away with a lot of the barriers to entry that protected the monopoly players.”

Under MiFID, execution venues will be able to trade pan-European stocks without needing to get approval from the regulators in each country. John Barker, managing director of Liquidnet Europe, notes that Liquidnet will no longer need the two-to-12 months it took to get authorized in each new European jurisdiction-when domestic rules didn’t prevent the platform from entering those markets in the first place. “In November it will be more straightforward. We effectively should be good to go everywhere in Europe,” Barker says.

As competition revs up, liquidity could disperse between markets, making it necessary for investors to access multiple destinations. The removal of the concentration rule will fragment liquidity in countries that previously forced trading onto exchanges, says Alasdair Haynes, agency broker ITG’s CEO for European operations, “but that will be way outweighed by the benefits of competition. End users, pension funds and mutual funds-those who want to get better performance through lower transaction costs-will ultimately profit.”

New Game

In a MiFID environment, national exchanges in different countries will confront varying levels of new competition. The main U.K. and German bourses already see significant competition for executions. They have thriving upstairs markets for block trades and crossing networks that execute orders away from the central market. Competitors may encounter fewer cultural hurdles launching new venues in those markets, but the incumbent exchanges have experience contending with home-grown rivals. The London Stock Exchange, for instance, faces competition for blue-chip U.K. stocks from London-based virt-x, an exchange owned by Switzerland’s SWX Group. Deutsche Brse, which gets 95 percent of the euro turnover in German stocks, has six regional exchanges nipping at its heels.

In comparison, countries that previously had a concentration rule are likely to see more off-board trading once that becomes possible. “It’s almost impossible that there won’t be more off-exchange trading in those countries,” says Nick Holtby, head of European client trading and execution at UBS.

One country that many surmise could see significant shifts in trading is France. Euronext’s Bellegarde points out that MiFID isn’t about encouraging on-exchange vs. off-exchange trading. However, he adds, MiFID will push Euronext to look for opportunities “to offer different tools and trading services for customers, including alternate ways to trade securities by auctions, block and indications of interest.”

Industry watchers stress that liquidity is notoriously difficult to move off a stock’s main market. But some exchanges have an “unrealistic market share,” says Ian Peacock, CEO of North American operations for Cheuvreux, the European brokerage subsidiary of French banking giant Calyon. “Those exchanges with all the liquidity in the past will retain the most liquidity in their home markets, but a proportion will move around to other venues.”

Green Light

Given MiFID’s green light for new markets, a number of platforms have thrown their hat in the ring. Among these are Instinet’s London-based Chi-X, a traditional limit-order book that began operating in March for pan-European stocks and will officially become an MTF in November, and Equiduct, which will launch as an exchange in January. Equiduct, based in Belgium, will offer a quote and order-book market called Hybrid and a separate platform, called PartnerEx, that enables brokers to internalize customer flow on the exchange and guarantee them best execution for pan-European stocks.

Project Turquoise, for its part, will have a traditional public limit-order book with a dark book sitting atop its displayed market. The expectation is that Turquoise’s eventual customers will execute smaller-size orders in the displayed market and blocks in the dark pool.

According to a Turquoise spokesman, the platform’s pricing is designed to reward those who provide more liquidity to the MTF. He says Turquoise was created to reduce the total cost of trading by around 50 percent-through lower execution fees and cheaper clearing and settlement costs. The seven banks behind Turquoise are Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley and UBS.

The LSE’s Nic Stuchfield, director of corporate development, notes that the powers representing Turquoise have a lot of heft. But he questions whether they control the order flow they receive. “Investment managers may want to trade in a certain market because of lower spreads or better liquidity, and a broker-dealer can’t countermand that decision,” he says. Stuchfield adds that brokers could go wherever they want for their proprietary trading, “but they’d want to go where business is likely to be executed.”

Many industry observers say there is no iceberg floating toward the major European exchanges in the form of MTFs. The exchanges, after all, have the weight of liquidity on their side and longstanding relationships in their markets. They have also had a couple of years to prepare for a MiFID environment.

Exchanges Ready

The largest exchanges have overhauled their trading systems and ratcheted up their execution speed to cater to the growing demand for less latency. Deutsche Brse, for instance, says its round-trip speed is now below 9 milliseconds for firms based in Frankfurt, down from over 100 milliseconds a year and a half ago. Euronext says its platform has greatly reduced its latency. The LSE this summer launched a new trading platform called TradElect to replace SETS, which had operated since 1997. TradElect’s message capacity is due to double later this year.

