What key features do successful exchanges share that encourage liquidity; how automated trading drives growth and why markets will attract incremental liquidity with the advent of global CSAs. Robert Barnes, Managing Director, Equities of UBS Investment Bank explains.
Market structures comprise the rules and institutions that determine competition and the framework of interaction, including Exchange fees, which ultimately shape order execution strategies. The focus includes external factors that impact business and operating models, driving opportunities to grow revenues and reduce costs.
Exchanges rebuilding liquidity is a priority market-wide theme in 2010 in the context of competition, transparency, and investor choice at trading and clearing layers. From a User perspective, we wish to work in a spirit of partnership with Exchanges and Regulators to promote liquidity and new business, and we thank the Authorities as they provide a framework within which we can behave as entrepreneurs.
Macro trends include rising number of trades, coincident with automated electronic trading. Regulation promotes competition, transparency, investor protection. This leads to a better result for clients via competitive execution policies. Competition, thus fragmentation, makes the world more complex. Not all brokers, however, can keep up with the technological arms race. Direct Execution models of electronic trading are evolving to address this. Latency reduction increasingly is sought for competitive advantage.
There is increasing awareness of a positive dynamic involving non-displayed pools and high frequency trading. The key insights are that markets allowing discretionary non-displayed broker crossing processes and non-discretionary dark pools effectively speed net liquidity onto order books. The benefits are lower market impact, greater efficiency, and a better result for end investors.
These benefits multiply if statistical traders are active. When orderbook liquidity increases, so too does the proportion of trading opportunities; and these stimulate further orders to the orderbook from automated strategies. This incremental liquidity, aggressive and passive, narrows spreads.
The world’s markets are split into those that support and benefit from high levels of automation, and those with the opportunity to encourage more. Investors’ current focus include global macro trends and emerging markets which means that moving toward more consistent electronic access models will help markets to take advantage of this burgeoning liquidity. A good start is to implement and enhance FIX specifications to offer advanced electronic flexibility. This adoption of standardisation can aid emerging markets in growing their scale of business.
One of the more “seismic” changes to Equity markets in recent years is the proliferation of commission unbundling and Commission Sharing Agreements, “CSAs”, or Client Commission Agreements,“CCAs”, in the USA. Initiated by UK regulators in 2006, this commission unbundling initiative spread across Europe (at the end of 2007) with the arrival of the Markets in Financial Instruments Directive, or “MiFID.” Global clients, preferring one consistent process world-wide, have led the demand for CSAs to become a market convention. With many CSAs established on a global basis, it can be easier than ever before for a newly automated market joining a broker’s network to attract liquidity.
Successful markets world-wide share key features and best practices that encourage efficiency and liquidity growth. These include :
• Electronic Trading
Clients want faster execution and access to more liquidity, so they increasingly employ Electronic Trading Services such as “DMA”(Direct Market Access) and algorithmic trading strategies that lead to better alignment of execution with client objectives, more ownership over the traded price and therefore more influence over best execution. Automation speeds the process, trading is safer with system-embedded checks.
Clients want the ability to trade with a spectrum of Algorithms as well as DMA, and Algorithms are more effective with a meaningful range of order types and the facility to quickly enter, modify and cancel orders.
• Anonymity of Broker identifiers :
Offering anonymity of Broker identifiers is a key to greater market liquidity and investor fairness.
and support for complementary liquidity pools: Many investors benchmark a market’s close; they appreciate a robust mechanism that also serves as a concentrated liquidity point.
on and off-orderbook continuously with no minimum size thresholds facilitates lower market impact and potential price improvement; frameworks should welcome crossing, including those matches where the same member legitimately interacts with its own opposite order.
as risk management tools for fund managers can reduce portfolio volatility leading to returns attributable to stock picking and less to market volatility, and through hedging, can contribute to Cash liquidity and an improved price formation process. Exchange harmonisation of adjustments to derivative contracts in response to corporate actions minimises legal and operational risk, contributing to confidence and liquidity for both OTC and Exchange-traded derivatives.
