The European market landscape is clearly changing since the implementation of Mifid in 2007 opened the way for competition among market centres. In addition, the newer alternative venues, called multi-lateral trading facilities (MTFs), are working to ease the frictional cost of pan-European trading. The market structure and regulatory changes promote competition, which ultimately facilitates the migration of order flow away from incumbent exchanges to alternative venues, and provides the potential for European trading to increase exponentially in the coming years.
Alternative trading venues emerged in the US during the mid- to late 1990s, when new order handling rules unleashed a wave of innovation driven by several electronic communication networks (ECNs) competing for market share. ECNs underwent rapid consolidation in 2005 as NYSE and Nasdaq acquired their relatively new and comparatively nimble competitors. Where there had previously been many choices of places to trade, US broker-dealers were now faced with a near-duopoly.
Start of a trend
To this end, BATS Trading was launched in January 2006 as a new ECN that would fill a void in the US marketplace for innovative, low-fee, alternative execution venues. BATS aimed to appeal to US broker-dealers by offering an aggressive maker-taker pricing scheme and, in contrast to competitors’ tiered pricing models, a simple ‘one cost for all’ pricing structure.
Price was not the only factor in the firm’s success. BATS also quickly earned a reputation for high performance trading technology. Its proprietary matching engine was one of the first to execute trades in sub-millisecond timeframes and maintain consistent low latency even during extreme market volatility.
BATS’ innovation in technology and pricing saw other major market centres start to upgrade their technology and reduce prices. As a result of increased competition, investors now benefit from innovative technology and lower overall trading costs.
Not content to remain an upstart ECN, the company set its sights on becoming a licensed US securities exchange and filed for SEC approval, which it received in 2008. Now BATS Exchange regularly matches about 10 per cent of US equity volume and is counted among the top three exchange operators in the world. The firm also recently announced plans to launch a US equity options exchange and a second US equities exchange in early 2010.
BATS’ executives also had their eyes on markets outside of the US, and during 2007 the landscape in Europe began to look familiar. The implementation of Mifid that year aimed to open the European marketplace to competition between trading venues for secondary market execution services. The hope was that market participants would benefit from competition in the form of increased choice, technology innovation and lower overall costs for securities trading.
Eyes on Europe
Pre-Mifid, the European market was dominated by countries’ incumbent exchanges, primarily the London Stock Exchange, Euronext and Deutsche Bourse, with each holding about 95 per cent market share of trading in their respective countries. While US market structure regulations opened to allow competition and, as a result, technology innovation, market structure in Europe remained closed with liquidity concentrated by incumbent exchanges in their respective markets.
Outdated exchange technology, high exchange fees, a fragmented clearing structure, as well as inconsistent tick size and symbology schemes, all contributed to a high frictional cost of trading for market participants.
The level of frustration toward the legacy trading environment in Europe heightened during the mid-2000s. European market participants from large and small firms watched as the US markets experienced exponential growth in share trading volume providing flourishing trading opportunities, while the markets in Europe remained hampered.
By providing a broadly equivalent secondary trading regulatory regime for incumbent exchanges and MTFs, Mifid created an environment in which MTFs could challenge the incumbent exchanges. As a result, a new exchange model has arisen anchored by a pan-European trading focus with competitive pricing, user choice of network connectivity and many free services for which exchanges typically charge.
The MTFs are already apparent as liquidity migrates away from incumbent exchanges to alternative venues. For example, BATS Europe launched in October 2008 and already regularly executes 8 per cent of the FTSE100 and 4-5 per cent of the FTSE100, FTSE MIB and CAC 40.
Out of the three largest incumbents, the LSE has thus far been most dramatically affected. At the start of 2009, the LSE held nearly 80 per cent of the market share in the FTSE100; in October 2009, that figure had decreased to 61 per cent. Euronext started this year with approximately 80 per cent of the CAC 40 and held about 70 per cent in October 2009; in the DAX, Deutsche Bourse dropped this year from 80 per cent to 72 per cent.
It is anticipated the downward trend of incumbent exchange’s market share is likely to continue. If the rate of decline holds steady, incumbent exchanges may, in just a few years, handle only 30 per cent to 40 per cent range for their domestic securities.
Race to release latent liquidity
In addition to increasing market share, a primary focus for BATS Europe has been working with other market centres and regulators to ease frictional trading costs for market participants.
The efforts to drive change are already producing significant results. For example:
- BATS Europe and other market centres have collaborated to develop a common securities symbology that uniformly identifies securities traded across Europe that will facilitate orderly and efficient pan-European trading
- The MTFs, as well as several incumbent exchanges, have agreed on a standardised tick size scheme that encourages both price improvement and liquidity formation, and implementation of the scheme is well under way
- Several CCPs have taken steps to interoperate and the availability of competitive clearing is approaching.
These three events, combined with the attractiveness of low prices and high performance, will facilitate the migration of even more order flow away from incumbent exchanges to alternative venues like BATS Europe.
Even more importantly, as obstacles are removed, the latent liquidity that had previously been constrained will be released and European trading opportunities will multiply. While total market capitalisation is comparable between Europe and the US, the combined trading in all major European markets accounts for only a tenth of the total notional value traded in the US.
With an opportunity of this magnitude waiting in the wings, the evolving market structure landscape is cause for optimism. Once European market participants begin to conduct their trading strategies unfettered by the expense, inefficiency and rigidity of the past, total notional valued traded, active securities and participants will multiply.
If the incumbent exchanges can offer similar trading experiences in terms of performance and economics, they too might benefit from the massive explosion in trading that is possible in the coming months. On the other hand, if the incumbent exchanges ignore these new trends, they will be left behind. n
Ken Conklin is global head of business development and marketing at BATS
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