Gunning for the Old Guard

MTFs set up shop to challenge established exchanges

It’s crunch time in Europe. Almost one year after the Markets in Financial Instruments Directive, or MiFID, went into effect, the battle to wrest market share from Europe’s stock exchanges is about to begin in earnest.

As Traders Magazine was going to press, three new displayed venues were in the process of establishing themselves, bringing to four the number of displayed multilateral trading facilities (MTFs) gunning for a piece of the $80-billion-a-day cash equities trading business. That’s the total aggregate value of shares that changes hands in Europe each day.

Turquoise, founded by broker-dealers that collectively trade more than half of European equities volume, launched Aug. 15. Nasdaq OMX was planning to launch at the end of September. BATS Holdings, whose subsidiary BATS Trading handles about 10 percent of all U.S.-traded shares, plans a launch early next month. The three join Chi-X, which is owned by Instinet and a consortium of 13 investment banks, and has already made inroads into European trading after nearly two years of operation.

“We are going after the primary markets in Europe,” Chris Concannon, Nasdaq’s executive vice president for transaction services, said at a recent press conference. “We hope to be greater than 1 percent [of the market] and closer to 5 percent within a year.”

Analysts expect MTFs will account for about 20 percent of total European equities volume in the next few years. They’ll get that from the incumbent exchanges, as well as a new crop of high-frequency traders expected to emerge as a result of MiFID.

No Easy Road

Still, the road to success for the MTFs is not expected to be easy. There are no requirements for brokers or exchanges to route orders to them, and the lack of a centralized clearing and settlement structure could discourage potential customers by adding costs on the back end.

In addition, the old guard is not standing still. The London Stock Exchange, NYSE Euronext, Deutsche Börse and two dozen smaller exchanges dominate their respective countries’ marketplaces and are taking steps to keep it that way. The Big Three collectively control about 70 percent of the trading in Europe, as counted by euro volume. In advance of the onslaught, they have been improving their technology, cutting their prices and introducing new services.

NYSE Euronext, for example, plans to introduce a new fee package for high-frequency traders. Both the LSE and Euronext plan to offer dark pool services for block trades.

As for Deutsche Börse, it is unfazed by MiFID, according to Michael Krogmann, the exchange’s executive director for cash market development. “When MiFID was implemented on Nov. 1 of last year,” the executive said at a conference earlier this year, “there was no real change to our business model, because we are used to competition. We have seven regional exchanges competing with us, using the same post-trade infrastructure. We have never had a MiFID concentration rule. It has always been an open space for competition.” Still, Krogmann noted that Deutsche Börse is taking the competition seriously. It will build out its systems capacity, reduce latency and “become more competitive,” he said.

Fresh Faces

MiFID went into effect on Nov. 1, 2007, but not much has changed. Chi-X has benefited from a surge in high-frequency arbitrage trading in the U.K. that didn’t exist before, giving the MTF about 5 percent of the value of all British shares traded. Turquoise was expected to launch earlier, but has been beset by delays.

These are still the early days, though. Turquoise is considered the name to watch because of its backing. Goldman Sachs, Morgan Stanley, Deutsche Bank and five other broker-dealers own the system and are expected to send some of their orders to the platform. The MTF employs the maker-taker pricing structure, paying liquidity providers a 15-basis-point rebate and charging liquidity takers 35 basis points. This pricing model has become the norm in the U.S., but is new to Europe.

Like Turquoise, BATS is also counting on its backers, heavy trading brokers, to propel its fortunes in the new Europe. That has certainly been the case in the U.S. “What has happened in the U.S. for the past few years will happen in Europe, as well,” Paul O’Donnell, BATS’s chief operating officer, said at a conference earlier this year. “BATS has done a remarkably successful job in the last few years in gaining market share because of technology, throughput and low latency, as well as a robust investor base that is very supportive of our efforts.”

Chi-X arrived at the same conclusion. Initially a wholly-owned subsidiary of Instinet, in January it decided to sell stakes to some of Instinet’s rivals. Many of its new owners are the firms that have brought Turquoise to life.

Repeat Performance?

Nasdaq, which last year tried but failed to buy the London Stock Exchange, has no big broker-dealer backers. Its ace in the hole, it believes, is the strategy it used to take share from the New York Stock Exchange. In the U.S., Nasdaq became a major trader in NYSE-listed names through an aggressive outbound routing strategy. With competitive pricing, the exchange encourages its customers to send their NYSE orders to Nasdaq first to check for a match. If no match exists, Nasdaq routes the order to the NYSE. That policy has enabled Nasdaq to equal and even surpass the NYSE’s market share in the trading of its own securities.