• Securities Lending
leads to more efficient markets by helping on-time delivery, supporting short-selling trading strategies, and enhancing returns on long positions.
• Tariff transparency and basis point comparabilit
of fees as a proportion of value traded at each of trading, clearing & settlement are meaningful via improving invoices by adding value processed, electronic delivery & better practice. Constructive improvements of front-toback fees include headline cuts, incentives for incremental flow, and simplification, including fair pricing of both sides & reducing/removing minimum fixed costs per trade.
• User choice of CCP
clearing keeps providers nimble on fees & functionality, and scales benefits for order profiles with most affinity.
On this last point, it is worth exploring that in recent years, while Exchange and post-trade costs per trade seem to be declining, if one translates these fees as a proportion of value traded, it becomes apparent that the trend of shrinking order book trade size in many markets, year-on-year, means that the relative cost of trading to process the same level of client flow becomes more expensive on a normalised basis.
The UK provides a prime case study summarised below:
High frequency and algorithmic trading, both on a client agency and proprietary basis, contribute to liquidity growth.
Cash Equities performed well during the recent crisis, coinciding with the growth of on-order book liquidity, particularly in the most successful markets. Figure 1 shows the evidence: in 2008, a record of more than $120trillion value traded on Equities Exchanges and related platforms worldwide. Compare this with the sound-bite of the Credit Default Swap Market, which at the height of open interest measured around $60trillion.
Short-selling bans, irrespective of whether a good idea or not, had the unintended technical consequence of curtailing liquidity.
Figure 2 shows a significant drop in 2009 in annual value traded regionally and around the world. Figure 3 provides a comparison of regional capitalizations and monthly value traded reflecting figures from the World Federation of Exchanges.
We can observe that regional capitalizations are approximately similar; certainly more so than comparing regional values traded. Why are the values traded so much higher in USA than Asia Pacific? The answer must be, at least in part, due to the mature presence of high frequency automated trading algorithms.
In 2009, for the first time since records began, Asian WFE members, driven particularly in China, recorded more value traded than those in Europe, a signal encouraging international investors further to Asia Pacific.
Aside from Australia, and to some extent Japan, Asia Pacific has yet to enjoy the dramatic surge of on-order book liquidity present in the more “electronically developed” US and European markets. The lesson to learn from Europe is that introduction of more sophisticated automated trading coincides with shrinking trade sizes. In this scenario, contra revenues, i.e. Exchange, and in particular, clearing and settlement fees as a proportion of value traded, substantially can increase.
Introduction of CCP ‘User choice’model is one approach to address this trend, (See Box on next page).
Automated trading drives liquidity growth. A market can increase its attractiveness by reducing frictional costs, enabling flexible automated behaviour, welcoming complementary liquidity pools, and maintaining a level playing field.
With the advent of global CSAs, markets more likely will attract incremental liquidity if they commit to high quality of markets criteria and if they join broker execution networks with clients that have global CSAs.
Progress and proliferation of Cash Equities CCP ‘User choice’
As brokers compete to provide faster execution, reduced market impact, and better results for end investors, the consequence to order books is a trend of increasing number of “bargains” and lower average bargain size. Depending on tariff structures, particularly those correlated with number of tickets, the growth in numbers and thus fees are outstripping growth by value. This is particularly true of the post-trade tariff models. The result can be that brokers processing the same value of client flow can suffer increasing costs of processing that flow year-on-year. This profitability impact is under scrutiny on the sell side.
Clearing and settlement are now priority themes for trading floors. The 2008 Lehman default dramatically highlighted the differences between markets that have, and do not have, Central Counterparties (CCPs).
The result is an imperative to introduce CCPs for markets that do not have them: for example, NASDAQ OMX Nordics launched mandatory CCP in October 2009.
Firms have different business models and profiles of order execution, margin, and collateral.
