New analysis from Nomura has attempted to shed light on the level of off-exchange trading in Europe, with the Japanese investment bank claiming that less than 10% of equity trading in the region should be classified as over-the-counter (OTC).
The proportion of European equity trading that can be considered OTC has been the subject of fierce debate between brokers and exchanges. The Federation of European Securities Exchanges (FESE) has argued that OTC trading accounts for close to 40% of European equity trading, a level it regards as too high, given that one intention of MiFID was to encourage more trading on regulated markets. Brokers responded by claiming that the data used to measure OTC trading is unreliable because it includes trades that do not result in a beneficial change of ownership, such as give-up trades and guaranteed VWAP trades, and therefore do not have an impact on price discovery.
One commonly cited source of reliability is double-counting. For example, a broker is required to report a guaranteed-price VWAP trade both while it is executed throughout the day in the broker's name and again after the trade has been completed and the price has been corrected to that promised to the client, via an internal cross. Brokers claim that buy-side clients do not use OTC data in pre-trade analysis, because of doubts over its validity.
In its research, Nomura asserts that exchanges are unlikely to benefit from a reduction in the number of OTC trades.
“OTC and order books are not equivalent and as such they do not compete; indeed, they are more likely to work in conjunction with one another as brokers seek to hedge or execute OTC transactions on a lit order book,” reads the bank's report.
Nomura also suggests that misperceptions have arisen about what constitutes acceptable OTC trading due to MiFID's definition of the activity as “ad hoc and irregular and carried out by wholesale counterparties … within a relationship which itself is characterised by dealings above standard market size”.
The paper notes that this description does not mean OTC trading has to be “rare and irrelevant” and asserts that it is the dealing relationship, rather than the individual trades, that is required to be large-in-size.
Nomura's definition draws on an analysis by the Financial Services Authority (FSA), the UK's financial regulator, which split OTC trades carried out in 2008/9 six categories: give up/give in trades; other agency or riskless principal trades; broker-to-broker trades; principal client business; systematic internalisers; and crossing processes or systems.
Using FSA data, and its own assumptions on how much trading in each of these categories is likely to be ”real' transactions that involves a beneficial change of ownership, Nomura estimates that only around a fifth of the 40% commonly cited as OTC can be classified as true liquidity, i.e. 8% of overall European equity trading.
“The unique feature of OTC is that liquidity and printing are not equivalent,” read the report. “Without true visibility of the market's behaviour, it is unsurprising that regulators are called to exorcise non-existent threats.”
In a recent paper sent by the Committee of European Securities Regulators (CESR) to the European Commission ahead of its review of MiFID, seven flags for labelling trades in post-trade data were recommended. These were designed to help market participants distinguish between the different types of executions included in both OTC and on-exchange post-trade data.
Andrew Bowley, head of electronic trading product management, co-author of the Nomura research paper and a member of the CESR working group created to improve post-trade transparency, is confident that the new version of MiFID will further clarify the true value of OTC trading.
“I have absolute confidence that this paper and the CESR working group will help to give market participants a better indication of what constitutes real liquidity in OTC trading in Europe,” he said.