“We can’t say what happened in the U.S. will clearly happen in Europe,” Concannon said. “But we want to connect traders to all those pools through our own liquidity pool so we can offer aggressive pricing. We will launch very aggressive routing strategies.” (Last month, Nasdaq signed a deal with Citi to provide pan-European routing services for its new MTF.)

Many expect routing to play a big role in Europe’s fragmenting market structure because MiFID forces brokers to get best execution for their customers. MiFID doesn’t dictate how brokers should make their decisions about where to send orders. But most of the newcomers are betting brokers will have to consider all market centers, not just the largest, when shipping out their orders.

For those brokers that do intend to take into account all trading venues, it is an open question as to whether they will establish connectivity to all the market centers themselves or rely on the exchanges or MTFs to route to them on their behalf.

Peter Randall, chief executive of Chi-X Europe, contends that brokers will have to change their approach to best execution as more trading venues emerge. At a Securities Industry & Financial Markets Association conference in May, he told the crowd: “For a broker to say: ‘I have a best-execution policy and that policy is to send all orders to the London Stock Exchange’ is no longer being accepted by the market. People are starting to ask, ‘Why can’t you get me to the Chi-Xs, the BATSs and the Turquoises?’ ”

And for those brokers that don’t have smart-order-routing technology, Chi-X offers the service. If an order doesn’t fill on its book, Chi-X will route it to the marketplace with the best price, Randall said.

Getting Routed

BATS intends to do the same. “We believe smart routing is a central tenet of an efficient market,” O’Donnell said at the SIFMA conference. “If someone sends us an order and we don’t have the best price, we have no choice but to send it somewhere else. We don’t want to execute outside the best bid or offer, however that will be defined. We fully intend to route to anyone who will allow us to.”

Still, while the MTFs are offering to route brokers’ unfilled orders on to their competitors, there is no guarantee the brokers will route to the MTFs in the first place. MiFID doesn’t require it.

“Brokers will connect first to wherever there is liquidity,” Roland Bellegarde, NYSE Euronext’s group executive vice president and head of European execution, said at the conference. “But they won’t connect to everyone. As long as you have a sizable market share, then all the brokers will connect to you.”

And for his part, Bellegarde has no plans to offer connectivity to his rivals. “I do not intend to route,” he said. “You expect the largest pool of liquidity to route to the smallest? It doesn’t make sense. And nothing in MiFID forces me to route. I’d rather have customers coming to me than route to the smaller pool of liquidity.”

MTF Challenge

In addition to recalcitrant exchanges and reluctant brokers, MTFs may face one more difficulty in capturing brokers’ orders: Many of Europe’s order and execution management systems may not be up to the task. As in the U.S., vendors such as GL Trade, Orc and Fidessa play very important roles in connecting brokers with exchanges and clearing organizations.

Chi-X’s Randall told conferencegoers he was not optimistic that the “independent software vendors would be able to deliver the complexity of smart order routing as most folks in this room would understand it. It is very, very difficult to do that within the European landscape.” This is one reason Chi-X offers a smart-order-routing service, Randall said.

In contrast, Turquoise chief executive Eli Lederman is more optimistic. He has been working with the vendors to ensure connectivity to his platform. “I think the problems will be ironed out. Vendors are creating consolidated market data feeds and consolidated order books,” Lederman said. “It is a very important part of our launch. We are making progress. We will have connectivity to all of them.”

Fragmentation isn’t just a trading problem. Because Europe’s clearing and settlement organizations are largely tied to individual stock exchanges, an order that gets filled on more than one marketplace will have to get cleared and settled by more than one organization. That could add cost and inconvenience to the process. Indeed, the situation could thwart the entire goal of MiFID of trying to create a unified European stock market.

“It has proved extremely difficult for the incumbent operators to get their acts together and offer seamless clearing and settlement,” Chi-X’s Randall said. “The dirty little secret of MiFID is that it forgot to deal with the post-trade situation.”

Euronext’s Bellegarde agreed. “You have different clearinghouses, different settlement processes and different ownership rules,” he said. “It’s very easy to trade, but please try to clear and settle-it is costly and complex.”

Despite all the hurdles MTFs face in growing their businesses, independent observers do expect them to find success. Aite Group, for instance, predicts that MTFs will take over 20 percent of volume by 2011. The Boston-based research group is betting that Europe’s market structure will start to look more like that of the U.S. and that the growing sophistication of buyside traders will help drive the changes.

“For the larger exchanges,” Sang Lee, co-founder and managing partner at Aite, wrote in a report on MiFID last year, “overlooking or underestimating the potential competitive strength of MTFs would be a huge strategic mistake, as clearly shown in the U.S. equities marketplace.”

(c) 2008 Traders Magazine and SourceMedia, Inc. All Rights Reserved.