Chi-X - behind the headlines

There is no doubt the launch of Chi-X has been an important milestone in the evolution of the European equity markets. This is not the first attempt to compete against the national exchanges in Europe, so why are expectation levels so high this time around, asks Toby Bayliss, head of electronic execution sales, Europe at Citi.

Free market data is a simple concept, but for Chi- X an important one. The first step towards selling any product is to enlighten a potential purchaser to its benefits or the detriment of abstention. Any consolidated order book covering European securities should now automatically incorporate quotes placed on Chi-X in real time at no additional cost, instantly alerting market participants to the prospect of improved pricing or liquidity as it becomes available on the new venue. The potential to view prices quoted at levels superior to where you are executing, without the possibility of interaction, can only play on a traders’ competitive and occasional mercenary traits.

The ability of Chi-X to often outperform rival venues in defining the best bid offer has, to a large extent, been achieved by moving away from the boundaries set by the national exchanges. Reducing tick sizes enables Chi-X participants to quote just ahead of the best bid offer defined by the national exchange. Chi-X currently facilitates trading in 202 blue chip names in the UK, Netherlands, Germany, France and Switzerland, but as the tradable universe expands, this functionality becomes even more valuable enabling market participants to jump ahead of the long queues which can exist on the best bid or offer in less liquid names with wide spreads. Explicit costs are also reduced, participants are paid 0.2 of one basis point to post liquidity, a clear advantage over the fee structure of traditional exchanges, while the cost of removing liquidity is also comparatively low at just 0.3 of one basis point. The low fee structure and smaller tick sizes reduce the total turnaround cost of entering into and then closing out a position. This phenomenon encourages new entrants into the market, allows statistical arbitrage players to profit from ever smaller pricing anomalies and, as has been witnessed in the US, creates a significant increase in total market volumes.

In Europe, settlement continues to form a significant component in the overall cost of trading and fragmentation only adds to that cost. Executing through a broker routing to multiple venues, clients are only willing to a settle a single trade. The cost of merging executions, covered by the broker, forms part of the order routing decision and venues which fail to correctly align their settlement process will not form part of the order routing decision. Many attribute the failure of Virt-x to capture liquidity outside of Switzerland, to the cost of merging settlement. Chi-X facilitates settlement via the same domestic route as the national exchanges.

The list of differentiating factors continues; innovative order types, hidden liquidity, extended trading hours and lower latency. Does this signal an end to the dominance of the national exchanges? Before success can be proclaimed it must be proven. If the success of a trading system was to be purely measured by the number of column inches, then Chi-X would be a clear market leader, but looking beyond the headlines market share statistics tell a different story. The expectation would be a steady increase in the utilisation of Chi-X. However, during the first month post- MiFID, after an initial peak, Chi-X market share has seen a steady decline (see Figure 1).

To assess the quality of the liquidity fragmentation it is necessary to compare the uptake of Chi-X liquidity by Citi with the market average. Citi, smart order routing the 202 names listed on Chi-X, is currently only trading off the primary exchange when there is a better visible price on the alternative venue or greater liquidity at the same price level. As Figure 2 demonstrates, Citi is consistently capturing a greater percentage of liquidity from alternative venues than the market providing improved fill rates and price improvement. This implies the majority of market participants are yet to take advantage of this additional liquidity pool, failing to achieve optimal execution. As an indication of the performance impact on a single stock level, smart order routing BP to both the London Stock Exchange and Chi-X provides on average a price improvement of 0.26 of one basis point versus trading on just the primary exchange with approximately 32% of the flow being directed to Chi-X.

The shift in liquidity towards alternative venues was always expected to take several months and will only accelerate as demand on brokers from both clients and regulators continue to push for ever more efficient execution. While Chi-X benefits from first mover advantage, it will be the major beneficiary from this shift in liquidity driven by the implementation of smart order routing technology. With the sole goal of achieving best execution, a smart order router lacks loyalty to individual execution venues and as competition increases Chi-X will continually need to reinvent itself to stay one step ahead.