Robert Barnes, CEO, Turquoise looks at the progression of European equities to date, and what the future might hold.
Modern equity market mega trends include global passive indexation and the desire to outperform benchmarks by trading block liquidity, increasingly in mid and small caps, diversified by geography. Today European real returns are near zero, so the focus is on efficiency of trading clearing and settlement at instant of investment to minimise slippage cost to enhance long term returns.
In 2001, The Committee of Wise Men on the Regulation of European Securities Markets1 noted that returns on assets over a period of time were growing faster in the US than in Europe. With rising population demographics and an increasing reliance on private sector pensions, European capital markets needed to be competitive for meaningful long term investment returns.
At the time, Europe featured an exchange landscape comprised of single country monopolies. While there were some advantages, this model did not serve well an increasing demand by the user community for nimbleness on fees and functionalities as equity volumes grew world wide. Europe as a ‘single market’ was underperforming its potential. Among contributing factors were higher costs of trading, clearing and settlement. The regulatory tool to address frictional costs was competitive entry.
The findings of the Wise Men report led to the European framework that became the Markets in Financial Instruments Directive (MiFID) which encouraged competition, transparency and investor protection. Best execution was redefined as a process to deliver best possible result on a continuous basis. What followed was a raft of new market entrants, of which some took hold and continue today. Competition reduced exchange fees for cash equities. Innovations driven by the private sector within the regulatory framework included introduction of single order books that could admit for trading securities from multiple countries via a single connection. Complementing these new ‘lit’ order books were broker crossing and external venue ‘dark pools’ where price and size is not displayed until after a trade. In an automated MiFID framework, post-trade transparency is like pre-trade transparency for the next trade.
Post-trade clearing and settlement
With competitive new entry, there was more customer choice and greater efficiency of execution venues, but this required more sophisticated tools and methods to manage. The next major innovation arose from addressing the challenges of clearing in that fragmented environment and the consequence of electronic order books: the trend of shrinking trade size.
In 1999, the average trade size on London Stock Exchange was £64,000. By 2008, this had fallen to below £10,000 per trade. Interestingly, the overall order book value traded from 1999 to 2008 had grown by six times for UK equities but due to the shrinking trade size, the number of tickets had grown by 35 times. Because clearing and settlement costs tend to correlate with the number of tickets, if nothing was done to address this post trade trend, then the overall cost of processing the same value of trades would grow year on year.
This was one of the catalysts encouraging introduction of interoperability of clearing, whereby customers of certain trade venues can choose a single CCP to consolidate their respective trades. Competitive scalable volume discounts drove reduced clearing fees.
Consolidating clearing into a single CCP of choice also offered significant settlement savings. Prior to the introduction of CCP interoperability, if one was trading, for example, Vodafone shares on multiple trading platforms, then, shares via London Stock Exchange would be cleared through LCH. Clearnet or SIX x-clear while trades executed on Chi-X or Turquoise would have be cleared through EMCF and EuroCCP respectively. As a consequence there would be at least three net settlement messages and three net settlement fees per stock per day. Today, that same member can save two-thirds in one step by directing each of those trades into the single clearing house of choice.
Block trading adds further benefit regarding post-trade costs. Let’s say a stock’s average trade size is ten thousand Euros with unit clearing fees charged per ticket. If one can trade a block of a million Euros, in one step, the clearing fee is one hundred times less than trading the equivalent value in 100 trades x the average trade size.
Block trading on order book
The bigger prize of block trading is to match size at a price while avoiding market impact. As buy side dealers often explain, there are a number of channels through which they may direct an order. Channel one might be the high touch sales trader, channel two might be the algorithmic smart order router slicing up and dicing small size into multiple order books, but there is a new channel appearing: the anonymous order book mechanism that can rest larger orders safely until finding another side to match in block size without informing the market until after the trade.
A feature of MiFID II that’s often discussed in cash equities is the potential spectre of the dark pool double caps that can prevent a stock trading for 6 months via a relevant ‘dark’ mechanism. The caps are, on a rolling 12 month average, matches of 4% of turnover on a single dark venue or, if that single stock trades across multiple venues, more than 8%.
MiFIR Article 4(1)(c) allows authorities to waive the obligation for orders that are large in scale (LIS) compared with normal market size. Currently, ESMA defines LIS bandings that reflect average daily trading values for stocks over 50 million a day for blue chip companies to micro-caps matching less than 500 thousand a day. MiFID II will add more bands.
Innovation will drive the future of European equities defined by client demand, buy and sell side, for market structures that comply with regulations, lower costs, and generate revenues. The opportunities are for those delivering the highest standards. It will be a fascinating year ahead.