All of Europe’s big bourses have also consolidated in the run-up to MiFID. Consolidation potentially gives them pricing power and cost savings through economies of scale in technology and operations. Euronext, which encompasses markets in France, the Netherlands, Belgium and Portugal, merged with NYSE Group earlier this year, followed by the tie-up between Deutsche Brse and International Securities Exchange. OMX, which owns exchanges in the Nordic and Baltic region, is expected to merge with Nasdaq. And the LSE, after spurning Nasdaq’s many advances, is tying the knot with Borsa Italiana.

Ruben Lee, managing director of Oxford Finance Group, a financial-services research and consulting firm in the U.K., points out that while the dominant exchanges have gradually responded to the potential of competition, their strengths and weaknesses are their large size. “Smaller players can satisfy niches and compete against incumbent exchanges, but it’s really tough,” he says. “Big exchanges can lower their prices to the level of competitors. And then, why should anybody send orders to the competitors, given that all the order flow already goes to the big exchanges?”

It’s also possible for MTFs such as Turquoise to be successful without thriving over the long haul. Diego Perfumo, an analyst at Equity Research Desk, a U.S. research and consulting firm, says he expects Turquoise to be a threat to European exchanges, particularly the LSE and Euronext, for only one or two years. “Then the threat will dissipate,” he says. “The exchanges will have been disciplined.” He predicts Turquoise will be “the BATS of Europe-it will get 10 percent of the volume and use that to move prices down.”

Exchanges Wary

MiFID’s leveling of the playing field makes competition a reality, but that doesn’t mean the major players will battle one another immediately. Members of the LSE and Borsa Italiana will be able to trade one another’s stocks once the Italian exchange moves onto the LSE’s TradElect platform, Stuchfield says. However, the LSE isn’t yet eyeing the listed stocks of its competitors.

“We don’t have any current plans to open up order books in stocks of other countries, whose natural liquidity is in other exchanges,” Stuchfield notes. “It’s very difficult for a challenger to gain critical mass and liquidity.”

Deutsche Brse and Euronext echo that sentiment. “We’ll let the lead brokers and banks decide. MiFID doesn’t affect the securities traded,” says Andreas Willius, an executive responsible for MiFID-related topics in the cash-equities segment of the German exchange. He adds that almost half of the exchange’s 285 members are non-German firms that have access to markets in other countries.

Euronext’s Bellegarde notes that “everything must be considered and everything is being considered.” But he points out that Euronext must determine where it can add value-“and that’s not by replicating what exists today in exchanges in different countries but just with lower prices. I don’t think that will attract a lot of liquidity.”

Despite the politesse, competition between the big exchanges is seen as inevitable. Chi-X, Turquoise and Equiduct will trade pan-European stocks. They may not pose a serious threat to the dominant exchanges, but they could shift liquidity around, compelling the exchanges to take a more aggressive stance.

“Regulated markets will offer trading in stocks they don’t list, but they’ll do it in response to competition,” suggests Merrill’s Beattie. “They don’t want to declare war on each other until there is clearly going to be competition.” Cheuvreux’s Peacock expects direct competition between the big exchanges to happen next year. “They’ll want to compete for the pan-European chalice,” he says.

Bob Giffords, an independent banking and technology consultant in the U.K., also expects to start seeing execution venues competing against one another in 2008. “I’d be surprised if any major exchange gets knocked off its perch, but I think we’ll start to see a significant minority of shares trade in other locations,” Giffords says. “Then the pressure will build, as investors start trading new names and upgrade their technology, and we’ll see more pressure for both consolidation and competition [among exchanges].” By MiFID’s 10th year, he adds, the European market “will look quite different than it does today.”

New Pricing

For now, the dominant exchanges are watching what the execution venues designed for a MiFID environment do. All acknowledge that Instinet’s Chi-X is on their radar, partly because it was the first to launch and partly because it offers a different model for trading equities than currently exists in Europe.

Chi-X was set up as a fast electronic order book to trade pan-European stocks, and has already rolled out trading in the Dutch AEX 25, German DAX 30 and FTSE 100 component stocks. It will expand that list to include the stocks in all the major European equity indexes.

For its market model, Chi-X inaugurated U.S.-style pricing in Europe-a maker-taker model in which liquidity providers are paid 0.2 basis points to provide liquidity and liquidity takers are charged 0.3 basis points to remove liquidity. Chi-X allows quotes and trades to three decimal places, instead of the traditional two decimal places in Europe. Chi-X also has a fast platform for latency-conscious executions, appealing to algorithmic and quantitative traders at hedge funds and sellside firms.