On 12 Dec 2008, UBS was the first broker to go live with the CCP‘User choice’ model via the LSE. The beauty of the User choice model is that benefits are available to those who elect to switch CCPs, yet those who wish to remain are not forced to change. This competition encourages providers to remain nimble on fees and functionality.
In 2010, the ‘User choice’ model enabled by CCP interoperability is becoming the rule rather than the exception. The landscape map summarises the current position of CCP competition in an increasingly fragmented post-MiFID Europe.
Reading the landscape map
Down the left side are the CCPs that serve more than one EU market, listed alphabetically.
Blue boxes include live dates, where available, from a functional readiness potential. Post the February 2010 announcement by Dutch Swiss UK regulators, some models may require additional time before launching due to additional regulatory review of new interoperability proposals. Across the top,
separated by vertical lines, are:
- Exchanges and MTFs ranked from left to right by largest number of trades using Federation of European Securities Exchanges (FESE) July 2009 year-to-date statistics. The more blue per row, the more markets that can be consolidated by that CCP, with higher weightings of fee saving potential where blue boxes cluster to the left: today CCP fees correlate more with number of tickets than value processed. In fact it is this fixed cost per ticket aspect of CCP tariffs in an environment of shrinking trade size that increases basis point costs to brokers as brokers process the same value of client business. Added to the CCP chart are average trade sizes measured in EUR thousands (EURk) per trading platform. So with average trade sizes for Chi-X at 6k/trade and Detusche Boerse at 12k/trade, broadly it requires 2 trades on Chi-X to process same value as 1 trade on Deutsche Boerse; this impacts the comparative clearing costs associated with Chi-X.
- EU third party dark-pools.
- SecFinex Securities Lending platform majority owned by NYSE Euronext.
- New entrants not yet ranked by FESE.
Note that Burgundy and Quote MTF are planning to start with EMCF and add interoperable CCPs later; Ireland uses a separate instance of Eurex Clearing.
Benefits of User Choice for CCPs
In general, we prefer organic market solutions to those imposed by prescriptive regulation. The commercial benefits of the‘User choice’ model are multiple and manifest:
- Introducing CCP with netting for bilateral markets saves significant CSD settlement fees: x1 per CCP net stock position vs many times each gross stock trade.
- Plugging in once to a CCP that serves multi-markets effectively gets access to the rest of oncoming markets ‘for free’.
- Competitive clearing via ‘User choice’ model encourages incumbents preemptively to cut fees e.g. as we have seen ahead of live dates for new entrant CCPs.
- Different firms may have affinity for different CCPs based on e.g. respective order execution profiles. Firms are not forced to bear switching costs, they have the freedom to choose to do so.
- Competitive clearing gives firms the opportunity to consolidate their multimarket flows onto a single (or fewer) CCP(s) of their choice and offers two more advantages:
- Where a CCP has a volume discount, incremental flow across names and markets saves significant CCP fees; and
- Where a single name trades on multiple platforms with different CCPs, consolidating to 1 CCP saves settlement fees: e.g. if VOD trades on LSE&x-clear + Chi-X&EMCF +Turquoise&EuroCCP, there are at least 3x net settlement fees / VOD reflecting 3 CCP net messages to the CSD; e.g. once a single CCP x-clear cross-nets all of VOD trades via LSE Chi-X Turquoise, 1x net settlement saves 2/3 costs x number of instruments traded.
With average orderbook trade sizes ranging from EUR 4k to 28k on the CCP slide, it is clear that focusing on a cost/trade metric can lead to spurious conclusions; the better basis point calculation enables more meaningful apples-to-apples comparisons. The EU Commission is helping with the critically important Code of Conduct tariff Transparency by encouraging trading and post-trading providers to include value-traded stats on respective fee invoices.
Exchanges that can grow liquidity are successful. Markets world-wide can encourage liquidity for the benefit of end investors by implementing the following priority action requests:
(i) Lowering fees and improving invoice transparency;
(ii) Enabling off-orderbook to complement on-orderbook activity; and
(iii) Offering users a choice of CCP to lower frictional costs and mitigate systemic risk.