Peter Randall, CEO of Chi-X, notes that the platform trades about e200,000 to e300,000 per day and regularly surpasses 5 percent of the market share in its most active stocks. He adds that there’s “ample evidence from the U.S. that end investors are inordinately sensitive to transaction costs. When you cut those frictional costs, volumes increase dramatically.”

The LSE’s Stuchfield points out that the London exchange launched the idea of differential pricing for liquidity providers and liquidity “aggressors” in 1997 when it initiated order-book trading. Liquidity providers on the LSE pay significantly less than those removing liquidity from the book. Still, Stuchfield says, “the jury is out on Chi-X’s pricing. Liquidity providers are attracted by being paid to provide liquidity, but only if they’re confident that people who want to see that liquidity are going to visit them in that particular pool.”

Deutsche Brse’s Willius also stresses that the big exchanges have the liquidity. He notes that MTFs may launch with attractive features but still may not make the grade for investors. “I doubt they will attract enough liquidity in a broad range of equities to provide significant order-book depth and the implicit cost benefits that an active and large liquidity pool like Xetra has,” he says, referring to the exchange’s electronic order-book market.

Moving Liquidity

UBS’s Holtby thinks the Chi-X pricing will have staying power. “In the U.S., that has been a successful way to move liquidity,” he says. “I think it will have a significant impact in Europe and new MTFs will use that type of pricing structure to compete.” He adds that the volume growth on European exchanges in recent years, combined with a drastic reduction in ticket size in some markets, makes pricing models pitched to price-sensitive players attractive.

Euronext’s Bellegarde says he’s skeptical that Chi-X’s pricing or trading platform will win a wide swath of converts. In his view, Chi-X’s main advantage over other markets is its use of three-decimal pricing. He says Euronext is preparing, if necessary, to trade in three or four decimal places and will be able to switch to the new prices overnight.

MiFID’s removal of the concentration rule and the expected competition among execution venues for statistical-arbitrage and quantitative traders are expected to accelerate the decline in average order size at the big exchanges. As in the U.S., that could make crossing platforms more attractive to buyside and sellside firms seeking larger executions with lower impact costs.

Europe’s main exchanges say they are ready to pounce if interest in dark liquidity takes off. The LSE’s Stuchfield, referring to midpoint orders and the possibility of offering a dark pool, notes that “these are developments we’re looking at and actively considering.”

Euronext’s Bellegarde says his exchange will be aggressive about adapting to the changing needs of traders. “We are monitoring [whether] it’s the right time or when it will be the right time to develop a platform for blocks or a crossing mechanism,” he says. “Compared to, for example, Turquoise or another newcomer, we have the advantage of already being connected to customers.” Bellegarde says Euronext has the technology to create a block-trading platform, but could also use NYSE Group’s MatchPoint crossing capabilities.

Over the next two years, dark liquidity is expected to grow in Europe, especially in the U.K. and northern Europe, according to U.S. research firm TABB Group. Both ITG’s POSIT Match and Liquidnet, which entered the European market in 1998 and 2002, respectively, have logged the bulk of their executions in the U.K. market.

Dark Competition

That’s now changing as the balance tilts toward European stocks. Both crossing platforms, gearing up for increased competition, recently lowered their execution fees to 7 basis points from 8 basis points. ITG will launch POSIT Alert, a product that allows customers to negotiate for size for midpoint executions, later this year. Liquidnet will roll out midpoint pricing for blocks by year-end and is contemplating a European version of Liquidnet H2O to enable sellsiders to interact with the network’s broad buyside pool. NYFIX, a New York-based broker and dark pool operator, plans to launch a crossing platform called Euro-Millennium later this year.

Europe’s bulge-bracket brokers are also ramping up their internal crossing capabilities. The big banks-Goldman, Morgan Stanley, Credit Suisse, UBS, Citi, Lehman and others-all plan to roll out their own dark pools in Europe, if they haven’t already. The ability to internalize trades will enable them to avoid exchange fees and potentially execute with less market impact.

“All broker dark pools are fledgling at this point,” says Merrill’s Beattie. “But they will grow, improve and be enhanced. Europe is behind the U.S. in terms of dark pool activity because we haven’t been allowed to internalize in all countries, but now MiFID will open that up.” For exchanges, that will mean more competition as investors’ execution patterns change.